Thomas Woods deserves a lot of praise and thanks from the free market community for writing this book and getting it out there so quickly. People are curious NOW and the timing of this book is very good. All credit and thanks to Mr. Woods for his wonderful work.

The idea is that a central bank’s low interest rates expand the money supply…

They have that reversed, right?

To Josh, welcome.

Sorry the long post below. But in short, lower interest rates leads to increasing the money supply. Fiat money is loaned into existence. Read the rest if you’d like.

I remember reading a long time ago, part of a book by John Kenneth Galbraith, part of FDR’s “brain” trust. I didn’t read it all, because it was so statist and dismal. It was at this point that I realized the power of the state in money creation/control, that I became much more laissez-faire than I had been previously. Anyway, he mentioned in the book that all new money creation is so simple some people can’t believe it. Galbraith noted in the book that all new money is loaned into existence under our federal reserve system. And the cheaper the borrowing rate (i.e. interest rate, payback terms, etc.) the more loans will be created, the more new money will exist.

After really contemplating the ramifications of money being loaned into existence, I realized our federal reserve system is seriously flawed. Now the existence of new money doesn’t mean we have more property in existence, it just means there is more money. And since the creation of new money doesn’t magically make more property also appear, it means more money chasing the same amount of goods, and that leads to overall price inflation. Something however, nagged at me, that more than simple inflation must be at work. But that is where my intellectual understanding of the federal reserve system stopped, not understanding the truly destructive nature of a centrally controlled (i.e. gov’t controlled) banking system….until I started reading about Austrian Business Cycle Theory.

It is that this new money ends up finding its way into areas, that with higher interest rates, would never have been put. It also leads to higher consumption at the expense of saving (especially saving to reinvest in capital used to produce the things society needs and desires). This leads to malivestment and booms/busts. The boom is where we consume and produce in areas we wouldn’t have, had the new artificial money not been loaned into existence. The boom becomes unsustainable as we move resources away from areas in the economy which wouldn’t have happened had the new money not been created. Think about all the new homes that were built that wouldn’t have been built had the easy loan policy not been created at gov’t levels. The end result was to create additional homes and drive up the prices of existing homes out of the reach of many people at the expense of not producing or saving for something else. Resources were artificially diverted to the housing sector. People took jobs in the housing sector they wouldn’t have taken. Some even left their then current employment for a job in a housing related sector. People went to work in the finance/lending sector of the economy, that wouldn’t have happened. Now many of these individuals are losing their jobs. Also, many poor souls not realizing what was happening, but wanting a house, purchased a home at inflated prices. Some, foolishly used the artificially high equity in their home, to purchase other items, hoping that prices would continue rising and they would sell the home later, get the money back and not have the debt associated with purchasing their new toys (i.e. boats, watercraft, cars, trucks, large TVs, etc.) We were, in short, consuming our capital at the expense of saving it. So instead of saving and reinvesting to produce more or improved goods in the future, we consumed today. After so much capital was consumed and no new debt able to be created, since people, couldn’t pay the mortgate even at no money down, interest only at some ridiculous low teaser rates, the real estate market in various areas of the country collapsed.

Now the losses incurred by these banks has happened. It is a real loss in funds. The money loaned into existence was disappearing as the loans disappeared and the foreclosures occurred. Normally, a bank would get a good portion of the money loaned back by foreclosing and selling the house. However, this time around many of these homes have declined in value by 30%, 40%, 50% or more in some areas of the country and the money was loaned out with little down payment from the borrower. In short some large banks and Fannie Mae and Freddie Mac, were quickly becoming insolvent.

Banks holding the mortgages (or derivative investments based on the mortgages) became insolvent. The Fed, in order to hide the insolvency and stop bank runs, poured lots of even more newly created money into various banks. The US gov’t followed suit with bail out money and TARP funds, etc, etc. Right now for the past year or so, people have wisely put spending into slow motion mode, saving up their money, paying down their debts. However, once this newly created money by the Fed starts to make its way into the economy, we’ll see large inflationary pressure.

For the banks to no longer be insolvent, the Fed can leave the newly created money in the banks, causing inflation or the banks can make profits through increased fees and interest rates and eventually cover the previously incurred losses.

Personally I believe there will be some combination of the 2, the Fed will leave money in the banks as long as it can before the inflation train leaves the station, trying to buy time for the banks to make profits to cover the losses. However, interest rates will eventually begin to rise if the Fed starts to withdraw those funds from the banks.

Rest assured, the Fed has a plan to keep wealth within its power. That plan is to make every current debtor and future debtor pay for the losses the banks incurred through risky lending practices, which lending practices by the way were heavily influenced by gov’t legislation.

Josh wrote: “…so it works both ways then (i.e., expanding the money supply causes interest rates to fall), correct?”

Well, yes, partly. The Fed can’t just print up more new money. It has to buy US Treasury Notes/Bonds first. So if the Fed isn’t buying any Treasuries, it is difficult to create new money that way.

