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The Federal Reserve: How it Hurts You-Part 2

Posted by Ender on March 5, 2009

This is Part 2 of of a series on the Federal Reserve.   In Part 1, we discussed Money, Fractional Reserve Banking and a brief history of the Federal Reserve.  It can be found here…in case you missed it.


What is inflation?  From the American College Dictionary: “A substantial rise of prices caused by an undue expansion in paper money or bank credit.”  Henry Hazlitt writes,”The word ‘inflation’ originally applied solely to the quantity of money. It meant that the volume of money was inflated, blown up, overextended. It is not mere pedantry to insist that the word should be used only in its original meaning. To use it to mean “a rise in prices” is to deflect attention away from the real cause of inflation and the real cure for it.”  (Hazlitt)

Inflation in Zimbabwe

Inflation in Zimbabwe: Maybe he can get a grain of rice...

How can the money supply be increased?  Using fractional reserve banking or no-reserve banking, the Fed can print money out of thin air and release it into the money supply.  There is no gold or value behind the new money printed, it is simply fiat money.  The other way money supply can be created is through credit.  The Fed, by artificially lowering the interest rates, can increase the supply of credit.  When monetary supply is increased with no increase in the supply of goods, prices increase.  Inflation causes the devaluation of each monetary unit’s worth.  Henry Hazlitt gives a concrete example:  “The total of money and credit so measured was $63.3 billion at the end of December 1939, and $308.8 billion at the end of December 1963. This increase of 388% in the supply of money is overwhelmingly the reason why wholesale prices rose 138% in the same period.”

Who loses when inflation occurs?  Ludwig Von Mises writes “inflation is detrimental to all creditors.”  He asks the question, “who is a creditor?  Does inflation touch only businessmen and financiers?”  (Mises) The answer is no.  If you save money in a bank you are a creditor, if you own a bond or T-bill you are a creditor, if you have an insurance policy you are a creditor.  The above examples probably include most people who are reading this, however, if you have Social Security taken out of your paycheck you are a creditor, this means 99.9% of you out there are creditors.  You are directly impacted by inflation.quote-11

How are you impacted?  The dollar you put into the bank, or buy a bond with, is worth more than the dollar you get back.  This makes sense  in light of what we learned above.  Two parties benefit from inflation.  The first is the debtor.  Obviously, the inverse of the situation above means that you can pay your creditor back with money that is worth less than the money borrowed.  The second is a little more complicated.  Inflation does not occur in a vacuum, meaning as soon as the devalued money is printed or credit created it does immediately raise prices.  So, the people who use the inflated money earlier in the cycle benefit more than those who receive later in the cycle.  If the Fed prints the money to fund project X the money is worth the most at the start. When it starts paying the vendors and those vendors start paying their vendors and employees, the money gradually loses value.  This means that the highest negatively impacted group is usually the individual.  The government and other elites benefit the most.  Once again, we are reminded of the founding fathers hesitancy to give power to the government because it harms the individual the most.

Good intentions resulting in bad outcome is a recurring theme when the liberal agendais applied.  This is just another example of it.  In fact, inflation hurts the people who liberals claim to help the most.  Inflation is used to fund or create all massive entitlement programs.  Unfortunately, low-income and fixed-income families or individuals bear the brunt of the devaluation of money.

In short, inflation is like a secret tax. The people being taxed have no say in the matter, and more often than not, no idea it’s happening.  The Government can expand its size, start programs, subsidize disastrous projects and do a number of other things that the voting public would never approve of if tax increases were needed to pay for them.

This is where morals and logic must take us:

“1. Theft is immoral. 2. Inflation is theft. 3. Fractional reserve banking is inflationary. 4. Central banking is government-guaranteed fractional reserve banking.”  Gary North

As if prices rising and devaluation of your money isn’t enough, the Fed through inflation, also causes Booms, Busts and Bubbles.  Look forward to part 3…

14 Responses to “The Federal Reserve: How it Hurts You-Part 2”

  1. […] « Introduction to Conservatism The Federal Reserve: How it Hurts You-Part 2 […]

  2. mattbenchener said

    The two articles on the central bank are interesting and well written–a solid historical account. But, a few things are important to recognize with the current role of the central bank.

