Lawson for Congress

I’m grateful that Dr. Tom DiLorenzo, professor of economics at Loyola College, took the time to write a rebuttal to an inexplicably ignorant hit-piece recently published in the Wall Street Journal entitled “A Short Banking History of the United States.”

The author of this article, Mr. John Steele Gordon, makes a number of spurious claims in an attempt to discredit the economic philosophy of sound money controlled by the people, and defend Alexander Hamilton’s loyalty to banking interests in the drive to create a private central bank to own our money supply.

Beneath Mr. Gordon’s flowery rhetoric, however, is a profound ignorance of a fundamental problem in our money and banking system: fractional reserve lending. As I noted in an article last August, this ignorance in the mainstream media is nothing new, and par for the course:

http://blog.lawsonforcongress.com/2007/08/29/what-cnn-doesnt-understand-fractional-reserve-banking/

What’s wrong with fractional reserve lending? This article from June outlines the details:

http://blog.lawsonforcongress.com/2008/06/04/whats-the-problem-with-banks/

Once you understand the root of the problem, namely that banks are given a monopoly on the ability to create money out of nothing based solely out of someone’s promise to pay it back with interest, the tragic absurdity of our current situation becomes clear:

http://blog.lawsonforcongress.com/2008/07/11/may-you-live-in-interesting-times/

I’m especially grateful, though, for Dr. DiLorenzo’s rebuttal that puts Mr. Gordon’s revisionist history in the proper context:

The system of financial regulatory dictatorship that Gordon praises, and which is about to be forced down the throats of the American public, has been tried before in other countries. During one of its own periodic financial crises, Italian government officials complained bitterly, as Gordon does, of regulation that has been “disorganic” and “case by case, as the need arises.” The Italian regime altered its regulatory system so that it could pursue “certain fixed objectives,” just as Gordon argues for a “unified and coherent regulatory system.” This highly centralized or even dictatorial regulatory system, the Italians argued, would supposedly “introduce order in the economic field” and achieve the goal of “unity of aim” with regard to government regulation of industry.

All of the words in quotation marks in the preceding paragraph, except for the last ones, are the words of Benito Mussolini. The “unity of aim” phrase was from Mussolini apologist/propagandist Fausto Pitigliani. There is, after all, a very keen similarity between Hamiltonian mercantilism — or an economy directed and controlled by government, supposedly “in the public interest” but in reality for the benefit of a privileged few — and the economic fascism of Italy (and Germany) of the 1920s and ’30s.

I encourage you to read the rest of Dr. DiLorenzo’s article, and to evaluate the credentials of those who praise our Federal Reserve and banking system carefully — including my opponent. As with many corporate interests in Washington, the fox has been left guarding the henhouse.

Once you’ve read the explanations of how banking works, you’ll really enjoy the below cartoon (from Sinfest) that beautifully explains the bailout in action:

Ladies and gentlemen, we’ve been jacked.

There has been much discussion about the use of the rebate package passed by Congress and signed by the President to stimulate the economy. B.J. recently covered the topic in his post, “Shiller vs. IMF,” laying out the arguments of those who favor using it and those who oppose it. As with most government initiatives, success is best measured by its unintended consequences:

President Bush Boosts Porn Industry With Economic Stimulus Plan, According to AIMRCo

NEW YORK, July 2 /PRNewswire-USNewswire/ — An unforeseen and surprising beneficiary of the Economic Stimulus Plan, a plan that George Bush contends will “boost our economy and encourage job creation,” has surfaced this week. An independent market-research firm, AIMRCo (Adult Internet Market Research Company), has discovered that many websites focused on adult or erotic material have experienced an upswing in sales in the recent weeks since checks have appeared in millions of Americans’ mailboxes across the country.

According to Kirk Mishkin, Head Research Consultant for AIMRCo, “Many of the sites we surveyed have reported 20-30% growth in membership rates since mid-May when the checks were first sent out, and typically the summer is a slow period for this market.

Jillian Fox, spokeswoman for LSGmodels.com, one of the sites reporting figures to AIMRCo, added, “In a June 15, 2008 survey to our members, thirty two percent of respondents referenced the recent stimulus package as part of their decision to either become a new member, or renew an existing membership.”

The economic stimulus plan, which includes a check for up to $600 for individuals and $1200 for married couples (among other benefits), is the product of an agreement between House leaders and the Bush Administration, focused on reviving a struggling economy in the wake of flagging economy.

Fox also added, “Getting more people to buy porn was probably the last thing Bush had on his mind when he came up with his ’stimulus package,’ but we’ll take it.”

One might reasonably question if the money we borrowed to pay for these “rebates” are going to spur capital investment and wealth creation. Or do these data suggest that we’re simply seeing “Congressmen Gone Wild”?

It appears our incumbent Representative and others in Congress who supported this legislation have succeeded in seeking a short-run economic boost to satisfy their constituents and facilitate their re-election while ignoring — and in fact exacerbating — very serious fundamental and long-run challenges.

Long-run economic growth results from a number of fundamental factors, which include the accumulation of physical capital (which is a function of personal saving in a healthy economy), human capital (which is a function of education), technological advancement, protection of property rights, and a strong legal system. The accumulation of high debt by government necessitates that resources in the future must be redistributed from investment in these productive forces to paying the bills we’re stacking up now, which crushes long-run economic growth.

Furthermore, the building of a large government debt has a number of negative by-products in an international economy. Absorbing private domestic saving necessitates reliance on foreign saving for domestic growth, as well as possibly on foreign purchasing of government bonds to finance deficit spending. When foreign investment decreases and/or leaves the country, which may occur for a number of reasons (market insecurity, a decline of the value of the dollar due to inflationary monetary policy or payment of foreign debt… either of these sound familiar?), then with it goes the source of growth. At this point, interest rates increase with high government borrowing, and the central bank is in a tough spot. It can either inflate to lower interest rates, which will hurt consumers, increase costs for businesses, and decrease returns of investors; or it can do nothing and allow high interest rates to lead to a recession.  In any of these situations, economic growth is either stagnant or significanlty negative in the end. Thus, “stimulus” spending ultimately gives no real economic boost at all.

By creating more debt to “stimulate” the economy, Congress is attempting to rebalance a house of cards and delay its eventual collapse, even at the cost of potentially worsening it. We are delaying action on making hard choices that must be made today to shore up the country’s financial future and are making the these choices much harder for ourselves down the road. A $9.4 trillion national debt — with more hundred-billion deficits and skyrocketing interest payments expected down the road — and $53 trillion in present value of unfunded liabilities are absolutely nothing to ignore. These are phenomena that will wreck the economy much more powerfully than any near-term recession that may come, and they will not go away on their own nor by creating a significant amount of new debt.

Finally, we should note that the “stimulus packages” being in the form of rebates implies somehow a lessened burden of taxation for now to achieve a change in some economic variable. Real tax cuts are cuts in the burden of government on the taxpayers, and as such, they are long-term commitments that allow us and our communities to keep more of their resources.

Cutting taxes in the short-term and continuing deficit spending in no way represent a tax cut, as the government has one of two options to finance remaining spending. It can borrow and accumulate debt, which necessitates either a future tax increase to pay off the debt or a stalling of long-term growth and decline in opportunities available to the future. Or, the government can print money to finance deficits, which causes price inflation that squeezes consumers. As Milton Friedman would say (paraphrasing), “A tax cut is not a tax cut at all without a spending cut.”

