Thinking Outside the Box

Yesterday's blog focused on the daunting economic problems America faces. What are the solutions?

Current thinking seems to be to cure the problems by forcing liquidity into the financial sectors of the economy. So far results aren't promising.

Current thinking doesn't appear to differ significantly from the thinking that created the problem bubbles in the first place. This of course brings to mind two famous observations by Albert Einstein. The first is on problem solving, "We can't solve problems by using the same kind of thinking we used when we created them." And, the second is perhaps even more on target for the strategies being employed by our fearless economic leaders. It is a definition of insanity: "Doing the same thing over and over again and expecting different results."

These observations by a man many consider to be one of the most brilliant people to ever live suggest that the solution has yet to be found and that the current approach is likely to fail. More importantly, Einstein's approach to problem solving and definition of insanity indicate that any solution with a prayer of success must come from outside the box and defy conventional wisdom.

If outside the box, unconventional solutions were to be attempted what might those solutions look like? The following are The Rainmaker's suggestions for how America might deal with various issues threatening this country and the world in areas beginning today with a discussion of the current economic/monetary crisis. In days to come issues such as health care (Medicare), elder care (Social Security), energy, ecology, immigration, crime and terrorism will become the focus.

The first outside the box solution is to return to the founder's intentions as defined in Article I Section 8 of the United States Constitution regarding creating a national currency.

Our money is typically something about which we aren't conscious. Like air or water, it isn't considered unless we don't have any. Then, it becomes a matter of life and death. Few of us can even define money. What is it really?

Money is best understood by its two primary functions.

First, it is a medium of exchange. This means that it facilitates transactions without our having to resort to barter. Second, traditionally, it is a store of value. This means that you can hold money and be confident that tomorrow or next year, it will by substantially the same goods and services as it will by today.

America's money still services the first function admirably, functioning as the world's reserve currency. However, as a store of value our money is an abject failure. Between 1913 when the Federal Reserve Bank was created and 2004 the purchasing power of a dollar dropped about 96%. The net effect of that decline in our money's capacity to act as a store of value is that a 2004 dollar would buy about 20% less than a nickel would buy in 1913.

Why is American money failing in its role as a store of value?

Although there are several reasons that explain the failure of U.S. currency to be a store of value, this discussion will initially focus on the role of interest and usury. Subsequently, the role of fractional reserve banking will be considered.

Interest is typically a charge levied on borrowers to compensate lenders for the risk of non repayment of loans. Usury is usually defined as loaning money at exorbitant or illegal rates of interest.

Prior to the creation of the Federal Reserve Bank in 1913, money was issued by government and various banks. Subsequently money has evolved to the point that it is issued by the Federal Reserve Bank as a loan to the U.S. Government. When you look at a dollar bill you will note that it says "Federal Reserve Note." A note is a promise to pay or a loan document. Thus virtually every dollar in circulation today is proceeds of a loan from the Federal Reserve Bank to the U.S. government or by banks that are members of the Federal Reserve system as loans to customers through fractional reserve banking. And, the Federal Reserve collects an interest charge on that currency circulating as a medium of exchange.

Yet, there is no reason to borrow the medium of exchange. There is no risk of loss. Nevertheless this interest charge distorts the American monetary system because although the money is issued by the Federal Reserve to facilitate transactions, the Federal Reserve doesn't issue the money to pay the interest charge. This adds what amounts to a hidden tax on every dollar in your pocket, your bank accounts, your retirement accounts. That isn't necessary to cover risk of loss. This is in effect usury on a massive scale.

As Americans struggle to pay this usurious hidden tax every decision, every transaction is distorted. It usually isn't much of a distortion but even a 1/10th of 1% change of course results in a major deviation slowly over time. Charging interest on the medium of exchange is a huge and unfair burden on all Americans.

The second value in the erosion of the purchasing power of America's money is the effect of fractional reserve banking. Every American dollar is borrowed into existence. First the Federal Reserve loans money to the U.S. government and it loans money to its member banks. These funds are spent in the case of the government. Government employees and contractors deposit those funds in their bank accounts. The balances in those accounts are then spent over time.

Those bank balances become part of the bank reserve and, since it is clear that on any given day depositors won't draw down their account balance, the bank can put that money to work by loaning against it to other customers. The cycle repeats. Banks are required to maintain a reserve, ranging from 3% to 10% of the gross deposits. So, if a bank receives a $100 deposit it can loan another customer $90 or more. When that loan is deposited into the customer's account the bank can loan an additional $81 and so on. Thus, if you do the math, a bank can extend about $1,000 in loans on a $100 deposit assuming a 10% reserve ration.

All this creates economic activity driven by fractional reserve. However, the goods available for purchase, being limited by physical reality, don't keep pace with this exponential growth of the money supply. Hence the purchasing power of a dollar falls.

The system is ultimately unsustainable.

