Federal Reserve's Exit Strategy and What It Means for the Stock Market

"Federal Reserve officials have mapped out a strategy for winding down an unprecedented $85 billion-a-month bond-buying program meant to spur the economy – an effort to preserve flexibility and manage highly unpredictable market expectations."

What does this mean? Why would the Federal Reserve reveal that they have "mapped a strategy" to stop their bond-buying binge?

First, the "what does it mean" question - nothing. It means nothing. No one expects the Fed to take any action in the immediate future.

The answer to the second question is more revealing; the Federal Reserve knows their policies have come to have a direct effect on the equity markets. This "leaked" bit of information was designed to gauge the reaction of the stock market to the inevitable end of the bond- buying program. The last thing they want is an overshoot to the downside in the market, so they are conducting research into possible actions to take. 

The great unknown is the effects of the ongoing currency war. The devaluation of the Yen makes the Fed's job infinitely more difficult by strengthening the dollar. It has also put immense pressure on the Eurogroup to act also.1

What to do?

I've been giving the warning that the current rise in the stock market is artificial and unsustainable. If you refuse to take my word for it, perhaps you would be interested in Bank of America's recently released strategy;

 1. Slow down of asset purchases

2. Slow down and then stop reinvestments

3. Raise short-term rates

4. Begin sell down of asset portfolios

1. I plan to do an article about the currency wars soon. The vast majority of people could care less about the price of money in Japan, but they should be very, very concerned, as it will have a profound effect on everyone.

Inflation Drifts Below Target - Why This Isn't Good News

The Treasury and Federal Reserve have been reporting that the inflation rate is "running somewhat below" their target rate of 2.0%. n the latest Board meeting, the decision was made to continue the current policy of buying $85 billion a month in bonds, and there is speculation this amount may be raised. 

So, is "inflation below target a good thing? In short, no. First, let me point out that the "inflation rate" they are talking about isn't the same one you think you are familiar with. The Federal Reserve uses the  Personal Consumption Expenditures (PCE) price index. The rest of the country uses various flavors of the Consumer Price Index (CPI). The CPI is near worthless for the evaluation of everyday prices and the PCE is even worse. By the way, the real rate of inflation, using the pre-1980 methodology, is running almost 10%.

There are two factors that make the current situation dangerous. First, the Fed's purchase of massive quantities of bonds is artificially driving money into other investments such as equities. This is the primary reason for the recent rises in the stock market. It's not an economic recovery. It's a bubble. Secondly, the 4.4 trillion dollars the Fed has already "printed" is a significant inflationary pressure. Every month the Fed buys up more bonds raises the water level behind the inflation dam. Right now, the 4.4 trillion, and the tens of trillions held by foreign banks, and the tens of trillions converted to Eurodollars are not accounted for in the inflation equation. When the bond market collapses, these factors will come into play rapidly.

If you are in the stock market (most people are, either directly or indirectly through pension plans, etc) be aware that conventional advisers such as Dave Ramsey are lying to you when they say the stock market is a great long term investment strategy. It isn't. The history proves it. And right now is the most dangerous time to be in the market since 1928. Be ready to move quickly.

Hyperinflation Warning - The Eurodollar Menace

The existence of the Euro-dollar market increases the total amount of dollar balances

available to be held by nonbanks throughout the world for any given amount of money (currency plus deposits at Federal Reserve Banks) created by the Federal Reserve System. It does so by permitting a greater pyramiding on this base by the use of deposits at U.S. banks as prudential reserves for Euro-dollar deposits.

- Milton Friedman, Selected Papers, No. 34

Not to be confused with the Euro currency, the monetary unit of the Eurogroup, a Eurodollar is;

"U.S.-dollar denominated deposits at foreign banks or foreign branches of American banks. By locating outside of the United States, eurodollars escape regulation by the Federal Reserve Board."[1]

I present a simplistic scenario to explain the effects and dangers of the Eurodollar:

Suppose a country creates a currency as a medium of exchange. Let’s say they start with 1 million units. If they then create 1 million more units, it is reasonable to assume the value of each unit, both the existing ones and the new ones, are decreased by half. (The reciprocal of the total number of units). This is classic monetary inflation.