Paige Michael-Shetley is the Volunteer Coordinator and Youth Coodinator for Lawson for Congress. He is a Senior at the University of North Carolina at Chapel Hill and is majoring in Economics and Math.

For those who study our financial system, the past few weeks have been interesting, and concerning. I don’t know if it’s possible to overstate my concern for our future — both as citizens as the United States of America, and as inhabitants of a world that is increasingly interconnected yet dependent on a fundamentally flawed financial and monetary system.

If asked to pick one word to describe why I’m running for Congress, that word is sustainability. Sustainability doesn’t mean stability, it doesn’t mean safety, and it doesn’t mean protection from life’s inevitable uncertainties. Sustainability does mean recognizing and obeying the natural laws that govern of our world.

Every branch of science has certain laws: Objects in motion tend to stay in motion; force equals mass times acceleration; every action has an equal and opposite reaction; energy in a closed system cannot be created or destroyed but merely changed in form; and closed systems tend towards increased entropy are a few good examples.

These laws of motion and conservation of energy are not limited to high school physics class. Every system in nature must obey these underlying principles — including our financial and monetary systems.

Let’s start with Newton’s laws of motion — it’s a short hop from there to defining leverage as the ability to move a large object a short distance using a small force exerted over a long distance. Leverage is a concept in finance, as well — using borrowed money to increase returns based upon small underlying price movements. Just as the car lifted with a hydraulic jack can hurt you if it falls, a small price movement in an imprudently leveraged investment can wipe out a lifetime of savings.

Next consider conservation of energy and open versus closed systems. Since energy within a closed system cannot be created or destroyed, and since closed systems tend towards increasing entropy, every growing system must be open to an external energy source. In this setting, one can immediately see problems with our debt-based monetary system.

What is debt-based monetary system? It’s where money is debt, and every dollar in circulation exists because a bank created it out of nothing based upon someone’s promise to pay it back, with interest.

Our economy is an open system relative to money, which is created and destroyed by banks. Banks create the money through loans — but they only create the amount you borrow. They don’t create the interest that you also promise to repay. Where do you get the interest? You have to earn it, but first it has to be created — yes, by someone else borrowing more money that they promise to repay with still more interest.

In the end, our monetary system is like a game of musical chairs — the banks create money based upon someone’s willingness to borrow, and the bank’s ability to lend. The constant demand for new money to repay interest on existing money compels growth and new money creation at an accelerating rate.

Refer to the chart of America’s total debt, which raises obvious questions about sustainability. Trees do not grow to the sky — and when banks cannot lend, or people are no longer willing to borrow, the music stops. When the music stops, there are more loans outstanding than money to repay, so everyone left standing loses whatever they pledged in exchange for their loans. Even worse, money that was created out of nothing through borrowing just as easily disappears back into nothing as asset values plummet — so when the music stops, the chairs start disappearing from the room.

Leverage, debt-based money, fractional reserve banking, and interest are fundamental features of our economic system. Our economic history of boom/bust cycles and decisions dominated by short-term gain as opposed to long-term stewardship are fundamental consequences of this underlying system. In short, our system has undesirable consequences and is fundamentally unstable — but it’s working as designed.

What we are experiencing today is a perfect storm of rising demand for natural resources in the setting of  global growth, a declining domestic currency due to decades of unsustainable debt (= money) creation and spending, coupled with an unfolding credit crisis that has crippled the debt (= money) creation system. What happens next?

I don’t know. Economists and analysts are searching for an analogy to our current position. Are we in the 1970s? Are we Japan in the 1990s? Are we entering the 1930s? Each situation is unique, and this one is no exception. There is evidence that we have experienced “peak credit“, and are popping a credit bubble that has been forming for over 20 years. That is reminiscent of Japan in the 1990s, or the 1930s. We’re also suffering from high energy prices, like the 1970s, although in this case we’re facing global tight supplies in the setting of rising demand.

Today’s news capped off several weeks of concerning developments. Illustrating the danger of leverage, our largest mortgage companies, Freddie Mac and Fannie Mae, are fighting rumors of insolvency:

The companies, Fannie Mae and Freddie Mac, have been hit hard by the mortgage foreclosure crisis. Their shares are plummeting and their borrowing costs are rising as investors worry that the companies will suffer losses far larger than the $11 billion they have already lost in recent months. Now, as housing prices decline further and foreclosures grow, the markets are worried that Fannie and Freddie themselves may default on their debt.

Under a conservatorship, the shares of Fannie and Freddie would be worth little or nothing, and any losses on mortgages they own or guarantee — which could be staggering — would be paid by taxpayers.

The government officials said that the administration had also considered calling for legislation that would offer an explicit government guarantee on the $5 trillion of debt owned or guaranteed by the companies. But that is a far less attractive option, they said, because it would effectively double the size of the public debt.

These companies funded 80% of the mortgages issued in the first half of 2008, and are thus almost fully responsible for supporting the housing market at its current levels. Ready to talk about leverage? In May, Fannie and Freddie had $83 billion in capital supporting over $5 trillion in debt and other obligations. That’s leverage — every dollar in debt is supported by less than two cents.

Here are some excellent commentaries on the dangers of these quasi-federal companies (read: we’re all going to take the hit) that inflate housing prices and define moral hazard:

Former St. Louis Fed President Poole Calls Freddie, Fannie “Insolvent”

Disaster Planning for Freddie and Fannie

Freddie and Fannie: Conservatorship as Endgame?

Fannie and Freddie Waterfalls Are Too Big to Bail

Fannie and Freddie are just the most recent problem to flare up, however. A contraction in the mortgage market was only the beginning — losses are spilling over throughout the economy. As Nouriel Roubini notes, total loss estimates from the credit crisis across all sectors of the economy are up to $1.6 trillion:

As I argued in writings last February such credit losses would be at least $1 trillion and could be as high as $2 trillion, well above the $300 billion of subprime writedowns that have been recognized so far. At that time the $1 trillion estimate was considered as lunatic but by now the IMF estimates these losses at $945 billion, George Magnus of UBS estimated them at $1 trillion; Goldman Sachs put them at $1.1 trillion, the legendary hedge fund manager John Paulson (who made last year $3.5 billion of income on shorting subprime) put them at $1.3 trillion; and a couple of days ago Bridgewater Associates estimated such losses at $1.6 trillion. Thus, as I argued then $1 trillion would be floor, not a ceiling, to such credit losses.

Of course such losses have been in part transferred from US banks to capital market investors and to foreign investors via securitization. But with the entire capital of the US financial system at $1.3 trillion such staggering losses will lead to a systemic banking crisis and systemic financial crisis. No wonder that Bernanke is now telling non-bank primary brokers that the Fed exceptional liquidity support (TAF, TSLF and especially PDCF) will be extended into 2009. And no wonder that Geithner, Paulson and Bernanke have now all three spoken of the need to find orderly ways to let even large and systemically important institutions go bankrupt if they are insolvent.

The consequences of this credit unwinding and a hard landing in the United States have damaging global consequences, as well. This article, again by Nouriel Roubini, outlines why the current international monetary regime known as Bretton Woods 2 could collapse in the wake of an expanding global credit crisis, and our current trade imbalances:

Will the Bretton Wood 2 Regime of fixed and/or heavily managed exchange rates in many emerging market economies collapse in the same way as the Bretton Woods 1 regime (the “dollar standard” regime that ruled after 1945 in the global economy) collapsed in the early 1970s? What are the similarities and differences between those two regimes? It is interesting to note that the same factors – U.S twin deficit, U.S. loose monetary policies and fixed pegs to the U.S. in the dollar standard regime of Bretton Woods (1945-1971) - that led to the commodity inflation and goods inflation in the early 1970s and thus to the demise of the Bretton Woods 1 regime (in the 1971-73 period) are also partially the same factors that are leading now to the rise in commodity and goods inflation in emerging markets that are pegging to the U.S. dollar and/or heavily managing their exchange rates.