    1. The gold standard does not matter: You mention that there is no value backing U.S. dollars due to the lack of a gold standard, and this therefore devalues currency and ultimately leads to inflation. However, what intrinsic value does gold have? Nothing–it looks nice, but has little utility. Gold functions like all other commodities, meaning that demand is all that gives it its value. The same is true for fiat money–its value is driven by demand. There is no intrinsic value in gold, it is soley driven by the market. Think of it this way: Why don’t we back our money with steel? It looks good, and has much greater utility than gold. All commodities are market driven, so the theory of fiat money having no value essentially says that markets have no value.

    2. A central bank is extremely important to regulate lending levels, monitor inflation, and oversee the money supply. Monetary policy, when used properly, helps keep the country out of depression and prolonged downturn. It works as a check on rising inflation rates, and can help keep the country out of stagflation or deflation. Most importantly, it helps provide the liquidity needed to move the market along. Without a central lender, commercial banks would not be able to borrow efficiently. Believe me, I am a proponent of the free market and small government, but this a financial institution that provides a necessary calming affect to the market. It is poor and irresponsible monetary policy that creates the problems, not the institution itself.

  3. Ender said

    This wasn’t meant to be a piece on the gold standard, however:

    1. I think you are making a huge error in your reasoning against the gold standard. There is an enormous difference between having money backed by gold or some other commodity and fiat money. The government cannot just magically create gold. They would have to mine for it. Can you say the same of fiat money? No, the government can create “more” money out of thin air, which devalues every other dollar out there. Using this logic, why not just print everyone in America a billion dollars? What would happen?

    2. Again, I disagree with your original statement. You say it keeps a check on rising inflation rates. Exactly the opposite is true. It creates inflation! The Fed is fundamentally responsible for the same problem you are saying it prevents. The Fed’s monetary policy itself puts the country into recessions and depressions as I will demonstrate in Part 3.

    Can you tell me why during the 20 year period starting in 1879 the U.S. experienced the greatest growth in prosperity in the nation’s history?

    Is it merely coincidence that they moved back to the gold standard during this time?

  4. HPX said

    Matt : 1 ) The main importance of a gold standard is not that you can trade your paper money for gold – because like you stated – you can’t eat gold. The single most important reason to have a gold standard is this : It requires people to find more gold if they want to print more money. It prevents central banks and politicians from printing money in order to “stimulate the economy”, or whatever their political goals may be. It prevents everything that has happened since 1971, and is happening now.

    There is a reason Nixon ended Bretton Woods – he wanted to print more money, and run up more debt. This wasn’t doable under the gold standard – because it lead to people demanding to get gold for their dollars, because they prefered gold. Why? Because everyone knew that printing more money led to the dollar becoming less and less worth, but gold would still keep its price. Gold does not have an intrinsic value per definition (its usage is quite limit), the value in gold is that it is

    a ) Scarce
    b ) Divisable

    A gold standard prevents massive inflation, and prevents destruction of currencies.

    2 ) Your statement about the central banks is completely off. The central bank does not act as a safeguard against inflation – it creates it! If government truly wanted to keep their currency stable, there is a simple solution – lock the monetary base. Legally forbid the central bank to give out money that it doesn’t have. This means that the central bank can not lend out more money until it has gotten back the money it previously lent out. The only reason no one sees this is because the Milton Friedman monetarists decided that society as a whole benefited from the “ever-increasing” money supply. It may look like it does this during economic booms – but when the recession/depression comes it is all the malinvestment that has occured during the boom that counters the effect. In the long run, the only thing that happens if you expand the monetary supply is that you remove the value from money, and create the roller-coaster effect that will now bring us back 40 years in development.

    The central bank is fundamentally flawed, because it is not needed. When Milton Friedman and Anna Schwarz came to the conclusion that the Great Depression could have been prevented if the Federal Reserve would have printed enough money – they set the stage for this crisis. The fact that there was actually banks failing during the great depression (as opposed to now) doesn’t really matter. What central banks and government policies has efficiently done is this is destroy the majority of built up capital in the entire world.

