Tag: Federal Reserve

We are recreating the “free market” conditions for The Great Depression!

Posted on by Lawrence

Could half of America’s banks suddenly go bankrupt and unemployment reach 25 percent of our labor force? If you are focused solely on the federal government’s deficit spending, you are missing a much bigger threat to our economy. It is our private banking system and how we are gradually and systematically removing the regulations that were put in place in the 1930s to ensure our financial safety, security and stability. The Trump advisors’ plan to abolish the Federal Deposit Insurance Corporation (FDIC) and transfer its function to the Treasury Department is just the latest is a series of deregulation moves over many years that have been setting us up for another Great Depression. To understand all this, we must first understand how our banking system actually works.

People naturally think that if they deposit ten one-hundred dollar bills (a thousand dollars) into a bank savings account, then the bank can take that money and loan it out to some business or person seeking a loan. Occasionally, a loan might go bad, but if the bank charges a high enough interest rate on loans (relative to the interest rate on savings that it gives to you), it can usually still make a profit, even when a few loans go bad. That sounds like a reasonably stable system. But it is not at all the banking system we have.

What most people don’t understand is that for many years prior to March 2020, if you put a thousand dollars into a savings account at a bank, then that bank could legally loan out as much as ten times as much money as you had deposited. This was known as our fractional reserve banking system. You put a thousand dollars in the bank. The bank doesn’t touch those ten one-hundred dollar bills. They can just sit there. What really happens as a result of your putting a thousand dollars into a savings account is that the bank can now loan out ten times as much money as you have deposited (prior to March 2020).

Someone who is a good cook decides that they would like to open a restaurant. But they need a loan to get the equipment, pay the rent and hire some restaurant workers to get things started. They go to a bank and ask for a loan of ten thousand dollars. Prior to March 2020, based on your deposit of one thousand dollars, the bank can create a bank account worth ten thousand dollars out of “thin air.” The bank doesn’t even need to touch your ten one-hundred dollar bills. It just creates an account out of “thin air.” The good cook can just write checks on that account as if it were real money, because it is real money. Most of the money in our economy is created by our private banks. (Note: The Federal Reserve can adjust the amount of money in circulation on the margin and move short-term interest rates up or down.)

This fractional reserve system is a lot more risky than just loaning out the money you deposited. The bank can get way out over its skis in making loans if it is not careful. Before fractional reserve banking was created in 1933, banks had no limits on creating loans out of “thin air.” The Great Depression demonstrated the danger of counting on the banking system to restrain itself. Allowing free market “creative destruction” to destroy our economy from time to time does not seem reasonable. That is why reserve requirement regulations were imposed on the free market.

The Glass-Steagall Act of 1933 was enacted by Congress to prevent banks from engaging in speculative and highly risky investments by separating commercial depository banking from investment banking. The Glass-Steagall Act was repealed and replaced with the Gramm-Leach-Bliley Act in 1999, which some people argue led to the 2007-2009 Great Recession. This freed up local banks to transfer local bank risk to Wall Street through such instruments as mortgage-backed securities. Local banks are more likely to understand local risks that don’t show up in the standard accounting measures. Local banks may know more about the backgrounds of individuals or businesses seeking loans. Transferring hidden risks to Wall Street protected the local banks but made the whole system less stable by making a lot more loans that were much more likely to fail.

Insurance is a way to cover threats to your health, your property or your business. However, even with insurance, you still have some incentive to protect yourself, your property and your business. But credit default swaps (CDSs) enable you to bet on someone else’s debt. You may have knowledge that the owner, the bank or the mortgage company don’t have, or you may even have an incentive to cash in on a debt default when you could have taken action to prevent the default on the debt. You might even think of CDSs as facilitating something like insider trading where you short a stock when you have insider knowledge about something bad that is about to happen.

