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How the Fed Rules and Inflates



[From chapter 23 of The Case Against the Fed.]

Having examined the nature of fractional reserve and of central banking, and having seen how the questionable blessings of Central Banking were fastened upon America, it is time to see precisely how the Fed, as presently constituted, carries out its systemic inflation and its control of the American monetary system.

Pursuant to its essence as a post-Peel Act Central Bank, the Federal Reserve enjoys a monopoly of the issue of all bank notes. The U. S. Treasury, which issued paper money as Greenbacks during the Civil War, continued to issue one-dollar “Silver Certificates” redeemable in silver bullion or coin at the Treasury until August 16, 1968. The Treasury has now abandoned any note issue, leaving all the country’s paper notes, or “cash,” to be emitted by the Federal Reserve. Not only that; since the U.S. abandonment of the gold standard in 1933, Federal Reserve Notes have been legal tender for all monetary debts, public or private.

Federal Reserve Notes, the legal monopoly of cash or “standard,” money, now serves as the base of two inverted pyramids determining the supply of money in the country. More precisely, the assets of the Federal Reserve Banks consist largely of two central items. One is the gold originally confiscated from the public and later amassed by the Fed. Interestingly enough, while Fed liabilities are no longer redeemable in gold, the Fed safeguards its gold by depositing it in the Treasury, which issues “gold certificates” guaranteed to be backed by no less than 100 percent in gold bullion buried in Fort Knox and other Treasury depositories. It is surely fitting that the only honest warehousing left in the monetary system is between two different agencies of the federal government: the Fed makes sure that its receipts at the Treasury are backed 100 percent in the Treasury vaults, whereas the Fed does not accord any of its creditors that high privilege.

The other major asset possessed by the Fed is the total of U.S. government securities it has purchased and amassed over the decades. On the liability side, there are also two major figures: Demand deposits held by the commercial banks, which constitute the reserves of those banks; and Federal Reserve Notes, cash emitted by the Fed. The Fed is in the rare and enviable position of having its liabilities in the form of Federal Reserve Notes constitute the legal tender of the country. In short, its liabilities — Federal Reserve Notes — are standard money. Moreover, its other form of liability — demand deposits — are redeemable by deposit-holders (i.e., banks, who constitute the depositors, or “customers,” of the Fed) in these Notes, which, of course, the Fed can print at will. Unlike the days of the gold standard, it is impossible for the Federal Reserve to go bankrupt; it holds the legal monopoly of counterfeiting (of creating money out of thin air) in the entire country.

The American banking system now comprises two sets of inverted pyramids, the commercial banks pyramiding loans and deposits on top of the base of reserves, which are mainly their demand deposits at the Federal Reserve. The Federal Reserve itself determines its own liabilities very simply: by buying or selling assets, which in turn increases or decreases bank reserves by the same amount.

At the base of the Fed pyramid, and therefore of the bank system’s creation of “money” in the sense of deposits, is the Fed’s power to print legal tender money. But the Fed tries its best not to print cash but rather to “print” or create demand deposits, checking deposits, out of thin air, since its demand deposits constitute the reserves on top of which the commercial banks can pyramid a multiple creation of bank deposits, or “checkbook money.”

Let us see how this process typically works. Suppose that the “money multiplier” — the multiple that commercial banks can pyramid on top of reserves, is 10:1. That multiple is the inverse of the Fed’s legally imposed minimum reserve requirement on different types of banks, a minimum which now approximates 10 percent. Almost always, if banks can expand 10:1 on top of their reserves, they will do so, since that is how they make their money. The counterfeiter, after all, will strongly tend to counterfeit as much as he can legally get away with. Suppose that the Fed decides it wishes to expand the nation’s total money supply by $10 billion. If the money multiplier is 10, then the Fed will choose to purchase $1 billion of assets, generally U.S. government securities, on the open market.

