THE FEDERAL RESERVE'S LINK TO INFLATION

Stuart K. Hayashi


           As one sits down reading this, one is probably getting poorer. How can this be? If someone earns a sum of money, and saves it rather than spends it, then, in no way can a person be losing wealth . . . if not for that hidden tax called inflation, which prompts the prices of all goods and services to rise. One may see this as a trend among businesses to maximize their profits. In reality, however, the root cause of the problem is not with businesspeople, but the Federal Reserve System continuously adding more money into the economy.

            Although the phenomenon of inflation affects all consumers, not much is known about it. Some people believe that it is simply caused by businessmen’s hunger for larger profits. In reality, what triggers the rise in prices is an increase of money in circulation, which is a result of the actions performed by the Federal Reserve. (1)

           The Federal Reserve, being the government agency responsible for printing the nation’s money supply, determines how many dollar bills are put into circulation. The dilemma arises because, when more money is added into the economy, then, even if an individual has not spent any of it, he or she is now poorer in relation to everyone else than he or she once was.

           To illustrate this point, say, for instance, that there is a society of only eleven people. One person has one hundred dollars, while the other ten only have ten dollars each. The total amount of money everyone has is two hundred dollars. The richest person therefore has fifty percent of all the wealth, while each other person has five percent. Relative to everyone else, the richest person is extraordinarily affluent.

           Now, say there is a sudden flow of cash to all citizens, and everyone receives one million dollars each. The total amount of money in the economy is now eleven million two hundred dollars. No one has spent any money since then, so the richest person now has one million one hundred dollars, while each other person has one million ten. The richest person now has only approximately nine-point-one percent of all the wealth, and so does everyone else. So, even though the richest person received more money and spent nothing, and he received just as much as anyone else, he is now poorer by forty-one percent when comparing his fortune to that of everyone else. Adding more money into the economy dilutes the value of each individual dollar, thereby decreasing its purchasing power.

           Inflation, however, tends to hurt the poor far more than it does the rich. For example, if a woman retires with four thousand dollars saved up, and the cost of a decent living is five thousand, then she only has eighty percent of what she needs to survive. Then, a year later, if there is one hundred percent inflation, then the necessary cost of living becomes ten thousand dollars. Even if that woman still had four thousand dollars, she would now have only forty percent of what she needed. As in the first example, the value of the dollar has gone down, since a dollar now only buys half of what it used to.

            Though they often have been blamed for inflation, businesses themselves are victims of it, as each company sees the costs of all of its resources rising. Retailers pay rising costs to distributors, who pay a rising cost to suppliers, who pay a rising cost for their resources. If a businessperson does not raise the prices of his or her own merchandise, while the prices of all of his/her resources are rising, then he or she will have to reduce profits or cut back on much-needed supplies and services to maintain the company, which, in the end, could mean less business and still result in less revenue. Thus, inflation necessitates that businesses raise prices and employees demand higher wages, which often takes place in a haphazard fashion. (2)

           There are numerous types of currencies, and inflation affects each of them differently. If only gold were used as money, then inflation could only occur when new gold was dug up. Under a gold standard, one can also use paper money backed by gold. If all paper money is backed by an objective gold standard, it is called receipt money, and it is difficult for each receipt to inflate, because law requires that it can only be exchanged for the amount that is printed on it. This sort of monetary system, however, requires that there is enough gold to back all of those receipts. (3)

           There are other types of paper money, however. One is of a fractional reserve system, in which gold only backs a fraction of all the money in circulation, as in the case of the United States dollar during the 1920’s. (4) This is often confused with having a direct gold standard (which can only exist with receipt money), though it is very different. The last type of paper money is fiat—legal tender backed by nothing, which is what America currently uses.(5) Under both of these systems, the government can print as many bills as it wishes, creating the ever-present risk of inflation.

            The effects of inflation under fractional and fiat monetary systems have caused numerous catastrophes throughout history, two examples of which are the stock market crash of 1929 and the economic crisis of pre-Hitler Germany.

           Though this student author was taught in his high school American History class that the 1929 stock market crash was brought about by “the greedy speculators on Wall Street bidding up stock prices,” and that “it is good that we have the Federal Reserve to prevent such a thing from happening again,” further reading on the subject has revealed that explanation to be incomplete, and the conclusion over-simplified. [For more info on what I was "taught" in high school, see "A Tribute to Mrs. S#@!+$".]

           Of all people, one would expect Alan Greenspan to be an expert on the subject of the Federal Reserve. After all, he is the agency’s current chairman, as he was during the Reagan Administration. (6) It should also be noted that the material prosperity of both the Reagan and Clinton Administrations has often been attributed to this individual’s knowledge of macroeconomics. (7) Considering all of this, it would seem that Greenspan would have an intimate knowledge of both the “Fed” and of the effects of monetary policy. Because of his position, it is interesting to note that it is the Federal Reserve that Greenspan blames for starting the Great Depression.

