Topic: Monetary Policy
Money doesn't grow on trees. Central banks might disagree... A free-market perspective on the distinction between money and wealth, the way central banks can endanger the economy and why full Fed transparency is necessary.by Wilson Locke
(libertarian)
Thursday, November 26, 2009
Most of us would say they make money. Some make a little, others make a lot, but we all make some as long as we engage in some form of productive activity... And yet if any of us actually got caught in the process of creating pieces of paper resembling Federal Reserve notes or banknotes from the Bank of Canada and using them to buy goods at the local shopping mall, they would probably end up in jail. So we all make money, and yet none of us actually makes any money in the real sense. How is that possible?
In reality, what we create in our everyday lives is not money but various goods and services useful to ourselves or other people. In the old days, when the average farmer could produce most of what he and his family would consume, there was little need for money. Goods that could not be easily made on a farm, such as tools and cookware, could be obtained in exchange for the farmer's produce. And yet, people could still provide for themselves and their families, albeit at a much lower level of technological sophistication. You could still talk about some farmers being "richer" than others despite the fact that none of them had any money.
In our day and age, we tend to equate wealth with money. A wealthy individual is someone who owns a large sum of money or various assets whose value is expressed in terms of money: stocks, bonds, mutual funds, etc. But if the economy suddenly came to a grinding halt and nothing could be bought or sold, what would all this money be worth? Surprisingly, it would hardly be worth anything because money is simply a medium of exchange, and its value is based entirely on the goods and services it can purchase on the market at any given time. Without the production of real goods and services by various businesses big and small, those green pieces of paper would be completely worthless. Money is only useful insofar as it can purchase real stuff in the real economy. Now you are considered reasonably wealthy if you have a million dollars in a bank account. But if the prices of everyday products were so high that a million dollars could only buy you a bottle of Coke, a "millionaire" would be nothing but a pauper.
Money was developed by our civilization to overcome some of the problems inherent in a barter economy, i.e. one in which goods have to be exchanged directly against other goods. Imagine that you are living in a small village, thousands of years ago. You desperately need a new wheelbarrow, and you happen to have one sheep too many. The man next door makes wheelbarrows, but he has no use for a sheep. Another person on the other side of the village needs a sheep, but they don't have anything you need. In such a primitive economy, several distinct transactions might need to be performed in order for you to get your wheelbarrow.
Many societies would eventually find one or two goods that a plurality of people would value highly. Most people would then accept those goods in exchange for the surpluses of their production because they knew they could easily find someone else who would accept them in exchange for whatever else they needed. Early attempts at this had various complications. Cultures in which most people were farmers or shepherds would sometimes use live animals (e.g. oxen) as the common means of exchange. While animals were readily accepted by most, the value of a single animal was too high for smaller transactions, and it was impossible to give someone half an animal in exchange for a smaller good. Precious metals eventually emerged in many cultures as the common medium of exchange because they were in small supply, and a very small amount of the metal could buy a large number of other, more useful goods. Furthermore, precious metals are durable and easily divisible, which makes them serve as a reliable store of value up until this day.
In those days, no single institution was in charge of supplying the population with money. However, the metals used were relatively easy to recognize, and their purity could be ascertained through the process of assaying. The government eventually took on the responsibility for certifying the weight and purity of precious metals in order to absolve ordinary citizens from the responsibility of checking if their money was fraudulent. The King's stamp on the coin would simply indicate that it was certified by the proper authorities to contain a certain quantity of gold or silver. However, it was the amount of gold or silver that constituted money, not the king's stamp or the face value of the coin.
Some princes would abuse the trust of their subjects and debase the value of the currency by either clipping the coins or mixing them with cheaper metals, such as copper. They were then able to produce more coins than their real wealth would allow them to, and they would then use them to buy goods on the market. While the prince could temporarily enrich himself at the expense of the public, the market would eventually catch on to the fact that the coins' value had been debased, and there were more coins in circulation chasing the same amount of goods and services. Other people would then have to pay higher prices for the goods they wanted. Their wealth had, in fact, been discreetly confiscated by the prince, even though no money had been physically been taken away from them. Rulers who got caught cheating the public this way would eventually be disgraced and dishonored while the value of the coins would be adjusted according to their actual metal content.
Paper money was initially introduced by banks as a claim against a fixed sum of gold or silver. People who possessed large sums of money could deposit them with the bank and receive a certificate, which would eventually be redeemed or transferred to another person. The certificates themselves were not money, but claims redeemable in money, guaranteeing that a certain amount of a precious metal was stored in the bank vault on the holder's behalf. There was no such thing as a national paper currency; each bank would issue its own bank notes.
These early bankers quickly realized that it was theoretically possible for them to issue bank notes for a larger amount of gold than they actually had in their vaults because it was highly unlikely that everyone would redeem their banknotes at the same time. This practice is now known as fractional reserve banking, and it is very similar to the concept of overbooking as practiced by some hotels and resorts. The biggest problem with this approach is that in times of uncertainty, if a lot of people do attempt to withdraw all their deposits at the same time, the bank will be unable to fulfill its obligations. Another problem is that since there is no one-to-one relationship between bank notes and a physical good, it can mislead people into believing that new wealth has been created in the economy, when in fact, all that has been created is new paper.
Whenever there was a panic in the market because many companies were unable to live up to their promises, people would tend to withdraw their savings from the banks, thereby causing this "house of cards" to collapse. The leading bankers would then arrange a meeting in order to establish "a bankers' bank", which could lend out money to troubled banks if the economy goes sour. This "lender of last resort" would then be officially chartered by the government as the nation's central bank, which, because of its real or imagined importance to the nation's economy, would obtain direct support from the government.
