Re: The Citizens' Guide to Money

On Jan 6, 8:15 pm, monetaryscie...@xxxxxxxxx wrote:
A relatively short and somewhat opinionated guide to Monetary Science,
targeted towards all interested citizens, is posted at
monetaryscience.blogspot.com . Welcome to come take a look.

I am also posting it here. (Visit the website to see original version
with hyperlinks)
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THE CITIZENS' GUIDE TO MONEY
by Monetary Science (monetaryscience@xxxxxxxxx)
Posted at monetaryscience.blogspot.com

"I care not what puppet is placed upon the throne of England to rule
the Empire on which the sun never sets. The man who controls Britain's
money supply controls the British Empire, and I control the British
money supply." - attributed to Nathan Mayer Rothschild [1]

INTRODUCTION
It is now widely recognized that we are entering a period of global
financial instability. The US is spending huge amounts on military
operations the world over, and needs to borrow about three billion
dollars a day to keep functioning. Many Americans households are
drowning in debt. The value of the dollar has been declining, and
there are worries that it may collapse altogether. There are fears of
another Great Depression in the US. Some people have begun arguing for
the reintroduction of the Gold Standard. What will all this mean for
us? How will our lives and communities be impacted by monetary
decisions taken at the top? To answer these questions we need a sound
understanding of the functioning of the modern monetary system.
Gaining this understanding is our goal in this Guide.
Monetary Science is the science of regulating the money supply in an
economy. It has profound effects on our lives. It is the duty of every
citizen to understand its fundamentals, and be vigilant about monetary
policies. Unfortunately, the subject is often made arcane and obscure,
perhaps deliberately. The state of affairs is nicely summarized in a
paragraph from a letter reportedly sent by the firm Rothschild
Brothers of London, in 1863 [2]:

The few who can understand the system ... will either be so interested
in its profits, or so dependent of its favors that there will be no
opposition from that class, while on the other hand, the great body of
people, mentally incapable of comprehending the tremendous advantages
that capital derives from the system, will bear its burdens without
complaint and perhaps without even suspecting that the system is
inimical to their interests.

I do not believe that monetary policy is "rocket science". Any one
with a little patience, and willing to give the subject some careful
thought, can easily grasp its essentials. I will not deluge you with
technicalities, but I will nevertheless be fairly complete and
logically sound. This may take upto an hour of your time. Hopefully,
you will be able to take away a deeper understanding of the difficult
economic questions that confront us today. The topics that we will
cover include:

* The Wealth of Nations: What makes a Nation prosperous?
* What is money?
* Inflation, Deflation and the transfer of wealth
* How monetary policy affects the "personality" of an economy
* The proper regulation of the Money Supply
* How money is injected into, and withdrawn from an economy.
* The concept of Interest
* The concept of Fractional Reserve Banking. Is it sound?
* Interest rates versus money supply growth rate
* The role of the Central bank in preventing instability
* Monetary Policy, Exchange Rates and International Financial
Flows
* How Central Bankers can profit from boom-bust cycles
* How to build a sound monetary system
* The Gold Standard debate

OK, here we go. Get a nice strong cup of coffee, sit up, relax, and
enjoy the ride.

THE WEALTH OF NATIONS: WHAT MAKES A NATION PROSPEROUS?
Let us start from the very fundamentals: What is it that makes a
nation wealthy? What is it that allows citizens to lead prosperous,
comfortable and fulfilling lives?

It is very clear that if each person had to grow or hunt his own food,
make his own shoes, build his own shelter, we would all be living in a
pretty barbarous fashion. This leads us to the principle that wealth
is generated through specialization of labour and exchange of goods
and services.

Wealth is also generated through ideas and innovation - better
technology and more efficient processes.

A third factor affecting the prosperity of a society is human
behavior: People should save and also make prudent investments.
Neither profligate spending nor miserliness is conducive to the
generation of wealth.