Original unit value = 1

Unit value after doubling the number of units = 0.5

Unit value after quadrupling the number of units = 0.25

…etc

Now suppose that the number of units is doubled, but all the new units “disappear”

Original number of units = 1 million

New units created = 1 million

Total number of units = 2 million

1 million units “disappear” – 1 million

Number of units in circulation = Still 1 million

Therefore, each unit value is still = 1, because the newly created units disappear and don’t have an effect on the value of the original units

This is what happens when U.S. dollars are created by the Federal Reserve and get converted to Eurodollars. Because of the U.S. dollar’s status as the world's reserve currency, other nations must convert (buy) U.S. dollars to conduct international trade. Some of these dollars are kept overseas and never return to the U.S. Just like in our example, they disappear.

This is a great deal for the U.S because it means it get goods essentially for free. As a nation, the U.S. can print dollars and trade them for imported goods. Because the dollars don’t come back, they do not cause inflation. It’s a free ride the country has been on since the end of the Second World War. This is the basis of America’s wealth. Not innovation, not the American work ethic; Trickery.

But in the end, the trick is on the U.S. All those Eurodollars didn’t really disappear. They are still out there. When the rest of the world decides to adopt a new reserve currency, a process that is well under way, they will no longer have a need for the 9.7 trillion dollars they now hold. The dollars will come flooding back into the U.S., inflation will quickly degenerate into hyper-inflation and the real losers will be those required to own dollars – the American taxpayer.

Are you prepared?

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[1] http://www.investopedia.com/terms/e/eurodollar.asp

What's Behind the Gold Price Plunge?

Since my time at REFCO (yes, that REFCO) I have maintained that gold is the most manipulated market in the world, behind fiat currencies of course. But what is going on with the dramatic price moves in gold lately?

First we need to examine what initiated the sell-off. It wasn't some world event or major development; the price move started after brokerage houses and Goldman Sachs notified private investors of an impending liquidation of gold by some large hedge funds. Has this happened? Not yet, and it probably won't.

Most of the price pressure has come from uncovered short futures positions. This isn't unusual in itself, considering the technical status and alleged overbought condition of the market. But we need to look at the bigger picture to get a clear understanding...

The Japanese have embarked on a qualitative easing campaign and the Federal Reserve is pressuring the Euro Zone to do the same. The answer to why, of course, is to prevent an uncontrolled crash of the Dollar because of the massive qualitative easing done by the Fed themselves in the past few years. There is an incredible amount of dollars out there that potentially represent a tremendous inflationary pressure. While the Federal Reserve tells their deflationary fairy tale on the one hand[1], on the other they are desperate to control the dollar. Gold presents a clear and present danger to the Fed's plan and so it is entirely likely they instructed Goldman Sachs and others to deflate gold.- Keep in mind, Goldman Sachs and the rest of the investment and fund houses will win no matter what. They are partners in crime with the Federal Reserve.

My advice -  I am not a "gold-bug" by any means. But ANY hard asset is better than dollars. If you have physical gold, hang on to it. Buy some if you have some extra funds, but don't tie up all your investment in it. The effort to prop up the dollar may get very ugly and gold volatility may go insane. If you have derivatives of any kind, and especially gold derivatives, you are gambling with your wealth. You might as well be at the casino.

---

[1] In a recent blog post, Gold Does Not Glitter, Paul Krugman tries to make the case that the gold price drop is proof there is no inflation danger.

Hyperinflation Warning - Debt Phase Transition

The Federal Reserve has been “printing money” on a massive scale for the last several years in support of various stimulus programs; a process they now call Quantitive Easing, or QE. Keynesian theory allows that spending, even deficit spending, results in economic growth. And this has actually been the case during various periods in the 20^th century. For example, increased spending during World War II resulted in a post-war economic boom. Keynesian theory supporters can point to several other examples. 
However, according to the Federal Reserve; 

"QE did not dramatically increase bank loans and the growth of broader monetary 
aggregates." 

What makes the current situation different? -  Economic growth is dependent on the utility of debt.

