William Greider, in Secrets of the Temple, his magnum opus on the Federal Reserve System, tells his readers that there was once a time when discussions of monetary policy were so common that they could be heard in small town cafes and barber shops. I know for a fact that Greider is correct because I am just old enough to have heard some of those conversations in my youth.
It has been almost 40 years since an old-fashioned prairie Populist first sat me down to explain the workings of money. In those years, I have read every book on monetary policy I could find, watched the Fed religiously, and have written extensively on the subject.
Monetary policy is not an easy subject to follow. There is a saying that "only two people really understand money and they disagree." It may not be that bad--but it is close. Most writers on monetary matters have an axe to grind. Some lapse into convoluted conspiracy theories usually involving a Jewish or Freemasonic plot. Others merely postulate obscurantist apologies for the ultimate wisdom of bankers. But I have found over the years that even though my views have become much more elaborate, the basic lessons of that Populist have gone unchallenged.
Understanding money is a liberating experience. Suddenly, everything makes more sense. The widespread confusion surrounding the latest moves by the world's central bankers means that many who would attempt to understand these economic disasters could profit from those lessons from my youth.
And, it turns out, money is not so very hard to understand.
Rule #1. Money is only information
We have Richard Nixon, surprisingly enough, to thank for ending any confusion on this subject. Money has taken many forms throughout history from cows to gold, and from cigarettes to paper.
When the U.S. finally abandoned the last vestiges of the gold standard in the 70's, many predicted dire consequences. Without a finite substance to 'fix' the value of money such as gold, there would be uncontrolled inflation--the doomsayers warned. And there was an ugly bout of inflation in the 70's. But with the Fed policies of Paul Volker, a recession was triggered that was just as ugly as any panic from the bad old days of the gold standard.
Money is now merely positive and negative charges stored somewhere in computer memory. The physical manifestation of money has changed, but the real nature of providing information has not changed at all.
In fact, since computer chips are the heart of the 'information age,' the issue may be easier to understand now than ever before.
Rule #2. The most interesting information that money conveys is that of value
There are many computer chips on the planet with very interesting information stored on them, but nothing affects people like the information about the size and quality of their bank balance. If the balance is large, houses, cars, sexual fulfillment, fine food and power are available to the individual fortunate enough to find that information attached to his name. If the balance is small, the same individual can find himself eating out of garbage cans and sleeping under a bridge.
Rule #3. Humans determine the value of money
Money has value because it can be exchanged for something else. For most of history, economics was about scarcity. Money defined this reality only by being scarce itself. Real estate is the ultimate example of a scarce good. The amount of land is essentially finite even though a few swamps have been drained and land, such as in Holland, has been reclaimed from the sea. But essentially the 'iron law' of money was pretty simple. Increase the supply of money, the price of real estate inflates.
The ancient world had other examples of scarcity such as attractive women, imported goods such as silks and spices, and human labor. An increased money supply would raise the price of each without changing the overall wealth of the society very much.
The Industrial Revolution changed everything. Wherever production was organized industrially, the economic problem became one of disposing plentiful goods rather than rationing scarce goods. The new reality of industrialization did not abolish the old rules--it merely added complications. While increases in the money supply only brought inflation to the pre-industrial societies, it produced new ventures in industrial societies. But even industrial societies had finite supplies of real estate which meant the old rules still applied in important sectors of the economy. Monetary policy must balance the needs of the economics of scarcity with the incompatible needs of industrialization.
With the coming of the industrial revolution came a fight over money. The new industrialists wanted more money in circulation to supply their needs. The fight, however, was really over something more basic--who was creating.
In pre-industrial societies, the creator of things of worth was assumed to be supernatural. People did not create land or jewels. Wealth was gathered or seized.
But agriculture first proved this assumption to be false. There is more to agriculture than the harvest. Agriculture is about planting and tending as well.
Those who did the work naturally resented those who assumed that growing was only about gathering what God had provided. Even so, farmers supply only a small fraction of the creativity necessary to produce a crop.
As the creative input became a greater fraction of the finished goods, the assumption that wealth is merely gathered became increasingly false.
Take a modern example of a manufactured product such as a microdisc filled with application software. Everything about the product has been processed beyond recognition. The case is plastic which is formed from molecules once found in an oil well. The metal originated in a mine.