Figure 10 and 11 below demonstrates this process, which occurs in two steps. In the first step, the Fed directs its Open Market Agent in New York City to purchase $1 billion of U.S. government bonds. To purchase those securities, the Fed writes out a check for $1 billion on itself, the Federal Reserve Bank of New York. It then transfers that check to a government bond dealer, say Goldman, Sachs, in exchange for $1 billion of U.S. government bonds. Goldman, Sachs goes to its commercial bank — say Chase Manhattan — deposits the check on the Fed, and in exchange increases its demand deposits at the Chase by $1 billion.

Where did the Fed get the money to pay for the bonds? It created the money out of thin air, by simply writing out a check on itself. Neat trick if you can get away with it!

Chase Manhattan, delighted to get a check on the Fed, rushes down to the Fed’s New York branch and deposits it in its account, increasing its reserves by $1 billion. Figure 10 shows what has happened at the end of this Step One.

The nation’s total money supply at any one time is the total standard money (Federal Reserve Notes) plus deposits in the hands of the public. Note that the immediate result of the Fed’s purchase of a $1 billion government bond in the open market is to increase the nation’s total money supply by $1 billion.

But this is only the first, immediate step. Because we live under a system of fractional-reserve banking, other consequences quickly ensue. There are now $1 billion more in reserves in the banking system, and as a result, the banking system expands its money and credit, the expansion beginning with Chase and quickly spreading out to other banks in the financial system. In a brief period of time, about a couple of weeks, the entire banking system will have expanded credit and the money supply another $9 billion, up to an increased money stock of $10 billion. Hence, the leveraged, or “multiple,” effect of changes in bank reserves, and of the Fed’s purchases or sales of assets which determine those reserves. Figure 11, then, shows the consequences of the Fed purchase of $1 billion of government bonds after a few weeks.

Note that the Federal Reserve balance sheet after a few weeks is unchanged in the aggregate (even though the specific banks owning the bank deposits will change as individual banks expand credit, and reserves shift to other banks who then join in the common expansion.) The change in totals has taken place among the commercial banks, who have pyramided credits and deposits on top of their initial burst of reserves, to increase the nation’s total money supply by $10 billion.


It should be easy to see why the Fed pays for its assets with a check on itself rather than by printing Federal Reserve Notes. Only by using checks can it expand the money supply by ten-fold; it is the Fed’s demand deposits that serve as the base of the pyramiding by the commercial banks. The power to print money, on the other hand, is the essential base in which the Fed pledges to redeem its deposits. The Fed only issues paper money (Federal Reserve Notes) if the public demands cash for its bank accounts and the commercial banks then have to go to the Fed to draw down their deposits. The Fed wants people to use checks rather than cash as far as possible, so that it can generate bank credit inflation at a pace that it can control.

If the Fed purchases any asset, therefore, it will increase the nation’s money supply immediately by that amount; and, in a few weeks, by whatever multiple of that amount the banks are allowed to pyramid on top of their new reserves. f I it sells any asset (again, generally U.S. government bonds), the sale will have the symmetrically reverse effect. At first, the nation’s money supply will decrease by the precise amount of the sale of bonds; and in a few weeks, it will decline by a multiple, say ten times, that amount.

Thus, the major control instrument that the Fed exercises over the banks is “open market operations,” purchases or sale of assets, generally U.S. government bonds. Another powerful control instrument is the changing of legal reserve minima. If the banks have to keep no less than 10 percent of their deposits in the form of reserves, and then the Fed suddenly lowers that ratio to 5 percent, the nation’s money supply, that is of bank deposits, will suddenly and very rapidly double. And vice versa if the minimum ratio were suddenly raised to 20 percent; the nation’s money supply will be quickly cut in half. Ever since the Fed, after having expanded bank reserves in the 1930s, panicked at the inflationary potential and doubled the minimum reserve requirements to 20 percent in 1938, sending the economy into a tailspin of credit liquidation, the Fed has been very cautious about the degree of its changes in bank reserve requirements. The Fed, ever since that period, has changed bank reserve requirements fairly often, but in very small steps, by fractions of one percent. It should come as no surprise that the trend of the Fed’s change has been downward: ever lowering bank reserve requirements, and thereby increasing the multiples of bank credit inflation. Thus, before 1980, the average minimum reserve requirement was about 14 percent, then it was lowered to 10 percent and less, and the Fed now has the power to lower it to zero if it so wishes.