A BRIEF HISTORY OF MONEY
Money plays an important role in our lives. Most of us use it every
day, and some of us dedicate their lives to accumulating more and more
of it. Yet few understand what money actually is. Those pieces of
paper which we call money are intrinsically worthless. We may struggle
mightily to acquire these pieces of paper, but their value can
evaporate before our eyes. That dollar bill in our pocket, earned with
the sweat of your brow, is not worth what it was a year back. But
then, where has that value gone? Has it simply disappeared, or has it
been surreptitiously transferred to somebody else? We will answer
these questions in due course.

The purpose of money is to enable the efficient exchange of goods and
services. So money plays an important role in facilitating prosperity.
Let us take a look at how our monetary system has evolved to its
present form.

The most basic form of exchange is barter - for example, a farmer
swapping his wheat for a pair of shoes from a cobbler. But barter can
be inconvenient. What if the farmer does not need shoes? The farmer
might try to swap the shoes for something else that he needs. But
shoes are not easy to swap. One solution is for the farmer to be paid
in another commodity, say salt. The farmer may not be able to eat all
the salt himself, but he may be able to swap it easily for things that
he does need.

Something that is accepted in exchange for goods and services is
called a currency. In the above example, salt is being used as
currency. A currency needs to be convenient to use and should retain
its value over time. As cultures evolved, pieces of precious metals
like gold came to be used as currency.

People found it necessary to keep their gold in safe repositories or
"banks". The banks would store the gold in their vaults and would
issue paper receipts or "notes". Anybody who went to the bank with a
note would be able to redeem it for gold. In that sense these notes
were "backed by gold". Eventually people began to use the notes as
currency, with the understanding that they were always redeemable for
gold.

Since these paper notes could be exchanged for actual goods and
services, some banks realized that they could profit by
surreptitiously printing more notes than were backed by the gold in
their vaults. The banker could use the extra notes to buy real stuff,
or even to loan out on interest. As long as the banker could make
payments in gold to those who demanded it, the bank would continue to
function. But sometimes people would get suspicious about a bank, and
then the depositors would frantically rush to the bank to get back
their gold. The bank, if unable to meet the demands of its depositors,
would collapse, leaving behind hordes for enraged depositors.

This unsatisfactory situation led ultimately led to the setup we have
today: We have in each country a "central" bank that is authorized by
the government to print currency notes. These are not redeemable in
gold or in anything else. This system is called a "fiat" currency,
because the notes have value only by the government decree that they
accepted as currency.

INFLATION AND DEFLATION
It is a universal principle that things which are plentiful are cheap,
and that scarce things tend to be valuable. This principle also
applies to money. The total amount of money circulating in an economy
is called the money supply. The greater the money supply, the lower is
the value of the dollar. Conversely, the lower the money supply, the
more valuable is the dollar.

Therefore, if the money supply is increasing, the dollar will lose
value and the prices will increase. This is called inflation. On the
other hand, if the money supply is decreasing, the dollar will
increase in value and prices will fall. This is called deflation.

THE TRANSFER OF WEALTH
It's a very interesting fact that both inflation and deflation lead to
a transfer of wealth. In an inflationary environment, someone who
saves and either holds his money in cash or puts it into CDs, will get
his returns in terms of devalued dollars. So he has lost some of his
wealth. On the other hand, a borrower will have to repay his debt in
terms of devalued dollars. So the borrower has gained wealth. Also,
someone who has invested in a business will see his revenues rise, not
only because prices increase, but also because people tend to spend
more when savings are penalized by inflation. Therefore, in an
inflationary environment, we have a transfer of wealth from savers and
fixed-income investors to borrowers and equity investors.

In a deflationary environment, the situation is reversed: A saver with
fixed income investments will get his returns in terms of a more
valuable dollar. A borrower has to repay his loan in terms of dollars
that are more valuable than the dollars he borrowed, and a business
owner will see revenues fall as prices decline and people stop
spending. Thus, there is a transfer of wealth from borrowers and
equity investors to savers and fixed income investors.

THE "PERSONALITY" OF AN ECONOMY
Now we can see how subtle and powerful a tool monetary policy is.
Monetary policy can influence the very "personality" of an economy: An
inflationary policy will reward borrowing and profligate business
investment, while penalizing savers and fixed income investors. A
deflationary monetary policy will reward miserliness, while punishing
those who borrow and invest in businesses.

