International Currrencies Made EZ: Chapter 5


* WHAT TO DO NOW: Learn what money really is. We use money so often that its real meaning often becomes invisible in its familiarity. However the importance of real money is not lost in the global marketplace. This is why the all too familiar U.S. dollar has fallen so far. Learn what real money is below.

* EZ CURRENCY DIVERSIFICATION: Put gold in your portfolio. This is the ultimate long term protection against currency turmoil. See page four.

* EZ PROFIT: Watch for conflicting conditions. Central banks make moves that affect your wealth based on economic conditions. Learn how and what to watch in the case study on page eleven.

Thin tendrils of clouds float like white whips in the brazenly blue sky. Waterfall sounds grow, a cascade of cool pleasure from the green jungle below. Fresh mountain breezes rise and the katydids awaken in the noon day sun and sing, it is time to relax. Siesta time is the time to sleep.

Rancho al Norte, Dominican Republic. Near this village two rivers meet and Merri, two of our daughters Francesca and Eleanor, are headed there on horseback. We have been riding through the jungles and now it is time for lunch and a good swim in the cool waters there. Then we’ll have a nap.

This is a wonderful way to spend the day, but as we move down the hill, I can’t help but reflect that when the day is done, the people who rented us the horses and helped us take this trip will prefer to be paid in dollars rather then the local currency. Here despite the weakness of the dollar, the local residents, even the most unsophisticated farmers, know that their currency is even weaker.

Why is this, I thought? Why are some currencies weak and others strong. What causes currencies to move and who makes these decisions?

The answers to these questions are important because it is almost certain that the value of your currency will move versus others in the years ahead. You will gain an enormous advantage if you know why and what to watch so that you can be prepared to hold currencies that are strong.

In this lesson we share information about what a currency is and who controls the money supply in the U.S. and in other countries. We’ll also learn how this money supply makes the value of a currency move.

Definition of Currency

In this lesson we dive deeper into money and currencies — how they are created, how inflation occurs, and how the value of money is determined by foreign exchange markets.

Money makes it possible for us to buy and sell without bartering. Money gives us a “medium of exchange,” which allows our complex economic system to function.

Money acts as a way to put tangible, universal value on commodities and services. It helps us compare the value of one thing with another. This gives us a “unit of value,” which allows us to make decisions about purchases and investments.

Money also functions as a way to store wealth — to preserve purchasing power for spending at a later date.

Money must be real to carry out these functions. We learned in earlier lessons that only money created by real production can be real money, but there are other qualities money must also have if it is to work properly. Money must have six specific qualities:

* Specific Money Quality #1: Money must be acceptable by both parties in a transaction. To be absolutely universal in value, money must be acceptable to everyone.

* Specific Money Quality #2: Money must be portable. One must be able to take money where it is needed. This is what has made paper and plastic money so much more popular than gold. Paper currencies, checkbooks and credit cards are so much easier to carry than lumps of gold and silver (though as we will see, the price we pay is high for giving up the discipline that comes from the rarity of precious metals).

* Specific Money Quality #3: Money must be rare and require effort (real production or work) to attain. If you look at all of the qualities of money, you can easily see why gold makes such good money. This precious metal has all of the qualities required of money. Yet if you compare gravel to gold, you will see that gravel also has most of these qualities, except rarity. Gravel is as common as dirt and if gravel were used as money instead of gold, the temptation to just pick it up on the road, rather then work for it, would be too great. Money must offer an incentive to work and apply discipline. Rarity creates this incentive.

We will see in this and later lessons how important this quality of rarity is when we see how governments reduce the rarity of money and how this action destroys money’s value.

* Specific Money Quality #4: Money must be divisible and uniform in quality. In other words, people must be able to know that each unit of the money is real, not forged or altered.

* Specific Money Quality #5: Money must have some intrinsic value, or be useful in itself or be backed by some intrinsic value.

* Specific Money Quality #6: Money must be naturally durable. There have been many times when goods or commodities such as chocolate, coffee, cigarettes or silk stockings, etc. have been used as money. The conditions were such that the commodity was so desirable and so rare that these two qualities were enough to make them a form of money. Yet they fail to last as a money because they are too fragile and once consumed cannot be used as money again. Real money must be naturally durable and able to be used again and again.

