Will the Federal Reserve be able to keep inflation down in a sluggish US economy?

No

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by Michael Greaney

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The Federal Reserve System is a tool - nothing more. As such, it has been misused almost from the moment of its inception in 1913.

The original purpose of the Federal Reserve (an interconnected series of 12 regional central banks for the United States) was to provide an adequate supply of money for qualified industrial, commercial, and agricultural purposes, avoiding the twin dangers of inflation and deflation. The idea was to continue to have gold and silver coin and certificates provide the bulk of the circulating money supply, supplemented by money "created" through the "discounting" process.

That is, money can be created as needed by the banking system. The process involves a prospective borrower taking a "financially feasible" project to a bank. ("Financially feasible" means that the project can pay for itself - repay the loan that financed its formation - out of future profits generated by the project itself.) The lending institution makes the loan, backed by the borrower's collateral, and "sells" the loan paper to the central bank (the Federal Reserve system) at a discount (hence "the discount window"). The central bank purchases the loan paper by creating a new demand deposit (checking account) or printing new currency, which is turned over to the borrower who has pledged his or her collateral to ensure repayment of the loan.

The borrower then forms the capital - that is, purchases or builds a project intended to generate income in the future. When the project becomes profitable, part of the proceeds are used to make "debt service" payments, that is, payments of principal and interest. The bank takes these payments, subtracts its service fee (how the bank makes a profit for the service it provides), and uses the rest to "buy back" the loan from the central bank.

The central bank turns the loan back to the bank, and cancels the currency or demand deposit, keeping the differential as its profit (by U.S. law, turned over to the U.S. Treasury). The bank in turn hands back the loan to the original borrower, whose obligation has been canceled by his or her debt service payments.

In this manner - detailed in Section 13 of the Federal Reserve Act of 1913 - it was intended that the U.S. currency would always be stable, and there would always be enough, and not too much, thereby causing inflation. The Federal Reserve, in an attempt to prevent it from financing government deficits, was strictly prohibited from dealing in "primary government securities," that is, from buying debt paper directly from the government. In order to be able to adjust reserve requirements of commercial banks, however, the Federal Reserve had to be able to deal in "secondary" government securities, that is, securities that had been issued by the Treasury and sold to the public, and were now on the "open market."

The Federal Reserve operated in this manner for three years - from 1914 to 1917. Then the U.S.'s entry into World War I required that the government finance the war effort. Doing it all through taxes was not politically popular, so the Federal Reserve, in a patriotic if misguided decision, figured out a way to finance the government deficit. It would purchase government securities through open market operations, passing the securities for a few microseconds through a select group of bond brokers, thereby turning primary government securities into secondary securities.

Added to John Maynard Keynes' mistaken belief that there is a trade-off between inflation and employment, the money creation policy of the Federal Reserve has resulted in a situation that cannot be rectified without substantial policy changes at the most basic level. In accordance with the "Chicago Plan" of the 1930s, fractional reserve banking should be prohibited and a 100% reserve requirement instituted.

Stopping there, however, would mean disaster. It is also necessary to make the prohibition against dealing in primary government securities effective instead of a dead letter. For this reason, the central bank must stop immediately all purchase of government paper on the open market EXCEPT from commercial banks and ONLY out of proven reserves. Instituting the 100% reserve requirement would effectively render it impossible for the central bank to affect reserve requirements, since they would be unchanging.

Another necessary step would be to use the discount window as originally intended: to provide liquidity for qualified industrial, commercial, and agricultural projects.

A final necessary step would be to mandate that all new money and credit financed the acquisition of capital by people who do not have any at present, and who will use the income for consumption once they pay off the acquisition loan - and to require the pay out in the form of dividends (tax deductible at the corporate level, similar to an S-Corporation) ALL income attributable to a shareholder's pro rata portion of ownership.

The only reason to retain earnings in a corporation is either to finance the formation of capital directly, or to collateralize the formation of capital on credit. Using insurance to collateralize the formation of capital on credit would remove the necessity to accumulate retained earnings for collateral, while creating money for productive purposes - not consumer or government spending - through the central bank would remove the necessity for saving in order to finance new capital formation.

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