Econ 101 part 5 (Money and the Central Bank)

Money is a crucial part of our economy and our society. Untold numbers of voluntary exchanges imply a division of labor in society, this is known as the "free-market". Everyone benifits because the division of labor allows for all of us to be much better off than we would be if we had to be self-sufficient which would reduce us to a pitiful standard of living.

As Rothbard noted:

Money is different from all other commodities: other things being equal, more shoes, or more discoveries of oil or copper benefit society, since they help alleviate natural scarcity. But once a commodity is established as a money on the market, no more money at all is needed. Since the only use of money is for exchange and reckoning, more dollars or pounds or marks in circulation cannot confer a social benefit: they will simply dilute the exchange value of every existing dollar or pound or mark. So it is a great boon that gold or silver are scarce and are costly to increase in supply.

But if government manages to establish paper tickets or bank credit as money, as equivalent to gold grams or ounces, then the government, as dominant money-supplier, becomes free to create money costlessly and at will. As a result, this "inflation" of the money supply destroys the value of the dollar or pound, drives up prices, cripples economic calculation, and hobbles and seriously damages the workings of the market economy.

The natural tendency of government, once in charge of money, is to inflate and to destroy the value of the currency. ...

So how does the American system work?

In modern central banking in the USA, the central bank is called the "FED" The FED is granted by the force of law the monopoly of the issue of bank notes. These 'bank notes' are identical to the the government's paper money. If the my bank needs to get cash for its customers, it must go to its own checking account at the FED which is, in effect, the bank's own bank.

It turns out that my bank keeps deposits at the FED in its checking account and these are its "reserves". It may then leverage that amount by ten fold.

Here's how the counterfeiting process works in today's world. Let's say that the Federal Reserve, as usual, decides that it wants to expand (i.e., inflate) the money supply. The Federal Reserve decides to go into the market (called the "open market") and purchase an asset. It doesn't really matter what asset it buys; the important point is that it writes out a check. The Fed could, if it wanted to, buy any asset it wished, including corporate stocks, buildings, or foreign currency. In practice, it almost always buys US government securities.

Let's assume that the Fed buys $10,000,000 of US Treasury bills from some "approved" government bond dealer (a small group), say Shearson Lehman on Wall Street. The Fed writes out a check for $10,000,000, which it gives to Shearson Lehman in exchange for $10,000,000 in US securities. Where does the Fed get the $10,000,000 to pay Shearson Lehman? It creates the money out of thin air. Shearson Lehman can do only one thing with the check: deposit it in its checking account at a commercial bank, say Chase Manhattan. The "money supply" of the country has already increased by $10,000,000; no one else's checking account has decreased at all. There has been a net increase of $10,000,000.

But this is only the beginning of the inflationary counterfeiting process. For Chase Manhattan is delighted to get a check on the Fed, and rushes down to deposit it in its own checking account at the Fed, which now increases by $10,000,000. But this checking account constitutes the "reserves" of the banks, which have now increased across the nation by $10,000,000. But this means that Chase Manhattan can create deposits based on these reserves, and that, as checks and reserves seep out to other banks (much as the Rothbard Bank deposits did), each one can add its inflationary mite, until the banking system as a whole has increased its demand deposits by $100,000,000, ten times the original purchase of assets by the Fed. The banking system is allowed to keep reserves amounting to 10 percent of its deposits, which means that the "money multiplier" – the amount of deposits the banks can expand on top of reserves – is 10. A purchase of assets of $10 million by the Fed has generated very quickly a tenfold ($100,000,000) increase in the money supply of the banking system as a whole.

All economists agree on how this process works. They might disagree on the effects of this process (they do), but all agree on the above process as described.

The US Dollar is worth about 2% of what is was in 1913 when the FED was established. This comes about because the FED continually produces more "money" and the law of supply and demand will mean that each dollar is worth less that it was before.

The 1974 Nobel Prize in Economic Science went to the great Austrian free-market economist Dr. Friedrich A. von Hayek. It was for the Hayek theory of the business cycle that puts the blame for the boom-bust cycle squarely on the shoulders of the government and its controlled banking system and it completely absolves the free-enterprise economy from the blame.

When a government's central bank causes the expansion of bank credit by inflating the money supple it causes price inflation. But that is not all it does; it causes malinvestments, unsound investments in capital goods, underproduction of consumer goods and many other errors in economic judgment which are caused by all the "easy money" coming into the economy. Then, when that "easy money" stops as it always does --- depression. By the way, in the '20s the economist von Mises warned of the coming depression which was being caused by the intervention of the government. His call was on target, was it not?

Next up; who benefits from inflation. (hint, it is not the poor!)