The Weiner Component Vol.2 #6 – Part 3: The Purpose of the Federal Reserve

The title page to Keynes' General Theory.

Unemployment rate in the US 1910–1960, with th...

Unemployment rate in the US 1910–1960, with the years of the Great Depression (1929–1939) highlighted. (Photo credit: Wikipedia)

The Federal Reserve was established on December 23, 1913. Its major mission was to avoid panics or major recessions in the future. It would at that time do this by being able to move money quickly anywhere throughout the National Economy. In essence since the nation functioned through its banking system the new Fed would protect its financial institutions from runs or panics where the depositors could all withdraw their funds, generally following a rumor that the bank was on the edge of failing.

 

In addition the United States economy had/has systematically gone through regular business cycles of recession, slump or depression, recovery, and boom. Invariably each of these stages of the economy leads to the next stage. During a boom period overproduction is invariably reached, workers are laid off, there is less income available, which accelerates the recession. This, in turn leads to a trough or low economic point which can be a depression with high unemployment. Eventually there is a shortage of goods and the amount of money being spent in the National Cash Flow increases; people are hired; there is more and more money available and recovery begins, continuing until a peak or production boom is reached again. The duration of the cycles can and do vary, going from less than a year to over ten years as the Great Depression did from 1929 to 1940. It was ended by World War II. These depressions can be regional or they can cover the entire nation, if not the world, as it did in 1929. They generally last between the two periods given above.

 

In simple terms this is the economic pattern of every industrial nation. Does it have to continue? That’s an interesting question. The probability is that it can be controlled by the Central Government’s actions.

 

In 1929 the science of economics was generally not understood well enough to determine exactly or why the depression was happening. In 2008 when the country had what is now called the Great Recession, enough was understood to avoid a greater depression than that of 1929. This depression was avoided by actions of the Federal Government.

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Even today economists disagree as to what caused the Great Depression and how it should have been dealt with. There are numerous theories. Probably The Keynesian theory is the most accepted. Keynesian economics deal with the various theories about how in the short run, mainly during recessions, economic output is strongly influence by aggregate demand or total spending. Aggregate demand does not necessarily equal the productive capacity of the economy. Instead it is influenced by a host of factors that can behave erratically, affecting production, employment, and inflation.

 

Keynes theories were first presented during the Great Depression in his 1936 book, The General Theory of Employment, Interest, and Money. Keynes’ approach contrasted with classical economics. Keynesian economists believe that the private sector’s decisions sometimes lead to inefficient economic outcomes which require active policy responses by the public sector (government). It is a combination of the two that stabilize output with the government exercising control over the private sector. Monetary policy actions are needed at times by the Central Bank and fiscal policy actions (Government spending.) in order to stabilize output over the business cycle. Consequently Keynesian economics requires a mixed economy, predominantly private sector with a strong role for government interventions during recessions and depressions.

 

Traditional or classical economics as developed by Adam Smith in his 1776 book, An Enquiry Into The Wealth of Nations, set the Market making all the societal decisions. The motivating force, according to Smith was the “invisible hand,” the profit system. Adam Smith was responding to an economic system called mercantilism, where gold was considered the basic wealth of the nation and the economic decisions were being made by the kings of the various countries.

 

John Maynard Keynes during the world economic disaster called the Great Depression was questioning the validity of this system, saying what was needed to solve this problem was a combination of private enterprise balanced by state control of the marketplace. To him unfettered classical economics had brought about the Great Depression.

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The actual causes of the 1929 Great Depression have been extensively discussed by economists and remains a matter of intense debate. In fact they are part of the larger debate about economic causes. The economic events that took place at that time have been studied thoroughly: a deflation in assets and commodity prices, dramatic drops in demand and credit, disruption of trade, widespread unemployment, over 13 million by 1932 the lowest point of the economic decline, and hectic poverty.

 

There is no consensus as to overall causes other than it started with the initial stock market crash that began on Black Tuesday, October 29, 1929 when panic selling of securities led to a continued dropping of value of the securities until the end of 1932 when it reached its lowest point. The Crash triggered the depression which had reached a high level of deteriorating economic conditions such as rising unemployment, over production, a totally unequal distribution of incomes, under consumption, and extremely high debt.

 

Both the stock market and the economy would slowly improve after 1933 with the new President, Franklin D. Roosevelt. It would rise to new heights after 1939 with the outbreak of World War II in Europe. The stock market and the economy would rise to new heights with a massive infusion of money for goods and services within the United States. War will have brought about its end within the U.S. It is interesting to note that it was the money spent during the war, first by European and Asian nations, then after December 7, 1941 also by the United States that specifically ended the Great Depression.