Let us consider the famous Widget Company. Say the Widget Company manufactures 100 widgets a day. They can take out a loan to buy additional or better equipment to increase their output to 500 widgets a day. Obviously then, the ability of the company to borrow money has some utility. If every dollar borrowed enables the company to earn more than a dollar, the Utility of Debt is said to be greater than 1.

Extrapolated to the entire economy, the same general principle applies. Historically every dollar created by the Federal Reserve has resulted in more than one dollar in increased economic activity. But there is a limit. Eventually a point is reached where the new dollar creates less than one dollar in new economic activity. This point was reached somewhere in the 1950’s. 

Debt Phase Transition is the term applied when the creation of a new dollar actually causes a contraction of economic activity. We have recently reached that point. We have reached a point of debt saturation. No amount of money creation (money printing) can cause economic recovery. Furthermore, the increase in money supply only makes the problem worse since each new dollar actually decreases activity. 

The only possible solution is the reduction of debt, and this can happen in only three possible ways – 1.) Repay the debt, 2.) Default the debt, and 3.) Erase the debt through hyperinflation.

It should be obvious that neither of the first two possibilities will ever happen. (If you do not agree, please see upcoming posts for proof.)

This leaves only hyperinflation. The massive amounts of money being put into the system has not caused inflation yet because it isn’t being used. Money Velocity is very low. (See chart below). But this money still exists, along with huge amounts that has been transferred out of the country because of our multi-decade trade imbalance. All of these excess dollars constitute a large reservoir that will flood the economy when the holders of these dollars decide to exchange them for something else – a process that has already begun.

At no time in the history of man and money has there been such a buildup of excess currency. The hyperinflation that must result will be unprecedented and will make previous hyperinflation events seem insignificant.

Economics Is NOT Rocket Science - Stages of the Economic Cycle

This blog was created to simplify the alchemy of economics. Economics is not rocket science, . I maintain that it isn't even a science at all. Behind the facade of formulas, theories and schools, the underlying principals are relatively simple. 

The issue is separating economics from business and investing. Both are essentially the study of people. In economics, if people do a, the result is x. If they do b, the result is y, and so on. The problem in business and investing is trying to predict if and when people will do a or b. Of course, this can be impossible, and is the reason business and investing is difficult....and complex. 

In economics there are "laws" or "rules". Economics doesn't follow the Austrian School some of the time and the Chicago School some of the time. This is ludicrous, despite the fact there is a huge industry of producing and employing economists and researchers. The Federal Reserve itself employs over 300 PhD level professionals. 

So in the interest of offering people a clear view into the obfuscated world of economics, I am re-posting an article from a couple of years ago outlining the true stages of the economic cycle. This cycle has been repeated over and over throughout the history of mankind, and despite of, or perhaps because of, our technical progress we are still subject to the same cycle. Because we are now in stage 11, it is important to know the truth.

True Stages of the Economic Cycle 

1. Hard Money. A form of currency is established to facilitate commerce. In order to gain acceptance the currency is backed by something of intrinsic value such as precious metals. This is known as Hard Money.

2. Debasement of the Currency. It is immediately evident that “free” wealth can be created by Debasing the Currency. In its most fundamental form this involves the practice of charging interest (or usury, the meaning has been exactly the same throughout history up until recent times).

3. Enactment of Legal Tender Laws. Without Legal Tender laws, implied values are self correcting and always closely match true value. Legal Tender laws greatly facilitate the debasement of a currency. The Founding Fathers knew this, Thomas Jefferson wrote: 

"If the American people ever allow private banks to control the issue of currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers conquered".
 

The U.S. Constitution, Art. I Sec. 10 Cl. 1, states: 

"No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts;"

The Supreme Court ruled in U.S. Supreme Court - Wheaton 1827; 

“The prohibition in the constitution to make anything but gold or silver coin a tender in payment of debts is express and universal. The framers of the constitution regarded it as an evil to be repelled without modification; they have, therefore, left nothing to be inferred or deduced from construction on this subject.”

