Inflation, booms and busts, their pathology and their cure

Never in history has a country that financed big budget deficits with large amounts of central-bank money avoided inflation. The Federal Reserve (the Fed) has been creating enormous amounts of money for years. The Fed is playing with fire, risking enormous price inflation in its efforts to stimulate the economy and avoid deflation. Inflation in producer and consumer prices always starts with and is caused by a preceding inflation in the supply of state fiat money. ¹

Deficits of the United States of America amounted to $6.7 trillion from 2006 to 2013, increasing the U.S. Public Debt by that amount. The Federal Reserve financed almost $3 trillion of these deficits by purchasing Treasury bonds and notes, a highly inflationary practice known as “monetizing the debt.” The Fed has also purchased massive amounts of mortgage-backed securities.

While this Post describes a pathological condition of the U.S. economy, it must be said that there are practical solutions to the pathology, solutions to rid America once and for all of the pathology of endlessly growing government debts and repeated booms and busts. First, the economy must be cleansed and purged of all the mistakes that caused the most recent booms and busts of the years between 1998 and the present. Such cure can come only by allowing bad investments to be liquidated through bankruptcy, including bankruptcy and reorganization of banks that have been considered “too big to fail.” That would be a first and temporary step. To make the cure permanent would require abolition of the Federal Reserve System.

America would be better off without such a central bank, notwithstanding oceans of literature and political argument to the contrary. America had two national banks in the 19^th century. They were highly controversial and distrusted by Presidents Thomas Jefferson and Andrew Jackson. In 1836 President Jackson vetoed an extension of the 20-year charter granted to the second Bank of the United States in 1816. Without a national bank the American economy grew in an historically unprecedented way from 1836 right up to the creation of the Fed in 1913.

Since large-scale monetary inflation has already occurred and is ongoing, price inflation must follow as the day follows the night. ²

The historically sound protection of individuals from the ravages of high inflation has been holding assets that cannot be devalued by government debasement of money, including precious metals, equity securities of leading companies, and real estate, provided that none of these assets were purchased at inflated, bubble-level prices, and their purchase was not financed by loans that would not be affordable during economic recession.

The Federal Reserve System that the U.S. now has was created through the agitation, propaganda and lobbying of the large banks in New York City, who persuaded the country, including leaders of smaller banks, that a central bank like those of European countries was a necessity. Bankers wanted a central bank to aid and abet their use of fractional reserve banking to make more loans and more profits on the loans, and just as importantly to bail them out when improvident lending threatened the banks with failure.

It is the conventional wisdom of academics and politicians that America suffered booms and busts in the 19^th century because of the lack of a central bank. Murray Rothbard has exposed the fallacy of that argument in a book cited in the reference note at the end of this post. Rothbard argues persuasively that 19^th century booms and busts were caused in large part by misguided political actions that stimulated unwise borrowing and speculation, the same problem American now has with the Fed. However, the busts of the 19^th century were of far shorter duration and far less intensity than those that have incurred since the establishment of the Federal Reserve. And there was no inflation in 19^th century America except during time of war when the federal state financed its military actions by spending large sums of money created out of thin air, for the purpose of military spending. Since the establishment of the Fed, inflation goes on perennially, during peace and war.

Returning to the problem at present, the Fed seeks to stimulate the economy by purchasing Treasury securities and mortgage-backed securities. The Fed literally has no money to purchase Treasury securities or mortgage-backed securities, or anything else. Individuals and companies have to earn money by providing goods or services or both. But not the Fed. It provides no goods or services that people use or consume.

The Fed as the monopoly source of money in the United States operating as a central bank has assumed the power to write a check in any amount that it pleases on its own account and to use those newly created funds to buy anything it pleases. For a private citizen or a company to do the same would be both illegal and impossible. Individuals and companies can only issue checks that will be honored on bank accounts with the assets to cover those checks. Their checks will clear only if they have funds on deposit to back up the checks.

The Fed has no such inhibition. It can write checks on itself at will and in any amount at any time. That is the source of perennial inflation, perennial devaluation of all other money representing real assets owned by real people and companies.

The Fed is the only agency of the United States that has no budget and is not accountable to anyone, not the people, not the people’s representatives in Congress, and not the President of the United States. ³ Therefore, actions of the Fed cannot be stopped short of Congressional legislation that would amount to a virtual revolution in the laws that created the Fed and have empowered the Fed to act as the nation’s central bank and monopoly source of money.

Legislation has been introduced in Congress twice to provide for an audit of the Fed, first in 1993, and then in 2009. The 1993 legislation was opposed by President Clinton and by the Fed and never came to a vote. The 2009 legislation passed the House of Representatives overwhelmingly, but it did not pass the Senate, is opposed by the Fed, and all indications are that President Obama would oppose it. A very limited audit of the Fed authorized by Congress in 2009 revealed that between 2007 and 2010, during the financial crisis that started in 2007, the Federal Reserve loaned more than 16 trillion dollars, nearly interest free, to banks considered “too big to fail” and to foreign central banks. ⁴

Throughout its history the Fed has tried to stimulate economic activity by purchasing assets such as Treasury securities and mortgage-backed securities from commercial banks. This stimulation has caused repeated booms and busts in real estate and in the stock and bond markets. The latest boom and bust cycle occurred from 2004 through 2008. The boom caused the real estate bubble that started to deflate in 2007 and the stock market crash that began in 2007.

