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Though many people talk about the U.S. Economy, few people understand how it really works.  In this article, I’ll try to explain, in the simplest terms possible,  how the U.S. Economy operates.

Since the Federal Reserve bank opened for business in 1914, the currency of the United States (the U.S. dollar) has been borrowed into existence from this private bank (otherwise known as “the Fed”).  The reason I say “borrowed” into existence is because every single dollar the Fed has ever created is not, in fact, property of the U.S. government, it’s actually owned by the Federal Reserve bank, and is owed back to that bank, with interest.

Most people mistakenly believe that the Federal Reserve is part of the U.S. Government.  It is not.  The Federal Reserve is an independent mega-bank, which is actually a private corporation owned by the largest banks in the world.  In 1913, the United States Government gave up its Constitutional right to coin money and regulate the value of it and passed that right to a private corporation owned by the Federal Reserve.

The way this private mega-bank works is as follows:  the Federal Reserve creates all currency, not the U.S. government, and lends it out to the U.S. government and private institutions (i.e. other banks) - with interest.

You may be asking yourself “If we pay back all the currency that was borrowed into existence, but we still owe interest, where do we get the currency to pay the interest?”

Answer:  We have to borrow it into existence.

This is one reason why the national debt keeps expanding. Even if we pay off all the currency that is borrowed, the government still owes interest. In order to pay that interest off, it would need to get more money from the Federal Reserve - which we would, in turn, owe interest on.

Because of this vicious cycle, the national debt can NEVER truly be paid off.  It is mathematically impossible.  But even more disconcerting than an ever expanding debt is the way the Federal Reserve creates our currency.  The process is actually terrifyingly simple:

1.  It makes loans to the government or banking system by writing a bad check.

2.  It buys something with that bad check.

In the Fed’s own words, published in a 1977 paper called Putting It Simply:

“When you or I write a check, there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn.  When the Federal Reserve writes a check, it is creating money.”

So the Federal Reserve is doing something daily what you or I would be thrown in jail for - writing bad checks, and using those checks to buy things.

But even scarier than that, the Federal Reserve is not creating MONEY, it is creating currency.

Currency is legal tender that has no real value other than the good standing of the Government.  Money is something of value.  However, the United States operates off a monetary system known as Fiat Currency.

A fiat is basically an arbitrary decree, order, or pronouncement given by a person, group, or body with the absolute authority to enforce it.  This means that anyone with an army backing him could declare a rock as a type of currency, simply because “They say so.”  All paper currency in use today is fiat currency.

It used to be that the United States operated on the “Gold Standard,” which meant that ever dollar the United States printed was backed by a certain amount of gold the government had in its possession.  Therefore, the purchasing power of the dollar was directly pegged to the value of gold.  This meant that inflation was non-existent.

The reason for this is that when countries experienced economic booms, they imported more goods from countries who’s economy was weaker than theirs.  The imported goods were paid for in gold, so gold flowed out of the booming country.  As gold flowed out of the countries, their currency supplies contracted (that is monetary deflation).

This caused these economies to slow down and the demand for imports to fall.  As the economy slowed, prices fell, making these countries’ goods more attractive to foreign buyers.  As exports rose to meet demand, gold flowed back into that country, then the process started all over again.  The value of currency - based in gold - was always moving up and down, in a narrow range, maintaining a certain economic equilibrium.

However, under President Richard Nixon, the gold standard was abolished.  Now our currency is backed by nothing but the United State’s reputation, which means the Federal Reserve can print as much money as it wants without having to worry about having an equal amount of precious metal to back it up.  In this sense, the currency of the United States is really all smoke and mirrors.

But that’s only our government’s role in the economy.  It gets even scarier…

Once those newly created dollars are deposited in the commercial banks, the banks get to employ the use of a practice known as fractional reserve banking.

Here is fractional reserve banking in a nutshell:  All banks have a reserve requirement, meaning they must keep a certain amount of currency on hand for withdrawals and such.  If the reserve requirement set by the Federal Reserve is 10 percent, the bank must keep 10 percent of the currency deposited on hand just in case someone wants to make a withdrawal; however, they are allowed to loan out the other 90 percent of those deposits.

So for every dollar you deposit in your bank account, the banks keep $0.10 on hand and loans out $0.90 (which they, of course, charge interest on).

Here’s the kicker.  The banks don’t actually loan out the currency that’s in the accounts.  Instead they create new fiat dollars out of nothing and loan those newly created dollars out, which means they too are “borrowed: into existence.

In other words, when you deposit $1,000, the bank can create 900 brand-new credit dollars with nothing but a book entry, and then loan them out with interest.

Then, if those brand-new loaned dollars are deposited in a checking account, the bank is allowed to create another 90 percent of the value of those deposits, and then another 90 percent of that.

This process of currency creation and loans is repeated as often as the bank wants.

Coincidentally, the same year that the Federal Reserve Act was passed, there was also an amendment added to the Constitution:  the Sixteenth, which created the dreaded income tax.

Before 1913 there was no income tax.  The entire government was paid for by tariffs (taxes on imports) and excise tax (taxes on things like alcohol, cigarettes, and gas).  These taxes, and only these taxes, generated enough income for the government to operate.  However, because it didn’t generate enough income to pay the interest due to the Federal Reserve - after the Federal Reserve’s creation - the income tax was created so the government could pay the interest owed on the money it spent.

To review:

• Since 1914, we’ve borrowed every dollar into existence.
• We pay interest on every dollar in existence.
• That interest is paid to a private bank, the Federal Reserve.
• The world’s largest banks, not the government, own the Federal Reserve.
• The United States can’t pay off its debt… it can only borrow more to pay the interest.
• Our government created income tax so we can pay this interest.

Seriously - this is how the United States economy operates.  And as the Government finds new initiatives that require it to spend money - such as war, social programs, etc. - it must create new money and increase taxes in order to pay for them.

How A Barack Obama Presidency Would Affect The Economy

Now that you know how the U.S. Economy operates, you can figure out for yourself how a Barack Obama Presidency would affect it.

Our entire currency system is built like a house of cards.  Money is created out of thin air and lent out in large quantities.  This has ensured the U.S. economy continues to grow, but should the Government continue to spend as it has been, disaster could be in the making.

Barack Obama has laid out numerous initiatives which would require more government spending.  This would require even more currency to be created by the Federal Reserve, which means the National Debt will continue to grow because of compiling interest on the new money.

Because of the added interest, income taxes would have to be raised to pay for what the Government owes on the newly created currency - and not just income taxes on the wealthy either.  Eventually, the wealthy will move their money away and the tax burden will have to be forced onto the poor and middle class.

But as if the prospect of an inevitable income tax increase wasn’t enough, we now have the “Bailout” situation, where the U.S. Government is buying out all the failing banks due to the subprime mortgage crisis.

This means that the government is now going to own the institutions which essentially create more currency!

When the government owns these financial institutions, whats to stop them from creating as much money as they want to spend based off the the money you deposit in the bank using fractional reserve banking?

Answer:  NOTHING.

This is no doubt, what will eventually pay for nationalized health care, social security, welfare, etc.

Some of you may ask yourself:  “What’s wrong with that?”  After all, if this is truly an endless piggy bank, isn’t that a good thing for everybody?

In an ideal world, you’d be correct.  However, if you understand the mechanics of a depression, you’ll see why this is so dangerous.

When we take out a loan from a bank, the bank does not actually loan us any of the currency that is deposited in that bank.  Instead, the second your pen hits the mortgage, loan document, or credit card receipt we are signing - the bank is allowed to create those dollars out of thin air as a book entry - it is not actually required to have that money on hand, ready to be paid out.

In other words, we are the ones who create the currency.  The bank is not allowed to do it without our signature.  We create the currency, and then the bank gets to charge us interest on what we just created.  This brand new currency we just created becomes part of the currency supply.  Much of our currency is created this way.

But when a home goes into foreclosure, a loan gets defaulted on, or someone files bankruptcy, that currency that was created simply disappears.  So as credit goes bad, the currency supply contracts, and deflation sets in.

This is what happened in the Great Depression of 1930-1933, and it was disastrous.  As a wave of foreclosures and bankruptcies swept the nation, one-third of the currency supply of the United States evaporated into thin air.

Why is this bad?

Because in a deflation, just about everything declines, including wages, prices, gross domestic product, and most importantly for any working American - your income.

However, one thing remains absolute:  DEBT.

How much money you owe stays the same no matter what.  If you owe $1,000, no matter how much deflation the economy experiences, you still owe $1,000.

When the stock market crashed in the Great Depression of 1929, the Gross Domestic Product of the United States shrank.  The Gross Domestic Product of the United States is how much money the country produces.  Our National Debt is a percentage of that.

With the Great Depression, debt as a percentage of Gross Domestic Product grew from 180% to 280%!!!!

So to put this in more personal terms, let’s say your income is $100 per month, and your debt payments are $40 per month for things like your mortgage, car payments, and credit card payments.  After paying your monthly debt payments, you are left with $60 to pay for food, utilities, insurance, and leisure activities.

In the Great Depression, nominal income fell by 53%.  If our economy suddenly became depressed, and the same thing happened again, your income would now be $47 instead of $100.

Now, you might think to yourself:  “Okay, but prices would fall too, so my purchasing power would be the same, right?”

Yes and no.

Even though prices would fall to match your income, your debt won’t.  That’s a fixed number.  So after paying your $40 in monthly debt payments, you’re essentially left with only $7 to meet all your bills, whereas before you had $60.  That means you can forget about going to the movies, having hot water, enjoying the benefits of electricity - pretty much everything but eating, and even that may be a struggle.

Now you have to sell your house, but you still owe $5,000 on it and you find out that in the depressed economy, its only worth $2,000, so now $3,000 is added to your debt.  Now you can’t afford to even pay your debt, and your car, furniture, and everything else gets repossessed, and you end up penniless and on the street.

