Last month, I posted a piece on bank excess reserves and the federal funds rate.  I was basically saying that the Fed was not really holding down the fed funds rate.  It makes this announcement after every FOMC meeting that it is keeping the rate at between zero and .25 percent.  This has been going on for a couple of years.  But because the banks have massive amounts of excess reserves, there is very little need for overnight lending.  Therefore, this keeps the federal funds rate low and the Federal Reserve’s monetary expansions or contractions have little to do with their target rate right now.

In my piece, I also cited an article by Kel Kelly.  In his article, he says that the only way that the Fed can raise rates is by paying the banks significantly higher rates on their excess reserves and that this is unlikely because it would lead to a recession.

I received a comment in response to my post.  The comment says, “The Fed can [lower] rates only by paying banks interest on reserves.  In your article, you addressed it as ‘raising’ rates, which is not the case.”

I understand this comment, but I maintain what I said in my post and that Kel Kelly is correct in his article.  It is a bit counter intuitive, so let’s go through it.

If the banks had virtually no excess reserves, as was common before 2008, then the Fed could more easily control its target rate.  Therefore, the commenter is right in one sense that if the Fed put a negative interest rate on excess reserves (charged banks for holding money instead of lending it), then this would force down the excess reserves.

But it does go the other way too.  The reason that the Fed started paying interest on excess reserves was so that it had more manipulation power.  It is no coincidence that the rate paid on excess reserves right now is a paltry .25%.  Let’s say that the Fed raised this to 5% tomorrow morning.  What would happen?  The banks would tie up their money in excess reserves and there would be very little money there for banks to lend overnight.  This would actually increase the Fed’s target rate.

Ben Bernanke himself is quoted as saying, “In principle, the interest rate the Fed pays on bank reserves should set a floor on the overnight interest rate, as banks should be unwilling to lend reserves at a rate lower than they can receive from the Fed.  In practice, the federal funds rate has fallen somewhat below the interest rate on reserves in recent months, reflecting the very high volume of excess reserves, the inexperience of banks with the new regime, and other factors.  However, as excess reserves decline, financial conditions normalize, and banks adapt to the new regime, we expect the interest rate paid on reserves to become an effective instrument for controlling the federal funds rate.”

The rate paid on excess reserves actually puts a floor on the federal funds rate.  It is not an exact science as even Bernanke struggled with this when the tool became available.  The Fed did not know exactly where to set the rate on excess reserves and it was throwing off their target rate.  So if the Fed announced a significant increase in the rate paid on excess reserves, this would in fact raise the fed funds rate.

So the Fed can control the federal funds rate, but it is unlikely to do so right now.  If it raises the rate on excess reserves, this would really hamper lending and it would likely lead to a quick and sharp recession.  If the Fed puts a negative interest rate on excess reserves (charges a fee), then banks will start to lend out their reserves and we will see massive price inflation very quickly.

The Fed will keep walking a tight rope between recession and inflation.  It will eventually run out of room and we will probably get both at the same time, if we don’t already.

With all of the economic problems we face today, there are a lot of myths out there.  These myths are promoted by the media and politicians and even some so-called economists.  They are Keynesians.  One of the biggest myths of all is that spending drives our economy.  When you think about it, this is really childish and yet many people believe this nonsense.  It is a mix up of cause and effect.

An economy grows because of production.  We get increased production from savings, capital investment, and increased technology.  An economy is not more productive because of consumer demand.  We can have all of the consumer demand we want, but it doesn’t make things appear out of thin air.  I’m sure that people living in third world countries would like to have ipods, flat screen televisions, and be able to dine out at fancy restaurants.  But they simply don’t have the wealth accumulation to have these things.  They can demand these things all they want, but they won’t appear until there is production.

There is more consumption in a place like America as opposed to a place like Ethiopia because there is more to consume.  There is more to consume because America is wealthier.  There is more wealth because of the prior savings and investment that has taken place.  This is because of stronger property rights and freer markets.

