The Economic Reformation Coming to America, Part 1

Part 1: Beliefs That Underpin Economics

by Richard Brawn, CCRA, MPA, November 20, 2005Print

An assessment of what the Federal Reserve must do to meet the challenges facing America. The assessment is in three parts.

Reformation: To return to an original form. To remake in a different form. To rediscover lost truths.

Part 1 - Our Beliefs

Here We Go!

The Brookings Institution and Virginia Tech urban planning professor Robert Lang, predict real estate build out will constitute a $25 trillion development market by 2030. Californians have voted themselves free lunch in the recent California elections. The voters of California have provided additional signals to legislators across the US that ballooning debt is not on the public radar screen. The economic paradigm people hold is that future cash flow/income should be converted to present value with the proceeds being immediately spent on consumption or leveraging debt. Continuous dollar depreciation by the government has had an effect. People do not believe in price stability any more. Hurt by lack of income tax indexation for price inflation people have become convinced that saving/capital creation does not work. They are convinced that buying today will avoid a higher cost of buying tomorrow. Over time this has changed our culture from one of personal savings to one based on debt and leveraging income. The consensus is that this process can go on indefinitely because it has worked well for so long and that it proves the system is sound. The final proof for people is their social security printout of annual earnings. People can calculate the difference between investing 10% of gross earnings each year with a return of 2% over inflation less taxes versus taking on debt to buy assets. The conclusion is inescapable: taking on debt rather than savings is what produces the wealth needed for a �living� retirement.

The requirement that debt also be beneficial to those left paying the bill in the future is not part of today's concerns. As long as everyone believes this can go on indefinitely, it probably will. The job for Dr. Bernanke will be to keep the economy on the current growth track and keep everyone a true believer that growth has no limit and therefore debt accumulation can go on forever. Believers are needed because economics is a really a religion, not a science. Economics claims it can deliver miracles hardly less impressive than the resurrection of the Christ or miracles cited by various other religions. Either you believe or you do not.

Looking inside the Religion of Economics

The new FED Chairman and his fellow Governors will have to create a new politico-economic framework within which to work. As we go through the process of analyzing why this is so, we need to do our best to refrain from wishful thinking and keep to basic reality as best each of us can perceive it. The general consensus of economists is that the US is in multiple binds. First is the skyrocketing price of natural resources and raw materials due to industrialization of huge new populations. Second, the demographics of the United States will create demands in excess of what the working/non-retired population will be able to deliver. Third is the inability of our education system to produce sufficient skilled graduates to keep America competitive. Then there is the financial bind and that will be the focus here because it is what the FED has to deal with.

On the current expenditure tack, the projected government expenditures will exceed all known sources of future revenue. Escape routes boil down to two choices, both of which will cause political turmoil. One is to reduce the allure of debt and the other is to monetize the debt. The choice will be the one that can be expected to produce the minimum ensuing political turmoil. The two most likely focal points for �Political turmoil� will be in the Congress and the people hurt by the policies. For Congress, political turmoil means the naked insecurity that politicians associate with diminution of the political capital that comes from reduced spending. Money spent equals power. So cutting real spending means loss of political power. The FED must judge if it is easier to use monetary policy to force a reduction in Congressional expenditure or go with the more conventional pattern of goosing money supply in order to force the growth that then brings in more tax revenue.

The FED knows that future tax revenues can be shifted to the present use. Debt does that. However, The FED also leverages its own powers to ship still more future tax revenue into the present and this aspect is less well known. Here is how that is routinely accomplished. All asset prices respond to changes in interest rates. Fixed asset prices are usually the last to respond to interest rate changes. By lending �new� Federal Reserve Notes at interest rates below that which the market would lend, the FED forces down the entire spectrum of interest rates. At the same time, the low interest rates inflate the value of assets. In our houses, we call this increased market value, owner equity built up. As these inflated assets are liquidated, they create unearned income that enhances tax revenue collection.

Since there is no such thing as a freebee, the same policy depreciates the ability of our retirement funds to income. We have to invest more money just to obtain the same future cash flow/income that we will need in retirement. By reducing the ability of people to buy annuities for retirement, the FED is creating hardship in the future. This process is very well known. In a speech in Europe last year, Alan Greenspan spoke to this operation and commented that it had been going quite well. His choice of location for addressing this matter was interesting in itself.