Thus, the Fed has the well-nigh absolute power to determine the money supply if it so wishes.1 Over the years, the thrust of its operations has been consistently inflationary. For not only has the trend of its reserve requirements on the banks been getting ever lower, but the amount of its amassed U.S. government bonds has consistently increased over the years, thereby imparting a continuing inflationary impetus to the economic system. Thus, the Federal Reserve, beginning with zero government bonds, had acquired about $400 million worth by 1921, and $2.4 billion by 1934. By the end of 1981 the Federal Reserve had amassed no less than $140 billion of U.S. government securities; by the middle of 1992, the total had reached $280 billion. There is no clearer portrayal of the inflationary impetus that the Federal Reserve has consistently given, and continues to give, to our economy.

  • 1. Traditionally, money and banking textbooks list three forms of Fed control over the reserves, and hence the credit, of the commercial banks: in addition to reserve requirements and open market operations, there is the Fed’s “discount” rate, interest rate charged on its loans to the banks. Always of far more symbolic than substantive importance, this control instrument has become trivial, now that banks almost never borrow from the Fed. Instead, they borrow reserves from each other in the overnight “federal funds” market.

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Some misconceptions about wage stickiness



When macroeconomists talk about wage stickiness, they are generally referring to nominal stickiness. Because nominal wages are slow to adjust, a sudden and unexpected change in NGDP will usually impact employment, often in a sub-optimal fashion.

It’s possible to construct a variable called “real wages”, but I don’t view that as a useful concept. This is partly because (like Keynes) I don’t view inflation as being a particular useful concept, except perhaps when trying to come up with ballpark figures for long run changes in living standards. The problem is not so much that inflation figures are wrong; it’s not even clear what inflation is supposed to measure.

Here’s Tyler Cowen:

The restaurant used to pay you $13 an hour, now they pay you “$13 an hour plus p = ?? of Covid-19.” That new wage is a lower real wage.

That’s a defensible claim, if you define “inflation” in a certain way. But it’s also an example where the nominal wage is “sticky”, and hence this example has no bearing on “sticky wage models of the business cycle”. Again, it’s nominal wages and nominal GDP that matter, ignore real wages.

Tyler’s post is entitled “Real wages are flexible now”.  But the post does not contain any supporting evidence for that claim.  A change in the real wage is not evidence of increased flexibility.

For example, real wages rose sharply in 1930.  Does the big change in real wages in 1930 show that real wages were increasingly flexible?  No, they rose because prices fell while nominal wages were fairly stable.  A flexible real wage is one that moves toward equilibrium, not one that randomly moves around due to some price level shock even as nominal wages are fixed.  As an analogy, if The Soviet Union had raised the official price of bread from one ruble to two rubles, it doesn’t mean that bread prices are becoming more flexible, just that they are fixed at a different level.

I expect unemployment levels to rise to new and scary heights, and yes I do think the government should do something about that. But if you are analyzing the status quo with “a sticky wage model,” that assumption is probably wrong. Even though it is usually correct.

It’s true that sticky wages are not the reason why unemployment is about to surge much higher.  We are facing an unusually large “real shock.”  Nonetheless, nominal wage stickiness remains very relevant, as it is quite likely that 12 months from today we will have an elevated unemployment rate due to sticky nominal wages and lower than trend NGDP.  I hope I’m wrong, but the financial markets seem to view it as a very real threat.


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The New Euro Stimulus Won't Save the Greek Economy



With fear of the coronavirus continuing to wreak havoc on every country in the West, almost all governments have taken radical measures for containment of the virus: mandatory quarantines for many, the closing of businesses, and the prohibition of many economic and social activities. I am not going to pretend that I am a medical expert and share my thoughts about how serious the virus really is. I will, however, focus on its economic consequences.

(Two very informative articles on healthcare policies for the virus are “Government Is No Match for the Coronavirus” and “The ‘Bootleggers and Baptists’ of the Coronavirus Crisis.”)

