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Post details: Tale of Two Islands

Tale of Two Islands

Once upon a dime, there was a vast sloshing ocean of liquidity and two islands bathing in its glittering waters. One was ruled by King Jekyll and the other one by Emperor Hyde. The islands were economically isolated from the rest of the world and, for the sake of simplicity, we will assume that their combined wealth was equivalent to $1000.

One day the citizens of Jekyll Island realized they needed a new bridge. The budget for its construction was estimated at roughly $100. The king quickly realized that if everyone chipped in 10% of their respective wealth, they would be able to pay a contractor and have the bridge built. Being an action king, he wasted little time and embarked on a noble campaign: he saddled his horse and went door to door around the island lobbying for a tax that would pay for the bridge. Much water passed in the river before he managed to smooth out all the wrinkles, answer all the objections and persuade all his knights about the advantages of the new civil engineering project. But at the end all were happy with the construction. The King collected the tax, paid the builder and before you could say "trick or treat", a stunning bridge spanning the little valley through which the river flowed was erected.

Meanwhile, Emperor Hyde caught an envy bug and concluded that their island needed a new bridge, too. But unlike King Jekyll, he did not have to worry about endless political battles associated with the bridge tax. Emperor Hyde possessed a cool contraption that obviated all the political negotiations: a money printing machine - a magical wand that allowed him to create arbitrary sums of money out of thin air. Rather than arguing with his electorate about the pros and cons of the planned bridgery, Emperor Hyde simply printed 100 brand new dollars into lighthearted existence. There was no need to obtain implicit "building permit" from his people in the form of the voluntarily remitted tax. All that needed to be done was to turn the crank of the press and voila! The builder was immediately paid and the new bridge was finished before you could say "trick".

But conjuring the new money up had a profound side effect on the buying power of the island's citizens. Wealth is obviously not created by printing banknotes. The total wealth of the island (now represented by the $1100 in circulation) was unchanged. Every dollar was thus worth roughly 10% less of goods and services then before. Here is how you can see it. Suppose all the money on the island before printing (which is $1000) could buy 10 ounces of gold. Each ounce was therefore worth $100. After the printing act that same amount of gold was being chased by $1100, hence each ounce was now worth $110. The citizens of the island just experienced a 10% inflation.

Note that building the bridge can be achieved under either system. Whether you choose to pay for it by explicit taxes or by inflating the money supply is just an implementation detail. Emperor Hyde's inflationary approach was certainly technically more feasible and avoided painful negotiations with neighbors about the usefulness of the new bridge. On the other hand, his citizens woke up one day and realized that the buying power of their money suddenly dropped by 10% without any warning or compensation. Nobody inquired whether they wanted the bridge or not. Nobody explained why it was necessary. In this light, inflation can be thought of as a cowardly tax. It is a little stab in the back of each family's budget.

From this example it must be clear that a printing press is a shady monster. While the ability to expand the money supply can significantly simplify obtaining the means for large public projects, it can also drastically tinker with citizens' real wealth. Ideally, the amount of money would grow in proportion to the amount of goods and services. That, however, is a very delicate balance, so the monetary policy needs to be very carefully monitored. Otherwise, Emperor Hyde could print oodles of money just to bail out his gambling courtiers or finance various preposterous and utterly useless businesses. Such chicanery would significantly reduce the buying power of his subjects with nothing to show for it, except maybe an overstaffed Bureau for Scrutinizing the Stalk Density of the Royal Lawn. That is why in modern states the power to expand the money supply does not rest with an individual, but rather with an institution. The Central Bank.

I have to admit that the adjective "central" always brings back painful memories of the Central Committee of the Communist Party of Czechoslovakia - an institution whose bumbling actions became a living proof that "centralized" does not necessarily mean "more efficient". Moral miasma and economic deterioration frothed liberally around the orifice of this cabal of cronies owing mostly to their fake policies, stealth bribery and raging incompetence. Perhaps this association is a subconscious reminder that institutions are no more immune to corruption than individuals. And central institutions doubly so.

Central banks must be placed under constant and intense scrutiny, lest they fall pray to inherent imperfections of the human race and further large sums of paper money to extended hands of failed entrepreneurs and crooked politicians. After all, turning the crank of the printing press is tantalizingly simple. In the fiat currency regime, the principles of capitalism can be light-heartedly tossed away, as problems can be (literally) papered over. Just ask the citizens of Zimbabwe. On the other hand, in the system based on sound currency (whether backed by gold or some other asset class) such fraud is impossible. Whoever gets paid for goods or services has to prove in the free market that (s)he deserves the remuneration corresponding to the intrinsic value of the currency.

At the end of November 1910, Senator Nelson W. Aldrich, Assistant Secretary of the Treasury Department A.P. Andrews and many of the country's leading financiers, gathered on a small island off the coast of Georgia to discuss monetary policy and the revamping of banking system that was still reeling from the debilitating crisis of 1907. Although the name of the venue for the meeting was Jekyll Island Club, it was Emperor Hyde who entered the American financial system through its dooorway. The US Central Bank (better known as the Federal Reserve System) was created in 1913 as a direct result of the island talks. Ever since, this opaque conglomerate swam in the murky waters between the government and private jurisdictions with only a little or perfunctory auditing.

Enter Ron Paul. His Federal Reserve Transparency Act of 2009 (H.R. 1207) is an attempt to perform a thorough and timely audit of the Federal Reserve System before the end of 2010. The importance of this bill in the wake of extraordinary measures taken in the Fall 2008 cannot be overstated. The wheelings and dealings of the Fed have to be made transparent and available for review by the financial experts and even public. Ryan Grim at The Huffington Post summed up the importance of this legislature in two sentences.

The measure, cosponsored by Reps. Ron Paul (R-Texas) and Alan Grayson (D-Fla.), authorizes the Government Accountability Office to conduct a wide-ranging audit of the Fed's opaque deals with foreign central banks and major U.S. financial institutions. The Fed has never had a real audit in its history and little is known of what it does with the trillions of dollars at its disposal.

Even though Ron Paul was very clear that this bill is not going to compromise the independence of the Fed in matters of monetary policy and it will not influence their enlightened decisions, some policy makers were suspiciously nervous about its wide support in the House of Representatives. One obvious example is Rep. Barney Frank (D-MA), who expressed concerns about the Fed's autonomy, although he did not elaborate how it would be jeopardized by a simple audit. Frank also created a masterpiece of demagoguery when he lamented that "inflationary expectations will be given a boost if Ron Paul measure gets adopted". Does he not know that inflation is a symptom of reckless and unchecked spending? How curious that the man who freely advocates dumping trillions of taxpayer dollars into endless bailouts is suddenly worried about inflation. Perhaps, the solution to this particular conundrum lies in the list of his top campaign contributors list which reads like Who is Who on the Wall Street.

The Fed audit has absolutely no ambition to twist the top bankers' financial arms in either direction, although some of their recent actions were not exactly taxpayer friendly. We the people just want to see what is happening with our money. Is that the reason to panic? If all is well in the Fed Land, it shouldn't be. But the amount of obfuscation and defensive reactions seen in the media indicates that many financiers are getting jittery. Thomas Jefferson clearly knew what he was talking about when he observed:

I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered.

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