Thus, like the rise of commodity and goods inflation led to the demise of BW1 the current rise in commodity and goods inflation in emerging market economies may be the trigger that will lead – as argued in my 2005 BW2 paper with Brad Setser and a more recent 2007 paper of mine – to the demise of BW2. It is true that BW2 is still alive as the massive ongoing reserve accumulation by BRICs, GCC and other emerging markets suggests. But the rise in inflation that these exchange rate policies are causing may soon lead to its demise: abandoning pegs and/or letting currencies appreciate at a faster rate will be the necessary step to control inflation in such emerging market economies.

Every country is between a rock and a hard place:

By now inflation has become so high in so many emerging market economies that – in some dimensions – it is almost too allow these currencies to appreciate: inflation is so high that only an abandonment of pegs or of heavily managed rates and a very sharp nominal exchange rate appreciation would be able to control inflation Even in that case nominal appreciation would not be enough to control expected inflation: a much tighter monetary and credit policy – that is feasible only if enough exchange rate flexibility is allowed – would be necessary to control actual and expected inflation. But now the global economic outlook has much worsened with the US recession and the sharp economic slowdown in most advanced economies. The need to control inflation with a stronger currency and much tighter monetary policy in emerging markets is happening at a time when downside risks to growth are emerging in these countries because of the US recession and the slowdown in the advanced economies growth rate. Thus, emerging market policy makers face a serious dilemma: controlling inflation requires exchange rate flexibility and much tighter monetary and credit policy. But such policy may exacerbate the growth landing of these economies at the time when global conditions are leading to a sharp slowdown of growth in advanced economies that – in due time – will slow down exports and growth of the emerging market economies.

Thus, it is not obvious that the members of BW2 will decide to phase out this regime and move to greater currency flexibility and tighter monetary and credit conditions. Rising oil, energy and food inflation in these economies is already leading to popular unrest, riots and – in some cases – ruling governments being toppled. Thus, the last thing that these economies need is a sharp growth slowdown on top of socially unpopular rising inflation. That is why – while the rational choice would be phasing out BW2, allow greater exchange rate flexibility, regain monetary autonomy, allow currencies to appreciate and tighten monetary/credit conditions – many of these BW2 may be reluctant to follow this painful policy path.

But again, these problems, consequences, and suboptimal “solutions” are simply the result of a suboptimal and unstable system working as designed.

Finally, we must consider these financial instabilities in a world where the fundamental life-giving resources such as food and energy are becoming increasingly precious:

Every Barrel Now Counts: What Prospects for More Oil Supplies?

IEA Medium-Term Outlook

While we complain about high food prices, other countries — some to whom we owe a great deal of money — are seeing riots and social unrest. The bottom line is that food and energy prices are not separate from this economic crisis. They are intimately related, for two reasons.

First, food and energy are fundamentally equivalent even beyond irrational corn ethanol subsidies. By some estimates, our unsustainable system of industrial agriculture requires 10 calories of fossil fuels for each one food calorie produced. What happens as fossil fuels become more expensive based upon growing global demand against finite supplies?

Second, many countries with food and fuel inflation high enough to spark riots and social unrest, and to whom we owe a lot of money, are keeping their currency artificially low against our dollar to stimulate exports. What happens if the pain of social unrest in China is great enough for them to abruptly let their currency float?

A rapid strengthening of China’s currency would reduce the value of their $1.4 trillion in dollar holdings. On the other hand, such a rapid appreciation would give them an instant discount on their dollar-denominated commodities such as fuel and fertilizer, and is the ultimate solution to their price inflation.  What would be the consequence for us, however, as high prices causing riots and social instability abroad transfer to our shores?

Mutually assured destruction did not end with the Cold War — our position in the global economy can also be described as mutually assured economic destruction.

We need principled leadership that recognizes the root causes behind the threats we face, and we need a government that empowers us to build a sustainable society. Such sustainability has not, and cannot, come from a federal government that consolidates power, exceeds its Constitutional authority, and serves corporate and special interests.

Critically, we must recognize that our economic, energy, environmental, and agricultural policies do not operate in isolation — they are all related, and they all exist on the foundation of an unstable monetary system that bring us to this precarious situation. We live in interesting times.

Robert J. Shiller is professor of economics and finance at Yale and co-founder and chief economist of MacroMarkets LLC. He also authored an article over the weekend in the New York Times this weekend arguing that “One Rebate Isn’t Enough”. Here are some key quotes:

TAX rebates have been arriving in bank accounts and mailboxes, and will eventually put more than $100 billion into the hands of consumers. The hope is that by spending the money, they will lessen the risk of economic disaster from the subprime crisis.

The theory supporting tax rebates was originally devised by John Maynard Keynes, one of the most influential economists of the last century. In 1931, during the Great Depression, he compared the economy to a stalled car. (The car, he said, had “magneto trouble,” referring to a device once commonly used in automobiles to generate an electric spark for ignition.)

In Keynes’s analogy, when an engine is running properly, each stroke of a piston gets the next piston ready to fire, which in turn gets another piston ready, in rapid sequence. Similarly, he said, when the economy is functioning properly, each time someone spends money, he provides income for another person, causing that person to spend money, and so on.

What was needed in the dysfunctional economy of the 1930s was a government stimulus to get things started again. Keynes referred to the additional rounds of expenditure, set off by the initial stimulus, as “repercussions,” and to their total effect as the “multiplier.”

But people who have studied such models find that these repercussions aren’t powerful enough unless the initial stimulus is really large. Consider the Fair simulation model (fairmodel.econ.yale.edu/main2.htm), a free Web site that embodies much of Keynes’s theory and is offered by Professor Ray C. Fair of Yale. With the “U.S. Model” on this site, I increased transfers from government to households (“TRGH”) by $100 billion in the second quarter of 2008. The results showed a $59 billion increase in 2008 gross domestic product. That is less than half of 1 percent of G.D.P.

The reality of the subprime situation, augmented by the energy crisis, at least suggests that we’d better get ready for another round of rebates. There is little talk of it now, but we should be putting in place another stimulus package like the current one, and stand ready for another after that, and another.

Let’s think about that for a moment. Our government is deeply in debt, and the declining value of our dollar on international markets reflects the fact that we’ve been borrowing and printing a lot of money. Now we have a decorated economist advancing the discredited Keynesian economic theory that we can “print our way to prosperity” — just by reloading the monetary guns and firing a few more times, we can spend our way through this latest crisis.

Well, if Keynes isn’t fully discredited yet, he will be once we listen to Prof. Shiller.

It’s true the American people do need more money, and they must keep more of what they earn. But it’s not just the money — it’s what the money will buy. We can try following Shiller’s advice of borrowing and printing a few hundred billion more dollars to throw at the American consumer, and it will be interesting to see what those dollars will buy in terms of gas and food at the end of that exercise.

If it were possible to “stimulate” the economy by printing money, Zimbabwe would be the richest nation on the planet.

Such suggestions, coupled with the mismanagement of our economy by the Federal Reserve, should give Americans pause as we consider our place in the global economic order. Is there anyone who will stand up to the destructive policies of our own government and financial system?