This is exactly what happened in the great depression.

So let’s say that an Obama Administration starts borrowing from the newly nationalized banks to pay for its ambitious social programs, and there’s a crisis where people want to withdraw their money and there is a run on the banks.

All of a sudden, the government has to produce the money it owes to the banks, so it can avoid a depression and the people can get what’s rightfully theirs.

Essentially, a huge bill just came due for the government, which it must pay because it owns the banks, or else it would be stealing from its own citizens.  In order to pay this bill, and keep the social programs going, it would have to print more money in order to keep deflation from shrinking the country’s money supply and plunging into a depression.

Now, because there’s a new flood of currency, suddenly hyper-inflation sets in.  This means your money is now worth less, and prices rise exponentially.  This means that the purchasing power of the dollar falls dramatically, and now you’re looking at $1,000 loafs of bread.  For a family that only makes $50,000 a year, that is a disaster!

Think this sounds far-fetched?  It’s not.  The type of hyper-inflation I just described happened in France in 1720, in Germany in 1923, and in Russia in the 1990’s.

This is a very real scenereo in an economy where the currency is not backed by gold or silver, and spending gets out of control.  And unfortuneately, it would appear that Barack Obama does not know what dangers his spending plans bring to the American Economy.

However, what many people don’t realize is that Robin Hood was actually stealing from the government - an oppressive aristocracy which was taxing its citizens unfairly - and giving back money which was originally the poor’s in the first place.

But does wealth redistribution actually help society? Is it more beneficial to the rich than it is to the poor? Is it a cheap stunt used by politicians to get votes? In this article, we’ll examine the concept of wealth redistribution, its effect on the United States, and more importantly - how it effects your average taxpayer.

Free Is Really, Really Expensive

These days the only way a politician can get elected is by promising more free stuff than the politician he is running against. But the public doesn’t seem to realize that free stuff isn’t really free.

It would be political suicide for a politician to even suggest that we should cut back in any area of the budget. If you suggest cutting the military budget, the right wing will tell you you’re un-American and there are terrorists under your bed. If you suggest cutting social security, the AARP will mobilize their tsunami of voters against you. And if you suggest cutting Medicare and Medicaid, the entire population will rise up against you screaming, “But health care is the single most important issue of our day!”

The problem is that every issue is the single most important issue of our day. That is why tough choices that need to be made to shore up our economy won’t be made.

To this you must add the fact that the United States Of America has essentially become a socialist society living under the delusion that we are still free market capitalists. We forget that WE ARE the government.

The government isn’t some benevolent, separate entity with deep pockets. Whenever a problem arises, the majority always says the same thing - “The government should do something about it.”

They all seem to think that our government should be everybody’s safety net. When major hedge funds overleverage themselves, they think the government should bail them out, and when homeowners over-mortgage their homes, they think the government should save them from foreclosure.

We don’t seem to make the connection that whenever the government “does something about it,” it does so at half the efficiency and twice the cost of the private sector. Then it hands the public the bill through either direct taxation or through inflation taxation (aka the “hidden tax“).

That means, in the end, we all pay.

One of the biggest problems is that we hire (i.e. vote for) the wrong people to decide how our currency is to be spent. I would venture to say 99% of the officials we send to Washington D.C. who are charged with the job of redistributing our wealth, and thus the task of running the economy, know nothing about economics.

And if they do know, they don’t really care because their term is only two, or four, or six years.

President George W. Bush, as captain of our economic ship, decided to correct our course with tax cuts, and then scuttle us on the rocks of reckless spending due mostly to Medicare prescription drug benefits and the war in Iraq. But unlike the captain of the Titanic, he’s not going down with the ship - we are.

The Dangers Of Big Government

The biggest problem facing America isn’t the housing crisis, the war on terror, or public education. The biggest problem facing America is really big government. It’s a huge monster that needs continuous feeding.

Before President Roosevelt’s New Deal, the federal government was just 3% of the economy. Today, it’s over 26%. And when you add in state and local governments, plus the cost of regulatory compliance, plus the cost of all the business that provides goods and services that support all the government agencies, it’s more than 50% of the U.S. economy.

The biggest threat the American people have to face in any economic crisis is government coming to the rescue. And with the government so big, and so pervasive, and with everyone expecting government to provide a safety net for every possible contingency - it will continue to grow.

That means it will require more money. Where does it get that money? From you and me. And when it needs more than we are able to give, it creates it out of thin air.

As the famous economist Milton Friedman puts it:

Government has three primary functions. It should provide for military defense of the nation. It should enforce contracts between individuals. It should protect citizens against crimes against themselves or their property. When government - in pursuit of good intentions - tries to rearrange the economy, legislate morality, or help special interests, the costs come in inefficiency, lack of innovation, and loss of freedom. Government should be a referee, not an active player.

People don’t realize what government bailouts of private financial institutions really cost. The savings and loan crisis of the late 1980s cost taxpayers $150 billion. In 1989 the U.S. population was less than 250 million. That means everyone inn the U.S. paid more than $600 each ($1,000 in 2007 dollars), either through taxes or inflation, to fix problems stemming from those financial institutions’ stupidity. But that was nothing compared to what looms on our horizon.

The reason the potential for systemic financial failure of our economy exists at all is because the public allowed themselves to be hoodwinked by big government and big banks. It was a process that took a few hundred years to unfold.

The first con job was that we allowed ourselves to be taken in by fractional reserve banking policies, which allows banks to create money out of thin air.

The second con job was allowing fractional reserve commercial banks to be pyramided on top of fractional reserve central banks (like the Federal Reserve).

The third mistake was not rising up against our government and the central banks in 1971 when the Federal Reserve, in collusion with President Nixon, made the U.S. dollar into a purely fiat currency.

The fourth, and probably biggest, mistake is allowing government to continue to create money and spend it unchecked as it continues to grow, and grow, and grow.

The result is simple: inflation, inflation, and more inflation.

What Is Socialism?

Socialism refers to a broad set of economic theories of social organization advocating social or collective ownership and administration of the means of production and distribution of goods, and the creation of an egalitarian society where labor is the main source of wealth.

In essence, in a socialist society, everything is owned by one organization, and all money flows into and out of that organization.

In this sense, Socialism is another word for one great, big, gigantic monopoly - where the government is the body that controls this monopoly.

In theory, this is a great system because it promotes “fairness” in the sense that it eliminates poverty. However it also eliminates incentives to succeed, to innovate, and to work hard. It also creates enormous inefficiency, stagnant to non-existent economic growth, and the creation of an elite ruling class that is rife with corruption.

In economics, a monopoly exists when a specific individual or enterprise has sufficient control over a particular product or service to determine significantly the terms on which other individuals shall have access to it. Monopolies are thus characterized by a lack of economic competition for the good or service that they provide and a lack of viable substitute goods.

When the government nationalizes an industry, it essentially gains a legal monopoly over that industry and eliminates all competition from the marketplace. The reason monopolies are illegal in the private sector is because when one entity has control over an industry, there are no price controls. Competition drives down the cost of goods and services. Without competition, there is nothing to keep the controlling organization from price gouging its customers.

This is especially dangerous when it comes to necessities, like food, water, medicine, etc.

When you allow government to grow and take over industry, you essentially allow the government to control the price of the goods and services in that industry.

Many people believe this is a good thing because government can keep the price of those goods and services low. However, price limits have historically backfired on all governments who have tried them, because the free market always wins out - no matter what you do to try and stop it.

Take the example from ancient Rome. In 301, Roman emperor Diocletian issued an order called the Edict on Prices, which imposed the death penalty on anyone selling goods for more than the government-mandated price.

Merchants could no longer sell their wares at a profit, so they closed up shop or moved to lands which allowed them to sell their goods at a free-market price.

When government mandates prices that are artificially low, it causes a transfer of wealth out of the country. To see evidence of this, simply look at the communist nation of Cuba. Though Cuba is communist, the difference between socialism and communism is that a socialist society is only about economic monopolies, whereas a communist society is about economic and political monopolies.

Since the communist revolution in Cuba in 1959, the country has seen a progressive economic downturn. Without the influx of money from the Soviet Union to bolster its economic, it has seen class equality achieved - everyone in Cuba (except for the ruling class) is poor.

Here is what Socialism has brought to Cuba:

• Production is run by the government and the labor force is run by the state.
• Capital investment is restricted and requires approval by the government. This ensures a lack of private sector jobs and economic competition.
• The Cuban government sets most prices and rations goods to citizens.
• Any firm wishing to hire a Cuban must pay the Cuban government, which in turn will pay the company’s employee in Cuban pesos.
• Preferential treatment exists for the ruling class of the Communist party, which get luxuries average citizens do not, such as access to transportation, work, housing, university education and better health care.
• Starting in the late 1980s the Soviet subsidies for Cuba’s state-run economy started to dry up. Before the collapse of the Soviet Union, Cuba depended on Moscow for sheltered markets for its exports and substantial aid. The Soviets had been paying above-market prices for Cuban sugar, while providing Cuba with petroleum at below-market prices. The removal of these subsidies sent the Cuban economy into a rapid depression known in Cuba as the Special Period.
• Since 1959 Cuba has experienced slow growth in its Gross Domestic Product relative to other countries that were in a similar situation in the 1950s, stagnant trade, and amassed a significant debt amounting to some $16.62 billion in convertible currency and $15 to $20 billion dollars with Russia
• Cuban citizens themselves have experienced a decrease in their caloric intake and a shortage of housing since 1959.
• For some time now, Cuba has been experiencing a housing shortage because of the state’s failure to keep pace with increasing demand.
• Food is rationed to Cuban citizens and state salaries are failing to meet personal needs of its citizens under the state rationing system chronically plagued with shortages.
• As the variety and amount of rationed goods available declined, Cubans increasingly turned to the black market to obtain basic food, clothing, household, and health amenities.
• There have been mass exoduses of Cuban citizens to the United States in an effort to achieve economic prosperity, causing a decline in productivity, innovation, and wealth creation in Cuba - not to mention a shrinking work-force, which contributes to the government’s failure to meet production demand.

