Wednesday, August 17, 2011

A Major Problem with the US Federal Reserve: The member banks are guaranteed by law a 6%/yr RROI

A recent US politician claimed that the US Federal Reserve Chairman would be a traitor if he allows the printing of money between now and the next election. This is an extreme statement. There is no need to threaten people with death (which is the punishment for treason) because you disagree with their political views. (There is no correct political system because there's no way to know that one system of governance works better than another system because you can't try both at the same time. All we have to go on is history, and history can only be a guide not a rule book for how act in the future.) While it's extreme to call the US Federal Reserve Chairman a traitor, there are a lot of people (myself included) who are very anger with the US Federal Reserve Chairman for printing money while there was already significant inflation. So, I wanted to discuss why people have so much angry towards the Federal Reserve system right now. The goal of this post is to discuss one of the little discussed secrets of the Federal Reserve: the member banks are guaranteed a 6%/yr rate of return, regardless of how the economy is doing, and can print money in order to raise the funds to pay themselves the 6%/yr rate of return. The reason this is a secret is that there is a lack of transparency in the Federal Reserve System.

In many of my posts, I discuss ways to improve the Federal Reserve by forcing it maintain a constant level of inflation (preferable 0% inflation.) While I have no ability to predict the future of the economy, I can claim the following:  if we adopted an electricity-backed currency (i.e. maintained a 0% inflation in the average price of electricity), then there would be transparency in the US Federal Reserve. "And no funny stuff!"  Right now, there is no transparency in the US Federal Reserve. The system is a mess. There is no certainty. For example, can you tell me whether the Federal Reserve is going to print money again? Is it aiming for a certain inflation rate?

Instead, we have created a system in which the few profit at the expense of the many. And because of this, we need to improve the US Federal Reserve operates. The relation between the people and central banks has evolved throughout US history; and the system we have currently will not, should not, and can not last. I suggest forcing the Federal Reserve to maintain a constant inflation rate (preferable 0% inflation in the price of electricity...but I'm open to other suggestions) and to adjust how much money they are able to pay themselves (see below) depending on how well the economy is doing.
We, the people, have a healthy fear of the Federal Reserve, and it's a healthy fear because we have created a system in which the largest banks in the US can print money pretty much whenever they want.

Here's the dirty, little secret that isn't discussed often. The banks that make up the Federal Reserve are guaranteed by law a 6% annual rate of return on investment.

From wikipedia:
The U.S. Government receives all of the system's annual profits, after a statutory dividend of 6% on member banks' capital investment is paid, and an account surplus is maintained. In 2010, the Federal Reserve made a profit of $82 billion and transferred $79 billion to the U.S. Treasury.[16]

I'm still doing research in this area and would appreciate help in doing research. Whenever I look at the US Federal Reserve's annual expense reports for 2005 or 2006, I see dividend payments on the order of $1 Billion. During this time, the balance sheet was on the order of $750 Billion. 6% of this number would be $45 Billion. This is 45 times greater than the reported dividends paid to the member banks. Could somebody help explain to me why the dividend payments were much less than the 6%/yr that the banks are allowed to take each year. Also, when wikipedia says that $79 Billion was transferred to the U.S. Treasury, how much of this $79 Billion in profits came from QE2? Is printing money considered profit? Or is only the money earned on lending out the Federal Reserve's money?

I'm am for auditing the Federal Reserve. I'm not going to call anybody a traitor. I just want to know how this system works, given that it has a significant effect on my life by allowing inflation and decreasing my purchasing power. And I would like to know why the banks are allowed to give themselves a 6%/yr rate of return on investment.

Don't get me wrong: I'm all for banks earning high rates of return on investment if they were investing in new power plants with high rate of return on investment (such as natural gas combined cycle...which depending on location can earn rates of return on investment on the order of 15%/yr to 25%/yr.)  However, my problem is that this is free money! The banks put money into the Federal Reserve system...which gets lent out to other banks at the Fed rate of ~0.25%/yr. The Federal Reserve only makes a small amount of money on the loans, so one might ask themselves: how can the Federal Reserve guarantee a 6%/yr rate of return on investment when the loans are only for 0.25%/yr?  [I think you already know the answer.]