As we mentioned at the beginning, prosperity of a nation requires both
saving and prudent investment. Neither miserliness nor profligacy is
good. So monetary policy indeed plays a very important role in
maintaining the right conditions for growth.

REGULATING THE MONEY SUPPLY
To avoid either inflation or deflation, we need to regulate the money
supply so as to keep prices stable. If prices fall, the money supply
needs to increase, and if prices increase, the money supply should be
reduced. Effectively, the money supply needs to increase at the same
rate as the real rate of growth of the economy. We shall have more to
say on this towards the end. Now we turn to a very important question:
How is the Money Supply increased or decreased?
The Central Bank, which is the case of the US is the Federal Reserve,
simply creates money "out of thin air". The newly created money could
either be in paper form, i.e. Federal Reserve notes, or in electronic
form, as book-keeping entries on a computer. But the Fed does not
really create something out of nothing: As the number of dollars
increases, each one becomes less valuable. Printing too many new
dollars will cause inflation.

Now comes a crucial question: How is this new money to be introduced
into the economy? Remember that the new money gets its value by making
the dollar in your wallet a little less valuable. So we had better be
careful about how it is used. Should the new money be distributed
equally amongst all the people? Should it be handed over to the
Government to use on pork-barrel projects? How do we make sure that
the new money is used in the most worthwhile way?

A reasonable answer to this quandary is that the Central Bank should
not simply hand out the money, but loan it. The interest rate on the
loans should be market determined. This will ensure that the money
will go to only those who can use it most productively.

This leads to a very natural question: Suppose the money supply is to
be increased by loaning out the money for say ten years. Then, after
ten years the loan has to be repaid with interest. Will not the net
effect, after ten years, be a net decrease in the money supply? The
answer is no, not necessarily. The Central Bank has not been sitting
still over those ten years. Recall that the Central Bank is required
to maintain price stability by increasing the money supply at the real
rate of growth of the economy. So, many other loans have been made
over that period, and the money supply will be larger in ten years
time, even if the original loan is repaid with interest. Thus, the
entire money supply is in the form of loans issued by the Central
Bank. The Central Bank is continuously making new loans and accepting
repayments of old loans, and is responsible for keeping the money
supply growing at the right rate.

Since, in today's world, economies are generally growing, rather than
contracting, Central Banks normally need to keep the money supply
increasing. But let us suppose that the money supply is to be
decreased. How can this be achieved? If the amount in new loans made
by the Central Bank is less than the amount being repaid, a net
decrease in the money supply is achieved. In fact, if the Central Bank
stops making new loans entirely, the money supply can, in theory, be
reduced to zero over a period of time, as the existing loans are
repaid.

In normal circumstances, the Central Bank is supposed to loan any
newly created money only to the Federal Government, via the purchase
of US Treasury bonds at market-determined interest rates. In these
degenerate times, however, the Fed is making loans to crooked bankers,
secured by the collateral of dubious subprime mortgages. If the
bankers go bust, the Fed will be left holding millions of foreclosed
homes. Should that matter to you? Yes - those loans were made with
money created by devaluing the dollar in your wallet.

THE CONCEPT OF INTEREST
As we have seen, our entire money supply is in the form of loans,
given on interest, of money that has been created "out of thin air".
In some traditions, interest or "usury", has been condemned as an
immoral practice. There are Islamic banks that manage to function
without explicitly charging or giving interest. I subscribe to the
view that interest has a legitimate role in an efficient economy.
Let's take a closer look at the concept of interest, to see why that's
so.

There are two ways in which one can view interest. First, suppose if
you save some of you hard-earned money, instead of splurging it on
wine, women and song. You delay your gratification, and make your
savings available some one else, who may want to use them for say
expanding his business. Should you not get any reward for this? That
is the role paid by interest.