And this is just the most recent example of how a government-run monopoly can wreck the economy. Keep in mind, this all started when Castro had his government seize the wealth and property of his country’s rich and wealthy, and took over the utilities and financial institutions.

Why Wealth Redistribution Is Good For The Rich And Bad For The Poor

Although socialism has long claimed to be for the poor, it has probably done more damage, on net balance, to the poor than to the rich. After all, the rich have enough money to leave the country if they think the socialists are going to do them any serious harm.

Some of our own rich here in the United States have already had their money leave the country, to be sheltered from the higher taxes that limousine liberals say we should all pay (to learn more about this, read our article on how the rich hide their wealth). Meanwhile, the mainstream media give them kudos for their selfless advocacy of higher taxes on higher income people, forgetting that these are not taxes on wealth.

Most of the people in the upper income brackets are not rich and do not have wealth sheltered offshore. They are typically working people who have finally reached their peak earning years after many years of far more modest incomes — and now see much of what they have worked for siphoned off by politicians, to the accompaniment of lofty rhetoric.

The rich have learned to adapt socialist policies to their own benefit. For example, a while back the city of Riviera Beach, Florida, was planning to demolish a working class neighborhood under its power of eminent domain, in order to prepare the way for a marina for yachts, luxury condominiums and an upscale shopping district.

What will the city of Riviera Beach get out of all this? More taxes from higher-income people, enabling local politicians to spend more money on programs to attract votes.

Meanwhile the rich get rid of lower-income folks without having to pay them the value of their homes and businesses that will be demolished. As in so many other cases, eminent domain is socialism for the rich.

Theoretically, those whose homes and businesses are demolished will get the “just compensation” to which the Constitution says they are entitled.

In reality, just announcing plans to demolish the homes in an area will immediately demolish part of their market value. Even if homeowners are compensated for whatever value remains when their homes are actually demolished — which can be years later — they have still been had.

For businesses, compensating them for the value of their physical assets — which may or may not include ownership of the place where their businesses are located — does nothing to compensate them for the often much larger value of the clientele they have built up over the years but who are now scattered to the winds by neighborhood demolition.

This game doesn’t work the same way in rich neighborhoods. Not only can the rich hire big-bucks lawyers to fight city hall, why would city hall want to get rid of upscale taxpayers, who are often also big donors to political campaigns?

Remember - in socialism, there is no equality. There is the ruling class, and everyone else. As evidenced in other socialist countries, the ruling class (those who control the monopolies) get special perks and privileges others do not.

In a socialist society, the rich, who can afford to lobby politicians, are usually awarded favorable treatment due to their ability to help finance political campaigns. In exchange, they are not only given preferential treatment, but in most cases, more wealth is transferred to them in the form of political power. This leaves the average working man out in the cold, as he now has no way to achieve success thanks to the anti-competition stance of a socialist government as opposed to the open opportunities of a free market.

How Will Obama’s Tax Policies Redistribute Wealth?

Barack Obama has stated numerous times that he is looking to create “fairness” in America’s economy, which is a socialist ideal. He has even stated that he wants to “share the wealth” by taking money from people who earn it in the form of higher taxes, and giving it to people who don’t. (The “rich guy and the waitress” metaphor he likes to repeat).

You can see him talk about his socialist-leaning beliefs in these videos:

This makes it obvious that Barack Obama does not see taxation as a means to pay for government works, rather he sees taxes as a socialist system of wealth redistribution.

If you apply Obama’s “fairness” policies to schools, you’ll get a better idea of how this works…

Let’s say your child is studying for an important test. He comes home from school and studies hard and diligently for hours. He learns the material, and when he takes his test, he gets an A+ thanks to his hard work.

But then the teacher goes to him and says “You did great, but Billy and Jack didn’t do so well. They both got D’s on the test. In order to make things fair, we’re going to take away two of your grade points and give it to them, so now you all have C’s.”

Your child cries to you about how he worked so hard to earn an A, while Billy and Jack played video games. You complain to the teacher about it not being “fair,” because your child worked for his grade while the other two didn’t. Your complaints fall on deaf ears, since to the school, their definition of fairness means everyone gets the same grade, while your definition of fairness is that you get what you work for.

Now, your child gives up studying and plays video games all day because he can’t see the point in studying hard when everyone gets the same grade due to the school redistributing them.

If it were your child this happened to, chances are you’d raise holy hell to make sure his hard work got rewarded. But when it comes to other people’s money, most wouldn’t fight for the “fairness” of others keeping more of what they worked hard to earn.

Remember - in America, we aren’t pegged into an income class. If a waitress making $4/hour plus tips wanted to, she could start her own restaurant and make more money. Or she could invest in stocks and get money from the market. Or she could learn a skill and get a better job. Just because that waitress works at a minimum wage job, does not mean she does not have opportunity to advance economically.

Barack Obama’s mantra of being “neighborly” is also flawed. Being neighborly implies you have a choice to be kind to someone in your community. If you like your waitress, you are free to choose to give her more of your hard earned money.

But when the government takes your money, you have no say in who that money is given to. While you work hard every day trying to provide for your family, that money you pay in taxes might be given to an alcoholic on welfare who watches TV all day and neglects his kids. You just never know, because you are not in charge of your money at that point.

The most telling effects that Barack Obama’s “share the wealth” philosophy will have on the Economy, however, are the effects on states that already practice his tax the rich, give to the poor policies.

Barack Obama’s Wealth Redistribution In Practice

Despite the federal government’s growing economic dominance, individual states still exercise substantial freedom in pursuing their own economic fortune — or misfortune. As a result, the states provide a laboratory for testing various economic policies.

In this election year, the experience of the states gives us some ability to look at the economic policies of the two presidential candidates in action. If a program is not playing in Peoria, it probably won’t work elsewhere. Americans have voted with their feet by moving to states with greater opportunities, but federal adoption of failed state programs would take away our ability to walk away from bad government.

Growth in jobs, income and population are proof that a state is prospering. But figuring out why one state does well while another struggles requires in-depth analysis. In an effort to explain differences in performance, think tanks have generated state-based economic freedom indices modeled on the World Economic Freedom Index published by The Wall Street Journal and the Heritage Foundation.

The Competitiveness Index created by the American Legislative Exchange Council (ALEC) identifies “16 policy variables that have a proven impact on the migration of capital — both investment capital and human capital — into and out of states.” Its analysis shows that “generally speaking, states that spend less, especially on income transfer programs, and states that tax less, particularly on productive activities such as working or investing, experience higher growth rates than states that tax and spend more.”

Ranking states by domestic migration, per-capita income growth and employment growth, ALEC found that from 1996 through 2006, Texas, Florida and Arizona were the three most successful states. Illinois, Ohio and Michigan were the three least successful.

The rewards for success were huge. Texas gained 1.7 million net new jobs, Florida gained 1.4 million and Arizona gained 600,000. While the U.S. average job growth percentage was 9.9%, Texas, Florida and Arizona had job growth of 18.5%, 21.4% and 28.9%, respectively.

Remarkably, a third of all the jobs in the U.S. in the last 10 years were created in these three states. While the population of the three highest-performing states grew twice as fast as the national average, per-capita real income still grew by $6,563 or 21.4% in Texas, Florida and Arizona. That’s a $26,252 increase for a typical family of four.

By comparison, Illinois gained only 122,000 jobs, Ohio lost 62,900 and Michigan lost 318,000. Population growth in Michigan, Ohio and Illinois was only 4.2%, a third the national average, and real income per capita rose by only $3,466, just 58% of the national average. Workers in the three least successful states had to contend with a quarter-million fewer jobs rather than taking their pick of the 3.7 million new jobs that were available in the three fastest-growing states.

In Michigan, the average family of four had to make ends meet without an extra $8,672 had their state matched the real income growth of the three most successful states. Families in Michigan, Ohio and Illinois struggled not because they didn’t work hard enough, long enough or smart enough. They struggled because too many of their elected leaders represented special interests rather than their interests.

What explains this relative performance over the last 10 years? The simple answer is that governance, taxes and regulatory policy matter. The playing field among the states was not flat. Business conditions were better in the successful states than in the lagging ones. Capital and labor gravitated to where the burdens were smaller and the opportunities greater.

It costs state taxpayers far less to succeed than to fail. In the three most successful states, state spending averaged $5,519 per capita. In the three least successful states, state spending averaged $6,484 per capita. Per capita taxes were $7,063 versus $8,342.

There also appears to be a clear difference between union interests and the worker interests. Texas, Florida and Arizona are right-to-work states, while Michigan, Ohio and Illinois are not. Michigan, Ohio and Illinois impose significantly higher minimum wages than Texas, Florida and Arizona. Yet with all the proclaimed benefits of unionism and higher minimum wages, Texas, Florida and Arizona workers saw their real income grow more than twice as fast as workers in Michigan, Ohio and Illinois.

Incredibly, the business climate in Michigan is now so unfavorable that it has overwhelmed the considerable comparative advantage in auto production that Michigan spent a century building up. No one should let Michigan politicians blame their problems solely on the decline of the U.S. auto industry. Yes, Michigan lost 83,000 auto manufacturing jobs during the past decade and a half, but more than 91,000 new auto manufacturing jobs sprung up in Alabama, Tennessee, Kentucky, Georgia, North Carolina, South Carolina, Virginia and Texas.

So what do the state laboratories tell us about the potential success of the economic programs presented by Barack Obama and John McCain?