For many years, under the Banking Act of 1935, which was passed in response to the bank failures in the Great Depression, the Federal Reserve typically required deposits of at least ten percent of the value of a bank’s total loans under our traditional fractional reserve banking system. But in March 2020,[1] after President Trump appointed new members to the Federal Reserve Board, the Federal Reserve went in the opposite direction and reduced the fraction of deposits that must be held on reserve to zero percent, effectively eliminating the reserve requirements for all depository institutions. This means that banks can now create as much money out of “thin air” as they want, whenever they want. Were you worried about the Federal government increasing the Federal debt? The private sector already creates more than ninety percent of the money in our economy and is now in a position to create even more money than that whenever it wants.

Under “The Chicago Plan”, which is based on the work of conservative economists Frank Knight and Henry Simons of the University of Chicago and Irving Fisher of Yale University in the 1930s, fractional reserve banking would be eliminated and replaced with one hundred percent reserve banking so that private banks could no longer create money out of “thin air” and could only loan out money that they actually had in deposits.[2] Somehow, since then, the meanings of the words “conservative” and “radical” seem to have been switched. Regulations that were deemed “prudent” before are now considered “government overreach.”

After all, it was the private financial system that collapsed and brought on the Great Depression and many recessions since then, yet the enormous money creation by banks with very little in the way of assets to back up their loans is generally ignored by economists and the general public which instead focus solely on federal government debt. In March 2023, Silicon Valley Bank, Signature Bank, Silvergate Bank and First Republic Bank all failed due to the drop in the value of the assets backing up their loans and investments.[3]

The real threat to our economic stability is less about the federal government’s debt and more about the debt of banks with inadequate assets to back up their creation of money out of “thin air.” Too often we face a private debt crisis and then just go back to focusing on and complaining about the federal public debt. The federal debt problem should not be ignored, but the instability brought on by the enormous growth in private debt of both banks and individuals should not be ignored either.

Prior to the 1929 stock market crash and the Great Depression the money flow had become more and more distorted with an ever greater portion of it flowing into the hands of the wealthiest people, who kept reinvesting it in the financial markets in an attempt to compete with others in building up their wealth as a measure and sign of their self-worth. The inflation that this distorted money flow created in the stock prices in the financial economy on Wall Street was ignored, because it didn’t show up in the usual inflation indices that measure inflation in the real economy on Main Street.

In the old days, many people believed that unrestricted free enterprise including unregulated financial markets were necessary for a healthy economy. Few people anticipated the financial collapse that followed the stock market crash in 1929 with half of the nation’s 25,000 banks destroyed and the unemployment rate reaching 25 percent. Before the Great Depression that lasted for ten years from 1929 to 1939, most economists believed in Schumpeter’s creative destruction where occasional economic downturns were seen as part of a necessary cleansing process to weed out less efficient enterprises. The money flow paradigm sees this as more of a competition destruction where many small mom and pop restaurants and other firms with insufficient capital resources to ride out the downturn either go bankrupt or are bought up by larger companies with greater liquidity. 

Before the Great Depression most people agreed that government needed to just stay out of the way and not interfere with free markets. After the Great Depression the practical problems and deficiencies of unrestricted free markets had to be addressed. The consensus that government oversight and regulation was a necessary part of protecting and preserving free enterprise more or less held until the election of Ronald Reagan as president of the United States in 1980.

Following President Reagan’s dictate that “government is best that governs least”, in 1982 the Securities and Exchange Commission (SEC) removed the prohibition on corporations buying back their own stock in the stock market. Prior to 1982 stock buybacks were considered insider trading and illegal. After 1982 stock buybacks were allowed along with all the manipulations and distortions that they introduced into the stock market.

The Efficient Market Hypothesis was considered sacrosanct so whatever prices the stock market produced were considered optimal in being efficiently based on all available information. Conservative Federal Reserve chair Alan Greenspan’s warning about irrational exuberance was ignored even after the 2000 to 2001 stock market crash and the 2007 to 2009 Great Recession.