A second way to look at this is as follows: Suppose you are willing to
provide your savings to a business that needs funds for expansion, and
that generates, on an average, a return of 12% a year. Naturally, due
to market uncertainties, that return cannot be guaranteed. You may
agree with the businessman to accept a lower return of say 8%,
provided that this lower return is guaranteed. So you have invested in
a business, and accepted a lower return in exchange for avoiding the
risk. This again leads us to the concept of interest. In any case, if
the players in an economy, by mutual consent, and for mutual benefit,
enter into a deal that involves interest, there is no need for any
third party to interfere.

FRACTIONAL RESERVE BANKING
Another feature of the modern economy that is sometimes the object of
criticism is the Fractional Reserve Banking system. So let's take a
closer look.

Under the Fractional Reserve system, from an initial deposit of say
$100, banks are required to keep ten per cent or $10 in reserve, and
are allowed to loan out $90. The bank earns interest on the loans, and
in turn pays interest to its depositors. But what if the depositors
want their money back? By a basic principle in probability theory
called the Law of Large Numbers, it is highly unlikely that more than
10% of the deposits will be withdrawn at the same time. Furthermore,
even if such an unlikely event comes to pass, the bank can take a
short-term emergency loan from the Fed, which will allow it to repay
its depositors. Once the loans made by the bank are repaid, the bank
can repay the loan taken from the Fed. Thus, the Fractional Reserve
System allows depositors to earn interest on their savings, even while
allowing their savings to be available for withdrawal at any time.

Let's follow for a moment what happens happens to that $90 that's been
loaned out. It will be used by the borrower for his own purposes, and
be transferred to some one else. It may then be deposited again in a
bank. This bank must, from that $90, keep ten percent or $9 in
reserve, and is allowed to loan out $81. That $81 may again be
deposited in some bank, and this process can continue ad infinitum. If
we work through the simple math, that initial deposit of $100 can give
rise to a maximum of $900 in loans from the banking industry, while
the total amount deposited with the banking industry is $1000. In
other words, from that initial deposit of $100, the banking industry
can create $900 in receivables and $1000 in payables. What is
happening is that the same dollar is being used again and again for
many transactions. Since the whole purpose of money is to facilitate
exchange, this should be regarded as a good thing. The banking
industry does not, as is sometimes alleged, create money out of thin
air through the Fractional Reserve System. It is only the Central Bank
or the Fed that is empowered to "create money out of thin air".

INTEREST RATE VERSUS MONEY SUPPLY GROWTH RATE
Currently Central Banks around the world follow a policy of Interest
Rate targeting - that is, they declare a target interest rate, and
then take action in the money market to achieve that target.

The Central Bank can indeed influence interest rates - by increasing
the amount that is available on loan, the cost of borrowing, i.e., the
interest rate, is decreased. By cutting back on lending, it can
increase the cost of borrowing. The current Fed target rate, as of
January 2008, is 4.25%.

However, there is a significant flaw in this policy: Interest rates
are not directly under control of the Central Bank. They are
determined by the market, in which the Central Bank is only one of the
participants. What is directly controlled by the Central Bank is the
Money Supply Growth Rate. As we saw above, the control over the money
supply is exercised by controlling the amount of newly created money
that is lent out.

The drop in the interest rate due to an increase in the money being
lent out by the Central Bank is only temporary. Over time, the economy
will adjust to the increase in the money supply growth rate. As we saw
earlier, an inflationary environment is favourable to borrowers, so
the number of borrowers will increase. Furthermore, over time, lenders
will demand interest rates that are high enough to compensate of the
inflation that results from the growth in money supply. In fact,
studies indicate that in the long run, interest rates increase with an
increase in the money supply growth rate [3].

Therefore, it would be far better for Central Banks to set policy in
terms of the Money Supply Growth Rate.

THE ROLE OF THE CENTRAL BANK IN PREVENTING INSTABILITY
There are players in the economy that borrow short-term to invest long-
term for higher returns. An example of such a player is a bank.

But financial markets can be fickle and emotional. If an institution
suffers a loss of public confidence, it may not be able to refinance
its short-term loans, or even come under pressure to repay them
immediately. Such a loss of confidence may or may not be justified.
Once a rumour gets going, it may cause a bank to fail, even if the
rumour is false. But if the investments that have been made are
fundamentally sound, the Central bank can provide a short-term
emergency loan to enable the institution to meet its obligations. This
loan can be repaid once the panic subsides. In this way, the Central
Bank plays an important role in calming the markets.