John McCain will lower taxes. Barack Obama will raise them, especially on small businesses. To understand why, you need to know something about the “infamous” top 1% of income tax filers: In order to avoid high corporate tax rates and the double taxation of dividends, small business owners have increasingly filed as individuals rather than corporations. When Democrats talk about soaking the rich, it isn’t the Rockefellers they’re talking about; it’s the companies where most Americans work. Three out of four individual income tax filers in the top 1% are, in fact, small businesses.

In the name of taxing the rich, Barack Obama would raise the marginal tax rates to over 50% on millions of small businesses that provide 75% of all new jobs in America. Investors and corporations will also pay higher taxes under the Obama program, but, as the Michigan-Ohio-Illinois experience painfully demonstrates, workers ultimately pay for higher taxes in lower wages and fewer jobs.

Barack Obama would spend all the savings from walking out of Iraq to expand the government. John McCain would reserve all the savings from our success in Iraq to shrink the deficit, as part of a credible and internally consistent program to balance the budget by the end of his first term. Barack Obama’s program offers no hope, or even a promise, of ever achieving a balanced budget.

Barack Obama would stimulate the economy by increasing federal spending. John McCain would stimulate the economy by cutting the corporate tax rate. Barack Obama would expand unionism by denying workers the right to a secret ballot on the decision to form a union, and would dramatically increase the minimum wage. Barack Obama would also expand the role of government in the economy, and stop reforms in areas like tort abuse.

The states have already tested the McCain and Obama programs, and the results are clear. We now face a national choice to determine if everything that has failed the families of Michigan, Ohio and Illinois will be imposed on a grander scale across the nation. In an appropriate twist of fate, Michigan and Ohio, the two states that have suffered the most from the policies that Barack Obama proposes, have it within their power not only to reverse their own misfortunes but to spare the nation from a similar fate.

Barack Obama says that his tax plan will only affect the top 5% of working Americans who earn more than $250,000 a year, otherwise known as the “rich” or “wealthy Americans” according to him and the Democrats.

However, what many Americans don’t realize is that the Rich know how to hide their wealth so that they are not forced to pay more taxes than the rest of working Americans.

What they do is not illegal.  They just use the tax code creatively to get as many deductions as possible, they segmentize their money, re-invest their money, park their money, and even move it away from the shores of the United States to avoid excess taxation.

Your typical American worker receives a paycheck, deposits that money in a bank account, and files a W-2 tax return every year based on the payment records from their employer.  Because of this, the average American worker thinks that rich Americans do the same thing.

However, nothing could be further from the truth.  Rich Americans instead rely on a strategy of “asset protection,” in which not only their money, but everything they own is protected from both government taxation and lawsuits.

Understand - many rich and wealthy Americans are entrepreneurs and investors.  In that sense, they are their own bosses, and own the entities through which they do business.

This means they do not have to pay taxes right away on the money they earn.  Your typical working American has money automatically deducted from his paycheck by his employer for taxes before he even gets his check.  People who work for themselves do not have to do this.  Instead, they can pay taxes on a quarterly or yearly basis.  This means they get to use (and spend, and hide) their money before the government does, as opposed to working Americans who never get the chance.

This might not seem like a big deal, but it is, because when you have access to your money before the government does, that gives you more leeway to spend it in ways that allow you to claim less earnings, which can mean less taxes in the long run.

The rich hide their wealth by creating what are known as “holding companies.”  These are corporations and other business entities created for the sole purpose of holding assets.  Typically, asset protection takes place in three phases…

1.  Public Companies:  These are the companies that do business that the public can see, that are directly linkable to the rich (for instance, Microsoft and Bill Gates).

2.  Mother Companies:  These are the business entities that public companies funnel their assets to.  The public typically doesn’t know about these, and they are hard to trace.  These can also take the form of Trusts and Foundations.

3.  Holding companies:  These are companies that are designed to do nothing but hold assets.  These are typically hidden as well.

By using these asset protection strategies, the wealthy and rich are able to preserve their wealth, not only from lawsuits, but also from taxes.

No One Knows Who’s Rich

There are hundreds of people in the world whose names you might never know but who own millions — if not billions — of dollars.

These wealthy individuals often go out of their way to hide their assets from scrutiny — sometimes from the public and sometimes from their own government.

Russians, for instance, are reportedly pouring record amounts of cash into London monetary markets to hedge against any future political retribution should the communist and “wealth redistributors” ever come back into power in Russia.

Figuring out how much money someone has is not an easy task.

Even Forbes magazine, which comes out with an annual list of the richest 400 Americans, acknowledges that its figures are just estimates and are “deliberately conservative.”

But in the United States there is very little information about how much the super-rich earn in general.

The federal government’s income surveys stop at $150,000 a year.

America has very, very bad information on the income of high-income people.  This makes it hard for the government to determine what tax bracket they fall into.  In fact, many of the richest and wealthiest people in the world actually own nothing.  On paper, they are dirt-poor.

There are a lot of public records and ways to find out what somebody is worth, but unless you have access to somebody’s bank account you can’t know it all.  And the IRS doesn’t have some magic wand that tells them how much money flowed through your bank account, unless they specifically target you.

Forbes says it goes through Securities and Exchange Commission filings, court records and calls analysts, employees, competitors, and even ex-wives to figure out who the world’s wealthiest people are for their list.

“We do not pretend to know everything on a private balance sheet,” the magazine states when explaining its methodology.

Forbes says it tries to include everything, from stakes in publicly traded or privately held companies, to real estate, art, yachts and mansions.

But in the end, it’s an educated guess. When Forbes says somebody is worth $7 billion, it means that the person is worth at least $7 billion.  But keep in mind this number is determined by ASSESTS, not dollars in the bank.  And though the wealthy may have access to assets, they don’t actually own those assets.

So if a rich or wealthy individual or business is particularly skilled at protecting and hiding their assets, this means that the federal government may never know how much money they truly make.

How Wealth Is Protected

Most rich and wealthy people are not motivated to avoid taxes — they are motivated to protect their wealth. They want to make it so that their hard-earned wealth remains theirs and can be passed down to their families.

(If you were wealthy, wouldn’t you want the same thing?)

It just so happens that protecting wealth means giving less of it to the government in the form of taxes.

The best way to protect wealth is to create separate entities to hold that wealth and and move it outside of the jurisdiction of the United State’s tax code.  So instead of having a savings account that has $1,000,000 in it, they may have five corporations who have savings accounts with $200,000 each in them.

This is important, because the owner of these companies can claim legal tax deductions under the corporation which he spends his money under.

For instance, he’s allowed to deduct the half the expense of his meals if it is related to the business.  So if he takes his family out to dinner and uses one of the company cards, half the expense of that meal is tax deductible.

And then, before they have to file a tax return, they can funnel money into an offshore corporation in a more tax friendly country, so they really don’t have to pay United States taxes on that money.

Think this sounds complicated?  Well, keep in mind if you have enough money, you can hire as many accountants and lawyers as you need to set this up for you.

Enron, for example, had 881 offshore subsidiaries, including 692 in the Cayman Islands alone, and many more in Turks and Caicos, Mauritius, and Bermuda. Scandal-plagued companies like Parmalat and Halliburton use similar devices in the Cayman Islands.

So even though they are not “skipping out” on paying taxes, they are taking advantage of tax deductions which allow them to claim less income than they really make and tax shelters which allow them to keep more of their own money.

Not only that, but they can also take advantage of off-shore banks which are friendly to people looking to protect their assets.  Typically, off-shore banks are used because it’s harder for the U.S. government to tell exactly how much money the rich and wealthy have in these banks because they are outside the reach of the accounting jurisdiction of the I.R.S.  Remember, I.R.S. stands for INTERNAL Revenue System.  If you money is EXTERNAL (i.e. in a foreign country) they can’t get to it.

This allows the rich to park money outside of the U.S. tax system.

For example, let’s say a wealthy business owner sets up a corporation in the Cayman Islands.  He can pay his money to that corporation for some type of “service.”  (usually a management fee of some type)  That money is then put into the company’s bank account in the Cayman Islands, and protected from U.S. taxation.  And the owner of both companies can take a tax deduction for the money sent to that account because it can be considered a “business expense.”

Wealth can also be transferred into Trust funds.  One of the best ways is to set up a revocable living trust.

Putting assets in such a trust doesn’t always shield them completely, but makes them harder to find.

Many trusts are set up in somebody’s initials. So, for instance, if you were searching for Bill Gates in a computer database of land records he wouldn’t show up because the property might be under the name of the B.G. 2007 Trust.

Limited Liability companies are also used to shelter assets.  The rich and wealthy usually have their homes, cars, stocks, bonds, etc. all owned by separate LLC companies.

So one LLC owns their house, while a different LLC owns their car, and yet another separate LLC owns their stock holdings.

This is a way to protect themselves from being sued.  If a car they own hurts someone, they can’t be personally liable for the injury because they don’t own the car, the LLC does - and the total value of the LLC is the net worth of the only asset it owns, which is the car.  So if someone sues, they sue the LLC, which can only be liable for the total amount of assets it owns.

But it also protects them from the government.  Should the IRS ever start seizing assets, they would have to track down every LLC which holds that asset, and if the LLC’s aren’t directly linked to the person undergoing the asset seizure, it makes it very difficult for the IRS to truly take everything.

What This Means Under An Obama Tax Plan

Obama plans on taxing individuals and businesses that make more than $250,000 a year.

If there is a business that makes $1,000,000 per year, all that business has to do is create five other corporations and divide its revenue up between them.

So instead of paying taxes on $1,000,000, they pay five sets of taxes on $200,000, which is below the Obama tax increase level.

This is perfectly legal, because the company can claim it bought services from those companies, and it is a legitimate expense that can be deducted.