Well, it’s just been reported that we have finally acquiesced to undergo a Financial Sector Assessment Program by the International Monetary Fund:

Officials with the International Monetary Fund (IMF) have informed Bernanke about a plan that would have been unheard-of in the past: a general examination of the US financial system. The IMF’s board of directors has ruled that a so-called Financial Sector Assessment Program (FSAP) is to be carried out in the United States. It is nothing less than an X-ray of the entire US financial system.

As part of the assessment, the Fed, the Securities and Exchange Commission (SEC), the major investment banks, mortgage banks and hedge funds will be asked to hand over confidential documents to the IMF team. They will be required to answer the questions they are asked during interviews. Their databases will be subjected to so-called stress tests — worst-case scenarios designed to simulate the broader effects of failures of other major financial institutions or a continuing decline of the dollar.

Under its bylaws, the IMF is charged with the supervision of the international monetary system. Roughly two-thirds of IMF members — but never the United States — have already endured this painful procedure.

The IMF has a long history of taking away irresponsible governments’ credit cards, and enforcing so-called “austerity measures” on the people of developing nations. I can imagine what they’d have to say about Shiller’s Theory of Repeated Stimulations.

I don’t consider an IMF assessment to be good news, however. It should concern all Americans who value national sovereignty, and economic sovereignty.

There’s one silver lining in the IMF investigation, at least for President Bush’s legacy. According to the article:

For seven years, US President George W. Bush refused to allow the IMF to conduct its assessment. Even now, he has only given the IMF board his consent under one important condition. The review can begin in Bush’s last year in office, but it may not be completed until he has left the White House.

In a previous post, we discussed the hazards (moral and otherwise) of fractional reserve banking. Once you understand fractional reserve banking, you understand why we need a central bank.

When you have a fractional reserve banking system, each bank is technically insolvent in that it cannot meet all of its depositors’ demands for their money. If all holders of demand deposits came to the bank to withdraw their funds, the run on the bank would force the bank to close down. It’s only the depositor’s confidence that the money will be there that keeps the bank in business.

Since that confidence proves shaky — witness the case of Northen Rock, or even Bear Stearns — the idea of “reserve pooling” gradually arose. The idea is that if an individual bank runs into trouble, other banks can temporarily lend it funds to meet its demands. The endgame for reserve pooling, however, is a single bank that has the power to arbitrarily create money — the central bank.

Our central bank, the Federal Reserve, was commissioned in 1913. It is not federal, and is owned by its member banks. The Federal Reserve interacts with the banking system in a simple but important way — it is the “lender of last resort”. That means that when a bank runs into trouble, the Federal Reserve will be there to bail it out, or orchestrate a merger or other transaction that will prevent collapse of the institution, or the entire system.

How does the Federal Reserve do its job? Today’s Federal Reserve is best known for setting the so-called “Fed Funds Rate“, or the price at which banks borrow money from each other overnight. Why would banks borrow from each other? One reason is to meet reserve requirements. If you own a bank, and make a new car or mortgage loan, you create new money for that loan in your borrower’s demand deposit account. You don’t need to have enough “reserves” in advance to make that loan, however — you can just borrow the necessary reserves in an overnight loan from other banks, and you should expect to pay close to the Federal Reserve’s target rate.

The Federal Reserve manages this interest rate by so-called “open market operations“, where the Federal Reserve buys and sells securities in an effort to keep interest rates close to its target. Right now, the Federal Reserve’s “Fed Funds Rate” is set at 2%. When banks are unwilling to lend to each other, and rates creep upwards, the Federal Reserve will add reserves to drive that interest rate down towards its target. Even if banks don’t have surplus reserves to lend, the Federal Reserve will still work to ensure that banks can borrow reserves at its target rate.

So what’s the problem with this system? Well, let’s take the words “add reserves”. The Fed “adds reserves” by purchasing debt, or providing a loan against debt (called a repurchase agreement, or repo).

When the Federal Reserve purchases debt from our government, or provides a loan against debt for a bank, it pays for that debt in Federal Reserve Notes. Where does the Federal Reserve get its Federal Reserve Notes? Well, the Federal Reserve has the unique ability to create new ones. In other words, the Fed has the ability to write a worthless check, and create new money.

Besides the moral issue of letting our central bank create new money that competes with money you’ve earned for goods and services, does this system really make sense?

No, it does not. Many people believe that in order for a bank to make a loan, someone must have first saved money, and made a deposit. That’s simply not true. When the Federal Reserve sets the interest rate at which banks can borrow to meet their reserve requirements, banks compete to make loans and create new paper money based upon their cost of borrowing, as opposed to the amount of reserves they have on deposit. Practically speaking, banks are limited in the amount of loans they can make based upon capital requirements, not reserve requirements.

In addition to the Federal Reserve’s ability to create money to lend to banks is the Federal Reserve’s ability to create money to give to our government. Our United States Treasury is constantly issuing new debt — we’re a “payday lender” nation whose government is constantly rolling over old debt into new debt, and issuing additional debt to pay for our constant budget deficits. Who buys all this debt?

Lots of people, and lots of institutions, purchase our Treasury’s debt. Many of these investors are overseas. The Federal Reserve also purchases our Treasury’s debt. But when the Federal Reserve purchases our government’s debt, unlike you or me, the Fed can give the Treasury a check with no money in the checking account. While you would be charged with fraud for writing worthless checks, it’s business as usual at the Federal Reserve. The Fed’s “checks” simply create new dollars in the Treasury’s checking account.

Money doesn’t grow on trees any more — it’s even easier than that. The Treasury just needs to sell some bonds, and if there aren’t enough willing purchaser with existing dollars, the Federal Reserve creates new electronic money to make up the difference.

So why do we have inflation? One important factor is the Federal Reserve’s new money competing with your earnings and savings for goods and services. Ultimately, our flawed system makes everyone’s dollar worth less.

While the American worker and saver gets hurt by this arrangement, who benefits?

Consider the banks — banks are protected from failure by a central bank that can create money out of nothing. Furthermore, this perception of “stability” allows banks to create loans out of nothing, backed with minimal reserves, and thus claim an ever-greater share of borrowers’ future income through interest payments. More loans leads to more profits — it’s definitely a winner for the banks.

Consider our government — politicians can make promises that we can’t begin to afford, but our central bank’s ability to create money to buy our government’s debt means that politicians can spend obscene amounts of money without raising taxes. Instead, they simply borrow and print new money. As long as the American public is unaware that government benefits are paid for by newly-printed money, and don’t understand the link with rising prices, this system is tolerated. Even the mainstream media is widely ignorant of how this system works.

But the dynamics are changing. We can no longer ignore gas prices, and grocery bills. We can no longer ignore the future costs that our children face. A speech on May 28 entitled “Storms on the Horizon” by Dallas Federal Reserve President and CEO Richard Fisher (world government fans unite — check out his biography in Spanish!) paints a surprisingly realistic picture:

Tonight, I want to talk about a different matter. In keeping with Bill Martin’s advice, I have been scanning the horizon for danger signals even as we continue working to recover from the recent turmoil. In the distance, I see a frightful storm brewing in the form of untethered government debt. I choose the words—“frightful storm”—deliberately to avoid hyperbole. Unless we take steps to deal with it, the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets that we are now working so hard to correct.

