This is Part 5 of a multipart series on Wall Street. Part 1 dealt with Republican economic philosophy over the last 30 years which has produced disastrous results for the American economy leading up to the 2008 crisis. Parts 2, 3 and 4 dealt with whether or not Wall Street banks should have been allowed to fail. Part 5 deals with the incestuous relationship between the Federal Reserve Bank and Wall Street.
By John Lawrence
The US Federal Reserve Bank is the central bank of the US. It’s mission is to control the nation’s monetary policy i.e. the amount of money circulating in the economy, and to maximize employment. It does this by raising or lowering interest rates. When interest rates are low, there is more money in circulation and it’s cheaper to borrow. Low mortgage rates encourage home sales and they also encourage the sale of large consumer items such as cars.
For the economy to improve, consumers have to borrow money from the banks for home mortgages or car loans. This drives up GDP because 70% of GDP is personal consumption. But at the same time debt is created because, after all, economic activity is being created in return for consumers going into debt. This is the only mechanism by which the Fed can encourage economic activity: the creation of more debt.
Low interest rates also tend to lead to inflation which, depending on circumstances may be either a good or a bad thing. Also the more money there is sloshing around, the more encouragement is given to speculation. When interest rates are high, there is less money in circulation, fewer sales of homes and autos and inflation is tamped down.
The Fed also provides liquidity to the big banks. As such it is the banker’s bank. That was its original purpose. It has morphed into a Chief Tinkerer of the economy taking the place of the capitalist free market. The Fed is involved in the central planning of the US economy and as such it represents the economic politburo.
Since 70% of US Gross Domestic Product (GDP) is consumption, when the Fed lowers interest rates, consumption and (theoretically) employment goes up. But it doesn’t seem to be working that way today. The unemployment rate at 7.6% remains stubbornly high. Since it had lowered interest rates all the way to zero and that had still not produced the desired results, the Fed adopted a new policy: Quantitative Easing (QE).
For all intents and purposes quantitative easing is simply printing money and adding it to the system. The Fed has been adding $85 billion each month. Before we can assess the consequences of forcing this much liquidity into the system, we have to understand what fiat money is.
All the money in the system is what is called fiat money. This means that a dollar is worth a dollar just because the US government says it is. Up until 1971, the dollar was backed by gold. Theoretically, at least, you could take $35 dollars to a bank and walk out with an ounce of gold. Then President Nixon took the US off the gold standard. He closed the gold window. From that point on all US dollars in the system became ipso facto fiat money.
When the Fed prints money, it is simply creating fiat dollars not backed by gold or anything else. Then in 1973 the US government abandoned fixed exchange rates in favor of floating currencies. That means that a currency only has value relative to some other currency. The value of a dollar is measured in terms of how many euros or pounds or yen it can buy.
The creation of floating rate currencies opened the door for speculators to enter in. They sold futures contracts which would be a hedge against changes in the exchange rate. This was the beginning of the financialization of the economy.
Conservatives are appalled by fiat money. They want a return to “sound money” such as that backed by the gold standard. Others are appalled by the way fiat money is created by the Fed and injected into the system. What the Fed does is to buy up government bonds mainly from the big Wall Street banks.
So the Fed printing presses are essentially printing money and loaning it to the Wall Street banks on very favorable terms. Meanwhile, savers suffer because interest rates are essentially zero. This is another way of facilitating the transfer of wealth from the middle class and poor to the rich.
Wall Street loves low interest rates. If the Fed were to raise interest rates, it would cause chaos in the bond market since the value of existing bonds would diminish. This is why some experts think Ben Bernanke, the Fed chairman, will go on with his QE policy of giving Wall Street $85 billion a month indefinitely. Wall Street has completely captured the Fed.
On June 19th Bernanke hinted that he would raise interest rates some time near the end of the year because the economy is looking to be stronger and in better shape and the stock market fell over 200 points. The next day it fell 353 more. Hiroku Tabuchi writing in the New York Times reported on June 11 that the Bank of Japan might also raise interest rates and the stock market there fell as the result of “concern about the potential end of economic stimulus in general.”
David Stockman puts it this way:
“Constrained neither by gold nor by a fixed money growth rule, the Fed in due course declared itself to be the open market committee for the management and planning of the nation’s entire GDP. In this Brobdingnagian endeavor, of course, the Wall Street bond dealers were the vital transmission belt which brought credit-fueled prosperity to Main Street and delivered the elixir of asset inflation to the speculative classes. Consequently, when it came to Wall Street, the Fed became solicitous at first, and craven in the end.
