Central Banks: Alchemists of Finance. Part I

This article is a continuation of the series, which started with “What is Money?” and followed it with “Does Fractional Reserve Banking Cause Inflation?”

Central Banks like the Federal Reserve in the United States are different than commercial fractional-reserve banks. As explained in the article A Brief History of Central Banks on the Federal Reserve Bank of Cleveland’s website,

People in the United States paid taxes, before the United States government had any legal tender. As a result, there was no way for the government to spend before it collected taxes.

A central bank is the term used to describe the authority responsible for policies that affect a country’s supply of money and credit. More specifically, a central bank uses its tools of monetary policy—open market operations, discount window lending, changes in reserve requirements—to affect short-term interest rates and the monetary base (currency held by the public plus bank reserves) and to achieve important policy goals.[1]

Unfortunately, this definition misses that fact that central banks are monopolies and therefore not part of a free market system (true Capitalism).

A central bank, or monetary authority, is a monopolized and often nationalized institution given privileged control over the production and distribution of money and credit. In modern economies, the central bank is responsible for the formulation of monetary policy and the regulation of member banks.[2]

According to this definition a central bank has control over “printing” the national currency, which in the modern world can be done by just a computer entry. If you look into the Federal Reserve of the United States you will find that they have control over printing paper money, while the Treasury has control over minting coins. However most currency today is just a computer entry and here the answers get even more obscure. The best answer is that direct money creation is a dance between Congress, the Treasury, and the Federal Reserve. Everything becomes convoluted when a central bank is added into the equation and so far we have only discussed direct creation of currency, not open market operations, discount window lending, and changes in reserve requirements. Politicians and central banks, not to mention the largest banks and brokerages, like this obscurity.

In order to make this less obscure I will analyze each “tool” of a central bank separately. In addition, we are going to analyze the direct money creation issue through the lens of Modern Monetary Theory (MMT). One reason to look at MMT it is how most central bankers see the world, which is illuminating. It also points out some uncomfortable truths and exposes some of the absurd Keynesian theories behind this. Wikipedia explains MMT as:

Modern Monetary Theory (MMT or Modern Money Theory, also known as Neo-Chartalism) is a macroeconomic theory which describes and analyses modern economies in which the national currency is fiat money, established and created by the government. The key insight of MMT is that “monetarily sovereign government is the monopoly supplier of its currency and can issue currency of any denomination in physical or non-physical forms. As such the government has an unlimited capacity to pay for the things it wishes to purchase and to fulfill promised future payments, and has an unlimited ability to provide funds to the other sectors. Thus, insolvency and bankruptcy of this government is not possible. It can always pay.”[3]

This quote is very revealing, especially the idea that “the government has an unlimited capacity to pay for the things it wishes to purchase and to fulfill promised future payments, and has an unlimited ability to provide funds to the other sectors.”  At the beginning of this series I pointed out that when money enters the equation in economics, people think magic happens and logic disappears. The MMT proponents think they can create wealth by manipulating money. MMT advocates believe money and banking allow for good magic while Austrian Economists argue that money manipulation destroys wealth.

The Source of Economic Growth, is a short treatise that shows that increases in real per capita wealth are created by applying Reason to the objective problems of life – in other words, by inventing and increasing our level of technology. Money is not wealth, as I showed earlier in this series. Money and banking are mainly a lubricant for the economy. Of course real inventions in money and banking do increase our per capita wealth, such as cryptocurrencies may do if the governments (central banks) of the world get out the way. Cryptocurrencies hold the promise of significantly reducing the cost of transferring money around the world.

Modern Monetary Theory is correct that the government cannot run out of money if it has legal tender laws, but that does not mean that “the government has an unlimited capacity to pay for the things it wishes.”  The Gross Domestic Product (GDP) of the United States in 2016 was around $17 trillion.[4] If the government decides to spend $20 trillion of wealth and continues to spend more than the total output of wealth of the United States, then the United States will go bankrupt. The ability to print (create) more money will not matter. Venezuela has a central bank, but it has not saved Venezuela or allowed its government “to pay for the things it wishes.”  The expected inflation rate in 2017 for Venezuela is 1,660% according to the International Monetary Fund (IMF). Its GDP fell 15% in 2016. It also did not save the Weimar Republic which had a central bank, and it did not provide the government an unlimited capacity to pay for the things it wishes. MMT’s answer to the Weimar Republic is that they were forced to repay their war debts in gold. According to the MMT, governments with a central bank and legal tender can be infinitely wealthy, which is clearly absurd.

The problem with MMT is that it confuses money with wealth. This is similar to how Keynesians reverse cause and effect, by arguing wealth is created by spending.

The problem with MMT is that it confuses money with wealth. This is similar to how Keynesians reverse cause and effect, by arguing wealth is created by spending (consumption). The ideas underlying MMT were proposed by John Law, who created the Mississippi Company in France in the early 1700s and almost bankrupted the whole country.[5]  It is a fascinating story, a footnote reference is provided for those who wish to delve into it.

