Curing alcoholism with free whiskey

Imagine you have an alcoholic brother who lives with your parents because he has trouble holding down a job when he lives alone. So your parents keep an eye on him, limit his access to alcohol etc. One day, you come home, and you find your dad calmly stacking cans of Milwaukee’s Best into the fridge. When you ask why, he explains that your brother has been under some stress, and your parents are trying to help the poor guy out.

This scenario is so ass-backwards that most people would doubt it could happen in real life. However, this is precisely what the Federal Reserve just did last week.

In a further effort to increase liquidity, the Fed wrote to New York-based Citigroup on Aug. 20, temporarily easing restrictions on the relationship between Citibank NA, the company’s U.S. bank, and its broker-dealer subsidiary Citigroup Global Markets Inc.
The change lets the bank channel money from the discount window to the broker-dealer, which would then lend it to clients holding “certain mortgage loans and related assets.” The exemption allows Citibank to lend up to $25 billion to the broker-dealer’s customers.

Citibank’s brokerage unit is out of money, because they made unwise investments. The Federal Reserve is encouraging the bank to divert money to its failing unit from the bank’s reserves, and if that fails, from the Federal Reserve itself. However, nothing, nothing is being done about the root causes of the brokerage arm’s near bankruptcy. When the new influx of money runs out, the unit will still be in the same bad shape, but now the bank will have fewer reserves on hand. Your alcoholic brother is not going to learn how to drink responsibly if you keep offering him beers.

To understand the danger, we must understand the Fed. It is a straightforward government protected cartel, an attempt by major fractional-reserve banks to socialize their losses while preserving their profits. Its sole function is to ensure that the member banks continue to turn a profit.

The Federal Reserve has only a few tools at its disposal: It can purchase stuff, paying for it with newly “printed” money (it’s actually adding a figure to ledger entry with no printing presses involved). It can loan money out charging a certain interest rate. It can manipulate reserve requirements for member banks.

To understand how the Federal Reserve works, we need to examine how it functions in a simplified economy. So let us assume that all the banks in the United States had merged into one single giant bank. Let us also assume that the economy of the U.S. consists of several factories and one store, so we have an economy with a few major players: the Bank, the Federal Reserve, the U.S. government, and Walmart, and her suppliers.

The Government wants to borrow money, so they print up a bond and offer it for sale. The Fed purchases the bond and writes a check for $100 to the government, who deposits it into the bank. The bank now was $100.00 in deposits, but only a 10% reserve requirement. So they call up Walmart, and offer them a loan of $90.00 to expand their business. Walmart uses the 90.00 to purchase capital equipment. Walmart’s capital equipment suppliers take their $90.00 in payment and deposit it in the bank. The bankers, again have $100.00 in deposits, and $90.00 in outstanding loans, meaning they have 52% of their reserves on hand. To meet the reserve requirement, they only need to have $19.00 in their vaults, so they loan out another $81.00 to the next most attractive customer after Walmart. This cycle continues, with the $100.00 being continually loaned out to increasingly risky borrowers and being redeposited in the vaults until $900 worth of loans have been made to various economic actors. So the $100.00 loaned by the Fed to the U.S. government has resulted in the creation of $900.00 of loans which must be paid back with interest. Unless the fed keeps buying bonds and pumping newly created money, somebody somewhere is not going to be able to pay back those loans. OK, most financial industry types say, have the Fed continually buy stuff. So long as they keep “injecting” more money, everybody can pay back their loans and everybody is happy.

To believe this, one must ignore a major impact of the newly created money. It causes price rises. People set their prices to the highest level they think they can set it to and still sell enough stuff. If more money is available to buy things, they will set their prices higher. When Walmart gets that first loan, they can bid up prices to buy the stuff they want, something that their competitors cannot do. So by “injecting” this money, the Fed transfers purchasing power from the people who last touch this new money to the people who first receive it. Thus, Walmart benefits, while the old widow who draws a pension from the company that made the rubber used in Walmart’s truck tires loses income. (A pedantic aside: inflation is the expansion of the money stock. The rise in prices that most people call inflation is merely a consequence of inflation. Falling and gravity are two different things. )

In effect, every injection of newly created money by the Fed, transfers purchasing power from people who are farthest from the central bank to those closest to it. These emergency measures transfer money from old widows to the guys making really risky investments that ultimately fail.

