Does the Fed really monetize government debt?

If monetizing debt is understood to mean printing money to pay for government deficits, then the Fed is guilty.

The basics are quite simple.  The federal government issues and the Fed buys interest-bearing debt certificates.  The Fed pays for these securities by creating digits on a computer that represent dollars.  In this Age of Ron Paul, more people are learning that the digits do not represent savings borrowed from the public.  The Fed is not a financial intermediary; it is a money factory.  And while factories under capitalism produce for the benefit of the masses, this factory cranks out dollars for the politically-favored, to the detriment of the masses.   The Fed is thus an anti-capitalist, anti-free market institution.  The 12 members of the FOMC decide how much money they need and create the digits on-the-fly, from nothing.  The idea of Bernanke or other Fed chairmen printing money is a metaphor, but an accurate one.  It’s simply more convenient for the Fed to create digits than to print money. 

It might be objected that this is not the equivalent of printing money because fiat money is not an interest-bearing asset.  By purchasing government bonds, the argument runs, the Fed collects interest from the Treasury, thus providing an additional windfall for the central bank, which also collects the principal.  The government would’ve been better off issuing a service order to its “money factory” and having it print the amount demanded and avoid the interest payments.  In other words, instead of Bernanke creating digits, have Geithner create them.

Simply printing money to pay one’s debts, though, even when done by a legitimate government, runs the risk of being seen as such.  Even eight-year-olds know a counterfeiter is a crook who prints money then spends it.  It’s always possible kids today would survive government schools to adulthood, still believing the emperor is stark naked, and that could lead to revolution.  Most adults, of course, have little interest in where money comes from as long as it buys things at the mall, and most economists have a habit of not biting the hand that feeds them, and thus lend support for an “independent” Fed.

If cheating is the goal, what’s needed is a circuitous means of printing money to keep the public befuddled and indifferent, and this is the reason for having a central bank.  It’s true, the Fed collects interest on the government securities it holds, but it gives most of it back to the Treasury.  After deducting for operating and other expenses, it pays member banks a 6% dividend on the stock they hold in their reserve banks, which in 2010 amounted to $1.5 billion.  (By law, member banks must subscribe to stock in the Federal reserve bank of their district equal to 3% of their capital, at a fixed rate of $100 per share, with another 3% subject to call of the Board of Governors.  See here.)  The remaining balance of the Fed’s interest receipts, including interest from assets other than U.S. bonds, is remitted to the Treasury at the end of each fiscal year.  In 2010, this amounted to $79.3 billion.  (See the 2010 annual report, pg. 130, Table 4 for details.)  Thus by giving the Treasury all the revenue it receives after deducting for expenses and dividends, the Fed in effect is granting the government loans at nearly zero interest.  As for the principal, the Fed simply keeps it on their books.  It could demand payment from the government, but so far it hasn’t.  If the Fed ever decides to defend the value of the dollar, unrestrained government as we've known it is doomed.

As we can see the government, in issuing bonds, is getting money for virtually nothing, then spending it.  As kings of old did when they literally ran the printing presses to pay for expenses beyond what they collected in taxes, today’s government does the same but through the esoteric world of central banking.

Why would bankers agree to such an unprofitable arrangement?

The commercial banks make their profits through the protection afforded by the government cartel of central banking.  Fractional-reserve banking has been the norm in banking for thousands of years, but while it can be very profitable it is also subject to instant disaster when banks over-inflate.  Under central banking in a fiat paper money regime, member banks inflate at a uniform rate and thus avoid currency drains from other banks and runs from the public.  And since money is paper or digits representing paper, the central bank, with its monopoly of the note issue and commodity money outlawed, can generate as much money as needed should problems arise.

As cozy as this arrangement is, most bankers don’t seem to recognize that central bank inflationary policies (“easing” or “accommodative”) will eventually bring an end to their scheme.  The money will become so worthless people stop using it.

The solution is to separate money and banking from the government, completely and permanently.