So, here is an outside the box suggestion to deal with the current monetary crisis. It is time to go back to the future so to speak and implement the Andrew Jackson solution to the impossibility of a National Bank collecting an interest change on the medium of exchange while expanding the money supply by issuing exponentially expanding FIAT currency in to a fractional reserve banking system.

The Federal Reserve Act of 1913 should be repealed. The money used as a medium of exchange should be issued by the United States Treasury interest free. In a perfect world this money would be backed by precious metals such as gold and silver. Imagine the United States of America issuing honest, real money.

If the United States were to go all the way, the government would allow other forms of currency to compete with the dollar, giving people the opportunity to shop for the strongest, most stable and most honest currency.

Actually, the financial performance of the United States economy after Jackson revoked the charter of the Bank of the United States and before the creation of the Federal Reserve was significantly superior to the economic and fiscal performance in the past 96 years since the creation of the Federal Reserve when measured in terms of relative growth and stable purchasing power of American currency.

Next up is the coming health care crisis.

"For whatsoever a man soweth, that shall he also reap."

The ancient Biblical wisdom quoted above accurately portrays what the world can expect over the next few years.

Incurring long term debt to finance consumption, speculating on successive stock, then real estate bubbles and dependence on unsustainable health and old age entitlements all carry costs. There really is no such thing as a free lunch.

The United States has been on a binge of funny money, entitlements, easy credit and unsustainable consumption for almost 100 years. Now its time to pay the piper. How bad will it be?

When the stock market crashed in the early 30s, it required 14 years after the bottom to recoup the lost value. That is probably a reasonable estimate of the time required for America to recover from this financial hangover, once we reach the bottom.

When will that depth be reached? Hopefully in 2009, but possibly not until 2010 when Medicare goes "cash flow negative." Possibly not until 2017 when Social Security follows suit.

The only certainty is that however long it took to dig this hole, it will probably take that long to climb out.

The risk is that in the attempt to stop the current bleeding a new bubble is being created, a currency bubble. The Federal government together with the Federal Reserve are inflating the currency to incredible levels in the so far futile effort to sustain liquidity. If they go too far, pass some ill defined unknown tipping point, then it's possible that hyperinflation could result.

To appreciate what that might mean read a little history about Germany during the third decade of the 20th Century. The crises eventually led to the end of the fledgling German Republic, which was replaced by the Third Reich.

In other words, our current situation is bad but it could easily get worse.

Hopeful in America

The speech today by President Obama touched all the right bases and provided a clear break from the past. He did what he had to do. And, he was gracious towards President Bush, going so far as to exchange a hug. The Rainmaker rating is 10 on a scale of 10.

Although the markets did close substantially lower; indicating continued skepticism of the new administration in the financial community. The rest of America and the world seems inclined to give the new President a chance.

President Obama enters the new term burdened by unreasonably high expectations and approval ratings. Although he has obviously attempted to lower expectations and urge caution, the majority of people seem to expect miracles. Miracles are unlikely and President Obama will no doubt suffer as time passes.

Nevertheless, the President clearly demonstrated today that he can talk the talk. Hopefully he will now show us he can also walk the walk.

For all or our sakes, let us wish the President success.

Wealth, Virtual Wealth and Debt

Frederick Soddy, winner of the Nobel Prize in 1921, wrote "Wealth, Virtual Wealth and Debt" in 1926, which anticipated the market crash of 1929. Given the current state of the economy perhaps it is time to revisit Soddy.

Soddy points out the the real world is subject to the laws of physics while the economic world is subject only to the laws of mathematics. Thus there is a limit to what humanity can physically produce and consume, which Soddy defines as wealth. But Soddy sees no theoretical limit to the amount of debt that humanity can incur. Virtual wealth is what we call money, a representation of wealth that can be traded as a medium of exchange or held as a store of value.

Why, asked Soddy should a medium of exchange and store of value representing real wealth be treated as a debt incurring an interest charge?

Yet debt based monetary systems, such as the Dollar, Euro, Yen and almost all other national currencies, compound debt through interest charges without regard to real wealth, creating obligations that can never be repaid. Every dollar in our pocket, checking account, savings account and retirement account incurs an interest charge collected by the Federal Reserve, a privately owned bank. Yet, we didn't borrow those dollars, we earned them. Why are we paying interest on those dollars?

When it is no longer possible to carry the debt (pay the interest and repay the principal) the debtor is in default and his or her property is seized by the debt holder (financial institutions, banks and ultimately the owners of the Federal Reserve). Thus there is a tendency in our ecnomy to concentrate wealth in fewer hands over time.

Soddy understood the inherent impossibility of a debt based monetary system to be sustainable. Such a system borrows money into existence without regard to real wealth, incurs an interest charge to use currency as a medium of exchange and multiplies debt without regard to the physical world's ability to carry or service the debt (pay the interest and repay the original principal)accumulated by a fractional reserve banking system.

"Wealth, Virtual Wealth and Debt" is still in print and worth reading for anyone wondering what is really going on in today's economy.