Questions about the Federal Reserve. Maybe You Can Help.

[reddpr]

After putting together the following e-mail and sending it off to the Institute contact e-mail, I noticed that there was an active Forum and thought I might have better luck posting my questions. Maybe some of you guys and gals can answer my questions.

Thanks:

To Whom It May Concern,

My name is Luis and I am a long time, faithful reader of the Ludwig Von Mises website. Though I must confess that I am not as laissez faire as your writers and most of your readers, your website has fostered in me a deep respect for the efficiency and effectiveness of the market.
With a Bachelor of Arts in Sociology and a Masters in Public Administration I must also acknowledge that my dominance in the field of economics is limited. For example, I have always perceived the Federal Reserve quite confusingly and after attempting to research it still have some misunderstandings. I thought that it would be a great idea to send a letter to your Institute in hopes that you could either answer some of my questions regarding the Reserve, or to point me to a source that would help me find the answer myself.

1. The Federal Reserve is at least in theory controlled by a Board of Governors who are nominated by the President and confirmed by Congress. I hear time and time again that the Federal Reserve is “controlled by the private banks”. I am unsure if they are speaking of an indirect control or a direct control. From the sound of some of the Youtube videos (including one made by your Institute in the 1990’s) it sounded as if it was the private banks that directly chose the Reserve leadership.
2. Lots of critics of the Federal Reserve make statements such as, “paper money is worth nothing it all since it is not backed by gold. It only has value because we assign value to it.” True, but doesn’t the same go for gold? Gold has value only because we assign value to it and are willing to use it to trade for goods and services.
3. I understand the concept of the gold standard (paper money is backed by gold, sitting somewhere in a vault). Gold is limited, so I could see how it would be more stable. But for the sake of argument, what if the populations were to discover additional gold? Or what if methods were discovered on how to molecularly construct gold from other, less valuable elements? Or what if by some freak of nature, the central vault of gold sinks into the ground, melts away into the cracks of the earth, or disappears?
4. Are there any countries that currently have a gold standard?
5. Let’s suppose that a new nation is born in some remote part of the world. They are writing a constitution, creating a government, and devising a monetary policy. What would a country do if it had no gold, silver, or other precious metals? What are alternatives to the gold standard without having to resort to a natural resource?
6. I read and hear time and time again, that as more money is printed, its value drops, inflation goes up, and consumer purchasing power is affected. This makes perfect sense, especially when the scenario is simplified and you apply the logic to other items that are abundant or rare – like paper and oil. But for a moment, let’s look at the government as a consumer. Say the government generates $100 through taxes and spends all of the $100 on fixing a road. Let’s suppose that the government wants to fix even more road without having the tax dollars to back it up. Let’s suppose that the government quietly prints up another $100 without letting anybody know, and uses it to fix the road. The contractor who receives the money, in turn, could go spend the money in other stores. I don’t see how this could decrease the worth of that $100. In a way it almost sounds beneficiary, as the contractor’s purchasing power is increased, stores sell more widgets, and the whole machine gets a push. The store owner will now produce and sell double the widgets, which in theory should bring down their cost of production, and thus the final price of their product. You would think that overall consumer purchasing power would actually go up as increased consumption lowers overall production costs. Can you tell me where my logic is wrong?
7. What if wages were pegged to inflation? Would that not eliminate the instability of purchasing power?
8. As an economic libertarian what would you prefer: inflation or taxes? What would be more detrimental to the market: a government that taxes its citizens a flat tax of 10% or a government that prints up enough of its own “free” money to set off a 10% inflation rate?

[bearchu]

1. It is a private corporation, owned allegedly by the 13 rich banking families.

2. Its a durable, divisable, transportable, hard to counterfit, you know what makes viable money money, absent the central bank, no one wants a piece of paper.

3. Gold is found everyday, it would be like increasing the money supply. Second is alchemy, never worked out. How wever much goes away, its like decreasing the supply of money. (prices rise up and down with the supply.)

4. Not sure

5. Well with out natural resources, or services, theres no point. Otherwise link it to any natural resource.

6. well when the money was first spent, there was a set of goods, if you consume one of those goods, one less good, 100 more dollars. You havemore more money chasing fewer goods.