Honest money in dishonest hands

People are always looking for better ways of doing things, and this includes a better way of imparting a message to a misinformed American public.  In particular, if a layman wanted to learn about the nature of our money and banking system I would direct them to Murray Rothbard’s What Has Government Done to Our Money?  In my view Rothbard’s classic has always been the best introduction to the topic.  But Gary North has written an elementary work called Honest Money that held my interest not merely for its economic reasoning, but for the many original touches I found throughout.  Would North’s book reach more people than Rothbard’s?

I must point out that Honest Money is subtitled, “The Biblical Blueprint for Money and Banking,” and each chapter begins with references to the Bible and Christian ethics.  In the introduction he says his book asks a question:

What violations of the principles of the Bible did the West commit that led us into this mess [referring to the crisis of 2008 and its aftermath]? It also asks this question: What should we build on the ruins of the present system after the collapse?

For those who would find relief knowing the Bible sanctions honest money, North’s work will come as a godsend (no pun intended).  Even for those reprobates who forswear a religious worldview, his book will provide a solid grounding in monetary theory and history.  North’s vast understanding of money and banking coupled with his lean, no-jargon writing style takes the labor out of reading.  His narrative carries us on a journey from the development of money in its innocent youth, where it was used solely as a means of facilitating trade, to money in its corrupt maturity, where today it also serves to facilitate power and profit for a ruling elite. 

Very importantly Honest Money also includes numerous bullet points at the end of each chapter covering the main ideas.  I found these bullets indispensable.  More good news: The book can be read comfortably in one evening.

Crusoe’s Choices

North begins with the familiar star of economic analysis, Robinson Crusoe.  But rather than the usual pedestrian account of how Crusoe will budget his time, North dramatizes the situation somewhat, as would be appropriate for someone recently shipwrecked on an unknown island.  He writes:

Say that [Crusoe] has a pile of goods to take from the ship. He has put together a crude and insecure raft that he can use to float some goods back to shore. The ship is slowly sinking, so he has limited time. A storm is coming up over the horizon. He can’t grab everything. What does he take? What is most valuable to him? Obviously, he makes his decision in terms of what he thinks he will need on the island. . . .

The value of a tool as far as he is concerned has nothing to do with the money it cost originally. He might be able to pick up a sophisticated clock, or an expensive musical instrument, but he probably won’t. He would probably select some inexpensive knives, a mirror (for signaling a passing ship), a barrel (for collecting rain water), and a dozen other simple tools that could mean the difference between life and death.

In short, value is subjective. . .  the value of the [tools he selects] is completely dependent on the value of [their] expected future output. . .  Then he calculates how much time he has until the ship sinks, how much weight each tool contributes, how large his raft is, and how choppy the water is. He selects his pile of tools and other goods accordingly.

There are objective conditions on the island, and the various tools are also objective, but everything is evaluated subjectively by Crusoe. He asks the question, “What value is this item to me?” His assessment is the sole determining factor of what each item is worth.

North then wonders: What if Crusoe knew the captain had a chest full of gold coins?  Would he go back to the captain’s quarters and drag the chest to the edge of the ship and attempt to lower it onto his raft?  Unless he expected to be rescued soon, he would not.  Gold coins would be of no help to a man marooned indefinitely on a desert island.  In Crusoe’s case,

Gold isn’t wealth. It’s heavy. It displaces tools. It sinks rafts. It’s not only useless; it’s a liability.

This is how North introduces the reader to the distinctions between objective reality and subjective preferences, and to the fact that money arises only in a social context.  With no one to trade with, poor Crusoe had no need of it.

What is money and where did it come from?

In subsequent chapters he builds on these ideas.  Money is a universally-accepted medium of exchange.  Originally, it was not imposed from above but evolved from competition with all other goods on the market, as the good most acceptable in trade.  Over the centuries, gold and silver became the most commonly used monies.

We know what money is worth right now because we observed what it could buy yesterday, and for this reason we expect it to have purchasing power tomorrow.  If we march back in time, (following Mises’ argument, as articulated by Robert P. Murphy) we can use the previously observed purchasing power component of this commodity we call money to explain the derived expectations of it.  If we continue going back, day after day, we reach the point at which this commodity was just a widely accepted medium of exchange (not yet money).  Going back further still, we reach the point where the first person accepted it as a medium of exchange.  From there, it became more acceptable because someone had previously accepted it not for consumption but to trade away for something else.  Prior to that, this commodity that is now money was valued strictly for its use in direct exchange.

