II. The "Modus Operandi" of Inflation

Nothing of the sort will happen through this type of transaction~ The new credit does not generate inflationary expectations; it is of the self-liquidating kind; the backflow in 90 days is assured, and the deposit will ·be wiped out. Ac tually, as it is being granted, a maturing loan may be ·paid back~ The total money supply need not be affected at all, or for a very short time only~ Even if it is affected, the additional dollar balance is matched, value for value, by the actual sale of new products~ The credit is noninflationary be cause it has grown out of an honest-to-goodness . business transaction. The bank did not. really create purchasing power; the bales of.cotton sold were the real pur chasing power that was not available at once to the seller. What the bank did was monetize in advance a commercial claim-to provide tempo rarily the money that was forthcoming anyway, and not much later either.

Note that the debtor had been credited with only 75 per cent of the sale's value; he, or someone for him, had to put up the rest. Someone had to risk $25,000 to make the transaction creditworthy. That alone limits the expansion of the money vol ume for such deals. And the number of such deals is limited for other reasons. The debtor himself must be creditworthy; often, shipping documents 11 AN INFLATION PRIMER are required. The bank has to be convinced that a genuine, productive deal had been consum mated, .in which all concerned are beyond doubt, including the buyer on the other side or his banker who guarantees for him. These qualitative controls) exercised by the pru dent banker, mean an "invisible" quantitative restraint that is essential in maintaining a balance between the increase of loans (and deposits) and the growth of marketable output. INFLATIONARY MONETIZATION Now, suppose that the government borrows from the bank ona three-month treasury bill.

Superficially, no difference exists between the two cases; in fact, the government's credit is better than the merchant's credit. Buying "short treas uries" is a very convenient transaction, involving no problem of qualitative control. It does not take an experienced, "prudent" banker to do this sort of business. But there is a world of monetary dif ference. The government is supposed to repay the short-term loan out of tax revenues. If it did, in flation would not occur any more than in the case of a commercial loan. Unfortunately, this is not the case. The government is in debt at the banks and may stay in debt (unless the public buys the short-term debt certificates from the banks, which it does for temporary holding only). One-half the marketable national debt is bor12 THE "MODUS OPERANDI" OF INFLATION rowed from the banking system, including the federal reserve banks. The latter's bond portfolio has increased almost l20-fold in less than thirty years and is now (September, 1960) much larger than the gold reserve: nearly $27 billion the one, under $19 billion the other. Contrary to the ori ginal statutes that restricted its operations mainly to the rediscounting of short-te.rm commercial paper, the Federal Reserve System now carries vir tually no commercial paper at all. The central bank, the last resort of the credit system, is in all but name a holding company for public securities.

By far the greater part (six-sevenths) of the mass of public debt owed to the banking system is of more than one-year maturity, not "short" even in name. Short or long, the b9nds are being held by institutions which paid for them by creating spendable funds, with no counterpart in purchas able goods. The government acquires deposits, representing the monetization of sheer "paper," and uses them to pay its deficit. The purchasing power thus put in circulation stays there. It has to; it did not grow out of commercial transactions that would provide for the money's backflow. Nor has. it a counterpart in tax· revenues. Instead of liquidating its debt to the banks, the government keeps rolling it over and borrows additionally from time to time. And the money issued by the banks keeps turning around. Not one of every hundred dollars borrowed by the government13 AN INFLATION PRIMER whether it was used to stockpile unsalable farm products or to finance global give-away programs -has added anything to the nation's stock of pro ductive, self-regenerating capital.

Small wonder that prices have doubled-more than doubled, on the average-since 1939. If they did not rise more, it is chiefly because of the great progress achieved by business in reducing costs by technological and organizational economies. LIQUIDITY-BY INFLATION As a matter of bookkeeping, the Federal Re serve System is a part of our banking system. In essence, it is much more than just another bank. It is the central organ of the entire credit struc ture. The fundamental import of its function may be shown by reverting to our earlier illustration, the New Orleans bank that loaned money on a cotton transaction. On top of all the "inhibitions," or qualitative controls, that limit the individual bank's loaning propensity, there is one more that should be men tioned: the necessity for the banker to keep his house "liquid." This is his legal and moral duty, as one entrusted with the public's money. The deposits, even the savings, have to be paid out whenever the depositors draw checks or ask for cash. Obviously, if the bank is not to be closed, it must have enough cash resources available to fulfill such drains as may reasonably be expected.