MONETARY POLICY, EXCHANGE RATES AND INTERNATIONAL FINANCIAL FLOWS
The world is getting more and more interconnected. Nowadays, a
country's international dealings are a important part of its economy.
An elegant principle, called the "Impossible Trinity", states that it
is impossible for a country to simultaneously achieve all three of the
following:

* A fixed exchange rate
* An independent monetary policy (i.e., control over the money
supply)
* Unrestricted international financial flows

So, for example, if a country allows unrestricted international
financial flows, but still wants to control the exchange rate, then
the country's central bank will have to intervene in the foreign
exchange market to maintain the target exchange rate. Thereby, it will
lose control over the money supply.

To illustrate, let's take China as a case study: The Chinese central
bank will be able to maintain an exchange rate of say 8 yuan for every
dollar by being willing to create and hand over 8 new yuan for every
dollar you take into China. But since China exports a lot of stuff,
and attracts a lot of foreign investment, there are many dollars
pouring into China. For each dollar that comes in, 8 new yuan are
released into the Chinese money supply. The result is that the Chinese
money supply grows too fast, leading to inflation. At the same time,
the China accumulates an increasingly large reserve of dollars, which
it typically invests in US Treasury bonds. To control inflation, the
Chinese government forces new yuan to be put into low-yield
"sterilization bonds". These low interest funds become available to
the Chinese government, and thereby to Communist Party cronies. So
it's a mess. But on the other hand, if China stops trying to control
the exchange rate, then the prices of its exports will rise, and it
will lose market share. The only solution is for China to rely on its
domestic market and raise the standard of living for its own people,
rather than relying on exports.

HOW CENTRAL BANKERS CAN PROFIT FROM BOOM-BUST CYCLES
We saw earlier how the Central Bank can, at will, expand and contract
the money supply. So it is perfectly possible for insiders to cause
expansion-contraction or boom-bust cycles in an economy. But why would
anybody want to do this?

The answer is that there is a lot of money that can be made by an
insider who knows in advance how the monetary policy will change.
Here's how the scam works: We have seen earlier how in inflationary
environment, there is a transfer of wealth from savers and fixed-
income investors to borrowers and business owners. In a deflationary
environment, there is a transfer in the reverse direction.

Therefore, at the beginning of the expansion, the insider borrows
money and invests in equities. At the peak of the expansion, the
insider liquidates his equity investments (which have been doing
rather well thanks to the inflationary environment), repays his debt
using the devalued dollars, and moves into fixed-income investments.
Then, as the contraction starts, borrowers have a hard time repaying
their loans and businesses see declines in revenue as prices fall.
Many businesses go bankrupt. Meanwhile, the value of the dollar has
been rising, benefiting the insider who holds fixed income assets. At
the peak of the contraction, the insider liquidates his fixed income
investments, borrows some more money, and buys into struggling or
bankrupt businesses at bargain prices. Then it's time for another
expansion.

Thus the show goes on. The economy is repeatedly pumped up and down,
and the insider watches the money come pouring in.

BUILDING A SOUND MONETARY SYSTEM
We need a monetary system that maintains price stability, that
prevents immoral transfers of wealth, and that encourages both savings
and prudent investment.

This can be achieved by linking monetary policy to the price of a
diversified basket of labour and commodities. The basket would include
the income of people in various job categories: supermarket workers,
dentists, machinists, bus drivers, managers, engineers and so on. It
would also include the prices of a large number of commodities. The
commodities selected should be domestically produced, and should be
commodities for which there is a competitive market - i.e., a market
with a large number of independent buyers and sellers. Commodities
which are monopolized should not be used.

The price of this diversified basket would be a weighted average of
its many items. The Central bank should continuously monitor this
price using scientific surveying methods, and should set a target
value for this price. Then, the Central Bank should increase the rate
of growth of the money supply when the price falls below the target,
and decrease it when price rises above the target. This monetary
policy will result in the money supply growing at a rate that is
roughly equal to the real rate of growth of the economy.