Remember that you can’t consume that which isn’t produced.  The excessive consumption of Americans in the last decade does not exactly mean that people consumed future goods.  It means that they consumed more in place of saving.  Due to the lack of savings, it will hurt future production.  We are beginning to pay for that now as we can see with the economy.  Unfortunately, the government continues to exacerbate the problem.

Look at this from an individual standpoint.  Let’s say that you have saved up $100,000 over the last several years.  You earned more than you spent each year and the difference was put into savings.  Now you decide to take an extravagant vacation.  You rent out your own private island for a month and get the best service available.  You have a great vacation, but you squander all of your savings of $100,000. Now you are left with nothing, except for your job.

This doesn’t mean that you will starve.  You still have the income from your job.  But your lifestyle will have to take a hit from your one month vacation.  You will have to go back to work and live within your means again.  If you want to save money again for the future, you will have to live below your means.

There is nothing wrong with consumption from an individual perspective.  We need some consumption on a daily basis just to survive.  But most people realize that we can’t always live for just today.  We do have to plan for the future.  This means saving money.  This allows capital investment, which increases future production.  It means we can have a higher standard of living in the future than what is possible today.

Government spending does not stimulate an economy any more than the person taking an extravagant vacation.  It might appear that your standard of living has increased, but in reality you are substituting savings for consumption.  You are simply living for today and not worrying about tomorrow.  The problem is, tomorrow is here now for Americans and for governments here and around the world.

The Federal Reserve met yesterday and today and Ben Bernanke held a press conference, which is a new gig designed to fight off Fed critics.  The FOMC said that it is keeping rates the same.  Of course, this is in reference to the Fed funds rate, which is almost at zero.  But the Fed is not really controlling that rate right now anyway because most of the banks do not need to borrow overnight money because they have a massive pile of excess reserves from all of the quantitative easing.

Other than some little changes in their forecasts for growth and inflation, there was not much new coming from the Fed.  Bernanke is saying that the Fed will continue to reinvest expiring bonds.  This means that the money supply should remain stable with the ending of QE2.  He did not make any promises for a QE3 and that is probably the reason that the stock market pulled back today.

It should not matter what one man says or does.  It should not matter what one small committee does.  Unfortunately, because they control the money supply of the money that is used in the largest economy on the planet, every little word by Bernanke has an effect.  It shouldn’t be this way, but it is.  Therefore, as investors, even if we don’t like the central bank, we still have to pay close attention to what it is doing.

It is impossible to predict what the Fed will do next.  If I had to guess, I think the most likely scenario is that they keep the monetary base steady for the next few months.  When the stock market does poorly, the economy continues to struggle, and unemployment doesn’t get any better, then the Fed will have an excuse to go forward with QE3.

Meanwhile, we have to continue to monitor all of the variables in our world.  There is continuing war, there are revolutions going on in the Middle East, there is a disaster still going on in Japan, there is the good possibility of default by Greece and other European countries, and there is the health of the economy in the U.S.  There are a lot of things that could go wrong right now and any one thing could trigger a financial panic.  Continue to play it safe with your money.  Playing it safe means putting a good chunk of money in the permanent portfolio and the rest in cash, gold, and silver (or equivalents).

We will also continue to monitor the adjusted monetary base and the excess reserves held by banks.  This will clue us in if we should expect serious price inflation in the next several months.

We often hear that libertarians advocate the gold standard.  This is certainly true, but it is important to understand why and what the true position is for a radical free market advocate.

As a libertarian and a follower of Austrian free market economics, I am in favor of a completely free market in money and banking.  Would we be better off under a government run gold standard?  Probably yes.  Would we be even better off if the government didn’t involve itself in money at all?  Yes.

For someone who holds radical free market beliefs, then the maximum role, if any, that the government should play in the money business is to protect people from force and fraud.  Anything beyond this and the government will use this power for evil purposes.

The reason that you will hear so many libertarians advocate a gold standard is because gold would most likely be the money of choice in a free market.  Gold and silver have been used as money for thousands of years.  Paper money is a recent thing in a long history of money.

Gold was chosen by the market to serve as money because of its properties.  It has a high value (this is why bricks or iron are not used as money).  It is divisible without ruining the value (this is why diamonds aren’t used as money).  It is durable.  It has longevity (this is why milk is not used as money).  For these and other reasons, gold (and to a lesser extent silver) have great qualities to be used as money.