7. Wages kind of are tied to inflation (cola). But the gov’s inflation is not reliable. ie(no food and energy)

8. No false dichotomy please. Niether.

[Rcder]

The Federal Reserve is at least in theory controlled by a Board of Governors who are nominated by the President and confirmed by Congress. I hear time and time again that the Federal Reserve is “controlled by the private banks”. I am unsure if they are speaking of an indirect control or a direct control. From the sound of some of the Youtube videos (including one made by your Institute in the 1990’s) it sounded as if it was the private banks that directly chose the Reserve leadership.

It depends who you ask. I would say that the government has indirect control over the Federal Reserve, while the banks have more direct control. For example, the Federal Reserve Chairman serves twelve-year terms and, like the other members of the Board of Governors, is appointed by the president. Congress, therefore, cannot recall a member of the Federal Reserve. The central bank of any country is typically made to be a very independent “fourth branch” of government. The private banks do not appoint the members of the Board of Governors.

However, the private banks do business with the Federal Reserve, put bank deposits in the Federal Reserve, are in constant communication with the Federal Reserve, and therefore have a much larger degree of influence in terms of directing Fed policy than the federal government.

Lots of critics of the Federal Reserve make statements such as, “paper money is worth nothing it all since it is not backed by gold. It only has value because we assign value to it.” True, but doesn’t the same go for gold? Gold has value only because we assign value to it and are willing to use it to trade for goods and services.

This is correct. All value is subjective.

I understand the concept of the gold standard (paper money is backed by gold, sitting somewhere in a vault). Gold is limited, so I could see how it would be more stable. But for the sake of argument, what if the populations were to discover additional gold? Or what if methods were discovered on how to molecularly construct gold from other, less valuable elements? Or what if by some freak of nature, the central vault of gold sinks into the ground, melts away into the cracks of the earth, or disappears?

To answer your first two questions, if the newly-acquired gold was turned into money, then there would be inflation. If it was turned into consumer goods, then the price of these goods would fall. For your third question, if the entire money supply of a nation was to disappear over night than the price mechanism would be hamstrung until the market switches over to a new currency (I’m assuming the nation/geographic area functions on a monometallic standard).

Are there any countries that currently have a gold standard?

No. Technically every developed nation starting going off the gold standard during WWII (there’s heated debate over whether they were ever on a gold standard to begin with), and as of now every country utilizes fiat currency.

Let’s suppose that a new nation is born in some remote part of the world. They are writing a constitution, creating a government, and devising a monetary policy. What would a country do if it had no gold, silver, or other precious metals? What are alternatives to the gold standard without having to resort to a natural resource?

The government wouldn’t have to do anything. Currencies arise naturally in the market as a means of overcoming the problems of direct exchange. Money throughout history has been anything from carved rocks to sea shells.

I’m going to split up your final question into separate parts to make it easier to answer.

I read and hear time and time again, that as more money is printed, its value drops, inflation goes up, and consumer purchasing power is affected. This makes perfect sense, especially when the scenario is simplified and you apply the logic to other items that are abundant or rare – like paper and oil.

This is all true. Money operates according to the laws of marginal utility and supply and demand. This is sort of off-topic, but I’m in the middle of reading “The Theory of Money and Credit” by Ludwig von Mises. A very interesting book if you’re into monetary theory.

But for a moment, let’s look at the government as a consumer. Say the government generates $100 through taxes and spends all of the $100 on fixing a road.

So far no inflation has occurred. No new money has been created.

Let’s suppose that the government wants to fix even more road without having the tax dollars to back it up. Let’s suppose that the government quietly prints up another $100 without letting anybody know, and uses it to fix the road. The contractor who receives the money, in turn, could go spend the money in other stores. I don’t see how this could decrease the worth of that $100.

It’s important to remember that people don’t exchange goods for money, they exchange goods for other goods and use money as a medium of exchange to simplify trade. If you create money out of thin air without having first produced a good or service (i.e. purchased the money in exchange), then you’ll be able to use your newfound purchasing power to bid up prices, and everyone who gets the new money will use it to bid up prices for other goods, so on. You have, in a sense, stolen purchasing power from other people.

It’s also very important that you Google and read up on optimal money supply theory, as that would answer many of the questions you’re asking here.

In a way it almost sounds beneficiary, as the contractor’s purchasing power is increased, stores sell more widgets, and the whole machine gets a push. The store owner will now produce and sell double the widgets, which in theory should bring down their cost of production, and thus the final price of their product.

