The growth of bureaucracy around the world has led to a proliferation of rules. This creates multitudes of problems, one of which is that the state has made understanding what it is doing impenetrable, boring, nuanced, and technical. With vast resources, numerous employees, activist attitudes, and widespread presence, government bureaucracies have become so complex that few people can, or even want to, keep track of their activities.
There is no better example of this than the Federal Reserve. When the Fed was founded in 1913, the US was basically on a gold standard. Slowly, but surely, the standard was diluted until Richard Nixon finally closed the gold window in the 1970s. Though, even after that, at least interest rates were tied directly to the amount of reserves that were in the system.
Then in 2008 the Fed changed the rules in such a dramatic way that they severed the connection between the amount of money in the system and the level of interest rates. The confusion this has created is rarely recognized. The press doesn’t ask questions about it, the Fed won’t explain it, people get numb thinking about it. And the world just moves on at its peril.
However, financial markets sense that monetary policy is unhinged. Even before inflation hit a 40-year high, gold prices started to rise. Now, gold has reached all-time record highs as markets watch central banks abuse money like they have so many times before.
At the same time, cryptocurrencies have become extremely popular. So popular that presidential candidates have embraced the crypto community in an attempt to reach the one in three voters who say a candidate’s stance on crypto is a consideration in how they will vote. In an effort to avoid cynicism, we assume politicians understand that crypto currencies are partly fueled by a mistrust of government. But in reality politicians may not understand and are simply placating this group to get votes. We hope this isn’t true.
The value of money is as least as important to a nation as its constitution. A constitution sets out rules for government and people in a society, while money (whether we like it or not) measures the progress and success, or failure, of those rules. Prices are key to determining the allocation of resources, but if the value of money cannot be trusted then social cohesion is frayed. Throughout history, governments have abused money…from the Romans clipping coins, to the end of the gold standard, to quantitative easing and the creation of an “abundant reserve” monetary policy in 2008.
Unfortunately, explaining this in detail requires time and can be tedious and nuanced. We hope you’ll settle in and take the time to understand how monetary policy has gone off the rails since 2008. The dangers to the US, and even the world, are very real, yet few people fully grasp the implications.
Scarce Reserves
Ever since the US shut the gold window in the early 1970s, monetary policy has had no real anchor. Gold conversion forced some discipline onto the government because investors could demand payment in a fixed price of gold for inflated and devalued currency. Ending that ability gave the Fed free reign to print money without a corrective mechanism other than when voters – and therefore politicians – revolted against inflation.
Nonetheless, the federal funds rate, the amount of reserves, and therefore the money supply were connected. It worked like this: if someone deposited $100 in a bank, that bank had to hold 10% reserves ($10) at the Fed. This made sense…even if government had no rules, banks still needed to hold reserves because deposits and withdrawals don’t always happen at the same time. Over time, 10% became the convention.
You can see in the chart below, from the 1960s through 2008, this is exactly how the system worked. Reserves averaged about 10% of M2 (a broad measure of bank deposits, including checking and savings accounts, CDs and cash). In 2007, the Fed’s Reserve Bank Credit (the Fed’s balance sheet) showed banks held $850 billion of reserves, while M2 was $7.5 trillion. This means banks held about 11% reserves at the Fed.
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This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.