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                                    The Federal Reserve        24 Feb 2010

 By Thomas F. McMasters              Candidate U.S. House of Representatives

The mission of the Federal Reserve and the tools it has to complete that mission need a major redefinition.  The primary mission of the Federal Reserve should be to secure for the United States Treasury the lowest possible interest rate in service of the National Debt.  A secondary mission would be to provide recommendation to the Congress on tax rates and implementation.  The way the Federal Reserve currently implements monetary policy promotes large corporations over small business and stifles innovation.  In this article I argue against the generally accepted Fed practice of using monetary policy to fight inflation.

There are two main reason I believe the Fed needs to get out of the business of trying to regulate inflation using monetary policy; The first reason is because the method they use to do this is to raise interest rates and raising interest rates is counter productive to paying off the national debt.  The second reason is because when inflation is caused by the products we use no matter what the cost (such as gasoline) the method doesn't work.  

The economic theory goes like this:  Whenever you have too much money flowing around people start bidding up the price of items causing inflation.  If the government makes some of the money unavailable the reduction of available cash will make it so people can not bid up prices.  The years 1979 to 1986 provide a perfect case study to argue against restricting the money supply (promoting higher interest rates) in order to knock down inflation.  Around 1979 two things happened that caused oil prices to significantly increase.  First - speculation about Iran's production capability and second was the deregulation of oil prices.  Oil prices rose from around $15 a barrow to around $45 in a very short time.  Though it seems common now this was very alarming at the time.  Prices for other goods and service adjusted in response.  The Fed responded by trying to ring out inflation by driving the prime rate as high as 20%.  As a result the government had to pay up to 15% interest on 30 year bonds.  This method seemed to have worked because the inflation rate did drop after 1983.  However, examination of the nations money supply shows there was a significant increase in the money supply despite the Feds effort.  One can easily argue inflation went down despite the high interest rates.   In this case, inflation went down because oil prices stopped rising.  Oil consumption did go down.  To me its obvious consumption went down because oil prices tripled.  To Fed fans the reduction in oil consumption rates proves high interest rates can reduce inflation.  

Revisiting Fed Fan logic, suppose in the "normal economy" of 1978 a farmer spent $100. Of that $100 he might have spent $15 to buy seed, $35 on farm equipment, $10 on energy (including diesel), $8 on interest, $6 in taxes, and $36 for household expenses.  In this simple breakdown of expenses items such as housing, food, recreation equipment (ATV or boats), savings etc all fall into household expenses.  Also, other farm cost such as irrigation etc are covered in either the seed or farm equipment categories.  With oil prices tripling by 1981 the farmer must now spend $22 on energy cost.  In order to do this he must either reallocate funds from one of the other categories or raise more money.  Fed Fans believe the natural inclination is for the farmer to raise his price in order to cover the cost.  In their eyes this leads to more expensive food.  This is inflation.  Inflation is bad therefore something must be done in order to convince the farmer not to raise prices.  Their solution is to make it hard for the farmer to get a loan.  In their eyes this will make the farmer give up the ATV and the boat and self finance the energy increase.  In the Fed Fans eyes, if they can convince the farmer to give up their ATV's then they can stop inflation.  The obvious flaw in this logic is that farmers weren't spending 30% of their household expenses on recreation.  Even if you make the farmer stop contributing to his savings this doesn't cover the additional energy costs.  Also, I'm pretty sure at the first increase in energy costs the farmers decided not to make new recreational purchases.  In contrast to Fed Fan logic my logic tells me that raising interest rates does nothing to reduce the farmers likelihood of buying a boat because the higher fuel cost already did that.  All that raising interest rates did was increase the amount of money the farmer must come up with in order to service his loan.  That is the farmer not only has to raise his prices to cover the $12 energy increase he must also raise his price to cover the $1.50  in extra interest he is paying.  Thus the policy pushed by Fed Fans actually drives up the costs of goods. 

Now this inflation only last as long as the Farmer stays in business.  If the Fed Fans can actually drive the farmer out of business then a bigger Corporate Farm can come in and buy up the farm at bottom barrel prices.  The corporate farm gets better finance rates, it bought the farm at the lowest possible price and they probably picked up the equipment cheaper than the previous farmer.  With these lower costs some of the inflation pressure is off.  Not only that but they can hire people with no expectation of ever being able to afford recreation activities.  And remember inflation is a measure of price increase.  That is -- even if the new corporation keeps charging the higher prices the previous owner implemented before going out of business the inflation rate is zero.   So the net result does not include lower consumer prices.  The net result is big corporations gain a competitive advantage over the small business operations. 