This ignores the fact that during inflation the prices of everything else are rising at an uneven rate. As a result, not only is there a misallocation of resources (artificially high prices with no actual demand behind them), but things like real wages and real profit are depressed. Whereas once the store owner could sell one widget to buy two loaves of bread, because of inflation, he can now only buy one loaf of bread with the revenue from his sold widget. Most (the people who didn’t receive the created money) become poorer, while some (the benificiaries of central bank benevolence) become richer.

Also, increased revenue does not bring down production costs, and goods and services are valued completely separately from their production processes.

[Smiling_Dave]

Welcome to the forum. Great post and cute baby picture.

1. Don’t know, try Wikipedia.

2. The difference between gold and paper is who is the “we”. In the absence of a govt imposing its will by coercion, people would still value gold for its intrinsic value, meaning you can do something with it, like make jewelry. So “we” is the individaul. Fiat money requires govt threats of violence for its acceptance. Absent that, no one would accept it as an exchange for his hard work. With fiat money, “we” is the govt.

3. Drastic changes in the supply of gold would mean people might start using something else as money.

4. No.

5. Ideally, people use whatever they want as money. My favorite is those tiny dollar size bottles of whiskey. In any case, as time goes on, if they had anything worthwhile to export, they could trade for gold and stock up.

6. The logic is wrong because when the govt uses that second $100, it depletes the amount of resources available to everyone else by $100, thus making those resources more expensive. Everyone else, taken together, has $100 less purchasing power, because there is less to buy. So they have taxed everyone without letting anyone know.

This is in contrast to a normal situation, where a person only gets to spend money [=use up resources] only after he works [=increases the pile of goodies in the world].

The argument that the govt spending those $100 will give the whole machine a push has the same flaw. The machine will get a push in one direction, but will get destroyed from another, since everyone but the govt and it’s immediate beneficiary, the contractor, has less purchasing power now.

I think you would benefit from reading Economics in One Lesson by Hazlitt, available for free on the interent and here at mises.org, which explains this very well, and is a good basic window into economics.

7. Where would the money come from to pay the higher wages? More money would have to be printed to pay the higher wages, thus increasing inflation yet higher.

8. Inflation is by far the worse option. Hazlitt’s free short book, The Inflation Crisis and How to Resolve It, available free on Mises.org, explains why.

[EmperorNero]

Let’s suppose that the government quietly prints up another $100 without letting anybody know, and uses it to fix the road. The contractor who receives the money, in turn, could go spend the money in other stores. I don’t see how this could decrease the worth of that $100. In a way it almost sounds beneficiary, as the contractor’s purchasing power is increased, stores sell more widgets, and the whole machine gets a push. The store owner will now produce and sell double the widgets, which in theory should bring down their cost of production, and thus the final price of their product. You would think that overall consumer purchasing power would actually go up as increased consumption lowers overall production costs. Can you tell me where my logic is wrong?

Hi and welcome. Look up the distinction between demand-side economics and supply-side economics. Your logic is a case of the former. Essentially, all these improvements in the economy don’t come out of nothing, they have opportunity costs. The store owner who produces more widgets will use resources that could have been used for something else. Even improving efficiency has opportunity costs, as the effort of engineers, the resources for new machinery, etc. are scarce resources. Giving the whole machine a push is not beneficial, what we lack is not purchasing power but productivity. Money is a way to allocate productivity to where it is most needed, if the government prints money to create additional purchasing power that purchasing power necessarily takes resources away from more productive uses.

[Rcder]

Continued.

What if wages were pegged to inflation? Would that not eliminate the instability of purchasing power?

No. To add to smiling dave’s response, inflation is never generalized, it is always specialized. Certain goods and services will be effected heavily by increases in the money supply, some very little, and some not at all. Therefore, there is no “level of inflation” that you could even peg wages to to begin with.

As an economic libertarian what would you prefer: inflation or taxes? What would be more detrimental to the market: a government that taxes its citizens a flat tax of 10% or a government that prints up enough of its own “free” money to set off a 10% inflation rate?

Taxes, if only because it doesn’t have the effect of horribly distorting the price system in the same way that inflation does. Ideally, I’d prefer no taxes and gradual deflation due to increases in production.