The most important quality of gold and silver to distinguish them from paper currencies is that they cannot be created on a computer or on a printing press.  The government can simply create fiat money out of thin air.  To obtain gold and silver, it usually involves intense labor and the supply tends to be very limited.  So while you can have inflation of gold or silver (an increase in the supply), it is not controlled by politicians.

So as libertarians, we really shouldn’t advocate a gold standard as it might imply that we think the government should manage it.  For a truly free market, it is the marketplace that should decide on what will be used as money.  Most likely, I would bet my fiat money that the market would choose gold again.

Below is my libertarian reading list.  I am only mentioning some of my favorite libertarian books.  There are now thousands of libertarian books to choose from.  I am just listing some of my favorites that have had an influence on me in the past.

Atlas Shrugged by Ayn Rand
This is my favorite fiction book and maybe my favorite overall.  I am not a big fan of Rand’s writing style.  I don’t completely agree with her philosophy.  I don’t think the book is that realistic and I think it gives a little too much credit to businessmen.  With all of that said, it really is a must-read for any libertarian. It will take you a while, but it really is a great journey.

Fail Safe Investing by Harry Browne
For anyone who follows this blog should know, I am a big advocate of putting some of your money in a permanent portfolio as outlined in this book.  I’m not sure if the book is libertarian, but it is written by a great libertarian.

Why Government Doesn’t Work by Harry Browne
It’s Harry Browne.  Enough said.

The Great Libertarian Offer by Harry Browne
This book is more important than ever.  As libertarians, we need to offer radical solutions to today’s problems.  We need to make Americans an offer they can’t refuse.  Would you be willing to give up your favorite federal programs if you never had to pay income taxes again?

How I Found Freedom in an Unfree World by Harry Browne
This is a self-help book that may be a great benefit to some people who feel trapped in their life.

How You Can Profit From the Coming Devaluation by Harry Browne
The fist 70 pages of this book was published again under the title of “99% of All You Need to Know about Money“.  If everyone read and understood this book, then we wouldn’t have the monetary problems that we have today.  It is very basic and very informative.  Don’t worry that this book was written so long ago.  Just add a few zeros to the numbers and it’s like it was written today.

Economics in One Lesson by Henry Hazlitt
A good primer on economic thinking.

The Law by Frederic Bastiat
Although this book was written over 160 years ago, it is a good short book on economics and liberty.

The Real Lincoln by Thomas DiLorenzo
It is important for all libertarians to be educated in the War Between the States (more commonly known as the Civil War).

Whatever Happened to Penny Candy by Richard Maybury
This is a great basic book on economics.  Although it is appropriate for high school students, most adults would benefit tremendously from reading it.

Meltdown by Thomas Woods
This is a good explanation of why the economy crashed in 2008.

Rollback by Thomas Woods
I will admit that I haven’t read this yet.  However, Tom Woods is great.  I have read excerpts and all of the libertarian reviews I have read have been complimentary to say the least.  I don’t think you can go wrong with Tom Woods.

End the Fed by Ron Paul
I can’t complete a libertarian book list without including Ron Paul.

This list is by no means complete.  It is just a few of my favorites that I thought I would pass along.  Overall, I would recommend most everything by Harry Browne, Richard Maybury, Tom Woods, Robert Murphy (who I didn’t mention above), and Ron Paul.

Ron Paul’s chances of becoming president are not great.  He could beat Obama, but he will have difficulty getting the Republican nomination because of the pro-war mentality of a majority of Republicans.  However, Paul’s chances are a lot better than they were the last two times he ran for president.

I was having a discussion with a libertarian friend of mine the other day.  He is fairly radical, like I am.  Our topic of discussion was the economy and a Ron Paul presidency.  Hypothetically speaking, if Ron Paul were elected president and served for 4 years, what would happen?

