"There is no maxim in my opinion which is more liable to be misapplied, and which therefore needs elucidation than the current one that the interest of the majority is the political standard of right and wrong...." ~ James Madison
What Is the Fed's 'Noble Cause'?
Federal Reserve officials periodically drone about their monetary policies targeting the federal funds rate, which is the interest rate banks charge one another for overnight loans. 'Changes in the federal funds rate trigger a chain of events,' the Fed's web site says, affecting other interest rates, employment, output, and the prices of goods and services. Oh, yes ' rate changes also affect the money supply.  The Fed plays down the fact that they manipulate bank reserves to alter the federal funds rate. Why? Perhaps because talking about something as tedious as the federal funds rate is safer than saying they're adjusting the supply of money available. If the Federal Open Market Committee announced they were increasing bank reserves, people might start to wonder just how 12 bureaucrats sitting around a table can bring money into existence. Once they learned how, they might ask 'Why?' and that could be incriminating. Admittedly, it's only a remote possibility that people would see Fed officials as engaging in something underhanded. Many people do have a decent understanding of how the FOMC conducts monetary policy and see it as right and proper, even if they grudgingly admit that increasing the money supply is a form of theft and potentially disastrous to the economy. As long as the production of money doesn't exceed the production of economic goods for long or by a great amount, they don't seem to care. Indeed, their cares are mostly directed the other way, that money growth will lag productivity. The terrifying possibility of low prices 'Inflation,' wrote economist Hans Sennholz, 'is the creation of money by monetary authorities.'  By this definition the Fed spends most of its time creating inflation, which they normally measure by changes in the level of some price index. Using their yardstick, even at an inflation rate of three percent, which is considered mild, the dollar will lose half its value in 14 years.  Edward Jones Company publishes a chart tracking the percent increase in the M2 money stock from 1960 to 2002. M2 increased every year.  Fed Chairman Alan Greenspan praises former chairman Paul Volcker for putting 'a very severe clamp on the expansion of credit' after he came into office in 1979.  Volcker's policies sent stocks plummeting, jobs out the window, and speculators to ruin  ' yet even then, the money supply continued to increase. The steady depreciation of the dollar never seems to bother the Fed. If it did they might close their doors and let the market work. Instead, Greenspan tells us they have an obligation to maintain 'price stability so as to ensure maximum sustainable economic growth."  Since Greenspan acknowledges that prices have soared since gold was abandoned in 1933,  it's hard to take such a comment seriously ' unless by 'price stability' he means never letting prices fall. What shoppers dream of ' low prices ' is one of the Fed's worst nightmares. 'The common man is supreme in the market economy,' Ludwig von Mises wrote, and what man, common or otherwise, would not want to pay less for the things he buys?  But central banks exist to prevent that from happening. In case the Fed hasn't been clear about this, former Fed governor Ben Bernanke set the record straight: '[T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.' To which he added: 'Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.' [10; emphasis added] Greenspan has emphatically applied 'the logic of the printing press' throughout his tenure as Fed chairman, adding $4.5 trillion to the M3 money supply since taking office in 1987 ' twice the total amount printed by all previous Fed chairmen.  With Bernanke as the betting favorite to replace him next year, we can expect no slowdown in the presses.  The Fed's printing press ' a metaphor for their tools of monetary policy, especially FOMC securities purchases ' is not a creator of wealth. Supply and demand determine prices on the market, including the price of money, which is its purchasing power. If the supply of some good increases while demand remains constant, its price will tend to fall. The same can be said for money; if the supply of money-units (dollars) increases, their price will drop. If the price of eggs declines, for example, the same dollars buy more eggs; if the price of money falls, the same dollars buy fewer eggs. Thus, the production of goods increases our prosperity; the production of money impairs it.  