[A-List] Henry Liu on central banking 3b

["Michael Keaney" <michael.keaney@xxxxxx>]

BANKING BUNKUM
Part 3b: More on the US experience
By Henry C K Liu
Asia Times, November 27 2002

Most central banks, led by the US Federal Reserve (Fed), see their prime
objective as the maintenance of "sound financial conditions", not economic
growth, on the belief that the former must be a precondition for the latter,
a belief not always validated by events.

It is sometimes said that war's legitimate child is revolution and war's
bastard child is inflation. World War I was no exception. The US national
debt multiplied 27 times to finance the nation's participation in that war,
from US$1 billion to $27 billion. Far from ruining the United States, the
war catapulted the country into the front ranks of the world's leading
economic and financial powers. The national debt turned out to be a
blessing, for government securities are indispensable for a vibrant credit
market.

Inflation was a different story. By the end of World War I, in 1919, US
prices were rising at the rate of 15 percent annually, but the economy
roared ahead. In response, the Federal Reserve Board raised the discount
rate in quick succession, from 4 to 7 percent, and kept it there for 18
months to try to rein in inflation. The result was that in 1921, 506 banks
failed. Deflation descended on the economy like a perfect storm, with
commodity prices falling 50 percent from their 1920 peak, throwing farmers
into mass bankruptcies. Business activity fell by one-third; manufacturing
output fell by 42 percent; unemployment rose fivefold to 11.9 percent,
adding 4 million to the jobless count. The economy came to a screeching
halt. From the Fed's perspective, declining prices were the goal, not the
problem; unemployment was necessary to restore US industry to a sound
footing, freeing it from wage-pushed inflation. Potent medicine always came
with a bitter taste, the central bankers explained.

At this point, a technical process inadvertently gave the New York Federal
Reserve Bank, which was closely allied with internationalist banking
interest, preeminent influence over the Federal Reserve Board in Washington,
the composition of which represented a more balanced national interest. The
initial operation of the Fed did not use the open-market operation of
purchasing or selling government securities as a method of managing the
money supply. Money in the banking system was created entirely through the
discount window at the regional Federal Reserve Banks. Instead of buying or
selling government bonds, the regional Feds accepted "real bills" of trade,
which when paid off would extinguish money in the banking system, making the
money supply self-regulating in accordance with the "real bills" doctrine.
The regional Feds bought government securities not to adjust money supply,
but to enhance their separate operating profit by parking idle funds in
interest-bearing yet super-safe government securities.

Bank economists at that time did not understand that when the regional Feds
independently bought government securities, the aggregate effect would
result in macro-economic implications of injecting "high power" money into
the banking system, with which commercial banks could create more money in
multiple by lending recycles. When the government sold bonds, the reverse
would happen. When the Fed made open market transactions, interest rates
would rise or fall accordingly in financial markets. And when regional Feds
did not act in unison, the credit market could become confused or become
disaggregated, as one regional Fed might buy while another might sell
government securities in its open market operations.

Benjamin Strong, first president of the New York Federal Reserve Bank, saw
the problem and persuaded the other 11 regional Feds to let the New York Fed
handle all their transactions in a coordinated manner. The regional Feds
formed their own Open Market Investment Committee for the purpose of
maximizing overall profit for the whole system. This committee was dominated
by the New York Fed, which was closely linked to big-money center bank
interests which in turn were closely tied to international financial
markets. The Federal Reserve Board approved the arrangement without full
understanding of its full implication: that the Fed was falling under the
undue influence of the New York internationalist bankers. This fatal flaw
would reveal itself in the Fed's role in causing and its impotence in
dealing with the 1929 crash.

The deep 1920-21 depression eventually recovered into the Roaring Twenties,
which, like the New Economy bubble of the 1990s, left some segments of
economy and the population in them lingering in a depressed state. Farmers
remained victimized by depressed commodity prices and factory workers shared
in the prosperity only by working longer hours and assuming debt with the
easy money that the banks provided. Unions lost 30 percent of their
membership because of high unemployment. The prosperity was entirely fueled
by the wealth effect of a speculative boom in the stock market that by the
end of the decade would face the 1929 crash and land the nation and the
world in the Great Depression. Historical data showed that when New York Fed
president Strong leaned on the regional Feds to ease the discount rate on an
already overheated economy in 1927, the Fed lost its last window of
opportunity to prevent the 1929 crash. Some historians claimed that Strong
did so to fulfill his internationalist vision at the risk of endangering the
national interest.

When money is not backed by gold, its exchange value must be managed by
government, more specifically by the monetary policies of the central bank.
Yet central bankers tend to be attracted to the gold standard because it can
relieve them of the unpleasant and thankless responsibility of unpopular
monetary policies to sustain the value of money. Central bankers have been
caricatured as party spoilers who take away the punch bowl just when the
party gets going.

Yet even a gold standard is based on a fixed value of money to gold, set to
reflect the underlying economical conditions at the time of its setting.
Therein lies the inescapable need for human judgment. Instead of focusing on
the appropriateness of the level of money valuation under changing economic
conditions, central banks often become fixated on merely maintaining a
previously set exchange rate between money and gold, doing serious damage in
the process to any economy out of sync with that fixed rate. It seldom
occurs to central bankers that the fixed rate was the problem, not the
economy. When the exchange value of a currency falls, central bankers often
feel a personal sense of failure, while they merely shrug their shoulders to
refer to natural laws of finance when the economy collapses from an
overvalued currency.

The return to the gold standard in war-torn Europe in the 1920s was
engineered by a coalition of internationalist central bankers on both sides
of the Atlantic as a prerequisite for postwar economic reconstruction.
President Strong of the New York Fed and his former partners at the House of
Morgan were closely associated with the Bank of England, the Banque de
France, the Reichsbank, and the central banks of Austria, the Netherlands,
Italy, and Belgium, as well as with leading internationalist private bankers
in those countries. Montagu Norman, governor of the Bank of England from
1920-44, enjoyed a long and close personal friendship with Strong as well as
ideological alliance. Their joint commitment to restore the gold standard in
Europe and so to bring about a return to the "international financial
normalcy" of the prewar years was well documented. Norman recognized that
the impairment of Britain's financial hegemony meant that, to accomplish
postwar economic reconstruction that would preserve British privilege,
Europe would "need the active cooperation of our friends in the United
States".

Like other New York bankers, Strong perceived World War I as an opportunity
to expand US participation in international finance, allowing New York to
move toward coveted international-finance-center status to rival London's
historical preeminence, through the development of a commercial paper
market, or bankers' acceptances, breaking London's long monopoly. The
Federal Reserve Act of 1913 permitted the Federal Reserve Banks to buy, or
rediscount, such paper. This allowed US banks in New York to play an
increasingly central role in international finance in competition with the
London market.

