Rooting Out Inflation
Where it comes from and why it matters
There are two competing narratives for explaining the inflation we have experienced in the United States this year. On the left we’re told that record corporate profits and greed are the root cause; on the right, the scapegoat is deficit spending by the federal government (some blame the Ukrainian conflict; there is some merit to these claims, but today I will keep my thoughts domestic). It is hard to decipher which narrative is accurate because both are based in fact: US banks saw a 90% increase in profits from 2020 to 2021, and in the same year the federal government ran a deficit equivalent to 12.3% of GDP. I am interested in and more than or, and accordingly will not be picking a side. Today I intend to detail a financial system in which deficit spending, inflation and corporate profits are interrelated features, hopefully reconciling these two narratives and identifying tangible systems that advantage a few at the expense of the rest of us.
The first piece of the puzzle here is deficit spending. Here I am referring not to the national debt, but to the annual difference between money spent and taxes collected by the federal government. For context, the 2022 federal deficit is projected to run somewhere around $1.4 trillion. The deficit becomes debt upon the sale of treasury bonds. Anybody can buy bonds, though most are bought by a small group of approved primary bond dealers that includes the likes of J.P. Morgan Chase, Citigroup and Goldman Sachs. These bond dealers turn around and sell their bonds to the Federal Reserve. These initial transactions allow elected representatives to escape accountability for their inability to balance the budget. Without this system they would have to either raise taxes or cut spending and face backlash from their constituents.
The Federal Reserve acts as the bank for banks. All major American banks have accounts with the Fed. When a bank sells government bonds to the Fed, the Fed creates money out of thin air and deposits it in that bank’s account. This is where inflation and high profits find their origins, through the wonders of fractional reserve banking. Under the fractional reserve system, a bank can lend out up to 10x its reserves. If it has $10 in its account at the Fed, it can lend $100 to businesses or consumers. To be clear - banks are permitted to loan out money that they don’t have. If you or I were to do this we could be prosecuted for fraud. Where does the money come from if the banks don’t have it? Under fractional reserve banking, banks create money by loaning it out. This puts the original bond purchase in context. On face value, no serious financial institution would buy debt from a state that has not run a consistent balanced budget since the 1920s. But consider the following example:
J.P. Morgan Chase buys $1,000 in government bonds. For ease of math, they then sell them to the Fed for $1,000. Now the federal government has been funded, and the Fed creates money to pay Chase. With $1,000 in the account at the Fed (money that did not exist before), Chase bank can now lend $10,000 to consumers. Assuming a modest 3% interest rate and a 5 year term, the bank will reap $10,781. The initial investment of $1,000 in government bonds yields a profit of $9,781 for the bank, and results in an increase of $10,000 in the money supply.
This convoluted system presents clear winners. First, our legislators avoid accountability for their inability to do their jobs. Rather than grapple with hard decisions about taxation and government spending, representatives from both major parties continue to spend money that we don’t have. In the private sector we see powerful institutions reaping massive profits. I don’t believe that making a profit is evil, so long as profits are made by adding value to the world. These profits, however, come about as a reward for funding a corrupt and incompetent government. The exclusive list of approved primary bond dealers make money hand over fist through this scheme. It is difficult to take an honest look at this system and not conclude that it is a textbook case of corruption.
Those of us who do not profit from the fractional reserve scheme are left with inflation. Inflation is multicausal - decreasing global demand for dollars, foreign policy blunders and legitimate shortages all play a role in increasing prices - but the relationship between money supply and inflation in a market economy is undeniable. Consider the 2021 deficit of 12.3% of GDP. Using the model described above, we could see an increase in the money supply of up to 123% of GDP. Doubling the supply of money without doubling the amount of goods and services produced will predictably lead to doubling prices over time.
Our earnings reflect time spent working and the value that time and effort bring to other people. A well regulated currency protects the value of a person’s accumulated time and effort. This is why counterfeiting is illegal - it allows one to get something for nothing and is not socially optimal. So for a small group to print money out of thin air, as a reward for propping up a political class that refuses to do its job, is entirely unacceptable. Effort expended doing things that matter is the driving force behind a healthy and well functioning society. This very effort is disincentivized and devalued every time money is printed.
For the reasons explained above, I believe that abolishing the Federal Reserve is one of the most pressing political issues of our time. The Constitution gives Congress the exclusive right to coin money and manage its value, a right that was outsourced to the Fed with the passage of the Federal Reserve Act in 1913. By returning this authority to Congress we will simultaneously stop this money printing scheme in its tracks and force accountability back onto our representatives, who will no longer be able to have their cake and eat it too.
Money can be an effective tool for improving people’s lives in a free market economy. When a currency is managed honestly it offers a sort of organic accounting system that rewards productive effort. Conversely, a corrupt financial system distorts the value of money and the decisions individuals make. A reliable way to store value is fundamental to fostering social trust and long term decision making; accordingly, the Fed must go.