The New Stimulus and QE for the Greek Economy

On Thursday, the European Central Bank (ECB) announced massive new stimulus programs, saying that it could buy up to €750 billion ($820 billion) in state and corporate bonds. This news comes just a week after it announced the last stimulus package. The aim is clearly to keep borrowing costs low and to provide money for European countries to deal with the current crisis. This is the first time that Greece has been included in an ECB QE program in a long time.

Shortly after the announcement, the Greek prime minister said that the Greek economy will receive a €10 billion stimulus package. This will be followed with other interventionist policies, the most notable of which provides an €800 subsidy to private workers, entrepreneurs affected by the current crisis, and every worker fired after March 1. But the madness doesn’t end there. There will also be new welfare benefits for almost every Greek, and a 40 percent discount on all rent payments has been enacted for the months of March, April, and May. The government has also made it illegal to fire employees during the crisis.

Why Will It Fail?

There is an old saying that you’ve got to save for a bad day. This means that you need to save some money so that you have the proper funds to get through a tough time. The problem that Greece and the EU face is that they don’t have any savings. Instead the Greek economy—and most European economies—are dependent on debt and on people spending money that they don’t have.

In a healthy economy people would be able to afford not working for a few weeks during such an emergency, because they would have savings, something that mainstream economists hate and have waged a huge war against. The Fed the ECB have artificially pushed down interest rates, prompting government, corporations, and consumers to borrow unsustainable amounts of money. Their response is more spending and “showering” the economy with money.

Bailing out one or two specific industries, although definitely bad economically, is at least feasible, because there are others to pay for it. But bailing out everyone is another matter. Where will the money come from for that? And where will it come from when the government decides to suspend tax payments because of the virus? There is no free lunch. If you cut taxes, you have to cut spending, and if you want to increase spending, you have to tax more. In the end, the deficit will have to be paid by future taxpayers. The money won’t come from lenders. After all, the bond market is crashing, since every country is facing the same crisis.

The only source for all this free money that remains is the ECB, which just like its American counterpart creates money “out of thin air.” But this won’t solve supply shortages in the market, which are sure to result from so few people working.

An Economy That Never Recovered

In Greece things are worse than in most of Europe. The country’s two biggest industries are tourism and sailing, which provide almost half of GDP. These have been hit hard as virus fears have mounted.

And Greece is facing this from an already weak position. According to the Heritage Foundation’s economic freedom index, government spending already amounts to 48 percent of GDP, layered over the still massive public debt, equivalent to 183 percent of  GDP. The economy never really recovered from the recession. Labor laws make hiring very expensive and risky. Public union cartels are the ones that really control the country, and they undermine production and entrepreneurship given any chance. The agricultural sector is heavily subsidized, and the the service industry is subjected to many price controls. Even during the years of the “austerity” government surpluses were minimal and were overtaken by deficits from future years. Indeed, the governments failed to cut spending and taxes, and in fact the massive debt has only increased.

Basically, the Greek economy is just a huge bubble of debt and spending. This was situation was sustained by endless bailouts from European taxpayers and low interest rates (even though they were some of the highest in the EU). If it had not been for that, Greece might have been more rational and less likely to be fooled by cheap credit, or it would have had to deal with consequences alone, becoming Europe’s Argentina. After all, if other Europeans were lending them money, the Greeks would have to print the money themselves. Or just stop spending. But the Greeks never saved or produced enough to justify their high standard of living compared to other countries. In other words, we are living beyond our means. Its not that Greeks are lazy; once again, it’s the state that is undermining production and fuels Greece’s famous anticapitalist mentality.

But the ECB’s repeated bouts of QE really do make things worse. It’s foolish to think that businesses that aren’t sustainable at 1.5 percent interest rate will suddenly become productive at 0 percent. If the economy runs on a 0 percent interest rate and doesn’t recover, what will happen when interest rates rise to 0.5 percent? Panic will ensue, making another European debt crisis likely. An economy in which business can’t pay for debts and expenses even with 0 percent interest is an economy ready to collapse.