4. The Accumulation of Debt is unavoidable with legal tender laws in general, and especially in a Central Banking scheme such as our current Federal Reserve, in which the perpetual increase of debt is an essential component.

5. An Illusion of Economic Prosperity is created by the accumulation of debt. This is no different in principle from a person going on a spending spree with credit cards. They have the illusion of being very prosperous, but in reality they are destined for a reckoning when the debt cannot be paid.

6. Monetization of the Debt. As the accumulation of debt becomes unmanageable, it become necessary to monetize the debt. The debt grows so large it cannot possibly be paid. There are a few ways to “resolve” this. 

• The most obvious way is through taxation, but this is never politically acceptable. 

• Another way is by directly devaluing the currency. This has been done many times in history, but is also not very politically acceptable.
• The third, and easiest (for leaders at least) is hyper-inflation. In simple terms hyper inflation erases debt by transferring wealth from individuals to government.

It is apparent that all three solutions have one thing in common – all transfer wealth from individuals to government, or more accurately, to the central banks.

7. Dilution of Currency Value The process of monetization directly causes a Dilution of Currency Value.

8. Loss of Confidence. In essence Consumer Confidence is a measure of how well the taxpayer is being fooled into thinking all is well. The dilution of his buying power caused by the dilution of currency creates a Loss of Confidence.

9. Inflation. As buying power decreases, the consumer tries to make up the difference by charging more. The merchant charges more for his goods, the laborer demands more for his services. This is classic Inflation.

10. Inflation Stabilizes as government  implements inflation control measures, but does nothing about the underlying problems, causing a:

11. Return of Inflation, quickly followed by:

12. Hyper-Inflation, which effectively erases the debt. If the U.S. experiences the level of hyper-inflation similar to Hungary in 1946/7 (42 QUADRILLION percent per month), the entire national debt could be paid off with less than a penny. This may sound like a good thing to some, but the truth is, wealth is simply transferred from private individuals to the government. This is the stage of Reckoning. It is obvious that there was no real wealth created in phase 2. This is the essence of my argument against the “Economy creates wealth” proponents. Economic trickery does not create wealth. It never has and it never will.

The wealth transfer causes:

13. Depression, which leads to:

14. Reorganization of Government. It is only at this point that a significant number of people understand the inextricable link between wealth and real money. This enlightenment leads to:

15. Return to Hard Money, and the cycle repeats.

These phases are exponential in nature. The time from the debasement of a nations’ currency to the loss of confidence in that currency can be measured in decades or even centuries. The time between the loss of confidence and inflation however, may only be weeks or months. In the later stages of hyper-inflation the loss of a currency’s value and the accompanying price increases can double in days or even hours.[1]

It should also be noted that inflation is not bad for everyone in equal measure. It is actually a good thing for those people of means who are in a position to borrow to purchase property. The reason is the same; the repayment of debts, is made in currency that is worth less than the currency originally borrowed. This is also the reason working people cannot prosper during times of inflation or hyper-inflation. Wages are generally not indexed to inflation and always lag price increases. Even in the case of the relatively few people whose wages are indexed to inflation, the adjustment is always done after the fact. Loses accumulated from the previous adjustment are never recovered.

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[1] In the Weimar Republic in 1923 workers demanded, and were paid three times a day in order to be able spend the money before it lost further value. 

Cyprus Crisis - Lessons for the U.S.

The Euro has essentially been split in two. There is the Cyprus Euro and the Everywhere Else Euro. Currency trapped in Cypriot banks is subject to capitol controls and export restrictions. While there are some aspects unique to Cyprus, there are important lessons to be learned and warnings to be heeded.

The latest estimates of the amount of “haircut” depositors will be subject to now range from 60 to 100%. Money held in-hand is still worth approximately the same as before the crisis unfolded. Money trapped in Cyprus banks is now worth 40 to 0% of what it was before the crisis. It is important to realize there isn’t really paper money in the banks. Deposits are simply accounting entries, because the Euro is a fractional reserve currency. 

- Just like the U.S. dollar.