You might wonder why a central banker would be concerned with fiscal matters. Fiscal policy is, after all, the responsibility of the Congress, not the Federal Reserve. Congress, and Congress alone, has the power to tax and spend. From this monetary policymaker’s point of view, though, deficits matter for what we do at the Fed. There are many reasons why. Economists have found that structural deficits raise long-run interest rates, complicating the Fed’s dual mandate to develop a monetary policy that promotes sustainable, noninflationary growth. The even more disturbing dark and dirty secret about deficits—especially when they careen out of control—is that they create political pressure on central bankers to adopt looser monetary policy down the road. I will return to that shortly. First, let me give you the unvarnished facts of our nation’s fiscal predicament.

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Doing deficit math is always a sobering exercise. It becomes an outright painful one when you apply your calculator to the long-run fiscal challenge posed by entitlement programs. Were I not a taciturn central banker, I would say the mathematics of the long-term outlook for entitlements, left unchanged, is nothing short of catastrophic.

Typically, critics ranging from the Concord Coalition to Ross Perot begin by wringing their collective hands over the unfunded liabilities of Social Security. A little history gives you a view as to why. Franklin Roosevelt originally conceived a social security system in which individuals would fund their own retirements through payroll-tax contributions. But Congress quickly realized that such a system could not put much money into the pockets of indigent elderly citizens ravaged by the Great Depression. Instead, a pay-as-you-go funding system was embraced, making each generation’s retirement the responsibility of its children.

Now, fast forward 70 or so years and ask this question: What is the mathematical predicament of Social Security today? Answer: The amount of money the Social Security system would need today to cover all unfunded liabilities from now on—what fiscal economists call the “infinite horizon discounted value” of what has already been promised recipients but has no funding mechanism currently in place—is $13.6 trillion, an amount slightly less than the annual gross domestic product of the United States.

Demographics explain why this is so. Birthrates have fallen dramatically, reducing the worker–retiree ratio and leaving today’s workers pulling a bigger load than the system designers ever envisioned. Life spans have lengthened without a corresponding increase in the retirement age, leaving retirees in a position to receive benefits far longer than the system designers envisioned. Formulae for benefits and cost-of-living adjustments have also contributed to the growth in unfunded liabilities.

The good news is this Social Security shortfall might be manageable. While the issues regarding Social Security reform are complex, it is at least possible to imagine how Congress might find, within a $14 trillion economy, ways to wrestle with a $13 trillion unfunded liability. The bad news is that Social Security is the lesser of our entitlement worries. It is but the tip of the unfunded liability iceberg. The much bigger concern is Medicare, a program established in 1965, the same prosperous year that Bill Martin cautioned his Columbia University audience to be wary of complacency and storms on the horizon.

Medicare was a pay-as-you-go program from the very beginning, despite warnings from some congressional leaders—Wilbur Mills was the most credible of them before he succumbed to the pay-as-you-go wiles of Fanne Foxe, the Argentine Firecracker—who foresaw some of the long-term fiscal issues such a financing system could pose. Unfortunately, they were right.

Please sit tight while I walk you through the math of Medicare. As you may know, the program comes in three parts: Medicare Part A, which covers hospital stays; Medicare B, which covers doctor visits; and Medicare D, the drug benefit that went into effect just 29 months ago. The infinite-horizon present discounted value of the unfunded liability for Medicare A is $34.4 trillion. The unfunded liability of Medicare B is an additional $34 trillion. The shortfall for Medicare D adds another $17.2 trillion. The total? If you wanted to cover the unfunded liability of all three programs today, you would be stuck with an $85.6 trillion bill. That is more than six times as large as the bill for Social Security. It is more than six times the annual output of the entire U.S. economy.

Why is the Medicare figure so large? There is a mix of reasons, really. In part, it is due to the same birthrate and life-expectancy issues that affect Social Security. In part, it is due to ever-costlier advances in medical technology and the willingness of Medicare to pay for them. And in part, it is due to expanded benefits—the new drug benefit program’s unfunded liability is by itself one-third greater than all of Social Security’s.

Add together the unfunded liabilities from Medicare and Social Security, and it comes to $99.2 trillion over the infinite horizon. Traditional Medicare composes about 69 percent, the new drug benefit roughly 17 percent and Social Security the remaining 14 percent.

What do we do about that? How can we begin to “fund” a $99 trillion liability?

Let’s say you and I and Bruce Ericson and every U.S. citizen who is alive today decided to fully address this unfunded liability through lump-sum payments from our own pocketbooks, so that all of us and all future generations could be secure in the knowledge that we and they would receive promised benefits in perpetuity. How much would we have to pay if we split the tab? Again, the math is painful. With a total population of 304 million, from infants to the elderly, the per-person payment to the federal treasury would come to $330,000. This comes to $1.3 million per family of four—over 25 times the average household’s income.

Clearly, once-and-for-all contributions would be an unbearable burden. Alternatively, we could address the entitlement shortfall through policy changes that would affect ourselves and future generations. For example, a permanent 68 percent increase in federal income tax revenue—from individual and corporate taxpayers—would suffice to fully fund our entitlement programs. Or we could instead divert 68 percent of current income-tax revenues from their intended uses to the entitlement system, which would accomplish the same thing.

Suppose we decided to tackle the issue solely on the spending side. It turns out that total discretionary spending in the federal budget, if maintained at its current share of GDP in perpetuity, is 3 percent larger than the entitlement shortfall. So all we would have to do to fully fund our nation’s entitlement programs would be to cut discretionary spending by 97 percent. But hold on. That discretionary spending includes defense and national security, education, the environment and many other areas, not just those controversial earmarks that make the evening news. All of them would have to be cut—almost eliminated, really—to tackle this problem through discretionary spending.

I hope that gives you some idea of just how large the problem is. And just to drive an important point home, these spending cuts or tax increases would need to be made immediately and maintained in perpetuity to solve the entitlement deficit problem. Discretionary spending would have to be reduced by 97 percent not only for our generation, but for our children and their children and every generation of children to come. And similarly on the taxation side, income tax revenue would have to rise 68 percent and remain that high forever. Remember, though, I said tax revenue, not tax rates. Who knows how much individual and corporate tax rates would have to change to increase revenue by 68 percent?

If these possible solutions to the unfunded-liability problem seem draconian, it’s because they are draconian. But they do serve to give you a sense of the severity of the problem. To be sure, there are ways to lessen the reliance on any single policy and the burden borne by any particular set of citizens. Most proposals to address long-term entitlement debt, for example, rely on a combination of tax increases, benefit reductions and eligibility changes to find the trillions necessary to safeguard the system over the long term.

No combination of tax hikes and spending cuts, though, will change the total burden borne by current and future generations. For the existing unfunded liabilities to be covered in the end, someone must pay $99.2 trillion more or receive $99.2 trillion less than they have been currently promised. This is a cold, hard fact. The decision we must make is whether to shoulder a substantial portion of that burden today or compel future generations to bear its full weight.

OK, so if we can’t cut spending, and if we can’t increase taxes, are there other options?

Now that you are all thoroughly depressed, let me come back to monetary policy and the Fed.

It is only natural to cast about for a solution—any solution—to avoid the fiscal pain we know is necessary because we succumbed to complacency and put off dealing with this looming fiscal disaster. Throughout history, many nations, when confronted by sizable debts they were unable or unwilling to repay, have seized upon an apparently painless solution to this dilemma: monetization. Just have the monetary authority run cash off the printing presses until the debt is repaid, the story goes, then promise to be responsible from that point on and hope your sins will be forgiven by God and Milton Friedman and everyone else.

