Monday, August 11, 2008

The Dollar and The Federal Reserve: A Love Myth

"Dishonest scales are an abomination to the Lord, but a just weight is His delight," says a Biblical Proverb. But beyond just being a mere proverb, this principle is a vital pillar in any sound monetary system. Weaken the pillar and an entire economy is put at risk. Yet despite the aforementioned aphorism, time and time again "credible" and astute individuals come to the fore in defense of the Federal Reserve System (FED). Few truly recognize that it actually represents a balance that distorts prices, and hence a tremendous liability to our nation and to our liberty.

Several weeks ago a letter was co-written in the Financial Times by James Livingston, a history professor from my undergraduate university and by Marc Chandler, the head of currency strategy at a global bank. The letter clearly propagates myths and perceptions of the Fed and passing them as truths. I will take one excerpt that at best represents misinformation and at worst is grotesque historical revisionism. But before i do, let me provide a brief overview of Fed.

Federal Reserve System

Most people may not know that up until 1913 the U.S. did not have a central bank. Several institutions prior to 1913 had been created, but never in the form of the FED; however, all were dissolved because of their unconstitutionality. The FED is made up of 12 regional banks, which in turn are owned by private banks. As you can imagine, there's nothing federal about the FED; technically it is a private organization. In fact, several court cases, most notably Lewis vs. U.S.A., have affirmed that the FED is "privately owned and locally controlled operations." Through the federal funds rate, the FED (via the Federal Open Market Committee) affect monetary policy mainly in three different ways: 1) open market operations where bonds are sold/bought to decrease/increase the money supply, 2) adjust banks' reserve requirement, and 3) adjust the interest rate changed for emergency loans to banks (discount window lending). Although its domain is deposit-taking banks, the FED has begun assisting investment banks (i.e. non-depository institutions) for the first time since the 1930s.

The official mandate of the FED, as dictated by section 2A of the Federal Reserve Act is "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

Historical Revisionism

According to the Financial Times letter,

"the establishment of the Federal Reserve in 1913 was a huge contribution to democracy and it was overwhelmingly supported by finance capital at the time as necessary means of crisis management. Thereafter the market could not appear as an abstract externality driven by laws no one could manipulate, or even understand. Human intentionality, and thus democracy, was amplified as a result."

Although not a topic of this post, Mr. Livingston and Mr. Chandler appear to disregard the dubious origins of the FED. Also, they disregard that a scant 16 after its creation, the U.S. experienced its worst economic recession in its history. By their standards and definition of democracy, the years prior to 1913 must have been stagnant. They fail to realize that the most prosperous economic times the U.S. has experienced were in the years the FED did not exist. In fact, the growth rate of output (see Table 1) between 1870-1913 was about 4.42%, but only 3.14% between 1913-1972. It appears that the way the co-writers define democracy is by how much the hands of the government can manipulate economic activity. Make no mistake, despite the fact that the FED is a private agency, it is still subservient to the government. It is amazing that professed experts can make such a statement without recognizing that it is the same underlying reasoning why communists desire to influence an economy.

Let us see for a moment how wonderful "human intentionality was amplified." In order to test their theory, we will choose the FED's mandate of stable prices. When the U.S. had the gold standard every dollar was backed by the valuable metal; inflation was virtually non-existent. When the FED was created 1 ounce of gold was worth $20.67, by 1934 the ounce of gold was worth $35 (notice how gold prices historically had been stable). In 1971, the dollar abandoned the gold standard and since then we have seen the astronomical rise of the commodity, reaching a current price of about $900 per ounce. This represents a loss in value of the dollar of about 97% since 1913. The loss in value has been transmitted in the form of inflation; in fact during the gold standard lower prices were the norm. Whether people are willing to recognize it, inflation is a tax that falls heavily in the middle and lower classes. Economists call this government benefit seignorage; that is, those that print money are the first one to use it at a higher value. Once that money enters the economy and reaches the hands of its citizens it is worth less (inflation) than when it was first printed. This is the norm nowadays not only in the U.S. but all over the world. In other words, what we have achieved a massive "dishonest scale."

No comments: