The Federal Reserve System Has Its Problems, But Is It A Scam?

Written by Dan Lieberman, Alternativeinsight

Mention the words The Federal Reserve System at a gathering and assuredly you will receive a barrage of invectives. Similar to the Internal Revenue Service, the Fed is not well admired. Those who meticulously analyze its functions and operations have found fault with its structure, errors in its performance and aroused doubts to the effectiveness of its principally operations:

1. Conducting the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices, and
2. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.

Criticism of FED operations have validity. However, the many reports, articles, and videos that characterize the FED as a Ponzi scheme and a scam that deceives and misappropriates the wages of the American public tend to be malicious and of questionable validity. A March 9th, 2014 post on Econintersect, Documentary of the Week: The Fed Scam, illustrated the misconceptions and exaggerations that characterize those who regard the FED as a scam.

Econintersec’s John Lounsbury replied effectively to the video with his article The Fed Scam: An Example of Confusion, but his report was limited. History and additional analysis show that the video’s thrust that the government and banks, with deficit spending and bank purchases of the debt, are a conspiracy to use the monetary system to enrich banks at the expense of the public is not credible.

Severe deficit spending (except for World War II) did not occur until the 1980’s, almost seventy years after the formation of the Federal Reserve System. The latter was formed six years after and in response to the 1907 financial panic. Why did this conspiratorial arrangement wait 70 years?

It was the Reagan administration that greatly stimulated the economy by Federal deficit spending and replaced a fall in consumer spending to emerge from a deep recession. After that time, the government debt, except for a few years during the Clinton administration, has grown asymptotically

The sale of government bonds to banks removes reserves from the banking system and partially replaces private credit. In order to re-stimulate private lending, the FED engages in open market operations, purchases the bonds in the open market and replaces the reserves. The suggestion that the FED purchases the securities at a marked up price in order for the bank to gain profits is not valid.

Not until 2011 did the FED rapidly increase its open market operations (again why did this conspiracy wait so long?) and its holdings of federal debt (which the federal government still owes), and essentially create money by crediting the banks with increased reserves. Until recently all interest was returned to the government and not credited to the banks. Now ½ of the interest is credited to the banks, which means they are getting less return than when they owned the bonds. The interest on the debt is only 20% of the total deficit and the FED owns only about 25 % of the federal  debt.

The suggestion that these dealings are part of a conspiracy and the FED is engaged in a scam is not credible. Suggestions that the government and the Federal Reserve financial transactions are counterproductive to a healthy economy have some legs, but are a matter of debate.

The attempt in the video to link private lending to the government spending is also wrong. Consumer lending, as mentioned by John Lounsbury, is independent of government spending and is backed by real assets – homes, cars, furniture, etc. This highlights one notable difference between private debt and public debt — private debt is backed by assets; government debt is backed by good faith and trust in the issuing authority.

There are other differences:

1. The government borrows at a much lower interest rate and can be more effective in stimulating the economy.
2. The government cannot go bankrupt and forfeit on the debt.
3. The government can roll over debt.
4. The Federal Reserve can essentially create money to temporarily pay the debt.

Which leads to the heart of the situation; the present monetary system is problematic, but not the problem. In my opinion, it evolved due to the real problem – how to provide purchasing power to a system that runs on profit.

Here is my analysis.

Wages in the system purchase goods that equal the costs of the goods produced. However, how can surplus goods be sold and profits made? How can panics and recessions be prevented if insufficient purchasing power is in the system to clear the production?

The Federal Reserve System and monetary expansion by fractional banking were devised to resolve that problem. Monetary expansion, which creates dollars from bank lending that requires less than 100% reserves for the credit, provides the additional purchasing power to clear the market and enable the profit for investment. When the credit outstanding reaches an unacceptable limit, the government deficit spending enters to fill the gap. Deficit spending creates consumer demand and also finances some of the profit. For those who contend the latter, note the relative slowness of the stimulus plans to move the economy and regain employment and the rapid advances of the stock market and corporate profits.

I’m not sure, but I believe Basel II and III regulations limit bank lending much below the money multiplier from fractional banking. Maybe someone can enlighten me on that subject.