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Once the Great Depression had started there were massive mistakes made by the Federal Reserve. The Fed actually caused a shrinkage of the money supply and greatly exacerbated the economic situation. Deflation caused people and businesses to owe ever increasing amounts upon money they borrowed actually shrinking the money supply in the U.S. by about 1/3.

 

With the election of Franklin D. Roosevelt to the presidency in 1932 a form of Keynesian economics became the policy of the President from 1933 on when he assumed power. Roosevelt’s policy was the “3 R’s: Relief, Recovery and Reform.” This comprised Roosevelt’s “New Deal;” his attack upon the Great Depression, which essentially lasted from 1933 to about 1938. The Federal Government put itself in a position to help turn the country around. It brought about great improvement but not a complete end to the Great Depression.

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Toward the end of 2007 in the last year of the George W. Bush’s Presidency what is generally called the Great Recession began. The Housing Market in the United States collapsed. A great many people had been using their home as bank or checking accounts generally from the 1980s on, constantly refinancing their home and taking their equity out as property values continually increased. People bought the toys they always wanted: new cars, fancy trucks, boats, expensive vacations; just about anything they felt was desirable.

 

This had been going on for about thirty years, the entire career of many people in banking had taken place during this period. Housing loans or second mortgages were divided into miniscule fractions, put into a multitude of different Hedge Funds and sold to the general public as safe interest paying loans. The process brought the value of the home loans up millions, if not billions of dollars. The banks were earning large amounts in fees as the demand for loans actually forced up the value of the homes. By 2007 the end had been reached, property values had been raised beyond the point of sanity. The bankers were in denial that conditions could possibly change. Some banks were lending out 125% of the appraised value of the properties, working on the premise the housing values would rise endlessly.

 

The economic collapse began during the second week of March, 2008. It tended to be worldwide. In the United States, on Tuesday, with the encouragement of the President, George W. Bush and the Secretary of the Treasury, Hank Paulson, the Chairman of the Federal Reserve, Ben Bernanke injected $236 billion dollars into the American banking system. Citigroup, the world’s largest bank spent one billion dollars bailing out six of its hedge funds. Lehman Brothers, America’s fourth largest bank went under. AIG, the world’s largest insurance company, had moved into the business of insuring leveraged debt right at the time when the financial system was at the point of collapse. When the Housing Bubble burst Ben Bernanke, as chairman of the Fed, announced an $85 billion loan for them. Hank Paulson, the Secretary of the Treasury proposed buying up hundreds of billions of dollars’ worth of toxic assets.

 

With the accession of Barack Obama on January 20, 2009 as President of the United States that country and the rest of the Industrial Nations continued to hover on the point of economic collapse. This would have occurred if the governments had not interceded with masses of cash. They prevented, using taxpayer money, a depression that would have made the Great Depression of 1929 look like a weekend holiday. It would have been the total collapse of the banking systems which, in essence, run the economies of all those nations.

 

(Interestingly Donald Trump’s administration wants to do away with all the regulation in the U.S. which came about to avoid a repeat of this situation. Memories are short!)

 

President Barack Obama continued the bailout, saving the banks from their own stupidities, and he added the American automobile industry which was also on the point of total collapse. The governments of the various countries spent a lot of money saving their economies and returning the world to economic sanity.

 

Recently President Donald Trump commented in one of his speeches that President Barack Obama increased the National Debt more than any other prior President. He did so cleaning up the financial messes that they had helped to create.

 

We have passed beyond Keynesian economics to the point where the Free Market is today a farce. The governments of the United States and of the other industrial nations have assumed responsibility for the welfare of both the rich and the poor within their societies. How long will it take for the populations to understand this?

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In the United States and in most industrial nation there are groups that want to return to the good old days. Whatever they were. Everything is changing. The 21st Century will be completely different from the 20th Century.

 

It should also be noted that it was the Federal Reserve, under Chairman Ben Bernanke, who used creative Monetary Policy in a period of a little over 24 months, with strong encouragement from President Obama, to buy up the toxic mortgage pieces throughout the United States at the rate of 45 billion dollars’ worth a month and also he added another 40 billion dollars a month directly to the National Cash Flow.

