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Still, as long as interest rates were on the rise, a loan today was better than a loan tomorrow because the markets realized that the purchasing power of the dollar was declining. Politicians kept the pressure on the Fed to keep interest rates low so they could keep their constituents happy. Those in govemment who were aware of the dangers of what was happening were afraid to act for fear of collapsing the house of cards and ruining Democratic hopes for the next election.

By the last quarter of 1979, the U.S. economy was universally engaged in a flight to real goods. Gold skyrocketed in price, peaking at nearly $875 per ounce in the futures markets in early January 1980. Nobody wanted to hold paper money. Rather, they bought stocks, futures, real estate, or gold, held it for a year, or even a few months, and then tumed it over for a 20% gain! Magic! Instant wealth! Doesnt this ring a bell-something like the Mississippi Scheme?

Fortunately, there was enough prevailing economic wisdom to realize that we were heading for a "crack up boom" similar to what existed in Germany in the 30s and what exists in some South American countries today. On Tuesday, October 12, 1979, Paul Volcker retumed prematurely from an Intemational Monetary FunWorld Bank meeting in Belgrade, Yugoslavia and announced an emergency meeting of the FOMC to take place on the following Saturday (The Fed likes to meet and make announcements at times when the markets cant react immediately to their pronouncements.)

At 6:00 PM. on that Saturday, Volcker convened a press conference in which he outlined a plan that would revolutionize the Feds approach to monetary policy.

Volcker announced that the discount rate would be raised from 11 to 12% and that new, restrictive reserve requirements would be imposed on banks foreign liabilities. Both actions demonstrated the Feds resolve to bring inflation under control. But the real kicker was Volckers proclamation that from then on, the FOMC would control the money supply directly by controlling reserves through open market operations rather than by shooting for target Fed Funds rates. At this point, Volcker was engaging in psychological tactics to cool the speculative fever. After the election in 1980, the real tightening would come.

My point in telling this whole story is to show that the philosopher kings really do control the economy and with very limited knowledge. The Fed has been experimenting with our economic lives by trial and error. But before I go into that aspect of the Fed, let me discuss open market operations in more detail.

Open Market Operations

Any open market operation-the purchase or sale of securities by the Fed-has a direct dollar for dollar influence on the amount of reserves available in the system; a purchase increases reserves, and a sale decreases reserves. If you understand how a gold-backed monetary system works, the Feds power with open market operations is tantamount to the Fed sitting on millions of ounces of gold and injecting or

removing it from the banking system at will-a power that would be considered monopolistic if wielded by the private sector.

There are several types of open market operations, and each has a slightly different effect on credit availability and monetary growth. Some operations are more hidden than others and some are very blatant. If you understand the different types and monitor the Feds activities, you can not only get an idea of the direction of monetary policy, but even more important, you can gain insight into the psychology of the men on the Board and the FOMC. And since it is the minds of these men that largely determine the direction that economic activity will take, it is essential to understand the direction of their thinking.

There are two basic approaches to open market operations: long-term and short-term. For trying to achieve long term operating objectives, the primary tool is the outright purchase or sale of securities, usually U.S. Treasury issues of bills, notes, and bonds. If the objective is to increase reserve availability, the manager will purchase securities from dealers in an auction process until the desired amount of reserves are added. If the objective is to remove reserves, the manager will sell securities to dealers, again in an auction process. Another method of withdrawing reserves is to let securities held in the systems portfolio mature without replacement.

compensate for short-term deficits in reserves caused by things such as increased seasonal demand for currency (as in the Christmas buying season) and other short-term technical factors, the Fed uses repurchase agreements (RPs). often called repos by the market. In a repurchase agreement, the Fed buys securities from dealers with the agreement that the dealers will buy them back within a specified period (the period can vary from 1 to 15 days but is usually 7) at a specified price, usually with the dealer having the option to terminate the agreement before maturity.

The flip side of repurchase agreements is matched sale purchase transactions. "Matched sales," as they are called, consist of a contract for an immediate sale of securities (usually T -bills), and a matching contract for purchasing the same amount of securities from the same dealer at a later date (usually not exceeding seven days). Matched sales are a way for the Fed to remove reserves from the system on a short-term basis in response to seasonal or other technical factors.

Described like this, these operations seem innocent, even reasonable. But at the risk of repeating myself, you need to be aware that all open market operations represent the creation or destruction of ink deposits in banking accounts. When additional reserves are created, the banking system has the capacity to increase the money supply by making new loans. In Von Mises terms, the gross market rate of interest is lowered, regardless of the nominal level of interest rates.

Conversely, if reserves are pulled out of the system by the sale of securities, the banks will lose credits in their reserve accounts at the Federal Reserve Banks. If the contraction reduces reserves to such a level that lending institutions have a net deficit in reserves, loans will be called in, inventories will be reduced, and a

business contraction will ensue-the gross market rate of interest is raised even if nominal interest rates remain unchanged.

Repos and matched sales, while short-term tools, can have a significant longterm impact. If the Fed regularly engages in repos such that there is a cons istent balance of securities held under repurchase agreements, then from the standpoint of the banking system as a whole, these balances are tantamount to outright purchases.

