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The Federal Reserve and Social Justice: Questions for Fed supporters



September 02, 2009 – Comments (10)

"Everyone must read this book -- Congressmen and college students, Democrats and Republicans -- all Americans. The Federal Reserve, which serves private banks, has compromised our economy and is undermining our freedom. It can and must be stopped now. Ron Paul shows us how and why we must end the Fed. Read this book!"
--Vince Vaughn 

Yes, that's the actor Vince Vaughn. He has joined our cult.  Sweet.  Another interesting celebrity addition to our cause is WWE wrestler Kane, aka Glenn Jacobs, who occasionally writes for, and has campaigned for Ron Paul.  Lest we jump to conclusions and question his authenticity, check out Kane's blog.  His writing is very good.  He is no empty headed jock.  I'm impressed.

Moving on, CAPS readers are thoroughly familiar with position on the Federal Reserve, but may be left wondering about reasons and solutions.  This post is an effort at clarification.  It's also for my friends.

We can make some logical deductions about the process in which money enters the economy, though as I have said no one can trace a trillion dollars to see exactly how and where it goes.

The Cantillon Effect

1. When the Fed creates new money (no matter the method of creation), it must be given to someone or some institution.  

2.  That institution gets to use the money while its purchasing power remains at old levels (before the introduction of new money).  Why?  Because the other individual actors in the economy are neither fully aware of the creation of money (often the Fed engages in these transactions in secrecy and announces after the fact) or aware of the total inflationary effect of the injection of new money.  

3. As the money gets passed through the economy, it drives down the value of all existing money - not all at once, but in steps.  This is known as the Cantillon effect, after the first person to discover the effects of expansionary monetary policy, Richard Cantillon.  It should be noted that Cantillon's discovery was made during the time when he and John Law were engaging in inflationary schemes that bear great resemblance to today's status quo Fed operations. 

4. The people who earn wages, and consumers, suffer the most at the hands of this inflationary policy.  By the time the money has stepped through the economy, the purchases they make are at the new pricing level, reflecting the increase in the money supply.  Furthermore, wages are the last to rise, forcing unions and wage earners into an endless negotiation struggle, chasing the rising cost of living.

So my first question for Fed supporters is, knowing the deleterious effects of the Federal Reserve on the middle class, how can you continue to support its existence?

Fixed Incomes

We also know that the Federal Reserve's constant creation of new money (the Fed targets 2-3% inflation every year as a policy), hurts people on fixed incomes.  Retirees, the eldery, and welfare recipients, all suffer from the Federal Reserve's policy of targeting yearly inflation.  If you retire at the age of 60, a 2% yearly inflation will reduce your purchasing power by 25% by the time you are 78.  So as you get older, and your medical expenses become more important and more expensive, you're wealth is eroded by a quarter simply so the Federal Reserve can continue to finance government largesse.   Of course, 2% is the conservative estimate.  The Fed rarely, if ever, keeps real inflation so low.  This is why the dollar has lost over 95% of its value since 1913.  If the average inflation is 4%, a person who retires at the age of 60 will lose 50% of his income's purchasing power by 78.  What about 6%, 8% inflation, etc.?

So my next question for Fed supporters is, knowing the damaging effects of the Federal Reserve's stated policy of inflation on the purchasing power of people on fixed incomes, how can you continue to support its existence?

The Impossibility of Central Planning

The Federal Reserve can never know the proper amount of money in an economy.  It is impossible.  Therefore, the Federal Reserve's stated policy of providing monetary stability is a sham, as history has clearly shown. 

There is a knowledge problem inherent in central planning, including the Federal Reserve's central planning of money.  Every piece of information used to plan is past information.  Unfortunately, the market is the ever evolving subjective evaluations of individual actors.  The preferences, tastes, and values held by producers and consumers is constantly evolving.  Once the central planners have figured it out, if they can (and that's quite a stretch), it's already changed.  This is why they always appear to be bumbling idiots.

Take the interest rate for example.  The Fed targets a rate, and handles monetary policy in order to achieve that rate.  Let's say they choose, for reasons they believe to be important, 5.5%.  That is now the price of money.  Why not 5.51%? Why not 16.7%? Why not 5.49999999999999983%?  Why not allow the market to set the price of money?  The Fed can never be right about the interest rate.  Never.  It would require the ability to peer into the brains of every single individual actor in the market place to determine their subjective evaluations of the price of money.  And EVEN if they could do that, by the time the information was assembled and an interest rate was chosen, the market would have changed its mind.

So my next question for Fed supporters is how can the Federal Reserve ever be right about the price of money?  And if you believe the Fed can manage the money supply, why don't they coordinate steel production, farming, etc?  Why not just set up a Communist State and get it over with?

The Proper Amount of Money

The proper amount of money is whatever amount the market can bear.  Currently, the cart pulls the horse.  Money is increased in an effort to stimulate the economy, to stimulate productivity.  This is backasswards. 

Increased productivity increases the amount of goods available.  This increase in goods leads to a drop in prices relative to the supply of money.  This drop in prices makes the production of money (real money - the stuff that the central banks hoard, gold and silver)  more profitable.  New money enters the economy. Prices rise again.  This is how the horse pulls the cart.  So why the switch-a-roo? 

"I am of the opinion that the main and final cause why the prince pretends to the power of altering the coinage is the profit or gain which he can get from it; it would otherwise be vain to make so many and so great changes.... Besides, the amount of the prince's profit is necessarily that of the community's loss." Nicole Oresme, Treatise on the Alteration of Money, 1371

David in Travel

10 Comments – Post Your Own

#1) On September 02, 2009 at 11:42 AM, chk999 (99.97) wrote:

You really need to read Lombard Street by Walter Bagehot to see why a lender of last resort is required.