“Apologists might claim that [free market economist] Milton Friedman could not have foreseen that the great experiment in discretionary central banking unleashed by his disciples in the Nixon White House would result in the abject capitulation to Wall Street which emerged during the [former Fed chairman] Greenspan era and became a noxious, unyielding reality under Bernanke. But financial statesmen of an earlier era had embraced the gold standard for good reason: it was the ultimate bulwark against the pretensions and follies of central bankers.”
Others such as Ellen Brown, author of Web of Debt, have argued that the problem is not with the creation or printing of fiat money per se. The problem is with how that fiat money is put into circulation. Presently, it is practically given to Wall Street in the hopes that it will be loaned out to consumers who will consume and thus increase GDP and raise employment. This doesn’t seem to be happening.
Since the production process has been automated, computerized and robotized, factories can churn out consumer products with little need for human workers. Consumer items that require intense worker participation have been farmed out to Third World countries such as Bangladesh where workers are exploited.
So rather than inserting printed fiat money into the banking sector where it sloshes around fueling speculative greed and never reaches the Main Street economy, why not insert it at the level of productive activity such as rebuilding infrastructure? This could be accomplished by putting the money into an infrastructure bank instead of a Wall Street bank. The amount of money printed under these circumstances would have nothing to do with not pissing off the bond market but would have everything to do with increasing employment and worker participation in the economy.
So rather than printing money for speculative purposes, which is essentially what the Fed and other central banks are doing today, the money could build actual public wealth in the form of a smart hardened power grid, the build-up of solar and wind power generation, high speed rail, hardening of storm prone electrical systems, replacing obsolete bridges etc.
The money could also go to teachers’ salaries, police and firemen salaries and other worthwhile projects. By spending money directly into the system, no debt is incurred and many jobs are created directly instead of the indirect methods used by today’s Fed which aren’t being effective in creating jobs.
The limitation on printing fiat money would either be full employment or building excessive, unneeded and unused physical structural capacity. Other countries notably China and Japan are today using fiat money for purposes of building or rebuilding infrastructure rather than loaning it to speculators in the hopes that some good will come from it. In China there is overbuilding resulting in excess housing capacity, whole uninhabited cities.
The problem then becomes what to do with workers after all building needs have been met. At that point only transfer payments from the rich to the poor can achieve the result of keeping money circulating through the economy. When money is inserted into the system at the worker level, it usually ends up being taken out of circulation after it is spent at Wal-Mart or equivalents. Transferring the money back into workers’ hands allows it to be spent at Wal-Mart again and so keeps the economy moving. After all how much money does the Walton family really need?
Ellen Brown’s idea has in fact been already tried in American history. President Abraham Lincoln used fiat money in the form of greenbacks to fight the Civil War, build the transcontinental railroad and create the land grant colleges. By the fact that the government printed the greenbacks and spent them into the system rather than borrowed the money, Lincoln saved the US government a total of $4 billion in interest by printing the money rather than borrowing it.
Brown contrasts a debt based society such as the US where economic activity only improves if people borrow and spend money with a society in which fiat money is spent rather than loaned into the system.
This is from her book: Thomas Edison observed: “If the Nation can issue a dollar bond, it can issue a dollar bill. The element that makes the bond good makes the bill good also. The difference between the bond and the bill is that the bond lets the money broker collect twice the amount of the bond plus an additional 20% whereas the currency, the honest sort provided by the Constitution, pays nobody except those who contribute in some useful way. It is absurd to say our Country can issue bonds and cannot issue currency. Both are promises to pay, but one fattens the usurer and the other helps the People.”
Note that the Federal Reserve, which prints all US money, is privately owned mostly by the big Wall Street banks and that the Constitution gives the US Government, not a private bank, the right to print its own money. Is it any wonder that the Fed is beholden to and controlled by Wall Street. An American central bank should be owned by the citizens of America not Wall Street.
Why aren’t the Fed’s methods being effective in creating jobs? Job creation according to the Fed is encouraged by getting people to borrow money and buy stuff. The problem is that the stuff can be produced in greater quantities not by hiring more workers but by further automating and robotizing the production process. More consumer buying does not mean more workers are hired. It just means that the machines just have to work harder and smarter.