 U.S. Bank Deposits vs. Currency

This chart plots total U.S. deposits and circulating currency[1]. At current levels, if the U.S. were to go through a similar crisis as Cyprus, non-cash dollars would lose 88%. In plain English, for every $1000 you had in the bank you would receive $120.Of course the U.S. government could take the non-Cyprus route and devalue the dollar instead, in which case you would get back the entire $1000 but it would only be worth $120. You lose either way. 

This is difficult for many people to grasp, but keep in mind, the 9.2 trillion dollars in deposits doesn't really exist! 

In both cases, capital controls would certainly include a restriction on the transfer of precious metals and possibly forced confiscation. Don’t believe for a second that it couldn’t happen because it already has; in 1933[2].

Comment;

This is one of the fundamental problems I have with main-stream economists and financial advisers. They invariable advise keeping assets in non-cash, non-good forms. The value of the dollar only has value because people think it has. It isn’t backed by gold or any other real asset, and it no longer is even backed by the classic ability of the government to tax. The world knows there will never be tax rates in the U.S. high enough to cover spending, and the world also has seen the U.S. government’s adamant refusal to balance the budget. There are also concerted efforts worldwide to destroy the dollar by removing its status as the worlds reserve currency. Most recently Australia agreed with China to trade directly in each others currencies, thereby bypassing the dollar. Russia, Brazil, India, Iran and others have also moved away from trading in dollars.

---

[1] Federal Reserve Statistical Release, H.6, March 28, 2013

[2] Executive Order 6102 Requiring Gold Coin, Gold Bullion and Gold Certificates to Be Delivered to the Government April 5, 1933

Federal Bank Excessive Reserves

This is a chart of how much money Federal Reserve member banks have on deposit in excess of what is legally required. WE are paying them interest on this money. I recently posted a comment about how nice it would be to be able to borrow 100 million dollars from the government interest-free and then loan it back to them with interest. Guaranteed risk-free income. This is EXACTLY what the banks are doing. Not sort-of, or kind-of-like or similar, it is exactly what they are doing. The money was loaned to the banks to re-loan and stimulate the economy. But they chose to, and were allowed to, keep the money. 

Full Faith and Credit

In a previous post, Financial Crisis, it was mentioned that Federal Reserve Notes are not backed by anything other than the "Full Faith and Credit of the United States" This term has been in use since pre-Revolution times, but is very misleading in the current context. On it's face, it means exactly what it says; particular obligations of the U.S. government, such as Federal Reserve Notes, are backed by the "Full Faith and Credit" of same.

But what is the underlying basis for faith and credit in the U.S., or any other government? After all, governments don't actually produce anything. But they do have the ability to tax those who do. That is what establishes the faith and credit of a government. The ability and the willingness to tax.

When the economy is strong, the ability to tax is taken for granted. Even during times of economic stress few people doubt the governments ability to raise funds, albeit at a reduced rate. The term "The government just prints more money" is a clique in our society. Of course, the government doesn't create more money, and in fact, they have nothing to do with the process. The money is created by the Federal Reserve out of thin air. 

But there is a limit to this ponzi scheme. When money is created by loaning it, (again, see Financial Crisis post) there is always interest attached. This is the ultimate downfall of the scheme.

 The money to pay the interest on the new loans doesn't exist yet in the system, and can only be created by creating more money.  

This has the effect of skimming value from the economy. At some point, the amount of value removed from the system hinders the ability of the government to collect taxes. Interest on the debt rises and rises until servicing of the debt becomes the primary expense of the government. Taxes are raised or "austerity" measures are implemented to patch the system. Both measures only delay the inevitable. Eventually ALL the value in an economy is owed as interest. Taken to its extreme, bankers own everything and governments become irrelevant. We are witnessing this now in Greece, and it is the ultimate fate of the U.S. system as well. 

Footnote:

Many pundits, especially on the Right argue that deficit spending is the cause of economic problems. This is not exactly true for the above mentioned reasons. Even if spending is in line with revenue, the fact remains that a portion of productivity is required to pay the interest created at the time the money was created. Deficit spending only speeds the process of ruin. 