Herbert Hoover, after losing his second-term US presidential election to
Franklin D Roosevelt as a result of the 1929 crash, criticized Strong as "a
mental annex to Europe", and blamed Strong's internationalist commitment to
facilitating Europe's postwar economic recovery for the US stock-market
crash of 1929 and the subsequent Great Depression that robbed Hoover of a
second term. Europe's return to the gold standard, with Britain's insistence
on what Hoover termed a "fictitious rate" of US$4.86 to the pound sterling,
required Strong to expand US credit by keeping the discount rate
unrealistically low and to manipulate the Fed's open market operations to
keep US interest rate low to ease market pressures on the overvalued pound
sterling. Hoover, with justification, ascribed Strong's internationalist
policies to what he viewed as the malign persuasions of Norman and other
European central bankers, especially Hjalmar Schacht of the Reichsbank and
Charles Rist of the Bank of France. From the mid-1920s onward, the US
experienced credit-pushed inflation, which fueled the stock-market bubble
that finally collapsed in 1929.

Within the Federal Reserve System, Strong's low-rate policies of the
mid-1920s also provoked substantial regional opposition, particularly from
Midwestern and agricultural elements, who generally endorsed Hoover's
subsequent critical analysis. Throughout the 1920s, two of the Federal
Reserve Board's directors, Adolph C Miller, a professional economist, and
Charles S Hamlin, perennially disapproved of the degree to which they
believed Strong subordinated domestic to international considerations.

The fairness of Hoover's allegation is subject to debate, but the fact that
there was a divergence of priority between the White House and the Fed is
beyond dispute, as is the fact that what is good for the international
financial system may not always be good for a national economy. This is
evidenced today by the collapse of one economy after another under the
current international finance architecture that all central banks support
instinctively out of a sense of institutional solidarity.

The issue of government control over foreign loans also brought the Fed,
dominated by Strong, into direct conflict with Hoover when the latter was
secretary of commerce. Hoover believed that the US government should have
right of approval on foreign loans based on national-interest considerations
and that the proceeds of US loans should be spent on US goods and services.
Strong opposed all such restrictions as undesirable government intervention
in free trade and international finance.

In July and August 1927, Strong, despite ominous data on mounting market
speculation and inflation, pushed the Fed to lower the discount rate from 4
to 3 percent to relieve market pressures again on the overvalued British
pound. In July 1927, the central bankers of Great Britain, the United
States, France, and Weimar Germany met on Long Island in the US to discuss
means of increasing Britain's gold reserves and stabilizing the European
currency situation. Strong's reduction of the discount rate and purchase of
12 million pound sterling, for which he paid the Bank of England in gold,
appeared to come directly from that meeting. One of the French bankers in
attendance, Charles Rist, reported that Strong said that US authorities
would reduce the discount rate as "un petit coup de whisky for the stock
exchange". Strong pushed this reduction through the Fed despite strong
opposition from Miller and fellow board member James McDougal of the Chicago
Fed, who represented Midwestern bankers, who generally did not share New
York's internationalist preoccupation.

Frank Altschul, partner in the New York branch of the transnational
investment bank Lazard Freres, told Emile Moreau, the governor of the Bank
of France, that "the reasons given by Mr Strong as justification for the
reduction in the discount rate are being taken seriously by no one, and that
everyone in the United States is convinced that Mr Strong wanted to aid Mr
Norman by supporting the pound". Other correspondence in Strong's own files
suggests that he was giving priority to international monetary conditions
rather than to US export needs, contrary to his public arguments. Writing to
Norman, who praised his handling of the affair as "masterly", Strong
described the US discount rate reduction as "our year's contribution to
reconstruction". The Fed's ease in 1927 forced money to flow not into the
overheated real economy, which was unable to absorb further investment, but
into the speculative financial market, which led to the crash of 1929.
Strong died in October 1928, one year before the crash, and was spared the
pain of having to see the devastating results of his internationalist
policies.

Scholarly debate still continues as to whether Strong's effort to facilitate
European economic reconstruction compromised the US domestic economy and, in
particular, led him to subordinate US monetary policies to internationalist
demands. There is, however, little disagreement that the overall monetary
strategy of European central banks had been misguided in its reliance on the
restoration of the gold standard. Critics suggest that the deep commitment
of Strong, Norman, and other international bankers to returning the pound,
the mark, and other major European currencies to the gold standard at overly
high parities, which they were then forced to maintain at all costs,
including indifference to deflation, had the effect of undercutting Europe's
postwar economic recovery. Not only did Strong and his fellow central
bankers through their monetary policies contribute to the Great Depression,
but their continuing fixation to gold also acted as a straitjacket that in
effect precluded expansionist counter-cyclical measures.

The inflexibility of the gold standard and the central bankers'
determination to defend their national currencies' convertibility into gold
at almost any cost drastically limited the options available to them when
responding to the global crisis. This picture fits the situation of the
fixed-exchange-rates regime that produced recurring financial crises in the
1990s and that has yet to run its full course. In 1927, Strong's
unconditional support of the gold standard, which emphasized the financial
predominance of the United States, with the largest holdings of gold in the
world, exacerbated nascent international economic problems. In similar ways,
dollar hegemony does the same damage to the global economy today. Just as
the international gold standard itself was one of the major factors
underlying and exacerbating the Great Depression that followed the 1929
crash, since the conditions that had sustained it before the war no longer
existed, the fixed-exchange-rates system set up by the Bretton Woods regime
after World War II will cause a total collapse of the current international
financial architecture with equally tragic outcomes.

The nature of and constraints on US internationalism after World War I had
parallels in US internationalism after World War II and in US globalization
after the Cold War. Hoover bitterly charged Strong with reckless placement
of the interests of the international financial system ahead of US national
interest and domestic concerns. Strong sincerely believed his support for
European currency stabilization also promoted the best interests of the
United States, as post-Cold War neo-liberal market fundamentalists sincerely
believe its promotion enhances the US national interest. Unfortunately,
sincerity is not a vaccine against falsehood.

Strong argued repeatedly that volatile exchange rates, especially when the
dollar was at a premium against other currencies, made it difficult for US
exporters to price their goods competitively. As he had done during the war,
on numerous later occasions, Strong also stressed the need to prevent an
influx of gold into the United States and consequent domestic inflation, by
the US making loans to Europe, pursuing lenient debt policies, and accepting
European imports on generous terms. Strong never questioned the parities set
for the mark and the pound sterling. He merely accepted that returning the
pound to gold at prewar exchange rates required British deflation and US
efforts to use lower US interest rates to alleviate market pressures on
sterling. Like Fed chairman Paul Volcker in the 1980s, but unlike Treasury
secretary Robert Rubin in the 1990s, Strong mistook a cheap dollar as
serving the national interest, while Rubin understood correctly that a
strong dollar is in the national interest.