Policies championed by Fed Fans result in the transfer of assets from small business enterprises to large corporation in other industries as well.  In periods when the economy thrives entrepreneurs and inventors start business and often come up with improvements to existing products or ideas that could replace standard equipment.  These innovations will cause a competition for resources between the small business and large corporations.   Fed Fans believe this competition will lead to inflation so in order to stop the perceived threat they advocate reducing the amount of money available to make loans.  In the process for gaining bank funding the large corporation has the competitive advantage over the small business.  The result is the small business ceases to operate  and either the innovation never gets adapted or the corporation buys it up at pennies on the dollar shutting out the innovator from receiving the just benefit from his or her efforts.  

In both the farm example and the innovator example the policy put forth by Fed Fans do nothing to reduce inflation but they do stifle innovation and act as a defacto corporate welfare system.  Beyond these cost the country also ends up increasing the national debt.  This is because the way Fed Fans make money more difficult for farmers and innovators to get is by promising that the federal government will pay higher interest rates.   Back in the early 1980's the Fed Fans promoted a policy that resulted in the government paying 15% on 30 year Treasury bonds.  What does this mean in terms of the national debt?  Well if the government pays 15% for every Trillion Dollars it has to finance we must pay $150 billion in interest every year.  If they borrow that money at an interest rate of 5% we must pay $50 billion instead.  Now the government never refinances all its debt in the same year so it is wrong to assume that the government pays $700 billion dollars in interest if the current interest rate is 5% and $2.1 Trillion if the current interest rate is 15%.  But the government does finance and refinance a large amount of money every year and every percent in interest rate increase significantly adds to the current budgets deficit.  That is why I believe the primary function of the Federal Reserve should be to work to minimize the interest paid by the Treasury to service the national debt.

I also put in a secondary function of the Federal Reserve and told you it should advise the congress on optimal tax rates.  I generally believe the innovation created during periods of high economic growth out weigh the negative of possible inflation.  However, I understand people being leery of high inflation.  Therefore I understand why some people may think it beneficial to take some money out of the economy.  I've already shown that doing this by the methods advanced by Fed Fans leads to higher deficits, stifles innovation and lowers disposable income for most people.  Therefore, if we are going to take money away from the economy it is obvious we are better served to do it in the form of taxes.  Proper use of the tax code will take money out of the economy but instead of driving up the deficit it will reduce the deficit.  The Fed can use its expertise to inform Congress when this needs to be done.  Making Congress do its job also helps stabilize the business environment.  That is because the tax code goes through the legislative process businesses can plan for upcoming changes.  This will allow better decision making.  For instance the farmer that was doing well in 1978 and chose to splurge on a boat had very little warning the government was going to try and run him out of business.  If the government had been forced to take money out of the economy via the tax code it would have given the farmer opportunity to plan better and he probably would have kept his farm.

In conclusion, Fed monetary policy needs to stick to ensuring the government gets the best interest rates.  The Fed should not be the agency trying to police inflation.  Instead, congress should use the Feds expertise to produce logical and appropriate tax policy.

Caveats:  Its foolish to think I can sum up and give a full and comprehensive summary of all the complex issues dealing with the Federal Reserve in just 10 paragraphs.  For instance about $2 Trillion of the national debt are held in the Social Security Trust Fund.  If the government has to pay higher interest to service the national debt then in theory the trust fund increases by about the same amount.  Also, when you hear reports that say the Federal Reserve increased the Fed fund rate, the money that is generated from these transfers goes into the Treasury.   This means a person can't conclude that all the money lost by businesses due to rising interest rates vanishes into the atmosphere.  When reading and making conclusions about the article above think about it as a start of a new direction of discussion and use it as a call for your representative to delve into the complex functioning of the Federal Reserve.  Your representative ought to be able to write or at least identify articles and books showing he understands these functions.  I think I should be willing to go on the record showing you the depth of knowledge and understanding of a subject and the possible direction of future investigation.  I start that here in this article. In my opinion, this is a good start and more than most candidates are willing to commit to.  However, this article is not as complete or comprehensive as I would expect from a person given the responsibility of making decisions on behalf of the people of the 8th district.    My desire is for it to convince you that once you chose me to graduate from the citizenry to your representative, I am capable of investigating and understanding the complexities better than others willing to step forward and assume the responsibility of being your representative.