Everyone makes the mistake (or believes the lie) that Federal Government spending is exactly like personal spending. It isn't. The source of personal income is work. The source of government income is the Federal Reserve, laundered through the economy, with the Fed skimming a non-earned profit. If you don't manage your money well, and spend more than you take in, you will go bankrupt. But the government is guaranteed to go "bankrupt" no matter what. It is only a matter of time.

True Stages of the Economic Cycle

1. Hard Money. A form of currency is established to facilitate commerce. In order to gain acceptance the currency is backed by something of intrinsic value such as precious metals. This is known as Hard Money.

2. Debasement of the Currency. It is immediately evident that “free” wealth can be created by Debasing the Currency. In its most fundamental form this involves the practice of charging interest (or usury, the meaning has been exactly the same throughout history up until recent times).

3. Enactment of Legal Tender Laws. Without Legal Tender laws, implied values are self correcting and always closely match true value. Legal Tender laws greatly facilitate the debasement of a currency. The Founding Fathers knew this, Thomas Jefferson wrote:

If the American people ever allow private banks to control the issue of currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers conquered.

The U.S. Constitution, Art. I Sec. 10 Cl. 1, states:

No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts;

The Supreme Court ruled in U.S. Supreme Court - Wheaton 1827;

“The prohibition in the constitution to make anything but gold or silver coin a tender in payment of debts is express and universal. The framers of the constitution regarded it as an evil to be repelled without modification; they have, therefore, left nothing to be inferred or deduced from construction on this subject.”

How Abraham Lincoln circumvented this well-established doctrine and set the country on a path to ruin, is the subject of an entire essay.

4. The Accumulation of Debt is unavoidable with legal tender laws in general, and especially in a Central Banking scheme such as our current Federal Reserve.

6. An Illusion of Economic Prosperity is created by the accumulation of debt. This is no different in principle from a person going on a spending spree with credit cards. They have the illusion of being very prosperous, but in reality they are destined for a reckoning when the debt cannot be paid.

7. Monetization of the Debt. As the accumulation of debt becomes unmanageable, it become necessary to monetize the debt. The debt grows so large it cannot possibly be paid. There are a few ways to “resolve” this. The most obvious way is through taxation, but this is never politically acceptable. Another way is by directly devaluing the currency. This has been done many times in history, but is also not very politically acceptable. The third, and easiest (for leaders at least) is hyper-inflation. In simple terms hyper inflation erases debt by transferring wealth from individuals to government.

8. Dilution of Currency Value The process of monetization directly causes a Dilution of Currency Value.

9. Loss of Confidence. Consumer Confidence is a greatly misunderstood term. It is NOT what your neighbor thinks of the economy. In essence Consumer Confidence is a measure of how well the taxpayer is being fooled into thinking all is well. The dilution of his buying power caused by the dilution of currency creates a Loss of Confidence

10. Inflation. As buying power decreases, the consumer tries to make up the difference by charging more. The merchant charges more for his goods, the laborer demands more for his services. This is classic Inflation

11. Inflation Stabilizes as government  implements inflation control measures, but does nothing about the underlying problems, causing a:

12. Return of Inflation, quickly followed by:

13. Hyper-Inflation, which effectively erases the debt. If the U.S. experiences the level of hyper-inflation similar to Hungary in 1946/7 (42 QUADRILLION percent per month), the entire national debt could be paid off with less than a penny. This may sound like a good thing to some, but the truth is, wealth is simply transferred from private individuals to the government. This is the stage of Reckoning. It is obvious that there was no real wealth created in phase 2. This is the essence of my argument against the “Economy creates wealth” proponents. Economic trickery does not create wealth.

The wealth transfer causes:

14. Depression, which leads to:

15. Reorganization of Government. It is only at this point that a significant number of people understand the inextricable link between wealth and real money. This enlightenment leads to:

16. Return to Hard Money, and the cycle repeats.

It is important to understand that these phases are exponential in nature. The time from the debasement of a nations’ currency to the loss of confidence in that currency can be measured in decades or even centuries. The time between the loss of confidence and inflation however, may only be weeks or months. In the later stages of hyper-inflation the loss of a currency’s value and the accompanying price increases can double in days or even hours. In the Wiemar Republic in 1923 workers demanded, and were paid three times a day in order to be able spend the money before it lost further value. 

