In 1913, President Woodrow Wilson was successful in publishing the Federal Reserve Act through Congress. The act allowed the government to establish the third central bank in the nation’s history.
Think of the Fed as the bank of banks, and the government’s bank — the gatekeeper of the U.S. economy. The board, which is run by seven governors and presided over by a chairman and vice chairman, is charged with managing the supply of money and credit to the economy. By manipulating interest rates and creating money, the Fed can either stimulate or stifle the economy. The Federal Reserve is the primary force in determining our nation’s money supply. The Fed’s two main goals are (1) to help stimulate economic growth and (2) to try to keep inflation low. These goals often conflict.
The central bank Federal Reserve System has a tremendous amount of power and a monopoly control over money and credit. The chairman of the Federal Reserves is more powerful than even the president because he has so much control over the economy. The Fed is the key to how much money and credit is in the U.S. economy in any given time. This is due to the fact that the United States currency is a fiat money — in other words, it is not backed by anything tangible, and therefore it can be created out of thin air.
The U.S. dollar was not always a faith-based currency. There was a time when for every dollar in circulation, there was a coinciding amount of gold to back it up — a gold standard.
“In the nineteenth century, starting with the Napoleonic Era, all the major money systems of Europe were anchored by gold,” Bill Bonner explains. “All of these countries had gold lining their systems, so when they traded with one another they could either trade their gold, or if you traded paper money, it was certain that there was gold backing their currency.
“And that system was very, very successful. The prosperity of the nineteenth century was amazing,” Bonner continues. “But that system broke down in World War I; the governments, as they always do, spent too much money. Britain borrowed too much, the French borrowed too much, and then they couldn’t pay it back because they didn’t have enough gold to pay that kind of expense.”
Even so, that gold-backed system lingered on throughout the twentieth century — but not perfectly — and the last stage of this system was Bretton Woods, which lasted until 1971.
Bonner tells us: “Prior to 1971, we had the Johnson administration, we had the Great Society and the Vietnam War, and those things were very, very expensive. And somebody told Johnson, ‘Wait a minute, you can’t have both guns and butter. You can’t have a huge domestic spending program and the Great Society, at the same time that you have a huge war going on in Asia. That won’t work, we can’t afford that.’ At the time the Democrats, led by Johnson, said, ‘Oh yes we can; we’re a big rich country, we can afford both guns and butter.’ Well, sure enough it wasn’t true, and they couldn’t afford that much without raising taxes, and they didn’t want to raise taxes because then they wouldn’t be reelected. So they had this big problem. And what resulted from that was a run on America’s money.”
Other countries, especially the French, led by Charles de Gaulle, noticed that the dollar was weakening. So de Gaulle told then-President Nixon that he wanted to exchange the dollars France had for gold. Nixon examined the situation and realized that if France took all of that gold, the United States would not have much gold left, and in turn decided to close the gold window. That was August 15, 1971, and since then, no foreign government could trade dollars for gold.
Money Supply and Inflation
Now, with the Bretton Woods System a thing of the past, when the Fed determines that the economy needs a stimulus, interest rates are lowered, borrowing becomes easier, and more money flows into the economy. This is known as opening the Fed window, and the result is an increase in the money supply. If the money supply is increasing, consumers are feeling wealthier and more money is changing hands as they buy goods and services.
This puts a chain of events into motion. Businesses see increased sales and therefore order more materials and increase production. This, in turn, increases the demand for labor and goods. What happens after that, in a buoyant economy, is that prices of stocks rise and firms issue equity and debt. If the money supply continues to expand, the prices for these goods and services begin to rise, especially if output growth reaches capacity limits — in other words, a bubble is formed. As the public begins to expect inflation, lenders insist on higher interest rates to offset an expected decline in purchasing power over the life of their loans. When inflation is rising, the dollar is quickly losing value, and the Fed raises interest rates, which means borrowing becomes more expensive and money eventually flows out of the economy.
When the supply of money fails, or when its rate of growth declines, economic activity declines and either disinflation (reduced inflation) or deflation (falling prices) results. Closing the Fed window decreases the money supply.
In a worst-case scenario, the economy can become stagnant and inflation can rise simultaneously, a situation called stagflation. The Fed is then faced with an extremely difficult choice, because it can’t raise interest rates and lower them at the same time. It must choose either to stimulate the economy or to fight inflation. This last happened in the United States in the late 1970s, and it proved to be very difficult time for the country.
The forces of inflation had been picking up steam throughout the 1970s, and the prices of just about everything were hitting record highs. Pete Peterson, then secretary of Commerce under the Nixon Administration, remembers this period in U.S. history clearly. “I was in the Nixon White House,” Peterson recalls, “first as an economic adviser to President Nixon and then as secretary of Commerce. History will record the Federal Reserve was part of the problem. They let money supply get out of control. When Paul Volcker took over he realized he had to take truly courageous action. And he did.”
Dr. Volcker’s office in New York City is adorned with poster-size caricatures depicting the former Fed chairman as a warrior, battling runaway inflation. And these cartoons are hardly exaggerating. Over the din of the ice skaters enjoying themselves at Rockefeller Center, 20-odd stories below. Dr. Volcker told us the tough medicine he had to spoon-feed the United States when he took the helm of the Federal Reserve in 1979. Inflation had reached a “crisis point,” he said, and in less than a year, the Fed’s key rate rose from 10 to 19 percent.
“Inflation,” explained Dr. Volcker, “gets built into expectations, and when people think it’s going to happen it affects their wage demands, it affects pricing policies, and it has a certain built-in momentum, which clearly happened during the 1970s.”
While his raising rates to an all-time high certainly caused some controversy, Dr. Volcker did what was necessary to achieve and sustain stability in the U.S. economy — and found that, overall, the country was ready for him to step in.
“I think the mood of the country was willing to accept action, which ten years earlier they wouldn’t have been willing to accept,” he told us. “And once the country got caught up in an anti-inflationary effort, while they were difficult years, I think there was a certain acceptance of a willingness to take, among other things, very high interest rates and eventually a rather severe recession, [because] there was this underlying core that the country had not been on the right path economically and that it needed to be shaken up, in a sense, to restore stability. And that faith not only sustained me, it sustained the country.
“One of the lessons of the early 1980s is don’t let inflation get started because once it gets momentum it’s very difficult to deal with, but it’s also destructive for economic growth and prosperity. If that happens — and right now it seems like there is a little flavor of it — we will all find ourselves in the days of stagflation and unacceptable economic performance.”
As Dr. Volcker suggested, current economic indicators show we’re entering a similar cycle in the economy. In the second half of 2008, Americans’ inflation expectations have jumped to their highest level since 1981, according to the Reuters/University of Michigan Surveys of Consumers. Not only that, but growing concerns over the country’s two largest buyers of U.S. home loans, Fannie Mae and Freddie Mac, drag down the already hurting U.S. stocks; the price of crude oil hits a new high every day; and consumers are seeing their grocery and energy bills grow by leaps and bounds.
“With respect to the fiscal crisis looming out there in the future,” says Paul Volcker, “We’ll see whether a democracy can deal with an obvious problem that’s going to be present in not too many years. The earlier we take action to deal with it, the better.”
Executive Publisher, Agora Financial
Executive Producer, I.O.U.S.A.
October 6, 2008
Greg’s Endnote: Addison and co-author Kate Incontrera have a lot more to tell us along with some fantastic interviews with Bill Bonner, Pete Peterson, Ron Paul, Paul Volcker, Alan Greenspan, Warren Buffett, and more. You can get your copy of I.O.U.S.A. at Amazon.com by clicking here.