Demand, Deposit, Inflation; A. Reinach

38 dicrous that citizens, in respect t< their money, passively permi1 their Federal government to vic· timize them by essentially thE same fraud as described above. ThE fact that. this fraud, monetary in· flation, will uncontestably perpe· trate more injustice in the nex1 decade than did the Spanish In· quisition at its height suggesb that there are precious few indio viduals who really understane monetary inflation. Technologically, money ha~ taken three basic forms: commod· ity, paper, and checking accoun1 funds. Collaterally, monetary in· flation has evolved from coin de· basement, to printing press, to thE creation of spurious demand de· posits. Because demand deposib are the monetary tools employee in over 90 per cent of America'~ financial transactions, it is demanc inflation that is destined to makE history's most notorious swindle~ look like Tootsie Roll thefts b) comparison.

1968 DEMAND DEPOSIT INFLATION 39 Recipe for Inflation To understand how demand de posit inflation works, imagine yourself in the role of a drug store 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 al ready 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 3112 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 check book, you summon Samuel to in form him of a proprietary position with which you are about to re ward 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. Samuel. No? 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-conven tional, that is, except for its naivety - you now have the where \vithal for your remodeling pro gram. 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 Sam uel conspired to create become diffused throughout America's en tire 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 40 THE FREEMAN January law to lend out roughly 80 per cent of their deposits, and because banks, since World War II, have been vigorously lending out virtu ally every dollar allowed by law, an additional $8,000 (80 per cent of $10,000) of loans - or invest ments in credit instruments, which is the same thing-will be prompt ly made. These new loans will be prompt ly 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 addi tional 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 govern ment 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 govern ment taxes $100 billion and bor rows $40 billion, still leaving it $10 billion short. At this point, were my drugstore analogy pro cedurally accurate, the U. S. Treas ury would enter in the role of Fiscal Pharmacy's owner, and the Federal Reserve would enter in the role of Samuel, Fiscal Phar macy'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 bil lion short. Treasury. Yes, so here's $10 bil lion 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 1968 DEMAND DEPOSIT INFLATION 41 Open Market Operations Open market operations are sim ply the buying and selling of gov ernment bonds by the Fed. One side of the open market operation coin has already been demon strated - the buying of govern ment bonds to help the Treasury sell its own. In theory, after the Treasury is rid of its bonds, the Fed turns around and starts mer chandizing its own recent pur chases. 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. 10 f V / ./ V V- ~-1966196419621960 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 marketplace 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 infla tionary; it is quite possible that the Fed might have to buy $11 billion worth of bonds in the mar ket to enable the Treasury to dis pose of $10 billion. The Fed claims to have three weapons of direct control over monetary inflation. But this claim would be valid only under circum stances which would make the weapons unnecessary: (a) when the government is balancing its budget, or (b) when the govern ment, having failed to balance its 50 budget, is willing to sell its bonds on a free market basis. When 40 neither situation prevails, the Fed's alleged weapons are ren-30 dered impotent and simply serve as disguises for monetary infla-20 tion. Those three weapons are: 1. Open Market Operations 2. Reserve Requirements 3. Discount Rate (or Rediscount Rate) 42 THE FREEMAN January Reserve Requirements Tend Toward Zero As already stated, banks are permitted by law to lend out roughly 80 per cent of their de posits. The figure today is nearer 85 per cent but 80 per cent illus trates the point and is easy to figure. The difference between 80 per cent and 100 - 20 per cent is, correspondingly, the figure com monly used as the average reserve requirement for the three cate gories of commerical banks which are members of the Federal Re serve 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 infla tionary 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 "fav orable" 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 require ment 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 in· flation whereas borrowing from the Fed will not. Therefore, tc carry the theory further, raisin~ the discount rate will discouragE borrowing and thereby counter in· flation, and lowering the discoun1 rate will encourage borrowin~ and thereby stimulate inflation Ironically, this theory more ofter than not operates in reverse Prompted by a costly discoun1 rate to counter inflation througr the liquidation of loans, commer· cial banks usually begin by sellin~ some of their government bonds This, in turn, will cause conster· nation in U.S. Treasury circles which will instigate telephone call~ to the Fed, which will triggel open market purchases, which wi!