The wealthy can also transfer their wealth off-shore, which will see more currency leave the United States, which means it is not being spent in the United States, which means a contraction of the currency supply, which could lead to economic depression.

Many wealthy Americans can also pay significantly lower income tax than they should, since they can have their corporations and holding companies hold their wealth.  Remember - if you set your asset protection up properly, you own nothing!  Most rich and wealthy Americans take a salary big enough to keep them from raising red flags at the IRS.

If you look at Warren Buffet, he is worth $65 billion, but his yearly salary is only $100,000 - well below the $250,000 cap Barack Obama proposes.

So Warren Buffet actually pays income taxes on his $100,000 salary.  And under the Obama Tax Plan, he actually pays less money than most small businesses.

Other wealthy and rich people do the same.  They may only claim a salary of $30,000-$50,000 per year, and shelter the rest of their wealth either off-shore or in holding companies.

The people who would pay their fair share of the tax code are small businesses making over $250,000 a year who don’t know how to protect their assets.

So the wealthiest Americans, who Barack Obama has targeted to pay more taxes, actually don’t pay their fair share (and most likely never will, no matter how many loopholes you close), while the burden falls to those hard-working middle-class business owners who’ve never dealt with or thought about asset protection before.

Remember - the rich are rich for a reason!  They understand how money works and they’re smart enough to know how to protect it.

Many Americans just don’t understand the extent the wealthy will go to in order to hide and protect their wealth.  The IRS tries very hard to make sure people pay their fair share, but they can’t get everybody.  With creative accounting, any wealthy American can get out of paying his fair share of taxes - and do so legally.

Just keep in mind that the last time the United States saw as high of tax rates on the wealthy as Barack Obama is imposing, it was under President Jimmy Carter in the 1970s, which caused a huge transfer of wealth to occur, with the wealthy moving their assets outside of the United States. This was a large reason for the increase in government spending and runaway inflation under President Jimmy Carter.

The rich have the ability to move away from an oppressive tax system, and history has shown that they will do so.  Corporations have also shown a similar habit.  Whenever higher tax rates are imposed, you see wealth leave the country, and that means the tax burden ultimately falls onto the people who remain - the lower and middle-income citizens.

History has a way of repeating itself. And under Barack Obama’s tax-the-rich plan, it most likely will.

Currently, the United States is in the middle of an economic conundrum which has become the focal point of the presidential election.  The mainstream media has dubbed this the “sub-prime mortgage crisis,” but people are calling it the “housing crisis.”

Both John McCain and Barack Obama have geared their talking points around the “greed of Wall Street” and how their recklessness has effected ordinary Americans on “main street.”  They both have plans on how to fix this economic crisis – both of which have to do with spending more money and increasing inflation.

In this respect, it is obvious that neither Barack Obama, John McCain, or most of the Congress or Senate have any idea how to actually fix this issue.  In fact, their plans for bailouts will only make things worse in the long run.

Because this issue is so important to the health of the economy, it is important for the public to understand the cause of this mess, what really happened that caused the economic downturn, and what should be done to fix it.

The Start Of The Crisis

Whenever some crisis takes place, the politicians are quick to play the blame game.  It started with the Democrats blaming President George W. Bush and his “failed economic policies.”

Then the Republicans shot back by saying it was the incompetent leadership of the Democratic Congress that really got us into this mess.

Then, it was President Jimmy Carter’s economic policies which forced financial institutions to loosen up lending standards for high-risk low-income individuals to buy affordable housing, a policy that President Bill Clinton took to the next level.

But tracing it back even further, we could lay the blame at the foot of President Richard Nixon, who took our currency off the Gold Standard.  Or perhaps it was President Lyndon Johnson’s fault, since he was the one to cheat the world’s economic system by funding the Vietnam War and aggressive social programs entirely through deficit spending.

But the true cause of this crisis goes to the very heart of how the U.S. economy works, with the creation of the Federal Reserve in 1914.

Remember that the Federal Reserve Bank is not a part of the U.S. government.  Unlike the CIA, FBI, Department of Defense, and other government agencies which are accountable to a Congressional committee which supervises their operations and controls their budgets and supervises their activities – the Federal Reserve is a private corporation.

That means the Fed is accountable to no one.  It has no budget.  It is subject to no audit.  And no Congressional committee knows of, or can truly supervise, its operations.  The Federal Reserve is virtually in control of the nation’s monetary system and is accountable to nobody.

The Birth Of The Fed, And The Start Of A Crisis

In 1907 there was a banking and stock market panic in the U.S., aptly called the Panic of 1907.  It was widely believed that the big New York banks known as the Money Trust had been causing crashes on Wall Street, and then capitalizing on them by buying up stocks from rattled investors and selling them for tremendous profit just days or weeks later.

The Panic of 1907 was a particularly devastating one for the U.S. economy, and there was an outcry by the general public for the government to do something.

In 1908, Congress created the National Monetary Commission to research the situation, and to recommend banking reforms that would prevent such panics, as well as to investigate the Money Trust.

Senator Nelson Aldrich was appointed chairman, and immediately set out for Europe, spending two years and $300,000 (that’s $6 million adjusted for inflation) to consult with the private central bankers of England, France, and Germany.

Upon his return, Senator Aldrich decided to take some time off and organized a duck hunt with some friends.  The friends he invited on vacation with him were the who’s who of U.S. economic power – the very New York bankers he was supposed to be investigating.

It’s estimated that the men on this duck hunt represented one-quarter of the world’s wealth.  But during this getaway, there wasn’t much duck hunting.  Instead, Aldrich and his guests spent 9 days around a table hatching a plan that eventually created the Federal Reserve.

Secrecy was important to the attendees of this summit because Aldrich, as the chairman of the National Monetary Commission, was charged with investigating banking practices and recommending reforms after the Panic of 1907, not to conspire with bankers on a remote island.

So the bankers who were under investigation for needed reforms got together with the chairman of the congressional investigating committee (the guy that was supposed to investigate the suspects) at a secret meeting on an isolated island and concocted a bill – the Aldrich Plan – for a private central bank that they (the suspects) would own.

When the bill was presented to Congress, heated debates ensued.  But the Aldrich plan never came to a vote in Congress, because it was a Republican-backed bill, and the Republicans lost control of the House in 1910, and the Senate in 1912.

Not accepting defeat, the bankers essentially took the Aldrich Plan and changed a few details.  In 1913, a nearly identical bill, called the Federal Reserve Act, was presented to Congress.

Again the debates raged.  Many saw this bill for what it was: a prettied-up version of the Aldrich Plan.  But on December 22, 1913 – after what was no doubt a long period of lobbying and payoffs – the Democratically controlled Congress gave up its right to coin money and regulate the value of that money, which was a right granted to it by the Constitution, and passed that right to a private corporation – the Federal Reserve.

Why is this such a bad thing?  How could this have created our current economic crisis?  Because it has to do with the way the Federal Reserve allows money to be created.

The Federal Reserve employs the use of what is called fractional reserve banking.  This states that for every dollar deposited in a bank, that bank can lend out 90% of that dollar, as long as they keep 10% in reserve.  This means that any bank can magically create money to be loaned out to people in the form of credit.

So for every $1,000 the bank has, it can create $900 to loan to people.  But the truth is, the bank doesn’t really give away actual money, it loans out money via entries created in its book-keeping, essentially creating money from nothing.  This is where credit comes from.

The Greatest Pyramid Scheme Ever

After World War I, the United States had most of the world’s gold, due to the free trade that allowed Europe to buy goods from the U.S. industrial base.  However, while the U.S. was rich with gold, many European countries had large supplies of U.S. dollars (and depleted gold reserves) because of the many war loans the U.S. had made to the Allies.

Thus was decided that under the gold exchange standard, the dollar and the British pound, along with gold, would be used as currency reserves by the world’s central banks and that the U.S. dollar and pound would be redeemable in gold.

In the meantime, the U.S. had created a central bank – The Federal Reserve – and given it the power to create currency out of thin air. How can you create currency out of thin air and still back it with gold?  Simple – you impose a reserve requirement on the central bank, limiting the amount of currency it creates to a certain multiple of units of gold it has in the vaults.

In the Federal Reserve Act of 1913, it specified that the Fed was to keep a 40% reserve of “lawful money” (gold, or currency that could be redeemed for gold) at the U.S. Treasury.

Fractional reserve banking is like an inverted pyramid.  Under a 10% reserve, $1 at the bottom of the pyramid can be expanded, by layer upon layer of book entries, until it becomes $10 at the top of the pyramid.

Adding a fractional reserve central bank, underneath fractional reserve commercial banks, is like placing an inverted pyramid on top of an inverted pyramid.

Before the Federal Reserve, commercial banks, under a 10% reserve ratio, could hold a $20 gold piece in reserve and create another $180 of loans, for a total of $200.

But with the Federal Reserve as the foundation under the banking pyramid and having a reserve requirement of 40%, the Fed could put $50 in circulation for each $20 gold coin it had in its vaults.

Then the banks, as the second layer of the pyramid, could create loans of $450 for a total of $500.

With the new gold exchange standard, foreign central banks could use dollars instead of gold.  This meant that if the Federal Reserve has a $20 gold piece in the vault, and issued $50, then a foreign central bank could hold that $50 in reserve and, at a reserve ratio of 40%, issue the equivalent of $125 of their currency.  Then, when that $125 hit the banks, the banks could expand that to $1,250 worth of claim checks, all backed by a single, solitary $20 gold piece.

That means that the real reserve ratio (the ratio of real money that could be paid out against their currency) was now only 1.6% instead of 40%.

Now there was an inverted pyramid, on top of an inverted pyramid, on top of another inverted pyramid.

As you can imagine, this is a highly unstable financial structure.  And once the Federal Reserve moved away from the Gold Standard, the situation just got more dangerous.