My friend is afraid that the Republican establishment would immediately surround him and try to influence his cabinet picks and his policy.  I have no doubt they would try, but that is one of the reasons that I support Ron Paul and almost never support anyone else.  He has proven himself time and time again to ignore lobbyists and the establishment.  He has kept his principles.  Reagan could not do this.  You can see this by his pick for vice president and his cabinet picks.

If Ron Paul were to get the Republican nomination, it is imperative that he pick a vice presidential candidate who is at least as radical as he is.  If the CIA knocked Kennedy off, then I cannot imagine they would be happy about a true anti-establishment candidate.

My first thoughts were, that we might not actually want Ron Paul elected.  Perhaps it would be better if he came really close, but lost.  This way, when the depression hits, he would not get blamed for it.

But I was talking and thinking through this with my friend.  If we have a President Paul, it would mean that public opinion had changed significantly.  It means that the economic depression was probably already in full force.  It means that, for those who supported him, they would be forgiving of an economic depression because they would realize that he didn’t cause it.

Ronald Reagan took office in 1981.  The country went through deep recessions in his first couple of years in office.  Then the economy started to recover.  Reagan won re-election by a landslide.  The situation we are in now is a lot worse than when Reagan took office.  Price inflation is not as bad yet, but the level of malinvestment is probably worse and the debt and so-called obligations are much worse.  Regardless of what the government does, there will have to be a severe correction to flush out all of the previous malinvestment.

In my discussion with my libertarian friend, he pointed out that the economy could recover in 6 months if dramatic changes were made.  He is usually a pessimist.  I am not sure I agree with 6 months.  It could be longer because of the huge debt and the huge misallocation of resources that has already taken place because of the government and Fed policy.

So let’s say that Ron Paul becomes president.  If he governs like Reagan, then the economy will continue to struggle.  But what happens if a President Paul makes significant changes?  Some things he can do just because he is president.  He can stop the wars.  He can pardon all non-violent drug offenders convicted in federal courts.  Essentially, he could end the federal war on drugs, at least while he’s president.

The president is not a dictator, even though the last several presidents have acted like it at times.  A President Paul could not simply eliminate all unnecessary spending.  Congress could override his vetoes. But if Paul were elected president, we have to believe that there had been a major shift in popular opinion.  He would have a mandate to cut government.  He could use his platform to influence Americans, who would in turn influence their congressman and senators.

If a President Paul could make significant cuts, the economy really would recover fairly quickly, even with all of the debt and malinvestment.  Let’s say that he ended all of the wars and ended all foreign aid.  Let’s say he ends several departments that are unconstitutional.  Let’s say he can get rid of the departments of education, labor, energy, housing, and agriculture.  Let’s say that he can balance the budget and still reduce taxes.

The economy is starving.  The economy needs savings and investment.  This is how an economy grows.  The government is sucking up resources with its huge spending and borrowing.  Since the fall of 2008, Americans have saved more and paid down debt.  Unfortunately, the federal government has done the opposite, which has negated the benefits of what a lot of Americans have done.  The government is using resources that should be used as savings and investment to increase our future standard of living.

If a President Paul, or any other president, were able to get spending way down, the economy would recover.  If the budget were cut from $4 trillion to $2 trillion, this extra $2 trillion a year would be used to increase capital investment.  It would lead to an increase in our standard of living.

I like to use the example of Germany and Japan after World War II.  These countries were devastated by the war.  After the war, the two countries adopted relatively free market policies.  Miraculously, because the governments did not interfere with their economies, the two countries saw tremendous growth and eventually became two of the richest countries on earth.

This whole discussion is not a prediction of any kind.  I am simply pointing out that, given a dramatic decrease in the size and scope of government, the economy could recover quite quickly and we could once again see a strong rise in our standard of living.

Here is a chart of the adjusted monetary base:
http://research.stlouisfed.org/publications/usfd/page3.pdf

Here is a chart of the monetary base with a longer time frame.  It shows the picture even clearer:
http://research.stlouisfed.org/fred2/series/BASE

With the ending of QE2, we should expect the monetary base to stabilize.  There will still be mild fluctuations.  As of right now, there has been no announcement for QE3, even though some analysts are calling for it.