Occasionally wiping out a lot of the retirement savings of some elderly people with the switch from companies providing defined benefits in the form of pensions to instead providing defined contributions in a 401K Individual Retirement Account (IRA) was just considered part of the risk that individuals had to bear under the deregulation agenda.

Even today politicians following President Reagan’s conservative doctrine justify the ever increasing concentration of American industries on the need to benefit from the economies of scale and network effects that such concentration bring even when those benefits go to fewer and fewer ever more wealthy people. Instead of lots of firms competing in an industry with occasionally one going bankrupt from a poor strategy or bad luck, the government watchdogs set aside such concerns and frequently bet an entire industry on one very large firm or a few large firms by ignoring the anti-trust laws and allowing the number of firms in many American industries to be consolidated.

The deregulation agenda was facilitated by the Supreme Court’s Citizens United ruling in 2010 which declared that corporations were people and entitled to the same freedom of speech rights as people. This ruling opened the way for corporations and wealthy individuals to directly or indirectly support politicians running for office who promoted the deregulation agenda.

It will be interesting to see how far out on the deregulation limb the United States can go in introducing more and more instability before the whole thing collapses in another Great Depression. It is ironic that the MAGA rebellion against the “know-it-all” intellectual elite (e.g., Dr. Anthony Fauci) is now being run by billionaires representing the financial elite (e.g., Elon Musk). The conflict over H1B visa technology immigrants is just the tip of the iceberg when it comes to the inherent conflict between Trump’s MAGA base and the billionaire agenda. Let’s hope that people wake up and realize where this is all heading before it is too late.

[1]  https://en.wikipedia.org/wiki/Reserve_requirement

[2] Fisher, Irving. “100% Money.” working paper. https://cdn.mises.org/100%20Percent%20Money_Fisher.pdf

[3] https://en.wikipedia.org/wiki/2023_United_States_banking_crisis

Money Flow Paradigm Reverses Say’s Law

Posted on by Lawrence

Economics became widely known as what Thomas Carlyle called “the dismal science” when Thomas Malthus predicted that the population growth rate will always exceed the food supply growth rate. Therefore, there could never be too much food because the population growth would at least keep up with (subsistence) and at worst exceed (starvation) the available food supply.  Demand would always increase to consume whatever could be supplied.  This led to what has become known as Say’s Law: “Supply creates its own demand” and the basis for supply-side economics. Economic growth, according to the dismal science, was always a supply-side phenomenon. You could take demand for granted and just focus on trying to increase supply.

From population explosion to population implosion

For centuries humanity spread out across the continents and populated the far corners of the world. It seemed like humans would eventually overpopulate the planet. Eventually, we would need to find another planet to colonize to keep on growing. Population growth was a given, until it wasn’t. Almost out of the blue, the unexpected happened. As countries reached higher levels of economic development, their population growth rates dropped. You might call this a Darwinian Natural Selection Paradox where when a species becomes more dominant and powerful, instead of increasing birth rates, its has falling birth rates.

Early on a Monday morning, I was about to begin my lecture about the international income distribution to my economics class at Notre Dame. But my students were all excited. They were all talking with one another about the great football game on Saturday where Notre Dame won at the last minute with an amazing play.  I couldn’t get their attention. Finally, I said: “Today we are going to talk about birth control.” My students were shocked. “Birth control?” they exclaimed. “The professor is going to talk about birth control. This is a Catholic university. He can’t talk about birth control.” But I persisted. “What is the most effective birth control method in the world?”, I asked. The students continued murmuring in apprehension and concern. Finally, I said: “The most effective birth control method in the world is per capita income. When per capita income rises above $6,000 per capita, birth rates drop like a rock.”[1]

With rising per capita income, birth rates drop. In rich countries, they have dropped below the replacement rate of an average of 2.1 children for each woman in her reproductive years. According to data from the US Census Bureau, the population growth rate in the United States in 2021 was just one tenth of one percent, which was the slowest population growth rate since the nation’s founding in the eighteenth century. Without immigration our population would be declining.