We know from centuries of evidence in countless economies, from ancient Rome to today’s Zimbabwe, that running the printing press to pay off today’s bills leads to much worse problems later on. The inflation that results from the flood of money into the economy turns out to be far worse than the fiscal pain those countries hoped to avoid.

Earlier I mentioned the Fed’s dual mandate to manage growth and inflation. In the long run, growth cannot be sustained if markets are undermined by inflation. Stable prices go hand in hand with achieving sustainable economic growth. I have said many, many times that inflation is a sinister beast that, if uncaged, devours savings, erodes consumers’ purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency.

Purging rampant inflation and a debased currency requires administering a harsh medicine. We have been there, and we know the cure that was wrought by the FOMC under Paul Volcker. Even the perception that the Fed is pursuing a cheap-money strategy to accommodate fiscal burdens, should it take root, is a paramount risk to the long-term welfare of the U.S. economy. The Federal Reserve will never let this happen. It is not an option. Ever. Period.

Mr. Fisher, I wish I could believe you. Based upon the performance of our dollar against other currencies, it appears that we are doing exactly that. In fact, Alan Greenspan was asked about the problem of how we could meet our Social Security obligations back in 2005. His response at the time? “We can guarantee cash, but we cannot guarantee purchasing power!” In other words, we can print the money, but it won’t buy anything.

Odds are, despite Mr. Fisher’s wishes, we keep borrowing and printing. As Mr. Fisher concluded his speech:

Of late, we have heard many complaints about the weakness of the dollar against the euro and other currencies. It was recently argued in the op-ed pages of the Financial Times [3] that one reason for the demise of the British pound was the need to liquidate England’s international reserves to pay off the costs of the Great Wars. In the end, the pound, it was essentially argued, was sunk by the kaiser’s army and Hitler’s bombs. Right now, we—you and I—are launching fiscal bombs against ourselves. You have it in your power as the electors of our fiscal authorities to prevent this destruction. Please do so.

Mr. Fisher, you are correct. We do have the power to prevent this destruction. The cause of this destruction is the system itself. We cannot afford a debt-backed monetary system controlled by a private central bank that creates money out of nothing — thus facilitating unrestrained spending by politicians interested only in their re-election.

Coupling an unstable banking and monetary system with a government that gives favors in exchange for growing its power is a recipe for collapse into tyranny.

I’ve been struggling with a blog post to outline my concerns with our economy in light of the challenges in the housing and credit markets. Two excellent books, Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash and Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, are timely additions to the dialog that explore the financial market’s “innovations” behind our current boom/bust cycle. However, as great as these books are at explaining the immediate cause of our difficulties, neither of them get to the root of the problem that has plagued our financial system, and economy, for generations.

Beyond the headlines of “writedowns” and management turnovers, the problems in today’s financial industry ultimately stem from its unstable, and many would say immoral, foundation. That foundation is “fractional reserve banking”.

What, exactly, is fractional reserve banking? Quite simply, it’s where banks lend more money than their depositors have given them for that purpose. Perhaps the best way to explain it is to talk about how “honest” banking would work, and then highlight the differences.

Broadly speaking, banks serve two customer needs: safeguarding wealth for the depositor’s peace of mind and convenience, and matching up savers who want to lend money with borrowers who want to borrow money. Those purposes are completely separate, and should not be confused. However, the temptation to confuse them in pursuit of greater profit has always led the banking industry to a precarious state.

In the world of “honest banking”, banks recognize two types of deposits, demand deposits and time deposits:

• Demand deposits, as the name implies, are available “on demand” and reflect the bank serving the customer’s first need: safeguarding wealth for peace of mind and convenience. Since the bank is offering this service, the customer should expect to pay for the safety and convenience offered by a demand deposit (or typical checking account). The customer expects that her money is always available, and effectively “in the vault”.
• Time deposits, in contrast, are not available on demand. They are savings that the depositor is looking to invest, and use to earn income. The simplest example of a time deposit is a Certificate of Deposit, or CD. CDs pay an interest rate, and the funds in a CD are returned with interest after a certain period of time. With a CD, the money is not available for immediate withdrawal. In fact, the customer expects that the money is not “in the vault” — she can’t access the funds until the CD matures since the money is literally “out working”, and being used to create value by another customer who borrowed it through a loan.

From the descriptions above, you can imagine that a bank’s income would come from two sources: fees for offering demand deposits, and the difference between interest paid to savers (who lend the bank money) and received from borrowers (who borrow money from the bank). That’s pretty much the way banking should work. Unfortunately, however, it doesn’t.

You see, unscrupulous bankers throughout history realized that they could increase their profits by loaning out their demand deposits as well as their time deposits. You can easily see the temptation — as long as most customers don’t ask for all their money out of their checking accounts, what’s the harm in loaning out some of that demand deposit money and earning interest for the bank? No one will know the difference, and it’s a profitable risk to take.

Even better, once merchants began accepting checks or receipts from this banker instead of the underlying “money” (whatever it was) itself, the banker began to realize that he could create even more loans. Who will know, if the community accepts the bank’s receipts as money? Suddenly the bank is no longer just in the business of storing money, and matching lenders and borrowers. Now the bank is in the business of falsely creating new money when a customer takes out a loan.

The problem is that eventually, inevitably, the bank’s customers get suspicious — perhaps in the face of rising prices, as new money floods the local economy. The customers realize that the bank has more receipts, or checks, outstanding than it can possibly cover. Once the bank’s customers lose confidence, they all show up and demand their money. The bank, of course, doesn’t have enough money to honor all the claims, so the depositors are left in the lurch. This “run on the bank” reveals the deception, and exposes the fractional reserve bank as an inherently bankrupt institution.

From a social perspective, what are the consequences of the banking industry creating new money (at essentially zero cost), only to loan it to you with interest? When the bank creates “money”, is it actually creating value? The answer is no — the banking industry is not creating value when it creates new money to fulfill a loan. In fact, the bank’s new money is taking value from everyone else by reducing the purchasing power of everyone’s savings, investments, and earnings.

You’d think that after generations of repeating the same pattern of booms, busts, and bank failures, we’d put control, and the rule of law, firmly on the side of the customers whose assets form the basis of society’s prosperity. You’d think that fractional reserve banking would be illegal, and those who fraudulently make multiple loans against the same money, or loan out money that already has another claim against it, would be liable for civil or criminal prosecution. In fact, even the Bible warns against this practice, termed “multiple indebtedness”:

If you ever take your neighbor’s garment as a pledge, you shall return it to him before the sun goes down. For that is his only covering, it is his garment for his skin. What will he sleep in? And it will be that when he cries to Me, I will hear, for I am gracious (Exodus 22:26-27)

This verse is talking about the prohibition of interest in loans to poor fellow believers, also known as usury. In this case, the borrower is so poor that his cloak is his collateral. While this is not a business loan, it’s still important, and acceptable, that the borrower offer collateral — even something as humble as his cloak. The fact that this impoverished borrower physically gives the cloak to the lender during the day is protection against the borrower being corrupt at heart — the borrower cannot make the rounds of moneylenders, securing loans out of sympathy from each, and pledging his coat multiple times as collateral. Since only one lender can hold the cloak, there can be only one loan made against it.

As a matter of common sense, and as a matter of morality, it’s wrong (and typically prohibited) to secure multiple loans with the same piece of collateral.

So how does the concept of multiple indebtedness relate to banks? In the same way that the poor man should not defraud lenders by taking out multiple loans on the same piece of collateral, banks should not defraud their customers by creating multiple loans against the same money, or loaning out money that already has another claim against it.