Metals such as bronze, gold and silver fit many of these categories. Some of the early goldsmiths, who took gold on account, offered scrips or tickets stating how much gold was being warehoused. Eventually people realized that these scrips in themselves had value, since they represented claims on a specific amount of gold. As a result, the scrips began to be exchanged as money. They were certainly easier to carry than the metal itself, and since they were backed by gold, why would they not be as good as gold?

Goldsmiths soon realized that it was possible to issue more scrips than could actually be converted into gold — if not everyone came at the same time wanting to convert their money into the precious metal standing behind it. Thus were born the first bankers, who in essence created money by issuing more of it than was backed by gold. Such money is called Commodity Money.

Important point to remember: The creation of commodity money is perhaps the most important step in the evolution of money for modern society. Fiat money if disciplined is essential for expansion. However the uncontrolled expansion of commodity money by governments to the point where the money is forced to become fiat money has been the prime ingredient in the destruction of currency after currency since this idea began.

Originally bankers were able to create paper money from their scrip because of their reputation. The bankers were the keepers of gold and the lenders of money. They were known to be prudent, honest and very disciplined. Their businesses, their reputations and the economic lives of the community were in the hands of the bankers’ judgement. Hence the reputation of the steely eyed, tough minded banker who lent money only to those who would be most likely to pay the loan back.

Once governments discovered that it was possible to create money without backing, they quickly caught onto the idea. No government in history has wanted to be left out of a scheme that creates money from thin air, so in short order most governments in the world took over the process themselves, issuing scrip not wholly backed by gold. Thus was born “commodity money”, which consists of paper money convertible to the precious metal designated. The money may be backed 100% by gold, or 50%, or 25% — or less than 1%.

“Fiat money” is coin or currency that is not convertible to precious metal. Issued by governments, it has value only because it provides all the necessities of money as described above — and because it is declared to be money by government decree. In fact, Webster’s defines the word fiat as “A decree, order, or sanction.” It comes from the Latin, “Let it be done.”

Pure fiat money (currency or bank deposits with no tie to precious metal or any commodity with inherent value) can be valuable only when it is scarce. If a government issues too much fiat money, the value falls and inflation results. Thus, the value of fiat money ultimately depends on the confidence people have in the government issuing the money.

Almost all currencies in the world today are fiat money not backed by silver or gold. A U.S. citizen cannot walk into a bank and exchange a dollar for gold. A dollar is valuable only because everyone believes (has confidence) that it will be accepted as legal tender by everyone else.

Important Point To Remember: As the confidence in the U.S. dollar erodes, the value of the dollar will fall. As the dollar is still the reserve currency of the world, other currencies that are backed by the dollar will lose confidence as well. Until confidence in the dollar is restored or until a new reserve system is created, there will be global currency turmoil.

We’ll look in this lesson at how money is created, but first let’s look at another way to have a multicurrency portfolio.

Gold

Gold has proven itself over thousands of years to be real money. The price of gold is volatile, can rise or fall dramatically and can remain depressed for years, even decades (as has been the case of the price of gold through most of the eighties and into the nineties). Every historical study of the long term price of gold shows that over time, it has always risen versus currencies that are not backed by gold or some other precious metal. Every investor should consider holding part of his investments in gold on a long term basis as insurance against currency turmoil. Since buying and holding physical gold is expensive (because of storage costs) and because physical gold does not pay any interest or dividend, an alternative to owning gold is gold backed investments, such as gold shares.

Listed below are mutual funds registered in financial centers that invest in gold shares.

Abtrust Atlas Gold, 13 Rue Goethe, BP 413, L-2014, Luxembourg. Tel: 011-352-4046-461.

BBL Invest Goldmines, 24 Avenue Marnix, Brussels, Belgium. Tel: 011-322-547-2744.

CS Gold Mines, Credit Suisse, BP 40, 58 Grand Rue L-1660, Luxembourg. Tel: 011-352-460-0111. Fax: 011-352-745541.

CU Privilege Portfolio Gold Shares, Centre Mercure, 41 Ave de la Gare, L-1611, Luxembourg. Tel: 011-352-4028-20261. Fax: 011-352-4028-20221.

Century Gold, Albert House, South Esplanade, St. Peter Port, Guernsey, GY1 1AP, Channel Islands, Britain. Tel: 011-44-1481-727066.