When Norman sent him a copy of John Maynard Keynes' Tract on Monetary
Reform, Strong commented "that some of his [Keynes'] conclusions are
thoroughly unwarranted and show a great lack of knowledge of American
affairs and of the Federal Reserve System". Within a decade, Keynes became
the most influential economist in modern history.

The major flaw in the European effort for post-World War I economic
reconstruction was its attempt to reconstruct the past through its
attachment to the gold standard, with little vision of a new future. The
democratic governments of the moneyed class that inherited power from the
fall of monarchies did not fully comprehend the implication of the
disappearance of the monarch as a ruler, whose financial architecture they
tried to continue for the benefit of their bourgeois class. The broadening
of the political franchise in most European countries after the war had made
it far more difficult for governments and central bankers to resist
electoral pressures for increased social spending and the demand for ample
liquidity with low interest rates, as well as high tolerance for moderate
inflation, regardless of their impact on the international financial
architecture. The Fed, despite its claim of independence from politics, has
never been free of US presidential-election politics since its founding.
Shortly before his untimely death, Strong took comfort in his belief that
the reconstruction of Europe was virtually completed and his
internationalist policies had been successful in preserving world peace.
Within a decade of his death, the whole world was aflame with World War II.

Central bankers around the world nowadays may not know about Marriner S
Eccles, the president of tiny First National Bank of Ogden, Utah, who became
nationally famous through his successful effort to save his bank from
collapse in the late summer of 1931. Eccles defused the panic of depositors
outside of his bank by announcing that his bank would stay open until all
depositors were paid. He also instructed his tellers to count every small
bill and check every signature to slow the prospect of his bank running out
of cash. A mostly empty armored car carrying all First National's puny
reserves from the Federal Reserve Bank in Salt Lake City arrived
conspicuously while Eccles announced that there was plenty of money left
where it came from, which was true except for the fact that none of it
belonged to First National. The crowd's confidence in First National was
re-established and Eccles' bank survived on a misleading statement that
would have been considered criminally fraudulent in a vigorous
investigation.

Eccles was a quintessential frontier entrepreneur of the US West and
politically a Western Republican. Beginning with timber and sawmill
operations, his family's initial capital came in the form of labor and raw
material. He learned from his father, an illiterate who immigrated from
Scotland in 1860, that the way to remain free was to avoid becoming indebted
to the Northeastern banks, which were in turn much indebted to British
capital. Among Eccles' assets of railroads, mines, construction companies
and farm businesses was a chain of local banks in the West. Immersed in an
atmosphere of US populism that was critical of unregulated capitalism and
Northeastern "money trusts", Eccles viewed himself as an ethical capitalist
who succeeded through his hard works and wits, free of oppression from big
business trusts and government interference. A Mormon polygamist, the elder
Eccles had two wives and 21 children, which provided him with considerable
human capital in the labor-short West. The young Eccles, at age 22 and with
only a high-school education, had to assume the responsibilities of his
father when the latter died suddenly. The Eccles construction company built
the gigantic Boulder Dam, begun in 1931 and completed in 1936, renamed from
Hoover Dam in the midst of the Depression and re-renamed Hoover Dam in 1941.

The market collapse of 1929 caught the inner-directed Eccles in a state of
bewilderment and despair. Through eclectic reading based on common sense, he
came to a startling awareness: that despite his father's conservative
Scottish teachings on the importance of saving, individuals and companies
and even banks, ever optimistic in their own future, tended to contribute to
aggregate supply expansion to end up with overcapacity through excessive
savings for investment. It was obvious to Eccles that the problem of the
1930s was that too much money had been channeled into savings and too little
into spending. This new awareness, like Saint Paul's vision on the way to
Damascus, led Eccles to a radical conclusion that contradicted all that his
conservative father had taught him.

>From direct experience, Eccles realized that bankers like himself, by doing
what seemed sound on an individual basis, by calling in loans and refusing
new lending, only contributed to the financial crisis. He saw from direct
experience the evidence of market failure. He concluded that to get out of
the depression, government intervention, something he had been taught was
evil, was necessary to place purchasing power in the hands of the public
which, together with the economy and the financial system, was in dire need
of it. In the industrial age, the maldistribution (excessively unequal) of
income and the excessive savings for capital investment always lead to the
masses exhausting their purchasing power, unable to sustain the benefits of
mass production that such savings brought.

Mass consumption is required by mass production. But mass consumption
requires a fair distribution of new wealth as it is currently produced (not
accumulated wealth) to provide mass purchasing power. By denying the masses
necessary purchasing power, capital denies itself of the very demand that
would justify its investment in new production. Credit can extend purchasing
power but only until the credit runs out, which would soon occur without the
support of adequate income.

Eccles' epiphany was his realization that Calvinist thrifty individualism
does not work in a modern industrial economy. Eccles rejected the view of
his fellow bankers that depressions are natural phenomena and that in the
long run the destruction they wreak are healthy and that government
intervention only postpones the needed elimination of the weak and unfit,
thereby in the long run weakening the whole system through the support for
the survival of the unfit. Eccles pragmatically saw that money is not
neutral, and it has an economic function independent of ownership. Money
serves a social purpose if it circulates through transactions and
investments, and is socially harmful if it is hoarded in idle savings, no
matter who owns it. Liquidity is the only measure of the usefulness of
money. The penchant for capital preservation on the part of those who have
surplus money has a natural tendency to reduce liquidity in times of
deflation and economic slowdown.

The solution is to start the money flowing again by directing the money not
toward those who already have a surplus of it in relation to their
consumptive needs, but to those who have not enough. Giving more money to
those who already have too much would take more money out of circulation
into idle savings and prolong the depression. The solution is to give money
to the most needy, who will spend it immediately. The only institution that
can do this transfer of money for the good of the system is the federal
government, which can issue or borrow money backed by the full faith and
credit of the nation, and put it in the hands of the masses, who would spend
it immediately, thus creating needed demand. Transfer of money through
employment is not the same of transfer of wealth. Deficit financing of
fiscal expenditure is the only way to inject money and improve liquidity in
a stalled economy. Thus Eccles promoted a limited war on poverty and
unemployment, not on moral but on utilitarian grounds.

Now, the interesting thing is that Eccles, who never attended university nor
studied economics formally, articulated his pragmatic conclusions in
speeches a good three years before Keynes wrote his epoch-making The General
Theory of Employment, Interest, and Money (1936). John Galbraith in his
Money: Whence It Came, Where It Went (1975) explained: "The effect of The
General Theory was to legitimize ideas that were in circulation." With
scientific logic and precision, Keynes made crackpot ideas like those
promoted by Eccles respectable in learned circles, even though Keynes
himself was considered a crackpot by New York Fed president Benjamin Strong
as late as 1927.