It appears that the only way this is possible is if the Federal Reserve is printing money! This appears to be the dirty little secret that the US Federal Reserve don't want the public to know. It loans money out for 0.25%/yr, but pays its member banks 6%/yr, and the only way it can sustain this mode of operation is by printing money.

The banks are hoping that we don't notice the printing of the money. When technological innovation is driving down the prices of goods, we don't notice the printing of money. It's only when the merry-go-round stops (i.e. oil prices sky rocket), that we notice that the prices of goods are increasing. In many countries, their Federal Reserves are forced to maintain constant inflation around 2%/yr. This means that if the price of oil is increasing by 10%/yr and the commodity price index is increasing by over 6%/yr, then their Federal Reserve is forced to remove currency from circulation as a means of forcing price inflation back to 2%/yr.

Of course, if the Federal Reserve is forced to remove currency from circulation, that means that it can't print money, and hence it can't afford to give itself a 6%/yr rate of return on investment while only loaning money out at 0.25%/yr.

Now, you can see why people, like myself, were so angry last year when the US Federal Reserve Chairman annouced QE2 (i.e. printing money while oil prices and the consumer price index were well above 2%/yr.) As they say, "they had to fed to the monkey." Printing money was the only way that they could afford to pay themselves 6%/yr. (Though, as stated earlier...I am not completely clear on whether the banks actually gave themselves a 6%/yr rate of return on investment. This is just the value that they are allowed to give themselves by the Federal Reserve Act of 1913.)

And now, hopefully you can see the problem with the US Federal Reserve system. The  Federal Reserve will print money even as all of the price indexes are inflating at over 2%/yr. We allow banks to legally print money and give themselves 6%/yr rates of return even when the economy is contracting. This is free money because it's guaranteed profit...even though it may not be increasing their purchasing power. (Obviously, if the commodity or consumer price index is 6%/yr and the banks pay themselves 6%/yr, then they have no net change in purchasing power at the end of the year. However, the money in the banks came from a lot of people, like you and me, who are only seeing 0%/yr to 2%/yr returns. This means that our money is losing its purchasing power by 6%/yr to 4%/yr, respectively.) Why should US banks be able to guarantee themselves 6%/yr returns off of our money when the time value of 'risk-free' money is only 0%/yr? Shouldn't the RROI that the banks are allowed to pay themselves be a function of how well the economy is doing?

The question are there people working for the banks that receive the 6% annual return on investment who should not be working for this free money, and should instead by working for companies that actually produce things of value. Is our Federal Reserve system creating a welfare system for banks that disincentivizes them from investing in projects that actually yield high rates of return on investment?
There is money to be made out there. Examples of projects with high rates of return on investment include: investing in natural gas drilling, and investing in natural gas combined cycle power plants (and all associated equipment/materials: such as gas turbines, generators, steam turbines, and steel mills.) When prices are increasing, we need to be investing in those projects that yield high rates of return on investment.
Instead, by allowing banks to give themselves 6%/yr rates of return, we have disincentivized them from investing in projects that can lower energy prices (such as drilling for cheap natural gas.) We allow people at the Federal Reserve to get paid salaries well over $100k. Instead, we need people in PA and NY drilling wells and building power plants that generate cheap electricity. We also need people drilling oil wells in the Bakken Shale in ND using horizontal drilling techniques as perfected by the natural gas companies in Texas.

And this completes the circle. The reason why a certain politician in the US has the guts to threaten the Chairman of the US Federal Reserve is that he can! He's the governor of the state in which companies perfected the horizontal drilling techniques are that are saving the US economy. And that makes him more powerful than the un-elected chairman of Federal Reserve. He rightfully fears angry US citizens than he fears the bankers in NYC.

We can't allow the member banks to give themselves 6%/yr RROI, regardless of what's going on in the economy. And this means changing the laws governing the Federal Reserve. In the mean time, this post is a call for all of us to stop wasting money by consuming crap. Our economy doesn't need more luxuries (right now...hopefully in the future we can return to the level of luxuries, but not right now.) We need more people drilling for natural gas and oil, and we need less people at the US Federal Reserve writing memos justifying the printing of money. If we force them to maintain constant inflation levels, then there will certainty in the markets and more people available to build, fuel and operate the power plants we need to grow our society.

1 comment:

  1. I think this article is related to this discussion. Lending/printing money for the big banks of the world.