The Fed Funds market is very efficient. It is in any banks interest to loan excess reserves, even if on an overnight basis. A continuous balance of reserves added to the system by repurchase agreements can have an important impact on the Fed Funds market and the Fed Funds rate. It is also significant if the Fed discontinues a regular policy of supplying short-term reserves through repos. This is a somewhat hidden way of tightening "a little bit." The converse is true for matched sales or changes in matched sales balances.

The most apparent and readable of all Fed policy actions are outright purchases and sales. The news wires report these immediately when they occur, and their effect is usually predictable.

Perhaps the best indicator of the effects of Fed policy, however, isnt the quantities of outright purchases and sales but the level and changes of the level of free reserves in the system.

Free reserves equal excess reserves minus discount window borrowings other than extended credit." This number, which is reported every Sunday in Barrons and other financial publications or can be obtained directly from the Fed. is a key measure of the degree of ease or tightness of Fed policy. As an approximation, if the free reserve number is positive, then you can multiply the number by 10 to calculate the approximate current potential credit availability on the market. A negative number means that a credit contraction is in progress. But, the number doesnt have to be negative to indicate Fed tightening.

The Fed can tighten while maintaining a positive 1 evel of free reserves. It is helpful to think in terms of Von Mises formulation of the gross market rate of interest. If the level of free reserves declines, then the gross market rate of interest increases, regardless of the nominal interest rate.

This means that less capital is apparently available for investment than before. The converse is true if the level of free reserves increases, other things being equal. To get the best reading, what you should look for is changes in levels of free reserves in njunction with changes in the Fed Funds rate, the discount rate, the rate of growth or decline of the adjusted monetary base, 1= the rate of growth of the money supply, and the CPI and PPI numbers.

One thing you can count on is that, on balance and in the long term. Fed policy will be expansionary, the money supply will continue to expand, and the purchasing power of the dollar will continue to fall.

According to the U.S. Department of Labor and the Bureau of Labor Statistics, what cost $1.20 in December 1988 cost only 30 cents in 1961 and only 10 cents in December 1913. But the Feds expansionary monetary policy isnt the only reason that the dollars value is diminishing. Our

govemments continuing policy of deficit spending is to blame as well, and it is important to recognize the impact that deficit spending has on the business cycle.

Deficit Spending and Its Effects on Money and Credit

Here are some hard facts. The last time the U.S. govemment didnt operate at a deficit was 1969, when it reported a surplus of approximately $4 billion. Since then, the trend has been toward an ever upward spiral of deficit spending so that the March 1990 deficit-the deficit for one month-was larger than that for the entire 1975 fiscal year.

According to Grants Interest Rate Observer, at the end of fiscal 1989, gross federal debt totaled $2,866 trillion, not to mention the $4,124 trillion face value of govemment insurance programs, and the $1,558 trillion in outstanding federal credit. Govemment outlays in 1989 were 22.2% of GNP, and that was a sevenyear low! The interest expense on federal debt was 3.3% of GNP and hasnt been below 3% since 1983. As of September 30,1988, the net worth of the country was estimated by the Comptroller General to be negative $2.4526 trillion, omitting public lands and mineral rights except at nominal values."

In large part, these numbers speak for themselves. The U.S. govemment is a debt junkie, and if the trend continues, the doses are eventually going to become lethal.

Suppose you have two credit cards, each from a different bank; and each month you pay the balance of one card by charging it to the other card, while simultaneously spending more than your paycheck each month. The respective banks, unaware of your practice, keep increasing your line of credit because you always pay in fuU-youre a good and valued customer in their eyes.

While the banks dont know whats happening, you start waking up in the middle of the night with anxiety attacks about the increased amount of inte rest you pay each month, wondering how long it will be before the scheme blows up in your face.

Thats basically the way our govemment has been operating for the last several decades. It borrows money from two main sources: the public, or the Fed itself: and it borrows more money in each cycle to pay its debts.

If you listen to politicians talk about deficits and their impact on the value of the dollar and the business cycle, youll be nothing but confused. The party out of power always blames deficits for chronic inflation, while the party in power declares that deficits have nothing to do with inflation.

Both statements are wrong. If the Treasury sells its bonds to the public to fund the deficit, money is transferred from the publics hands to the govemments hands. The govemment then spends the money, putting it back into the publics hands, albeit redistributed. There is nothing inherently inflationary in this process-no new money is created as a direct result of the securities sale.

On the other hand, if the Treasury sells securities directly to the Fed, the money used to pay for them is "printed"-the Fed credits the Treasurys account with the purchase price of the bonds, plus it increases its inventory of securities for open market operations. This process is obviously, and directly inflationary, but it is not a common practice. But there is a more subtle way that deficit spending induces inflationary policies by the Fed.

If the govemment is a debt junkie, the Fed is the pusher providing the supply of the deadly substance-credit. It works something like this: If the govemment needs to sell $100 billion in govemment securities to the public (including the banking system itself), the Fed buys $10 billion of securities on the open market to enable the banking system to lend the $100 billion needed to finance the new Treasury issue.

Its a rich and self-fulfilling scam-no different in principle from the Missis sippi Scheme. When the govemment operates this way, it guarantees a supply of credit for itself in the short term and financial trouble for all of us in the long term.

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