In one single testimony in 1933, Eccles in his salt-of-the-earth manner
convinced an eager US Congress of his new economic principle and outlined a
specific agenda for how the federal government could save the economy by
spending more money on unemployment relief, public works, agricultural
allotment, farm-mortgage refinancing, settlement of foreign war debts, etc.
Eccles also proposed structural systemic reform for achieving long-term
stability: federal insurance for bank deposits, minimum wage standards,
compulsory retirement pension schemes, in fact, the core program that came
to be known as the New Deal. Eccles also helped launched the era of liberal
credits, through government guarantee mortgages and interest subsidies,
making middle-class and low-income home ownership a reality. It was not a
plan to do away with capitalism as much as it was to save capitalism from
itself.

Eccles also rescued the Federal Reserve System from institutional disgrace.
For this, the Fed building in Washington has since been named after him. The
evolution of political economy models in the early 1930s, a crucial period
of change in the supervision and regulation of the financial sector, can be
clearly seen in the opposing policies of the Hoover and Roosevelt
administrations. It resulted in a change of focus in the Federal Reserve
Board from orthodox sound money initiatives to a heterodox Keynesian
outlook, and the push toward centralizing the monetary powers of the Federal
Reserve System at the Board, away from the regional Federal Reserve Banks.

With support from Roosevelt, despite bitter opposition from big money center
banks, Eccles personally designed the legislation that reformed the Federal
Reserve System, the central bank of the United States founded by Congress in
1913 (Glass-Owen Federal Reserve Act), to provide the nation with a safer,
more flexible, and more stable monetary and financial/banking system. An
important founding objective of the original Federal Reserve System had been
to fight inflation by controlling the money supply through setting the
short-term interest rate, known as the Fed Funds Rate (FFR), and bank
reserve ratios. By 1915, the Fed had regulatory control over half of the
nation's banking capital and by 1928 about 80 percent. The Banking Act of
1935 designed by Eccles modified the Federal Reserve Act by stripping the 12
district Federal Reserve Banks of their autonomous privileges and veto
powers and concentrated monetary policy power in the seven-member Board of
Governors in Washington. Eccles served as chairman for 14 years while he
continued to function as an inner-circle policy maker in the White House.
The Fed under Eccles had no pretension of political independence. Galbraith
described the Fed under Eccles as "the center of Keynesian evangelism in
Washington".

The term "monetary policy" as used by the Fed nowadays refers to the actions
undertaken by a central bank to influence the availability and cost of money
and credit to help promote national economic goals. The Federal Reserve Act
of 1913 gave the Federal Reserve responsibility for setting monetary policy.

The Federal Reserve controls the three tools of monetary policy: open market
operations, the discount rate, and bank reserve requirements. The Board of
Governors of the Federal Reserve System is responsible for the discount rate
and bank reserve requirements, and the Federal Open Market Committee (FOMC)
is responsible for open market operations, with transactions handled by the
New York Fed.

Bank reserve requirements are the amount of funds that a depository
institution must hold in reserve against specified deposit liabilities.
Within limits specified by law, the Board of Governors has sole authority
over changes in reserve requirements. Depository institutions must hold
reserves in the form of vault cash or deposits with Federal Reserve Banks.
The dollar amount of a depository institution's reserve requirement is
determined by applying the reserve ratios specified in the Federal Reserve
Board's Regulation D to an institution's reservable liabilities. Reservable
liabilities consist of net transaction accounts, non-personal time deposits,
and eurocurrency liabilities. Since 1992, non-personal time deposits and
eurocurrency liabilities have had a reserve ratio of zero. The reserve ratio
on net transaction accounts depends on the amount of net transaction
accounts at the depository institution. The Garn-St Germain Act of 1982
exempted the first $2 million of reservable liabilities from reserve
requirements. This "exemption amount" is adjusted each year according to a
formula specified by the act. The amount of net transaction accounts subject
to a reserve requirement ratio of 3 percent was set under the Monetary
Control Act of 1980 at $25 million. This "low reserve tranche" is also
adjusted each year. Net transaction accounts in excess of the low reserve
tranche are currently reservable at 10 percent.

Using these three tools, the Federal Reserve influences the demand for, and
supply of, balances that depository institutions hold at Federal Reserve
Banks and in this way alters the FFR. The FFR is the interest rate at which
depository institutions lend balances at the Federal Reserve to other
depository institutions overnight. Changes in the FFR trigger a chain of
market events that affect other short-term interest rates, foreign-exchange
rates, long-term interest rates, the amount of money and credit, and,
ultimately, a range of economic variables, including employment, output, and
prices of goods and services.

The FOMC consists of 12 members, comprising the seven members of the Board
of Governors of the Federal Reserve System; the president of the Federal
Reserve Bank of New York; and four of the remaining 11 Reserve Bank
presidents, who serve one-year terms on a rotating basis. The rotating seats
are filled from the following four groups of Banks, one Bank president from
each group: Boston, Philadelphia, and Richmond; Cleveland and Chicago;
Atlanta, St Louis, and Dallas; and Minneapolis, Kansas City, and San
Francisco. Non-voting Reserve Bank presidents attend the meetings of the
committee, participate in the discussions, and contribute to the committee's
assessment of the economy and policy options.

The FOMC holds eight regularly scheduled meetings per year. At these
meetings, the committee reviews economic and financial conditions,
determines the appropriate stance of monetary policy, and assesses the risks
to the economic outlook, based on forecasts prepared by the Fed staff that
are kept secret for five years. The committee's policy decisions are
undertaken to foster the long-run objectives of price stability and
sustainable economic growth, the definitions of which are constantly
affected by the latest theories of monetary economics.

To this day, using the tools of monetary policy, the Fed affects the volume
of money and credit and their price - interest rates. In this way, it
influences employment, output, and the general level of prices. Commercial
banks, despite their initial opposition to the National Banking Act of 1863,
enacted during the Civil War, have benefited from double-layer protection:
the Federal Deposit Insurance Corp (FDIC) and Fed discount lending.
Non-interest-bearing checking accounts were another subsidy for the
commercial banks prescribed by law at the expense of depositors. The
Glass-Steagall Act of 1933, which was finally repealed in 1999 after almost
seven decades, separated investment banking from commercial banking and
forbade banks from participating in a whole range of other financial
services. The repeal of Glass-Steagall has been identified as a key factor
behind current bank scandals of conflicts of interest and their unsavory
role in widespread corporate fraud.