The other course of action that could be taken would be to increase taxes. But that would cut individual after-tax income and thus also reduce discretionary spending. In this scenario, people would blame the government for their suffering. Political practicality says that taxes can only be raised when the economy is booming. If the economy is stagnant or declining, raising taxes places Congress clearly in the people's crosshairs.

Because politics is like a crab basket with everyone willing to do whatever is expedient to get ahead, timing the actions is extremely difficult and the judgment of which choice will produce the least political disruption is colored more by self-interest than by public interest. If we put aside the politics of self-interest, the choice boils down to this: will people object more if they lose their current income due to a tax increase or will they object more if they lose the real value of their savings/retirement due to FED manipulation of interest rates and monetization of debt.

Money

Without money, the politico/religious/science of economics would only be about markets.

The central focus of economics is about money. So, what exactly is this thing we call �money�? Does money have intrinsic value? First, money is a belief. It is so deep-seated in our culture that we absolutely take it for granted. In order to understand it as a belief, the belief/idea/concept must be taken apart, piece-by-piece. All currencies are a type of money called �fiat money.� The difference among currencies is the geographic area in which the use of that �fiat money� is enforced. Within the national geographic area, fiat money acts as medium of exchange to be used in lieu of direct barter and the authority of the state guarantees the authenticity of the currency. All purchase/sale transactions are a form of barter. Two products are always exchanged. When currency/fiat money is used as a medium of exchange, the currency is given a relative value by each of the parties to barter. The transactions are transparent to others. The apparent relative value given by the two parties in the barter is witnessed. Because these transactions are on-going all the time, these transactions make currency/fiat money appear to have value all the time. The function of money as a unit of account allows barter transactions to be daisy-chained forever. What is not apparent in these transactions is that the value of money is zero after completion of each transaction. Currency acts only as a unit of account during the transaction. Fiat money has no value when there are no transactions. Proof of this absence of value for fiat money is that outside its national geographic area, a currency is virtually useless.

Here is another way of thinking of the situation. When a real estate broker executes a tax-free property exchange, the broker is acting as a medium of exchange between two parties engaged in a trade. Does the exchange give value to the real estate brokerage? Our perception of this ongoing process is perhaps the same as what happens when we watch a movie. We only see the lighted frames of the film, not the dark gaps. We give �value� to money the same way we give a movie its continuous motion. Our brain is programmed by our natural environment to expect continuous flow. Nothing in nature appears and disappears like the images in a film. Our mind reasons that the same holds true for money flow. So, when we encounter an interrupted barter/exchange transaction, our brains smooth the process by bridging the gap. Our mental software is called �culture.� When first born, our minds have to learn to deal with the world. During that very early childhood brain development, the neurons actually migrate to form new �firmware� that gives us pattern recognition capabilities. Then that firmware hardens into mental anagrams that sociologists call cultural patterns. That is why as adults, we perceive continuous motion in movies and why the same mental anagrams have us perceive continuous value in fiat money.

We Americans still think of a barter exchange using currency to be a three-part exchange (product - intrinsic value - product), not a two-part exchange (product - no value unit of account - product) that it really is. We cannot accommodate the idea that an exchange can take place involving a third entity that has no value so we compensate by giving our currency a bridging value. True believers believe that paper currencies have intrinsic value.

Over the decades, money has been parsed into several components that we see today: utility (unit of account), scarcity (supply & demand), and intrinsic value. Fiat was substituted for intrinsic value of money by introduction of the Federal Reserve Note. Whether being legal tender for all debts, public and private equates to the intrinsic value that had been given by precious metal content is endlessly debated between the believers and the non-believers. From a physical standpoint, money is just a piece of paper used as a medium of exchange. The bearer does not even own it. It is illegal to deface US currency and mandatory acceptance is enforced only within the USA. Nor does the term legal tender imply that the government is guaranteeing prices. Using dollars as the medium of exchange, prices are set by the buyer and seller, not by the currency.

The scarcity is controlled by seigniorage (the right to issue money.¹) The desire of government to maintain that authority is as fundamental to government as instinct is to individuals. It is a source of power that rivals tax collection in its power. In politics, money is power. Power that money possesses stems from the willingness of people to do things for the government without the government using coercion. That facet gives stability to political power that coercion could never give. This is money-power.