 

The Republican dominated House of Representatives from 2011 on did nothing to help the situation. They should have applied Fiscal Policy, creating jobs by spending money on infrastructure modernization. Instead they tended to cut government spending and worsen the Great Recession. Mitch McConnell, the Republican majority leader in the Senate, announced that they would make Obama a one term president by not cooperating with him on anything. To them no price was too high in order to make Obama a one term president. Somehow the needs of the American people were lost.

 

It was the Federal Reserve and the President who saved the country from falling into the worst depression in its history. The Republicans, once they got control of the House of Representatives, refused to pass anything that would make President Obama look good. This was true even if it had a negative effect on the country and hurt the majority of its citizens. President Obama offered a Bill that would engender spending on our decaying infrastructure. It did not even come up for discussion in the House of Representatives.

The Weiner Component Vol 2 #1 Part 2 The Introduction

Deviations from the long term growth trend US ...

Deviations from the long term growth trend US 1954–2005 (Photo credit: Wikipedia)

Business Cycle

Business Cycle (Photo credit: Wikipedia)

To avoid the vicissitudes of the business cycle and the inequality of the distribution of the National Income, the Gross Domestic Product, we need a new economic model or we have to make intensive changes in our present system.  If we stay essentially with our present model then the government has through a tax and redistribution system to balance incomes. A realistic minimum standard of living has to be set.  Those earning more than this level will have to be taxed on a realistic graduated level.  Those earning less would receive transfer payments from the government to bring their standard of living up to the minimum level which has to allow for a decent standard of living.  With this system, which more or less exists today in many European nations, we can keep the profit system and have all its so-called advantages.  But would this end the vicissitudes of the Business Cycle?

 

The amount of productivity today per working unit/person is constantly increasing.  One individual working continually provides for more and more people.  In order to keep constantly producing goods and services this productivity must be continually used up so more is always needed.  Consumption now becomes as important as production if the economy is to continually grow.  Therefore the consumer whether or not he/she is employed is needed as much as the producer.  This system can only flourish through government taxes and a redistribution of the National Income.  The producers can earn assorted amounts of surplus income which they can spend, save or invest while the unemployed or underemployed population can receive government transfer payments which will allow them to properly consume the necessary goods and services to both keep production going and have a decent standard of living.

 

Of course if we can create a new economic model which would allow for a fair distribution of goods and services without using the profit system then we would be far better off.  But this would probably require a complete change in our overall thinking and value systems.  We would also have to deal with the issues of what to produce and how to produce it without the motivating force of the profit system. 

   

Is it possible?  We would have to separate production of goods and services from money and find another reason to labor other than individual profit.

 

There is a disparity between the use of money as income, a means of exchange, and storage for labor and profits.  The distribution and expenditure of money determines where we are on the Business Cycle.  This, in turn, can throw the economy into recession or depression and cause a breakdown in the production of goods and services and partial or massive unemployment.  The extent of the distribution of money can cause a partial or full cessation in the distribution of goods and services.  They are two separate entities that are tied together in an unwholesome relationship.  If they were separated the economy would be far better off.  The problem, of course, is how to separate them.

 

Generally speaking, the overall public reaction to all of this is to return to the thinking of the late Nineteenth Century: the “safety” of the profit system. This, I believe, President Donald J. Trump will attempt to do; and this, seems to be today, the basic Republican value for economic growth.

 

     MONEY: ITS HISTORY AND USE:  The two entities which keep any economy functioning are self-interest and money.  Self-interest would affect every working individual from owner, entrepreneur, to physical laborer who wants the greatest return he/she can get from their endeavors.  Money is the grease that operates the economy: it is wages, salaries, profits, rents, interest, and dividends.  The spending of money determines demand, production, and also the phases of the Business Cycle.

 

The entrepreneur, factory or store owner will charge the greatest amount they can legitimately and pay his employees the least amount they can get away with.  Thus prices will be as high as possible while money paid to worker will be as low as it can be.  The producer will maximize production to increase profits; the workers will not be able to purchase all the goods and services produced because of low wages and over-production will eventually result.  This will lead to recession, unemployment, business failures, and depression.  Self-interest, which is the major motivating force of the economy, also tends to eventually cause the economy to malfunction into depression.

 

What is the problem?  It is the process of the distribution of money throughout the economy.  Whenever the distribution breaks down the economy goes into recession and depression.  It ceases to operate for the benefit of its members.

 

The use and distribution of money becomes the problem.  What then is money?