    Doesn’t it seem strange the rate the economy is collapsing? There is a reason – because the overconsumption and malinvestment has been so GIGANTIC that we can no longer afford our living standard. We might have – had our money not been a complete fraud, and had the central bank and government policies not fooled us into thinking that there were savings. There are none. The system is resetting.

    And while we could have been resetting rather quickly (say 1-2 years) if the government and central bank did nothing, what we will get now is at least a decade of decrease in living standards. Why? Because the idiots refuse to admit it is their fault! The major currencies of the western world are at risk of becoming completely destroyed (can you spell triple-digit-inflation?), which means that the entire middle class of many countries may be wiped out. This is what lead to Germany becoming a totalitarian state in the 1930’s.

    It is time to wake up. It is time to realize that the government and central banks are running this world straight into a concrete wall. Why? Government because its run by politicians, who live for special interest. The central banks because they are run by economists who have been so fatally indoctrinated with the wrong ideas that they cannot understand simple logic anymore. This has been predicted on multiple occasions, by Mises, Hayek, Rothbard, Rand etc. This is nothing new – it was coming all along.

    So don’t say that we need a central bank, because that’s like saying we need a good beating over the head with an iron pipe every other sunday.

    P.S Once again – there will not be any deflation. We can HOPE for stagflation – hyperinflation is becoming more likely by the day right now D.S

  5. freesoul said

    An ounce of gold in ancient Rome would buy a nice tunic, belt and sandals. Today it will buy a nice suit, belt, and shoes.

  6. mattbenchener said

    My point earlier is that the Federal Reserve does much more than print money or as you say ’cause inflation.’ It is a key tool for the government to regulate the money supply, and is another trigger to pull to help stave off massive fluctuations in both the market and the financial system. Furthermore, inflation is not a bad thing–only hyper inflation is bad. If you have no inflation, then your economy is not growing relative to other economies. That’s why interest rates have been kept so low during this recession, it has helped us from falling into massive deflation.

    My worry is that some of conservatism is drifting far into libertariansim. By some of the logic above, it seems you would have us do away with the IRS, Dept. of Education, and any government regulation–the Ron Paul model. This is dangerous, in that it tends toward the extreme, and impractical for prudent governance. I’m sure this will get some responses about how terrible the IRS and Dept. of Education are, and I understand their flaws. The point, however, is that while many of these institutions suffer from bureaucracy and government waste, they serve a necessary regulatory function. This is the case with the Federal Reserve–again, advanced monetary policy has kept the American economy relatively stable.

    Also, we can hope for stagflation? Please take a look at Carter’s era of economic stagflation, or note the damagin effects of deflation throughout history. Slight inflation is a normal part of a healthy economy–deflation is a sign of regression. The Federal Reserve can help regulate inflationary monetary policy, and provide the necessary liquidity to the market and to banks (no one has countered this point yet), though it may come with flaws.

    And again, I stand by the point that gold has no intrinsic value, it is only valued as the market places weight on it. The fact that it is limited in quantity only means that the government cannot produce more of it, but government monetary production is not the only, or even central source of inflation. Often, inflation comes with overinflated commodity or market bubbles, which then move prices faster than the supply and demand curve. Let’s not throw out the baby with the bathwater.

  7. Ender said

    Matt, thanks for taking time to respond and vet our philosophies in this forum.

    How is devaluing the dollar (through inflation) not a bad thing? Inflation does not equal growth. Again using that logic, why not just print a billion dollars for everyone in America?

    What causes these “massive fluctuations”? The business cycle, bubbles, booms, busts, recessions and depressions are primarily caused by the Fed’s monetary policy. You say “inflation comes with overinflated commodity or market bubbles, which then move prices faster than the supply and demand curve.” How does this happen? With this statement you are proving my point. How do the market bubbles get created? In the article, I talk about inflation not occurring in a vacuum. This is what causes bubbles, certain sectors start feeling the benefit of the inflated money while others do not. Prices start adjusting. But, eventually the money works its way through the whole economy and then the Fed stops the flow and everything drops from its artificially high price.