Even so, a blank microdisc is only worth a few cents. The rest of the value is contained in the program written on the blank disc. The software writer can legitimately claim that the raw materials necessary to produce his product are less than 1% of the total value of the finished item for sale. If money merely reflects the bounty of nature, it cannot accurately describe the creative value of human input.
For all its complications, the argument about the nature of money in post industrial societies is rather simple:
- Money must be created in sufficient quantities to accommodate growth.
- Someone must do creative work to give worth to the new supply of money.
All other questions about money are secondary.
Humans have been determining the value of the creations of nature for a very long time. The whole idea of the 'free market' was formed around this very problem. The creations of humans are quite another problem altogether.
If a new product appears on the market, its value is determined by a formula which looks something like
V is the amount of money validated
HN is an assessment of human need whether physical or psychological;
CD is the creative design input which is a combination of learned information plus the intuitive flash;
T is the existing technology;
RI is the resource input from nature;
HE is the physical effort or work supplied by humans; and
E is the energy supplied from nature in the form of fuels.
Because all six elements are critical, many forms of human endeavor do not add to value. For example, the value of the Russian Ruble is based almost completely on the value of their raw materials.
Their manufactured goods, are in the main, essentially worthless because they fail in so many areas. They are not very creative, they do not meet human needs very well, they do not represent much real work, and are manufactured with primitive technology. So even though Russian goods are made with prime natural resources and use large amounts of fuel in the manufacturing process, they fail to create value because they fail so miserably in the other four areas. Interestingly, the manufactured products the Russians DO sell (Kalashnikovs, nuclear power plants, titanium processing) are products where the real investments were made in USSR days.
On the other hand, suppose an industrial manufacturer goes through all six steps and the money supply does not increase to match the added value, a vicious form of deflation follows. Two things happen:
- The new product must displace others in the fight for the available currency. Factory-produced cloth displaced the output of weavers. The result was a massive displacement of artisans. In the early stages of industrialization, most advances were of this type because the new product was a cheaper form of the old product. There was little need to educate the customer about his need for cloth. Of course, this would not have created any problems if there were other ways to prosperity for the displaced artisans. Which leads to problem
- If a manufacturer introduces a new product which does not displace an old one and the currency supply does not expand, the product will simply fail. The fight for the share of the currency pie is simply too hazardous. Even if prices for everything deflate so that there is room for the new product, there may still be insufficient currency for it. Not only do buyers instinctively close their purses in times of deflation, but the new producer, in fulfilling the six requirements, has incurred fixed costs. There is a minimum selling price below which, a producer simply cannot operate.
Typically, the more sophisticated the product, the higher the fixed costs. Sophisticated goods must either sell very widely to justify the high fixed costs, or they must command a very high selling price. Both requirements are extremely difficult in times of deflation.
Technologically sophisticated goods, then, must have an orderly growth of the money supply, and creative, clever, hard-working, well-educated people to make the new money valuable. Both are absolutely essential.
Rule #4. Those who set the rules for the formation of money determine everything else
By now, this rule should seem obvious. Someone has to create the new money in an orderly fashion. Someone must also determine which bright-eyed inventor or entrepreneur has a project which will ultimately validate money. In most countries, this job goes to the bankers. The process goes something like this:
A producer approaches a bank for an operating loan. He needs the money for a new product.
- The banker assesses the creditworthiness of the producer. If he is likely to make something which would validate the new money with the loan and has sufficient collateral should the enterprise fail, the banker will consent to grant a loan.
- Under the standard procedures of banking, banks may legally loan out money at multiples of their basic capital. The total capitalization represented by stockholders and depositors normally ranges between 3% and 20%. The asset base of a bank is represented by its loans. The banks are allowed and encouraged to "create" new money. Increasing the amount of money in circulation is often considered banking's primary social function. This is most often done through the checking system. The bank approves the producer's loan, the papers are signed, and new money is entered into the producer's checking account.
- The producer spends his "borrowed" money for production equipment, materials, energy, etc.
- The producer makes something to be sold at market. Using the money, he repays the loan with interest.
