Tuesday, March 17, 2009


I just want to throw out an idea out for discussion. A few days ago, Neighborhood regular and frequent commenter Applesaucer & I were discussing the nature of the federal reserve system & central banking in general. More specifically, Applesaucer threw out the idea that the federal reserve system is just a gigantic ponzi scheme.

I agree.

In brief, that dollar bill in your wallet is described as a "federal reserve note." A debt instrument. In other words, the federal reserve issues these notes, with the implied promise to pay the bearer what that debt instrument is worth. In this case, US$1. Or US$100, what have you. Easy so far.

But here's where it gets dicey. What backs that debt instrument? Another currency? No. A tangible asset like land or cattle or crops? No. Gold or silver? Hell no! That's clearly not the case, as the federal reserve -- while hording a sizable chunk of the world's gold reserves -- doesn't have nearly enough gold to cover its debts.

None of the above. The federal reserve's debts are backed by the full faith and credit of the U.S. government. Meaning that the U.S. government backs and covers these debts should we all decide to make a run on the federal reserve banks. And where does the U.S. government get the "money" to cover those debts. Well . . . uhhhhh . . . it borrows money to generate its own debt instruments -- U.S. Treasury bonds, T-bills, Treasury notes, each varying by maturity. And from whom does the US government borrow that money? Let's see, we have the U.S. citizenry, whose worth is measured in the amount of federal reserve notes it holds.

And then there's China, who have shown a recent reluctance to keep lending money to the US government. And if things get really tight, the US government can get the "money" to back the debts of the federal reserve banks by borrowing money from . . . the federal reserve.

And where will the federal reserve get the "money" to lend to the US Treasury? Easy! It'll create federal reserve notes from thin air. Which is cool, because after-all, the US government -- with its full faith and credit -- will back those federal reserve notes that the federal reserve is lending to the US government.

And on and on it goes. Get the idea? The inevitable end result? Insolvency & Default. Or Currency Devaluation & Inflation. That's it. There are no other possibilities. This is what constitutes an economy in 21st century America. I have a different name for it:

A Ponzi Scheme.

Anyhow, as I said, this is the fruit of an e-mail discussion. I may well have made some errors here in my description, and I'm sure Applesaucer will correct me. Please, everyone join in. Questions, comments, thoughts, disagreements, suggestions.



Blogger Mark Herpel said...

IMHO this is very correct, 100% to be exact. Now the Fed is simply printing up money out of thin air to buy bad assets. Additionally, they are going to loan the IMF (World's lender of last resort) and few more 100 million. You can't just keep printing and hope that will solve all the world's problems, it just won't work. The first time the TV news says, "well we are heading out of the recession...what was everybody so worried about?" This is the moment when all that paper will come home in the form of hyperinflation. If you don't own precious metals at that time your dollars are toast, that event will wipe out most of America's middle class in an instant. Bad stuff in my opinion is ahead.

9:10 AM  
Anonymous Applesaucer said...


It would be interesting to know what all the art means on our currency. I'm not talking about all the conspiracy theories about the Illuminati, Masons, etc. Like WTF does that pyramid with eye on top of it represent?

Not worth spending much time on it, of course, but interesting. At least to me, if no one else.

Anyway, I think you've done a good job here. Up until this past decade, I never really thought about where our "money" comes from, what it means, etc. I just figured the government printed up some currency -- coins, bills and digital forms thereof.

One thing I understand now is that "money" has no concrete definition. Do you just include currency in circulation ("CiC"), or do you add checking accounts, savings accounts, undrawn lines of credit, etc. The government issues all sorts of definitions to cover various aggregates -- Adjusted Monetary Base (M0), M1, M2, etc.

But I think it's safe to say that "money" is just a medium of exchange -- whatever it is, it is simply a commodity that is exchangeable for other things.

Anything can serve as money, but some things are better than others. Gold has worked off and on for thousands of years, not because there's any magic to it, but because it has certain attributes which make it so. I think Aristotle once discussed the handful-or-so key attributes that make something an appropriate form of "money."