The Greek state needs to stop its unsustainable policies involving ever growing handouts. Government spending always undermines the private sector’s production, which is made possible by saving. Instead, government policies should be encouraging saving. In order for Greece to survive the economic fallout of the coronavirus it needs to realize that it needs to let the bubble pop.

This means that there will be even harder years ahead for Greeks. But in the long term, it makes more sense. With unsustainable bubble businesses evicted from the market, resources and capital can be used less wastefully. Greece needs more production of goods and services. That’s what makes a nation and its citizens wealthy. Paper money isn’t wealth. If Greece doesn’t do this, then, yes, in the short term it will be less painful. But this means more pain in the long run.

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What Should The Government Spend To Save A Life?



The staggering economic toll of the new coronavirus is becoming abundantly, unavoidably clear. On Thursday, a Department of Labor report showed that a record-shattering 3.3 million people applied for initial unemployment claims last week. And with entire industries shuttered for the foreseeable future, economic output will almost certainly shrink dramatically.

As economic forecasts grow darker, talk of tradeoffs is getting louder: Is protecting Americans from COVID-19 really worth all this disruption and economic pain?

On March 22, before President Trump floated the idea of reopening the economy by Easter, against the recommendations of his own public health experts, he tweeted, “WE CANNOT LET THE CURE BE WORSE THAN THE PROBLEM ITSELF.” Other politicians, meanwhile, rejected the idea that economic costs should be a factor at all. New York Gov. Andrew Cuomo dismissed Trump’s push to get the economy moving again, saying, “No American is going to say, ‘accelerate the economy at the cost of human life.’ Because no American is going to say how much a life is worth.”

Cuomo’s sentiment might be a nice bit of political rhetoric, but it’s not really true. Economists might not be able to say how much an individual person’s existence is worth, but they have figured out a way to calculate how much the average person is willing to pay to reduce the risk of death — which allows them to put a price tag on the collective value of saving one life. That figure, which currently hovers somewhere around $9 or $10 million, is known as the “value of statistical life,” and it’s the basis for all kinds of high-stakes decisions that involve tradeoffs between public safety and economic cost — from food and automobile regulations to our responses to climate change.

As cold-blooded as it might seem, several economists told me that, at least in theory, a pandemic is exactly the kind of situation this metric is designed to help with. “Essentially, we’re trying to figure out what our society is willing to pay to reduce the risk of mortality,” said W. Kip Viscusi, an economist at Vanderbilt University and one of the leading experts on these calculations. “In that sense, a pandemic isn’t so different from a terrorist attack or a pollutant that’s threatening to kill large numbers of people — it’s just happening very quickly and on a very large scale.”

The idea that a life could have a monetary value isn’t necessarily easy to swallow from an ethical perspective. Economists and government regulators have to balance the risk of death against all kinds of other factors, though, and the concept of the VSL was developed several decades ago because economists didn’t like the idea of assigning that value through other, more intuitive means, like our contributions to the economy as workers. “It’s fairly simple to value someone’s life based on how much money they make,” said Spencer Banzhaf, an economist at Georgia State University who has written about the history of the VSL. “But in addition to being baldly crude, that’s just not reflective of the way we think about people. We don’t think a retired person is worth nothing.”

The VSL, instead of trying to sum up the value of a life, approaches the question from the other direction — how much are we willing to spend to reduce the odds of dying?

Economists draw the numbers from multiple sources, including surveys and assumptions about our own choices, like how much additional money people earn for especially dangerous jobs, or how much a premium they’ll pay for a safer car. The estimates do vary, but they fall in the same basic range — the EPA’s valuation falls around $9.4 million, while Viscusi’s latest calculation is $10 million. To put it another way, Viscusi’s estimate means that if a group of 10,000 people is facing a 1-in-10,000 risk of death, they’re willing to pay $1,000 per person to reduce the odds that any given member of the community will die.

These numbers show why spending trillions of dollars to combat a threat like the coronavirus pandemic can be a good investment, despite the high cost. “Let’s say one of our worst-case scenarios comes to pass, and 2 million people die,” said James Hammitt, an economist at Harvard’s T.H. Chan School of Public Health and the director of the Harvard Center for Risk Analysis. “Multiply that by $9 million or $10 million and we’re talking about up to $20 trillion as the value of preventing those deaths. That suggests it’s worth expending a fair amount of our resources to mitigate this.”