Guinness Flight GSF Global Gold, PO Box 250, La Plaiderie, St. Peter Port, Guernsey, GY1 3QH, Channel Islands, Britain. Tel: 011-44-1481-712176. Fax: 011-44-1481-712065.

Hermes Gold, Hermes International Funds, 4 Boulevard des Tranchees, Case Postale 193, CH-1211, Geneva, Switzerland. Tel: 011-41-22-789-1010.

Lloyds IP Gold Fund, PO Box 195, Waterloo House, St. Helier, Jersey, Channel Islands, UK. Tel: 011-44-1534-22271. Fax: 011-44-1534-27380.

Indosuez Pacific Gold, # 2606, One Exchange Square, 8 Connaught Place, Central, Hong Kong. Tel: 011-852-25-214231. Fax: 011-852-2-868-1447.

Mercury International Gold & General, Forum House, St. Helier, Jersey, Channel Islands, Tel: 011-44-1534-600600.

M & G Island Gold, Westbourne, The Grange, St. Peter Port, Guernsey, Channel Islands, Britain. Tel: 011-44-1481-727111.

Schroeders Asia Gold, 25/F Two Exchange Square, 8 Connaught Place, Hong Kong. Tel: 011-852-25-211633. Fax: 011-852-2-8681023.

What To Do Now

Write for information from these funds. As always look at the depth and history of the management company. Look as well at the performance of these funds and compare them to the movement of the price of gold. Look at what these managers say about gold as real money.

More Types of Money

The final stage in the development of money is when bank deposits themselves become regarded as money. Today, the largest part of all world currencies is in the form of bank deposits. In fact, only about 8% of the U.S. money supply is in coins and bills. The other 92% is in checkbook and savings account money, held in bank deposits.

To understand this kind of money, let’s define the terms often used to describe money in the bank. The terms are: M1, M2, and M3. These are terms used to described the money supply (money in bank accounts).

M1 is all currency in circulation plus all checking account deposits (short-term deposits).

M2 is M1 plus all savings account deposits (short-term time deposits).

M3 is M2 plus all long-term deposits (CD’s).

To fully understand this, realize that when money is paid out of a checking account and put into a savings account, M1 is decreased and M2 is increased. When money is taken out of a savings account and put into a checking account, M1 increases — but M2 stays the same because M2 is the total of M1 and all savings deposits.

Once governments took control of currency and the money supply, it became simple for them to control money. To better understand how governments manipulate money, we look here at the United States Federal Reserve Bank and how it works. In later lessons we will also review the Bundesbank and the Bank of Japan in the hopes that understanding the role of the three largest central banks to money will help our understanding of all money and how currencies work.

The U.S. Federal Reserve (The Fed) and the Creation of Money

The United States Federal Reserve Act, approved by Congress on December 23, 1913, created the Federal Reserve System (known as the Fed). This Act was supported by authority of Article I, Section 8, Clause 5 of the United States Constitution: “The Congress shall have the Power … To coin money (and) regulate the value thereof …”

The Federal Reserve Act created twelve regional reserve banks — Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Dallas, Kansas City, Minneapolis, and San Francisco. These regional banks are not government agencies. They are private corporations owned by commercial banks that are members of the Federal Reserve System.

Federal Reserve headquarters are in Washington, D.C. Free information about international economic conditions is available from the Research and Public Information Office, Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, Mo. 63166-0442. Tel: 314-444-8809.

Who Controls the Fed?

Five Governors of the Federal Reserve System are appointed by the President of the United States. Each Governor serves a 14-year term, with their terms overlapping. The President also appoints a Chairman and Vice Chairman of the Federal Reserve, each with 4-year terms. These five Governors, the Chairman, and the Vice Chairman serve on the Executive Board that determines the discount rate.

When voting on the Federal Funds Rate (the interest rate that banks charge each other to borrow among themselves — always slightly higher than the discount rate) the Board also consists of the Presidents of five of the Federal Reserve Banks from around the country. These Presidents are selected by boards within their regions, with the approval of the Federal Reserve Governors. The banks represented on the Board rotate, so that all twelve are actively involved over the course of a year.