Of course, there is a solution: a wise man might insist that his pension be guaranteed in gold, or wheat, or salt or some other commodity. Then, just as the collapse of the Zimbabwean dollar does not affect you, the man can rest easy knowing that the cratering of the U.S. dollar will not affect his pension. However, legal tender laws, coupled with the government’s insistence that taxes be paid in dollars makes this too expensive, legally risky (as in some modern day Asst. US Attorney Giuliani sending you to a PYITA federal prison), or impractical for most. This is, or course in the central bank’s interest. If people were free to abandon the currency, the managers of the U.S. dollar could find themselves masters of a sinking ship that no one cared to rescue.

Since Alan Greenspan took over the chairmanship from Paul Volker, the Federal Reserve has been “injecting liquidity” into the U.S. banking system like the bars outside of Norfolk’s Navy Base selling booze to sailors coming off deployment. We have been very fortunate that, for a variety of changing reasons, foreign central banks have been quite content to purchase U.S. dollars with valuable goods and services exported to people living in the U.S. That era will someday come to an end. When it does, people who do business with U.S. dollars will find themselves chained to a ship caught between the Scylla of a depreciating currency and the Charybdis of an imploding banking sector.

In the late 1920’s, when the first Fed-induced boom was heading south, Presidents Hoover and then his successor Roosevelt tried desperately to keep the boom going by bailing out people who had made bad investments and by printing money. Roosevelt even embraced many of Mussolini’s economic policies and attempted to turn the U.S. economy into a fascist one for the duration of his administration. Roosevelt even went so far as to outlaw alternatives to Federal Reserve notes by criminalizing the ownership of more than token amounts of gold in the form of jewelry. The politicians turned what should have been a massive contraction lasting perhaps one or two years into a depression that lasted over fifteen years. Today, many politicans do not have any understanding what happened during the great depression, and the federal reserve is dominated by men like Bernanke who think that the problem was the result of the Federal Reserve not inflating enough. In other words, we have people with bad theories, bad incentives and guns who are in a position to really wreck the economy. People assume that these kinds of problems only afflict people living in backward, barbaric, places like Zimbabwe. They can happen here too. Human nature is pretty much the same throughout the world. Politicians have the same incentives. People have similar capacities for violence. It can happen here too.

To me, our financial sector’s weaknesses are a bigger threat to our lives and welfare than any other issue. Al Queda can kill a few thousand here or there, but that is nothing compared to the millions who would die if our systems for distributing goods like food or medicine over long distances were to break down. It is a drop in the bucket compared to the lives that will be shortened by child-hood malnutrition of people go back to eating Ketchup sandwiches as my grandfather observed during the worst of the Depression.

Our structurally unsound financial sector is an existential threat facing the liberties of all Americans. The solution to this problem is quite simple, though. It is to widen people’s freedom and to repeal the laws that encourage or permit the current scheme to continue. What we need to do is to repeal legal tender laws, and to dramatically reduce the amount of taxation and governmental borrowing taking place, in other words to slash government spending. Unfortunately, this is not likely to happen. I fear most Americans will make the same mistakes that their grandparents and great-grandparents made 80 years ago, and call for more government intervention and less freedom.

I am an anarcho-capitalist living just west of Boston Massachussetts. I am married, have two children, and am trying to start my own computer consulting company.
  • somebody

    Well, the problem is many people don’t understand economics and assume that government (if run by intelligent people) can fix the market. This is why people have to be educated on subjects like the Fed. Everyone who reads this should Digg it via the “Share” option and try to get as many people to read it as possible.

  • Chepe Noyon

    I think that you miss an important factor at work. Yes, all those loans do increase the money supply, but they also permit the outright creation of wealth. When Walmart purchases capital equipment, that improves is productivity, which in turn permits it to create more wealth. Thus, the supply of wealth increases because of those loans. In the ideal world, the money supply grows just as fast as the supply of wealth, and so the ratio of money to wealth remains constant. Err on one side and you get inflation; err on the other side and you get deflation.