But back-of-the-envelope calculations can obscure some of the knottier questions that plague economists who have studied this issue for decades. The VSL varies by country, because the wealth of the average person in a rich country like the United States is much higher than that of a person in a poorer country like India, which means Americans can “pay” more to avoid risk. That outcome is liable to make most people uncomfortable, and weighing the value of other types of lives — for example, the young versus the old — is tricky, too .

For example, even though the coronavirus appears to result in much a higher mortality rate for older people — prompting some politicians to propose that they should consider sacrificing themselves to save the economy — trying to put a lower price tag on their lives hasn’t worked well in the past. Joseph Aldy, a public policy professor at Harvard’s Kennedy School of Government, said that under President George W. Bush, the EPA tried to put a lower value on the life of an older person in calculating the benefits of air quality regulations. In their analysis, the life of a person over the age of 70 was worth 37 percent less than the life of a younger person.

“It was a political disaster,” Aldy said. The policy was christened the “senior death discount” and in response, AARP ran ads featuring a picture of an elderly woman with a “37 percent OFF!” tag hanging from her glasses. The EPA backed off and never implemented the proposed changes.

Outside the glare of the political spotlight, though, that experience hasn’t stopped economists from exploring whether age-based valuations are right in some circumstances. There’s evidence, Aldy said, that people’s willingness to pay to reduce the risk of mortality starts to decrease after age 50. But those kinds of calculations, he added, are sometimes disconnected from the moral valuations we make collectively. “We spend the vast majority of our health care dollars on people over the age of 65, and yet one might say the age-adjusted value of statistical life for that population is lower,” Aldy said. “It’s a kind of social compact — we recognize your contributions to our society and will provide the resources to keep you healthy as you age. So how far can this economic analysis really go when we’ve made that decision as a society?”

And even accounting for age might not provide a compelling argument against the measures currently being taken in response to the pandemic. Two economists used age-adjusted VSL in a recent analysis of the economic cost of social distancing — and they still found that the public health response to coronavirus had “substantial economic benefits.”

The sheer uncertainty of the coronavirus crisis is another problem — both in terms of the potential death toll and economic impact. Estimates of how many people might die in the U.S. are all over the place — some as low as 200,000, others as high as 2 million. And Banzhaf said that just as age-based calculations have their limitations, the scope of the economic costs has to go beyond earnings or GDP. “Depending on how long this shutdown goes on, we’re talking about a huge hit to the common good and our way of life,” he said. “If symphonies, hotels, art galleries, restaurants close and can’t come back — that’s a loss that goes way beyond earnings dollars. I don’t know how you begin to quantify it.”

If anything, though, the uncertainty and fear of the coronavirus pandemic could drive the value of statistical life even higher. Studies have shown, Hammitt said, that because people are more afraid of flying on airplanes than driving in cars, they are willing to shell out for airplane safety measures. “We see the same thing with terrorism risk,” Hammitt said. “When a kind of death is more dreaded or ambiguous, people are willing to pay more to avoid dying that way.”

But Aldy told me that cost-benefit analyses would have been most helpful at earlier stages of the crisis, when the government had the opportunity to invest in testing and surveillance. At this point, he told me, he wasn’t sure why a cost-benefit analysis was needed to drive home the cost of a huge loss of life — particularly since he, like many other economists and public health experts, thinks that containing the virus is the best way to ensure the economy rebounds quickly.

“Let’s say we’re talking about 1 million deaths or 2 million deaths,” he said. “When you think about the economic damage and the damage to families and communities all over the country, I don’t think you need an egghead like me to try to put a price on that. It’s catastrophic.”

CORRECTION (March 27, 2020, 12:35 p.m.): An earlier version of this article misstated the odds required for 10,000 people being willing to pay $1,000 per person to reduce the odds that any given member of the community will die. It is 1-in-10,000 odds of dying, not 1-in-1,000.

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