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Paul Hayden

The Fed and Deficit Spending are to Blame

September 7, 2009

Unfortunately, that which has actually caused our present economic crisis is not even being given lip service by anyone. How in the world can proper action be taken to address our country's economic problem when the cause is being ignored? Unfortunately, the cause has existed over many years and addressing it would take power to manipulate our monetary system away from politicians who now use it toward their own ends. That which is the cause is not difficult to understand.

As every family knows, when it spends more than it earns it can only make up the difference by borrowing or increasing income. It is the same for the government except they also have the power to print money.  Let's look at how government appears to get away with running continuing deficits while any of us who did the same thing would eventually be forced into bankruptcy. When the government spends more money than it receives, the Treasury Department has the power to borrow the difference by offering bonds for sale at market interest rates. Ready buyers of these bonds are those foreign countries who sell more of their products and services to U.S. entities than is purchased from them. The dollar difference (trade deficit) must eventually return to the U.S. and is predominantly used to buy this debt.

When the amount of funds required to satisfy the deficit exceed the amount of trade deficit dollars available to buy our bonds, the Federal Reserve Bank (Fed) buys the bonds. The Fed presently owns around 40% of the national debt and this means the government essentially owns this portion of its own debt. They buy these bonds by crediting the attendant purchase amount to the bank accounts of the dealers that sell them.  Since by law banks are allowed to operate on a fractional reserve system based on a 10 to 1 multiplier, they are required to only maintain 10% of their deposits in reserve. They can then lend up to 10 times that amount. This 10 to 1 leverage is further increased when money is moved by transactions to other banks.

Why should this be of concern?  Because this created money is just like any other commodity and its purchasing power decreases when the amount of it available increases. When there is more supply than demand of a commodity the value of that commodity decreases. Hence, the devaluation of the dollar and resultant eventual inflation that will result in deleterious effects on economic recovery.

Our present economic condition has been brewing for many years. Its beginning can be traced back to what ensued after it was agreed by 29 nations at the Bretton Woods Conference in 1944 that the U.S. would guarantee to sell gold at $35 an ounce effectively pegging the value of world currencies to the U.S. dollar.  Subsequent continued deficit spending that exacerbated in the 1960's coupled with an increasing trade deficit resulted in marked devaluation of the dollar relative to gold. This led to the issuance of what were called "special drawing rights (sdr's)" that were in essence iou's, to offset the difference between the market price of gold and $35 an oz.

In 1971 the continuing increased national debt and ensuing pressure from speculators and central banks forced President Nixon to abandon the gold standard. Thus the dollar became a fiat currency whose value was to float in relation to other world currencies. Without the restraint of the gold standard, deficit spending accelerated and rose from under $500 Billion in 1971 to $9 Trillion in 2008. During this period the Fed continued to manipulate the money supply resulting in an inordinate increase in the price of homes followed by a marked decrease in these prices circa 1985 to 1998. What then transpired brought us to our present economic predicament described as follows.

In order to allow banks to obtain additional funding Fannie Mae and Freddie Mac (GSE'S) were created many years ago by our government. By being able to sell loans through Fannie Mae, Freddie Mac and others, retaining fees for servicing and a small profit margin, banks could again use these derived funds to make more loans. Once loans are sold the lender no longer bears the risk of foreclosure when borrowers default. The result has been to progressively relax loan standards to allow marginal buyers to qualify.

We see this specifically when the Fed placed an excessive amount of money into the economy to address the recession that started just prior to the GWB presidency and extended to ease the economic blow of 9/11. This inordinate amount of money deposited into our banking system had to be loaned out since that is how banks make money. The ability to easily sell the loans removed the liability of foreclosure and the result was the accelerated development of creative loans to meet the demand.

The increased demand caused home prices to increase markedly attracting speculators. The increased need for buyers of these loans was met by Wall Street's investment bankers. They created bonds that were backed by a bundled package of a variety of mortgage types and initially priced by a complicated mathematical formula. Called Mortgage Backed Securities (MBS) they became considered as highly desirable investment vehicles and were sold worldwide.

Meanwhile, attempting to counteract what was occurring the Fed started to reduce the money supply. This increased the Federal Funds Rate multiple times but was unable to curb the excesses that had been created and the housing price bubble finally burst. The collapse of housing prices also resulted in the collapse of the market for MBS. Their value could no longer be adequately determined by the market or by the original pricing mechanism due to the complexity of this security.

In correspondence I had with economist Milton Friedman over a ten year period in the 1990's he stated that the Fed board should be eliminated and the responsibility of controlling the money supply should be left to a computer. The PC would be programmed to keep the money supply increasing only in general proportion to the increase in population (about 3-5% per year). He also sent me graphs from his computer to show that it took two years for the economy to react to a change in the money supply. Thus the Fed's power to control the money supply should not be used to counteract fiscal policy. He believed that deficits should be addressed by either cuts in spending or increases in taxes. However, he preferred cuts in spending.

He believed that taxpayers would more likely spend money in an economically beneficial way than government and, by that virtue, was more likely to increase our national income (GDP). The benefit of a growing GDP is higher tax revenue that can be used not only to pay for government services but also our national debt. The interest alone on our massive national debt caused by deficit spending is huge.  

If the money supply was limited in growth as Dr. Friedman suggested then the legislative and executive branches of government would be forced to either curb spending or raise taxes to balance the budget. This would mean that these elected officials would have to answer to the voters and would be more likely to be more fiscally responsible.

There is no question that deficit spending has led to our present economic predicament.  Increasing the money supply to offset deficit spending must eventually cause an inordinate increase in inflation. In the past we have seen the rise in prices on goods due to this problem. Six dollars in 2009 is equal to one 1950 dollar. Thus devalued dollars are used to pay off debt. The extraordinary increase in deficit spending will at some point in time accordingly devalue the dollar resulting in dire effects on the economy and will especially negatively affect the growing senior community who live on fixed incomes.

Unfortunately, until this is recognized and steps are taken to no longer use the Fed to bail out actions taken by the legislative and executive branches of government, our country will continue to face continuing and worsening cycles of economic boom and bust leading to periodic financial tsunamis.

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Copyright ©2009 Ben Cerruti

Now a senior citizen, Ben Cerruti has been involved in espousing his views in writing for the last 20 plus years in various San Francisco bay area newspapers and has been actively involved in taking positions on ballot measures in writing and on television. He has had extensive correspondence with Milton Friedman, renowned economist and Nobel Laureate that provided him with intimate knowledge of the functions of the Federal Reserve System.