The Federal Reserve Act of 1913 defines the goals of monetary policy. It
specifies that, in conducting monetary policy, the Fed and its FOMC should
seek "to promote effectively the goals of maximum employment, stable prices,
and moderate long-term interest rates". In the past three decades, with the
ascendency of monetarism, the central bank has increasingly focused
primarily on achieving price stability by an interest-rate policy that
allows unemployment to fluctuate. A sound money bias is now justified by the
claim that a stable level of prices is the condition most conducive to
maximum sustainable output and employment and to moderate long-term interest
rates; in such circumstances, the prices of goods, materials, and services
are undistorted by inflation and thus can serve as clearer signals and
guides for the efficient allocation of resources. This is despite the fact
that the boom-and-bust business cycle continues to plaque the economy. Also,
a background of stable prices is thought to encourage saving and,
indirectly, capital formation because it prevents the erosion of asset
values by unanticipated inflation. This view of neglect-on-demand management
has led to the precarious situation of overcapacity and speculative bubble
we are facing today.

The concept of a natural rate of unemployment is a key contribution by
monetarism to modern macroeconomics. Its use originated with Milton
Friedman's 1968 Presidential Address to the American Economic Association in
which he argued that there is no long-run tradeoff between inflation and
unemployment: as the economy adjusts to any average rate of inflation,
unemployment returns to its "natural" rate. Higher inflation brings no
benefit in terms of lower average unemployment, nor does lower inflation
involve any cost in terms of higher average unemployment. Instead, the
microeconomic structure of labor markets and household and firm decisions
affecting labor supply and demand determine the natural rate of
unemployment. If monetary policy cannot affect the natural rate, then its
appropriate role is to control inflation and, in the short run, help
stabilize the economy around the natural rate. Doing so would be consistent
with maintaining low and stable inflation.

A second important unemployment rate generally accepted by monetarist
economists is the "Non-Accelerating Inflation Rate of Unemployment", or
NAIRU. This is the unemployment rate consistent with maintaining stable
inflation. According to standard neo-classical orthodox macroeconomic theory
enshrined in most undergraduate textbooks of economics, inflation will tend
to rise if the unemployment rate falls below the natural rate. Conversely,
when the unemployment rate rises above the natural rate, inflation tends to
fall. Thus, the natural rate and the NAIRU are often viewed as two names for
the same economic phenomenon, providing an important benchmark for gauging
the state of the business cycle, the outlook for future inflation, and the
appropriate stance of monetary policy, identifying full employment and
inflation are partners in economic crime, based on the assumption that the
value of humans is inversely proportional to the value of money. In other
words, money exists not to serve the welfare of people, but rather, people
must be sacrificed to serve the stability of money. This explains why Paul
Volcker, the US central banker widely credited with ending inflation in the
early 1980s by administering wholesale financial bloodletting on the US
economy, quipped lightheartedly that "central bankers are brought up pulling
legs off of ants".

While the two terms are often viewed as synonymous, the natural rate is the
unemployment rate that would be observed once short-run cyclical factors
have played themselves out. Because wages and prices adjust sluggishly for
social or legal reasons, the natural rate can be viewed as the unemployment
rate when wages have had time to adjust to balance labor demand and supply.
The NAIRU is the unemployment rate consistent with steady inflation in the
near term, say, over the next 12 months.

The average long-run unemployment rate measured in the United States since
1961 is 6.09 percent, and during the 1980s and early 1990s, most economists
placed the natural rate quite near that, in the 6-6.5 percent range. NAIRU
has been subject to much criticism, yet it continues to appear in policy
discussions. NAIRU or the natural rate of unemployment would be less obscene
if the unemployment were not concentrated on the same group of people. But
structural unemployment tends to create a permanent unemployed class,
institutionalizing social injustice as a structural aspect of the economy.

The central bank, by adopting the natural rate of unemployment or NAIRU as a
component of monetary policy, is condemning 6 percent of the labor force to
perpetual involuntary unemployment. It seems self-evident that the
population has a natural right not to be forced to be part of this 6 percent
of unfortunate souls in the workforce. A natural rate of unemployment flies
in the face of US political culture. The "inalienable rights" of all people
(not some people) to life, liberty and the pursuit of happiness is a concept
not compatible with chronic involuntary unemployment caused by government
policy, aimed at protecting the value of money at the expense of a
particular segment of the working class. One is reminded of the Declaration
of Indepence: "... to secure these rights, governments [of which the
privately owned central bank claims to be part] are instituted among men,
deriving their just powers from the consent of the governed, that whenever
any form of government becomes destructive of these ends, it is the right of
the people to alter or to abolish it ..."

No worker has given any central bank his or her consent to be involuntarily
unemployed so that the value of money can be preserved. The right to gainful
employment in an industrial society where employment opportunities are
systemically determined comes from this simple and direct relationship
between the governed and the government. It is as sacrosanct as the right to
vote. Governments that cannot guarantee full employment simply cannot
legitimately claim the right to govern.

Full employment being defined as a level with 4 percent structural
unemployment is an official policy of the Fed, as defined by the Full
Employment and Balanced Growth Act of 1978, known as the Humphrey-Hawkins
Act. The act introduces the term "full employment" as a policy goal,
although the content of the bill had been watered down before passage by
snake-oil economics to consider 4 percent unemployment as structural; and
now full employment is defined as at or above that level, currently around 6
percent. Any level near or below that is deemed economically inconsistent,
due to its impact on inflation (causing wages to rise! - a big no-no), thus
only increasing unemployment down the road. Tragically, aside from being
morally offensive, this definition of full employment is not even good
economics. It distorts real deflation as nominal low inflation and widens
the gap between nominal interest rate and real interest rate, allowing
demand constantly to fall behind supply.

Humphrey-Hawkins has been described as the last legislative gasp of
Keynesianism's doomed effort by liberal senator Hubert Humphrey to refocus
on an official policy against unemployment. Alas, most of the progressive
content of the law had been thoroughly vacated before passage. The one
substantive reform provision: requiring the Fed to make public its annual
target range for growth in the three monetary aggregates: the three Ms,
namely M1 = currency in circulation, commercial bank demand deposits, NOW
(negotiable order of withdrawal) and ATS (auto transfer from savings),
credit-union share drafts, mutual-savings-bank demand deposits, non-bank
traveler's checks; M2 = M1 plus overnight repurchase agreements issued by
commercial banks, overnight eurodollars, savings accounts, time deposits
under $100,000, money market mutual shares; M3 = M2 plus time deposits over
$100,000, term repo agreements.

In 2000, when the Humphrey-Hawkins legislation requiring the Fed to set
target ranges for money-supply growth expired, the Fed announced that it was
no longer setting such targets, because money-supply growth does not provide
a useful benchmark for the conduct of monetary policy. However, the Fed said
too that "the FOMC believes that the behavior of money and credit will
continue to have value for gauging economic and financial conditions.
Moreover, M2, adjusted for changes in the price level, remains a component
of the Index of Leading Indicators, which some market analysts use to
forecast economic recessions and recoveries."