Thus, money evolves from a commodity used in direct exchange, to a good used in indirect exchange, to a widely used medium of exchange, to a universally accepted medium of exchange.   

What about the supply of money?  Who determines that?

If we have honest money, the market controls its supply.  In today’s world it’s a committee.  Just as we wouldn’t want a committee to set prices for us, North says, “why should it be allowed to control the supply of money in which all prices are quoted?”

There’s another question. How do we know that the committee will act only in behalf of us citizens? How can we be sure that the committee won’t start fooling around with the money supply in order to feather its own economic nest?

Fooling around with the money supply was more difficult when money was a precious metal.  Yet, fraudsters found ways to cheat.  Normally, the weight of the money would be far lower than the weight of the item being purchased, and the seller could adjust the scales to make the money even lighter and the product heavier.  Interestingly, North tells us that God delivered men from bondage and has the power to enslave them again if they cheat in money matters.  For Christians, is central banking an expression of God’s wrath?  Whether it is or not, our arrangement with the Fed is a form of enslavement.

Fraudulently adjusting the scales is an attempt to get something for nothing.  Coin clipping and coin debasement are likewise early entries in the cheaters‘ bible.  Paper money issued as pseudo-receipts for commodity money inaugurated a new era of theft: “A counterfeit coin . . . can be weighed.  A piece of paper looks just like other pieces of paper.” And the biggest cheat of all are the government-issued fiat paper currencies that have proliferated the world since August 15, 1971. 

A complacent public

But what about the hapless public through all this?  Will they ever revolt?

Not very often. The public decides that paper money is money, not pieces of shiny metal. If paper is acceptable by the store down the street, then who cares? Who cares if prices go up, year after year? What’s “a little” price inflation? We’re all doing better, aren’t we? . . . .

“Inflation can’t hurt anyone too badly” is a delusion of fully employed younger workers. It can hurt everyone who isn’t staying ahead of it with pay increases, and I mean after-tax pay increases.

Inflation acts as a turbocharger for the progressive income tax.  The latter was passed in 1913 with rates so low and applied to incomes so high that almost no one worried, just as no one worries about a little inflation.  The average family made $1,000 a year, but the tax didn’t kick in until the $20,000 level, and even there it was only 1%.  Those few who made $500,000 or more were “soaked” at only 7%.

But once the law was in place the politicians changed the rules.  Imagine that.  In 1916, while Woodrow Wilson was bragging to voters about keeping us out of war, the top rate was bumped to 15%.  The following year, while Wilson was shipping American men “over there,” the bottom bracket plunged from $20,000 to $2,000 while the top rate reached 67%, then 77% a year later. 

Here was their plan: lower the level of taxable income, and increase the rate of taxation in every bracket. Next, inflate the money supply, so that everyone is pushed into higher and higher taxable brackets. The higher your money income, the larger the percentage of your income gets collected by the State.

And as Rothbard has noted,

As luck would have it, the new Federal Reserve System coincided with the outbreak of World War I in Europe, and it is generally agreed that it was only the new system that permitted the U.S. to enter the war and to finance both its own war effort, and massive loans to the allies; roughly, the Fed doubled the money supply of the U.S. during the war and prices doubled in consequence. [p. 120]

Inflation is another name for counterfeiting.  Counterfeiters create money from nothing then spend it.  The private counterfeiter and the government counterfeiter have the same goal: to get something for nothing.

The public doesn’t trust private counterfeit money. The public does trust government counterfeit money, at least for a long time, until people’s trust is totally betrayed (mass inflation).

What is the difference in principle between private counterfeiting and government counterfeiting? None.

A Tale of Three Counterfeiters

One of the most memorable parts of Honest Money is North’s tale of the counterfeiters.  Counterfeiting is evil, right?  It’s an act of swindling others.  But it acquires a high moral luster if it’s practiced in plain sight by the right people.

