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Chapter 1: the Fed and You: a Brief History 1 The Fed and You: A Brief History I was reading in the paper today that Congress wants to replace the dollar bill with a coin. They’ve already done it. It’s called a nickel. — Jay Leno It may feel like you have no relationship with any federal entity. But, if you’re using money to transact business or if you’re investing in the stock market for your retirement, you have a deep relationship with at least one – the Federal Reserve. It’s ironic, too, because the Federal Reserve (the Fed) isn’t a public body nor is it an official part of the government. The Fed is a private bank with the superpower of manag- ing the country’s money. The Fed has a dual mandate – to maintain full employment and to keep prices stable. However, it’s this one power of managing the money supply through the setting of interest rates and the printing of money that allows it to have massive influence the world over. COPYRIGHTED MATERIAL How It Was versus How It Is During the post–World War II period job security, pension security, and health security were relatively more stable than has been the trend since the 1990s. You could save money in an account that generated a decent return and you were able to maintain purchasing power in part because 3 Ryan705369_c01.indd 3 07-11-2020 08:36:14 4 THE HISTORY OF ECONOMIC CYCLES AND MONETARY POLICY 250 Productivity 200 150 % Change 100 Typical worker’s hourly compensation 50 0 1949 1955 1961 1967 1973 1979 1985 1991 1997 2003 2009 2015 Year Figure 1.1 Productivity versus Compensation Source: Economic Policy Institute. you had US currency that was also money. It was a store of value because it was backed by gold. If you wanted to get a higher return, you could buy government or municipal or corporate bonds and, for risk-adjusted returns, you were doing quite well. There wasn’t any need to take big risks in the stock market or to start your own business if you wanted to lead a middle-class life. Until the early 1980s, the gap in income between blue-collar and white-collar workers was relatively stable. Moreover, the average mul- tiple between the highest paid person at a company (like the CEO) and an average worker was between 10 and 20 times difference. There was more equality within the income system, which favored being an employee in the risk/reward calculus as productivity was shared across the organization. In 2016, the US CEO-to-worker pay ratio was 276 to 1. We see productivity continuing to increase (see Figure 1.1) while pay has remained stagnant. Therein lies the opportunity. Start a business and take advantage of productivity to increase your personal income return. The tax structure was also completely different. Back in the 1950s and 1960s the highest tax bracket for earned income was 90%! Can you imag- ine that? This influenced lots of decisions. One was the risk-­versus-­reward ratio of trying to start a business. If you could only keep 10% of your earn- ings after taxes, would it be worth it to take outsized risk? Probably not. Ryan705369_c01.indd 4 07-11-2020 08:36:14 The Fed and You: A Brief History 5 In the twenty-first century, many companies don’t expect to keep their employees for 10 or 20 years. Employers let workers go through reduction in forces (RIFs), layoffs, or a variety of other means. Due to the Employee Retirement Income Security Act (ERISA), a law enacted in the 1970s, the government made a huge change to retirement and how we go about saving and investing for retirement. Like so many laws, the law enacted did the exact opposite of what its named implied. It did not secure employee retirement income. It converted risk from the employer to the employee by moving from a defined-benefit plan to a defined-contribution plan. This was an enormous change. Now we have defined-contribution plans like a 401(k) or a 403(b) where the risk and onus of a person’s retirement lie squarely with the employee. That was not the case under a defined-benefit plan. Today’s savings accounts do not produce any real return. You’re lucky if you can get 0.1% interest rate per year. The US dollar is not maintaining its pur- chasing power like it did in the olden days. This happened in 1971 when Nixon took us off the gold standard. He turned our US dollar from a commodity currency to a credit currency. The US dollar is now good for being a medium of exchange but not good as money that is a store of value. Inflation eats away at purchasing power over time. While we’re conditioned to think 2% inflation is healthy, inflation is actually a stealth tax that hits every American. It is disproportionately worse for the poor because they pay the same tax of inflation as the rich at the same rate. Moreover, they are more likely to use savings accounts versus investing if they have any wealth at all to save. So how is it that our pillars of middle-class security were shaken by these megatrends in monetary policy, demographics, technology, and the global economy? Monetary Policy – The History of the Federal Reserve In search of an answer to this question, I start with a week-long discus- sion with my friend Dax about the Federal Reserve (the Fed). It was a few years ago when we both read an article about the Federal Reserve and it sparked a discussion about whether the Fed is harmful or helpful. Our conversation focused on an article written by a former Fed advisor, Danielle DiMartino Booth, “How the Fed Went from Lender of Last Ryan705369_c01.indd 5 07-11-2020 08:36:14 6 THE HISTORY OF ECONOMIC CYCLES AND MONETARY POLICY Resort to Destroyer of American Wealth.”1 Dax was skeptical of the article and wanted to discuss its positions. Dax (DH) started the conver- sation with this question: DH: One of the recurring complaints I hear from some fiscal conservatives is about the Federal Reserve and how evil it is. I’m trying to understand why and have been doing a little research. I have read a lot of people complain about the era of “cheap money” and how it is having a terrible effect on the real US economy despite all the traditional mark- ers like the unemployment rate and the Dow looking really good. Is it justified? JR: Consider this. If I offered you a $100 bill or $100 in gold, which would you take? What if I made the same offer to you in 1913 when the Federal Reserve (the Fed) was established? Which option would provide you with more pur- chasing power today? The answer is $100 worth of gold in today’s currency. The US dollar has lost over 95% of its purchasing power in 100 years. One hundred dollars’ worth of gold in 1913 would now be worth over $2,000 in today’s currency. The Fed decided to situate the entire economy on top of an abstrac- tion of the monetary system. The abstraction, decoupling the money system from real assets, allows them immense and unchecked power. Most people are not aware of it. The Fed does not answer to Congress. They are not audited by our government. The Federal Reserve is a pri- vate corporation. By targeting 2% inflation, you’re targeting a 2% “tax” on the entire economic system and it’s a regressive tax. With that target, we are all agreeing to reduce our purchasing power by 2% per year. Every percentage point of inflation erodes everyone’s purchasing power by design. And, this “tax” affects the poor most. The Fed has helped the US dominate the world economy by using many levers and tools. We can import or export inflation as needed by many Fed maneuvers. It has been great for US citizens, but the rest of the world has caught on and they are tired of it. They are tired of the US dollar reigning supreme as the world reserve currency because it allows us to force our country’s debt on the whole world. If they hold US dollars as reserve assets and the purchasing power of the US dollar diminishes by 2% per year, they are losing value. This does not include the other Fed tools used to create negative real return for bondholders. We can monetize our debt, a phrase that was typically reserved for developing nations. We’ve been able to do this because of the Bretton Woods agree- ment after World War II. It tied the US dollar to gold and then all other major currencies, like the yen and the British pound, to the US dollar. This probably would have been fine if Nixon hadn’t pulled us off the Ryan705369_c01.indd 6 07-11-2020 08:36:14 The Fed and You: A Brief History 7 gold standard in 1971. It is this move that changed everything. Nixon was forced to do this, however, because the US government was spend- ing way more than it had and there was a currency war going on with France. Charles de Gaulle et al. knew the US couldn’t back every one of its dollars with gold, so he kept exchanging dollars for gold until Nixon was forced to act. An economy is ultimately based on trust and we are at the end of that ride.
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