The Link Between The Fed, Money, Debt And Taxes


The U.S. banking system is one of the largest, most complex, controversial and misunderstood business structures in the world. In this article, we will look at four specific features of the U.S. banking system that have caused much of the skepticism and confusion surrounding U.S. banks. With this information, we can then determine if economic production should be used as a proxy to link the complex interrelationships that exist between the policies of the Federal Reserve, the money supply system, the national debt level and corporate income taxes.

The Federal Reserve System and Money Supply
The Federal Reserve was created by Congress in 1913 in order to administer monetary policy. Since its creation, many people have questioned the constitutionality of the Fed. In addition, the Fed's use of a fiat currency system, the elusive manner in which the Fed creates money out of "thin air," the Fed's use of a fractional reserve banking system and the Fed's reliance on the economic concept known as the velocity of money, have helped promulgate much of the controversy surrounding the manner in which the Fed operates. Here is an overview of four of the issues that need to be better understood about the Fed.

Fiat Currency
The Federal Reserve utilizes a medium of exchange known as a fiat currency system. President Nixon established this system in 1971 when he took the U.S. monetary system off the gold standard. To this day, many people are upset with this policy and stridently believe that the U.S. currency should be tied to some form of commodity. This, in turn, has caused an ongoing controversy that the Fed has had to deal with for more than 40 years.

Money Creation
The Federal Reserve effectively creates money by implementing policy through its Open Market Committee's operations. To create money, the Fed simply buys government securities such as Treasury Bills, Treasury Notes and Treasury Bonds from participating banking institutions. The Fed does not buy Treasury securities directly from the Treasury Department. Instead, the Fed buys Treasury securities in the "open market," in order to operate in compliance with the Federal Reserve Act of 1913.

The money that the Fed uses to buy Treasury securities has not existed before, but it does have value, because the Treasury securities that the Fed receives and holds in trust, as collateral for the new money it has created and put into circulation, has value. Ironically, when the Fed buys Treasury securities, it does not have to print money to buy them. Instead, the Fed issues a credit to the banking institutions and records the transactions by placing the value of the Treasury securities on its balance sheet. The banking institutions treat the credit just like money, even though no actual cash has been printed.

This process is guaranteed by the full faith and credit of the U.S. government. This, in turn, means that the entire U.S. banking system is dependent upon the ability and willingness of U.S. taxpayers to honor the financial obligations that are implemented by the Fed.

Fractional Reserve Banking System
The Federal Reserve also increases the money supply level via the use of a fractional reserve banking system. This system facilitates the expansion of the money supply through a process known as the multiplier effect. The multiplier effect is implemented through the establishment of a reserve requirement that has been set forth by the Fed for each of its banking member institutions. Since, 2006, the reserve requirement has been set at a rate of 10% for transactional deposits.

Given this level of collateral requirement, the Federal Reserve has put in place a mechanism where the money supply level could be theoretically increased by a factor of up to 10 times the amount of assets held on the Fed's banking member institutions' balance sheets. Of course, this depends on how the banking institutions decide to lend the money and what the borrowers do with the money that they receive. History has shown that a significant amount of money will be held out of circulation by consumers. Therefore, the actual increase in the money supply level will likely never approach the maximum level that could be created by the use of the fractional reserve banking process.

With that said, the multiplier effect is a crucial part of the U.S. banking system, because it allows the monetary system to operate with a money supply level that is far smaller than the amount of money needed to foster the economic production that takes place in the U.S. economy.

Velocity of Money
The Federal Reserve also relies on an economic concept known as the velocity of money in order to help ensure that the U.S. banking system has enough money in circulation to foster all of the transactions associated with U.S. economic production. The velocity of money represents the frequency in which a single unit of currency turns over within the economy in a given year.

For example, if a dollar is used to allow a farmer to buy corn seed, who then grows and sells the harvested corn to a company that makes cereal, which in turn sells the cereal product to a grocery store to be sold to a consumer, a single dollar could theoretically be used to facilitate four dollars of economic activity in a given year. This means that the number of dollars that are required to be in circulation would only need to be one-fourth of the economic production that takes place in the economy.

In actuality, empirical evidence shows that the velocity of money, as defined by the M2 money supply, is less than a factor of two. This means that a dollar is typically turned over less than two times per year in the U.S. economy. Nevertheless, the Fed relies upon the velocity of money in order to meet a portion of the demand for money that is needed to be in circulation in order to foster all of the economic production that takes place in the U.S. economy.