Printing fiat money and injecting it into the system should theoretically produce inflation since the more money that is available, the more prices will be bid up. That should cheapen the dollar and make it weaker compared to other currencies. But that isn’t happening today. Why not? One reason is that the world’s other central banks, the Bank of Japan and the European Central Bank are doing the same thing.
The other reason is that the dollar is the world’s reserve currency. Oil purchases must be made in dollars so the central banks of the world need to hold dollars and not simply exchange them for some other currency that may be more sound. The third reason is that the euro is having terrific problems of its own so exchanging dollars for euros doesn’t seem like a wise thing to do at this point in time.
So if the Fed is injecting money into the system at the top and the money isn’t being invested for productive (and job producing) purposes, where is that money going. It’s going into the financial sector where it is sloshing around and being used for more casino gambling in the same way it was being used when the economy came crashing down in 2008. The Fed thinks it can go on printing money with impunity as long as inflation is not occurring. But there may be other unforeseen consequences that the wise men at the Fed have not taken into account.
What will happen when the Fed discontinues its policy of Quantitative Easing? The potential consequences could be disastrous. The bond market has become addicted to quantitative easing the way an addict becomes addicted to a new drug. In short all hell could break loose. The bond market could plummet since, when interest rates or yields are raised, the value of existing bonds at lower interest rates decreases. Also a huge amount of derivatives are in interest rate swaps.
Higher interest rates could trigger defaults on these derivatives in the same way that defaults on derivatives caused the Great Recession. For these reasons some people believe the Fed will never be able to discontinue Quantitative Easing or else the system will come tumbling down. There is a debt overhang in the economy that is precariously cantilevered over the Main Street economy which could come crashing down if the Fed does not continually prop it up by QE.
Another possible consequence might be that the national debt could increase due to the fact that interest rates on Treasury bonds would go up. Since the Fed is buying up government debt, when the Fed tries to sell all those bonds back into the market, interest rates will go up considerably adding to the government’s expenses. But it just might not ever sell those Treasuries; they might repose at the Fed forever. Also the stock market which has ballooned up because interest rates have been so low might collapse when money is taken out to buy new Treasuries at higher yields.
So if the Fed can go on indefinitely printing money and buying up US government debt, why are deficits any problem at all? Why do taxpayers have to worry? Rather than ‘borrow and spend’ or ‘tax and spend’, the solution to all our problems may just be ‘print money and spend’. When Treasury Secretary Henry Paulson ran around Washington with his hair on fire demanding that Congress pony up $800 billion for TARP, why were taxpayers upset?
Come to find out, that was a small sum compared to the $7.7 trillion that the Fed printed up and gave to banks all over the world. So in a sense Dick Cheney was right: deficits don’t matter since the Fed can buy up government debt. It then goes into the Fed’s black hole never to be seen again or the Fed’s roach motel, if you prefer a different metaphor. US debt goes in but it never comes out.
The problem is that eventually the US dollar may not be able to maintain its privileged position as the world’s reserve currency. At that point the chickens could come home to roost in the form of hyper inflation induced by all those dollars sloshing around in the world economy. Or the casino economy encouraged by all those sloshing around dollars could collapse again the way it did in 2008.
The Dodd-Frank bill which was supposed to rein in the big banks has been effectively neutralized and vitiated by lobbying activity to the point that it is worthless. Also rich investors and speculators from all over the world might decide to abandon the gambling casino and use their winnings to buy up US assets instead. They might use their political influence to privatize public assets, buy them up at fire sale prices and turn around and sell at exorbitant prices commodities necessary for human survival such as food and water.
Democracy might be thrown on the ash heap of history as a new class of robber barons gains control of both the economy and the body politic and turns the public into debt slaves in much the same way that students have been turned into debt slaves by virtue of their student loans.
Anna Daniels says
Even if the banks were making low interest loans available to consumers, worker wages have been flat for decades now. Workers and students are incurring a tremendous amount of personal debt.
Unlike European nations using the euro, we have the ability to print money as needed. As you note, we are not using that monetary flexibility in a way that actually stimulates the economy-ie people who rely on paychecks (the majority of us) as opposed to those (1%) who live off of investments.
The steady rise of temp jobs, contract work and low wage service sector jobs are reducing us to a condition of feudalism.