In theory, the Federal Reserve Chairman has only one vote among the others, but hardly ever does the Board go against his decision. The timing of Governor-appointments is set up so that any one President (serving one 4-year or two 4-year terms) may not have more than a few Governors actually appointed by him. And, in fact, the Chairman’s term overlaps with the President’s, meaning that a President may operate from time to time with a Fed Chairman that is not his appointment. Nonetheless, the timing of interest rate hikes and drops seem closely linked with political expediency for the President.

How the Fed Creates Money

The Fed creates money in three ways: through the Discount Window, through purchase of Treasury bonds and other certificates of debt and through alterations in reserve ratios. Let’s look at each method.

* Money Creation Method #1: The Fed makes loans to member banks through what is called the Discount Window.

The Discount Window, is really just a loan mechanism. When banks run short of money, they borrow from “the banker’s banker” — the Fed. A bank may need a loan for various reasons. It might have a sudden temporary shortage of reserves because of customer demand for cash or because of a large influx of checks written on accounts it holds. Or it might have made bad loans it has to write off.

Actually, it’s not unusual for a bank to have a temporarily negative reserve of money.

The Fed makes loans to banks at the “Discount Rate” — which is less than what the bank will charge customers for loans. The Fed adjusts the Discount Rate from time to time, based on what the Fed sees is required by the country’s economic climate. Suffice it to say that banks don’t mind borrowing from the Fed at a certain rate, because they can readily turn around and loan the money at a higher rate. The Fed’s Discount Rate actually determines loan rates in the country.

For example, if the Fed loans money to banks at 5%, banks may turn around and loan money to customers at 7.5% or 8%. If the Fed raises the interest rate it charges banks (the discount rate) to, say, 6%, banks will have to charge 8.5% or 9% on loans to customers to make profits. Thus, if the Fed wants interest rates to rise in general, it can raise the discount rate. If the Fed wants interest rates to fall, it can lower the discount rate.

* Money Creation Method #2: The Fed purchases Treasury bonds and other certificates of debt.

The Fed creates money by purchasing and selling securities in the following steps:

Step #1. The federal government creates Treasury bonds or notes, which in essence are pieces of paper promising to pay a specified sum at a designated rate of interest. This debt eventually becomes almost all of the nation’s money supply. The bonds are offered to the public, and many are bought by private individuals, corporations, or foreign governments.

Step #2. Unsold bonds are given to the Fed. When the government gives a bond to the Fed, the bond becomes an “asset” within the Fed’s accounting system. The Fed considers the bond an asset because it assumes that the government will keep its promise to pay.

Step #3. Since the Fed now has an asset, it has the power to create a liability, so it writes a Federal Reserve Check to the government, paying for the bond.

Step #4. The government deposits Federal Reserve Checks into private banks and uses the funds to pay government expenses.

Step #5. Recipients of government checks deposit them into their own bank accounts, where they become Commercial Bank Deposits.

Step #6. The banks can then loan out the money, based upon the reserve requirements established by the Fed. More will be said about these requirements in a moment.

The Fed also buys and sells U.S. government securities from large banks and brokerage firms. When these securities are bought, the Fed simply writes a check to the banks or brokerage houses.

Note: The checks the Fed writes are not backed by funds or credit. They are a straightforward creation of money. When the Fed writes such a check, say for $100 million, then $100 million dollars is added directly to the money supply. (Remember, money is defined not only as cash and coins in circulation, but also as bank deposits and bank assets.)

In this way, the Fed directly creates money. The only limit to this procedure is the judgment of the Federal Reserve Directors. Thus, they directly affect and control the supply of U.S. dollars. On any given day they can buy or sell hundreds of millions — even billions — of dollars worth of Treasury Securities. These securities are obligations fully backed by the U.S. government, so the Fed, in effect, is creating money out of thin air — all secured by the government.

Interest Rates and Reserve Requirements

* Money Creation Method #3: The Fed establishes and changes the reserve ratio that determines the reserves member banks need to keep when making loans.