World population declines

Japan is ahead of many other countries in the transition to an economy where an aging population is dramatically increasing the ratio of non-working elderly relative to a shrinking active workforce.   In the absence of much immigration, Japan must increase its productivity in terms of output per worker to make up for its shrinking number of workers. Japan’s population was at its maximum in 2010 with 128 million people, but shrunk to 125 million by 2021, and is expected to fall below 100 million before long. In 2022 Japan’s birth rate fell to its lowest level ever and its marriage rate fell to the lowest since World War II. Consequently, with older people living longer than ever, the elderly’s share of Japan’s population has grown substantially. The elderly generally demand fewer products and services except for health services than young families, but eventually need more personal medical services. Health costs rise while government revenues fall, and aggregate demand is sustained through massive deficit spending necessary to keep the workforce fully employed. 

Over 90 percent of the world’s countries currently have a birth rate below the population replacement rate with at least 20 countries expected to cut their native populations in half by 2100 including Japan, Italy, Spain, Portugal, Germany, Thailand, and South Korea, among others. Russia’s population peaked at around 147 million and is currently heading down toward 142 million because of an aging population, falling birth rates, relatively higher death rates including military deaths and suicides, and emigration (especially young people) exceeding immigration. China’s economy has recently reached a level of per capita income over $10,000 with its population reaching a peak and then declining significantly thereafter. Populations are increasing primarily in poor regions of Africa such as Nigeria and Ghana, where the natural resource curse[2] keeps most of the population in poverty with just over $2,000 income per capita. 

Around the turn of the millennium, millions of people in China were moving out of poverty into what for many would become what we would call a lower-middle-class lifestyle. This improvement in their economic well-being was quickly changing “the dismal science” into something not quite so dismal. As noted above, Japan had already gone through this transition and had a birth rate well below the 2.1 child per woman of child-bearing age known to be the replacement rate for maintaining a constant population. Japan, Germany, Italy, Russia, South Korea and many other developed economies already have shrinking populations. As a result of China’s historic one-child policy (which it dropped in 2016) and its rising per capita income, China’s population is reaching a peak and will start declining.

If it weren’t for immigration, the United States would have a falling population as well. To some extent American immigration has enabled the United States to offset its declining birth rate. For a given level of technology and, therefore, productivity, a declining workforce means a decline in gross domestic product (GDP) and less money from the earnings tax which funds the Social Security system. Consequently, elderly people who depend on Social Security have a vested interest in encouraging immigration, especially because they are retired and, therefore, no longer in the workforce to compete for jobs with immigrants. The elderly have a special interest in encouraging immigration or at least a guest worker program in farming such as in picking fruits and vegetables in California farms to keep the cost of food low, where food and medicine constitute a greater portion of the budgets of elderly people relative to younger people who have expanding families needing lots of basic products such as home furnishings, clothing, and cars and trucks. Of course, immigration could tend to keep wage rates low to the extent that they substitute for instead of complementing the current workforce. However, there is not a fixed number of jobs in this world to be fought over (what economists refer to as the “Lump of Labor Fallacy”). Rather, through infrastructure spending and other expenditures, governments can increase the demand for workers and, thereby, increase wage rates in addition to maintaining full employment as long as it is not so much as to cause excessive inflation.

Distorted money flow reverses Say’s Law to read: “Demand creates its own supply.”

