Questions about the Federal Reserve. Maybe You Can Help.

Reply

Rcder replied on Mon, May 9 2011 5:31 PM

rated by 0 users

Suggested by Rcder

The Federal Reserve is at least in theory controlled by a Board of Governors who are nominated by the President and confirmed by Congress. I hear time and time again that the Federal Reserve is “controlled by the private banks”. I am unsure if they are speaking of an indirect control or a direct control. From the sound of some of the Youtube videos (including one made by your Institute in the 1990’s) it sounded as if it was the private banks that directly chose the Reserve leadership.

It depends who you ask.  I would say that the government has indirect control over the Federal Reserve, while the banks have more direct control.  For example, the Federal Reserve Chairman serves twelve-year terms and, like the other members of the Board of Governors, is appointed by the president.  Congress, therefore, cannot recall a member of the Federal Reserve.  The central bank of any country is typically made to be a very independent "fourth branch" of government.  The private banks do not appoint the members of the Board of Governors.

However, the private banks do business with the Federal Reserve, put bank deposits in the Federal Reserve, are in constant communication with the Federal Reserve, and therefore have a much larger degree of influence in terms of directing Fed policy than the federal government.

Lots of critics of the Federal Reserve make statements such as, “paper money is worth nothing it all since it is not backed by gold. It only has value because we assign value to it.” True, but doesn’t the same go for gold? Gold has value only because we assign value to it and are willing to use it to trade for goods and services.

This is correct.  All value is subjective.

I understand the concept of the gold standard (paper money is backed by gold, sitting somewhere in a vault). Gold is limited, so I could see how it would be more stable. But for the sake of argument, what if the populations were to discover additional gold? Or what if methods were discovered on how to molecularly construct gold from other, less valuable elements? Or what if by some freak of nature, the central vault of gold sinks into the ground, melts away into the cracks of the earth, or disappears?

To answer your first two questions, if the newly-acquired gold was turned into money, then there would be inflation.  If it was turned into consumer goods, then the price of these goods would fall.  For your third question, if the entire money supply of a nation was to disappear over night than the price mechanism would be hamstrung until the market switches over to a new currency (I'm assuming the nation/geographic area functions on a monometallic standard).

Are there any countries that currently have a gold standard?

No.  Technically every developed nation starting going off the gold standard during WWII (there's heated debate over whether they were ever on a gold standard to begin with), and as of now every country utilizes fiat currency.

Let’s suppose that a new nation is born in some remote part of the world. They are writing a constitution, creating a government, and devising a monetary policy. What would a country do if it had no gold, silver, or other precious metals? What are alternatives to the gold standard without having to resort to a natural resource?

The government wouldn't have to do anything.  Currencies arise naturally in the market as a means of overcoming the problems of direct exchange.  Money throughout history has been anything from carved rocks to sea shells.

I'm going to split up your final question into separate parts to make it easier to answer.

I read and hear time and time again, that as more money is printed, its value drops, inflation goes up, and consumer purchasing power is affected. This makes perfect sense, especially when the scenario is simplified and you apply the logic to other items that are abundant or rare – like paper and oil.

This is all true.  Money operates according to the laws of marginal utility and supply and demand.  This is sort of off-topic, but I'm in the middle of reading "The Theory of Money and Credit" by Ludwig von Mises.  A very interesting book if you're into monetary theory.

But for a moment, let’s look at the government as a consumer. Say the government generates $100 through taxes and spends all of the $100 on fixing a road.

So far no inflation has occurred.  No new money has been created.

 Let’s suppose that the government wants to fix even more road without having the tax dollars to back it up. Let’s suppose that the government quietly prints up another $100 without letting anybody know, and uses it to fix the road. The contractor who receives the money, in turn, could go spend the money in other stores. I don’t see how this could decrease the worth of that $100.

It's important to remember that people don't exchange goods for money, they exchange goods for other goods and use money as a medium of exchange to simplify trade.  If you create money out of thin air without having first produced a good or service (i.e. purchased the money in exchange), then you'll be able to use your newfound purchasing power to bid up prices, and everyone who gets the new money will use it to bid up prices for other goods, so on.  You have, in a sense, stolen purchasing power from other people. 

It's also very important that you Google and read up on optimal money supply theory, as that would answer many of the questions you're asking here.

In a way it almost sounds beneficiary, as the contractor’s purchasing power is increased, stores sell more widgets, and the whole machine gets a push. The store owner will now produce and sell double the widgets, which in theory should bring down their cost of production, and thus the final price of their product.

This ignores the fact that during inflation the prices of everything else are rising at an uneven rate.  As a result, not only is there a misallocation of resources (artificially high prices with no actual demand behind them), but things like real wages and real profit are depressed.  Whereas once the store owner could sell one widget to buy two loaves of bread, because of inflation, he can now only buy one loaf of bread with the revenue from his sold widget.  Most (the people who didn't receive the created money) become poorer, while some (the benificiaries of central bank benevolence) become richer.

Also, increased revenue does not bring down production costs, and goods and services are valued completely separately from their production processes.