The Creation Of Credit Bubbles

Every pyramid scheme flourishes in its early days, and so did the gold exchange standard.  With all the new currency available from the central banks, the commercial banks could now generate many more new loans than it could before.

This abundance of currency led to the greatest consumer credit expansion thus far in American history, which in turn lead to the biggest economic boom America had ever experienced.

In a real sense, cheap credit put the roar in the roaring twenties.  Whenever credit becomes easily available, you see an increase in the currency supply.  This is because whenever someone signs a mortgage paper, a car loan, or a credit card slip, new currency springs into existence.  The Federal Reserve tries to control the creation of this new currency by manipulating interest rates.  When the currency is being depressed and contracting, it lowers rates to bring more money into existence.  When inflation starts to rear its ugly head, it ups interest rates to try and keep the money supply from expanding.

When a currency supply is increased, it has to go somewhere, and people start buying things left and right.  This is what happens in a credit bubble – when money becomes easy to get, people start buying, the bubble expands.

The bubble pops when the currency supply contracts – due to defaults on loans, mortgages, and bankruptcy.  When this happens, the currency gets depressed, and people stop spending.

Thus, these bubbles start with the creation of credit and loans.  This is important, because its at the crux of the current housing crisis.

The Start Of The Subprime Mortgage Crisis

What is a subprime mortgage, you may be wondering?

Subprime lending is a financial term that involves financial institutions providing credit to borrowers deemed “subprime” (sometimes referred to as “under-banked”). Subprime borrowers have a heightened perceived risk of default, such as those who have a history of loan delinquency or default, those with a recorded bankruptcy, or those with limited debt experience. Although there is no standardized definition, in the U.S. subprime loans are usually classified as those where the borrower has a credit score below a certain level, e.g. a FICO score below 660. Subprime lending encompasses a variety of credit types, including mortgages, auto loans, and credit cards.

So subprime mortgages are mortgages awarded to people who are less likely to pay back those loans.

Now, you may ask yourself - if these subprime people are so high risk, why would any bank be willing to give those loans to people with such bad credit?

The answer is because they have to.

This issue is traced back to President Jimmy Carter in 1977 with the “Community Reinvestment Act.”  This is a United States federal law designed to encourage commercial banks and savings associations to meet the needs of borrowers in all segments of their communities, including low and moderate-income neighborhoods. The Act was intended to reduce discriminatory credit practices against such neighborhoods, a practice known as ‘redlining‘.

The Act requires the appropriate federal financial supervisory agencies to encourage regulated financial institutions to meet the credit needs of the local communities in which they are chartered, consistent with safe and sound operation. To enforce the statute, federal regulatory agencies examine banking institutions for CRA compliance, and take this information into consideration when approving applications for new bank branches or for mergers or acquisitions.

In short:  If the banks did not loosen up their lending practices, they would be punished by the government.

In July 1993, President Clinton asked regulators to reform the CRA in order to make examinations more consistent, clarify performance standards, and reduce cost and compliance burden. Robert Rubin, the Assistant to the President for Economic Policy, under President Clinton, explained that this was in line with President Clinton’s strategy to “deal with the problems of the inner city and distressed rural communities”.

Discussing the reasons for the Clinton administration’s proposal to strengthen the CRA and further reduce red-lining, Lloyd Bentsen, Secretary of the Treasury at that time, affirmed his belief that availability of credit should not depend on where a person lives, “The only thing that ought to matter on a loan application is whether or not you can pay it back, not where you live.”

Bentsen said that the proposed changes would “make it easier for lenders to show how they’re complying with the Community Reinvestment Act”, and “cut back a lot of the paperwork and the cost on small business loans”.

In 1995, the CRA regulations were substantially revised to address criticisms that the regulations, and the agencies’ implementation of them through the examination process, were too process-oriented, burdensome, and not sufficiently focused on actual results.

The agencies also changed the CRA examination process to incorporate these revisions. Information about banking institutions CRA ratings were made available via web page for public comment. The Office of the Comptroller of the Currency (OCC) also revised its regulations, allowing lenders subject to the CRA to claim community development loan credits for loans made to help finance the environmental cleanup or redevelopment of industrial sites when it was part of an effort to revitalize the low- and moderate-income community where the site was located.

During March 1995 congressional hearings William A. Niskanen, chair of the Cato Institute, criticized the proposals for political favoritism in allocating credit and micromanagement by regulators, and that there was no assurance that banks would not be expected to operate at a loss. He predicted they would be very costly to the economy and banking system, and that the primary long term effect would be to contract the banking system. He recommended Congress repeal the Act.

Responding to concerns that the CRA would lower bank profitability, a 1997 research paper by economists at the Federal Reserve found that “[CRA] lenders active in lower-income neighborhoods and with lower-income borrowers appear to be as profitable as other mortgage-oriented commercial banks“.

Speaking in 2007, Federal Reserve Chair Ben Bernanke noted that, “managers of financial institutions found that these loan portfolios, if properly underwritten and managed, could be profitable” and that the loans “usually did not involve disproportionately higher levels of default”.

According to a 2000 United States Department of the Treasury study of lending trends in 305 U.S. cities between 1993 and 1998, $467 billion in mortgage credit flowed from CRA-covered lenders to low- and medium-income borrowers and areas.

In that period, the total number of loans to poorer Americans by CRA-eligible institutions rose by 39% while loans to wealthier individuals by CRA-covered institutions rose by 17%. The share of total US lending to low and medium income borrowers rose from 25% in 1993 to 28% in 1998 as a consequence.

Because banks were now being forced to loan money to high-risk borrowers, this lead to practices of predatory lending.  This meant that companies that sold mortgages could participate in predatory lending practices - getting gullible borrowers to sign up for exploitative high-cost loans - because they knew the banks would be open to granting the loans because of the Community Reinvestment Act.

Many companies which aggressively marketed these predatory loans would come up with packages the required no proof of income or assets to get the borrows to sign up for the loan.  However, many of these loans were structured to enact payments that were significantly higher than the borrower could afford to pay once it came time to start repaying the loan.

The people who sold these mortgages worked on commission, which meant that the more loans they got people to agree to, the more money they made.  This means the mortgage brokers did not care who was signing for loans, as long as they got them to sign.

These mortgage companies would then bundle their mortgages together and sell them to banks, which would then turn around and sell them to Wall Street, who would then sell them to foreign investors.

It was this practice of selling high-risk mortgages which lead to the crisis.

How The Crisis Happened

The government circulates the currency by paying people and buying stuff.

People deposit currency into banks, so the banks and other entities end up with lots of currency.  When a person wants to buy a house, they go to the bank and take out a loan by signing a mortgage.

The mortgage basically says: “IOU x-amount of currency, plus X-amount of interest.”

The bank creates a book entry for the amount of currency you borrowed and at the same time, a book entry is made as a debt that you owe on your loan account.

On the bank’s balance sheet, liabilities are netted out against assets, the books stay balanced, and the bank is happy.  But the bank didn’t loan you any of the currency it had on hand.  It just created book entries.

When you signed that mortgage, the currency the bank loaned you sprang into existence the second your pen hit the paper.  The bank just expanded the world’s currency supply.

The bank then takes a bunch of mortgages and packages them all into a bond (i.e. an IOU) called a “Mortgage-Backed Security.”  These Mortgage-Backed Securities are a way to limit a financial institution’s risk when it comes to debt.

Look at a Mortgage-Backed Security this way – you’re at a bar, and your friend asks if he can borrow $20 for a drink.  Your friend writes on a napkin “I owe you $20.”  You give your friend the $20 to get his drinks, but you get hungry and now want $10 to buy food.  You then turn to another friend, and offer to give him the IOU in exchange for $10.  Your friend sees it as a good deal because he’ll make $10 by buying the IOU from you, so he gives you the money.  You lose out on $20, but you have $10 in your hand, which you can use to buy the food you want at the bar.  So you’ve eliminated your risk that your buddy won’t pay you back.

A Mortgage-Backed Security is basically the same as that IOU napkin your friend gave you for drinks, only the napkin is backed by the idea that a person is going to pay off their mortgage.  The bank then packages the Mortgage-Backed securities together and sells them to Wall Street, who then packages it and other loans together and sells them to investors world-wide.

Think of it like this:  People are basically buying and selling your debt.

The current housing crisis stems from the fact that the Federal Reserve kept interest rates so low for so long, that it caused an immense wave of currency and credit creation, which devalued the dollar and caused housing prices to rise at record levels.

With credit so cheap, and currency so plentiful, soon banks were loaning money to anyone who wanted it – whether they could afford it or not.  Not only that, they were being encouraged by the government to loan money to high risk borrowers under the Community Reinvestment Act.

The banks then sold these mortgages to Wall Street, who repackaged those loans and sold them off to investors.

Why would investors buy these Mortgage Backed Securities?  Because owning debt can actually be good business.  When you buy debt, you also buy the interest that debt generates.  So a $500 debt with a 10% monthly interest rate means you get $50 per month until the $500 debt is paid off.  Depending on how long it takes, you could essentially double your investment.

The problem with buying debt is the risk involved with that debt being defaulted on.  That’s a risk most investors, however, are willing to take.

Wall Street uses expensive software to help them calculate the risk they take on when buying these Mortgage-Backed Securities, to see if the rewards outweigh the risk.  Typically, because banks practiced conservative lending standards, worse case scenario was a default rate of 12%.

This meant that according to past data on the defaulting of mortgage loans, the worst the investor could stand to lose in a bundle of Mortgage-Backed Securities was 12%.

So even if 12% of the mortgages went bad, the investor could expect to recoup his loss on 88% of the other mortgages.  (And remember, that was worse case scenario.)

The problem was that Wall Street was using numbers that weren’t congruent with the new loans being aggressively sold by the mortgage companies.  They were using OLD numbers that did not take into account the higher number of mortgages given to high risk borrowers.