- When the banker is repaid, the money continues to circulate only if the banker uses the money to pay himself or his shareholders and the money is spent. The money may also be used to increase the basic capitalization of the bank. In this case, the money which was created when the loan was made is now extinguished--removed from circulation. It does not completely disappear, however. Because this "money" remains on the bank's books as capitalization, it allows the bank to make increasingly larger loans.
Both Producers and Bankers agree this is what happens. Both know that money has been created out of thin air. And while Producers question the fairness of the whole arrangement, they are certainly convinced that this system is superior to the gold-based monetary systems it replaced.
But if money can literally be created and destroyed by keystrokes on a computer, the logical question becomes--when and why does this money become valuable?
The banker's argument is that money gains value through sound fiscal management. By adhering to the capital reserve requirements fixed by the central banks (Step #2) the banker has prudently maintained the value of money by not creating an excessive amount. This argument, incidentally, is the central theme of what has become known as "monetarism."
A sociologist might argue that money becomes valuable when it is spent and the merchant honors the check. (Step #3) However, if too much money has been created, eventually the merchant may not honor the check. As a result, the merchant's faith in the value of the money in the producer's checking account seems to be an important, but secondary phenomenon. The real work of making money valuable lies elsewhere.
The producer argument is much more convincing. The producer point is that it was he who made the money valuable. (Step #4) It was he who performed the magic of turning computer keystrokes into a finished product. It was the producer who paid back the loan which allowed the banker to increase the wealth of the bank. (Step #5) A producer would point out that even the banker agrees with him. The purpose of the banker screening loan applicants, after all, (Step #1) is to determine which producer is capable of turning money into food, clothing, shelter, etc.etc.etc.
Some still argue that wealth comes from the earth because no matter how clever, every producer must have natural resources with which to work. These people have a point. But while all wealth may originate in the earth, what becomes of it is in the hands of the producers. After all, people stepped on diamonds for thousands of years before anyone ever thought of making jewelry and hundreds of years more before anyone thought to make drill bits and phonograph needles of them. Iron ore existed for millennia before anyone made a bridge out of it.
In fact, the argument "all wealth comes from the earth or is a gift from God" is usually made to discredit the role of the producer and provide cloak of legitimacy to the banker.
Rule #5. Interest rates ultimately determine the effective supply of money
Charging interest is usually considered the service fee to the banker for the job of managing money. Under the story-book version of banking, this seems quite reasonable. Traditionally, bankers are considered sober citizens who find money that is not being needed, pays 7% to induce the owner of this money to deposit it in his bank, lends it to someone else who needs the money at 10%, and pockets the difference. And this is the way simple lending procedures in fact operate.
But certain institutions are empowered to create money. In the U.S. it is the Federal Reserve Bank and commercial banks. For them, the real process is as was described above. For these institutions, charging interest is not necessary at all because they are, in fact, receiving effectively 100% interest on newly created money even if the interest rate was zero.
Actually, this is not quite true. If the banker picks a producer who does not validate the new money effectively, the new money becomes inflationary. Because some producer is always screwing up somewhere, any society which increases its money supply will have an underlying rate of inflation. Add to this monopolies which can raise prices no matter what else is happening in the economy, and the finite natural order which will not increase no matter what humans are doing, and minor inflation is a fact of modern societies. The Fed and the commercial banks charge interest most probably out of courtesy to those sister institutions which do not have the power to create money. So no matter what happens, the basic interest rate must be at least equal to the rate of inflation so that lenders at least do not lose ground.
But since lenders are in business to do more than merely not lose ground, they must also take a part of the increase supplied by the producer/borrower. Assuming the producer has followed all the above steps, he will have added to the value in excess of the money spent for simple raw materials and energy. His creative work will have validated the rest. This process when looked at in a large context does not produce inflation but growth. This growth is regularly measured in industrial societies and is measured in the Gross National Product. If accurately measured, G.N.P. growth is simply a measurement of how much new money is being validated.
If the interest rate is inflation plus growth in G.N.P., then the effective rate of interest on newly created money really is 100%. In other words, bankers are taking control of money from the producers as fast, on a society-wide scale, as it is being created and placed into their hands.
Over the years, there has been a huge argument over the subject of usury. In the beginning, usury was defined as any interest payment. For 1500 years, Christianity taught that usury is a sin . Since without interest payments, money-lending would not happen, Christians turned to Jews for the service until John Calvin came along and made moneylending at interest something Protestant Christians could do. Lending created prosperity which, in turn, took the onus off charging simple interest.