According to MMT, the government creates money by spending. As this article, Why a Central Bank Can Never Run Out of Money, explains:

“The U.S. government spends its currency into existence. This is important, too. The government spends first and then collects taxes. (Logically, this is how it began, or else how would people get the money to pay taxes?) Taxes are what give the dollar value. As Alfred Mitchell-Innes, a diplomat and credit theorist, once put it: ’A dollar of money is a dollar, not because of the material of which it is made, but because of the dollar of tax which is imposed to redeem it.’”

According to this statement, increasing spending causes inflation, while increases in taxes cause deflation. In the United States the Democrats (socialists) always want to increase spending and taxes, which cancel each other out according to the MMT. Republicans (conservatives) want to reduce spending and taxes which would also cancel each other out by this theory. This analysis again confuses money with wealth and it ignores debt financing.

Another amazing thing about this statement is that if you or I “spent money into existence” it would be called counterfeiting and would be considered theft. Somehow, when the government does this, it is okay and according to MMT stimulates the economy (creates wealth).

The parenthetical comment “else how would people get the money to pay taxes?” is easily refuted by history. People in the United States paid taxes, before the United States government had any legal tender. As a result, there was no way for the government to spend before it collected taxes. Even a cursory review of history provides numerous other examples, including early man in which there was no formal government. In addition, the article on Banking shows that banks create money when they create loans, which any MMT advocate should know.

No sense can be made of the final statement that the value of a dollar is created because of the tax necessary to redeem it. This statement could only make sense to a totalitarian. Totalitarians believe that when the government spends money it gives up some of its power and when it taxes and redeems the money, it redeems this power.

This article explains the mechanism by which money is created as:

The Treasury spends dollars into existence through the central bank. The central bank credits the accounts of banks, and banks credit whoever is getting paid. Taxes reverse the process. Banks then debit accounts, and the central bank debits the banks. The government cannot run out of credits.

Note that no liability is created by the government in this direct money creation and no one is paying interest on this money, just like no one pays interest when money is printed. There is a myth that all money in the United States (most modern countries) is created by a loan and that we have to pay the banks interest on all money created. This is incorrect, the money created by this direct money creation process is not a loan and no one pays interest to have this money.

Central banks do not arise in a free market system (real Capitalism); they are a distortion of the free market.

This process of money creation is only possible because the government has legal tender laws. In my earlier article on Banking, I pointed out that legal tender laws were necessary for the government to counterfeit money. Since a central bank is tasked with controlling the money supply they require legal tender laws. One of the fastest ways to undermine (eliminate) the Federal Reserve is to eliminate legal tender laws.

In theory, Congress has to first authorize the spending. However, in the United States we are not allowed to audit the Federal Reserve. Thus it is possible that the Federal Reserve creates money (direct money creation as opposed to a loan) and no one knows about it. For instance, the Federal Reserve admitted that it could not account for $9 trillion of off-balance sheet transactions.[6]  While these may have been loans (we don’t know because we cannot audit the Federal Reserve), it shows how easy it would be for the Federal Reserve (or Treasury) to just credit someone’s bank account without anyone knowing.

“Simple Inflation” under a Central Bank

In Banking and Inflation, we defined simple inflation as that which occurs because of printing money or debasing the currency. This direct creation of money function is the same as these processes. The amount of direct money created is equal to the total amount of money spent by the government, less the amount of taxes received, and less the amount of money borrowed by the government. When a government resorts to direct money creation to pay for a large part of its operations, it results in rapidly increasing inflation rates. Venezuela is the most blatant example today.

 
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What we have learned:

*Central banks do not arise in a free market system (real Capitalism); they are a distortion of the free market.

*Central banks require legal tender laws in order to fulfill their mission of controlling the money supply.

*The amount the government spends less the amount it taxes and borrows is the amount of money created by the government (government counterfeiting), which results in simple inflation.

*Modern Monetary Theory confuses money with wealth.

*The fastest way to undermine (eliminate) the Federal Reserve is to eliminate legal tender laws.

 
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[1] Bordo, Michael D., A Brief History of Central Banks, Federal Reserve Bank of Cleveland,

http://www.clevelandfed.org/research/commentary/2007/12.cfm, A Brief History of Central Banks, December 1, 2007.

[2] Investopedia, Central Bank http://www.investopedia.com/terms/c/centralbank.asp#ixzz4V5iaLeW, accessed January 7, 2017.

[3] https://en.wikipedia.org/wiki/Modern_Monetary_Theory, accessed January 13, 2017.

[4] We can debate the accuracy of the actual number, however the point is the same.

[5] https://en.wikipedia.org/wiki/Mississippi_Company, accessed January 13, 2017.

Related Posts:

1. What Did Capitalism Require to Emerge?
2. Rand v Hayek: Who Gets It Right?
3. The Moral Case against Vaccine Passports

   

About the Author: Dale B. Halling

Dale B. Halling is a software developer with a BSEE, an MS in Physics, and a JD. He is the author of The Decline and Fall of the American Entrepreneur: How Little Known Laws and Regulations are Killing Innovation and the Source of Economic Growth. He is the coauthor of the novels Pendulum of Justice and Trails of Injustice. Dale B. Halling is also a named inventor on nine patents.