Recently my cousin contacted me out of the blue (I hadn't spoken with him in several years) and said that he had stumbled upon Austrian economics and was now voraciously consuming all kinds of material. We discussed the apathy of the average American--maybe I'll start writing columns about AAA--and how frustrating/depressing/infuriating it was that so much freedom was vanishing with so little fuss.

My cousin asked me to check out Zeitgeist Addendum, since it had some pretty bold claims and he wanted my opinion. (Here it is on Google Videos.) My general reaction is that it was typical of a high-quality leftist critique of modern society: It accurately noted the suffering and injustice of the world--especially endured by the poor--and it understood the depravity of governments, including our own. But unfortunately, it incorrectly generalized and blamed "free trade" and "capitalism" for the evils it correctly linked with the World Bank, IMF, and "right wing" governments.

Before I delve into more specifics, let me offer the following clip that comes in the beginning of the movie. I think it is a perfect summary of what Zeitgeist has to offer:



Money = Debt?

The opening chapter is the movie's strongest. They go through the mechanics of the Federal Reserve System, and they really do a great job showing how insane and evil it is. Despite my serious misgivings with the rest of the movie, this piece on the Fed might make it on net a positive contribution, since I think it will wake up a lot of leftists on just how corrupt our financial system is.

In particular, I finally understood why so many people harp on the notion that with our system, "money is debt," and that the system is thus inherently biased towards more inflation, because the Fed needs to print more money in order for borrowers to pay off the last injection (plus interest). Several times on Free Advice (e.g. here) I have borderline ridiculed such a claim, since it overlooked the fact that even with a fixed money supply in gold coins, you can easily have positive interest rates because the money can change hands during the course of the year. (All that really happens is that you perform a flow of services and work off your debt that way.)

Another problem I have with people calling our current money "debt" is that, if anything, it's the opposite! Under the gold standard, the green pieces of paper issued by the Treasury really were liabilities--they had printed right on them a promise to deliver a certain amount of gold when the bearer turned in the Treasury note:



But under a fiat system, those green pieces of paper mean nothing. As Bill Barnett humorously observed to me on the phone one time, "Bob, on the Fed's books currency is listed as a liability. But if I turn a $100 bill over to the Fed, what do they owe me in return?" I thought for a second before answering, "Umm, a $100 bill?"

Now Zeitgeist did go too far, in my view, by basically saying that interest on loans was per se a bad thing, since it was "obviously" impossible for people collectively to pay back more than they had borrowed in the first place. The movie featured quotes from people suggesting that this way a very efficient way to enslave people, that it was the source of mortgage defaults, etc.

Yet even though I think the movie (or more accurately, documentary, but I don't want to keep typing out that high-falutin' term) painted with too broad a stroke, it did jolt me out of my cynicism to see their point: The way our monetary and banking system is set up right now, when the Fed increases bank reserves through open market operations, the commercial banking system then pyramids much more money creation on top of this through the creation of loans. In other words, in our system, most new money enters not through running the printing press, but rather through private banks deciding to lend money to people that the banks create out of thin air.

It's odd that it took Zeitgeist to get me to focus on this point, since I "knew" it all along. Yet for some reason--perhaps my rejection of the Fed and all its works--I always focused on the central bank's "creating money out of thin air," rather than the much more significant (in terms of the total increase in monetary aggregates like M1) acts of commercial banks doing the same thing.

Creating Money Out of Thin Air

Let me walk through this to make sure we get the point; it's very subtle and, like I said above, even though I "knew" it and had taught it to undergrads, it never really hit me until my cousin told me about this movie.

When a private corporation, let's say IBM, buys a financial asset, it writes a check drawn on its bank account. Let's say IBM buys $1 million in government bonds from the Acme Bond Dealer. So IBM writes a check drawn on its bank, let's say Chase, and gives it to Acme. IBM's balance sheet is unchanged in total size: Its liabilities (and shareholder equity) remain the same, while on the asset side, its checking account goes down by $1 million, while the value of its Treasury bonds go up by $1 million. The opposite happens to Acme's asset-side of the balance sheet.

Of special importance however is that this purchase doesn't affect the total quantity of money held by the public, and so it is neither inflationary nor deflationary per se. In the most obvious case, suppose Acme is also a customer of Chase Bank. Then when the check hits the bank, Chase simply reduces IBM's checking account by $1 million, and increases Acme's by $1 million. Total demand deposits are the same as before the transaction; money has just been swapped for bonds, nothing more.

OK now what happens instead if the Fed decides to buy $1 million in bonds from Acme? Well the Fed writes a check on itself and acquires the bonds. Its balance sheet goes up by $1 million (remember that IBM's didn't budge). Rather than one asset going up, while another going down, what happens to the Fed is that its assets go up by $1 million (the market value of the bonds it bought). There is no finite "checking account" balance that the Fed needs to debit; it can write an infinite amount of checks on itself.

