Most of the subject matter discussed in this blog post is also discussed in an article on the money supply written in 1995 by Murray Rothbard, available here. Please read it.
The Federal government in the last two years has embarked on a massive taxation campaign. Because people often make the (false) assumption that money at a grand scale (in the trillions) works substantially different than money at small scales, they shroud governmental monetary policies in an aura of glorious mystery. While the complexity of the economy itself may defy most analyses, the government is just a big organization, and organizational decisions are never so complex as to be utterly inexplicable.
So, how has Bush raised your taxes? What about all those kickers and tax cuts for the corporate fat cats? Isn't Bush a tax cutting conservative?
Well, the Federal government has been raising your taxes by playing with the discount rate (an interest rate on loans from the Federal Reserve to private banks in the Fed system). As this interest rate is lowered, the toal amount of money in the economy is increased by the private banks who get more loans from the Fed and in turn grant more loans (they can grant more loans because the cost of money to them is less). These loans from the Fed are just "virtual money," money that the Fed just declares exists. This has a similar effect as if the Federal Reserve had simply fired up a printing press and started printing cash for government revenue expenditures, as I will explain below.
Let's break this down step by step, so you can follow it. Don't let the billions and trillions intimidate you, money works the same at large scales as it does at small scales. I'll walk through the discussion in the layman's terms in which I understand the issues and hope you find the discussion useful.
What is inflation?
Let's go back to the old days. You are a king and you have a currency, that is, gold or silver (or copper, or whatever) coins, probably with your image stamped onto them. The image helps commoners assess the value of the coin without having to do the (costly) business of melting the token down to assess its true value. If I, a commoner, trust you my king, I trust that your silver pieces are made completely of silver, so when another commoner hands me a silver piece with your image on it in payment for a basket of wheat, I am confident that I have not been shortchanged or conned. I have been payed in full.
But you want to go to war and war is expensive. You have already raised taxes many times on your lords and they won't have any more tax increases without trouble stirring at home. So, you get a bright idea - what if instead of putting 1 oz. of silver in each silver coin, you put .9 oz. of silver in each silver coin and made up the difference with some other alloy metal? Then, with 1000 ounces of silver, you could make 1,111 coins. That's 111 free silver pieces! Then, you could pay your armorers and merchants who purchase the goods necessary for war (possibly from foreign merchants) with these new coins, but you could make more coins with the same amount of silver.
This is called "debasement." By diluting the amount of precious metal in each coin, you increase the total number of coins (the total amount of precious metal in the world is nearly constant since only a very small amount of precious metals are mined each year). But, when you increase the total number of coins you simultaneously reduce the value of each of those coins. You might not believe this is the case, but history amply illustrates that the marketplace is highly responsive to debasement. As a government debases its currency, merchants will insist on more of the debased pieces to pay for the same good.
Debasement is a form of inflation.
So, if I have 100 silver pieces and you (you're still king) release a glut of debased coinage into the market (by paying for goods and services with them), merchants will become suspicious and conservative, assuming that all silver pieces are the new, less valuable ones. If I was foolish enough to hold onto my silver pieces instead of spending them as soon as word got around that you were debasing the coinage, I will be stuck with 100 coins that now only have the purchasing power of, say, 90 coins because merchants will require that I hand over more coins for the same goods and services. If the debasement is drastic enough, I may actually bring the old coins into a precious metalsmith to have them smelted and sold as bullion for payment in the new, debased coins. In this way, I may avoid some of the effects of the debasement, but I still have to pay a metalsmith, which still imposes costs on me.
The point, however, is that most people don't do that, and the debasement is rarely so dramatic that it's worthwhile to smelt down old coins into bullion for payment in new coins.
So, what is the net effect? The net effect of debasement is that you, the king, have more money to spend to prepare for war, while the money I have will purchase less goods than it would have before debasement. It's as if money just magically disappeared from my hands and appeared in your hands. Debasement is a surreptitious tax.
Is all inflation a surreptitious tax?
