Demand Deposit Inflation
JANUARY 01, 1968 by ANTHONY REINACH
Mr. Reinach, an occasional contributor to THE FREEMAN, is a New York businessman, freelance writer, and monetary economist.
Suppose that yours is a small community which, before automobiles, would have been referred to as a "one-horse" town. Today it might be called a "one-gasoline-station" town. Its government is centered in a mayor who has promised to render generous services on a parsimonious budget. Actually, the mayor seems to be achieving his contradictory objectives. In truth, however, he has prevailed upon the proprietor of the town’s only gasoline station to mix his gas with water and share with the town government the profits generated by the dilution. The exposure of this knavery triggers a campaign to justify it as "government policy in the interest of the people." Notwithstanding, I suspect that righteous indignation will still be aroused in even the town’s most benign citizens.
Although such knavery is, of course, ludicrous, it is just as ludicrous that citizens, in respect to their money, passively permit their Federal government to victimize them by essentially the same fraud as described above. The fact that this fraud, monetary inflation, will uncontestably perpetrate more injustice in the next decade than did the Spanish Inquisition at its height suggests that there are precious few individuals who really understand monetary inflation.
Technologically, money has taken three basic forms: commodity, paper, and checking account funds. Collaterally, monetary inflation has evolved from coin debasement, to printing press, to the creation of spurious demand deposits. Because demand deposits are the monetary tools employed in over 90 per cent of America’s financial transactions, it is demand inflation that is destined to make history’s most notorious swindles look like Tootsie Roll thefts by comparison.
Recipe for Inflation
To understand how demand deposit inflation works, imagine yourself in the role of a drugstore owner. The name of your drugstore is Fiscal Pharmacy, and you operate it with one employee, Samuel. You wish to remodel your store at a cost of $10,000, but all your funds are being used for other purposes and you have already stretched your credit to just about the last penny. It seems that you will have to abandon, or at least postpone, your remodeling program. But then you get an idea!
You go to your local printer and instruct him to print up $10,000 worth of 30-year bonds on Fiscal Pharmacy, to yield 31/2 per cent. In addition, you instruct your printer to make up a checkbook for "The Samuel Trust Company." A few days later, armed with the freshly printed bonds and checkbook, you summon Samuel to inform him of a proprietary position with which you are about to reward him for his loyalty:
You. I have decided to remodel Fiscal Pharmacy. It will take $10,000.
Samuel. That’s a lot of potatoes.
You. Yes, and I haven’t been able to raise the first dollar.
Samuel. Maybe you should cut your personal living expenses.
You. And have my wife throw me out?
Samuel. So what do you propose?
You. Here’s my plan. From now on, you will function not only as a clerk, but also as the private banker for Fiscal Pharmacy.
Samuel. But I haven’t got $10,000.
You. You won’t need it. In fact, you won’t need any of it.
You. No. Here’s $10,000 worth of bonds on Fiscal Pharmacy and a checkbook for "The Samuel Trust Company." Your bank now owns the bonds, so please pay for them by issuing a $10,000 check to Fiscal Pharmacy.
Having deposited this check with a conventional bank—conventional, that is, except for its naivety — you now have the wherewithal for your remodeling program.
The funds you subsequently transfer to your contractor will soon be transferred by him to his own creditors and others, and so forth. Thus begins the process by which the $10,000 you and Samuel conspired to create become diffused throughout America’s entire commercial banking system. However, the atomized dispersion of that $10,000 will in no way diminish its impact on the nation’s money supply.
Because banks are permitted by law to lend out roughly 80 per cent of their deposits, and because banks, since World War II, have been vigorously lending out virtually every dollar allowed by law, an additional $8,000 (80 per cent of $10,000) of loans — or investments in credit instruments, which is the same thing—will be promptly made.
These new loans will be promptly returned to the banking system as new demand deposits and will, in turn, enable the banks to lend out another $6,400 (80 per cent of $8,000), which will likewise be deposited and generate the additional lending of $5,120, et cetera, et cetera, et cetera. The result will be $40,000 of derivative demand deposits spawned from the initial bogus $10,000 demand deposit, for a grand total of $50,000.
The Government Procedure That Triggers Inflation
Fictitious? Yes. Fantastic? No. With one major modification, the conspiratorial procedure by which you and Samuel created the initial bogus $10,000 is essentially the same procedure by which government triggers monetary inflation. How such money mushrooms into five times its original amount is not even privileged information; indeed, it is publicized by the government itself.
Monetary inflation begins with the Federal budget which, let us suppose, is $150 billion. To raise this money, the government can tax, borrow, or inflate. Let us further suppose that the government taxes $100 billion and borrows $40 billion, still leaving it $10 billion short. At this point, were my drugstore analogy procedurally accurate, the U. S. Treasury would enter in the role of Fiscal Pharmacy’s owner, and the Federal Reserve would enter in the role of Samuel, Fiscal Pharmacy’s private banker:
Treasury. Our expenses this year are $150 billion.