As we described earlier, a good way for the Central Bank to introduce
new money into the economy is by loaning it out at market-determined
rates of interest. This ensures that the money is used in the most
productive possible way. The money supply is reduced if necessary by
simply loaning out less money than is being repaid. There is nothing
inherently wrong in using a debt-based fiat currency. However, it is
necessary that everything should be done in a completely transparent
manner. The items in the basket, the weights used to calculate the
average, and the money supply growth rate should all be disclosed to
the public.

THE GOLD STANDARD DEBATE
The alarming circumstances in which is US economy is in today, and the
continuing decline the the value of the dollar has given rise to a
debate on monetary policy. Some people, notably Presidential candidate
Ron Paul, have been promoting the idea of returning to the Gold
Standard as a solution for the US' monetary problems. Let's take a
closer look.

The Gold Standard means defining the dollar as a certain quantity of
gold, and issuing only as many dollars as there is gold in Fort Knox.
Ron Paul also proposes allowing private banks to issue gold backed
notes.

There is a serious problem with this. Somebody who has large reserves
of gold could manipulate the money supply of a country on the gold
standard: By bringing gold into the country, and loaning out money
based on that gold, a monetary expansion can be effected. If the money
is not lent out again when the loans are repaid, a contraction
results. We have already seen what damage can be caused by repeated
boom-bust cycles.

As a general principle, it is a bad idea to use as a basis for your
currency any commodity that can be monopolized, such as gold. It would
be far better to link the value of the currency to commodity like
wheat, for which there is a more competitive market. There is not
enough transparency about who holds the large gold reserves. Until
very recently the world price of gold was fixed twice daily at the
London offices of N.M. Rothschild and Sons. Lately, several countries
in Europe, including the UK, France, Germany and Spain, have
liquidated their gold reserves. This has been followed by a sharp rise
in the price of gold, which has meant a large loss for the taxpayers
of these countries. We need data about who has been buying that gold.
There are serious doubts about how much gold there really is at Fort
Knox, and about how reliable the audits have been. Do we know how much
gold is held in vaults controlled by private banking families such as
the Rothschilds, the Warburgs and the Schiffs? The Rothschilds alone
are reputed to be worth several hundred trillion dollars.

Another important point is that the monetary policy should be tailored
to maintain price stability for the broad variety of goods and
services that are needed for modern life. Maintaining the correct
money supply growth rate, while tying the currency to any single
commodity is difficult enough. Tying it exclusively to a commodity
like gold, which is subject to being monopolized, and has to be
imported, makes it far worse.

We saw how the Central Bank has an important role to play in calming
instabilities and panics in the financial system. The Central Bank is
authorized to make emergency short-term loans of fiat money. There is
no limit amount on the amount of fiat money the Central bank can
create. This fact in itself discourages unscrupulous operators from
trying to create panics and profiting from the ensuing chaos. Were the
Central Bank's hands to be tied by the Gold Standard, it would be
seriously limited in its efforts to prevent and calm instabilities.

For insight on how ruthlessly the economy of the United States was
jerked around while it was on the Gold Standard, a good resource is
the book "The Great Red Dragon" by Woodfolk, on the economy of
nineteenth century America. We really do not need to go through all
that pain over again. You can find other good material on CJ Bjerknes'
blog.

Well, that brings us to the end of this Citizen's Guide to Money. It
has been nice having you along for the ride. I hope you have found it
enjoyable and useful. You are welcome to post comments at
monetaryscience.blogspot.com, or send them by email to
monetaryscience@xxxxxxxxx .


References:
[1] "Secrets of the Federal Reserve" by Eustace Mullins, Chapter 5.
[2] "Vindication" by Judge Rutherford. See http://users.cyberone.com.au/myers/money-masters.html

[3] Money and interest rates, by C. Monnet and W.E. Weber, Federal
Reserve Bank of Minneapolis Quarterly Review, Fall 2001, Vol. 25, No.
4, pp. 2-13, available at http://minneapolisfed.org/research/qr/qr2541.pdf
.