The answer is no. Imagine that everyone only ever used gold to do transactions (never paper money, never anything other than gold). If you bought a pair of pants in 1850, they would have cost you significantly more (in real income) than an equivalent pair of pants today, which is why people can afford more clothes (if they want) today than they could in 1850. Due to technological advancement, the real cost of goods has gone down... a LOT. Let's say that the government minted gold coins in various sizes (denominations) such that a pair of pants cost 1 gold penny in 1850 (pretend this fictional gold penny is the smallest denomination). Over the course of the next 50 years, due to the cotton gin, textile innovations, transport innovations, etc. the cost of a pair of pants goes down in real terms. Now, you need a new pair of pants (after 50 years, that first pair has finally given out). So, you go back down to the general store. Since the government refuses to change its currency (gold standard and all that jazz), the smallest denomination is still one gold penny. But you can buy a lot more with one gold penny than you could fifty years ago. In fact, you can now buy three pair of pants for the price of one gold penny. And since all you have in your pocket are gold pennies, you cannot purchase less than three pair of pants. That is, you can't buy just one pair of pants because you don't have any denominations that small.
If an inflated currency were available, it would sure be convenient, since you could use that inflated currency (less value per unit denomination) to purchase just one pair of pants, since one pair is all you need. Currency inflation (printing more money, minting alloyed gold coins, etc.) allows the advantageous devaluation of denominations to allow fine-grained purchases as everything in an economy becomes less expensive.
In other words, because technological progress makes the goods we buy ever cheaper, we have a constant need for ever smaller units of money to purchase things with! But people who hold on to the original currency still get hurt by this process. That's why money "under the mattress" actually goes down in value.
Why is counterfeiting bad?
You own a 7-11. You're minding the till while your employee takes a lunch break, when someone comes to the counter to buy a carton of smokes and gives you two, crisp fake 20's. You immediately hand them back, cuing from the appearance of the individual whether to bawl them out and call the cops, or just let this one slide. Either way, you're not taking the counterfeit bills.
But why? What difference does it make to you? If we all just chose not to care whether a bill was counterfeit or not, then it wouldn't matter, right? But it would matter. So, why is counterfeiting bad?
Well, in the extreme case, it's easy to see why counterfeiting is bad. Let's say there is 1 million dollars of cash in the whole economy. If someone prints out $1M of counterfeit money that is so good, it can't be distinguished from the real thing, what happens? Well, what happens is that the counterfeiter is $1M richer, but if you have a bank account with $1000 in it, it is now effectively worth only $500. Why? Because merchants can't tell the difference between the genuine bills and the fake bills, but bear the risk that they will be caught with the hot potato (i.e. that the bank or the Mint or whoever will determine that their bills are indeed counterfeit and they get confiscated without recompense), so they price that risk in to their inventory. When everybody does this across the economy, prices overall rise (in this case, they should approximately double). So, counterfeiting causes prices to rise, which reduces the effective buying power of the savings (and future income) of everyone. Counterfeiting magically makes money disappear out of everyone else's hands and into my hands.
Sound familiar? Counterfeiting is a form of inflation.
The key lesson to take away from both debasement and counterfeiting is that the debaser or counterfeiter only benefits to the extent that everyone else using the currency loses. As the saying goes, money doesn't grow on trees.
Why does the Federal Reserve exist?
The Federal Reserve exists for a bunch of really complicated reasons most of which I don't understand, but probably the most important function the Fed performs is setting the federal funds rate and discount rate. By changing these rates, the Fed can (the theory goes) control or influence inflation. By preventing inflation from getting out of control - or spurring inflation to increase the availability of credit - the Fed is supposed to prevent economic catastrophes like the Great Depression from occurring.
The last time the Fed drastically cut interest rates - under Alan Greenspan - after the slump induced by 9/11 and the tech bubble burst, inflation did not greatly increase. This is because there was a real tightening of credit availability, so the extra money which the Fed put into the economy went into making loans for which there was a high demand. I'm not sure whether that makes it a good thing but it's at least not the most horrible thing ever.
But this last bout of rate cuts has been made in the face of too much credit, as evidenced by the mortgage "crisis." So what purpose do these rate cuts serve? There can only be one purpose, and that is to increase the available Federal funds (financed through debt) - that is, the government is essentially printing money by earning interest (from the private banks in the Reserve network) on loans of fictitous money. The government uses these inflation dollars to pay for the war machine, write Medicare and Social Security checks and so on.