14 THE "MODUS OPERANDI" OF INFLATION The law requires that the member banks keep a fraction of their liabilities deposited at a federal reserve bank as a primary reserve. Sheer prudence requires that another fraction should be kept in the form of assets that can be turned quickly into cash. These "quick assets" are the banker's sec ondary line of defense. In our system, as it has operated since 1933, this secondary liquidity con sists essentially of treasury obligations. The point is that th~ credit expansion of. com mercial banks is limited by liquidity considera tions. Since the law requires (on the average) 10 per cent of the bank's liabilities to be held in ','cash," and prudence requires at least another. 30 per cent to be readily available in the shape of "short treasuries," the bank's ability to create purchasing power is trimmed ~ccordingly. So far, so good. The rub is that these reserves are literally produced by the.Federal Reserve Sys tem. It has the power to do SO,2 and it makes ample use of this power. That is the difference between the rank and file of banks on the one hand·and the central bank on the other. Both create purchasing power, but the former would soon be stymied (except for gold inflow) if the latter did not pro vide the ultimate means of payment which keep the deposits convertible into cash and the banks from going broke. Thereby, the credit expansion, whether sound or not, is being kept going.

15 AN INFLATION PRIMER THE CENTRAL ENGINE OF INFLATION Technically, the Federal Reserve has three direct methods by which to provide the banks with "liquidity," enabling them to extend credit to the economy. It "rediscounts" (buys) such short-term commercial paper as the banks may offer, if they have any to offer. It makes "advances" to them, usually using government obligations as collateral. Or it buys federal securities, mostly of the short-term variety, in the open market, the proceeds being credited to the bank account of the dealer who sold the obligations. In any case, the banks acquire balances at a federal reserve bank and their worries over cash reserve require ments are over (for the time being) . In the process, the Reserve System accomplishes something else that goes far beyond its proper function and begets a nefarious inflationary drift. Indirectly, the Federal Reserve provides the mem ber banks with their "secondary" reserves as well.

It does so by creating a safe and secure market for public securities, U.S. Treasury bills, certificates, and notes, in particular. Within that one-year maturity range alone, there are some $70 billion available. (Another $115 billion in up to ten-year maturities are virtually supported, too.) Thereby, these securities become equivalent to cash. Their monetization by the banks and re-monetization by the Reserve System is the hard core of the process 16 THE "MODUS OPERANDI" OF INFLATION by which the currency.is being diluted-and the door opened for nefarious manipulations. Espe cially, the politicians' "freedom" to run the federal budget into deficits is greatly enhanced when nothing more serious seems to be at stake than throwing a few billions of additional "short treasuries" on the market. 1. "Banks" include commercial and mutual savings institu tions as well as the Federal Reserve System. The savings and loan associations are. savings banks, too, but in the statistics they do not appear among the banks.

2. The sole legal limitation of that power is a 25 per cent gold (certificate) reserve requirement against the Federal Re serve System's own notes and deposits. But at this writing, it still might go to the length of some $28 billion of new legal money before reaching that limit-which the Congress then might lower again, as it did in 1945. 17 III THE FOUNTAINHEADS OF INFLATION THE MONEY-PRINTING AUTOMAT The Federal Reserve System is wrapped in for bidding technicalities and regulations. Yet the principles of its operation are so simple as to be within easy reach of the average person who wishes to understand them. Neither the Federal Reserve System (and its organ, the Open Market Committee) nor the twelve reserve banks are banks in the common sense of the word, as mentioned before. Profit is not their objective; most of the money they earn goes to the Treasury. They take no deposits from an ·individual or .an ordinary business firm, ·and give very few of them loans. Together, they con stitute the central bank of the nation, dealing chiefly with the member banks; with the U.S.