In a political democracy, maintaining that power over people is a political imperative. The holder of discretionary power to act �in the public interest� is our modern version of the power held by the nobility in the feudal system or warlords in some present day political systems. The power is the same everywhere. The people simply defer to the authority. The only difference is in our personal perception of the legitimacy. As in the past, the present political nobility considers maintenance of personal power (incumbency) to be their paramount concern. Holders of money-power in feudal times were constrained by the availability of precious metals. Holders of money-power today are constrained by knowledge of supply and demand. However, if their survival in office depends upon printing more money, then that is exactly what their instinct tells them they must do. �We the people,� have no direct say. The founders of the country were well versed in money-power and intended �we the people� to have no say.

So, if one incorrectly supposes that fiat money really has value and that value is really linked to scarcity, then value is determined by the power needs of the incumbents in political office. This concept is captured by the modern economic concept of �money supply�. There is a certain convenience for both the electorate and the politicians to accept that mirage as reality. The political magic trick is to make something that can be infinitely reproduced seem to have value and keep its �value� over time. Keeping its value is essential to being able to leverage future income/tax revenues and influence people without coercion. The people want the stability that comes with stable, paternalistic political leadership. Therefore over time, the maintenance of the mirage of value is the modern source of political power that gives government its legitimacy. The loss of that power means loss of a major source of legitimacy in the minds of the people. The people view the government as having lost legitimacy during periods of economic depression or rapid price inflation. In the minds of the people, when stability of prices disappears, the legitimacy of government falls. That is the genesis of the FED role to maintain price stability.

This magic is also the basis for people accepting bank accounts. The exposure that people have to billions of never ending transactions daisy-chained using currency as the medium of exchange gives the currency the appearance of value. Our brain absorbs that illusion and couples it with psychological sense of denial and gives us our perception that money has real value. We simply want it to have value because we want stability in our lives. A key point to consider is new role of fiat money in the global market. What happens is that relative prices for goods and services in a two-way barter define the currency. This has huge implications in the global economy where exchange rates create arbitrage that produces price inflation or price deflation within internal national markets. It creates micro-inflation/deflation in shortage items like raw materials, food, and natural resources. This is the risk-driven reason for all nation states to maintain gold stocks. When this truth is re-discovered by Americans, it will lead to the reformation of economics.

Current FED Mission Statements

What will be the role of Dr, Bernanke? His role will be to serve the interests of the current incumbents of political office. The envelope of power that he will accede to needs to be understood. Probably the best start point is to read the way the FED sees its job by looking through the prism of its current mission statement.

The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded.

Today, the Federal Reserve�s duties fall into four general areas:

Conducting the nation�s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates
Supervising and regulating banking institutions to ensure the safety and soundness of the nation�s banking and financial system and to protect the credit rights of consumers
Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation�s payments system

Without being particularly astute one can see that these mission statements do not have any order or priority. Second, in execution of its operations, the statements conflict with one another. Bullet number 2 uses the cunning trick of reverse wording. The second bullet could be reversed to read: To ensure the safety and soundness of the nation�s banking and financial system and to protect the credit rights of consumers, the FED supervises and regulates banking institutions. The rewritten statement is a statement of accountability where as the FED mission statement is not. Fourth, there is no mention of the American people. So, the mission statements imply is that the FED has no direct role looking after the direct interests of �the people.� Indeed, the FED role in the USA is strictly governance.

By statute, The FED enjoys the same sovereign status as the President and the Congress. In America, the people enjoy no rights of referendum with which to intercede, if necessary. The Constitution allows no enforcement mechanism outside the Executive Branch. The Executive Branch and Congress agreed not to police or audit the FED. Because it is not subject to audit or election, the FED probably has more sovereignty within the United States than any constitutionally created branch of government. The three-way dealings among the FED, Executive Branch and Legislative Branch are private except for occasional testimony before very limited number of members of Congress. Where the constituency of the US Treasury is finance and industry, the constituency of the FED is the banking establishment. As long as the FED enjoys the confidence of the incumbent legislature, the President, and the banking community, it can do whatever it wants without being subject to check, audit, or discipline. Statutes do not constrain use of the FED blank check. It can do as it pleases.