But the amount of goods and services which you can buy with the money in your bank account goes down as a direct consequence. Sound familiar? It should, because the government is surreptitiously taxing you just as surely as if it were minting alloyed gold coins and stamping ".9999 fine" on them. The difference is that it takes a lot of words (like this post) to explain how they're doing it. So, most people don't get it.
Let me fill in a gap. Exactly how does lowering interest rates create more money in the economy? It seems like a change in interest rates should just change the price of money (the interest rate on a loan is the "price" of the money which is being loaned.)
Well, this happens through something called fractional reserve banking or lending. Imagine you start a bank. You happily take in deposits, until you have $1M in deposits. One day, Farmer Joe comes in for a $100,000 loan. You grant it. Then, Contractor John comes in for a $100,000 loan. Should you grant it? What if more than 80% of customers came in to your bank demanding their deposits right now? What do you do? This limit (the percentage of deposits which you will not loan out) is the reserve ratio.
Banks in the US cannot legally operate at less than a 10% reserve ratio (they can lend out no more than 90% of what they have in actual deposits).
Now, here comes the tricky part. The Reserve network is a network of banks which give loans to businesses, individuals and each other. By loaning to one another, they can actually leverage the total amount of money to well above the amount they all hold in deposits.
Here's how it works. Bank A can loan out up to 90% of its $1M and Bank B can also loan out up the 90% of its $1M. So, Bank A makes a $900,000 loan to Bank B, raising Bank B's total deposits up to $1.9M. Bank B can now loan up to 90% of its $1.9M, or a total of $1.71M, in deposits. If Bank B makes this loan to Bank A, Bank A's total deposits now come to $2.71M. Bank A now can now loan up to $2.44M. With each loan to the other, the banks magically create money so that Bank A, despite having only $1M in deposits, can actually loan out $2.44M in loans. I'm not familiar with the relevant law, but I would suppose that this blatant example is probably prohibited. Nevertheless, the exact same leveraging effect can be achieved by sufficiently indirect loans involving many banks. In essence, the banks in the Federal Reserve network have the power to arbitrarily inflate the money supply.
When the Fed lowers interest rates, it has the effect of lowering the reserve ratio of the private banks by enabling them to borrow more money from each other or from the Reserve itself. So, more loans are made. It's almost as if the banks have printing presses and start printing money when the interest rate goes down, (the reverse happens to an extent when interest rates go up, but obviously there is more time delay since it takes longer to call in loans than to give them out).
Is fractional reserve banking theft?
The answer is, it depends. A better question is, if there were a free market in banking, would fractional reserve banks exist? In the past when the US banking system was less monopolized, fractional reserve banks did exist and issued their own currencies. So it is clear that the market demands fractional reserve banks, and if that is what the market demands then it cannot be called theft since it is the money which the members of the market hold which is being diluted by the fractional reserve banking which the market demands!
I speculate that the reason the market demands fractional reserve banking has to do with the problem of denomination sizes. As the amount of money required to purchase a lollipop shrinks in absolute terms, finer grained currency is required. This creates a natural pressure for the money supply to expand (slightly devaluing currency in that money supply). As long as money is not sitting under a mattress (it's being loaned out or doing other useful work), it will not be harmed by this creeping expansion.
So long as consumers are free to choose which bank's currency they will accept and which they will not (on the basis of its fractional reserve reputation), then the leveraged crediting is voluntary between the bank and its customers and users of that bank's currency.
However, if there is a banking monopoly and only one bank with the privilege of printing banknotes (currency), and there is no freedom to refuse that bank's notes in the satisfaction of debts (legal tender), then fractional reserve lending is theft. It is indistinguishable from counterfeiting. The Federal Reserve's ability to simply declare there to be more money (and earn interest on this imaginary money, which it loans to private banks) is surreptitious taxation, or theft. Its effect is indistinguishable from every other kind of historical inflation, whether debasement or paper money inflation.
When the Federal Reserve monkeys with the interest rates, or just declares there to be more money and loans that to banks in the Reserve network, it is running an electronic version of the old paper printing press, to exactly the same effect.
As always, this can only benefit the Federal government (who shares some of the benefits with private banks in the Reserve network) at the expense of everyone who uses the currency, that is, all of us. Even for something as complicated as the Federal Reserve, money still does not grow on trees.
What can we do about it?
