Workingman’s Fed

James Rickards Contributor
Font Size:

One of the most successful pieces of propaganda ever is the myth that the Federal Reserve exists to protect the dollar.  Like all great myths it unifies its believers and shields them from the facts.  But facts are stubborn things, as John Adams observed, and it is a fact that since the creation of the Federal Reserve the dollar has lost 92 percent of its purchasing power.  If you had a nickel and three pennies in your hand, that’s what’s left of the dollar since the Fed took charge.  Imagine if the Fed were in charge of air safety and 92 percent of the flights crashed on takeoff.  That’s how well the Fed has done its purported job.

If the Fed does not protect the dollar, what is their job exactly; what do they really do?  A little history helps here.  In 1907, a financial panic nearly destroyed the banking system in the U.S.  The system was rescued personally by J. P. Morgan who held all night sessions in his New York mansion and cajoled other bankers to join a rescue fund which barely saved the day.  But it was a close call and the bankers realized they needed greater resources, a lender of last resort, to save them the next time.  They knew there would be other panics and J. P. Morgan would not be around forever.  They spent the years from 1908 to 1911 working on a solution in which the U.S. government would backstop the system with the ability to print potentially unlimited amounts of money but the system itself would be dominated by the bankers.  The result was the creation of the Federal Reserve in 1913.  Thus began the long, slow, persistent destruction of the dollar.  The name for this process is inflation.  That is what bankers really want and that is what the Fed gives them.

The Fed’s vaunted independence means it is barely connected to the U.S. government except to the extent it so chooses to carry out its own purposes.  Fed governors are chosen by the President but with very few exceptions come from one of two sources – either the Fed’s New York Reserve Bank or the elite ranks of academic economists trained in the monetary manipulation of Milton Friedman and the deficit spending of John Maynard Keynes.  Regional banks of the Fed system are even more insulated from the democratic process.  They are owned by the banks in their regions and are controlled by local bankers.  Now the Fed is seen for what it is – a super-bank created by other banks to bail them out when they’re in trouble by printing money to cause inflation.  And inflation does not have to be very noticeable in order to work.  Even 4% inflation will cut the value of your money in half in less than 18 years.

Doesn’t inflation hurt banks too by reducing the value of their loans? Don’t they get repaid in cheaper dollars? Yes, but consider the alternative.  In deflation, the burden of loans gets heavier to the point that borrowers cannot repay.  A banker would rather get paid in cheaper dollars than not get paid at all.  And banks are leveraged institutions because they finance the loans with deposits.  With inflation, their loans may be worth less but the deposits are worth less too so the banks are barely affected.

The Fed also bails out banks by keeping short term rates extremely low.  So banks just borrow from depositors at 1% and invest in Treasury notes at 3% and pocket the 2% difference.  They leverage this trade using deposits at a ten-to-one ratio to their capital so the 2% spread becomes a 20% return on capital once the leverage does its work.  The only risk is that the 1% cost of funds goes up before all of the profits can be collected.  Don’t worry says the Fed, we’ll make sure rates stay low as long as it takes and we’ll give you plenty of warning of an increase so you can unwind the trade before you lose money.  Having the Fed on your side is as close to a sure thing as markets ever provide.

If Fed inflation and rigged interest rates are great for the banks, who suffers in this scheme?  As usual, it’s the average working man or woman.  Imagine asking your boss for a raise in this economic climate.  The boss will probably tell you you’re lucky not to get fired and go back to your desk and quit complaining.  Now imagine your salary stays the same but the price of everything you buy goes down.  You still don’t have a raise but you do have a higher standard of living and increased purchasing power.  A new car that used to cost $24,000 now costs $16,000 and is much more affordable.  That’s the power of deflation; call it the workingman’s bonus.  In a severe economic downturn, deflation happens naturally; it’s how purchasing power is restored and it’s how the average worker improves his standard of living when he can’t get a raise.  The government dreads deflation because if you got a real raise they would tax it but when you get improved purchasing power through deflation the government cannot tax that.  For the average worker, deflation is better than a raise because it can’t be taxed.  The Fed causes inflation to cancel out the deflation.  They take away the worker’s raise but the bankers still get theirs.

Perhaps you believe that Fed economic policymaking is complicated.  It’s not.  The Fed is controlled by the banks and its job is to prop up the banks even at the expense of average Americans.  Now you know.  Feel better?

James G. Rickards is a writer, lawyer and economist and the former General Counsel of Long-Term Capital Management. Mr. Rickards holds an LL.M. (Taxation) from the New York University School of Law; a J.D. from the University of Pennsylvania Law School; an M.A. in international economics from the School of Advanced International Studies, Washington DC; and a B.A. degree with honors from the School of Arts & Sciences of The Johns Hopkins University. He can be contacted at james.rickards@gmail.com, and on Twitter at @JamesGRickards.