 

To understand what it is and its use(s) we need to have knowledge of how money was used both historically and at present.  Presumably, at first, man begins with barter: goods and services were directly exchanged for goods and services.  At some later point in time these were exchanged for their exact value, generally, in precious metals.  Rather than continue using scales to weigh the metal one group of traders, probably the Phoenicians, began stamping the weight on the metal piece.  This became the initial use of money.  The idea was then picked up by other groups or nations and coins came into being: an exact weight of a precious metal with the country or ruler or some symbol stamped on the metal to guarantee its value.  What happens here is that a good is exchanged for its exact value in the metal: equal value for equal value.  This allowed for free trade throughout the Mediterranean several thousand years ago.

 

Money, as it existed at this time, was labor or a good whose value was exchanged for its equivalent in gold, silver, or cooper coins.  Similar worth was exchanged for similar worth.

 

As time proceeded the coins became more ornate.  Rulers images were stamped on the coins, various designs were used.  Different denominations appeared, allowing coins to be minted in different sizes and weights; and also in different metals.  And thus was value exchanged for value, money for goods and services.

 

Of course, into this economic system occasionally various enterprising individuals and/or governments began a process of “watering” some of the coins minted; that is, mixing base metal with the gold or silver, thereby hoping to get more goods and services for less gold or silver.  This process would be done on a large scale by such individuals as the Roman Emperor, Nero; who tended to need more money than he could collect in taxes.  The result was to cheapen the value of the specie bringing about inflation which also resulted in a lowering of overall wages and other disruptive problems to the economy.

 

However, this economic system worked and continued to work successfully as long as conditions in the society(ies) were stable; that is, there is no rapid infusion of massive amounts of gold or if large amounts of money don’t have to be transferred over distant areas.

 

The discovery of the New World by Christopher Columbus brought into Europe, in the Sixteenth Century, massive amounts of gold over a fairly short period of time.  The Americas were systematically looted.  The gold passing through Spain and went on to the Netherlands, which was ruled by the same person as Spain, and then into rapid circulation throughout Europe.  This caused, what has been referred to as, “The Gold Revolution” which decreased significantly and continually the value of gold in its relationship to goods and services, and brought about unbelievable economic hardships to the wage earning working classes of Europe.  Wages remained essentially fixed while the value of the money dropped continually in a never ending cycle of inflation; thus bringing about a tremendous drop in standards of living.  It took about a century for a new reasonable balance between the value of gold in relation to the cost of goods and services to come about.   

 

Another problem which could upset the economies was large scale trade over great distances and/or between different nations. There was great danger from bands of thieves on land or pirates when shipping gold over bodies of water.  A safe way had to be found to ship gold. 

 

During the late Middle Ages different cities, city-states, provinces, and countries became known for producing certain products.  These were desired throughout Europe.  Also some of the Italian city-states, after gaining control of the Mediterranean Sea, gained a monopoly of trade with the East for spices and other products.  (It was the search for a new route to the East that brought about Columbus’ expedition.)  This and other factors brought about a need for the safe transfer of specie over long distances.  In addition the breakdown of Feudalism and the rise of Kings brought about a necessity for the availability of large amounts of money for the payment of armies and other large scale projects.

 

To offset these economic needs there arose in various cities: first in the Germanies and then in the Italian city-states merchant families who eventually traded in money as a commodity.  These became the merchant bankers of the Hanseatic League and the Italian city-states.  They set up branches of their banks in different countries which allowed for immediate transfers of gold; and they became in many cases the new nobility: the merchant princes.  Of the Medici family of Italy two of the women became queens in France and one of the Medici became a pope.  Cosimo, the founder of the family had been a money lender whose symbol of trade was three brass balls.

 

From the Italian Renaissance on (Fourteenth Century) banking was fully developed with the banking families, in many instances, ruling the Italian city-states.  The goods of the East came to Europe by way of the eastern Mediterranean, through the Italian city-states, and on to the general population of the continent.  The fleets of ships plying that sea were controlled by the merchants of the city-states; who also controlled banking and, among other enterprises, made high interest loans to the emerging kings.

 

It was the potential profits from the trade that caused the new nations like Spain, Portugal, England, and France to explore, searching for a new route to the East.  This was the justification for sailing west to get to Asia and thus discovering the Americas.  Prince Henry of Portugal began sending expeditions south, exploring Africa trying to find a river crossing Africa west to east.  Eventually one of the expeditions rounded that continent and was able to bring back to Europe a cargo of spices worth many times the value of the ship and cost of the expedition.  Portugal controlled that trade for about fifty years. 

