Inflation, the Insidious WMD

by George F. Smith

In a speech delivered recently at a Mises Institute conference on “The Trouble With Taxation,” Lew Rockwell told his audience about how Alabama governor Bob Riley tried to con taxpayers into handing over more money.  Not only did Riley try to get voters to approve the largest tax increase in state history, his proposed bill would have changed the state constitution to make it easier to fleece taxpayers in the future.  [1]

Riley, of course, didn’t call his sought-after heist a tax increase; he labeled it a much-needed tax reform.  Alabama had the biggest budget deficit since the Great Depression and ranked near the bottom in national education measures.  Without an increase in revenue, Riley said, lawmakers would have to cut so deeply into the budget that Alabama’s government might cease to function.  [2]

Perhaps this thought cheered Alabamans.  Or perhaps, as some said, they believed a tax increase would simply give the state more money to squander and never end up in education.   Despite widespread support from the press and other friends of government, Riley’s proposal met an ignominious defeat at the polls.

This tale is indeed “inspiring,” as Rockwell said in his talk.  In spite of appeals to their Christian love for the destitute and the threat of turning 5,000 inmates loose if they rejected his plan, voters knew when someone was trying to pick their pockets.

In a variation of Bastiat’s principle of “what is seen and what is not seen,” the people of Alabama saw a hand reaching for their billfolds and swatted it away.  Good for them.

Unfortunately, there’s a roundabout way of looting that people generally don’t see.  If only Governor Riley had been President Riley, the budget mess wouldn’t have mattered.  If fact, he could’ve tossed a little tax relief voters way, had he wished.

Alabama’s deficit was $675 million.  The federal government runs half-trillion-dollar deficits.  The president doesn’t go on TV and give a Riley speech about inmates terrorizing the countryside if people don’t fork up the additional taxes to cover the overspending. He doesn’t do this because he has Alan Greenspan.

The Intoxicating Power of Liquidity

How many people understand what Alan Greenspan does?  Gleaning from the comments of people who think monetary central planning is the Twentieth Century’s unsung wonder drug, Greenspan sits perched next to God (the president) watching over the economy and tweaking it occasionally through interest rate adjustments and confidence-boosting forecasts that no one can quite  understand but everyone trusts.  He’s so highly regarded, Queen Elizabeth II knighted him in 2002. [3] He’s received honorary degrees from Harvard, Yale, Pennsylvania, Leuven (Belgium), Notre Dame, Wake Forest and Colgate universities. 

So what’s this guy got that makes him so special?

Greenspan had been at the helm of the Federal Reserve for about 11 weeks  when the stock market crashed on October 19, 1987.  Through a press release, he assured the country that the Fed stood ready “to serve as a source of liquidity to support the economic and financial system.”  [4] Imagine trying to explain “liquidity” to your 10-year-old.  Or to yourself.  But this thing – liquidity – was what would pull us out of a 508-point (23%) drop in the Dow.

When things go very wrong, in other words, Alan Greenspan applies this magic called “liquidity” to the economy and everything’s better again, until the next time things go very wrong.  It’s a method of monetary inundation that in modern times dates back to John Law in early 17th Century France and reached its peak in the great hyperinflations of the 20th Century.

Greenspan has been flooding the world with liquidity.  He poured liquidity on the recession of 1993, the Asian Currency Crisis, the Russian Crisis, the collapse of Long Term Capital Management (another crisis), the end of the world known as Y2K, and the Great Bear Market of 2000.

He’s the greatest liquidity creator in the history of the U.S.  Since his first day in office in 1987, he’s added $4.5 trillion to the money supply as measured by M3 – “doubling the amount printed by all the Fed chairmen before him.” [5]

Much of his liquidity went overseas as foreigners took dollars in exchange for cheap goods.  As long as they hang onto those dollars, life’s a beach.  Is it any wonder the queen knighted him?

Since the laws of our country allow for only one counterfeiter, we’re prevented from going toe-to-toe with the liquidity champ, but we can at least make an effort to understand his methods.   For that I call upon Murray Rothbard, who explains it lucidly in his masterpiece, The Mystery of Banking.  [6]  How exactly does Greenspan’s cartel work, and more importantly, how does it affect you and me?