The Fed affects interest rates within the country in a third way by creating an economy of tight money or easy money. If bank reserve requirements are set very high, say about 10%, money will be tighter because the banks will have to keep more money as reserves. This means that banks have less money to loan and as money becomes scarce, interest rates will naturally rise. If the Fed relaxes reserve requirements, money becomes easier to get because the banks don’t need to keep as much in reserve, and interest rates fall. If interest rates had been, say, 7%, and the Fed increases reserve requirements, interest rates may rise to 8% or 9% or even more as natural laws of supply and demand affect the value of loans. When there is a small supply of money to loan, banks can charge more for the loan. Since a bank’s charges for a loan are, in effect, the interest it charges for the loan, interest rates will always rise when money is scarce.

How high can interest rates rise? They rise to the point at which the public (individuals/businesses) don’t want to pay the high rate of interest for loans. At that point, demand for loans drops off, and banks will have to lower their rates of interest in order to attract business.

So we have now learned that the Fed creates money supply in the U.S. banking system in three ways: through discount loans to banks, through the purchase of U.S. government debt and through changing reserve requirements at banks. But as you will see there, once the Fed starts the ball rolling the process does not stop there.

Money Out of Thin Air

If any individual undertook the operations just described, he or she would quickly end up in prison. But the Fed, by decree of Congress, is allowed to create fiat money with the stroke of a pen, or in many cases, with the click of a computer keyboard. Federal Reserve Checks are deposited into banks, which use the funds to create currency and checkbook deposits. But this is only the first step in the creation of money as you will see below.

Fractional Reserve Banking

We have seen above that commercial banks get money from the Fed either through loans or through the sale of government securities. Once the bank has this money from the Fed, it make loans of the money. The Fed sets a reserve percentage (which is described in more detail below), requiring banks to hold a certain percentage of their funds in reserves. The rest they can use for loans to customers.

As an example, say that a commercial bank has customer deposits and money loaned by the Fed totaling $10,000. If the reserve requirement is 10%, the bank needs to keep only $1,000 in reserve, but it can loan out the rest — namely, $9,000.

The system doesn’t stop there! The $9,000 loan is, perhaps, used by a customer to buy a car. The car dealer takes this $9,000 and deposits it in his bank, which then can keep 10% as reserves ($900) and loan out the rest ($8,100). This goes on from bank to bank until the original $10,000 produces $90,000 in new loans.

This process is known as Fractional Reserve Banking, in which banks can keep back a fraction of their assets as reserves and use the rest for loans. For every $1,000,000 the Fed injects into the commercial banking system, up to $9,000,000 in new checkbook money can be created. This money is created as if from thin air.

The Fed’s Job

It is the opinion of many hard money economists that the main job of the Fed should be to make sure that the U.S. dollar remains real money, in other words to make sure that the money supply does not grow faster than the production of the country. In other words, money supply should grow at a rate equal to Gross National Product. But the Fed does much more.

The Fed raises or lowers interest rate mainly to slow or stimulate the economy. A continual balancing act goes on. If the Fed creates too much money through buying Treasury securities or lowering reserve requirements, interest rates in general decline (because there is more money in the system, money is easier to get and therefore less costly). The Fed can also cause interest rates to decline by lowering the discount rate. Declining interest rates stimulate commercial and personal borrowing. When that occurs, spending and employment increase, and prices rise — potentially leading to inflation.

For example, say that the U.S. economy is sluggish. The discount rate is 9%. The rate that banks charge its best customers, usually large corporations, is at 10%. Consumer loans are at 12.5% or 13%. Mortgages are at 12%. Car loans range from 10% to 12%, depending on the terms and added incentives. Business activity and public spending in general are down. Not many people are buying houses, cars, and general consumer items like TVs, camcorders, computers, hairdryers, furniture, etc. As a result, businesses are reluctant to invest money in large inventories. And they are deathly afraid to invest in research and development, that intangible investment that may or may not lead to future profit. To save money, they lay off employees. The news is full of layoffs, doom and gloom financial reports, and fears that the upcoming Christmas season will not be good for retailers.

Because of this, the Fed lowers the discount rate, say to 8%. Then, a few months later, it lowers the rate again, to 7.5%, then to 7%.

This changes things. Consumer loans come down to 9%. Car loans are at 8.5%. The bank’s rates to best customers are at 7.75%. Suddenly, things begin to move. People may not have wanted to buy a house when mortgages were at 12%, but at 8.25%, people start to think that perhaps the time has arrived. When car loans were at 11%, people thought twice about purchasing, but now that they’re at 8.0%, it’s a whole new ball game. People start buying, and business in the nation perks up.