The Fed chairman is required to testify before both the House and the Senate
to explain these goals and any deviant from the targets. Thus monetarism has
now gained center stage, through the televised hearing on current chairman
Alan Greenspan's testimony, riding on the legislative carcass of fading
Keynesianism. Twice a year, the nation, and indeed the world, holds its
breath waiting for the cryptic deliberations of Greenspan on his views on
where the economy had been going and why and where he wants it to go. This
ritual of esoteric transparence is neutralized by the cat-and-mouse game
that the FOMC does with the market with its closely guarded secret on its
FFR target until 2:12 pm on the day of its meeting. And its staff forecast
on the economy on which the FFR target is derived is kept secret for a
period of five years. It is a strange way to shoot for market stability, by
institutionalizing policy surprises and keeping forecast analysis secret.

The US economy now sits on top of the pyramid of a globalized economy
wielding the fearsome sword of dollar hegemony, sucking wealth from the rest
of the world. Economic policy in the United States exerts a major influence
on production, employment, and prices worldwide in what Greenspan calls US
finance hegemony. The dollar, a fiat currency of the world's most heavily
indebted nation that is most used in international transactions, constitutes
more than half of other countries' official foreign-exchange reserves. A
handful of US banks abroad and foreign banks in the United States monopolize
a globalized international financial market. The policies and activities of
the Fed control the globalized international economy. Thus, in deciding on
the appropriate monetary policy for achieving basic economic goals, the Fed
Board of Governors and the FOMC consider the record of US international
transactions, movements in foreign-exchange rates, and other international
economic developments, including war and economic sanctions, which are
really economic warfare. And in the area of bank supervision and regulation,
innovations in international banking require continual assessments of and
modifications in the Fed's orientation, procedures, and regulations. The
development of structured finance and the Fed's reluctance to regulate
needed disclosure and management of risk associated with derivatives
trading, particularly over-the-counter (OTC) derivatives, which are traded
off exchanges directly between counterparties, has made transparency an
illusion. Not only is the economy distorted by a debt bubble, it is also
distorted by an invisible bubble.

Not only do Fed policies shape and get shaped by international developments,
the US central bank also participates directly in international markets,
being both market regulator and market participant, with inevitable conflict
of interest. The Fed undertakes foreign-exchange transactions in cooperation
with the US Treasury, compromising its "independence" in deference to
national-security concerns. These transactions, and similar ones by foreign
central banks involving dollars, may be facilitated by reciprocal currency
(swap) arrangements that have been established between the Fed and the
central banks of other countries.

US monetary policy actions influence exchange rates directly. Thus, the
dollar's foreign-exchange value is one of the channels through which US
monetary policy affects the US economy. In theory, when Fed actions raise US
interest rates, the foreign-exchange value of the dollar should rise. An
increase in the foreign-exchange value of the dollar, in turn, would raise
the foreign price of US export goods traded on world markets and lower the
price of goods imported into the US. These developments could lower output
and price levels in the US economy. This may lead to a US trade deficit. But
low-price imports would help reduce US inflation, allowing the Fed to lower
interest rates. If the low-cost import is used as part of a US product, it
may lower the export price of that US-made product, neutralizing the adverse
impact of a strong dollar.

An increase in interest rates in a foreign country, in contrast, could raise
worldwide demand for assets denominated in that country's currency and
thereby reduce the dollar's value in terms of that currency. US output and
price levels would tend to increase in directions just opposite of when US
interest rates rise. But high US interest rates attract investment into US
financial assets, producing a capital account surplus.

Therefore, in formulating monetary policy, the Board of Governors and the
FOMC draw upon information about and analysis of international as well as US
domestic influences. Changes in public policies or in economic conditions
abroad and movements in international variables that affect the US economy,
such as exchange rates, must be evaluated in assessing the stance of US
monetary policy. The Fed also works with other agencies of the US government
to conduct international financial policy, participates in various
international organizations and forums, and is in almost continuous contact
with other central banks on subjects of mutual concern, all to maintain what
Greenspan proudly calls US financial hegemony. In other words, the free
market is a mere figment of the conservatives' imagination and a propaganda
slogan of neo-liberals. Central banking is the biggest private financial
monopoly with governmental power in the world economy.

In the 1980s, recognizing their growing economic interdependence, the United
States and the other major industrial countries intensified their efforts to
consult and cooperate on macroeconomic policies. The Plaza Accord in 1985
forced Japan to raise the value the yen to reduce its trade surplus with the
US. At the 1986 Tokyo Economic Summit, formal procedures to improve the
coordination of policies and multilateral surveillance of economic
performance were agreed upon among the Group of Seven (G7) industrialized
nations. The Fed works with the US Treasury in coordinating international
policy, particularly when, as has been the norm since the late 1970s, they
intervene together in currency markets to influence the external value of
the dollar.

Using the forum provided by the Bank for International Settlements (BIS) in
Basel, Switzerland, the Fed works with representatives of the central banks
of other countries on mutual concerns regarding monetary policy,
international financial markets, banking supervision and regulation, and
payments systems. (The chairman of the Board of Governors also represents
the US central bank on the Board of Directors of the BIS.) Representatives
of the Federal Reserve participate in the activities of the International
Monetary Fund (IMF), on which the US has a controlling vote, discuss
macroeconomic, financial-market, and structural issues with representatives
of other industrial countries at the Organization for Economic Cooperation
and Development (OECD) in Paris, and work with central-bank officials of
Western Hemisphere countries at meetings such as that of the Governors of
Central Banks of the American Continent. The dubious policies of the IMF
around the world as an international lender of last resort to the world's
troubled central banks in deep financial crisis have been essentially
dictated by the United States.

The Fed has conducted foreign-currency operations, the buying and selling of
dollars in exchange for foreign currency, for customers since the 1950s and
for its own account since 1962. These operations are directed by the FOMC,
acting in close cooperation with the US Treasury, which has overall
responsibility for US international financial policy. The manager of the
System Open Market Account at the Federal Reserve Bank of New York acts as
the agent for both the FOMC and the Treasury in carrying out
foreign-currency operations.

The purpose of Federal Reserve foreign-currency operations has evolved in
response to changes in the international monetary system. The most important
of these changes was the transition in the 1970s from the Bretton Woods
system of fixed exchange rates to a system of flexible exchange rates for
the dollar in terms of other countries' currencies. Under the latter system,
while the main aim of Fed foreign-currency operations has been to counter
disorderly conditions in exchange markets through the purchase or sale of
foreign currencies (called intervention operations), primarily in the New
York market, the net effect has often been high market volatility. During
some episodes of downward pressure on the foreign-exchange value of the
dollar, the Fed has purchased dollars (sold foreign currency) and has
thereby absorbed some of the selling pressure on the dollar. Similarly, the
Fed may sell dollars (purchase foreign currency) to counter upward pressure
on the dollar's foreign-exchange value. The Federal Reserve Bank of New York
also carries out transactions in the US foreign-exchange market as an agent
for foreign monetary authorities.