With these issues in mind, let us now look at a host of changes that could be made to the current U.S. banking system in order to simplify its structure and resolve the issues surrounding its existing operations. Ironically, this new approach will rely heavily upon keeping the national debt level in concert with U.S. economic production.

An Approach to Linking the Fed, Money, Debt and Taxes with Economic Production
As most people are aware, in September of 2012, the national debt level in the United States surpassed $16 trillion dollars. This amount seems very high when it is analyzed on a per-household income basis; therefore, it appears that the U.S. is quickly approaching financial calamity. However, when one takes into account that current U.S. economic production is also approximately $16 trillion dollars, one can see that there are important factors to consider when assessing the appropriate level for the country's national debt.

Let us assume that both the U.S. Congress and the Federal Reserve wanted to establish a robust U.S. banking system that was free of any of the current issues and skepticism surrounding its current operations. The Fed could theoretically accomplish this goal by taking a multi-step approach. First, the Fed could endorse a policy that would directly tie the money supply level with the level of economic production. This policy would also require the national debt level to be tied to the level of economic production, because the Fed would need to increase the money supply in circulation to a tune of $16 trillion dollars. This, in turn, would require the Fed to purchase $16 trillion dollars of U.S Treasury securities. By tying the money supply level and the national debt level directly to the level of economic production, the use of a fiat currency system would have a clear and logical basis, and therefore the use of a fiat currency in the U.S. banking system would be completely legitimized.

Once the Fed tied the money supply level and national debt level with economic production, the Fed could then eliminate the reliance on the use of a fractional reserve banking system and disregard the theoretical concept of the velocity of money, in order to remove the operational policies that are responsible for raising so much of the skepticism surrounding the current operations of the U.S. banking system. With that said, this type of policy change would also mean that the Fed would need to raise the total assets on its balance sheet from approximately $3 trillion dollars to $16 trillion dollars. This, in turn, would validate the actions of the Fed and the size of its balance sheet, and the U.S. banking system would have a clearer and more robust structure.

Implications of Linking the Fed, Money, Debt and Taxes with Economic Production
The implications of linking the money supply level with economic production would have a profound impact on the U.S. banking system and the perception of the national debt level. First, the Fed would have much more power due to the fact that the amount of assets under its purview would increase substantially. While this may be a cause for concern with those people who question the legality of the Fed's existence, this provision would in fact remove the arbitrary and capricious nature in which the Fed is perceived to rely upon in order to carry out current U.S. banking operations and, instead, replace it with a clear and logical approach that everyone understands.

Second, a banking system that matched the money supply level, economic production and the national debt level would require a provision that would only allow Treasury securities to be purchased by the Fed. Third, Treasury securities would need to be issued as zero coupon bonds, where the discount rate on the bonds matched the expected long-term growth rate of economic production. Fourth, the ongoing issues surrounding the appropriate national debt level would become a moot conversation, as the national debt level would be deemed appropriate, if it matched the level of annual economic production. Fifth, a national debt level that exceeded total economic production would be the new policy issue that would require justification by policymakers. Sixth, the national debt level would need to increase each year in a manner that would accommodate the growth in U.S. economic production from the prior year.

The Importance of Corporate Income Tax Policy
The corporate income tax system has a key role to play in a U.S. banking system where the Fed's balance sheet, the money supply level, the national debt level and annual economic production were maintained at similar levels. In order to help explain the importance of corporate income tax policy under this type of new banking structure, keep in mind that in a modern economy technological advances and process efficiencies develop as a result of innovation and invention. Since we know that these types of technological improvements increase production far beyond the level that is capable of being generated by human labor alone, a concentration of economic productivity will naturally accumulate to a smaller number of market participants that are utilizing these new types of technological efficiencies.

This means that personal income tax revenue will become less important in the future, as a greater percentage of economic production will be attributed to technological efficiencies at the corporate level. As a result, there would clearly be a need for corporate income tax policy that is correlated with economic production, in order to ensure that enough tax revenue is being generated to meet the money supply level of a growing economy. With this in mind, a balanced budget amendment would then need to be implemented by U.S. policy makers in order to keep the Fed's balance sheet, the national debt level, the money supply level and total economic production at relatively comparable levels. This, in turn, would help solidify a well-designed U.S. banking system and the actions of the Federal Reserve.

The Bottom Line
In a mature economy, where a country's national debt level is approximately the same size as its economic production, a valid argument can be made that the amount of assets on the Fed's balance sheet, the money supply level, the national debt level and economic production should be maintained in equilibrium, in order to maintain a logical and robust banking system. Accordingly, this type of banking system would require major changes in how the Federal Reserve currently operates and would place a much higher importance on corporate income tax policy.

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