The Fed and the 1930s If the Fed can be said to have one job, it is to inflate the money supply. But some commentators claim that during the Depression the Fed wasn't doing its job, that in the mid-1930s Fed and Treasury officials restricted credit and thereby cut short a promising recovery. For example, Michael D. Bordo and David C. Wheelock, in their review of U.S. stock market booms, claim that '[t]he adoption of highly restrictive monetary and fiscal policies in 1936-37 snuffed out the economic recovery and brought a halt to the stock market boom in early 1937.'  Economics professor Richard Timberlake says that the 'Fed policy [of increasing reserve requirements] effectively smothered the money-creating potential that old gold had already provided. For the next three years the economy stagnated.'  Noting that the money supply grew at an annual average of only 6.5 percent in the last three quarters of 1937, historian Jim Powell asserts that the 'reduced monetary growth was to have a depressing effect on the economy.'  Today's monetary authorities look back on that period as a lesson never to be forgotten. The Fed abandoned 'the logic of the printing press' and kept the economy from pulling out of the Depression. But in fact the Fed was doing its job ' a job no one should've been doing. Not only is this 'lesson' used to justify chronic inflation, but it helps maintain the illusion that the New Deal was an engine of prosperity leading us out of the Depression until the Fed cut off its fuel. Roosevelt nationalizes the gold supply Gold is a natural inflation fighter because government cannot easily increase its quantity. For this reason, perhaps, Franklin Roosevelt began his presidency by making it illegal to own. On April 5, 1933, President Roosevelt issued Executive Order 6102, which prohibited Americans from 'hoarding' gold coins, gold bullion, and gold certificates in excess of $100 and ordered owners of such gold to turn it into the Federal Reserve no later than May 1, 1933. In return for their gold, Americans would get government coins or fiat paper. People who willfully violated his order could be fined $10,000 and thrown in prison for 10 years.  Foreigners, significantly, were excluded from the order. As an interesting aside, Yale economist Irving Fisher, who Milton Friedman called 'the greatest economist of the Twentieth Century,' had strongly urged Roosevelt to replace gold with fiat money. When Roosevelt took us off gold, Fisher told his wife he was sure 'we are going to snap out of this depression fast.' In the late 1920s, Fisher, certain of permanent prosperity, had heavily invested his wife's and sister-in-law's family fortune in the stock market and was desperate for Roosevelt to reflate stock prices.  Through the Gold Reserve Act of January 1934, the Treasury took all the gold from the Federal Reserve banks and locked it away for its own purposes, giving the banks nonmonetary gold certificates in return. Roosevelt immediately devalued the gold dollar by raising the price of gold from $20.67 an ounce to $35.00 an ounce, providing an immediate 'profit' of $2.86 billion to the government.  Of this amount, $2 billion went into a Stabilization Fund that the Treasury reserved for buying gold on the foreign exchange market, though as it turned out only 10 percent of this total was actually used.  Imported gold balloons the money stock As a result of the devaluation, the gold stock rose from $4 billion to nearly $7 billion immediately, though without affecting bank reserves. But the devaluation also precipitated a 'golden avalanche,' with foreigners selling their gold to the U.S. Treasury. As the recovery progressed, every ounce of imported gold created $35 in member reserves. From January 1934 to January 1941, member bank reserves rose from $2.85 billion to $14.4 billion.  Normally, the Fed buys government securities through the FOMC to inflate bank reserves. But as economist Joseph Salerno points out, 'Treasury gold purchases were now economically identical to inflationary Fed open market purchases, substituting demonetized gold for government securities.'  When banks add to their reserves, of course, their fractional reserve pyramiding machine kicks in. The amount of credit banks can extend depends on their minimum reserve requirement, which the Fed sets within a range established by Congress. The lower the requirement, the more credit they can pyramid on top of their reserves. As Murray Rothbard explains, 'the amount banks can pyramid new deposits on top of reserves is called the money multiplier, which is the inverse of the minimum reserve requirement.' Thus, MM (money multiplier) = 1/reserve requirement  A $1 million purchase of gold, for example, would initially add $1 million to the banking system's reserves. If the reserve requirement were 10 percent, then normal lending activity would inflate the money supply as follows: $1 million x (1/(1/10)) = $1 million x 10 = $10 million Rothbard