This did not, however, stop the argument over usury--which now became the process of charging excessive interest. The question becomes "What is excessive?"
The industrial answer is simple. If the basic rate of interest is higher than inflation plus growth in G.N.P., damage will eventually accrue to industrial societies. Since the goal is growth and producers who are successful in validating new money should and must be rewarded, the point where interest becomes usury is slightly less than the growth in GDP plus inflation. This point, hereinafter referred to as the Natural Usury Point, (NUP) would be 6.5% if inflation were 4% and growth in GDP were 3%. Any figure above NUP will cause deflation and other forms of economic distress. Any figure below this rate will cause general and widespread prosperity.
One other proviso. NUP only applies to simple interest. Compound interest--the process of adding accrued interest to principle--poses another set of problems altogether. If simple interest can be justified, compound interest can never, ever be justified. The reason is simple--compound growth of ANYTHING in a finite biosphere is simply impossible.
When someone wishes to describe the glories of compound interest, the story of Caesar's cent is trotted out. The story varies, but if someone had invested a penny at the time of Caesar a 5% compounded interest, by now that investment would have grown to a size where all the pennies in the world, even if the planet were made of copper, would not represent the figure today. The problem is not that one could not convert the pennies into some less bulky form of money. The problem in that all geometric growth curves eventually reach the stage where they are asymptotic.
The growth curve has become vertical. Interest rates have become essentially infinite. Compound interest has only one real purpose--to bankrupt the borrower. It can never lead to widespread prosperity.
Simple interest brings order to monetary dealings. This is true, if for no other reason than that it keeps the producer on the treadmill. It keeps him honest and provides incentive to be industrious. The sooner money is paid back, the sooner the returns accrue to the investor. A producer has incentive to pay back today because tomorrow there is more to pay back.
Having said this, it should be noted that interest rates above NUP will provide an even more effective treadmill. The problem is, if the treadmill is run too fast, more than the producer is destroyed.
The damage to the economy when interest rates exceed NUP
Since 1979, the prime rate of interest in the U.S. has exceeded NUP by a considerable margin. In fact, the recession/depression of 1991 can be considered a direct outgrowth of excessive interest and this latest financial panic can easily be traced to 17 consecutive interest rate increases. The problem of excessive interest is that more money is being removed from a producer's control than is placed at his disposal.
The honest producer cannot validate money fast enough. When interest rates too high, only a thief can repay the loan. Even if the producer does not steal from another, he will be forced to 'steal' from his employees, the future--his children, the environment, or a combination of all of them.
Excessive interest rates in a highly leveraged society where almost everyone borrows and those who do not, have governments who borrow in their name, cause society-wide damage. Damage is caused in two ways--when interest rates are far above NUP, or, when interest rates are slightly above NUP but are kept that way for an extended period of time
Stage 1 Damage. The first victims of usury are small producers in competitive, credit-sensitive industries. Start-up enterprise must compete in shrinking markets. Most fail.
Stage 2 Damage. Existing companies take shortcuts, defer maintenance, cut back on R&D, etc. Wages drop. Layoffs begin
Stage 3 Damage. Social order is disrupted. Financial institutions start taking unnecessary risks because few producers can pay the returns required. This leaves the fools and charlatans. Layoffs cascade. Governments are stressed trying to cope.
Stage 4 Damage. Whole industries begin to fail. Sections of the country are ruined. Homelessness and crime increase. Prosperity, such as is left, becomes further and further removed from the production of goods.
Stage 5 Damage. Financial institutions begin to fail. Orderly financial transactions are replaced by speculation, greenmail, etc. Sober bankers become gamblers and crooks.
Stage 6 Damage. Governments are bankrupted. Insurance for financial institutions are exhausted. Financial distress becomes widespread.
Actually, when the above factors are taken into account, predicting the latest recession/depression was like the prediction of a sunrise--it was never a problem of if but when.
This is the outcome of a foolish experiment in what became known as monetarism--a pre-industrial example of monetary thinking if there ever was one. Actually, monetarism was only one possible response to the inflations of the 70's. Those inflations had many causes--monopoly power to raise prices most especially in the area of energy, foolish investments in production of no value, and poorly directed increases in the money supply. The problem was made infinitely more difficult because energy prices were set overseas.
