Saturday, February 14, 2009

Saving Part 4: The Federal Reserve System

The stated purpose of the Federal Reserve is to prevent industrial depression. It does so not by sober management of the supply of money and credit, but rather by allowing the inflationary boom to occur, and then attempting to prevent the resulting deflation by shoveling new money into the economy faster than it can disappear. In doing so, it transfers wealth from those who have earned it to a few favored parties who are "at the spigot" so to speak.

There are three basic ways the Fed increases the money supply.

It is most commonly done through the purchase of government securities: Treasury notes, that is. Banks may find themselves unable to lend due to the fact that previous lenders are defaulting on their loans... and the assets forfeited are not worth as much as it was appraised to be when the loan was first made. This is the problem the banking industry found itself in when house prices began to collapse: the economy began to slow, debtors walked away from their houses, which were worth significantly less than the loan at this point, and the banks no longer have sufficient reserves to open up new loans.

The Fed comes to the rescue by buying government securities (bonds) from the banks, thus giving the banks the liquidity needed to return to making loans. (Thus, banks are relieved of the duty of making sure their borrowers are people who can actually repay.) The money the Fed pays for the bonds does not come from any reserve they've been holding for such a purpose; rather, they simply declare it into existence. This is an increase in the money supply, which increases the wealth of the people who receive it before prices rise, at the expense of those who must pay the higher prices before they receive the new money.

The second way is to change the size of the reserves banks are required to keep on hand, enabling to make more loans against fewer deposits. The third is to lower the rate at which the Fed loans money directly to member banks. These two options were not used as often as the first under Alan Greenspan, though Bernake has made extensive use of both.

The first is of greatest interest to me because, in addition to increasing the money supply to the benefit of well connected speculators at the expense of the common man; it also enables the government to appropriate revenues indirectly through inflation. This is how it works:

The Treasury issues bonds to cover expenses in excess of tax receipts. Various private parties (as well as the central banks of other governments) purchase these. If the buyers hold these bonds, they receive payments of "interest" over time. This, in itself, represents a government transfer of wealth from the working class to the creditor class. It doesn't stop there, I think I'll stop here a moment to illustrate one of the consequences of a system like this.

The United States Treasury issues Treasury notes, and sells them to the general public. At the same time, trade is going on between the United States of America and the People's Republic of China. If they chose to do so, the Chinese could use those dollars to purchase goods exported from the United States. However, their government keeps the money for the most part, and their people are not in any position to demand a greater share of export revenues. At any rate, they have another option: They can use it to purchase Treasury Notes, and as a result, receive "interest" on those notes.

So you have the Chinese government, which returns US Dollars to the United States by way of the government, rather than in standard trade, creating what to the rest of us feels like a trade imbalance. On the one hand, poorly compensated Chinese workers send goods to the United States, but don't get as much in return as they could. On the other hand, American workers find industrial jobs migrating to China at a faster rate than would otherwise occur. So at the top of this scheme, you have the United States Government giving future American tax revenues to the Chinese Government in exchange for past Chinese tax revenues. (This is not to mention the rest of the world's creditor class, which subsists to a significant degree off tax revenues.) At the bottom, you have both American and Chinese laborers, both suffering a grave injustice.

But as I said before, it does not stop there. If this were the end of it, and they were borrowing the money that arises naturally from society, there would be a limit to how much can be borrowed. For the more the government borrowed against future tax revenues, the less that would be available for private businesses, with the interest rate rising in response to the government's contribution to the overall demand for loanable funds. This would slow economic growth, "crowding out" business finance in favor of government finance.

Thus, the Federal Reserve steps in to save the day, by inflating the supply of money and credit, artificially lowering the interest rate.

As I said before, they do this by purchasing government securities. So the circle is complete. The Treasury sells them to the general public. The Fed then buys them from the general public. The middleman, generally the Wall Street investment bank, obviously won't sell unless they're going to make out better than they otherwise would; thus, they make a "profit" off the exchange. And the the Federal Reserve Banks are required by law to return 3/4 of the interest they receive on government securities to the US Treasury... relieving the government of much of the interest they would otherwise have to pay.

Thus, new money is issued, with the Government getting to spend some of it, and the "investors" (or should I say "fences?") who act as middlemen between the Treasury and the Fed getting a cut, as well. Wealth is transferred to both parties, at the expense of everybody else. The second spenders, of course, are the government's workers and suppliers, who maintain corps of lobbyists to ensure they retain this privilege. Their workers and suppliers are the third spenders, benefiting less, until the money finally crosses the line into the hands of those who saw prices rise before they saw the new money come into their hands.

Hence, inflation IS a tax, which employs bankers and speculators as well paid tax collectors. It is also a highly regressive, as the poorest of workers also tend to be furthest from the government money spigot, while those who are closest, if they aren't already wealthy, will be pushed in that direction. And it occurred to me as I was writing this that, given the state of the US Dollar as the "World's Reserve Currency", nobody is further from the spigot than the poorest of the poor in a third world country. This dynamic may go far to explain third world poverty. I shall have to explore the issue further in the future.

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