also provides a straightforward formula for the money supply: M (money supply) = Cash + (total bank reserves x MM)  It's important to remember that when depositors make withdrawals they lower M, and when they add to their bank accounts M increases. Notice, too, that if banks fail to extend credit on top of their reserves to the maximum allowable, which sometimes happens in a struggling economy, M will fail to inflate to its full potential. In 1932, when people were storming the banks getting their money out, President Hoover was furious because they were defying his campaign to raise prices through inflation. The Fed had soaked up $1.1 billion in government securities that year to flood the market with credit, but the money supply actually fell by $3 billion because of bank withdrawals and the reluctance of banks to make risky loans. Hoover blasted the banks for their 'lack of cooperation' and ripped the public for their 'traitorous hoarding.'  The 'problem' of excess reserves Why would Roosevelt's devaluation cause such rapid inflows of gold from overseas? According to Gresham's Law, when government overvalues its money, it drives undervalued money out of circulation. European governments that had gone off the gold standard or whose currency lacked a fixed rate of exchange with gold put Gresham to work. With the dollar stabilized to gold at $35 an ounce, Europeans were reasonably confident they could sell gold to the Treasury and redeem their dollars in gold at any time for face value. The fear of Hitler also drove people to harbor their gold in the U.S. ' a fear that became panic after 1938 as gold inflows accelerated.  The sudden accumulation of money in the Fed's fractional reserve banking system presented problems, however. In the 1930s banks worried about their customers' ability to repay loans and about depositors making massive withdrawals. As gold flowed into the country and their reserves piled up, some of that money, called excess reserves, was put aside as a hedge against liabilities and not used for expanding credit. By July, 1934 the Fed estimated excess reserves at $1.87 billion. With the money market flooded, interest rates had been driven down to 'fantastically' low levels. Call loans to the stock market sat at 1 percent; prime rate in the big cities was 1.5 percent.  As excess reserves grew to $2.78 billion by August, 1935 interest rates stayed low; they could hardly go lower. Excess reserves continued to rise throughout the decade, but they had almost no impact on interest rates. Money was cheap. Meanwhile, in mid-1935 and early 1936, the Supreme Court terminated two centerpieces of New Deal legislation, the National Industrial Recovery Act and the Agricultural Adjustment Act. With the NRA off their backs, Americans began to make the economy work again ' from August 1935 to May 1937 production, private-sector employment, and stock prices rose.  Believing, perhaps, that the economy would take off like it did after the depression of 1920 ' 1921 and fearing a runaway credit expansion, the Fed raised reserve requirements in August 1936 by 50 percent, while announcing two more increases of 25 percent each for March and May of 1937, the last being postponed until November 1941.  The Treasury made moves as well. In December 1936, Secretary Henry Morgenthau Jr. began a process of 'sterilizing' imported gold ' that is, the Treasury borrowed money from the commercial banks to pay for the gold and thus prevented it from expanding bank reserves.  Economic indicators started to sour in August 1937. The Dow went from 190.38 on August 14 and fell almost without interruption to a low of 97.46 on March 31, 1938.  Business activity and industrial production declined at comparable rates. In response, Morgenthau abandoned the gold sterilization policy in April 1938. Did the economy suffer from a scarcity of credit? As noted earlier, the first billion and a half of excess reserves drove interest rates down to unprecedented lows. Piling on more excess reserves didn't push the rates lower, nor did the deflationary actions of the Treasury and the Fed nudge them up enough to discourage business borrowing. Quite the contrary. Benjamin Anderson, who was the economist at Chase National Bank during this period, points out that commercial loans of member banks 'increased dramatically' from the third quarter of 1935 through 1937 ' from $4.8 billion to nearly $7 billion.  Increasing the reserve requirements raised interest rates 'from levels absurdly low to levels still absurdly low' and 'did not in any way interfere with the rising tide of business, with the rising tide of commercial loans, [or] with rising bank deposits.' The government's gold neutering policy 'merely prevented incoming gold from adding to the money supply, a supply already very excessive.'  