It should also be noted that inflation is not bad for everyone in equal measure. It is actually a good thing for those people of means who are in a position to borrow to purchase property. The reason is the same; the repayment of debts, is made in currency that is worth less than the currency originally borrowed. This is also the reason working people cannot prosper during times of inflation or hyper-inflation. Wages are generally not indexed to inflation and always lag price increases. Even in the case of the relatively few people whose wages are indexed to inflation, the adjustment is always done after the fact. Loses accumulated from the previous adjustment are never recovered.

How Money Works - Automated Financial Crisis

The financial meltdown we are experiencing (it is not over by any means) could, and was, predicted long ago. In the same vein, what will happen next can be plainly discerned, given a thorough study of the financial system and its pitfalls.

The Federal Reserve Act

It is important to recognize that our current monetary system was created by the Federal Reserve Act of December 23, 1913. The Founding Fathers knew, wrote and spoke about the dangers of a Central Bank. More on this topic in a later piece.

Contrary to widely held and persistent belief, the Federal Reserve is not a part of the Federal Government. It is a private corporation owned by its member banks, which in turn are owned by a group of individuals whose identities are protected by law. The Federal government has delegated power to create “legal tender” to this Central Bank. It did not delegate power to “Coin” money as this would violate the Constitution and the Coinage Act.

How Money Works - Simple Version

In the Federal Reserve system, money is created when a member bank deposits money in the Federal Reserve Bank (the “Fed”) It is a circuitous process but for the sake of example we will begin at the point someone deposits $1000 in their local member bank (All National banks are required to be members of the Federal Reserve, State banks’ membership is optional). Since the system is what’s known as a “Fractional Reserve” system, the member bank is only required to keep a portion of the money in reserve at the fed. For simplicities sake, let’s say that reserve is 10%. That leaves $900 for the member bank to re-loan to other customers. But it does not loan it by using the $900 in its Reserve account. If it did that, there would be no money creation involved, and banks readily admit that they create money when they loan it. The bank loans the $900 by adding it to the account of the borrower in return for their IOU (note) for that amount. Now the bank has an "additional" $900 on deposit, balanced on its books by the borrowers IOU. Now with that $900 on deposit, only $90 need be kept in reserve. So the bank is free to loan the remaining $810 again by simply adding it to the account of another borrower. Only $81 of that loan needs to be kept in reserve, so another $729 can be loaned.

Deposit	Reserve Requirement	Excess Reserves (Available to Loan)
$ 1,000.00	$ 100.00	$ 900.00
$ 900.00	$ 90.00	$ 810.00
$ 810.00	$ 81.00	$ 729.00
$ 729.00	$ 72.90	$ 656.10
$ 656.10	$ 65.61	$ 590.49
$ 590.49	$ 59.05	$ 531.44
$ 531.44	$ 53.14	$ 478.30
$ 5,217.03	$ 521.70	$ 4,695.33

	Deposit	Reserve Requirement	Excess Reserves (Available to Loan)
Original Deposit	$ 1,000.00	$ 100.00	$ 900.00	Moved to next line as deposit
	$ 900.00	$ 90.00	$ 810.00	Moved to next line as deposit
	$ 810.00	$ 81.00	$ 729.00	Moved to next line as deposit
	$ 729.00	$ 72.90	$ 656.10	Moved to next line as deposit
	$ 656.10	$ 65.61	$ 590.49	Moved to next line as deposit
	$ 590.49	$ 59.05	$ 531.44	Moved to next line as deposit
	$ 531.44	$ 53.14	$ 478.30
Totals	$ 5,217.03	$ 521.70	$ 4,695.33

The original $1,000 deposit becomes $4,695.33 of “money” loaned by the bank, all of which is simply created on paper. The actual Federal Reserve Notes (Dollars) are simply representations of the accounting figures. The represent nothing else and are not “backed by anything. Some make the assertion that the deposits are backed by the “Full faith and Credit of the US Government” but that is miss-leading and simplistic. Again, more on that in a latter post.