           According to Greenspan, as well as Nobel Prize-winning economist and presidential advisor Milton Friedman, the reason for the crash was that the Federal Reserve printed too many bills, and kept the interest rates drastically low, thereby encouraging too much money-lending, thereby putting too many dollars into the economy.(8) All of the bills in circulation gave investors the impression that the economy was in better shape than it really was, leading to a “speculative boom.”(9) When the true situation was discovered, there was a run on the banks. Because there was not enough gold to back all of the dollar bills, those who reached the banks first got their money, while those who got there later ended up with nothing at all—reduced to poverty in a matter of days.(10) As Greenspan explains, “The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets.” (11)

            The “Fed” chairman believes it was unfortunate that the laissez-faire gold standard was attacked as a result, since the real culprit was the government’s mismanagement of the money supply. Says he, “The irony was that since 1913, we had been, not on a gold standard, but on what may be termed a ‘mixed gold standard’; yet it was gold that took the blame.”(12)

            Supposedly to prevent such an egregious event to ever reoccur in the United States, all ties the dollar bill had to gold were severed on August 15, 1971, in an executive order sent by then-President Richard Nixon.(13) America has had a fiat monetary system ever since. Still, there is no reason to believe that this alleviates the nation of economic worries. After all, the overuse of fiat money in Germany, after World War I, created an even deadlier financial catastrophe.

           After the Great War’s end, France and England demanded tremendous monetary reparations from Germany. Because the German government feared the political consequences of raising taxes, it instead printed a multitude of new marks and sent them to the two victorious counties. Britain and France spent all of that money on German products, thereby putting all of that money back into Germany’s economy, flooding it. In the beginning, four marks equaled one dollar. After rapid inflation, however, a single dollar was worth 4,400,000,000,000 marks, rendering worthless the life savings of so many Germans. As everyone’s purchasing power decreased, vendors raised prices and workers demanded higher wages. There was massive pandemonium and rioting in the streets, as everyone grew poorer without knowing why. (14) The massive plight led people to yearn for a leader to take them out of this mess. Unfortunately, they put their trust in Adolf Hitler. (15) Government management over the economy did nothing to prevent this, though it certainly helped bring it about.

            The best way to combat inflation is nothing short of radical: a return to the gold standard, meaning a real gold standard, in which all of each paper receipt is backed by gold; not by just a fraction. Banks that would be legally expected to deliver cash upon request would issue the receipt bills. Since new gold is rarely discovered, the purchasing power of each bill would remain more stable than it would if the government had the power to create more money.

           One may wonder if the there is enough gold in the world to fuel the international economy. No one knows for sure, but it should be noted that the Federal government holds immense stacks of gold (that does not back our money) that could be sold to the public. (16) Such a process would certainly be difficult, but many of the problems associated with inflation could at least be averted. As Alan Greenspan put it, “Deficit spending is simply a scheme for the ‘hidden’ confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.” (17)

           The gradual but constant trend of rising prices for goods and services, as well as in wages, is only the logical result of the Federal Reserve System in action. In order for to halt inflation, the Federal Reserve’s central banking must be put an end to, and a free market in gold must be re-instituted.



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END NOTES

1 Milton Friedman, Nobel Prize-winning economist and presidential advisor, with Rose D. Friedman, Free to Choose: A Personal Statement, Reprint edition, (San Diego: Harcourt Brace, 1990), p. 248, 254.

2 Ken Schoolland, Principles of Macroeconomics: ECON 2015D Course, Hawaii Pacific University, Wednesday, 20 October 1999.

3 G. Edward Griffin, The Creature from Jekyll Island: A Second Look at the Federal Reserve, Second edition, fifth printing, (Appleton: American Opinion, 1996), pp. 151-2.

4 Griffin, p. 165.

5 Ibid., p. 91.

6 “Inside the Mind of Greenspan: Fed’s Powerful Chief a Regular Guy Who Enjoys a Good Laugh, Mozart,” USA Today, Sunday, 28 May 1999. Reprinted in The Honolulu Advertiser Business Section, p. G1, G4.

See also Martin Crutsinger, “Greenspan’s Decade Prosperous.” Reprinted in The Honolulu Star-Bulletin, Hawaii Inc. Section, Monday, 11 August 1997, p. C-4.

7 “Inside the mind of Greenspan,” p. G1, G4. Also Crutsinger, p. C-4.

8 Alan Greenspan, current chairman of the Federal Reserve, “Gold and Economic Freedom,” Capitalism: The Unknown Ideal, edited by Ayn Rand, (Signet: New York, 1967), pp. 96-109. When Greenspan wrote this article, he was the chairman of Townsend-Greenspan & Co.—a successful New York economic consulting firm. Friedman, pp. 70-90.

9 Greenspan, pp. 99-100.

10 Friedman, pp. 73-4.

11 Greenspan, p. 101.

12 Greenspan, p. 100.

13 Griffin, p. 91.

14 This event was described in great detail by: Ken Schoolland, 20 October 1999.

15 Friedman, p. 70. Schoolland, 20 October 1999.

16 Ken Schoolland, Friday, 15 October 1999.

17 Greenspan, p. 101.




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The above essay is Copyright © 1999 Stuart K. Hayashi, and may not be reproduced by any means without his written consent. All rights reserved.