As this happens, retailers simultaneously start thinking that they should stock up for the future. Business is good now, and it might get better, they think. So they borrow to get funds to pay for added inventory. And they start hiring employees to promote and sell their products.

Almost instantly, large manufacturers have to increase production. They borrow (at the new lower rates) to buy raw materials for production. They borrow to pay for adding to their work force. And, eventually, they borrow to fund research and development. Everything looks good all of a sudden. Business is great, so why not think it will continue to be great? Research and development is the only way to assure new, more competitive products in the future.

Price Increases Result

How does all this affect the economy and prices? In a very straightforward way. Demand goes up on every front. Consumers want more from retailers and service providers. Retailers want more from manufacturers, and manufacturers need more materials to produce goods. And, at every level, employment is up. But it takes time for manufacturers to produce goods. Consumers can walk into a store and buy a TV in a matter of minutes, but it may take months in the process for a manufacturer to order raw materials and produce a TV. The results — demand rises on the retail level faster than products can be supplied.

This very quickly results in price increases. When cars are sitting on dealers’ lots for months on end, the prices are going to go down. But when dealers can’t keep cars in stock, and even have a waiting period to get more cars, prices are going to go up.

So prices rise, all as a result of the Fed lowering its discount rate. (Note that the same effect, on a somewhat more long-term scale, can be achieved by the Fed creating money too quickly by buying too many Treasury bonds or by lowering reserve requirements for banks.) All this happens, of course, over a period of time, and it’s often difficult for the Fed to directly chart how much effect its actions will have — and how long it will take for anything to happen.

The Fed may lower rates, then lower them again, and not much will happen. Then, all of a sudden, the mechanism clicks in and prices rise quickly. People borrow from the banks, pouring more and more money into the system by the fractional reserve banking mechanism — until the money supply quickly outstrips production and inflation takes off.

On the other hand, if the Fed creates too little money (by purchasing too few Treasuries), interest rates will tend to rise in general because money becomes scarce. Also, if the Fed raises the discount rate it charges banks for loans, interest rates in general rise. When interest rates rise, borrowing becomes expensive and commercial and public borrowing declines. Business activity and private spending falls, unemployment rises, and prices fall — potentially leading to recession.

For example, say that the discount rate is 4%. Mortgages are at 7.25%. Car loans are at 7%-8%. Consumer loans are at 8%. The rates banks charge best customers is at 6.5%. Business is growing. Production is up. Consumers are borrowing and buying. Unemployment is low as businesses rev up for increasing sales, inventories, and R&D.

But prices are also heating up, and the Fed is concerned that inflation is developing. How to slow things down? Raise interest rates. As a start, they raise the discount rate from 4% to 4.5%. Then to 5%. Then to 5.5% and 6%. In response, banks have to raise rates on loans. Mortgages go up to 10%, then 10.5% and 11%. Car loans rise to 11%. Best customer loans are at 8%, then 8.5%.

The general business climate cools as consumers and businesses cut back on suddenly expensive borrowing. Businesses cut back on loans for inventory. They stop financing research and development. Consumers purchase fewer cars, homes, camcorders, etc. The economy slows. Business lay off employees. This hurts, but prices are held in check and inflation is held at bay.

Interest Rates and Value of the Dollar

Up to this point, we have looked only at the effect that the Fed’s actions have on the U.S. economy. I should mention that when the Fed raises interest rates, it also strengthens the dollar on the world market. There are two steps to this mechanism. First, as has just been seen, when the Fed raises interest rates, inflation tends to come under control. When the dollar (as with any currency) is not tending to inflate, it becomes stronger on world markets in comparison with other currencies. Second, a higher discount rate tends to lead to higher rates on Treasury securities and other fixed interest investments. These higher rates attract interest in the currency (from both private investors and governments), making the currency stronger and more desirable — and thereby strengthening it on the world markets.

We’ll discuss these topics in depth later, but it’s interesting to note that the Fed’s interest rate changes affect both the country’s internal business climate and the external strength of the dollar. The strength or weakness of the dollar has tremendous significance in world trade, so the Fed’s activities are extremely important. In the next lesson we will look in more detail at what happens to the parity of the U.S. dollar versus other currencies when the Fed creates money and/or raises and lowers interest rates. But for now, let’s look at a case study that will lead us to the next lesson.