Bernanke really is in a box.  What will he do when the economy visibly turns down again?  Why will QE3 accomplish what QE2 didn’t?  What happens if price inflation goes higher while the economy continues to struggle and unemployment stays high?

Ron Paul asked him this question one time.  He essentially asked Bernanke what he would do if we have 10% (price) inflation along with bad economic growth.  Bernanke responded that that scenario would be unlikely.  Of course, Bernanke has been wrong with just about everything else, so why stop being wrong?

The federal government and the Federal Reserve continue to make things worse.  They not only do not do the right things, but they do the opposite.  The policies coming out of DC will continue to make things worse.  The only way we will see a robust recovery is if the government dramatically cuts spending and the Fed stops buying huge amounts of government debt.  The two go hand in hand.  We need private investment and savings, not more government spending and money creation.

QE2 is almost over.  If the Fed is going to create significant amounts of new money out of thin air, then we will move on to QE3 or some other name.  Either way, there is a lot of uncertainty about what the Fed will do and what is going to happen.  There are a lot of variables to consider.

Today was another big down day for the stock market.  Oil was down almost 5%.  The dollar strengthened considerably against the other major currencies.  The one notable thing is that, despite the strong dollar, gold was actually up a little today.

It is anyone’s guess as to which way things will go in the next couple of months.  Some of the variables include the Fed’s decision on QE3, Greece, the debt ceiling, revolts in the Middle East, and war, just to name a few.  There is, of course, always the possibility of some other unforeseen event occurring.

While I maintain my prediction that the Fed will continue to help Congress in a backdoor default by devaluing our money, the short term outlook is far more uncertain.  If the Fed starts pumping more money or if the banks decide to start loaning out their massive amounts of excess reserves, then we will see significant price inflation sooner, rather than later.

If the Fed stops its money creation for a while and the banks continue to hold their excess reserves with the Fed, then we could see consumer prices stabilize and we could see a significant drop in the stock market with a strengthening dollar.

Right now, investors should just concentrate on wealth protection.  I would recommend that at least a majority of your investments go into the permanent portfolio fund, the mutual fund PRPFX, or something similar.  For the rest of your money, I would put a little extra into investments related to precious metals and I would hold some cash or cash equivalent that you can use to buy up bargains later, if that time comes.

This will continue to be a roller coaster ride.  There will be ups and downs with stocks, gold, oil, the dollar, price inflation, and even real estate.  For the longer term, I still expect more inflation from the Fed and would not be surprised to see stagflation like the 1970’s.  If that is the worst that we get, we will be very lucky.  I do not expect the Fed to go to hyperinflation.  I think it will choose a depression over the complete destruction of the currency.  At that point, Congress will be forced to cut spending.

I watched most of the Republican presidential debate last night.  There were seven participants, which included Ron Paul.  The media, while paying more attention to him, continues to discount him being a contender.  I think he will have trouble overcoming the pro-war majority in the Republican Party, but it would not surprise me if he won some primaries/ caucuses.

Ron Paul made a better showing than most would have imagined four years ago.  He is starting way ahead from where he was then.  Most people outside of his district and outside of the libertarian movement had never heard of him before 2007.  Now he is a household name with a big following.  With the internet and his new notoriety, he has gained even more of a following since then.

One thing I found interesting about last night’s debate was the stance the candidates were taking on war.  Ron Paul is, for sure, the only anti-war candidate.  He is the only one who would begin troop withdrawals immediately.  But I couldn’t help but notice that the other candidates were far less hawkish than what we saw in 2007 and 2008.  Part of this may be the candidates themselves.  There is no John McCain or Mike Huckabee.  A little part of it might be because of Ron Paul.  In addition, these candidates are running against Obama and do not feel the need to defend Bush.

One other significant factor in the less hawkish war stance is public opinion.  The majority of American people have soured on the wars in Iraq and Afghanistan and most of them were never on board for Libya.  Perhaps the Republicans are starting to realize that they can’t advocate endless war and still expect to win.

One thing that surprised me about the debate was just how nice everyone was.  If I have one criticism of Ron Paul from last night, it would be that he is just too nice.  I think the candidates should be attacking Romney (the supposed front runner and establishment favorite).  They should point out that the Republican nominee cannot be someone who invented Obamacare before Obamacare even existed.  The other candidates should be asking if this election should be Obamacare vs. Romneycare, or about a real choice.