Secrets of Fed Counterfeiting

Once a month or so, Fed officials hold a meeting of what they call the Federal Open Market Committee to decide (1) whether to buy or sell assets on the open market and (2) how much to buy or sell.  If their goal is to increase “liquidity,” they will purchase assets.

Under the Monetary Control Act of 1980, the Fed in theory can buy any asset it wishes and in any amount.  In practice, though, it almost always buys government securities, usually bonds.

Each week a member of the Federal Reserve Bank of New York contacts private securities dealers and either buys or sells U.S. government securities in accordance with the FOMC’s decision.  The Fed does not buy new bonds; it purchases bonds the Treasury had previously issued and sold to private individuals, corporations, or financial institutions.

The first step in the Fed’s increase in “liquidity” is the manner in which it pays for these bonds.  If it buys $1 billion in bonds, it simply writes a check on itself for that amount.  Where does it get the $1 billion?  It creates it out of thin air.

Inflation has just gone up by $1 billion, but as the song says, “We’ve only just begun.”

Because the Federal Reserve only accepts deposits from member banks and not private individuals or firms, the securities dealer takes the Fed’s check and deposits it in a commercial bank – let’s call it Darin’s Bank.  Darin’s bank, in turn, deposits it with the Fed, where it becomes part of the banking system’s reserves and therefore subject to the money multiplier.

Under our centralized system of fractional reserve banking, banks are required to keep a minimum reserve of cash at the Fed, and the rest they loan out.  If the minimum is 10 percent, then loan officers at Darin’s Bank will try to make $900 million in loans.  Let’s say Joe borrows the $900 million and buys something from Harry for that amount.   Harry then takes Joe’s check down to his bank and deposits it. 

To simplify matters, let’s assume Harry does his banking at Presley’s Bank.  After Harry deposits Joe’s check for $900 million, Darin’s Bank will transfer the $900 million to Presley Bank’s account at the Fed. With its reserves increased by $900 million, Presley’s Bank can then loan up to 90 percent of that amount, or $810 million.

The lending process continues, with each bank loaning 90 percent of its increased reserves, so that we have loans in the amount of $900 + $810 + $729 + $656 + $590 + $531 + $478 + . . . million.   After 17 banks have loaned to their reserve limit, the total loans amount to $7.5 billion.  As the lending process continues, the original injection of $1 billion (created from nothing) will have been inflated to $10 billion by the Fed’s 10 percent reserve requirement, or money multiplier of 10:1.

Clearly, the banks are in counterfeiter’s heaven.  The only “asset” behind this money is the promise of the government to loot taxpayers for the amount due on the bonds, plus interest.  The borrowers of all those counterfeited millions are, of course, required to repay their loans plus interest with money earned on the market.

We said the Fed buys old bonds.  What about newly issued Treasury bonds to cover the government’s deficits?  What happens in that case?

In what’s known as “monetizing the debt,” the Treasury sells bonds to the commercial banks, which create demand deposits to pay for them. If the banks buy $100 billion in bonds, the government gets the new money to spend at existing prices, while taxpayers in the years ahead are forced to pay $100 billion to the banks plus a sizable interest.

While the Fed carries on these operations week after week, everyone in the economy is forced to live with the destructive effects of its inflationary policies – a depreciating dollar (now worth about a nickel since the Fed took charge), tinsel booms followed by painful recessions, time spent trying to protect our wealth from Fed plunder, additional pretexts for government intervention in the economy, more money for government wars, more corruption, more political pork (such as the $40 million upcoming inauguration), and a rising cost of living.  We also have to live with a chorus of commentators telling us the Fed’s our friend and protector and the economic outlook is by-golly rosy.

Three cheers for people protesting higher taxes.  Now if they could only do the same with  inflation.

References

1 The Tax Reform Racket, Lew Rockwell

2 Alabama Voters Reject Record Tax Hike

3 Knighthood for Fed’s Greenspan

4 Bonner, William with Addison Wiggin, Financial Reckoning Day: Surviving the Soft Depression of the 21st Century, John Wiley & Sons, Inc., Hoboken, NJ, 2003.  p. 141

5 Ibid., p. 141

6 The Mystery of Banking, Murray Rothbard