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#2) On September 02, 2009 at 11:54 AM, whereaminow (< 20) wrote:


A lender of last resort is required because fractional reserve banks always fail.  

Always.  Everywhere.  I suppose you enjoy living with a 3rd century BC relic of a financial system. (the history of fractional reserve banking precedes Bagehot's justification by at least 2100 years of recorded history.)  I would like to live in the modern age.  

You keep referencing Bagehot.  I wonder if you can actually explain his justification. 

David in Travel

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#3) On September 02, 2009 at 12:03 PM, whereaminow (< 20) wrote:

I have to run, so as fun as this debate was about to be, let me go ahead and spoil the party.

Bagehot noted that providing a lender of last resort and eliminating competition in currency, a central bank actually increased monetary instability. (I would suggest a re-reading to chk999 but he thinks he knows what he is talking about.)  

The mere existence of a lender of last resort “encourages banks to take on excessive risks, leading to trouble. . . ."

This problem, which has been called ‘The Bagehot Problem’ would be avoided if the lender of last resort followed Bagehot’s advice — in offering support only to solvent institutions at penalty rates.

Bagehot proposed that central banks could avoid this fate by only helping solvent banks and by doing so at penalty rates!  

But in reality, the Federal Reserve and central banks never follow Bagehot's advice, which is why I find it so unusual that a Bagehot reader would use Bagehot to justify policies Bagehot would find despicable.

David on His Way Out

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#4) On September 02, 2009 at 5:42 PM, leohaas (30.15) wrote:

David is right. We can get rid of a central bank. All we have to do is abolishing fractional reserve banking...

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#5) On September 02, 2009 at 7:19 PM, redneckdemon (< 20) wrote:

I think that folks might think that by abolishing fractional reserve banking, you mean to abolish banking in all forms.  Perhaps they simply can't imagine any other form of banking, I don't know.

People just naturally tend to assume that if you want to get rid of something, it has to be replaced by something else, which is rarely discussed in this case.

I agree with you whole-heartedly on the FED.  End it, tear down the bloody building, and replace it with "not a damn thing".

I also agree that fractional reserve banking should be abolished, but we have seen that it will take care of that on it's own, it the Gov. stays the hell out of it.  The smart banks and the banks that maintain 100% reserves (backed by gold and silver if you REALLY want to be safe) don't need a lender of last resort.  They don't and didn't need bailout funds, and they will get plenty of market share.

Unless, of course, the Gov. steps in and saves the poorly run banks.  Then they can develope cut-throat policies designed to do nothing more than take customers away from the good banks, knowing that they can lose all the money they want and the Gov. will be there to save em.

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#6) On September 03, 2009 at 10:59 AM, leohaas (30.15) wrote:

"I think that folks might think that by abolishing fractional reserve banking, you mean to abolish banking in all forms.  Perhaps they simply can't imagine any other form of banking, I don't know."

Probably. But there are alternatives: full-reserve banking and free banking. If full-reserve banking were to become a requirement, we would need some institution to enforce it. That means government interference. Borrowing money would be really difficult. With free banking, banks become like all other businesses, subject to the same rules, including bankruptcy laws. It would allow banks to chose their own model (full-reserve or fractional-reserve), and it would be up to their clients to decide which model they prefer. And (probably most important to the Libertarians who push this) it would be possible to set this up without any government interference because there would not be any rules to enforce. Bank bailouts do not exist under true free banking: if a bank is failing, it will go under.

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#7) On September 03, 2009 at 11:22 AM, Chromantix (90.16) wrote:

On September 02, 2009 at 7:19 PM, redneckdemon (98.05) wrote:

"I agree with you whole-heartedly on the FED.  End it, tear down the bloody building, and replace it with "not a damn thing"."


With all due respect, sir: I disagree.

The building should be demolished and used as a multi-level parking lot - it alone would create more revenue than the previous tenants.

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#8) On September 03, 2009 at 4:12 PM, DaretothREdux (55.67) wrote:

+1 to David and +10 to Chromantix's comment!


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#9) On September 04, 2009 at 3:44 PM, bigpeach (30.96) wrote:

Lots of complaining, but no ideas. What would you have instead?

Free banking? It's been tried to some degree or another, and has mixed success/failure. The most notable problem of course is the lack of a uniform currency.

Full reserve banking? You could never get a loan.

No banking? Mattresses would become very expensive.

Something else entirely?

Fractional reserve banking is not perfect, but I would prefer it to all of the above.

Finally, let me address this, which you frequently point out: fractional reserve banks always fail

Everything fails eventually. All banks fail (fractional reserve or not). All companies fail. All governments fail. All nations fail. Eventually, all life on Earth will fail. Eventual failure is not a vaild argument for a banking system being a bad idea.

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#10) On September 27, 2009 at 2:49 PM, RalphMusgrave (< 20) wrote:

Bigpeach and leohass above claim that without fractional reserve, getting a loan would be far more difficult.  Not true. Under a “full reserve” system the government / central bank would have to greatly expand the monetary base to make up for the destruction of “commercial bank created money”. Net result would be that the total amount available to borrow would be roughly the same.

Also someone above suggested that under full reserve banking a bank cannot go bust. I dont see why not. What if a bank made a series of silly loans?

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