What, then, brought on the collapse of the economic recovery? The same policies that prolonged and deepened the Depression. Roosevelt goes on the warpath Roosevelt was bitter about the recovery because it was proceeding over the dead body of his cherished NRA. With advice from Harvard law professor Felix Frankfurter, he began considering an amendment to the Constitution that would allow him to pack the Court to his liking. Other advisers urged him to heighten his attack on big business and on the wealthy, whom he labeled 'economic royalists.'  And so Roosevelt hit harder at business. Some of the lowlights of this period include: 1. The Banking Act of 1935 relocated the Fed's center of power from Wall Street to Washington. Roosevelt's new Fed chairman, Marriner S. Eccles, had coauthored the Act's controversial Title II with New Dealer economist Lauchlin Currie. Currie had convinced Eccles earlier that recovery should focus on the money supply, which would require 'total political control' and concentration on 'open market operations for rapid inflation.'  To this end, Title II gave the Federal Reserve Board in Washington a majority presence on the Open Market Committee, which had previously been composed of the 12 governors of the district Federal Reserve banks.  Economist H. Parker Willis, one of the founders of the Fed in 1913, said the Banking Act of 1935 established 'perhaps the most highly centralized and irresponsible financial and banking machine' ever known in the modern world.  2. The Securities and Exchange Act of June 6, 1934 made it more difficult and costly for businesses to obtain capital. Because of the increased difficulty in raising capital, 'the SEC seems to have made recovery more difficult and thereby helped prolong the Great Depression,' Jim Powell writes.  3. The undistributed profits tax of 1936 penalized companies for building up their savings for investment. Because smaller businesses were less likely to get bank loans and usually didn't issue stocks or bonds, the UP tax hit them the hardest. The only way most smaller firms could raise capital was to save.  The business community presented their case to Congress, pointing out that some companies had irregular incomes and had to save for periods when revenue was low. They described case after case in which a small business would grow from a staff of three or four workers to a company employing hundreds by plowing profits back into the business. None other than Ford Motor Company, the country's largest business at the time, expanded in this manner. Many businesses were under contract with creditors or were obliged by state laws to retain reserves. But government claimed that 'oversavings' was the root of our troubles. 'The greatest depression in the history of the country followed the accumulation of the greatest corporate surpluses in the history of the country,' a Treasury spokesman said. But even this wasn't true; the greatest accumulation of corporate surpluses preceded the depression of 1920-1921 and was one of the reasons it was short-lived.  4. Higher taxes and securities regulations created a 'thin' stock market, driving people out of stocks and creating a situation in which moderate selling brought about big swings in price.  5. The anti-trust division of the government, suppressed under the NRA, went on the hunt and initiated litigation against the major oil companies, Alcoa Aluminum, the financing divisions of the auto industry, Ethyl Corporation, and many others.  6. The Social Security Act of 1935 raised taxes on employees and employers alike. As economics professor Gene Smiley observes, 'the tax was phased in between 1936 and 1938 and 'tended to reduce consumers' and businesses' purchasing power, and thus economic activity. But because no one was eligible to begin collecting Social Security payments, there was no offsetting increase in purchasing power. The resulting decrease in net spending was a force working to contract economic activity.'  7. The Wagner Act (AKA the National Labor Relations Act) of July 5, 1935 granted special coercive privileges to labor unions, while blaming labor violence on employers who chose not to deal with unions. Section 151 of the Act also blames employers for the Great Depression itself, by depressing wage rates.  As Anderson notes, 'A main factor on the industrial side in bringing the revival of 1935 ' 1937 to a close was [a] startling increase in wages, due not to scarcity of labor, because unemployment remained at 6 1/4 millions for the year 1937, but due rather to a tremendous burst of activity by trade unions under the Wagner Act ' a rise in wages unmatched by a corresponding rise in the productivity of labor.'  