Case Study

The year is early 1995 and the Fed is between at least four contradictory forces. Force #1: The U.S. economy which grew strongly through 1994 has now slowed down and there is a risk that the economy could suddenly come into an abrupt slowdown. If the economy falters, it is highly likely that the ensuing recession would be at its worst in late 1996 which is during a U.S. Presidential election. The solution to this problem is to lower the discount rate and stimulate the economy, except there is force number two.

Force #2: There have been great fears that there would be run away inflation in the U.S. as 1993 and 1994 had been years of higher than usual growth. Fears of this inflation made 1994 one of the worst years in decades for bond values and has caused the U.S. dollar to fall enormously. The solution to this problem would be to raise the discount rate, yet there is alway force number three to consider.

Force #3: The U.S. had built huge trade debts with Germany, Japan and many other nations. The dollar has fallen to an all time low versus the German mark and Japanese yen, which beggars-these-neighbors. The weak dollar stimulates the U.S. economy in the short term, makes business easier for U.S. exporters and hurts the Japanese and German importers enormously. To raise the discount rate now and make the dollar stronger could weaken the U.S. economy in the short term. The solution here is to leave the discount rate alone or lower the rate so that the dollar does not become stronger.

Force #4: The U.S. dollar is so weak that foreign goods have now become much more expensive. The U.S. has become so reliant on imports there is a risk of importing inflation. Automotive parts, electronics, gas and oil products, for example, can become much more expensive. These more expensive imports can cause the price of all goods in the U.S. to rise. If the dollar remains weak, the process can cause inflation to rise in the U.S. economy. The solution here is to raise the discount rate so that a higher interest rate will strengthen the U.S. dollar.

What do we learn from this study? The lesson that we can learn here is similar to the lesson we learned in the Lesson Four Case Study. External economic matters can have an enormous impact on internal economic conditions and external factors often counteract internal conditions. The Fed has a very tough decision to make and the wrong one made at this time could cause either the U.S. economy to falter or the dollar to go into yet another tailspin.

Glossary

Currency. Something of value that is used for exchange for goods, services, and other units of value. To be used as money, a currency must be: 1: acceptable by both parties in a transaction, 2: portable, 3: divisible and uniform in quality, 4: it should have some intrinsic value, or be useful in itself, 5: scarce, 6: durable. Currency may have some tie to a scarce precious commodity, such as gold or silver, or have no tie whatsoever with a precious commodity.

Fiat money. Coin or currency that is not convertible to precious metal. Webster’s defines the word fiat as “A decree, order, or sanction.” Issued by governments, it has value only because it is declared to be money by government decree, and because it is agreed to have value by all involved individuals, businesses and governments. When a government issues too much fiat money, the value falls and inflation results. Almost all currencies in the world today are fiat money not backed by silver or gold. Thus, the story of modern economics is the story of many different currencies all inflating at different rates, with the U.S. dollar falling faster than most.

Central Bank. A central bank is an institution responsible for the creation and control of the money supply of a country. This institution can be government-controlled, quasi-government controlled, or privately- owned (as the United States Federal Reserve). The central bank of Great Britain is the Bank of England; of Germany the Bundesbank; of Japan the Bank of Japan. Central banks literally create money out of thin air as you will see in the explanation of fractional reserve banking.

United States Federal Reserve. “The Fed,” as it is often called, is a privately-owned organization chartered by the U.S. government. It creates and maintains the U.S. monetary supply by buying Treasury certificates, loaning money to banks, and designating interest rates. On a daily basis, the Fed decides if it wishes to add to the U.S. money supply. If it does, it buys U.S. Treasury securities directly from the government or from major banks and brokerage companies. To pay for these securities, the Fed writes a check on its own account — but in reality it has no assets in its account, other than the assurance of the U.S. government that it will pay the bearer of the securities in full. In effect, the Fed has created money with the stroke of a pen (or a computer stroke, to be more accurate). The Fed also makes direct loans to U.S. banks, charging them a specific interest rate (discount rate) that determines the rate banks charge customers for loans. When making such loans, the Fed, again, simply writes a check, creating money with the stroke of a pen.

 


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