Federal Reserve Talk

I’ve been discussing the function of the banking with Educators of Liberty founder and technology coordinator Scott Barber. EOL is a great pro-liberty organization here in North Texas that I’ve been lucky enough to join, but more on that sometime later.

After a recent weekend EOL meeting, we got into a discussion of central banking and the Federal Reserve, an institution which serves as ground zero for the funding of the warfare-welfare state imposed on us today. Personally, ending the Fed is the impetus and foundation of my political activism, because without the counterfeiting Fed it would be next to impossible to fund a $3 trillion empire in Washington, D.C. That says nothing of the wealth redistribution and wealth destruction it is responsible for.

During out talk, Scott had leveled a critique of the Fed that I just couldn’t buy, namely that the creation of money traps borrows into a, like, loop-back pattern since they can’t all pay back the principal and interest from the total money originally borrowed. And that makes sense on its face. How can you pay back 101 dollars, the principal and interest total, when there are only a total of 100 dollars in existence?

As despicable as the Fed is, I didn’t see this as a claim against central banking, but rather against banking in general. And I thought there was a simple answer to this charge; that the same dollar is “recycled” through an economy and can be spent multiple times over a period of time.

(Note: I’m grateful to Scott for allowing me to reproduce our e-mail exchange from the past week. Here are the relevant portions below.)

Hey Scott,

I was thinking of what you said about the Federal Reserve that it creates the need for more loans to pay off the interest from the original loan. Forgive me for not thinking of this Saturday when we were talking about it, but the easiest way to show that is not true is by showing how money moves through the economy multiple times.

Say Albert lends Bob $1000 at 10 percent interest, and Bob turns around and uses that money to buy a lawnmower and equipment for his business. It could still benefit Bob to borrow the money even if Albert were his only customer. Bob could make his payment of $100 each month, and Albert would turn around and pay Bob $100 for cutting his lawn every month. Month after month, Bob’s remaining debt would decrease until the principal and interest were paid in full.

Now there could be a scenario where there is little if any need for Bob’s services. In this case, Bob would not make enough money to pay off the loan. But that is not the fault of Albert for the lending the money; that is Bob’s fault for misjudging the market for his services.

What do you think?

Scott said:

I understand your analogy. But in this analogy, neither of the people in question are the one’s who create the money. They are simply using money that has been create “above” them.

My second e-mail:

I can see what you’re saying. But my analogy is the same. Albert creates 1000 Albert Dollars backed by gold or any asset for that matter. Bob agrees to borrow the lump sum and make payments of 100 Albert Dollars to Albert for the next 11 months. Bob performs some service for Albert each month. So long as Bob earns an average of 10 Albert Dollars per month, the debt will be paid in full.

The Fed gets away with using a fiat currency because legal tender laws force you to accept them as payment. That is why the Albert Dollars had to have an asset backing them since he has no government monopoly. Nevertheless, if Bob has misjudged the demand for his work, the loan will default. That is the fault of Bob, I believe, and not the lender.

Scott’s second reply:

Ok, with this analogy, there are “Albert Dollars.” 1000 of them in existence to be exact. ALL of the dollars are borrowed from Albert and Bob pays them back at 100 per month. Now what happens if Albert wants interest, and will ONLY accept “Albert Dollars” in return. There are only 1000 of these in the entire universe. How does Bob get the needed “Albert Dollars” to repay the INTEREST on this loan without borrowing more dollars that then come as a new debt with new interest? At 8% interest, Bob would need 1080 “Albert Dollars” but there are only 1000 “Albert Dollars” in our universe. Where do the extra 80 “Albert Dollars” come from?

I respond:

To the question of the missing $80: money can be spent many, many times over the course of a year. After the first month’s payment, Bob would have $900, while owing $980, and Albert would have $100. Then Bob does some work for Albert worth at least $80, and Bob now has enough money to pay off the principal and interest in full (Bob $980, Albert $20). In fact, if Bob could get regular work each month from Albert, they could just pass back and forth the same $90 ($1080/12 months=$90/month) and Bob would still have about $990 ($1080-$90=$990) at the end of the year.

The kind of work they agree to is going to depend on what kind of reserves are backing the Albert Dollars. If Albert has the currency backed by one ounce of gold, then that is going to be relatively easier work than if the currency were backed by 1000 ounces of gold. You see, while Albert is using that gold as reserves, he incurs an opportunity cost because he is not able invest those assets. For his sake, he has to earn enough interest revenue to cover the costs for the gold storage meet the expected investment returns he believes he could have earned on the open market under similar risk. (There are probably many more costs of creating your own money.)

But what if Albert does not hire Bob for any work, so Bob defaults on the loan. But then why would Albert want to loan Bob more money if he knows he won’t get paid back?

Or what if Bob makes less than the $80 for the interest? Then Bob has to take out another loan or sell some other property to cover the rest. But that is the fault of the borrower, not the lender, for misreading the demand for his work.

Or what if Albert pays Bob for work in some other currency? That would make sense if Albert no longer wanted the maintain his own currency. Then why wouldn’t he accept different forms of payment once there were no more Albert Dollars on the market?

Oops, kind of got long-winded there.

Scott says:

In this example, Bob works for Albert directly. In the case of the federal reserve [sic], we don’t work for them. We don’t give them their “payments” and then collect our pay-check.

My final response:

You’re right that the circumstances are not the same, and I guess that’s the problem with using analogies. My goal was to highlight the principle of how an interest-bearing loan works practically: so long as the lender puts some of the currency back into the market, the debts can be repaid. There are lots of ways Albert or a bank could put the money back into the economy, and for simplicity’s sake, I chose that one.

In the Fed’s case, it has not only put some of the money back into the system. It has multiplied the money supply 25 times over by monetizing government debt and using fractional reserve banking. After all, how surprised are we that someone with a license to freely print money would abuse that power?

I get the last word for now.