In retrospect, what is surprising is not that the recovery of 1935 ' 1937 collapsed but that it ever got underway. Aside from the specific legislation working against recovery, there was the 1936 election in which Roosevelt defeated Republican Alf Landon by an electoral landslide of 523-8 and the Democrats won three-fourths of the seats in both houses of Congress.  If we're looking for 'deflation' in this era we've found it, as the election took the fight out of many business leaders. The Fed needs government favors As we've seen, the Fed kept interest rates low during the mid-1930s while New Deal policies penalized business expansion and productivity. Economic crises should call attention to the fact that government has violated economic law, not that the market has failed. Roosevelt's program of deficit spending, high taxes, inflation, and massive regulation of business was a well-known recipe for disaster, but political demagoguery won out. A central bank like the Fed 'is not a natural product of banking development,' British economist Vera Smith wrote in the 1930s.  It works only with the aid of government favors that grant it a monopoly on the issue of what we're forced to accept as money. Perhaps an economist with the courage of a Cindy Sheehan will confront the Fed chairman and demand to know for what noble purpose we are burdened with a government-created banking cartel that imposes a hidden tax on us in the form of a chronically depreciating currency. References 1 The Federal Reserve Board, FAQs: Monetary Policy, http://www.federalreserve.gov/generalinfo/faq/faqmpo.htm 2 Sennholz, Hans, Age of Inflation, Western Islands, Belmont, Massachusetts, 1979, p. 22 3 Bonner, William and Wiggin, Addison, Financial Reckoning Day: Surviving the Soft Depression of the 21st Century, John Wiley & Sons, Hoboken, New Jersey, 2003, p. 139 4 Cited in North, Gary, 'Gold Standard? Not Even An Iron Pyrite Standard!', http://www.lewrockwell.com/north/north398.html 5 'Ron Paul vs. Alan Greenspan,' Before the House Financial Affairs Committee, July 20, 2005, http://www.lewrockwell.com/paul/paul267.html, transcript by Jude Wanniski 6 Financial Reckoning Day, p. 139 7 'Greenspan: Faster rate hikes possible,' http://money.cnn.com/2004/06/08/news/economy/fed_greenspan/ 8 Remarks by Chairman Alan Greenspan Before the Economic Club of New York, New York City, December 19, 2002, http://www.federalreserve.gov/boarddocs/speeches/2002/20021219/default.htm 9 von Mises, Ludwig, Economic Freedom and Interventionism, Chapter 3: The Elite Under Capitalism, http://www.mises.org/efandi/ch3.asp (Reprinted from The Freeman, January 1962) 10 Remarks by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C., November 21. 2002, Deflation: Making Sure 'It' Doesn't Happen Here, http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm 11 Financial Reckoning Day, p. 141 12 'Who will replace Greenspan?', http://www.msnbc.msn.com/id/7793393/ 13 Rothbard, Murray, What Has Government Done to Our Money?, Ludwig von Mises Institute, Auburn, Alabama, 1990, p. 32 14 Bordo, Michael D. and Wheelock, David C., 'Monetary Policy and Asset Prices: A Look Back at Past U.S. Stock Market Booms,' http://research.stlouisfed.org/publications/review/04/11/BordoWheelock.pdf 15 Timberlake, Richard H. 'Gold Policy in the 1930s,' The Freeman: Ideas on Liberty ' May, 1999, http://www.fee.org/vnews.php?nid=4324 16 Powell, Jim, FDR's Folly: How Roosevelt and His New Deal Prolonged the Great Depression, Crown Forum, New York, New York, 2003, p. 224 17 The Gold Confiscation of April 5, 1933, http://www.the-privateer.com/1933-gold-confiscation.html 18 Rothbard, Murray, A History of Money and Banking in the United States: The Colonial Era to World War II, Ludwig von Mises Institute, Auburn, Alabama, 2002, pp. 303-304 19 Anderson, Benjamin, Economics and the Public Welfare, D. Van Nostrand Company, Princeton, New Jersey, 1949, pp. 348-349 20 Ibid., pp. 349-350 21 Ibid., p. 409 22 Salerno, Joseph, 'Money and Gold in the 1920s and 1930s: An Austrian View,' The Freeman: Ideas on Liberty ' October 1999, http://www.fee.org/vnews.php?nid=4448 23 Rothbard, Murray, Mystery of Banking, http://www.mises.org/mysteryofbanking/mysteryofbanking.pdf 24 Ibid. 25 Rothbard, History, p. 296 26 Anderson, p. 408 27 Anderson, pp. 410-412 28 Smiley, Gene, Rethinking the Great Depression: A New View of Its Causes and Consequences, Ivan R. Dee, Chicago, Illinois, 2002, pp. 103-106 29 Anderson, pp. 410-413 30 Anderson, pp. 419-420 31 Anderson, p. 438 32 Anderson, p. 440 33 Anderson, p. 444 34 Smiley, pp. 106-107 35 Rothbard, History, pp. 335-336 36 Rothbard, History, p. 337 37 Rothbard, History, p. 343 38 Powell, p. 109 39 Powell, p. 80 40 Anderson, pp. 378-382 41 Anderson, p. 449 42 Powell, pp. 231-243 43 Smiley, p. 111 44 Powell, p. 195 45 Anderson, p. 446 46 Powell, p. 208 47 Smith, Vera, The Rationale of Central Banking and the Free Banking Alternative, Liberty Press, Indianapolis, Indiana, 1990, p. 169