In a nutshell, that’s the problem with our financial system. If a pawnbroker were to make loans against family heirlooms with counterfeit paper currency photocopied in his office, he would be arrested. But when the bank gives you a mortgage against your house, and creates a new deposit in your checking account that’s only partially backed by depositors’ money, the bank has created new money just as certainly as the pawnbroker with counterfeit bills.

For an entertaining description of fractional reserve banking and its interaction with paper money, watch this video:

While this video does an excellent job of showing the problems with our current system, there’s still much discussion to be had on proposed solutions. But we need to begin an honest discussion as we look towards the future.

On a more humorous note, here’s a great video on the Northern Rock bank failure in Great Britain:

Next, we’ll explore how the Federal Reserve and our government attempt to keep this fragile system intact.

A poster child for bad legislation is H.R. 2419, the Food and Energy Security Act of 2007 — better known as the Farm Bill.

In a rare feat of bipartisanship, the House and Senate passed the final version last week by a veto-proof majority. Amazingly, details of this legislation are still coming to light. Given that the bill itself is 673 pages long, it’s not surprising that there wasn’t time to read it between horse trading in conference committee and the final votes.

I have four objections the Farm Bill, besides the simple fact that it is an unconstitutional disruption of our nation’s food supply, with negative global implications.

The first concern is the premise behind agricultural subsidies. We’re all familiar with rising grocery bills, and we’re feeling the impact of global commodity prices near all-time highs. The Farm Bill essentially “locks in” these high prices by setting subsidy payments for 2009 based upon today’s record levels:

Since the amount of the subsidy for 2009 is tied to recent record prices, farmers could reap a windfall if prices drop suddenly.

“I don’t think many people on the House side who voted for the farm bill realized there were $16 billion in potential higher costs in there,” said Deputy Secretary of Agriculture Charles F. Conner. “The budget exposure is tremendous.”

A blog item posted Monday by the agricultural magazine Pro Farmer described the new program, known as Average Crop Revenue Election (ACRE), as “lucrative beyond expectations,” and said it is a “no brainer” for farmers to sign up for it.

The Agriculture Department estimates that subsidy payments to corn farmers alone could reach $10 billion a year if prices — which have been $5 to $6 a bushel — were to drop to $3.25 a bushel, a level seen as recently as last year. The $10 billion figure assumes most farmers would participate in the program, a view disputed by key lawmakers.

Think about it — the government has locked in today’s high prices so that we’ll be borrowing and printing money to subsidize farmers even if prices were to decline to year-ago levels. Does that make sense?

But that’s just the impact on our country. What do these farm subsidies do to the rest of the world, and the ability of other nations to feed themselves?

LAST week, both Houses in the United States Congress passed a Farm Bill that continues the present system of high agricultural subsidies, rewarding big farmers that have already gotten much richer because of the recent hike in food prices.

This is a real pity, even a scandal, because the US farm subsidies are the main cause (together with the subsidies in Europe and Japan) of the greatest distortion in world trade.

The subsidies enable high-cost farmers and food companies to sell their products at below the cost of production and unfairly beat off the products of farmers in developing countries that don’t have the same kind of money to subsidise.

Many developing countries around the world have been importing artificially cheapened imported rice, wheat, corn, and chicken from the US and Europe.

Their own small farmers, which are often more efficient than those in the rich countries, have been displaced by these subsidised imports – one reason why agriculture has fallen in many developing countries, making them vulnerable to the present crisis of food shortages and high prices.

While our subsidies might benefit foreign consumers when prices are low, as prices have risen rapidly, developing nations’ lack of domestic agriculture leaves them exceedingly vulnerable to supply disruptions.

My third objection is Department of Homeland Security’s slipping in an unrelated power grab to bring Foot and Mouth Disease research onshore, and taking control of that transition from the Department of Agriculture:

Lawmakers on Wednesday tentatively agreed that national security officials should fully control the expected transfer of research of highly contagious foot-and-mouth disease from an offshore laboratory to the U.S. mainland near livestock.

The Bush administration requested the legal change, which would erode the traditional role of the Agriculture Department in deciding the safest location to research one of the world’s most contagious animal viruses. The virus does not infect humans but could devastate livestock herds.

House and Senate conferees, negotiating a major farm bill, agreed to the administration’s wishes to place the Homeland Security Department in full control of the transfer, according to two Senate sources who demanded anonymity because conferees were not ready to announce their agreements.

I object to moving this research in close proximity to agriculture and large population centers from its current island-based location. Regardless of my opinion, however, it is a controversial issue that deserves to be debated separately. Here’s one more reason to embrace the One Subject at a Time Act.

The final problem with the Farm Bill is the pork:

Individual lawmakers, mostly senators, slipped several dozen “earmarks,” or pet causes, into the $290 billion bill that have at best tentative connections to the tilling of the land. There’s tax breaks for horse owners, water for Nevada desert lakes, aid for the Pacific Coast salmon fishery industry and a crackdown on puppy trafficking.

Rep. Jeff Flake, R-AZ, a leading opponent of earmarks, complained that some had been “airdropped in” at the last minute. “If you dig into them, you might find something untoward. You might not, but the fact is we don’t have time to do that.”

Note Rep. Flake’s frustration about not even being able to read the bill. As a physician, if I sign off on a report or study without reading it, I could easily be sued for malpractice. Congress routinely passes legislation that is not read, nor even readable in the time provided. Congress desperately needs some help in this regard — I support the Read the Bills Act, which would require that Congress actually read legislation before voting.

The Farm Bill is expected to cost $300 billion. Our Rep. David Price voted Yes — perhaps he didn’t read it, or perhaps he erroneously believes we can afford it.

We may not be able to sue Rep. Price for malpractice, but we can certainly express our desire for change in November.

Our three children are not economists, but they understand that going shopping with $14 means that they can’t afford something that costs $16. There’s simply not enough money.

David Price, however, has built a legislative career embracing the “gimme now” philosophy: if you can’t afford it, simply borrow and print the dollars necessary to make up the difference.

Two months ago, Rep. Price voted in favor of House Concurrent Resolution 312, which is a planning document that sets priorities for discretionary spending and annual budgeting over the next five years. This budgetary plan projects federal income of $14 trillion, yet plans to spend $16 trillion.

And that missing $2 trillion? More debt.

It’s been said that failing to plan is planning to fail. Our legislators are not failing to plan, however, they’re just flat-out planning to fail. In fact, they’re so committed to failing, that they even celebrate the fact that they’re completely divorced from reality. Here’s Rep. Price’s statement on this particular vote:

“This budget is a clear reflection of our priorities to build a stronger economy, keep our communities safe, and to do both in a fiscally responsible way,” Price said. “After President Bush and the Republican Congress turned projected surpluses into record deficits, this Congress is committed to reversing the damage.

Let’s see if I understand: throw some divisive partisan rhetoric out there, and claim that our massive fiscal irresponsibility is actually “responsible”. If we claim that we’re “reversing the damage”, perhaps we’ll escape blame for the inevitable damage that results when we can’t find foreigners willing to buy this next $2 trillion in debt.

The good news for our country, and our future, is that the people are beginning to discover the truth. It’s not a partisan issue — with gas prices and grocery bills heading up, people are beginning to understand that there are real consequences with the federal government borrowing and printing all this money. Yes, that’s right — when the government creates new money to pay for spending we can’t afford, the dollars you earn and save are less valuable due to the inflation our government itself creates.