With gold and many other things, it is unneccessary for the government to have any thing to do with its issue or coinage.

Legal tender is another matter. It is the government issued and approved form of money.

Anyway, regardless of whether the monetary unit is "free" or legal tender, its value is determined solely by what it can obtain in exchange. In the United States, legal tender has value because it's what you MUST pay your taxes with and because individuals and governments, domestically and abroad, are ready, willing and able to subjectively decide what they'll exchange for it.

So it's a mixture of compulsion and "confidence."

Now, most of the world operates on a "central banking model" whereby central banks issue liabilities -- "money" (Federal reserve Notes in the case of the US -- the dollar I'm looking at right now is a liability of the Bank of San Francisco) -- in return for assets, mostly debt instruments of their central government (in the case of the US, it's treasuries issued by the US Treasury).

For the accounting buffs out there, it works like this:

The Federal reserve has a balance sheet that, like any other balance sheet, is defined by the classic accounting equation: Assets = Liabilities + Shareholder's equity.

Addressing these things, in reverse order:

Shareholders Equity -- for a public company, this would be the amount of the claim that common stockholders have on the company. i.e., if you own common shares of Microsoft, the claim you have at any given point is on MSFT's shareholder's equity. The shareholders of the Fed are a group of US and European banks. Ownership of the Fed, therefore, is in private hands; however, policy is set by the public, in that Fed officials are appointed by the Prez and approved by the Congress. Therefore, it is a quasi-public/private entity.

Liabilities = like I said before, Federal reserve Notes. Our "money."

Assets = US Treasuries that promise to pay interest and principal in the form of Federal reserve Notes; Agency securities; gold; and, now, a whole bunch of crappy loans that the Fed took on its balance sheet starting in Summer/Fall 2007 in repsonse to the then-called "liquidity crisis."

It's important for me to stop here and point out that the Fed had nearly a $trillion worth of unencumbered US treasuries on its balance sheet; it has exchanged or encumbered over half of those treasuries in exchange for bad loans that might end up being worth far less than their face value.

Now, I don't know that any of us could actually go to a bank, whether it be on the block or at the Federal reserve, and exchange our dollars for anything. But, if we could, it would be on some portion of the Federal Reserve's assets.

Therefore, you ask, who cares what's on the Federal reserve's balance sheet?

IMHO, here is the answer: when the Fed increases its liabilities, it retains a tool for redeeming such liabilities: by selling assets on its balance sheet in exchange for such liabilities.

Starting last Fall, the Fed more than doubled the monetary base -- its liabilities -- and balance sheet.

These liabilities have been mostly trapped at the banking level. That is, banks must lend this money into existence and, so far, they haven't done so at nearly the same rate as the monetary base has grown. Banks can lend this money into existence at multiples of their reserves; i.e., fractional reserve lending.

One might pause to note that not only is our money "debt" that is backed by 'debt," but also that it is "lent into existence" at a multiple to such debt. IN other words, our entire monetary system is a debt pyramiding mechanism.

And, in case you think that banks won't lend this money, don't be so sure that this will be the case for more than the next few months to years -- for example, M1, M2, etc. have been growing at low, double digit rates. High by historical standards.

But, more importantly, banks don't have to lend this money to individuals or corporations; they can lend it to the government. And why won't they? Afterall, if they are paying deposit interest, they have to make money somehow. They can do this by lending to the government.

So, when all this money pours into the system, how will the Fed take it back at the appropriate time, whenever that is?

It used to be that they could take it back by selling treasuries. But remember what I pointed out earlier: they've exchanged or encumbered over half their treasury holdings for GARBAGE, private debt.

So you what has happened, to a greater degree than ever before, our money is "backed" by GARBAGE.

In other words, your savings that is currently in the form of Federal Reserve Notes has not only been diluted -- there's twice as much of it in the banking system, with barely any increase in the things that you can buy with it -- but it is now backed by deteriorating assets.

It's like being a debtholder of Circuit City, where your claim is backed by increasingly-worthless inventory.

The Fed is very highly levered now (liabilities/shareholders equity is at its highest level, ever) with a garbage balance sheet. In other words, it stands in the same position as Lehman Brothers was before it went bankrupt.