Industrial inflation, because it has many causes as well as manifestations, usually needs a multiple counter force to address as nasty an outbreak as happened in the 70's.
There are wage-price controls. But wage-price controls run up against the precious theories of the 'free market' (another relic of pre-industrial thinking brought to us by 'economists' who still believe that hunter-gatherer societies are a valid model for industrial societies.) 'Free market' ideologues hold sway throughout the English-speaking economics profession. These folks would have us believe that because 'free markets' can establish the price of blueberries and fresh fish, they have something to do with the phone bill, the price of oil, or the level of interest rates.
Wage-price controls are only necessary to control inflationary practices of monopolies. As there are only about 10 labor unions and 500 companies with monopoly power, the technical problems of wage-price controls are not very large. The political problem, however, is quite another matter indeed. Those 10 unions and 500 companies have considerable clout. They did not want wage-price controls so we never seriously tried them in spite of Nixon's small experiment.
Oil prices posed an even greater problem. In order to counteract price hikes set overseas, the only available option to fight the inflation so induced was to significantly reduce energy consumption. This would have required a 'moral equivalent of war' to achieve because energy consumption is a function of the design of the industrial infrastructure.
Energy demand, as a consequence, is not very elastic. For example, the fuel required by an automobile can be lowered slightly by driving slower, keeping the engine in tune, or checking the inflation of the tires. Alternatively, people could drive less. But to achieve real energy savings, the fuel-wasting automobile would have to be replaced by one much more energy efficient. To achieve society-wide savings, the whole automobile fleet would have to be replaced. This solution encountered technological, economic, as well as political difficulties.
The same problems were encountered in other areas of energy consumption. It is extremely difficult to make a building more energy-efficient once it is built. Electrical generation is already at the technological limits of efficiency and represents a huge capital investment. A "moral equivalent of war" was actually suggested by Jimmy Carter and he was almost hooted out of Washington for his suggestion.
Raising taxes will also remove money from circulation which would counter inflation as readily as removing the money with usury. Raising interest rates is the shotgun approach. Tax increases represent the superior, targeted, rifle approach. But even to fight inflation, there is never a political groundswell for raising taxes. So this solution to the inflation of the 70's was also rejected.
With all the industrial solutions to inflation eliminated, a resort to the old-time religion of pre-industrial usury became the only real option left. And sure enough, the criminal level of usury given us by Fedmeister Paul Volker drove inflation from the system.
(Actually, the level of usury was not legally criminal because by the early 1980s, a host of states had changed their laws so that Volker's industrial usury was decriminalized. Some states even had to change their constitutions to make legal what had been illegal since the 1930s.)
Why all that legislation was easier than raising taxes, legislating new energy efficiency standards, or creating wage-price controls, speaks volumes about the powerful nature of the banking interests and the old-time religion of monetarism.
The problem with fighting inflation with only monetary deflation is that in industrial societies the cure is worse than the sickness. Inflation is cured by putting the whole country on a going-out-of-business sale. The monetarists were correct--money matters very much. But any idiot can wreck things--even the work of genius which much of the industrial state is.
Volker's version of the old-time religion led to unemployment, an agricultural depression, and a de-industrialization of American society that meant by 1985, we had not only lost the international lead in industrial matters, but had actually become a debtor nation. Corporate debt, personal debt, government debt, are all logical outcomes when banks raise interest rates above the NUP in an industrial society. It is debt that cannot be repaid. It is the debt caused by a philosophy of usury designed to bankrupt the borrower.
This is the ultimate insanity of Volker's experiment. In industrial societies, it is in the interest of bankers that their borrowers prosper. The bank wants the income from enterprise. They have no use at all for an idle factory, a vacant farm, or an empty office building. Bankrupting the borrower only makes sense if a lender wants the collateral. If the collateral is a bar of gold, this makes some sense. But the fundamental rule of industrial banking is, "never kill your customer!"
After Volker, usury may not have been technically criminal. But it was still very stupid. Failure of debtors leads to failure of creditors. It is not a wonder that as above NUP interest rates prevail, banks are in trouble and the whole debt-house of cards is threatening to collapse.