I don't think there's much that anyone can do about it. Abolishing the Federal Reserve would probably be harder than abolishing the IRS and that's harder than making 2 and 2 equal 5. I suppose that a more important question than asking what can we do about it, is what can you and I each do to protect our own savings from erosion due to inflation.
Unfortunately, most economists treat the Federal Reserve as a given, or worse, view it as an obligatory feature of our economy. The reality is that the Federal Reserve is just a banking and currency monopoly with the power to inflate the currency, which it is doing at an accelerating rate.
Bush has raised taxes more than ever
There are an infinite number of creative ways in which the Federal government finances itself, but the Federal Reserve enables the government to make up shortfalls by creating new money in the form of the interest on loans of fictitious money that it creates, and other means. Government spending has increased more than ever under George W. Bush. The myth of being a conservative, tax-cutting, small government President would be laughable, if it weren't so sad that as much as 50% of the public believes it.
The monopoly on banking and currency which the Federal Reserve system represents is the fiscal expression of our nation's fascist sickness. In terms of controlling the executive, every four years we play this game of seeing who gets to impose their view of the way it oughtta be on everyone for the next four years, conservatives or liberals. But really, our fiscal policies express this situation 365 days a year. Approximately 50% of the Federal budget is spent on defense or defense-related expenditures, and approximately 50% is spent on health & human services, that is, welfare. We're having this big debate over whether to socialize health care (i.e. increase government spending in the HHS wing of the Federal budget), where we were just debating 6 years ago whether to have this global war on Terror and establish a "Department of Homeland Security" (i.e. increase government spending in the DoD wing of the Federal budget).
It's a sick joke - the government bureaucracies funded under the DoD wing of the government got 50% of the US public saying to the other 50%, "What? Do you think we should just let Osama bin Laden get away with murder and do nothing to protect our country? Have you no patriotism?" and the government bureaucracies funded under the HHS wing of the government have that other 50% saying to the first 50%, "What? Do you think poor people should be kicked to the curb and left to die by an ER if they don't have money to pay for their treatment?" all the while all 100% of us are footing the bill for these government expansionists. We each believe we're saving the world and the nation by arguing for funding our favored government programs, while we're really just being soaked by the whole bureaucracy.
And please don't mistake this as a conspiracy theory. It could not be further from a conspiracy. It's the opposite of a conspiracy, it's utter mayhem. It's the inevitable consequence of taking what is privately owned (individual income) and making it publicly owned (tax revenue). Milton Friedman says, "People never take care of the property of others as well as they take care of their own." We're voluntarily impoverishing the nation by taking what will be well cared for (individual income) and converting it to that which will be wasted (tax revenue) by the very government bureaucracies it funds for the sole purpose of justifying yet more waste (tax revenue).
Government spending equals taxation. The Republican narrative for the last eight years has been "Oh, we're spending, but don't worry, we're cutting your taxes to increase government revenues and make up the difference on increased economic activity." This is just dog-wagging.
Why is the dollar weakening?
People keep talking about the "weak dollar" as if this has something to do with the American economy weakening for some mysterious reason, or a softening of our strategic power. This is hogwash, the weakening of the dollar is probably a very good way to measure just how much we are being taxed through the Federal Reserve. It's easy to illustrate why:
You are a money changer, you convert dollars to Yen (fictional). Let's say there are 1 million dollars in the world and 1 million Yen in the world. As a money changer, this means you will convert the currencies 1 to 1 (1 dollar for 1 Yen and vice versa) less fees. Now, let's say a counterfeiter dumps $1 million of high quality bills into the economy. If you are a money changer, are you going to stick with the official numbers and keep changing 1 to 1? You'd be a fool to do so. What you will do is start "weakening the dollar" until you will probably changing very close to 2 to 1, that is, two dollars for one Yen.
Do you see the logic? If there are the same number of Japanese Yen in the world today as there were two years ago, but a lot more US dollars than there were two years ago (because the Fed is flooding the market with them to generate Federal revenue), the dollar is automatically going to "weaken" that is, money changers will no longer exchange one dollar for the same amount of Yen as they would have two years ago.
It's simple arithmetic. Money is just numbers, the size of numbers doesn't change the arithmetic.
We need to throw the bums out, all right, once and for all.
For follow-up reading, I highly recommend this latest article from Lew Rockwell from the Ludwig von Mises Institute.