Meltdown Review part 01 of 04: Shell Game

How the Federal Reserve Causes Inflation

Here are some quotes from the book "Meltdown" by Thomas Woods (2009) followed by my own comments. I think it is important for humans to understand the world in which they live. I live in a world where I will spend ten to twenty years of my life working indirectly for bankers. I will sweat, they will eat the bread.

I am not upset about this. There is an abundant and gracious God in Heaven who has opened my heart to the beauty of the world. I will only be here a short while. He will make all things right in the end. Nevertheless, it is the song of every soul to improve the world, and to bring truth to light.

And so here I go.

The Federal Reserve controls the American money supply and can influence interest rates either upward or downward; it can also function as a “lender of last resort.” Although people use the phrase “printing money” as a kind of shorthand for what the Fed does, the Fed increases the money supply not by printing cash and putting it into circulation, but by what are called “open-market operations,” which involve the purchase and sale of assets. Strictly speaking, the Fed can purchase any kind of asset it wants, but it normally purchases government bonds. If it wants to increase the money supply, it purchases, say, $1 billion in bonds from a bond dealer. It makes the purchase by writing a check on itself for $1 billion and handing it to a firm like Goldman Sachs in exchange for the bonds. It creates this $1 billion out of thin air.

Goldman Sachs then deposits this $1 billion check from the Fed in its bank. That bank doesn’t put the e$1 billion in a special vault with “Goldman’s Money” on the door. Instead, the bank will lend out most of that $1 billion, since the law only requires it to keep a small percentage of its deposits on reserve. (Most of the banks’ reserves, incidentally, are kept in its own account at the Fed, with a small amount in cash in its vaults to satisfy normal day-to-day requests for cash by the bank’s depositors.) When the bank, in turn, lends out the money, borrowers spend it, and it winds up in accounts in other banks, which use most of that money in still another round of expansion, and so on. With a reserve requirement of ten percent, the initial $1 billion will have supported $9 billion in additional lending by the time this process is complete. All of this $10 billion has been created out of nothing: the initial $1 billion check from the Fed, and the additional $9 billion in loans that the fractional-reserve banking makes possible, were produced out of thin air. Should the Fed wish to contract credit, it follows this procedure in reverse: it sells the bonds to the banks, and the money it receives for them—and the further increase in the money supply that the fractional-reserve system then created on top of it—are withdrawn from the economy.

Although people often define inflation as a general rise in prices, and economists themselves employ that definition as a kind of shorthand, inflation is actually the increase of the money supply itself (which in turn leads to higher prices than would otherwise have prevailed). Specifically, it is an increase in the amount of money in circulation not backed by the monetary commodity—in other words, an increase in paper-note claims tot gold not backed by increases in gold itself. Under a fiat standard, which the countries of the world have now, in which the monetary system is not backed by a commodity, we can define inflation simply as an increase in the amount of paper money in circulation.

Consider this question: in what order and in what way does the new money make its way through he economy? When eh government inflates the money supply, the new money does not reach everyone simultaneously and proportionately. It enters the economy at discrete points. The earliest recipients of the new money include politically favored constituencies…: banks, for example, or firms with government contracts. These privileged parties receive the new money before inflation has pushed prices upwards… the privileged firms that are lucky enough to get the new money benefit from being able to make their purchases at the previously existing price level—thereby silently looting those from whom they buy. When the average person gets his hands on this new money… prices have already been rising for quite a while… The value of his money was diluted by the new money before it ever reached him.

Now imagine a situation in which business firms or banks connected to the government receive a new influx of money courtesy of Fed credit expansion. That money comes out of thin air, not from the sale of some previous good or service. Thus when these favored firms spend this money, they are in effect taking goods out of the economy without providing anything themselves. Here we see very clearly how they benefit at the expense of the rest of society: they take from the stock of goods without giving anything in return. The money they pay for their goods didn’t originate in a good or service that they themselves had previously provided; it came from nowhere. The analogous case under a system of barter would be one in which, instead of trading my bread for your orange juice, I just [drink] your orange juice.

-- Thomas Woods, Meltdown (2009)

Shawn's Comments
I have read this book twice now, underlining and taking notes. The first third of the book is an overview of recent history; the bailouts (even a few notes about those in the last few decades), deregulation, regulation and nationalizing banks. Then the meaty parts: the core mechanics of how things work; what is money? what is inflation? The book ends with a chapter entitled "What Now?" which gives suggestions about how sound principles can restore some sense of reason

All of this has been of profound effect on me. I wasn't expecting this book to help me in the micro-economic function of my business, but it indeed helped me to understand my universe better and to act on it. I have cut the banks out of the loop. I have started integrating the ideas of commodities, barter and real money into my life. I have started living more within my means.

I don't like conspiracy theory. Even if it were true, what could I do about it? That's why on this blog I try to take a more "common-man-bolts-and-nuts" approach.

One profound impression I had is that the common man is indeed capable of understanding these things. Indeed, I think that each citizen would do well to put down the game-controller for a month and gulp down a few books on economics.

It doesn't take a genius to know that if every dollar were suddenly twinned, then prices would go up.. how much?

Why are homes and college educations so expensive? These are sectors where credit expansion is the most rampant, and where government has distorted economic reality the most.

If a house were to cost $50,000 could you buy one outright? Could you save up over time?

Right now, home prices are seeking their real, true value.

It's starting to make sense.

As usual, I invite differing viewpoints. Is this book wrong? Are there factual errors? Am I not seeing the whole picture? I am just an average guy trying to put it together.



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