But the Fed won't go bankrupt like Lehman Brothers did, since it can print its way out of its insolvency.

Just ask yourself what that means for your savings. How much will you be able to buy with your Federal reserve Notes when it is apparent to the world that the Fed will not be able to take them back?

You can bet that the government and the Fed will respond to this crisis via extraordinary and extra-legal means. I'm talking about price controls, which will lead to shortages, which lead to rationing.

The Fed has also talked about issuing its own form of debt in addition to Federal Reserve Notes. In other words, at some point, they might force banks to accept some sort of Federal reserve debt that is a zero coupon note, in exchange for federal reserve notes that are worth face value.

The banking system will be almost entirely a part of the state apparatus at that point.

It will be like living on a war footing and it is inevitable.

And WHY did all of this have to happen? The answer is that the Fed's purpose is to support the existing national banks. They will have completely destroyed the currency for this purpose. But just as Alan Greenspan was taken care of after he stepped down (with some hefty Wall St. speaking and consulting fees), so will Ben Bernanke, Tim Geithner and Larry Summers.


10:52 AM  
Anonymous Applesaucer said...

I want to add something to my previous post, which was way to long as it is:

It is on the subject of banking, money and credit.

First, if one understands "money" as a "medium of exchange" then one will one understand that increasing the number of units of such medium of exchange will not improve overall well-being. That is, if total global money supply doubled overnight, the world would not experience a sudden increase in living standards.

There would be winners and losers, of course: fixed rate debtors would see their debts effectively cut in half; fixed rate lenders would see the value of their loans suddenly cut in half.

Under current definitions of GDP, it might be that its growth is dependent on money supply growth. But "growing GDP" does not translate into "improving living standards." Improving living standards means, at the simplest level, more plentiful and higher quality goods and services, which, in turn, require, innovation, discovery, improved delivery mechanisms, etc.

Simply printing more paper doesn't accomplish any of these things.

All printing more paper allows for is for the printer to direct the medium of exchange as it sees fit, and divert resources from one party to another.

Some object to a gold standard based on the flawed idea that living standards cannot improve without "more money." It's true that some countries might find themselves short of gold at a particular time, but all they would need to do to make up for such a shortfall is to produce something of value for gold. They could even borrow gold in exchange for a promise to provide such services.

Some similarly object to gold-as-money on the grounds that there is "not enough gold." But this, again, is silly, from both a principled and experienced-based perspective. It's true that world wide gold supplies have increased at decreasing levels -- only 1-2% per year as we speak -- but pretty much all the gold that's been mined still exist and investor demand is still in existence.

Even with a fixed gold supply, all this means is that with increased production would come decreasing prices -- which is the promise of capitalism.

And you could also engage in gold-based credit transactions. Keep your gold in a warehouse and use a card that draws on such stock. Simple.

Which brings us to banking. The problem in the US and the rest of the world is that banking has been turned into a cash cow for BANKERS without commensurate benefit for the rest of us.

Worse than that, the current global banking model is doomed to fail, over and over again, even as banksters get rich. Why is that? because banks: (1) lend multiples of the money they actually have in reserve; and (2) even if banks only lent what they held in reserve, they do not match the timing of deposits in loans; i.e., you can, as a depositor, ask for your money NOW, but borrowers don't have to pay until later.

So if only 10% of the depositors of any one bank wanted to claim their money, the bank would not be able to meet their claims.

Sound banking would require that for every dollar in loans there would be a dollar in deposits. And that the durations for such loans would be matched.

But in such regime, bankers wouldn't get filthy rich!

So what's the answer?

The deposit insurance and the Federal Reserve System. Deposit insurance keeps depositors feeling safe so that banks do not have to establish that they are, indeed safe and sound.

But, as we see, the FDIC doesn't have nearly enough money to insure all deposits -- even deposits that it is, by law, required to insure.

Where will the FDIC get this money? From the banks themselves, but mostly from the US Treasury.