I think Ron Paul should also try to distinguish himself more (if that is possible) on economic issues.  He spoke about monetary policy which no other candidate touched and that is good.  But he is letting these other people get away with deceiving their audience with generalities.  Just about every Republican candidate is saying we need to cut spending and cut taxes.  But where, specifically, would they cut?

Since the debate moderators won’t hold them accountable, I think Paul should point out that these calls for spending cuts are not specific.  He should say that he would abolish the departments of education, agriculture, housing, labor, energy, etc.  He would end all foreign aid.  He would end all corporate welfare.  Try to force the others to take a position.

Overall, Ron Paul is a great representative of the libertarian philosophy.  Libertarians should be so thankful that we have someone who is consistently on message and who is principled and intelligent.  His many years of advocating liberty has made him into one of the best.  It is not easy in a debate when you have no idea what specific question will be asked.  He can hold his own and he will continue to help educate others on the benefits of a free society.

If I were a betting man, I would bet that Ron Paul will not win the Republican nomination, but he will surprise many.  He will probably come in second or third and he may actually win some states.  I don’t completely discount him taking the nomination, but it is still a long shot at this point with the party being so pro-war.  If Paul did win the nomination, he would have a good chance at beating Obama.

In conclusion, if Ron Paul takes second place or better in the primaries, I think libertarians should be very optimistic about the future.  If he places third, then I think there is reason for some optimism with the realization that there is still a lot of work to do.  If he does worse than third, then Galt’s Gulch becomes more appealing (a reference to Atlas Shrugged).  I think we will be pleasantly surprised.

Many in the libertarian camp believe that the U.S. dollar is headed towards zero.  Some of these same people also believe that real estate has yet to hit bottom and may stay down for many years to come.  In fact, this isn’t just a position by some libertarians, but also by many others in the investment world.

While they have been somewhat correct over the last few years and may be right for a few more, there is a limit as to how much they can be right.  If you are arguing that the U.S. dollar will continue to go down, then it should favor hard assets, one of which is real estate.

The dollar has done poorly over the last decade.  This is in relation to other currencies and this is with other currencies being devalued as well.  The price of gold has gone up in terms of all of the major currencies, but it has gone up even more in terms of U.S. dollars.  It should be noted though that there have been exceptions to this trend.  In the fall of 2008, the dollar strengthened quite a bit due to the major downturn in the economy and the flight to safety (which for some reason, people still view the dollar as safe).

It is certainly possible for the U.S. dollar and real estate to both go down some more in the short-term.  The reason for this odd circumstance is because of the previous huge bubble in housing.  The prices in real estate went up so far and so fast that they are still trying to correct, even with the government’s interventions.  Real estate is not liquid like stocks.  Therefore, it can take some time to clear the excess inventory.  In addition, the government has been trying (without much success) to prop up real estate due to the major hits that banks would take if there were even more foreclosures and short-sales.

Long-term, let’s say more than 5 years, this trend is unlikely to continue.  The U.S. dollar will not continue to go down while real estate goes down too.  Just to clarify, I am simply talking about real estate prices in nominal terms and not in real terms.

If the U.S. dollar goes down by 50% compared to other currencies in the next 5 years, then it would be 50% cheaper to buy a house for a foreigner if housing prices stayed the same.  If housing prices continue to go down, then it would be even cheaper.  And this isn’t even accounting for the fact that the foreigner’s currency probably experienced some depreciation of its own.  At some point, housing will be a bargain that just cannot be ignored.

I expect that there is a strong likelihood that the dollar will strengthen again in the near future, especially with the problems in Europe and a likely default by Greece.  Once the Fed goes ahead with QE3, then we may start to see the dollar fall again.  At some point, when velocity picks up, there will be a rush away from U.S. dollars.  People will be looking for hard assets.  Since a house is a hard asset and everyone needs a place to live, it would not surprise me to see housing prices go up again in a few years, at least in nominal terms.