John Lawrence says
Thanks for your comment Anna. I should point out that the European Central Bank and also the Bank of Japan are printing money like crazy too. Any central bank, not just the US Fed, can print money. That money though is just going to rich investors, as you point out, and not to help students with student loan debt or to mortgagees who are underwater in their mortgages.
The rate on student loan debt just doubled despite Elizabeth Warren’s attempt to get Congress to pass a law giving students the same loan rates as the Fed is giving to the big banks which is next to nothing. Of course, the Fed wouldn’t do that because it is literally owned by the big Wall Street banks.
The only way the Fed as presently constituted can improve the economy is to induce consumers to borrow and spend i.e. to go into debt. There is an alternative: public banking as espoused by Ellen Brown.
Oregon recently proposed a plan whereby students would get free tuition in return for paying a small percentage of future salary presumably to a state run banking institution.
The point is that we need a central bank that serves the public interest whether in the form of infrastructure loans, student loans etc, not one that only serves Wall Street in the hopes that some of the money will trickle down. Instead it is used for speculation and the Fed has to go on giving billions every month to Wall Street to prevent the debt overhang from collapsing the way it did in 2008.
Tim O'Connell says
The Fed could switch to buying municipal bonds issued by cities and states for infrastructure like repairing bridges, highways and building schools instead of Treasury and corporate bonds. That would put money into the economy as local wages (you really can’t send infrastructure construction overseas) and at the same time make our economy more efficient (lousy roads alone cost billion$ each year). But then the banks would only get small fees and would not be able to gamble with the newly printed money.
John Lawrence says
Good point. So why won’t the Fed do it? Because it would not lower interest rates or keep them at zero.
Frank Thomas says
For more effective state and local financing and expansion of local lending capacity, Tim O’Connell suggests a practical option: the Fed should be able buy up municipal bonds rather than restricting its purchases to Treasury and/or Corporate bonds. The publically-owned Bank of North Dakota (BND), founded in 1919, has been doing exactly that for decades now. However, while it’s legal for BND to buy state and municipal bonds — and borrow at the Federal Reserve’s discount window rate and lend directly to local municipal governments at lower interest rates than the municipal bond market provides — the Federal Reserve Act prohibits the Fed’s purchasing of municipal debt with a maturity of more than six months. So none of the real benefits from this creative option of quantitative easing (QE) is achievable — unless the Fed has the authority to buy longer-dated municipal paper.
Other problems are the highly fragmented municipal bond market and the moral hazard of bailing out profligate municipalities or buying low quality bond issues. Experts confirm that many municipal bond issues are illiquid. It is felt, however, these problems are solvable. There’s almost $4 trillion in municipal debt outstanding in U.S. today, representing a Huge marketplace for the purchase of municipal bonds by a BND institution as well as an opportunity to secure reduced interest rates on bonds. I feel that state banks, like BND, which cannot create out-of-air actual money but only credit within the limits imposed by their reserves, are the ideal way to escape our corrupt debt-money accounting mechanism over the long term. I don’t think getting our national government into the game of running a giant banking monopoly is a good idea … nor does Ellen Brown favor this as some suggest. She believes states like California — that deposit hundreds of billions of state revenues in large Wall Street banks which leverage that money, lend it out-of-state, and remit hardly any funds back to the state — are missing a substantial economic opportunity to borrow at a very low cost and to recycle far more taxpayer funds internally to the economic benefit of all Californians.
This is essentially what has happened in North Dakota with its attractive, highly transparent public bank institution long ago started in a predominantly red state. Every state in the union, EXCEPT North Dakota, deposits all its state and local taxes and fees in a private bank. The bulk of these tax revenue deposits — our tax dollars — end up in TBTF Wall Street banks which leverage them with speculative trades (derivative bets)and loans to entities around the world. According to Marc Armstrong, executive director of the Public Banking Institute, more than $1 trillion of state and local tax dollars reach the Wall Street banks. In contrast, all of North Dakota’s tax revenues go through its public state bank which invests these funds in productive investment WITHIN the state economy — e.g., small businesses, public infrastructure partnerships with many community banks. A large part of BND’s profits are remitted to the state’s general fund, easing the pressure of tax increases.