This meant that though Wall Street predicted a worse case scenario of 12%, it was actually more like 60%, because the vast majority of loans were being given to people with no means to pay them back.

In this sense, what the public now mistakes for “Wall Street Greed” was actually nothing more than an accounting error that lead our financial institutions to believe it was getting a good bargain.

So why did so many people begin defaulting on their loans?

Because banks were reckless with their lending standards, they gave loans to people for houses these borrowers really couldn’t afford.  Suddenly, feeling rich, those people pulled money out of their houses as if they were ATM machines and spent it, often on depreciating items like TVs or cars.

Then, the expected rate adjustments that were clearly spelled out in the sub-prime loan documents came due, and suddenly people couldn’t make their payments.  When these loans began to default, the Mortgage-Backed Securities that were being bought, repackaged, and sold began to fail.

Now, foreclosures on vacation properties in Florida were causing investors in Norway to go bankrupt.

But more than that, investors in Wall Street lost money, and began to panic.  They stopped buying the Mortgage-Backed Securities, and banks were suddenly left holding massive amounts of debt they could not sell off to recoup the money they “created.”

Now, financial institutions are panicking, and that means they are not lending as much money as they used to because they can’t manage risk by selling it off to investors as easily as they used to.

Fallout

In the summer of 2007 when problems with the subprime mortgage sector could no longer be concealed by the banking system, and the crisis finally made the news.

In August, the Fed cut interest rates by 0.5%, and the European Central Bank (ECB) started injection liquidity (currency in the form of cheap loans to banks).  Later that month, there were some small panic runs on branches of Countrywide Bank of California, the bank that wrote most of the subprime mortgages, as depositors demanded their currency.

In September, the Fed cut rates 0.5% again.  Then October saw bank runs across England when word got out that Northern Rock, the eighth largest bank in England, was in a credit crunch because of the Mortgage-Backed Security crisis and had to borrow from the Bank Of England (England’s central bank).

As USA Today recounted:

“The most visible sign of economic jitters were the Depression-era-like lines that formed outside Northern Rock’s bank branches Friday morning after Northern Rock had gone to the Bank of England for an emergency loan to meet its obligations.”

The $80 billion bailout will cost British taxpayers some $1,500 per person.

That same month the Fed cut rates 0.25% and another 0.25% in December, and the Fed, the ECB, the Bank of England, and other central banks created another $40 billion of cheap credit, but it wasn’t enough to halt the meltdown.

So on December 19, 2007, the ECB injected another 350 billion euros into the economy, the equivalent of half a trillion U.S. dollars.  In January, the Fed cut rates 0.75% on the 22nd, and 0.5% on the 30th.  Once again, the global currency supply was exploding.

Then on March 5th, the Carlyle Capital Fund had a little problem when it found that some Mortgage Backed Securities it bought from Fannie Mae and Freddie Mac were pretty near worthless.  That was the little problem.  The BIG problem was that, like LTCM, this bet was highly leveraged, $31 of each $32 Carlyle had bet was borrowed.

Now trouble really started brewing.  A good portion of that borrowed currency had come from Bear Stearns, which, coincidentally, was one of the major participators in packaging and selling Mortgage Backed Securities and was already in the process of taking huge losses on the Mortgage Backed Securities they owned.

On Wednesday, March 12, 2008, Carlyle announced that it was unable to pay the loans on its bets and that its creditors would be seizing all remaining assets.

Bear Stearns, being a major creditor, didn’t need more Mortgage Backed Securities, and when word got out, the company collapsed.  On Friday, March 14, as reported by USA Today:

“Bear Stearns was crippled when market rumors began to swirl about the size of its exposure to mortgage-related securities and whether it had ample reserves to cover potential losses.  That led clients and investors to demand their money back, causing a run on the bank.”

Sound familiar?  If you’ve read our article on the Great Depression, it should.  This is the same thing that happened back then.  A financial institution made too many loans thanks to fractional reserve banking, and when those loans were defaulted on and the currency supply contracted, there was a run on the banks that were unable to pay out because they did not have enough actually money on reserve to pay out, thus causing them to fail.

To try and stop the bleeding, the Fed did an emergency rate cut of 0.25% on Sunday, March 16 and another 0.75% cut on March 18.  Finally, the Fed has arranged a wedding where J.P. Morgan Chase, which through mergers and acquisitions is probably the largest stockholder of the Federal Reserve, will gain control of Bear Stearns at 95% off its price from the year before.

But the story gets even better!  The Fed will buy the worst of Bear Stearns Mortgage Backed Securities before Morgan even takes over.  And it’ll cost us, the U.S. taxpayer, another $30 billion.

Bear Stearns is only the beginning.  Bailouts like these will get bigger and become more frequent, thus causing the currency supply to expand, and thereby lowering the value of your hard-earned cash.

It is already happening, as seen by the latest failures of Fannie Mae and Freddie Mac.

How Barack Obama’s Policies Will Make The Crisis Worse

Right now, our leaders in Washington have been focusing on saving the banks from failure.  Barack Obama has stated that he wants to do two things to keep the crisis from getting worse:

1.  Help people who defaulted on their mortgages to keep their homes.

2.  Help stimulate the economy to make credit easier to get.

There are two components to this that we need to focus on. Most of the focus on mortgage borrowing is on initial mortgages, but there are also millions of Americans who have borrowed from their home equity - using their homes essentially as piggy banks. These people are at risk of foreclosure if prices plummet and they get into a situation where they have to sell their home, like extended unemployment.

The unemployment picture in many states most affected by the housing bubble is growing dramatically worse.

• California Unemployment 9 months ago 4.8% Today 6.1%
• Nevada 9 months ago 4.3% Today 5.8%
• Arizona 3 months ago 3.3% Today 4.7%
• Florida 9 months ago 3.3% Today 4.7%

Compared to states where the bubble never hit:

• Texas Unemployment 9 months ago 4.3% Today 4.5%
• North Carolina 9 months ago 4.5% Today 5.0%

The big concern for the next few years is that the housing bubble will be solely blamed on reckless mortgage companies, and not on “smart growth urban planning.” If smart growth does not get the blame, this cycle will repeat in just a few years. Excessive urban planning is the main reason why prices have soared and plunged.

Barack Obama not only wants to create another credit bubble, making money cheap and increasing the currency supply again - but he also wants to continue the practices of Jimmy Carter and Bill Clinton of forcing financial institutions to give loans to high-risk borrowers, because a large part of his base is made up of those low-income, high-risk people.

And now that the government controls much of our financial institutions, it will be easy for them to loosen up lending standards whenever they want, which could cause an even bigger crisis in the future.

Much of Obama’s rhetoric is focused on punishing Wall Street - since many Americans see the rich Wall Street investment companies as the bad guys in this mess.  However, the REAL bad guys are in the government!

Not only are these the people who inflated the currency supply in the first place, they are the people who forced banks to adopt looser lending standards, which lead to predatory lending, which is what started the subprime lending crisis.

If we want to truly fix this crisis, we need to have leaders in government who understand economics, who will control the creation of our currency, and who will allow our financial institutions to practice sound business without interfering.

It is obvious from Barack Obama’s stated plans, that he is not one of them.  In an Obama Administration, the House and Senate wil continue to spend more money, create more currency, and enforce looser lending standards.

Most people think that the United States is borrowing most of the world’s savings to fund the deficit.  Ben Bernanke, the chairman of the Federal Reserve, who is presiding over ever higher inflation rates, even made a speech in 2005 called “The Global Savings Glut and the U.S. Current Account Deficit.”

The speech makes it sound as if the rest of the world has way too much savings, so much so that they don’t know what to do with it except loan it to the United States.

People think that the excess dollars that go overseas due to the U.S. trade deficit are being loaned back to us.  This is not entirely true.  To be sure, there is a lot of real foreign investment happening in the United States, but it’s not nearly to the extend reported.

So where does all that extra currency that purchases all those U.S. Treasury Bills to fund a large part of the deficit come from?

The countries that are the U.S.’s major trading partners create it.

China is the best example.  When someone in the U.S. buys something in the U.S. that was made in China, that U.S. vendor bought that product from a Chinese businessman and paid in U.S. dollars.

The Chinese businessman then deposits those dollars into his checking account at his local Chinese bank.  The bank then converts those dollars to yuan, the official Chinese currency.  Now, the local bank has a glut of dollars and a shortage of yuan, so it sells the extra dollars to the People’s Bank of China and buys more yuan.

As long as the trade between the two countries is in equilibrium there is no problem with this.  But when one country is running continuous trade deficits and the other continuous surpluses, as the United States and China currently are, a problem arises.

In the case of China, because there is more currency flowing into China than out, the People’s Bank of China ends up with a huge glut of U.S. dollars.  Under the rules of the game of international trade and currency exchange they are supposed to sell those excess dollars on the Forex (foreign exchange market) and buy yuan.

But that would mean that there would be a glut of dollars and a shortage of yuan, which would cause the dollar to fall in value and the yuan to rise.

This means Chinese goods would then become very expensive in the U.S., slowing China’s exports, and that’s the last thing China wants.

So to get around the international trade and currency exchange game, China bends the rules.  The People’s Bank of China takes the extra dollars and neutralizes them by buying a dollar-denomenated asset, most often some sort of interest-bearing investment instrument, like U.S. Treasuries.

This keeps the yuan from rising and the dollar from falling.

This is known as “neutralizing” or “sterilizing” excess currency inflows.  The funny thing is that the U.S. was doing the same thing by sterilizing excess gold inflows all through the 1920s to keep the dollar artificially low and exports up, and it was one of the major factors that contributed to the Great Depression.

So if the People’s Bank of China used excess dollars to buy U.S. Treasuries, and didn’t buy the yuan on the Forex to sell to the businessman’s local bank, where did the People’s Bank of China get the yuan?