Clear and Present Danger

In the near term, no significant economic danger is apparent. If it were evident, the stock market would be in a funk. As Allan Greenspan has testified to the Joint Economic Committee, and Dr Bernanke just recently testified in his confirmation hearings, the economy has been remarkably resilient and appears to be taking the current interest rates and monetary accommodation in stride. However, both Greenspan and Bernanke are well aware that sometime in the next 10 years, America has to go through a wrenching change. Either the binds previously addressed will be dealt with sequentially and by choice or they will have to be dealt with en masse as they happen. This fact is accepted and well known to be an economic scenario that poses a clear danger to America even though it is not a �present� danger. The timeframe for the scenario is sometime beyond the immediate foreseeable future. Exactly when change will start and whether it will be a jolt or an evolutionary change remains unknown.

Simply stated, the government will not have sufficient money to conduct all critical facets of governance. More specifically, servicing debt and paying operating costs of government cannot be met by sources of revenue that are foreseen. Raising taxes will reduce economic activity and thus reduce total tax collection. Rolling over old debt will increase the total debt load and increase debt service costs that will have to be met. Rising global prices due to demand exceeding supply for crucial materials directly related to standard of living, quality of life, and maintenance of life styles, cannot be rectified by a US recession. Inflation will be imported into the US economy. Debt service costs can and have been put-off, but they cannot be completely avoided.

Why Growth is Critical

Economic growth and stable prices underwrites the quality of debt issued by the America�s private and governmental issuers of debt instruments. If growth fails to materialize, note holders will suspect that the US will simply monetize debt and reduce the value of the currency relative to other currencies. To reduce their exposure to this risk, they would dump their holdings before maturity thus producing the net effect of accelerating repayment of debt. Even the hint of not being able to meet debt service payments without monetizing debt would start the process of accelerated debt repayment. Stable exchange rates are absolutely dependent upon stable prices and vice versa. Accelerated debt repayment would damage currency stability that, in turn would destroy price stability. It would drive up interest rates and force down the value of capital assets (cash flow capitalized into present value). Investment losses claimed against income would further decrease tax revenue.

Now, let's return briefly to an earlier thought. The participants in the exchange of goods and services determine the value of the currency. In a global market, rising worldwide prices outside the US plus a declining dollar relative to other currencies would degenerate in to what we, in the US would perceive as rapid price inflation. The Federal Reserve Note has no backing beyond the gold in Fort Knox. The gold in Fort Knox is the only capital owned by the government that is internationally liquid. Without intrinsic value to act as a buffer, the dollar could be extremely vulnerable. Again, the gold in Fort Knox is the only asset held by the US government that could act as a buffer in a currency crisis. However, at current gold prices the value compared to worldwide holdings of dollars, it is a drop in the bucket.

In short, government spending appears to be at or near the equivalent of peak oil. We can expect, as with discussions about peak oil, various Pubahs in the media will give contrasting opinions simply because they differ on the timing of the peak. We are somewhere near a point where the availability of world savings that sustains today's current US consumption will start to decline. If consumption decreases, this will directly affect tax revenues. For Congress, this would mean contemplation of sharply lower tax revenues. If we are really at the apex of maximum possible tax revenue receipts, then the choice is limited to either a decrease spending, with its horrific effect on incumbents, or to monetize debt. If the belief were prevalent that this situation existed, suspicion would intensify that the FED would respond to political pressures and act to monetize debt. Dr. Bernanke�s job will be to manage the economy in order to avoid this kind of loss of power. The only way to accomplish this will be by creating an economic reformation with a new set of economic beliefs to provide believable/plausible explanations for the hurt people will feel.

¹ The term seigniorage has various definitions. One definition is the difference between the cost to create currency and its face value. The definition I use is simply the right to issue a currency. It has evolved from the probably comes from the feudal term seigneur or lord and the absolute right to power. In old English the term is seigneurage meaning the right to take the difference between the value of the bullion used and the face value of the coin.

Contact Information
Richard K. Brawn, CCGA, MPA
Petaluma, CA USA
Email
California Certified General Appraiser (CCGA)
Master Public Administration (MPA)