Wednesday, May 12, 2010

The Dollar, Inflation & The Capital Markets

It is a warm wet morning here in Cincinnati. The grass is green and the flowers are blooming. Rain continues to fall and every now and then there is thunder in the distance. So, why on a day like today do I feel like talking about money? I have said about as much as I can about the credit rating agencies (CRAs), so, I think it is time to give that a rest. Now that the Justice Department is awake to the role the CRAs played, perhaps more truths will come to the surface.

But, like the credit rating agencies that, in my opinion, provided the conduit to blow up the housing bubble, the Federal Reserve Bank is another villain in my story. Keep in mind that a central bank like the Federal Reserve Bank does not have to be a villain, if run properly, but here lies the jump off point for my discussion. What is the proper role of a central bank?

First, I am not an economist. I do not have a PhD in anything. My ideas come out of my own head. Now, that said, I will give you my take on the proper role of a central bank. Some would no doubt argue that the work of a central bank is not that simple. That a central bank, like our Fed, is a most complex fixture of a very complex financial system that is world wide in scope. Yes, all this is true, but the principles that should govern a central bank, in my humble opinion, are not that complex.

First and foremost the central bank must protect the integrity of the nation's currency. What do I mean "must protect the integrity of the nation's currency?" The central bank needs to provide enough reserves to the banking system so that the nation's economy can function, but if the central bank prints too much money (Federal Reserve Notes) this can cause inflation, and a disincentive for people to save their money in traditional savings accounts.

When there is a disincentive to save, people are forced to invest their money in an effort to maintain the purchasing power of the money they have saved. If placing your money in a savings account with a bank at a low interest rate over a period of many years will not permit one to save for their retirement, their child's college education, or even a state run pension fund, or a university's endowment, or a foundation's philanthropy, people turn to investing those monies in the stock and bond markets.

With the trillions of dollars that are flowing into the capital markets to keep pace with inflation and maintain purchasing power, people and institutions place themselves in the direct line of fire for those that regard them as marks or so many fish to be shot in a barrel. When given the choice of keeping their money in savings accounts or investing in the markets, responsible people that have to provide for the retirement of millions choose the investment alternative. In fact, the actuaries will tell those in leadership positions with various organizations what number they will need down the road to meet their financial obligations to the people they represent.

In plain English, knowledgeable and responsible people know that in order to provide for the people that they are entrusted to provide for, must invest in the capital markets. With the trillions of dollars pouring into our capital markets and an attitude among those in political power (the President, the Congress and the Federal Reserve Bank Chairman) that these capital markets will self regulate, the scene is set for the greatest money grab since the formation of this republic.

Several words ago, I started out talking about the role of the central bank and its responsibility to the integrity of the currency. I have attempted to draw a line showing how the policies of the Federal Reserve Bank and the idea of self regulating capital markets brought about the financial crisis which lead directly to the economic crisis of 2008.

While the Congress plays with ideas for more comprehensive regulations for the capital markets, they just might want to turn their attention to the policies of the Federal Reserve Bank. If monetary policy in the United States started with the integrity of the currency, the U.S. dollar, then perhaps people and institutions would not be forced to place so much faith in investing in the capital markets to make up for the erosion of the dollar's purchasing power.

Stay tuned.


winslow said...

Perhaps the government should not tax "savings" to encourage individuals to save more.

moneythoughts said...

Winslow, how about taking that idea one step further. How about indexing savings in bank savings accounts to the rate of inflation plus 3% interest on your money. Then placing a small tax when you withdraw the money to use it, or something like that. That would encourage people to save in a traditional savings account and people would not have to invest in money market funds to realize a decent total return.

Robert said...

Seems like our official measure of the inflation rate has been inaccurate over the past two decades or so. This may be one factor leading to central banks of the world, like the Federal Reserve, setting extremely low interest rates.

It looks like inflation is low because so many products and services remain cheap thanks to cheap imports and technology. For instance, computer technology can bring a lot of prices down.

When these figures get aggregated into the inflation rate, they make it look low. At the same time, certain necessities have been inflating at a brisk pace over the past 20 years. Housing costs and health care come to mind.

Low interest rates have inflated the housing costs over the past 20 years, but Federal Reserve and other central banks didn't put on the breaks, even though this inflation was happening, because they thought inflation was low.