Despite the rising deficit and health costs, and in the absence of sustained government stimulus spending over the long run, deflation with falling prices and wages threatens to dominate, rather than the widely feared and reviled inflation, as measured by the typical market basket of goods and services used to calculate the consumer price index (CPI), or, alternatively, measured as the personal consumption expenditures (PCE) index. As baby boomers die and the population declines, consumer demand shrinks, while technology expands and speeds up the global supply chain. More can be produced and moved through ever increasing automation and driverless vehicle technology. Say’s Law may have worked back in the day when populations were exploding and every crumb of supply was snatched up, but today the problem is a distorted money flow diverting money primarily to those with the lowest marginal propensities to consume (the wealthy) while leaving the poor and middle class up to their eyeballs in debt. In the United States to counter high levels of unemployment the Federal Reserve uses quantitative easing (QE) to pump money into the New York financial markets which drives up stock and bond prices to benefit the wealthy. But when inflation threatens, the Federal Reserve punishes the poor and middle class by raising the cost of borrowing, while the wealthy get a higher rate of return on their bonds and certificates of deposit. In either situation, one requiring economic expansion, or one requiring economic contraction, the Federal Reserve inadvertently acts to reward the rich and punish the poor. (See Karen Petrou’s book “The Engine of Inequality” and Christopher Leonard’s book “The Lords of Easy Money.”) The Federal Reserve is implicitly following Say’s Law and supply-side economics while ignoring the fundamental changes in globalization, productivity and population that have taken place to reverse Say’s Law to invoke demand-side economics as revealed by the money flow paradigm. Note that this is not the Federal Reserve’s fault. They have just not been given the correct set of tools by Congress to properly control the economy (as explained in my forthcoming book “Distorted Money Flow” and in earlier commentary at https://sites.nd.edu/lawrence-c-marsh/home/ ).

Workers are no longer paid the value of their marginal products

In the United States before 1976 worker compensation kept up with worker productivity, but after 1976 productivity continued increasing, but worker compensation flattened out in real terms. In other words, workers are no longer paid the value of their marginal products. Consequently, over the long run, in the face of an increasing money flow distortion where a larger and larger proportion of the quantity of money flows to the wealthiest people who have the lowest marginal propensities to consume, aggregate demand threatens to fall short of aggregate supply, because the bottom 90 percent of the population can no longer buy back the value of the goods and services they are producing unless government maintains and expands its flow of stimulus money to them, paid for through deficit spending or the pre-distribution (more money to Main Street before taxes) and/or redistribution (more money to Main Street and less to Wall Street after taxes).

Money flow paradigm reveals distorted money flow that has reversed Say’s Law

In conclusion, by following the flow of money and its effects on economies everywhere, the money flow paradigm has revealed the fundamental problem of the distorted money flow that has greatly restricted demand while providing excessive amounts of money for supply. This has reversed Say’s Law which said: “Supply creates its own demand” and replaced it in facing a reality very much the opposite where “Demand creates its own supply.” The money flow paradigm has shown that where supply-side economics made sense back in the day, it no longer applies to the world as we know it which is today better represented with demand-side economics.

[1] Historically, having a child was viewed by some people as an investment, especially after the advent of agriculture, and during the industrial revolution with the use of child labor in manufacturing. Eventually, this developed into a slave trade where the costs of raising a child were bypassed with the capture of fully grown slaves from Africa. Entrepreneurs in London could invest in the slave trade where the hard work of others provided a good return on investment. Hard work paid off, but not for the slaves. Their hard work paid off for the investors. This natural product of capitalism and free enterprise was abolished through government intervention when laws and regulations were passed banning child labor and slavery. Even today companies that follow the “I-win-you-lose” mindset treat their employees as just another factor input such as coal or fuel oil and not as team members. On the other hand, most successful companies follow the “win-win” strategy and recognize the dynamic creative potential (the agency) of their employees.

[2] Ironically, countries with large deposits of natural resources, which can cause an excessive demand for their currencies, are unable to produce and sell other products at competitive prices given the high value of their currency. This has been labeled the “Dutch disease” by The Economist magazine in reference to the high price of the Dutch guilder when Dutch natural gas and oil were in great demand before the Netherlands adopted the Euro as its official currency.