 

With the new routes and the emergence of pirates in the eastern Mediterranean, Italy lost control of that body of water and the trade and profits moved to the new emerging nations.  Incidentally the Renaissance now became the Northern Renaissance and banking and trade moved to these countries.

 

Money, during this period, remained as it had always been: equal in value to the goods and services for which it was exchanged.  Spain’s looting of the gold from the New World and having it pass directly into the European economy brought about a 90 year period of inflation in the Sixteenth Century but did not change the concept of value for value.  Actually by making gold more plentiful and less expensive it allowed for a more rapid economic growth.

 

With the coming of the wonders of the Industrial Revolution (the development of machines going from wood to metal, transportation: put a steam engine on wheels and you have a train, advances in medicine: ever increasing abilities to fight the assorted diseases, phenomenal population growth, advances in metallurgy, gas and electric engines, etc., etc.) the nations of the planet underwent massive changes: national populations went from the low millions to the high millions approaching and exceeding in one or two cases a billion people.

 

As we moved into the Twentieth Century (in addition to the major wars which wiped out millions) with the tremendous growth of business, of  the needs for ever increasing goods and services there were not enough precious metals to allow for an exchange of goods and services based upon value for value.  For this and other reasons in 1929 we have the Great Depression.

 

Paper money when it was first used consisted of silver and gold certificates which supposedly could be exchanged for actual specie at any time at one’s bank.  (However, if everyone were to do it at the same time there would be a run on the banks and they might well become bankrupt because there was never enough metal to satisfy everyone’s needs.)  In point of fact the Industrial nations eventually got off the direct gold standard by collecting and storing the gold bullion and printing paper money supposedly based upon the value of this stored bullion.  Silver coins would maintain a certain amount of precious metal for a while.  Later in the Twentieth Century virtually all nations will go off the gold standard basing the value of the money on the prestige of the particular country. The remaining silver coins became copper sandwiches.  By the beginning of the Twenty-first Century money is, in all cases, devoid of any precious metal or anything else of real value except the credit of the nation issuing it.

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Since 2008, when the United States went through what is generally called today The Great Recession the country has been recovering from what could have easily been The Greatest Depression in its history.  This economic condition had been building rapidly since the presidency of Ronald Reagan in the 1980s, when all government restrictions on trade, many of which were developed by the Roosevelt administration during the Great Depression, had been done away with by the Reagan administration.  The banking industry in the country had a free hand to do whatever they wanted.  And what they wanted was to increase their profits astronomically.

 

The banking industry convinced a large percentage of homeowners to turn their homes into bank accounts by a process of continually taking equity funds out of their homes.  They did this by constantly refinancing their properties.  In the process of doing this the paper value of the homes continually increased.  Presumably people were spending what they believed was their never ending increases.

 

This became rampart from the Reagan administration on.  By 2007 the oncoming crash was apparent but the banking industry was in denial.  At that point mortgage refinancing was raised to 125% of the appraised value of the home.  In 2008 the crash came and the Housing Industry collapsed.  Many of the banking houses were overextended and also at the point of collapse or bankruptcy. 

 

Since the basic financial structure of the entire economy or nation is based upon the banking structure and their functioning the Bush administration in 2008 lent large amounts to the banks.  This, however, was not enough money and the incoming Obama administration had to make more massive loans to the banking houses in order to save them.  The Obama administration also set conditions about massive remunerations to executives which the Bush people had not done.

All of this was in 2008 and 2009.  The trillions of dollars the Federal Government spent at this time saved the country from going into a more massive depression than that of 1929.  In fact we would still be coming out of it if the government had not jumped in. 

 

What emerged instead has been called The Great Recession.  In 2009 the unemployment rate had risen to 7.6%.  By 2010 it had reached 9.8%.  Thereafter it began to fall, reaching 4.6% by November of 2016.

 

In this process millions of people were underwater in their homes, suddenly owing more on the house than it was worth.  The banks, with aid from the government, largely recovered, with some being taken over by other banking houses.  Even with virtually no regulation some of the banking actions were illegal.  No one went to jail.  Instead the banks paid fines, which taken together were in the billions of dollars. The banks eventually repaid their government loans and executive pay rose to new heights.

 

We are still in a recession, with unemployment at the tail end of December 2016 at 4.5%.  For recovery, on the business model to occur, the range of people not working would have to reach 2.5%.  Is that a future possibility with President Donald Trump?  Probably not.  Since the Republican image of creating jobs has nothing to do with current levels of economic understanding.  They believe that jobs are created by doing away with government regulation.  It would seem that by their way of thinking as pollution increases and so do jobs.