Intervention operations involving dollars could affect the supply of
reserves in the US depository system. A purchase of foreign currency by the
Fed with newly created dollars, for instance, would increase the supply of
reserves. In practice, however, such operations are not allowed to alter the
supply of monetary reserves available to US depository institutions. That
is, interventions are "sterilized" through open market operations so that
they do not lead to a change in the market for domestic monetary reserves
different from that which would have occurred in the absence of
intervention.

The New Deal did not become fully Keynesian until after the 1937 recession,
which most economists have since laid blame on Eccles' Fed policy of
doubling the reserve requirement for commercial banks from 12.5 percent to
25 percent at the same time as the executive branch was tightening its
fiscal policy. Gaining confidence from the recovery of 1935, Eccles
permitted the Fed's institutional penchant to be activist in monetary
policy. It was an error late in his career that would tarnish his earlier
reputation as a New Dealer. The 1937 recession would re-establish
monetary-policy passivity for the Fed for decades to come, until the
chairmanship of Paul Volcker and now of Alan Greenspan. The focus on
interest rates instead of stable money supply to stimulate aggregate demand
became the Fed's operational mode for decades after.

The liberal economists of the Kennedy "New Economics" of the 1960s were in
tune with the political wind of their time, that fiscal-policy-engineered
government deficits were considered therapeutic to a slowing economy.
Expansionist budgetary shortfalls can be compensated by increased economic
activities that enlarge the revenue base. The pie gets bigger faster than
the shrinking slice of tax take. At its peak, the New Economics managed to
bring unemployment down to 3.5 percent, from 7 percent when president John F
Kennedy took office, and sustained an uninterrupted economic expansion for
106 consecutive months.

However, this focus by the Fed on interest rates and credit conditions to
accommodate the fiscal policies of the New Economics of Kennedy, instead of
a focus on stable value of money and gradually expanding money supply, was
attacked by Milton Friedman and his monetarist colleagues of the Chicago
School. Besides attacking Keynesian fiscal policies as producing only
ephemeral results, Friedman asserted that the only effective government
influence over the private sector of the economy was its control of money.
The Fed's short-term manipulation of the money supply was criticized as
consistently destabilizing and damaging. Yet not until mid-1960s was
Friedman taken seriously, when president Lyndon Johnson's Vietnam War
spending was sinking the New Economics. The unraveling of the New Economics
that began in 1968 was caused by the political system's unwillingness to
follow Keynesian rules in good times.

Galbraith concluded that "Keynesian policy is unavailable for dampening
demand if taxes cannot be increased except under the force majeur of war and
public expenditure cannot be decreased for any reason". The failure of
fiscal policy to slow an overheated economy left it to monetary policy to do
its nasty chore.

Friedman emerged as the intellectual leader to challenge three decades of
Keynesian supremacy. Wall Street analysts, following Friedman's theory, find
the weekly fluctuation of M1 a more reliable indicator of economic swings
than the slow-changing federal budget. Friedman's 1976 Nobel Price firmly
enthroned the rise of monetarism as a mainstream concept, validated
temporarily by recent events.

In 1966, the consumer price index (CPI) increased by more than 3 percent,
the steepest in 15 years. By 1969, the annual price increase was above 6
percent. Even president Richard Nixon's brief wage-price controls failed to
bring inflation below 3 percent, despite price-induced shortages in many
industries, including toilet seats for restrooms in new office buildings.
The Cold War was still going strong and there was no globalized trade to
supply low-price imports and the Vietnam War was feeding inflation at home
as well as exporting it to the non-communist world. By 1973, the CPI rose
8.8 percent and the Organization of Petroleum Exporting Countries (OPEC)
embargo and price hikes pushed the 1974 CPI increase to 12.2 percent. The
Fed tightened money and promptly produced a recession that lasted five
months, with unemployment jumping to 9.1 percent and gross domestic product
(GDP) shrinking by 15 percent. But inflation kept roaring toward double
digits throughout the recession. A fundamental disconnect now confronted
Keynesian theory - inflation and unemployment were moving in the same
direction, which was not supposed to happen. There was plenty of blame to go
around for the inflation, but none of it explained the high unemployment.

Friedman offered a simple and plausible alternative: he blamed the Fed for
the inflation when it eased monetary policy over time and for the
unemployment when the Fed tightened abruptly. A new term, "stagflation",
came into common use. Friedman's slogans "money matters" and "inflation is
everywhere and anywhere a monetary phenomenon" became headlines in the
financial and even popular press. Friedman advocated a fixed expansion of M1
at 3 percent long-term to moderate the runaway business cycle overstimulated
by Keynesian measures.

At its base, Friedman is against government intervention not merely because
it may be ineffective, but because it is immoral. To him, the Fed has
forgotten its institutional role as a stabilizer of the value of money, in a
quest for power and influence. A strict-money rule, such as the later Taylor
rule, would restore sanity to the Fed. The rule proposed by John Taylor, now
Treasury undersecretary, is that if inflation is 1 percentage point above
the Fed's goal, rates should rise by 1.5 percentage points, and if an
economy's total output is 1 percentage point below its full capacity, rates
should fall by half a percentage point.

Friedman's criticism of the Fed as protector of its constituent - the
commercial banks - is populist but his willingness to allow the market to
impose high interest rates and to allocate credit only to the creditworthy
is biased toward the rich. It is the syndrome of the banker who offers
umbrellas only when it is not raining. To carry Friedman's theory to its
logical conclusion, there would be no need for a central bank in truly free
financial markets, while the need for a national bank might be argued on
nationalist political grounds.

As engineered by Eccles, the independence of the Fed is a peculiar, uniquely
American institution. The institutional conflict between the Treasury and an
"independent" Fed has yet to be resolved. Nixon accused Fed chairman William
McChesney Martin of costing him the election loss to Kennedy, not without
reason. As president finally in 1968, Nixon was to consider himself a
Keynesian by proclaiming: "We are all Keynesians now."

The Fed's political base is the commercial banks. As more banks resigned
from the Federal Reserve System, the system ran the risk of being exposed to
political attack. The Fed's control of monetary policy technically requires
membership of no more than the 400 largest banks. Universal membership
brought in thousands of small regional and local banks that were crucial for
the Fed's political protection, not for monetary policy requirement. Since
its beginning in 1913, the Fed has been subjected to criticism that it is a
captive institution of the big banks.