In terms of the accounting, the balance sheet still balances, because on the liabilities side, the Fed adds $1 million to the reserves under the account of Chase. This is because when Acme gets the check from the Fed, it deposits it in its own checking account (Chase Bank), who then clears it with the Fed. So from Chase's point of view, they increase the checking balance of its client, Acme, by $1 million (just as in the IBM scenario), but now, instead of reducing some other client's account by $1 million, instead Chase increases its own "checking account balance" with the Fed by $1 million.

Thus, even at this stage the economy now has $1 million more in money "held by the public"; Acme has $1 million more in its checking account, and no other private person or company has a smaller amount of currency or checking balance.

But we're not done. At any given time, a bank must satisfy reserve requirements, meaning that it must have a certain fraction (let's say 10%) of its outstanding demand deposits, backed up in the form of vault cash or reserves on deposit with the Fed. For example, if Chase's customers added up all of their checking account balances and the grand total were $50 billion (I have no idea what a realistic number would be for this), then Chase would need to hold (let's say) $5 billion as reserves, either in the form of actual currency--green pieces of paper--in the vault, or as part of Chase's own checking account with the Fed itself.

Sooo, now that Chase's reserve balance at the Fed has instantly jumped up by $1 million, it means that Chase is holding "excess reserves," and can increase the total amount of checking account balances held by its customers, by $900,000. (This part always stumped me in the past--why couldn't Chase make new loans of up to $10 million right off the bat? After all, $1 million in reserves can support up to $10 million in expanded checking balances, right? The answer is that when its customers get these new loans, presumably they are going to write checks for much of the principal, which means other banks will "call in" a lot more of this new influx of reserves, than would be true on average for the original situation before the Fed open market operation. In other words, if Chase tried to expand the money supply to the fullest extent in the first step, it would end up being way below its reserve requirements.)

Don't worry, I'm not going to follow it through the next steps, when each subsequent deposit leads to further and further expansions because of new loans by other banks. I just want to point out that Chase bank officials are here creating new money, in a very real sense, and they are doing it by creating the amount of debt owed by the public. What happens to Chase's balance sheet at this stage is similar to, but not the same as, what the Fed does when it creates money out of thin air.

Let's say that Chase exploits its excess reserves by granting a loan to a homebuilder for $900,000, at a 5% annual interest rate. So now on Chase's balance sheet, its liabilities have increased $900,000--it just bumped up the homebuilder's checking account by that amount. The homebuilder can now start paying workers, buying lumber, and buying real estate, writing checks up to $900,000 on this account.

On the asset side, Chase has acquired a "bond" issued by the homebuilder. In other words, in order to get the loan from Chase, the homebuilder has promised a stream of $45,000 annual payments, with the principal to be repaid in x years. (I'm translating the homebuilder's "bond" into something comparable to the Treasury bonds that the Fed buys; you get the idea I hope.)

Now it's crucial to understand the mechanics (and any experts out there, please correct me if I botched the accounting above), but it's also important--once you've mastered what the heck is actually happening--to step back and see the big picture: Just as the Fed writes checks on itself--"creating money out of thin air"--in order to buy debt, so too private commercial banks can write checks on themselves, and thereby create money out of thin air, in order to buy debt. And in practice, the amount of this being performed by the commercial banks is several multiples of what the Fed itself does.

And here's the best part: Ever since that "savior of capitalism," FDR, instituted FDIC, if this house of cards ever collapses, then taxpayers are on the hook to bail out the bankers who mismanaged their portfolios and somehow managed to get wiped out, even though they have the ability to create money out of thin air and lend it on whatever terms they deem safe.

That is breathtaking, when you really comprehend it. Thanks for opening my eyes, Zeitgeist Addendum.

Economic Hitmen, and Then a Bunch of Bunk

The interview with the Confessions of an Economic Hitman guy is also very sobering. I am not bothering to cross-reference his tales with any other "normal" sources, but he tells a very plausible account of how the CIA, IMF, and World Bank muscle financially strapped Third World countries into signing away their lucrative natural resources to multinational companies. When two populist rulers say Go Home Yankee, they coincidentally go down in separate plane crashes.

After those scenes, however, the movie descends into anti-capitalist and anti-religious bunk. I'm not going to bother critiquing it, but let me just give some examples of how silly it is: At one point, the narrator "explains" that Jamaica (I think?) got destroyed by the evil multinational bringing in food that was so cheap it put the locals out of business. Now on the face of it, that's pretty funny: A leftist complaining that the capitalist nations aren't charging poor people higher prices for food.

But beyond the absurdity of it, this charge contradicts the claim made later in the movie, when it says that capitalism is based on scarcity, not abundance. In other words, it's not in the capitalist system's interest to increase production, because then prices (and "hence" profits) go down. So then, what was the story with the evil free trade and Jamaica?