Archive for December 2013

Happy Birthday to the Federal Reserve?

12/26/2013

The Federal Reserve Act was passed by the Senate on December 19, 1913, by the House on December 22, and was signed by President Wilson on December 23 – 100 years ago. Should we celebrate the Fed’s 100th birthday? Or should we re-examine the monetary system the Act created?

It is surprising for many people to realize that money is continually being created, and it is created out of nothing. As populations and economies grow, more money is needed. The critical question for any monetary system, although one that is seldom discussed, is “Who gets to create the money?”  Creating money is a lucrative privilege. The question starts out as a multiple choice question with only two possible answers: A. The money is created publically, or B. The money is created privately, by banks.

Historically, there has been a continuous struggle over these options. Occasionally governments asserted the right to create money, as did the writers of the U.S. Constitution (Article 1, Section 8). More often throughout history, bankers managed to acquire the privilege of creating money.

When money is created by governments, the money is spent into circulation, and becomes a public asset. No one is in debt as a result of the money being created that way. The American colonies created their own money, and did very well economically before the British bankers convinced King George III to forbid it, an event Benjamin Franklin cites as a major cause of the Revolution. The U.S. government under Abraham Lincoln also created its own money, the greenbacks, to fund the Civil War.

When money is created privately, by banks, it is created as credit; that is, it is created as banks make loans. This money is created as debt. For the public, this money is a liability because it is on loan, and, in principle, must be paid back. It comes as a surprise to many to learn that this is the way money has been created in the U.S. for 100 years. (Federal Reserve Banks also create money when they buy government securities (government debt), known currently as Quantitative Easing (QE). They do this in the hopes that the private seller of these securities will invest them in the economy to stimulate job creation.)

This raises the question as to whether the Federal Reserve is an agency of the federal government. The members of the Board of Governors of the Fed are appointed by the President and confirmed by the Senate. But the business of the Fed is carried by its 12 member banks, all of which are privately owned. The 12 Governors participate on the Federal Open Market Committee (FOMC), along with the presidents of 7 of the regional Federal Reserve banks. This committee establishes the Fed’s monetary policy, which consists of setting interest rates, establishing reserve requirements of commercial banks, and deciding on open market transactions (QE), transactions which are carried out by the member Fed banks. A court decision in 1982 made it clear that the member banks are private, and not part of government. They are regulated by government (specifically by the FOMC), as are many private businesses. The Fed was established so as to be independent of the political control of the government. Historically, it has often worked at cross purposes with Congress and the administration.

People often have the impression that, because the U. S. Mint makes coins and the Bureau of Engraving and Printing prints bills, the government makes the money. It is true that coins are created by the government; it costs only 11 cents to make a quarter, and the government can exchange 4 of its quarters for a dollar bill at any bank. The bills, however, which also cost about 11 cents each to print, are sold to Federal Reserve Banks for the cost of printing them, which means, in effect, they are given to the banks. All of the coins and bills, however, make up only a small fraction of the total money in use, about 3%. The rest is money in accounts existing only as accounting entries (digital money). This is the money created by banks.

How well has the Fed done in its 100 years? Its stated objectives are 1) maximum employment, 2) stable prices, and 3) moderate long-term interest rates. The Fed was unable to prevent the Great Depression of the 1930’s or the current recession triggered by the crash of 2008. Under the Fed leadership we have seen recessions on the average on one every 6 years since 1940. Each of these recessions involved increased unemployment and hardships for many. The dollar has lost 95% of its value over the life of the Fed. Interest rates have fluctuated greatly, from a peak of almost 20% in the early 90’s, as the Fed tried to halt inflation, to the current low levels, as the Fed tries to stimulate the economy.

The current efforts of the Fed to stimulate the economy aren’t very effective, because the Fed doesn’t have the tools it needs to do the job. Low interest rates fail to stimulate the economy because potential borrowers with good credit ratings are few. The business climate is uncertain, not conducive to major risk being taken in the private sector through investment in business expansion. Instead of making loans, banks are invested heavily in safe government securities. The $82 billion per month created through QE goes to those wealthy enough to own substantial government securities and willing to sell them to the Fed, and that money finds its way, not into demand for more goods and services, not into Main Street in support of the real economy, but into the speculation that we see driving the stock market.

The Fed can only create money as debt, and too much debt is the problem. Debt, both private and federal, is at an all-time high. We see cities in this country and nations elsewhere struggling with debt. The current system can only offer them more loans to help pay off the current debt, which simply creates more debt for them.

The interest on the U.S. Federal debt is the government’s third largest expenditure, behind only defense and health care. Interest payments systematically transfer money from the tax payers to those wealthy enough to loan money to the government, mostly banks and other financial institutions, domestic and foreign. It contributes in a fundamental way to the increasingly distorted range of pay scales, in which the median income is falling while that of the 3 million Americans in the upper 1% is increasing. This is a dangerous trend, which threatens the stability of society.

The legislature is caught in a bind, because it can’t reduce the federal debt without cutting spending or increasing taxes, both of which take money away from the populace and will result in further recession.

But there is a way for government spending to stimulate the economy without raising taxes or the federal debt. That is for Congress to take back its Constitutional authority to create money. This has been proposed in legislation introduced in the last Congress as H.R. bill 2990, The National Emergency Employment Defense Act. 

It may seem bizarre to suggest putting money creation in the hands of a dysfunctional Congress. But the ability to spend while also cutting, or at least not increasing, taxes and the federal deficit should appeal across the spectrum. It may make Congress less dysfunctional. Congress did well with the greenbacks 150 years ago.

While providing for money creation by the government, H.R. 2990 halts money creation by banks, limiting banks to doing what most people think banks do, namely taking in money from savers and investors and loaning it to borrowers. H.R. 2990 provides for a Monetary Authority within the Treasury Department to determine the appropriate rate of money creation based on population and economic data, so that the money supply grows as it is needed by the real economy, rather than being driven by speculation bubbles as has repeatedly happened under the current system. The Monetary Authority is designed to be shielded from political pressures, as was the Fed back in 1913. H.R. 2990 provides for a smooth transition from Federal Reserve notes to U.S. money.

Perhaps at the 100th anniversary of the Fed it is time to re-examine our monetary system and ask the question, “Who should have the benefits of creating money, the American people as a whole or the folks in the financial sector?” Can we get out of the current mess without addressing this fundamental question?

JNH 12/21/13

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