Fed. That’s a lot of potatoes. Treasury. We were able to tax only $100 billion.
Fed. Maybe you should raise taxes by 50 per cent.
Treasury. And get voted out of office?
Fed. Well, how much were you able to borrow?
Treasury. $40 billion.
Fed. That still leaves you $10 billion short.
Treasury. Yes, so here’s $10 billion worth of bonds. Please issue a check in payment for them.
If the actual procedure were this brazen, the naked chicanery of monetary inflation would be too fully exposed. Consequently, the Treasury rarely sells government bonds directly to the Fed. Instead, the Treasury simply notifies the Fed when it has unsold bonds. The Fed, in turn, starts buying government bonds in the open market with the exclusive purpose of creating the very market-place climate required by the Treasury to liquidate its sticky inventory. The final result, of course, is the same as if the Treasury had sold the bonds directly to the Fed in the first place. In fact, the net result may be even more inflationary; it is quite possible that the Fed might have to buy $11 billion worth of bonds in the market to enable the Treasury to dispose of $10 billion.
The Fed claims to have three weapons of direct control over monetary inflation. But this claim would be valid only under circumstances which would make the weapons unnecessary: (a) when the government is balancing its budget, or (b) when the government, having failed to balance its budget, is willing to sell its bonds on a free market basis. When neither situation prevails, the Fed’s alleged weapons are rendered impotent and simply serve as disguises for monetary inflation. Those three weapons are:
1. Open Market Operations
2. Reserve Requirements
3. Discount Rate (or Rediscount Rate)
Open Market Operations
Open market operations are simply the buying and selling of government bonds by the Fed. One side of the open market operation coin has already been demonstrated — the buying of government bonds to help the Treasury sell its own. In theory, after the Treasury is rid of its bonds, the Fed turns around and starts merchandizing its own recent purchases. In practice, regrettably, the Treasury is rarely without bonds for sale, at least these days. As a result, the Fed’s ownership of government bonds has increased from $26 billion to $48 billion on the past 7 years, and that is the launching pad destined to rocket prices in the forthcoming decade.
Reserve Requirements Tend Toward Zero
As already stated, banks are permitted by law to lend out roughly 80 per cent of their deposits. The figure today is nearer 85 per cent but 80 per cent illustrates the point and is easy to figure. The difference between 80 per cent and 100 — 20 per cent —is, correspondingly, the figure commonly used as the average reserve requirement for the three categories of commercial banks which are members of the Federal Reserve System. This means that these member banks must deposit with the Fed 20 per cent of their total demand deposits. By raising reserve requirements, the Fed would deter part or all the inflationary impact threatened by its government bond purchases. This, however, would "tighten money", which would cause higher interest rates, and would thereby make it more difficult for the subsequent sales of government bonds at "favorable" rates of interest. As a result, reserve requirements for city banks have not been raised in over 15 years. (On November 24, 1960, the reserve requirement for country banks was raised from 11 to 12 per cent.)
The discount rate is the interest rate member banks must pay the Fed for borrowing money from it. When a bank becomes temporarily "under-reserved" (has more than 80 per cent of its demand deposits out on loan, which is the same as having less than 20 per cent of its demand deposits available for deposit with the Fed), it has a choice of either borrowing from the Fed or liquidating some of its loans. In theory, the second course of action will counter inflation whereas borrowing from the Fed will not. Therefore, to carry the theory further, raising the discount rate will discourage borrowing and thereby counter inflation, and lowering the discount rate will encourage borrowing and thereby stimulate inflation. Ironically, this theory more often than not operates in reverse. Prompted by a costly discount rate to counter inflation through the liquidation of loans, commercial banks usually begin by selling some of their government bonds. This, in turn, will cause consternation in U.S. Treasury circles, which will instigate telephone calls to the Fed, which will trigger open market purchases, which will add more fuel to the inflationary fire than was initially withdrawn by raising the discount rate. For this reason, the discount rate is useless as a weapon to combat inflation.
Prime Commercial Paper is America’s most valued interest-bearing credit instrument, and it interest rates are the most sensitive to shifts in financial sentiment. Since World War I, there have been 24 trend reversals in the Federal Reserve discount rate. Without exception, these trend reversals were preceded by trend reversals in Commercial Paper interest rates. In other words, and notwithstanding the lofty pronouncements of "positive constructive action" that attended many of these 24 trend reversals, the Federal Reserve discount rate for half a century has been tagging after the Prime Commercial Paper rate like an obedient puppy.
Change in Discount Rate A Powerless Weapon
Twice, in 1926 and again in 1927, when stock market speculation rather than monetary inflation was the object of "summit" control, the Fed reversed the discount rate trend by reducing it half a percentage point. In total disregard of prior reductions in Commercial Paper rates, an entire generation of monetary intellectuals has been placing part of the blame for the subsequent stock market boom and bust on one or both of those two discount rate reductions. Even the Fed’s own documents make it abundantly evident that the discount rate is just as powerless to combat the current generation’s inflation as it was to combat the last generation’s stock market boom.