Seems like a pretty good system at first glance, there is lots of money to go around, lots of money to loan, and lots of money chasing goods and services. A couple of problems are evident right away; Firstly, suppose that 4 people want to actually withdraw the cash for a purchase instead of using a check? Remember there was only $1000 cash in the beginning, all the rest of the money is only numbers on paper. This problem has a simple solution. The member bank  requests money from the Federal Reserve who in turn instructs the Bureau of Engraving and Printing to print more. The Fed only pays for the actual cost of printing the money, not the face value. This is where money comes from. The Federal Government has no involvement in the process other than Appointing the Federal Reserve Chairman and actually printing the bills at the command of the Fed.

A serious problem arises however if we discover the original $900 IOU is no good. Now, we don’t just have $900 in jeopardy, but $4,695.33 is in danger of disappearing. This is the essence of the so-called sub-prime crisis. A huge percentage of defaults is not necessary to bring the whole system crashing down. A relatively few bad loans are enough to crumble the entire scheme.

Of course it is plain to see that the system is geared to promote more and more loans and more and more consumption. There is a real incentive to make more loans. More loans mean more money to lend and charge interest on, more loans mean more money to loan, etcetera. It is not simply a matter of a few greedy mortgage brokers or bankers or homeowners buying beyond their means. The problem is systemic. The fatal flaws are built in. Anyone can turn on the news or search on the Internet and hear or read countless complex explanations for the financial crisis, but in the simplest terms the Federal Reserve system is the cause of the problem. To be sure, there are countless other much more complex interactions and factors not taken into account in this article such as interest or derivatives. These are complete topics in themselves.

The more one studies the financial system, its history and structure, especially from an un-biased outside view, the more obvious the near and long term consequences become. What should you do to protect your assets? It is NOT what you hear and see on the mainstream media. We have seen that the Federal Reserve is at the root of the problem, the Federal government has capitulated its duties and mainstream talking heads are regurgitating the official line with little variance. What should you do? Stay tuned.

 

Do you remember reading earlier of the crisis that will arise when a nation's total productivity is insufficient to pay the interest on its debt? After all, our modern money provides no means for the ultimate payment of debt, but only its continual rolling over by re-borrowing. Well, that is happening now in Poland and Mexico. It places the largest banks--those that loan to governments--in jeopardy. But organizations smaller than governments also get loans from smaller banks, and these organizations and banks are also in trouble. Perhaps these banks are not big enough to be rescued by the international monetary fund. They may be allowed to fail. Eventually, larger and larger banks will fold as the companies whose IOUs they hold collapse under the crushing burden of debt.

It is not a matter of conjecture that the banks of the world are cooperating to provide further funds to Poland, for the reason that its default would be unthinkable. But it is equally unthinkable that Poland's inability to pay its debts can be remedied by placing it still further in debt. But when money is perceived of as debt, what is the alternative?

You will occasionally hear people express concern that the United States government may go bankrupt if it does not curtail spending. That is nonsense. The banks will not allow that for the same reason that they will not allow Poland to go belly-up. A bankruptcy of that magnitude would pull the entirely monetary system down. The fractional reserve requirement is a very sharp two-edged sword. It permits my deposit of $1,000 to be parlayed into $10,000. But it also permits an equally drastic contraction of loans (deposits) if the reserve should cease to exist, as in a bankruptcy. So why should the government go bankrupt, and bring the entire economy down? It isn't as though the government owes something like silver or gold. All it "owes" are its "obligations," which are not obligations at all. Bankruptcy is out of the question.

So much for the "good" news. The "bad" news is that the means by which the government avoids bankruptcy leads to what is at least as catastrophic: namely, runaway inflation. The government can always pay off its debts by borrowing ("rolling over" the debt) from the banks, which can hardly refuse the loan request, for to do so would trigger catastrophe. But the rapidly mounting flood of "money" tends to quickly become worthless. So the choice is between disaster on one hand, and catastrophe on the other. 

But you are forewarned. The people who will be hurt the most are the holders of---"money!" Do you have an IRA, or time-deposit?