Since 2008 the Fed has been trying to stimulate the economy with still more monetary inflation. This has not worked to stimulate the economy. Economic activity remains sluggish as evidenced by persistent high employment and under-employment, a real estate market that remains depressed in most of the U.S. and stagnation in the level of real, inflation-adjusted income for most people.

Much of the money created by the Fed since 2007 remains on deposit with the Fed to the credit of accounts held by commercial banks. These deposit accounts with the Fed are the reserves banks maintain against withdrawal demands by their own depositors.

Currently the amount of these bank reserves exceeds by $2.5 trillion the amount legally required to be maintained by the banks to honor depositors’ requests for withdrawals. Were these bank reserves to be deployed in new bank lending it would be a shot in the arm for the American economy. However, banks are reluctant to lend because they are still recovering from losses sustained in the real estate bust, and credit-worthy borrowers are reluctant to do much borrowing due to a variety of factors that make entrepreneurs and business managers reluctant to take on new debt. To the contrary, the cash position of major U.S. corporations is at a very high level because of pessimism about the prospects for the economy.

One anomaly that epitomizes the current pathology in lending and borrowing is the way banks pay interest and the way they charge interest. Interest paid on deposits has been at a near zero interest rate since the beginning of 2009; but interest charged on credit card balances of individuals runs as high as 20% per annum or more, even for individuals with impeccable credit. That factor alone, the wide spread between interest on bank accounts and interest on credit card debt, explains in part the sluggishness of the American economy.

According to Professor Allan H. Meltzer, a man of widely recognized expertise in the operations of the Fed and commercial banks, idle bank reserves constitute an enormous stock of fuel for greater inflation once a significant increase occurs in lending and borrowing between banks and their customers. That is what occurred in the 1970s when Fed policy caused high price inflation culminating in double digit annual inflation rates in 1979-1980. Then in 1979-1981 Fed Chairman Volcker convinced the Fed’s Board of Governors to raise interest rates to very high levels in order to put a stop to the inflation that was threatening to escalate toward a feared hyper-inflation.

The actions of the Volcker Fed brought down price inflation but also caused a severe business recession and high unemployment in 1982-1983.

A similar course of events occurred in 1937-1938. At the time the Fed was concerned that borrowing and lending by individuals and businesses was getting out of control, so it doubled the reserves that banks were required to maintain with the Fed. That forceful Fed action pushed a still weak economy into renewed economic depression, one that has been called a depression within a depression, as it occurred in the seventh year of the Great Depression of the 1930s. In 1937-1938, the stock market fell nearly 50% after the Fed tried to reign in lending and borrowing. The Great Depression continued through 1940 until it was ended by massive federal spending and conscription to the military as the U.S. geared up for WW II.

The fact of the way the Great Depression ended can never be justified as a future means of bringing prosperity. Spending for WW II brought a false prosperity that required the nation to wage all-out war and suffer over 400,000 military fatalities. It is far better to avoid war and most wars of the U.S. were avoidable, and to avoid the misguided political and economic ideas that caused the Great Depression.

To avoid the kind of damaging inflation the U.S. experienced in the 1970s and early 1980s, the Fed could raise interest rates to induce banks not to lend out their reserves and to deter individual and commercial borrowing as the Paul Volcker Fed did from 1979 to 1981 when America was suffering from double-digit price inflation. However, interest rates high enough to discourage borrowing and lending would likely send the economy into another damaging recessionary tailspin, as occurred in 1982-1983.

The Fed’s unprecedented quantitative easing (i.e., money creation) since 2008 failed to lead to a robust recovery. The unemployment rate has gradually declined, but the main reason is that workers have withdrawn from the labor force. The stock market recovered from its crash of 2007-2009 but the rise in stock market price didn’t stimulate new investment in capital or new hiring.

It is remarkable how little attention has been paid to the pathological development in the level of interest rates on safe commitments to bank accounts and high-grade bonds. The near zero rate of interest on these investments is robbing and imperiling the least sophisticated people, by means of the negative rate of return on bank accounts and bonds (a return lower than the rate of price inflation), and also by inducing them to take much greater risk than the bank Certificates of Deposit that many of them relied on in the past. Risk taking of this kind usually ends in losses and disaster.

Americans now face, unwittingly for the most part, a terrible inflation in the future—inflation caused by the fatal conceit of the Governors of the Fed that they can manage the enormous American economy by manipulation of the money supply and interest rates. The economic depressions and the booms and busts of the past are evidence that the Fed cannot produce prosperity by creating money and credit out of thin air. To the contrary, it has produced only booms and busts.

Consider the proof of this in the record of the past 28 years, when the Governors of the Fed under the leadership first Alan Greenspan and then Ben Bernanke were a principal cause of the stock market boom, bubble and bust of 1988 to 1990, the stock market boom and bust of 1998-2002, and the real estate and stock market booms, bubbles and busts of 2004 to 2009.

Are not three cycles of boom and bust within twenty years all the proof necessary of the impotence, incompetence, and incapacity of the Fed to provide a beneficial and stabilizing effect on economic life?

The Fed knows only one policy to stimulate the economy, and that policy is perennial inflation, evidenced by not only repeated booms and busts starting with the 1920s—calamities the Fed was supposed to prevent—but also the 96% loss in purchasing power of the U.S. dollar since creation of the Federal Reserve System by Congress in 1913. ⁵