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The Origination of Our Current Monetary System
Article 1, Section 8 (the Powers of Congress) clause 5 of the US Constitution, gave Congress the Power to Coin Money, and Regulate the Value thereof. Whether through shear stupidity or conspiracy, Congress extended it’s power to the Federal Reserve through passage of the Federal Reserve act of 1913.

Since then, our monetary system, termed a “floating currency“ system, consists of fiat money (as described by Fed Chairman Bernanke) created out of thin air, by simply printing it at the Bureau of Engraving & Printing, on behalf of the Federal Reserve System. Operations are supposed to be coordinated with the U.S. Treasury, which has responsibility for formulating U.S. policies regarding the exchange value of the dollar. However, Congress has consistently reneged on it’s obligation to “regulate the value thereof“.

Eventually the money created becomes a source of funding when the government sells bonds at public auctions or exchanges them with the Federal Reserve, for a line of credit equal to the amount of the bonds, which is held at the Fed in the form of a checkbook credit. It is put into circulation whenever the government writes that check or when a bank extends a loan. The fractional reserve system will be explained later.

How Does Money Get Its Value
Basically, the Federal Reserve (the Fed) controls the value of money, by adding “liquidity“ to, or subtracting “liquidity“ from the system. There are two methods employed in doing so. One being the Fed Funds Rate and the other is the “Discount Rate“. The Fed Funds Rate is decided at FOMC Federal Open Market Committee 8 times a year. The discount rate (primary credit rate), is the rate paid by commercial banks and other depository institutions on short term (usually overnight) loans, from the Federal Reserve. (Banks use the discount window when their reserves fall below the amount required by the Fed and usually only when they cannot borrow from other banks.)

To put things into perspective, since the creation of the Fed, One dollar is still one dollar. But the actual purchasing power of that one dollar has declined in value from $1 in 1913, down to 5 Cents in November 2007. Put another way, goods or services purchased in 1913 for $1.00 would cost $ 20.84 today. (Try the Fed’s CPI calculator yourself.)

What really changed? Only the value of money has changed, due to the increased money supply.

What Causes Inflation
When the Fed increases rates the value of the dollar rises. (Fed REMOVES Liquidity) So then, deflation occurs with the increase in purchasing power of money. The cost of goods and services in terms of money is deflated, or the money price falls. The Fed raises interest rates to slow the economy. Raising interest rates increases borrowing costs and increases the cost of doing business and impedes the ability for businesses expansion and growth (reduces demand).

As the central bank removes dollars from circulation relative to the amount of goods there are to buy, the money is said to be deflated. Following the law of supply and demand, there are fewer dollars which means the value is higher and therefore in more demand and more goods which means the value is lower and therefore in less demand.

When the Fed cuts rates the value of currency falls. (Fed ADDS Liquidity) So then, inflation occurs with the deterioration in the purchasing power of money. The cost of goods and services in terms of money is inflated, or the money price rises. Cutting interest rates, encourages traders to sell the dollar pushing the value lower (stimulates demand).

As the central bank creates more dollars relative to the amount of goods there are to buy, the money is said to be inflated. Following the law of supply and demand, there are more dollars which means the value is lower and therefore in less demand and fewer goods which means the value is higher and therefore more in demand. This is how the Fed boosts the economy.

For example, gold and other commodities have been going up in value recently, as the dollar has been going down in value. It takes more dollars to buy the same amount of gold.

Prices will continue to rise, as long as the Fed continues to create money faster than goods can be produced.

When people’s income relative to prices fall, their ability to maintain a certain level of well-being is diminished. The cost of living increases. The Cost of living, or CPI (Consumer Price Index) is used as an indicator of Inflation. The work force in the US has experienced stagnation in their earnings for the past 10-15 years, relative to the inflation for daily expenditures food, energy, imported goods and healthcare, etc..

Will the Fed Raise or Cut Interest Rates?
If CPI (Consumer Price Index) levels rise above the Fed’s comfort level, then rate hikes are likely, as inflation may be increasing. The economy needs to be slowed. If the CPI (Consumer Price Index) is falling, then the Fed may cut interest rates to stimulate the economy. Rates will be held steady if consumer prices are near unchanged. If central bankers

The real estate boom of 2005 -2006, and the subsequent expansion of credit over the last 12 months, is a prime example of an artificially induced inflationary bubble. Money was plentiful and real estate prices were skyrocketing in relation to the inflated dollar. Beginning in January 2001, the fed began pumping money into the economy relentlessly. Both the Fed Funds Rate and the Discount Rate were slashed 13 times over a 13 month period, until they were down to 1%. Then the Fed fell asleep at wheel.

Now, the Fed must continue to pump even more money into the system (lower rates), in order to compensate for the deflating real estate industry and to prevent a banking system collapse, caused largely by the Fed’s failure to reverse course and raise rates. Cutting or raising rates should be done before, not after the problem occurs.

And now for the bad news! For the first time since the US Dollar Index was initiated, the dollar fell below 7500. This puts the Federal Reserve in a very precarious position. With the deflation occurring in the housing, automotive, retail and banking industries in full swing and the US Dollar already at its lowest level ever (The highest level of inflation ever, based on the facts given above), how will they solve this dilemma? Deflation and Inflation going on at the same time. Actually, the term for this type of economy is called stagflation. It was coined back during the Ford administration and continued into the Carter administration. The stagflation of that period culminated in hyper inflation. Interest rates rose to 21.5 % in 1979. This time, because the economy is much larger than it was then, we could see that number jump to 25-30%.

If the Fed cut rates further (Dec. 2007), they could drive Asia and the Middle East in to dumping what could turn out to be a worthless dollar. If they raise rates, they could cause the worst stock market crash in history. Regardless of what the Wall Street analysts and the Fed says, we are facing the first depression since the Great Depression of 1929-1939. When the interest rate is at or near zero, the Fed is powerless to stimulate the economy.

Fractional Reserve System
The Federal Reserve increases the money supply by purchasing government securities on the open market in exchange for Federal Reserve notes which are made available to banks to loan through “fractional reserve banking“.

The Federal Reserve decreases the money supply by selling government securities on the open market in exchange for Federal Reserve notes which makes money to loan, less available

Member banks, that is, banks who are chartered by the Federal Reserve Bank, or who have deposited the required “reserve“ (6%) with the Federal Reserve Bank, can also borrow short term, usually overnight, from the Fed ’s discount window, at the rate established at Fed meetings.

By Michael Scoglietti
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