Arthur Burns, the Fed chairman appointed by Nixon, in trying to ensure the
president's re-election, laid the seed of hyperinflation that left
post-Watergate president Gerald Ford with having to fight inflation with his
ludicrous WIN (Whip Inflation Now) lapel buttons. In hoping to get
reappointed by Jimmy Carter, who defeated Ford as president in 1976, Burns
continued to pursue an easy-money monetary policy in the first two years of
the Carter administration. To Burns' disappointment, G William Miller became
chairman of the Fed in 1978 when Burns' term expired.

Miller, chief executive officer of Textron, a high-tech defense contractor,
true to the empire-building tendency of a CEO, decided to halt the
membership decline in the Federal Reserve System. Commercial banks had been
electing to withdraw from the Federal Reserve System in protest of the Fed
not paying interest on reserve balances. Banks that withdrew could place
their lower reserves, required by state banking regulations, in
corresponding banks to earn income from securities.

During the '70s, as hyperinflation pushed up interest rates, the no-interest
hidden "tax" on Federal Reserve member banks became proportionately more
burdensome. Miller decided to pay interest to member banks for their
reserves, over the opposition of Congress, which considered it another
giveaway to the big banks. Not only were the big banks getting free
safety-net protection through emergency borrowing at the Fed's discount
window, they also enjoyed a free check clearing and payment system from the
Fed. Congress thought the banks were pigs for complaining about the
no-interest "tax" since the tax was lower than user fees for services the
banks received. The effective tax rate in the 1980s for financial
institutions was only 5.8 percent, compared with 34.1 percent for retail,
24.5 percent for electronics, 16.4 percent for aerospace, and 10.9 percent
for utilities.

Senator William Proxmire, a Democrat from Wisconsin who chaired the Senate
Banking Committee, and Representative Henry Reuss, his counterpart in the
House, answered Fed interest payments with the Monetary Control Act of 1980
(a misnomer, since its real effect was to decontrol, just as the Full
Employment and Balanced Growth Act of 1978 actually legitimized structural
unemployment), enacted just when the Fed pushed interest rates to historical
peaks, requiring all depository institutions, members and non-members alike,
to maintain reserves with the Fed. Ostentatiously, since the Fed now paid
interest on deposited reserves, the small banks ought at least to get the
benefits of Fed services and protection and bypass the fee-paying
correspondence relations with big banks.

It was amazing that the Fed was able to get a Congress increasingly hostile
to government regulation to consolidate the Fed's institutional base at a
time when the Fed was imposing intrusive conditions in the private economy.
The rationale was based only marginally on economics and heavily on
politics. Fed membership was a non-issue as far as monetary control was
concerned, and governor Henry Wallich, the Fed's most scholarly economist,
said as much publicly. The legislation favored the Fed's main constituent in
the private sector, the large money center banks, forcing all other regional
and local financial institutions to fall in line and accept the terms that
are most operative for the big internationalist banks.

The Fed's legislative victory was delivered on the back of a larger issue -
the deregulation of finance. In companion legislation, Congress repealed
virtually all of the remaining government limits on interest rates and
regulation on lending that had existed since the New Deal, much as the
enactment of the Gramm-Leach-Bliley Act (GLBA) in November 1999 in effect
repealed the Glass-Steagall Act, the long-standing prohibitions on the
mixing of banking with securities or insurance businesses, and thus
permitting "broad banking". The price of money was free at last to seek its
"natural" equilibrium in the market place.

The prime rate rose above 15 percent in early 1980 when the deregulation
legislation reached its final stage. The Democratic Congress voted
overwhelmingly for a package that condemned borrowers to high cost and
favored lenders with high returns, by arguing that the benefit of high
interest on pension accounts justified the high cost of mortgage payments.
In other words, as Pogo the cartoon character said: "The enemies, they are
us." The populist Regulation Q, which regulated for several decades limits
and ceilings on bank and savings-and-loan (S&L) interest, was phased out.
Banks were allowed to pay interest on checking account - the NOW accounts,
to lure depositors back from the money markets. S&Ls' traditional
interest-rate advantage was removed, to provide a "level playing field",
forcing them to take the same risk as commercial banks to survive. Congress
also lifted restrictions on S&Ls' commercial lending, instead of the
traditional home mortgages, which promptly got the whole industry into
trouble that would soon required an unprecedented government bailout of
depositors with tax money. But the developers who made billions were allowed
to keep their profits. State usury laws were unilaterally suspended by an
act of Congress in a flagrant intrusion on state rights.

The political coalition of converging powerful interests was evident.
Virulent high inflation had damaged the holders of financial wealth,
including small savers, created by a period of benign low inflation earlier,
so that even progressives felt something has to be done to protect the
middle class. The solution was to export inflation to low-labor-cost areas
around the world, taming domestic inflation with the export of jobs and the
domestic inflation devil - US wages. Neo-liberalism was born with the twin
midwives of sound money and free financial markets, disguising economic
neo-imperialism as market fundamentalism.

There was even a devious argument that universal Fed membership serves to
dilute the institutional bias of the Fed toward big banks. Commercial banks
of course argued for free market competition when they knew very well that
predatory acquisition rather than fair competition was what unregulated
markets sustain. Labor, small business and small local banks and S&Ls
complained, to no avail. US labor, unlike its European counterparts, focused
union contracts on wages and benefits on a shrinking unionized workforce
while management shifted jobs overseas wholesale with the support of the
internationalist banks as a painless way to control domestic inflation, in
the name of free trade. Many Fed economists, Volcker included, actually knew
that financial deregulation with the elimination of interest-rate ceilings
would weaken the Fed's control over expansion of credit.

To gain support for the Monetary Control Act of 1980, the Fed offered member
and non-member banks that, under universal membership, the existing levels
of reserve would be lowered for every bank. Reserves required for demand
deposits, the checking accounts that represented the core of bank funds,
were reduced from 16.25 to 12 percent. This would mean a substantial loss of
revenue for the Fed. The Fed had been paying a handsome dividend to the
Treasury from surplus income from reserve holdings invested in government
securities over operating expenses, $9.3 billion in 1979. According to the
Board's 1999 Annual Report, the Federal Reserve System had net income
totaling $26.2 billion, which would qualify it as one of the most profitable
companies in the world if the system were a typical corporation. These
profits were distributed as follows: $342 million, or 1.4 percent of the
profits, was paid to member banks as dividends. Another $479 million, or 1.8
percent, was retained by the 12 Reserve Banks. The balance of $25.4 billion,
or 96.9 percent of the profits, was paid to the Treasury.

The Fed started to charge banks for its services when the new reserve rules
were fully phased in. The larger money center banks welcomed this
development since they intended to provide their own service system for
banks in competition with the Fed, and with the Fed charging a fee, it would
make it easier for the big banks to lure away customers. To get the
endorsement of the American Bankers Association, the Fed agreed to drop
reserve requirements on time and saving deposits. This concession meant a
vast benefit for the big banks whose balance sheet depends on
large-denomination CDs (certificates of deposit).