Monday, December 17, 2007

Federal Reserve and the Inflation Tax

The Federal Reserve system and monetary policy are topics that are barely ever talked about in American Politics. Sure, we hear about them in economic news when people wonder whether the Fed will change short-term interest rates, but it rarely comes up as a political issue. But some of us believe it is the most important issue facing Americans because it is the root cause of many of the problems we are experiencing including
  • A mortgage crisis that threatens to destroy our banking system and cause millions of Americans to lose their homes,
  • A weakening dollar that is resulting in increasing prices of things we buy from overseas (which is most things at this point),
  • Increasing income inequality between the poor/middle class and the wealthy,
  • A $9 trillion Federal debt that continues to rise.
There are entire books dedicated to explaining what the Federal Reserve is. I'll give a brief explanation for how it relates to this topic, but if you want to take the Red Pill and see how far down the rabbit hole goes, I recommend watching Fiat Empire - Why the Federal Reserve Violates the US Constitution for a detailed explanation.

In brief, the Federal Reserve is not an agency of the Federal Government, nor is it a private company. It is a cartel made up of the largest banks with special privileges granted to it by the Federal Reserve Act. Its exact shareholders to this day are kept secret. This cartel is not unlike OPEC or other cartels. It's goals are to reduce competition and maintain control over its product, in this case, money and credit in the United States. It was granted the power to have a monopoly over the legal tender of the United States. The Federal Reserve produces Federal Reserve Notes by fiat and there is very little oversight of it granted to the Federal Government. Many people believe the Federal Reserve Act violates the Constitution.

So besides possibly violating the Constitutional and having little oversight, if the Federal Reserve is so bad, why does Congress allow it to exist? The reason is that as government grew over the years, Congress needed to find ways to pay for all its programs. Congressmen often get elected by promising money to their constituents and special interests. How can they pay for these programs and handouts? Raising taxes is one way, but it's very unpopular and would cause them to lose elections. This is where the Federal Reserve comes in. Congress can spend more money than it receives by simply issuing debt, effectively borrowing the money. The Federal Reserve makes this possible by effectively printing money. When the US dollar was backed by gold and silver, this wasn't possible because the money was redeemable in gold. This is why old Federal Reserve Notes used to say "Will pay to the bearer on demand N dollars." A dollar was defined as a certain number of grains of gold or silver. Today, we have fiat currency and fractional reserve banking. Money is created as debt by the banking system. This first half of this video explains how that works.

This printing of money by fiat causes many of the problems we experience today. The most important one is probably the inflation tax. This is barely ever talked about. When new money is created by our Federal Reserve system via the issuance of debt, the money does not uniformly distribute itself throughout the economy instantly. The people who get the money first benefit from it because the prices in the economy are based upon the amount of money that previously existed. The people who first get the money include the banking system, the military-industrial complex via large defense contacts, and other large recipients of government spending. As this money is spent and percolates throughout the economy, the market starts to react to all the new money. The actual amounts of goods and services haven't increased because the new money isn't the result of real growth in economic activity. According to the laws of supply and demand, as there is a higher supply of money but virtually the same number of goods and services, prices must rise to balance supply and demand. This results in things rising in price that every day Americans buy like food, energy, clothing, health care, college tuition, and entertainment. The problem is that the wages don't catch up as quickly as prices rise so people find that their standard of living must go down to accommodate the expenses or they must work harder (like have both parents have full time jobs to support the family when only one was necessary in the past).

This inflation tax affects the middle class and poor people much more than the wealthy. Wealthy people keep most of their investments in hard assets such as real estate, precious metals, oil production, utilities, and the general stock market. These assets have real intrinsic value and their real value, in aggregate, stays somewhat constant over time. Middle class people and poor people may have some savings but it's mostly in bank accounts denominated in dollars. They also live on incomes that do not keep up with the overall pace of inflation. In this way, the inflation tax is the most regressive tax of all. It transfers wealth from the the poor and middle class to the wealthy. This is why you will hear Dick Cheney say that the Federal Debt doesn't matter.

For more information, see

Wikipedia Inflation Tax
Inflation Tax by Ron Paul
Mish's Economic Analysis on how inflation is really counterfeiting

This is just one aspect of why the Federal Reserve system is bad. In subsequent posts, I'll talk about how it creates the boom and bust business cycle, how it created the subprime mortgage crisis, what this has to do with China, why prices should naturally fall if it weren't for monetrary inflation, the differences between monetary inflation and price inflation, and other related topics.

For now, I'll leave you with some quotes from Thomas Jefferson:
If the American people ever allow private banks to control the issue of their currency, first by inflation then by deflation, the banks and the corporations will grow up around them, will deprive the people of all property until their children wake up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.

I believe that banking institutions are more dangerous to our liberties than standing armies.

I wish it were possible to obtain a single amendment to our constitution - taking from the federal government their power of borrowing.

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