The central bank of the United States is called the Federal Reserve System, and it is currently composed of twelve regional privately-owned Federal Reserve Banks headed by a Board of Governors, which is appointed by the President. It came into existence in 1913 when the Federal Reserve Act was signed into law by President Woodrow Wilson. Most industrialized countries now have their own central banks, which are, in most cases, directly owned and operated by each country's government. The American central bank is unique in its hybrid nature: it is privately owned like a commercial bank, but the people who set its policy are appointed by the Executive branch.
The stated purpose of a central bank is to ensure price stability and to provide a cushion for the nation's economy in case of an emergency. However, the power of a central bank and the potential for its misuse should not be underestimated because it can now engage with impunity in the same practice that the princes of old performed illegally, often condemning themselves to public disgrace and dishonor.
Up until the Great Depression and the New Deal, the U.S. dollar was redeemable for a fixed amount of gold; more specifically, one dollar was equal to one-twentieth of an ounce. While the central bank added an extra layer of "overbooking" to the economy, its ability to manipulate the nation's money was still limited by a gold standard.
In 1933, faced with an inability to finance the expansion of government in a shrinking economy, Franklin Delano Roosevelt passed an executive order to confiscate all gold held by the people and then made it impossible for Americans to obtain gold in exchange for their money. This removed the restraints from the central bank and the banking system in general because Americans could no longer come back asking for their gold, and domestically circulating banknotes were effectively backed by an empty promise.
Some economists might argue that Roosevelt had nothing else to do because the depression had allegedly been caused by insufficient government intervention in the first place. This presumption, however, has been demonstrated to be false by the Austrian School of Economics, since the stock market crash actually resulted from the boom that preceded it; more specifically, the banking system was expanding credit at a faster rate than the economy could absorb it and convert it to real goods and services, and this had been made possible by the central bank's extra layer of fractional-reserve overbooking. It has also been shown that the various public works programs instituted during the Great Depression only made matters worse by detracting labor and capital from valuable wealth-producing activities. In the absence of such interventions, the economy would recover much more quickly. This was the case in the Panic of 1920 when the government refused to intervene, and the economy recovered on its own.
Up until 1971, foreigners could still redeem dollars for gold at a fixed rate, but President Nixon decided to close that window, which then became known as the "Nixon Shock". Today, the value of the U.S. dollar and most other currencies, for that matter, resides entirely on trust. People accept money as payment because of their conviction that anyone else would do likewise, but little is known about how much this money is going to be worth next year. As we now know, the creation of money does not create wealth. If the central bank increases the number of dollars in circulation, other things being equal, more money will be chasing the same quantity of goods, and the prices of these goods will rise. However, this privately-owned, presidentially controlled consortium of banks we call the Federal Reserve has the ability to add money to the economy any time it wants to whether to protect a financial institution that got into financial trouble because of its unsound business judgment and management practices or to "stimulate" the economy, as if by magic. It should also be noted that many modern-day wars and the expansion of the surveillance state could not be financed without a central bank -- the government would simply run out of money, and there is only so much it can collect in taxes. But to someone who is operating close to the central bank, whether in a public agency or a private, politically-connected corporation, it seems like money grows on trees with its supply being infinitely elastic and expanded at will But if creating money does not create wealth, where on Earth does the wealth come from?
It's plain and simple. The wealth comes from the goods and services regular Americans would have been able to buy had their prices stayed put. It comes from your own productivity and the compensation you rightfully earned. Money might grow on trees, but products don't (unless we're talking apples). Their production requires labor and capital. Monetary expansion is, in effect, a subtle, under-the-hood transfer of wealth from everyone who has saved some money to whoever receives the new money first. The markets eventually catch on to the fact that the monetary base has been expanded, but by the time it happens, the wealth has already been transferred. As a result, people who would have been employed in productive businesses delivering valuable products and services to their fellow citizens are now working for zombie corporations whose bankruptcy has been artificially postponed or government boondoggles that no one asked for. Wealth and capital have been diverted, and no one will notice it until it's too late, and everyone's savings are worth only a fraction of their original value. Many of us invest their money in risky assets just in order to maintain its purchasing power at a constant level. It didn't use to be that way, and it doesn't have to be that way.
As it stands, the Federal Reserve is completely independent from the U.S. Congress and the American people, but it has been charged with a task that is part of the nation's public policy. In peaceful times, nothing affects the average American family more than unexpected changes in the value of their savings, and yet, we have allowed this institution to be completely unaccountable, answering only to itself and the financial institutions it serves and yet completely free from normal market pressures with its large forest of money trees.
Ron Paul's (R-TX) bill to audit the Federal Reserve (H.R. 1207) was introduced in early 2009 and has now gained over three-quarters of the House of Representatives. If this bill was signed into law, it would put a check on the central bank's power to create money by subjecting its operations to public scrutiny and letting people know who gets the newly-printed money. However, those who depend on money trees for their careers are constantly at work to prevent this from happening. It is, therefore, important to ensure that it passes the House and the Senate before it gets diluted and torn apart like all previous attempts to put a fence around the money trees. The next battle will be about sound money.
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The views expressed in this
article are those of Wilson Locke only and do not represent
the views of Nolan Chart, LLC or its affiliates. Wilson Locke is
solely responsible for the contents of this article and is not an
employee or otherwise affiliated with Nolan Chart, LLC in his/her role as a columnist.
Posted By: Jake Towne, the Champion of the Constitution
Date: 2009-11-26 07:23:58
Thumbs up, great article!!! I would add my own private definition of "wealth" which is anything that increases my "weal" or well-being. Defined this way, my health is my prime source of well-being, and all the rest are lesser forms, as I wrote here http://www.nolanchart.com/article6502.html
Happy Turkey Day!!
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