But where will the Treasury get this money? It will sell US Treasuries? And who, ultimately, will buy these US Treasuries? The Federal Reserve. And where will the Federal reserve get this money? It will print it.

So, again, the banking system is a Madoff-like ponzi scheme, with one crucial difference: the ability to print money out of thin air.

This allows bankers to make profits way beyond their true contribution to society. We know that printing money doesn't create wealth. But the distribution of the new money is uneven: it goes mostly to the first receivers of such money, the banks. By the time the wage earner -- the factory guy -- gets the money its worth less than when the banker got it -- and he got a lot more of it through banking fees.

And if you think about it, bankers earn a fee on almost every transaction you make, from bank loans to credit card transactions. YOU go into debt to buy things; the financial service sector goes into debt lending you that money. But the individuals at the higher levels of the various financial services companies earn the fees.

If you think I'm crazy, just look at the percentage of overall US wages by the financial services sector. It's surely lower now, but as of 2007 it approached 30-40% of all wages, from high-single-digits-to-low-double digits decades ago.

But has the rest of America become "wealthier?" More in debt, to be sure. But the balance sheet side of the average American has suffered a catastrophic blow over the last 2-3 years, because much the asset side of the average American consisted of home equity, which was at a mania high in 2006.

A massive transfer of wealth has occurred over the last several decades. Left and Libertarian can agree on this point. But I suggest that the biggest reason for this is the unsound money, banking and credit system that's been at worked. By design, it should fail. The mechanism for keeping it afloat is deposit insurance, the Federal Reserve System and fiat currency.

If you don't believe me, take note of how both Dumbya and Obama have addressed the banking crisis: they have proposed shoring up bank balance sheets by one method or another. They have said its a short-term liquidity or confidence crisis.

But that's not the problem: the problem is that banks are insolvent and people are broke. BROKE.

Each administration could have said: let's give money to people to pay down their debts and wipe out the banking system and rebuild it anew. But aside from a feckless little program for a small proportion of homeowners, they have not done this. Rather, they have elected to give banks money and say some nasty things about bank executives, after-the-fact.


11:50 AM  
Blogger Smitty said...

What's to say that you and Applesaucer haven't already said?

I think that the comments and general ideas on the blog have been heading to the conclusion for a few weeks now. This is the logical conclusion to draw from all of your posts. In other words: I agree, and it makes sense how we got here.

And so here I am again, wondering: now that we know this, what do we do with it?

12:49 PM  
Blogger steves said...

I know I expressed some disdain for a return to the gold standard, but I am slowly changing my mind. Some of the problem has been the people advocating it. Prior to reading this site, most of the people I knew that suggested a return to the gold standard were of the tin-foil hat variety. I know that there are plenty of really smart people that support this, too, but I suppose I was too lazy to go look.

Anyway, I stumbled upon some articles that Alan Greenspan wrote in the early 80's that make a compelling and realistic case for a return to the gold standard.

4:42 PM  
Blogger Mike said...

now that we know this, what do we do with it?

Many things you can do. At very least, we can continue to learn, and to encourage others to understand. One of the reasons banks have been able to bend policy there way for 96 years is because so few people understand what the federal reserve is and does. Think about how differently the last 20 years might have played out of the average American really understood what Greenspan was doing. Or what it meant when they read the news on a Wednesday morning and discovered that the previous afternoon the fed again "lowered interest rates."

Another thing you can do is allocate your capital appropriately if you have an idea about the true value of the dollar.

Another -- and this one plays into your hand, Smitty -- is to add this issue to the growing bad of goodies you want to let your representative know you're wise to. Which loops back to the first point. Educated citizens can democratize an area of the government that has acted a something of a shadow world for nearly a century, even though nothing was hidden.

The only thing that kept it hidden was the public's ignorance.

I stumbled upon some articles that Alan Greenspan wrote in the early 80's that make a compelling and realistic case for a return to the gold standard

Ironic, and sad, that Greenspan became the ultimate villain in a story he understood and predicted. From hard money advocate to fiat currency maestro. Check out his 1966 essay, "Gold and Economic Freedom.


6:57 AM  

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