Over the years, the Fed also has enlisted gold to minify the threat of inflation. Until the early 1960′s: "Gold [was] the basis of Reserve Bank credit because… the power of the Reserve Banks to create money through adding to their deposits or issuing Federal Reserve notes is limited by the requirement of a 25 per cent reserve in gold certificates against both kinds of liabilities. That is to say, the total of Federal Reserve notes and deposits must not exceed four times the amount of gold certificates held by the Reserve Banks. Thus, the ultimate limit on Federal Reserve credit expansion is set by gold." Yet, on the preceding page in the same publication, the Fed confesses that when circumstances in 1945 "threatened to impinge upon the Federal Reserve’s freedom of policy action…, Congress deemed it wise to reduce the reserve requirement of the Reserve Banks from 40 per cent for Federal Reserve notes and 35 per cent for deposits to 25 per cent for each kind of liability."’
In 1963, Dean Russell concluded: "Whenever the technical cutoff relationship between gold and ‘money’ has been approached in the past, Congress has modified it—and will unquestionably do so in the future, even to the point of abolishing the technical requirement altogether."2 Was Dean being a prophet, or just a realist?
Or perhaps Dean was simply taking the Fed at its word for, by 1963, it was no longer terming "gold…the basis of Reserve Bank credit…", but was saying instead: "… reserves in gold constitute a statutory base for Reserve Bank power to create Federal Reserve credit." Then, two years later, came the dismantling of that "statutory base": "The law determining the minimum holdings of gold certificates required as reserves against the Federal Reserve Banks’ liabilities was changed on March 3, 1965. The Reserve Banks are no longer required to hold 25 per cent reserves against their deposit liabilities, but they are still required to hold gold certificates equal to at least 25 per cent of their note liabilities." Was Dean’s predicted reason correct, that "the technical cutoff relationship between gold and ‘money’ (was being) approached"? Letting the Fed speak for itself: "If the change had not been made, the amount of ‘free’ gold certificates on March 31, 1965, would have been [down to] $1.0 billion.”2
Monetary and Other Factors Affect Impact of Inflation
There are many minor monetary factors constantly influencing the impact of inflation. One of the more important is the conversion of demand deposits into cash, and vice versa. For example, the withdrawal of $100 from your checking account not only immediately reduces demand deposits by $100, but also ultimately extinguishes an additional $400 of derivative demand deposits. Consequently, money is customarily "tight" just before Christmas—when the demand for cash is at its height.
There are also many "non-monetary" factors constantly influencing the impact of inflation. The standard here is productivity. Thus, the most aggravating factor is war, and the most moderating factors are technological advances and industrial expansion. Labor strikes, because they curb production, aggravate the impact of inflation. Labor contracts that result in the curtailment of laborsaving devices also aggravate the impact of inflation, but labor contracts that merely call for the escalation of wages do not. A population increase of productive citizens moderates inflation’s impact, but a population increase of nonproductive citizens or a population decrease of productive citizens aggravates it. England’s "brain drain" must aggravate the impact of that nation’s inflation, but will moderate the impact of America’s inflation to the extent that we inherit those "brains." The flight of capital to foreign countries is an aggravating factor whereas the influx of foreign capital is a moderating factor. In a related vein, a so-called "favorable balance of trade" is an aggravating factor whereas an "unfavorable balance of trade" has a moderating effect.
Assessing the Consequences
Some factors which seem to counter the impact of inflation actually intensify it, and vice versa. For example, credit and price controls, inflation’s two most inevitable corollaries after rising prices, put sand in the gears of production. Both, thereby, intensify the impact of inflation. On the other hand, increases in the velocity of money (its change-of-hands frequency) are inflationary in theory, but, in reality, counter the impact of inflation. The reason is that most money velocity increases are attended by and generate even greater production increases.
Far more crucial than the factors influencing the impact of inflation are and will be its withering consequences on American life. Historically, every nation whose government resorted to monetary inflation suffered unremitting demotions of its "general welfare." Nor has any government ever abandoned an entrenched policy of monetary inflation. Therefore, barring the revocation of the lessons of history, one need not be a prophet to chart America’s economic future.
For 2,500 years, man has been given but two grim choices in respect to his money: "managed" and "convertible gold standard." Chronic monetary inflation goes with a "managed" money system just as chronic money panics go with a "convertible gold standard" money system. The 19 or more money panics that afflicted America in her 170 "convertible gold standard" years negate "convertible gold standard" money as a rational alternative to "managed" money. The only remaining alternative is free enterprise money. This, of course, would require the elimination of government from the money business.
1 The Federal Reserve System, Purposes and Functions, 3rd edition, sixth printing, 1959, pp. 96 and 97.
2 Dean Russell, "Money, Banking, Debt and Inflation," unpublished paper, 1963.
3 The Federal Reserve System, Purposes and Functions, 5th edition, 1st printing, 1963; 2nd printing, 1965; pp. 165 and 175.