Regulation, Part IV: The Federal Reserve Shell Game

The virtual complete freedom of action and lack of accountability with which control over money and credit vests the State is a very, very bad thing. That is why the proposals of Messrs. Obama, Geithner, and Bernanke should make every American citizen extremely nervous. The declaration attributed to Baron Rothschild may be apocryphal, but that doesn't make it any less true: "Give me control over money and credit, and I care not who makes the laws."

Nevertheless, we can't ignore the effect that such concentration of power has on the economy as well as the political order. When faced with the spreading fear and chaos that inevitably accompanies economic disruption on such a scale, people will almost inevitably seek leaders and policies that promise to correct the situation and restore order again.

The fact that such restoration of order comes at a very high price (as the German people found out in 1933) is, when people are terrified, usually considered a price well worth paying . . . sometime in the future, after we're all safely dead. "In the long run," Keynes was fond of saying, "we're all dead." This dictum seems to have been the guiding principle behind Keynesian economics and the political and economic policies based on the teachings of the Great Defunct Economist. We are now faced with having to pay the price for dead generations, and (true to human nature reacting against seriously-flawed institutions) are busily trying to refinance the debt so that future generations will pay instead of us.

Thus a minor problem like a shift in the backing of the currency becomes major when its real effects begin to be felt. To understand what has happened, we should look at things from an accounting perspective.

In accounting terms, the backing of the currency has shifted from current assets to a contingency. A "current asset" is an asset that is either cash, or is expected to turn into cash within one "accounting period" (usually a year). By the terms of the 1913 Federal Reserve Act, all new money created by the Federal Reserve was to be backed by liens on productive assets and the present value of future production. This loan paper was to be "discounted" (sold) to the Federal Reserve for terms not to exceed 90 days, thereby categorizing all such "qualified paper" as "current assets."

A "contingency" on the other hand, is "an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (hereinafter a "gain contingency") or loss (hereinafter a "loss contingency") to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur." (FASB No. 5, "Accounting for Contingencies")

Accountants are generally cautioned to avoid listing contingent gains on an organization's financial statements to avoid inflating the value of the company and distorting the picture of the firm to be gained by users of the financial statements — including banks and other financial institutions who, on the basis of a listed contingent gain, might be tempted to lend money to a company that otherwise would not be considered a good credit risk.

By backing the currency with future tax collections, which should be classified as a contingency, not a current asset, the federal government is creating several problems. Most obviously, it is not certain how much can be collected in taxes once the currency has been destabilized in this manner, or whether, in light of the continuing deficits, there will ever be enough collected in taxes to pay off the loans the government has floated.

The more subtle (and much more damaging) problem, however, is that having disconnected money from production by shifting the backing of the currency from production to debt, the federal government has seriously compromised its ability to collect taxes at all. If people cannot obtain financing for productive projects and the financing is not directly linked to the productive project being financed, production will necessarily fall as the number of feasible projects brought to banks and other financial institutions and intermediaries declines. As production falls, people's incomes will decline: production = income. As income declines, the tax base erodes, and the State's tax revenues fall.

What then happens under the current Keynesian paradigm only accelerates the growing financial crisis. As tax revenues fall, the government prints increasing amounts of money backed only by future tax revenues . . . which revenues become increasingly ephemeral as the erosion of the value of the currency progresses. The more money the government creates and spends on non-productive purposes (e.g., bailouts, infrastructure that doesn't generate its own repayment, welfare, political pork, etc.), the worse the situation becomes. The very thing that the State does to cover its expenditures makes it impossible to meet those expenditures, to say nothing of destroying the economy on which the money that the State insists on issuing without an asset backing relies.