The Fed, Inflation, and The Federal Deficit

The past 6 months have been very educational for me from a macro-economic standpoint.  I have never been interested in technical economics to the point that i am now, except for some things I naturally understand, like free markets.  A Free Market economy is easy to understand to me because it’s my natural reaction to the world of trade.  If you’ve ever had a garage sale, or sold something on eBay, you understand it too.  It’s simple – you put something up for sale, and if people think your price is reasonable, they will buy it.  If not, you have the option of lowering the price.

But when all these bailouts started last September, my Father and brother, who are both professional economists to a degree, started teaching me, as a much more interested student, about the macro economics being massively affected by all of this government intervention.  So i started really trying to understand the big picture, and at this point, i think i have a pretty good understanding of it.  I can say it seems pretty simple – almost exactly like free markets.

The Fed & Money Supply

Not many people know what “The Fed” is, except that Alan Greenspan used to run it, and now Ben Bernanke runs it.  And it’s real important to the economy.  And they can lower interest rates.

The Federal Reserve System was originally created, from what I understand, to provide emergency cash to banks when there is a potential bank panic – where too many depositors withdraw their money because of fear that the bank may fold.  The purpose seems to have evolved to some kind of political entity that sets the interest rates in order to loosen or tighten the money supply, usually because of the hype surrounding a recession, or inflation fears.

How The Fed affects interest rates

Banks loan money to us that they get from two different sources: Depositors, and The Fed.  The Fed will create money out of thin air and loan that money to a bank at the discount rate, who, in turn lends money to private citizens and businesses.  This increases (or inflates) the total money supply, and when the bank pays the money back, that decreases / deflates the money supply.  A lower discount rate will attract more borrowers to banks, causing the lending of money to outpace the repayment of money, resulting in a net increase in the money supply.  A person or business may default on a loan to the bank, but the bank still has to pay back the money it borrows from The Fed.  If the bank fails, then the unrecoverable money it owed to The Fed is non-performing, and will forever be added to the overall money supply – The Fed will have to raise interest rates in order recoup that. 

The Credit Crunch, or recent contraction in credit beginning last summer, began mainly because of ridiculously low interest rates for mortgages, usually in the form of ARM’s, to subprime borrowers began to default at high rates.  The free market reaction to high default rates is to increase interest rates (who wants to lend at low interest rates when default rates are increasing?)   In order to keep interest rates low, The Fed creates MORE money out of thin air, and  purchases debt on the open market. This is called Quantitative Easing, and it also increases / inflates the money supply.

The only way to decrease the money supply from quantitative easing is to sell those assets back on the open market for cash (which will increase interest rates), or when those loans are paid by the original borrowers, in the case that they are performing loans.  In the case that they aren’t performing loans, who the heck would buy them?  If the loans aren’t marketable (i.e. non-performing) then that money is also forever lost to the overall money supply, and the only way to make up for it is for The Fed to raise interest rates.

And if that isn’t enough pressure…

For the first 6 months of this budget year, the US government has already doubled the amount of money it has borrowed all of last year – at the same time our trade deficit has been cut in half.  The US government (not to be confused with The Fed) borrows money by holding auctions for Treasury Bills (short term) and Bonds (long term).  In March alone they borrowed $192B.  Normally in a market where people with money want to loan less of it (exporters to US, banks, etc), and the number of people who want to borrow money is increasing (US Treasury), you would have a price increase – higher interest rates. 

The people who normally buy our treasuries (the Chinese, Japanese, Saudis, etc.) all have seen their net exports to the US decrease substantially.  At the same time, the US is selling 4x the amount of debt???  There’s only one way this can unfold – more quantitative easing.  Ben Bernanke is going to purchase US treasuries in order to keep interest rates down.  I’ve heard that the Chinese will continue to buy our debt, but how much can they buy?  Are they going to have 1.7 Trillion dollars extra this year, with exports to the US cut in half?  Are they going to even have 5 trillion over four years – let alone 5 trillion to lend to us?

Stealing your wealth 101

This is where free markets come in… Our currency is traded on free markets – anyone with a pile of money can trade it for other “stuff” – groceries, gasoline, stocks, treasury bills, wheat futures, Euro’s, Yen, etc.  If you sell stuff, you may decide to take US Dollars in trade.  If supply is greater than demand, the price goes down, and if demand grows faster than supply, the price goes up. 

The same thing goes for currencies – if the supply of the currency is greater than demand, then the exchange rate of that currency goes down.  If you increase the supply of a currency by 10% – guess what?  It’s value decreases by about 10%.  By increasing the supply of US Dollars, The Fed and the US Government are essentially confiscating wealth from anyone holding them.

To Summarize…

• The Fed creates money by loaning money to banks and / or buying assets on the open market, which has the effect of lowering interest rates.
• The Fed decreases the money supply only when loans are repaid to it or when it sells assets it previously purchased, which has the affect of raising interest rates.
• The US Government is borrowing money like there’s no tomorrow, in times when nobody has any to lend.
• Because nobody has any money to lend the US Government, The Fed purchases debt from the US Government with printed money.
• More money causes inflation.  Lots more money causes massive inflation. 
• Inflation causes interest rates to go up, causing The Fed to create more money to keep them down, causing more inflation, causing The Fed to create more money…  you get the picture.
• Holders of US Dollars see their holdings decrease in value, causing them to sell their $, causing the US Dollar to decrease in value even more, causing other holders of US Dollars to sell theirs, causing…  you get the picture.
• Finally, with exchange rates for US Dollars at very low rates, the sellers of things we import (remember we import about half of our oil, and most of our consumer goods) will want more US Dollars for them – increasing our prices!

How can you prepare?

If you want to watch something educational, check out this 8 part video.  Watch the whole thing to get a good idea of what’s going to happen, keeping in mind that this video was made in November of 2006.  This set of videos focus primarily of Peter Schiff’s speech, but the Western Regional Mortgage Bankers Association presented two points of view, the “bull market” view coming from Dr. Barry Asmus.  Peter’s predictions are uncanny, and Dr. Asmus’ rebuttal’s are embarrassing in hindsight.

How can one guy get it so right – to the “T”, and the other guy be so wrong?  How did Peter know?  My guess is that Peter Schiff has known for a long time that bad monetary policy is the root of all evil.  It’s like government interference that nobody realized is happening.

If you go to the first question in part 7 of 8, there is a dude who explains to Peter how entrenched into the real estate market he is and then asks if he should slit his wrists…  I’ll bet that he now really regrets his skeptical attitude, and wishes he would have believed Peter.  If he could go back in time and sell all of his houses in 2006, he probably would.  All of Peter’s predictions came true, so who knows – maybe he did slit his wrists.

So if you listen to Peter Schiff now, he would tell you to move your assets out of the US Dollar.  Buy gold, silver, foreign stocks, foreign currencies, etc.  I would recommend that you buy his book – Crash Proof – also written before the credit crunch – and follow his advice.