But there is another way. The other way new money is created is by the Fed lowering the Fed discount rate (the rate that member banks can borrow directly from the Fed). If this rate is low enough, banks, which make money on interest spreads, will have an incentive to borrow Fed funds directly at the discount rate, then loan it out. Voila, new money was just created when the Fed loaned out the money. More new money is created again when the banks loan it out to borrowers. This is where the real inflation machine kicks in due to the 10% reserve requirement.

Here’s a simple example. The bank B takes $100 borrowed from the Fed, loans it out to Person A. Person A buys a new car from C, $100. C takes the $100 car money and puts it into the bank. Now bank B can loan out $90 of the money it got from C, 10% reserve requirement. Bank B loans out $90 to Person D. Voila, more new money was just created. Started with $100 created, now we’ve got another $90 created. So at the end, Bank B has $10 in cash, $190 in receivables (A & D). Total $200 in assets. Bank owes $100 back to the Fed and $100 back to Person C (checking account). Total $200 in liabilities. If persons A and D don’t pay the loans back, the created money disappears. Now bank B has $10 in assets, $200 in liabilities, and Person C may lose his money. If Person C wants all his money back now, bank B only has $10 and no more money coming in from Persons A & D. It’ll have to borrow more from the Fed or some other bank, or get more deposit customers, etc.

With the 10% reserve requirement, the original $100, goes like this, I’m rounding. $90 loaned out, $10 kept.
$90 redeposited, $81 loaned out, $9 kept.
$81 redeposited, $73 loaned out, $8 kept.
$73 redeposited, $66 loaned out, $7 kept.
$66 redeposited, $59 loaned out, $7 kept.
$59 redeposited, $53 loaned out, $6 kept.
$53 redeposited, $48 loaned out, $5 kept.
$48 redeposited, $43 loaned out, $5 kept.
$43 redeposited, $39 loaned out, $4 kept.
$39 redeposited, $35 loaned out, $4 kept.
$35 redeposited, $31 loaned out, $4 kept.
$31 redeposited, $28 loaned out, $3 kept.
$28 redeposited, $25 loaned out, $3 kept.
$25 redeposited, $22 loaned out, $3 kept.
$22 redeposited, $20 loaned out, $2 kept.
$20 redeposited, $18 loaned out, $2 kept.
$18 redeposited, $16 loaned out, $2 kept.
$16 redeposited, $14 loaned out, $2 kept.
Etc., etc., etc.

The above only happens with new borrowing. If a borrower borrows money to pay off a previous loan, no new money is created, it is exchanging debt for debt. If the new loan is higher than the paid off loan balance then the difference b/t the 2 is newly created money.

The above example doesn’t take into consideration depositors wanting their money back, writing checks, etc. When that happens banks either can borrow from other banks, issue better interest rate CDs, savings, checking accounts, etc., (to attract depositors), or once again borrow from the Fed (which creates money) if the rates are low enough.

Now if the Fed increases its discount rate, then banks can’t make quite as big an interest rate spread, so they start paying it back, making fewer loans (because interest rates become less conducive to lending). Its less profitable for the bank to pay back depositors with borrowed Fed discount rate dollars, while waiting for the loaned funds to come back in with interest. The overall money supply will begin to shrink as the money created through loans is repaid. So, if the federal gov’t were to stop going into debt and start repaying some of it (hah!), that would cause everyone’s dollar to have greater purchasing power, kinda like getting a tax cut.

But if the borrowers default, that money starts disappearing much more rapidly. This is why the Fed has shoveled large sums of money into the banking system, to stop a deflationary process from occurring and to give the air of confidence to the depositors that their money is still safe, so to stop bank runs from occurring. They want to keep the created money in existence. However, if they shovel too much money, inflation will start kicking in.

As I’ve said before, I believe the Fed is trying to play a let’s buy some time for the banks game. While the loans are defaulting and the money supply is contracting, the Fed is sending money to the banks to stop an overall contraction. However, what happens when the loans stop defaulting and individuals have paid down enough debt that they’re ready to borrow again. Well, if the money supply didn’t shrink very much (because of the extra Fed money), we’ll see inflation set in as the borrowed money increases the money supply. Now I think the Fed is going to try to ease into making higher rate hikes to offset the inflationary pressure. But my concern is that a) that will produce recessionary pressures, b) it may put that banks back into a position of insolvency if they haven’t been able to make profits high enough to cover the previously incurred mortgage and loan losses. So the Fed may be forced to leave some portion of the recently created money in the banks by not changing the Fed rates or changing them in smaller increments than would be needed to stave off inflation. We could end up in a 1970s style stagflation. I hope not, but it is a definite possibility. There is also the possibility that it will be worse than the 1970s, and we will reach hyper-inflation. The US gov’t over the top spending budget for the upcoming year may just be the culprit to do it.