With a population of 700,000, North Dakota has more local banks relative to population than all other states. Over last ten years, lending per capita by small banks (with assets under $1 billion) averaged about $12,000 vs. $3,000 nationally. Over same period, lending to small businesses averaged 434% more than the national average (see: “Bank of North Dakota,” by Institute for Local Self-Reliance, May 5, 2011). In its Partnership in Assisting Community Expansion, BND provides below-market interest rates loans to businesses if, and only if, those businesses create at least one job per $100,000 loaned. Is it any wonder North Dakota’s unemployment rate has been consistently relatively low for many years? If the more than $1 trillion of U.S.-wide state and local tax deposits that now go to Wall Street were deposited in all 50 states using the BND approach, up to 10 million jobs could be created over time. (see: “North Dakota, A Socialist Haven,” by Les Leopold, May 29,2013).
Recently, the Federal Reserve Bank of Boston issued a report advising against a Massachusetts bill to investigate a state bank on grounds that the public bank on its own”could not stop financial crises that directly impact North Dakota, like the one in the 1980s (even if it did alleviate the problems).” The Boston Fed report argued policymakers “would be better off studying the federal programs that have been augmented since the crisis.” In other words, “status quoism, no real reforms! What is the real reason behind the Bosten fed’s decision advanced by some think tanks? The Boston Fed has been accused of playing politics, indirectly playing on the fear that public banks in many states are a threat to big banks as well as community banks.
Of course, nothing could be further from the truth. Evidence shows that big banks are increasingly lending less to small businesses, and federal programs for small businesses are ineffective. North Dakota’s public bank has clearly proven the opposite over many decades. The Association of Community Banks in North Dakota is solidly behind the state’s BND. Assisting and supporting North Dakota’s community banks and credit unions is a fundamental part of BND’s mission — to the extent of participating in 19% of the total loans originated by state’s small and medium-sized local banks in 2010. BND has a relationship with almost all of the state’s 94 local banks! (see: “The People’s Bank, North Dakota’s Public Bank,” by Abby Rapoport, April 1, 2013).
This joint participation enables local banks’ to expand their lending capacity and thus keep their customers when the banks’ businesses grow rather than see customers flee to larger banks. Same applies to residential mortgages. North Dakota’s community banks prefer to sell these mortgages to BND rather than to bank giants like Wells Fargo which are inclined to market their other products and services to community bank customers. BND’s provision of a secondary market for loans originated by local banks frees up local banks’ lending capacity WITHOUT handing customers over to their competitors. BND even has a bank stock loan program to help expand the local ownership of community banks and their capitalization. The goal here is to ensure that long-standing community banks can continue to be owned locally.
In short, North Dakota’s public bank institution has intensified the circulation of money WITHIN the state rather than having taxpayer funds deposited in large banks where they can be excessively expropriated for use OUTSIDE the state.
The public bank concept is complex and still beyond the general public’s understanding at this time. It needs lots of education and a visually simplified graphical illustration of how it works from a bottom-up perspective in order for the common man to get behind it like he did in North Dakota.
But it has truly amazing possibilities as a supplement to our private banking system to bring sustainable fair growth locally at a minimum debt cost. As Sam Munger of North Dakota’s Center for State Inovation says: “While a state bank can’t save a state economy ‘single-handedly,’ the countercyclical nature of the bank will ‘help cushion’ the effect of the next inevitable boom-and-bust cycle. Build it now so it’s in place and can be effective and functioning the next time.”
FOOTNOTE: Hope to find time for more thoughts on effectiveness of Federal Reserve’s quantitative easing actions (QE1,QE2,QE3), Fed’s fight against continuing dangerous disinflationary pressures, potential chaos in bond market when Fed slows down on QE, conventional wisdom that printing money creates inflation, and Congress’s critical responsibility for fiscal policy initiatives (e.g. an Infrastructure Bank) that will spur economic growth and job devlopment.
Latter is not the Fed’s role as Bernanke has often stated. He’s done all he can to lower safe short-term and long-term more risky interest rates to counter deflation and stagnant growth. As he has said,”Most of the economic policies that support robust economic growth in the long-term are outside the province of the central bank.”
John Lawrence says
Thank you, Frank, for a very penetrating analysis. What I can’t understand though is why North Dakota which has a very progressive banking system is a red state with so many right wing Republicans there? The same is true for socialist Alaska which distributes checks from its sovereign wealth fund every year to its citizens. Yet Alaska is a right wing Republican nut case state as exemplified by Sarah Palin.
There is a disconnect between policy at the state level and the mindset of a majority of its citizens in these two states.
Frank Thomas says
Correction: 3rd paragraph, 1st sentence… This is essentially what DID NOT happen in North Dakota …