    Also, keeping interest rates low only increases inflation. The article states that there are two causes for inflation increase in money supply and increase in credit. Lowering interest rates increases credit, therefore inflation follows. Read more about correct bank behavior here:

    Two points on your libertarian comments:

    1: You are forgetting the roots of the conservative movements. Research the coalition Buckley built. Or research the most conservative time in American history, its founding.

    2: I don’t consider myself a full blown libertarian, however, there is only one economic school that has correctly predicted the problems in our history, our current situation and future situations with regards to economics and that is the Austrian School. It’s time to start listening. They say that trying to keep the market artificially inflated will only be more costly in the long run. I’m not going to defend every word Ron Paul has muttered, but the Dept. of Education is one of the worst violations (in a long list) of the US Constitution.

  8. mattbenchener said

    First, I’m glad to take part in these discussions–I think this type of discourse and discussion is what helped lead to the founding of our country. It’s great to engage in this way, and it’s troubling that more people can’t/won’t talk rationally about policy and ideologies, even if they disagree.

    In that light, I’m certainly not pushing aside or forgetting the roots of hte conservative movement. I simply believe that there is a fine line between conservatism and libertarianism. Our government has grown beyond what it should be, especially now, and we would both agree that small government is both more efficient and more just. But, there are many government institutions that now serve a positive and vital role in society. When run well and correctly, these institutions provide thought leadership, necessary checks and balances, and a consolodated place for good policy to be implemented. I believe that the Federal Reserve is one of those institutions. Has monetary policy been misued? Certainly. But, the tools at the hands of the Fed. can be extremely useful, stablizing, and enabling.

    Also, to your earlier point about inflation and growth, I never said that inflation equals growth in and of itself. Rather, small steps of inflation (1-3%) are indiciators of a healthy and growing economy–there is a serious difference there that must be taken into account. Finally, do you think the Fed was really to blame for the recent housing bubble? I haven’t heard anyone argue that, economists or politicians. The monetary policy had nothing to do with the Tech. bubble of the late 90s or the recent housing bubble–it was investors chasing profits through derviatives and poor legislative policy (CRA etc.). The Fed, when used appropriately, can stave off and limit these bubbles by restricting the flow of money.

    And of course low interest rates leads to inflation, but again, low interest rates are necessary to keep the credit markets from freezing and the economy from stalling completely during recession.

  9. hpx83 said

    Matt – good to see someone who likes a proper discussion. Here are a few questions/statements for you :

    – What can the Federal Reserve do that doesn’t in the end lead to inflation? They have a printing press, and the possibility to buy anything they wish, and later sell it. They can set the primary interest rate, the discount window rate, and these days supply Term Auction Credit. These are all monetary “tools” that in one way or another create inflation.

    – The US should do away with the IRS, Dept. of Education, and government regulation. These are the things that have become so bloated that they risk driving your country into poverty, argentina-style.

    – Necessary regulatory function assumes that you are competent enough to regulate. Government institutions are per definition not. Look at SEC and Madoff. Look at CRA and “Guidelines to fair lending”. Look at whoever was supposed to manage the TARP funds – ooops, we gave them to bankrupt auto companies.

    – Slight inflation is a sign of one thing : Someone is fiddling with the monetary base. This will cause inflation, and in extreme cases hyperinflation. How can you be worried about deflation as the monetary base has rocketed through the roof, into the stratosphere. Heard the news that Bernanke is looking to see if the Fed get more control over bank reserves. You want to know why? He has pumped 800 billion dollars into the primary capital base, and he has no way of getting them out!!

    Deflation = Less money in circulation. This can only happen if banks go bankrupt. Banks are not going bankrupt. You can have “deflationary effects” when the economy slows down – but these are due to temporary one-time deleveraging effects. If you lower interest rates here, you build up an underlying inflationary pressure, and once the economy has reset, you will be hit by an inflationary bomb. Yes, you should hope for stagflation, because the alternative for the US today is double-digit hyperinflation. And maybe not even the double-digits that start with “1”.