In North’s tale three men counterfeit and are discovered.

The first one is a businessman with an offset printing press who prints 500 $20 bills and spends them into circulation. 

The second man is an employee of the Bureau of Engraving and Printing who prints a million $20 bills, and the government spends them into circulation.

The third is the chairman of a major New York bank that has loaned a billion dollars of fractional-reserve money to Pemex, the oil company owned by the Mexican government.  Pemex cannot meet interest payments on the loan because the price of oil has collapsed.

What happens to these three men?

The businessman is convicted of counterfeiting and sent to prison.

The government employee continues to print money until he reaches age 65, when he retires and collects a pension.

The bank chairman calls the Fed, who in turn calls the Mexican government to get them to issue a bond for $25 million.  The Fed subsequently creates $25 million to buy the bond.  The Mexican government sends the money to Pemex, which then sends it to the New York bank to meet its quarterly interest payment.  “The chairman of the New York bank gets a round of applause from the bank’s board of directors, and perhaps even a $100,000 bonus for his brilliant delaying of the bank’s crisis for another three months.”

The $25 million then multiplies through the U.S. fractional reserve banking system, creating millions of new commercial dollars in a mini-wave of inflation.

The World’s Most Powerful Insurance Company

Counterfeiters need protection if they are to succeed.  The biggest counterfeiters, the major banks, sought and established the protection they wanted in 1913, with the Federal Reserve System.  The details of the Fed were developed in a highly secret meeting of banking elites and a U.S. senator held at Jekyll Island, Georgia in 1910.  For years, the Fed’s defenders not only denied the meeting took place, but regarded any suggestion that it did as laughable.  In 2010, the denials were long forgotten when Fed officials met at Jekyll to celebrate its founding. 

The Fed’s public purpose was to prevent banking panics, as recessions were once called.  It was to create an elastic currency to meet the needs of business, through dispassionate and skillful management of the money supply.

The elasticity has stretched mostly in one direction - expansion - as the bank has created many hundreds of billions of dollars out of nothing since it began operations in 1914.  Under its watch, the economy has experienced at least 11 recessions over the last century, including the longest one on record, 1929-1945.

From 1930-1933 6,000 banks failed, only one of which was considered a major bank, The Bank of the United States.  Unlike the other big banks, it was not an “insider’s” bank, but was financed mostly by small merchants, especially Jewish merchants.  The state of New York shut it down in 1930, North tells us.

One of the greatest services the Fed does for government is monetize its debt.  When the federal government can’t raise taxes without facing a tax revolt and borrowing from private sources would entail high interest rates, it calls on the Fed to buy its debt on the cheap. 

The Treasury creates the debt certificates (usually on a computer entry: liability). The central bank buys them by creating another entry: money. The computer blips are swapped. . . .

The money is then used by the government to buy whatever it wants (mainly votes). This new money goes through the economy. If the banking system is a fractional reserve system, the money multiplies many times over. This is the process of legalized counterfeiting we call inflation.

The Fed doesn’t buy the government securities directly.  It buys them from a select group of about 20 banks and securities trading firms in New York City, who collect commissions from the trades. 

Question: Why doesn’t the Fed buy these bonds directly? Answer: because it couldn’t generate commissions for the favored 20 banks.

Conclusion

Honest money is not necessarily a gold - silver standard, North says.  “The only standard that matters is the no fractional reserves standard, coupled with the no false balances standard.”

Honest money is the product of honest people.  “[It] requires honest law and people who are self-disciplined. Let the people have what they want, just so long as it is morally valid, non-fraudulent, and non-coercive.”

As long as the Fed is around, we will never have honest money.  The purpose of the Fed is to inflate for the benefit of its friends: the big banks and government.  Honest money is a rare commodity and as such is an inflationist’s nightmare.  In light of this situation we should never question the success of government schooling.  Even today, there is widespread belief that the Fed is the nation’s number one inflation fighter, and few people would know how to disagree, including trained economists.

My recommendation: Give John Q copies of Rothbard and North.   Like me, he just might get hooked.