    No, this is not a grand conspiracy to cheat the little guy. Yes, if inflation is high, then pensioners lose, but debtors win. If there’s deflation, then pensioners win and debtors lose. The ideal, again, is to get no inflation — but that’s almost impossible to achieve in the real world.

    In general, I oppose government meddling in the economy, but the Fed is one of few government institutions whose intervention has generally been beneficial (in the last few decades). The example you cite (called ‘moral hazard’) is a fundamental problem with all government meddling in the economy. The problem is that, if the government takes no action and permits the financial institution to fail, then a great deal of wealth is destroyed and the effects ripple through the entire economy, hurting lots of people — including lots of little guys.

    The better analogy would be the alcoholic brother developing a liver disease because of his alcholism. Do you treat the disease, so that he continues to live as an alcoholic, or do you let nature take its course and let him die?

  • Chepe Noyon

    I just noticed this quote at the top of your page and can’t help correcting it:

    “No state has an inherent right to survive through conscript troops and, in the long run, no state ever has. Roman matrons used to say to their sons: “Come back with your shield, or on it.” Later on, this custom declined. So did Rome. Robert Heinlein, “The Notebooks of Lazarus Long””

    Heinlein is wrong for two reasons. First, it wasn’t Roman mothers, it was Spartan mothers — and Sparta declined largely because of its militarism. The decline of the Roman Empire has been attributed to many, many causes, but the conventional claim that it was due to libertinism is way off the mark. The biggest problems were an increasing concentration of wealth and the intrinsic weakness of a slave-based economy.

  • http://na eric mortensen

    Senator Dodd and the “savior” FHA?

    Well, from what I read, Sen, Dodd has a great plan to change the operationg rules governing the FHA, and allow them to take over the adjustable rate loans (coming due for reset)…. and convert them to fixed rate loans. So, the FHA moves “bigtime” into the mortgage / refi biz, if Dodd has his way?

    Yesterday, it was the NY Federal bank which went into the asset-backed / commercial paper biz, accepting ” that paper” as collateral on loans to banks. ( this is a FIRST, in history).

    LOTS OF RULE CHANGIN’ GOIN’ ON …more govt intervention / less private operation – is this more like Communism / Socialism, or what? Whatever did happen to the private marketplace?

    Back to the FHA / Sen. Dodd … It was my original idea that if a BAILOUT of the adjustable rate homeowers was to be done, well, why not just give em’ each $15,000 , to allow them to buy-out of the adjustable loan ( refi penality)…and allow them to go to a private lender, to refi… i.e. let the marketplace work. Don’t have the govt. involved “from soup to nuts”…holding the “paper”, too.

    But then, it occured to me that 63% of those loans were “liar loans”, so those individuals might not even qualify for a refi-to- fixed loan, esp. with the tougher lending stds, going into place (now that the horse is out of the barn).

    So, hahahaha…yeah, I guess Dodd has a point – perhaps the govt. will (have to) be the one to hold it’s nose, look the other way…not ask for proof of income…and just ‘do the dirty deed…refi anything and everything that’s crawling out there…. Do anything to keep the 2 million homes from going into foreclosure, adding to the (already) huge supply of unsold homes.

    Of course, those loans do have that sticky “refi penality” attached…. and those lenders who made those loan contracts (or the ones now holding them), will want the “refi penalty” money, won’t they?

    You’re probably looking at $30 Billion to “buy out” those refi-penality clauses…I don’t think the lenders will simply hand over their portfolios to the FHA, without being compensated…they want that $30 Billion, right? ( and perhaps that’s why Wilbur Ross suddenly has an interest in owning some mortgage company assets? … I believe he’s already a ‘partner’ now, in Accredited Home Lenders? you’d have to check the news to see exactly what Wilbur is up to – but if he sees the FHA handing out money, to cover those refi penalities, well… money is money)