    Ask yourself this : Where will prices go if

    a ) We increase the monetary base
    b ) There are less goods and services produced due to unemployment
    c ) The dollar finally gives up because of the government debt, and tanks (imports expensive – exports cheap)

    Deflation? No, no and no.

    And on the contrary – government and central bank policies are the only, I repeat, ONLY reason you can have constant inflation. If they didn’t interfere, we would have a very slow overall trend of declining prices, due to the fact that the economy becomes more and more efficient.

    Finally, YES the Fed is to blame for the housing bubble. If you haven’t heard this argument before, it’s because you are listening to the wrong people. Because while the economist-of-choice screams about deflationary traps, there are actually people out there who saw this crisis coming years ago. What are they predicting? Hyperinflation.

    Lower interest rates will never be necessary to keep credit markets from freezing up. Lower interest rates serves the purpose of “stealth theft” of existing wealth by reducing purchasing power of existing money. It promotes unsustainable business, that is created because credit is too cheap. It promotes unsustainable consumption, because consumers expect credit to always be available, and cheap. It leads to the boom-bust cycle. The interest rate policy of Alan Greenspan is what created this crisis. The interest rate policy of Ben Bernanke is what is going to create the next. And as things look now – the US won’t be out of this crisis before the next one hits. Thanks to the FED, the US will then have mass-unemployment, $2 trillion deficit, zombie banks AND a currency that isn’t worth the paper its printed on.

    Sound fun? If not, don’t try to justify the FED.

  10. Ricky said

    There has been discussion here about money backed by gold and money backed by government through a federal reserve bank. Why should gold, as opposed to something else, be used?

    Why do people turn to gold in times like these? What is gold used for? Yes, there are industrial uses and there are consumer uses in jewelry and the like. But recessions and inflations don’t cause people to want to wear more jewelry or stock up on industrial metal. The investor demand ultimately reflects consumer demand for gold. But that still leaves us with the question of why the consumer demand exists in the first place. Why gold and not sugar or wheat or something else?

    There is no getting away from it: investor markets have memories of the days when gold was money. In fact, in the whole history of civilization, gold has served as the basic money of all people wherever it’s been available. Other precious metals have been valued and coined, but gold always emerged on top in the great competition for what constitutes the most valuable commodity of all.

    There is nothing intrinsic about gold that makes it money. It has certain properties that lend itself to monetary use, like portability, divisibility, scarcity, durability, and uniformity. But these are just descriptors of certain qualities of the metal, not explanations as to why it became money. Gold became money for only one reason: because that’s what the markets chose.

    Why isn’t gold money now? Because governments destroyed the gold standard. Why? Because they regarded it as too inflexible. To be sure, monetary inflexibility is the friend of free markets. Without the ability to create money out of nothing, governments tend to run tight financial ships. Banks are more careful about the lending when they can’t rely on a lender of last resort with access to a money-creation machine like the Fed.

    A fixed money stock means that overall prices are generally more stable. The problems of inflation and business cycles disappear entirely. Under the gold standard, in fact, increased market productivity causes prices to generally decline over time as the purchasing power of money increases.

    In 1967, Alan Greenspan once wrote an article called Gold and Economic Freedom. He wrote that:
    “An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense – perhaps more clearly and subtly than many consistent defenders of laissez-faire – that gold and economic freedom are inseparable, that the gold standard is an instrument of laissez-faire and that each implies and requires the other. . . . This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.” If only Greenspan had heeded his own advice.

  11. […] 1, we discussed Money, Fractional Reserve Banking and a brief history of the Federal Reserve.  In Part 2, we discussed […]

  12. […] 1, we discussed Money, Fractional Reserve Banking and a brief history of the Federal Reserve.  In Part 2, we discussed Inflation.  In Part 3, we discussed the Austrian Business […]

  13. […] Part 1, we discussed Money, Fractional Reserve Banking and a brief history of the Federal Reserve. In Part 2, we discussed Inflation. In Part 3, we discussed the Austrian Business Cycle. In Part 4, we […]

  14. […] of the Federal Reserve say that you need the Fed to control monetary supply and inflation. In our series on the Federal Reserve we argued that the Fed itself creates inflation. So, in light of recent events it appears that the […]

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