jims musings

I’ve spent the past year or so mak­ing occa­sional com­plaints about the state of the world. Com­plain­ing is easy and even, some­times, fun.
But, being the hairy-chested (and –backed) he-man that I am, com­plaint isn’t good enough. No sir, it’s time to start work­ing towards solu­tions. There­fore, I now begin a long-term study of our prob­lems. This will be an E-Ticket ride, I assure you. I’m old enough that I actu­ally had E-Ticket rides.
I believe a key source of our cur­rent woes is gov­ern­ment debt and infla­tion. Infla­tion, or the devalu­ing of money, saps our buy­ing power, our sav­ings, and makes the future more expen­sive and harder to plan for. As infla­tion increases, so does the cost of loans, and so credit becomes more expen­sive (inter­est rates).
This year, the US Fed­eral Gov­ern­ment will spend around $410,000,000,000 (410 Bil­lion Dol­lars) more than it takes through taxes. The gov­ern­ment will raise these funds by sell­ing bonds.
What hap­pens is this: Con­gress will autho­rize the Pres­i­dents bud­get request, adding plenty of their own pork along the way. The Pres­i­dent will be so happy that he got what he wanted, he’ll gladly sign the approved leg­is­la­tion. This new law will autho­rize the Trea­sury Depart­ment to sell bonds to raise the needed money.
These bonds are sold at auc­tion, with attrac­tive inter­est rates. Nearly any­one can buy them, and they do. The over­all effect, though, is to vac­uum money out of cir­cu­la­tion. Instead of invest­ing, sav­ing or spend­ing, peo­ple are giv­ing money directly to the fed­eral gov­ern­ment. This decrease in the money sup­ply dri­ves up inter­est rates. How­ever, ris­ing inter­est rates are bad. It makes the cost of credit go up, the cost of doing busi­ness increase, and the cost of goods and ser­vices to rise. Ris­ing costs slow the econ­omy. This is bad.
The Fed­eral Reserve, which is not really a organ of the fed­eral gov­ern­ment but is really a asso­ci­a­tion of large banks, believes that the best way to keep inter­est rates down is to expand the money sup­ply.
Now watch care­fully– here is where the magic occurs; most peo­ple miss it.
The fed has three tools for con­trol­ling the money sup­ply, the most pow­er­ful of which is this: It can buy gov­ern­ment bonds.
So here we are: the Gov­ern­ment has just sold a bunch of bonds. Inter­est rates are ris­ing. The fed wants to lower rates– so it issues a notice, say­ing it wants to buy gov­ern­ment bonds. A price is set, and peo­ple come out of the wood­work to sell their bonds to the Fed. The Fed pays for the bonds with a check– which gets deposited into the account of the seller and even­tu­ally makes its way back to the fed, which then sends money back to the bank. The bank in ques­tion can then use that money to lend out to other peo­ple.
Under cur­rent reserve require­ments (10% for trans­ac­tional accounts), a $1 Bil­lion bond buy­back from the fed expands to around $10 Bil­lion in the econ­omy. This money floods back into the econ­omy, and the rise in inter­est rates is staved off until next month.
Here’s the magic: Where did the Fed get the money to buy the bonds? The answer is sur­pris­ing: nowhere. The money was sim­ply “made” out of thin air– almost. The fed has an IOU from the Trea­sury Depart­ment. Book entries are kept, and if actual phys­i­cal money is needed, the Trea­sury will print it up and deliver it.
This process is known as “mon­e­tiz­ing of the debt.” You prob­a­bly heard it in High School, though you likely didn’t real­ize the sig­nif­i­cance. Your teacher prob­a­bly didn’t, either. This process is a key dri­ver of infla­tion, and demon­strates the link between gov­ern­ment deficits and infla­tion. The money in your wal­let is a Fed­eral Reserve Note, and is really a (very) tiny piece of the Fed­eral debt, processed by the Fed.
(And for those that are con­cerned, I am pur­posely exclud­ing frac­tional reserve bank­ing as a sec­ondary source of money sup­ply expan­sion towards my pur­pose of mak­ing clear how gov­ern­ment debt is linked to infla­tion.)
To con­trol infla­tion is to con­trol gov­ern­ment spending.