add more fuel to the inflationar~ fire than was initially withdrawl by raising the discount rate. FOl this reason, the discount rate i~ useless as a weapon to combat in· flation. Prime Commercial Paper i~ America's most valued interest· bearing credit instrument, and ib 1968 DEMAND DEPOSIT INFLATION 43 interest rates are the most sensi tive to shifts in financial senti ment. Since World War I, there have been 24 trend reversals in the Federal Reserve discount rate. Without exception, these trend re versals were preceded by trend re versals in Commercial Paper in terest rates. In other words, and notwithstanding the lofty pro nouncements of "positive con structive action" that attended many of these 24 trend reversals, the Federal Reserve discount rate for half a century has been tag ging 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 specula tion rather than monetary infla tion was the object of "summit"

control, the Fed reversed the dis count rate trend by reducing it half a percentage point. In total disregard of prior reductions in Commercial Paper rates, an entire generation of monetary intellectu als 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 ev ident 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 de posits or issuing Federal Reserve notes is limited by the require ment 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 tiInes the amount of gold certifi cates held by the Reserve Banks.

Thus, the ultimate limit on Fed eral Reserve credit expansion is set by gold." Yet, on the preced ing page in the same publication, the Fed confesses that when cir cumstances in 1945 "threatened to impinge upon the Federal Re serve's freedom of policy action ... , Congress deemed it wise to reduce the reserve requirement of the Re serve Banks from 40 per cent for Federal Reserve notes and 35 per cent for deposits to 25 per cent for each kind ofliability."l In 1963, Dean Russell concluded: "Whenever the technical cutoff re lationship between gold and 'mon ey' has been approached in the 1 The Federal Reserve System, Pur poses and Functions, 3rd edition, sixth printing, 1959, pp. 96 and 97.

44 THE FREEMAN Januar1J past, Congress has modified it-and will unquestionably do so in the future, even to the point of abol ishing 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 Re serve Bank power to create Fed eral Reserve credit." Then, two years later, came the dismantling of that "statutory base": "The law determining the minimum hold ings of gold certificates required as reserves against the Federal Reserve Banks' liabilities was changed on March 3, 1965. The Reserve Banks are no longer re quired 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 liabili ties." Was Dean's predicted rea son correct, that "the technical cutoff relationship between gold and 'money' (was being) ap proached"? Letting the Fed speak for itself: "If the change had not been made, the amount of 'free' gold certificates on March 31, 2 Dean Russell, "Money, Banking, Debt and Inflation," unpublished paper, 1963.

1965, would have been [down to] $1.0 billion."3 Monetary and Other factors AHect/mpad ~ ~na~on There are many minor monetar) factors constantly influencing thE impact of inflation. One of thE more important is the conversior of demand deposits into cash, anc vice versa. For example, the with· drawal of $100 from your checkin!1 account not only immediately reo duces demand deposits by $100 but also ultimately extinguishe~ an additional $400 of derivativE demand deposits. Consequently money is customarily "tight" jus1 before Christmas-when the de· mand for cash is at its height. There are also many "nonmone· tary" factors constantly influenc· ing the impact of inflation. ThE standard here is productivity Thus, the most aggravating factol is war, and the most moderatin!1 factors are technological advance~ and industrial expansion. Labol strikes, because they curb pro· duction, aggravate the impact oj inflation. Labor contracts that reo sult in the curtailment of labor· saving devices also aggravate thE impact of inflation, but labor con· tracts that merely call for the es· 3 The Federal Reserve System, Pur poses and Functions, 5th edition, Is printing, 1963; 2nd printing, 1965; pp 165 and 175.

1968 DEMAND DEPOSIT INFLATION 45 calation of wages do not. A popu lation increase of productive citizens moderates inflation's im pact, but a population increase of nonproductive citizens or a popu lation decrease· of productive citi zens 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 capi tal is a moderating factor. In a related vein, a so-called "favor able balance of trade" is an ag gravating factor whereas an "un favorable balance of trade" has a moderating effect. Assessing the Consequences Some factors which seem to coun ter 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 im pact of inflation. On the other hand, increases in the velocity of money (its change-of-hands fre quency) 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 fac tors influencing the impact of in flation are and will be its wither ing consequences on American life. Historically, every nation whose government resorted to monetary inflation suffered un remitting demotions of its "gen eral welfare." Nor has any government ever abandoned an entrenched policy of monetary in flation. Therefore, barring the rev ocation 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 re spect 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 Amer ica in her 170 "convertible gold standard" years negate "converti ble gold standard" money as a ra tional alternative to "managed" money. The only remaining alter native is free enterprise money. This, of course, would require the elimination of government from the money business. ~ Reprints available, 10 cents each.