But the obvious manifestations of Volker's insanity may not be the most serious. Thousands of otherwise valid enterprises failed since the 80's or were not even started. Kill infant enterprise and mature enterprise of the future is snuffed out.
The list of foregone enterprise is almost infinite but it includes environmental process and waste management controls, techniques for sustainable agriculture, solar and other renewable energy generation, urban and industrial renewal, and energy-efficient structures.
What we got instead was disaster. Take the sad example of agriculture. Of all the socio-economic advances in history, none rivals owner-operated farms. Family farms--as they are referred to in the U.S.--are so successful because they are self-managing. A farmer who works his own land cares for the resource. He knows what plants grow best, he knows how each field should be worked, he doesn't have to be told to go to work or supervised when he works, and best of all, he tends the land as an investment for his children.
When the usury of the 80's hit American agriculture, hundreds of thousands of farmers, many third and fourth generation on the land, were forced into bankruptcy--only to be replaced by absentee landlords like insurance companies. Sustainable agricultural practices were abandoned in favor of 'mining' the soil with the methods of mega-agribusiness. Soil erosion and chemical pollution skyrocketed.
For what he did to agriculture alone, Volker should be condemned. But this list only begins. The effects of usury can be seen in deforestation and global warming, lawless pollution, and the building of cheap, energy-wasting junk housing throughout the sunbelt in the 1980s which ultimately leads to ozone depletion.
Think of the absurdity of it all for a minute. All the ills listed above, and many others not included, were brought to us by usurers with pre-industrial mentalities who accomplished nothing but the reprogramming of some computer chips. Worshiping pre-industrial ideas is bad enough, but worshiping misprogrammed computer chips utterly redefines the concept of idolatry.
A Way Out!
Recognizing the fundamental problem of an ill-conceived monetary policy as the world careens towards global depression is not enough. Changes must be made or the 90's threaten to make the early years of the 21st Century look like a picnic. The folks in the 30's actually had more options open to them than the U.S. has today. The government was not in debt and so could engage in deficit spending. In those innocent pre-nuclear days, world war could eventually bail them out. No one is foolish enough to believe that warfare is good for the economy anymore. Then the U.S. was a creditor nation and had total control of its economic destiny.
This time, there is no option but to engage in monetary reform. This will take more courage than exhibited by Congress of late. They will have to rise above their PAC mentality which brought low the 'Keating Five.' The U.S. government must finally stand up to the usurers.
Item 'A' on the agenda must be a reimposition of usury laws. Never again should the prime rate exceed NUP. If this cannot be achieved, then the time has come to nationalize the Federal Reserve System and make the governors stand for election.
Nationalization seems such a foreign concept to Americans, but public policy of the import of monetary policy is simply too important to be left in the hands of pre-industrial technological illiterates with a plunderers mentality. Every bank that the taxpayers are forced to 'bail out' in the 90's should become public banks. The argument that public bureaucrats are unsuited to make industrial decisions is utterly specious. Banks have been picking industrial 'winners' and 'losers' for a long time now. For over a decade, they have been making preposterous decisions. Elected officials can do no worse.
Of course, elected officials can have the same mentality exhibited by the monetarist bankers. In fact, most do. The electorate must insist on bankers, public or private, who understand that the industrial revolution happened and further, that they have some understanding of what that means.
Not all interest rates must be limited to the NUP rate. Only the important ones. And only on those loans guaranteed by public agencies such as the FDIC. The list of those activities slated for NUP-rated loans is, in fact, quite short. It includes:
Agriculture--especially loans to owner-operated farms and most especially to young farmers who are committed to sustainable agricultural practices;
Renewable energy generation and energy-efficient technologies;
Environmental or 'green' technologies;
Public infrastructure such as mass transit, sewage systems, and schools;
Start-up manufacturing enterprise that makes pieces for any of the above; and,
Housing--but limited to the primary residence.
It is certain that if public banks began to write loans at NUP rates for serious, legitimate reasons, prosperity, such as has not been seen in the U.S.. since the 60's when NUP rates were public policy, would return with a rush.
The choice is really between a 30's style collapse of the American economy and the next golden era. Are we really going to let a bunch of pre-industrial, techno-illiterate, computer-chip idolaters march this country down the road to ruin? Really?