It’s time to reject the “gimme now” school of economics. Our children deserve better, and David Price needs to understand that his well-meaning but misguided attempts to “help” are only making things worse for working Americans.

We simply can’t afford The Price.

I’ve dissected the credit crisis in previous posts since last August, and outlined the bureaucratic overreach that we can expect as a result:

http://blog.lawsonforcongress.com/2008/02/24/mortgage-fun-and-games/

http://blog.lawsonforcongress.com/2007/12/19/a-review-of-the-mortgage-crisis/

http://blog.lawsonforcongress.com/2007/12/09/unintended-consequences/

http://blog.lawsonforcongress.com/2007/11/19/whered-the-money-go/

http://blog.lawsonforcongress.com/2007/08/30/obamas-gonna-fix-it/

Since then, we’ve witnessed the Bear Stearns debacle, where a bankrupt investment bank will have its trading losses covered by the Federal Reserve for up to $29 billion in taxpayer dollars. Clearly, these actions illustrate that the Federal Reserve puts the interest of Wall Street well ahead of Main Street. Even worse, these actions open a pandora’s box where further bailouts will be justified and expected.

So what is a bailout, anyway? Essentially, the government (through the Federal Reserve) is using its ability to create money out of thin air. This new money is given to those affected either directly or in the form of “loans” backed by questionable assets. That new money from the Federal Reserve enters into the banking system, and competes with your hard-earned dollars for goods and services. Did the Federal Reserve give you your Bailout Bucks today? If not, you suffer from the higher prices that result as your dollars purchase fewer goods and services.

Our financial system is broken. The inherent instabilities we’ve been experiencing are a symptom of a debt-based paper currency that’s managed by a money monopoly headed by our nation’s third central bank, the Federal Reserve. The Federal Reserve’s shareholders are its member banks, so it is owned by the banking industry. Furthermore, the Federal Reserve also regulates the banking industry. Talk about the fox guarding the henhouse.

The Federal Reserve has been widely implicated in the financial crises that have afflicted our economy since its founding in 1913, starting with the Great Depression. Here’s a recent apology for the Great Depression from our own Ben Bernanke:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

The “Anna” mentioned in Bernanke’s apology is revered economist Anna Schwartz. Dr. Schwartz doesn’t seem too impressed with the apology, as this past January she publicly blamed the Federal Reserve for its creation and mismanagement of the current credit crisis:

The high priestess of US monetarism - a revered figure at the Fed - says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. “The new group at the Fed is not equal to the problem that faces it,” she says, daring to utter a thought that fellow critics mostly utter sotto voce.

	Anna Schwartz wrote a seminal text on the causes of the Great Depression

“They need to speak frankly to the market and acknowledge how bad the problems are, and acknowledge their own failures in letting this happen. This is what is needed to restore confidence,” she told The Sunday Telegraph. “There never would have been a sub-prime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for,” she says.

The Federal Reserve’s ability to create new money and allow the government to live beyond its means without raising taxes is the primary driver of inflation — you’ve noticed this recently if you’ve been watching your grocery and gas bills. Indeed, since the Federal Reserve was founded in 1913, its $1 Federal Reserve Note (a.k.a our dollar) now requires $21.38 to purchase the equivalent goods (by the government’s own optimistic estimates). So much for a stable currency.

Given this mess, one would think that we’d finally be ready to ask questions about how to arrange an alternative to the current system. Instead, Treasury Secretary Henry Paulson and the Bush administration propose to give us more of the same — more regulatory powers to the Federal Reserve, more bailouts for its friends on Wall Street, and higher prices for working American families.

Not surprisingly, the Wall Street crowd is singing its praises:

Wall Street’s main lobby group, the Securities Industry and Financial Markets Association, embraced Paulson’s proposals. “Our present regulatory framework was born of Depression-era events and is not well suited for today’s environment where billions of dollars race across the globe with the click of a mouse,” said Tim Ryan, chief executive of the association. “That fact, teamed with the current market conditions, result in an universal agreement that it is time to modernize and revitalize the current system.”

And our Chairman of the House Banking Committee is weighing in with his support:

Last week, Massachusetts Congressman Barney Frank said Congress should authorize the Fed to act as a risk regulator across the markets. “To the extent that anybody is creating credit, they ought to be subject to the same type of prudential supervision that now applies only to banks,” he said.

Instead of Frank’s gentle acquiescence, here’s the key question we need to ask: Can we continue allowing banks and other financial institutions to have a monopoly over creating money, through credit, in Federal Reserve Notes? The answer is no, we cannot. The current system is not sustainable, and we need to provide an option for the American people that includes the use of Constitutional money. Americans need to be free to save, invest, and transact business in gold and silver in addition to Federal Reserve Notes, without any sales or capital gains taxes.

While treating the symptoms of the credit crunch through “liquidity injections” and bailouts is a short term solution that may prevent the financial system from freezing up, it will cause accelerating inflation and further rob American workers of their purchasing power. The true solution to our current financial crisis is not giving more power to a broken system. That’s simply rearranging the deck chairs on the Titanic. We need the Honest Money Act, HR 2756. Allowing Americans to transact business with honest, Constitutional money instead of only paper created out of thin air by our central bank will provide a needed alternative during this period of turbulence.

An article in today’s Financial Times notes several disturbing trends that are affecting American families. Even with rapidly rising food and gas prices that are excluded from “headline” inflation numbers, our inflation is still well below that in developing nations:

The [inflation] threat is from emerging economies. Inflation there is now too high, reflecting high weightings towards food and energy where prices have soared. Inflation in the Bric economies hit 8 per cent year-on-year last month, double the level in February 2007. State policy is partly to blame. Short-term real interest rates are negative in Russia and China, while the latter’s currency peg is unhelpful. But prices also reflect structural shortages. In physical commodities it will take time for capital investment to get new supply on line. Meanwhile it is conceivable that some foods might run out: this week India, Egypt and Vietnam restricted rice exports to boost domestic supply.

The consequences of inflation in China and other emerging nations are important to Americans:

But inflation in emerging economies will eventually feed through into their exports. And dirt-cheap consumer products from abroad have been central to keeping western prices low. There is a credible risk that this is an inflection point. Hence, monetary authorities should be firm – precisely the stance they are unable to take due to the banking crisis.

In short, we’ve been exporting a massive amount of dollars for a very long time in exchange for the world’s oil and manufactured goods. Some of those dollars get turned around and used to buy American goods and assets, but many of these dollars have been sloshing around the world’s central banks and forming the basis for inflation in these developing nations. It’s as if the rest of the world, sitting at an All You Can Eat Dollar Buffet, is starting to get full.

As the world has its fill of dollars, and as prices start rising in China and other nations, our trading partners return our inflation to us through higher prices and the continued devaluation of our dollar. As of today, the Chinese RMB broke through 7:1, and is trading at 6.9975 per dollar. When I was in China last July, the exchange rate was 7.5 RMB per dollar. That’s an almost 7% decline in the dollar (or 7% higher prices for Chinese goods) in eight months. Our politicians have been asking for a stronger Chinese currency (and thus a weaker dollar), and now we’re getting it.

While logic would suggest that we need to restrain the creation of new money in the face of these inflationary forces, the article highlights the fact that we’re between a rock and a hard place with respect to the banking system’s insolvency in the current credit crunch. When in doubt, though, bet that the Federal Reserve will continue to support the liquidity of the banking system, and the right of Bear Stearns executives to drive really nice cars:

Is that really the right move for the American people?