Answer:  China creates it!

During recent years, the U.S.’s current account deficit has been financed primarily by money created by the central banks of other countries, in particular China.

Therefore, it is not a matter of the United States using up all the rest of the world’s savings to fund its deficit.  It is a matter of the deficit being financed by the central banks of the United States’ trading partners, and, for their part, Asian central banks in particular have consistently demonstrated their ability and willingness to create money in order to finance the U.S.’s current account deficit.

So China is now sterilizing excess currently inflows just like the United States did in the 1920s.  But why hasn’t China fallen into a depression like the U.S. did when it played the sterilization game?

Because China has added a little twist.

In the 1920s, Europe paid for U.S. imports with gold, and the Federal Reserve would cheat gold by locking it away instead of expanding the currency supply to match, thereby preventing the commensurate inflation it would have caused, keeping the price of U.S. goods low, and insuring a continuing trade surplus.

This was hugely deflationary.

As the rest of the world bought cheap American goods, gold would just disappear into the black hole of the Federal Reserve and the world money supply would contract.

And when currency contracts, deflation ensues.

When China sterilizes excess currency inflows, however, it’s extremely inflationary.  For every excess dollar that China neutralizes by buying U.S. Treasuries, the People’s Bank of China has to conjure up a commensurate amount of yuan out of thin air.

This is brand new currency, also known as “high powered money” because when it hits the commercial banks it is used as the reserve asset for fractional reserve banking.  If you remember from other articles, Fractional Reserve Banking means that when someone deposits one dollar in the bank, the bank can keep that dollar in reserve to pay out deposits, and under a 10% reserve, they are allowed to create $9 in loans for every $10 deposited.  Essentially, they are creating money based on 90% of your deposit.

For more than two decades the inflation of China’s currency supply has puffed up their financial, stock market, and manufacturing sectors.  However, now it is finally down to the consumer level.  Price inflation is heating up big-time, with workers complaining about the cost of living, and causing Bejing to ask local governments to raise minimum wages - which is a cost that companies will have to pass on to consumers in the form of higher prices, which will cause workers to complain about the cost of living, and so on.

But the increase in prices that were caused by the inflation of its currency supply isn’t just a local problem with China.  Soon, one of China’s leading exports to the world will in fact be the price of inflation itself.

As inflation increases in China, the price of their goods will go up, making them less competitive.  This means prices will go up for the CONSUMERS of those goods (i.e. the citizens of the United States).

All this is the free market once again winning out over a government’s meddling and correcting the imbalances.  China pegged its currency low to keep exports cheap.  To maintain that low peg, it had to create currency.

The extra currency is causing the cost of living to increase.  Increased worker’s pay causes the cost of Chinese goods, whether consumed domestically or exported, to rise.  (Remember, companies do not eat price increases imposed by the government, they pass them onto the consumer!)

Then, the increased price of Chinese goods in the U.S. causes U.S. consumers to buy less of them.  This trend will continue until the balance is corrected.

As a result of all the currency games being played by China (and other countries), the total U.S. deficit has grown to over $7 trillion since the dollar was taken off the gold standard by President Nixon in 1971.  These deficits are sustained by fiat currency from other central banks around the world.

All the while, these foreign banks are hoarding ever increasing amounts of U.S. debt (in the form of Treasuries) and artificially propping up the value of the dollar.

Much of our debt cannot be repaid, and if our trade partners begin to dump U.S. Treasuries on the world markets, the whole credit bubble will implode, resulting in a worldwide depression.

The longer governments and central banks try to cheat the free markets, the greater the pain will be when the correction occurs.  Remember, in the end, fixed markets lose, and free markets always win.

How Does This Relate To An Obama Tax Strategy?

Keep in mind that Barack Obama is planning to increase government spending, therefore creating more debt that can be bought by foreign countries.  This isn’t much different from what other Presidents would do, but the difference is in how Barack Obama and a Democratic Congress would meddle in the economy.

Essentially, Barack Obama wants to do exactly what China is doing in respect to its inflationary problems.  Barack Obama is in favor of raising minimum wage for workers.  This in turn will drive up the cost of goods, making American exports less competitive.  Obama’s spending initiatives would require more currency to be printed, driving up inflation, which increases the cost of living, which will require the minimum wage to be raised again, making us less competitive, and so on.

In addition to that, the cost of doing business under an Obama administration will be increased because of Barack Obama’s proposed tax hikes on Corporations.  Though Barack Obama likes to point out that most small businesses don’t make over $250,000 per year, he fails to point out that the businesses that do will pass that added expense onto their customers, therefore further driving the cost of living up.

Not only that, but businesses trying to pay the extra taxes and the government mandated health care will be forced to cut expenses - and possibly fire employees - to afford the increased cost of doing business.  This will put an added drain on social programs, which means more government spending, which means more currency creation, which in turn means more inflation and the devaluation of the dollar.

As you can see, this is an extremely slippery slope for the American public.  Just remember - the bigger government gets, the more it tries to control prices and regulate trade.  In a free market economy, this is always a recipe for disaster, since the market has a tendency to correct itself despite the government’s best efforts.

Should the United States suffer from hyperinflation, this will negatively effect the foreign banks that have purchased our debt, causing a world-wide economic crisis.

What’s the solution to prevent such a thing from occurring?  Have the U.S. government control spending, pay off some debt, keep government from meddling in the free market, and keep from creating new currency.

Unfortunately, it is obvious under an Obama Presidency, such fiscal discipline would not occur.

Before 1913 the vast majority of loans had been commercial.  Loans on nonfarmland real estate and consumer installment credit, like auto loans, were almost nonexistent, and interest rates were very high.  But with the advent of the Federal Reserve, credit for cars, homes, and stocks was now cheap and easy.

The effect of low interest rates combined with these new types of loans was immediate - economic bubbles sprang up everywhere.  There was the Florida real estate bubble of 1925, and then of course the infamous stock market bubble of the late 1920s.

During the 1920s, many Americans stopped saving and started investing, treating their brokerage account as a savings account, much like many Americans treated their homes in our most recent housing bubble.

But a brokerage account is not a savings account, nor is a house.  The value of a savings account depends on how many dollars you put in.  But the value of a brokerage account or a house depends solely on the perception of others.

If someone thinks your assets have value, then they do, but if they don’t think they have value, then they don’t.

In a credit-based economy, whether the economy does well or does poorly is largely based on people’s perception.  If people believe things are great, then people borrow and spend currency.  If they have doubts about the economy, then they save and hoard their money.

In 1929, the stock market crashed, the credit bubble burst, and the U.S. economy slid into a depression.

The popping of a credit bubble is a deflationary event, and in the case of the Great Depression it was massively deflationary.  To understand how deflation occurs, you need to know how our currency is born, and how it can disappear.

When we take a loan from a bank, the bank does not actually loan us any of the currency that was on deposit from the bank.  Instead, the second someone signs off on a loan, the bank is allowed to create those dollars as a book entry.

In other words, we create the currency, and then the bank gets to charge us interest on the currency we just sprung into existence.  This brand new currency we just created then becomes part of the currency supply.  Much of our currency supply is created this way.  So every time you sign off on a mortgage, car loan, or credit card purchase, currency is brought into existence in your bank’s account sheet.

But when a home goes into foreclosure, a loan gets defaulted on, or someone files bankruptcy, that currency simply vanishes into the ether.  So as credit goes bad, the currency supply contracts, and deflation sets in.

This is what happened in 1930-1933, and it was disastrous.  As a wave of foreclosures and bankruptcies swept the nation, one-third of the currency supply of the United States evaporated into thin air. Over the next three years, wages and prices fell by one third.

Bank runs are also enormously deflationary events because when you deposit one dollar into the bank, the bank carries that dollar as a liability on its books.

That’s right, your asset is the bank’s liability.  Why?  Because the bank owes that dollar back to you, should you ever wish to make a withdrawal!

However, under our system of fractional reserve banking, the bank is allowed to create currency in the form of credit (i.e. loans) in an amount many times that of the original deposit, which it carries on its books as an asset.

So under a 10% reserve, a $10 liability can create another $9 of assets for the bank.

This is normally not a problem, as long as the bank isn’t loaned-up to the maximum amount permitted.  With just a small amount of “excess” reserves, the bank can cover the day-to-day fluctuations because most of the time deposits and withdrawals come close to balancing out.

But a serious problem can develop when too many people show up to make withdrawals at the same time without the counterbalancing effect of the relatively same amount of people making deposits.

If withdrawals exceed deposits, the bank will draw from those “excess reserves.”  But once those excess reserves are used up, fractional reserve banking is thrown into a vicious reverse.  From that point on, to be able to pay out $10 against deposits, the bank must liquidate $9 of loans.

This was what was happening in 1931, and it was one of the major contributing factors to the collapse of the U.S. currency supply.

Also, prior to the advent of the Federal Reserve, the public had about one dollar in the bank for each dollar in its pockets, and the banks kept one dollar of reserves on hand to pay out against each $3 of deposits.  But thanks to the Federal Reserve, by 1929 the public had $11 in bank deposits for each dollar in its pocket, and the banks only had one dollar on hand to pay out against every $13 in deposits.

This was a very dangerous situation.

The public had lots of deposits and very little cash, and the banks also had very little cash to back up those deposits.

On November of 1930, bank failures were more than double the highest monthly level ever recorded.  Over 250 banks with more than $180 million in deposits would fail that month.

But this was only the beginning.

How Bank Runs Affect The Economy

The largest single bank failure in U.S. history happened on December 11, 1930.  The sixty-two branch Bank of the United States collapsed.  This failure would have a cascading effect, causing over 352 banks with more than $370 million in deposits to fail in that month alone.

Worst of all, this was before deposit insurance.  People’s entire life savings were lost in the blink of an eye.

Then, to top it all off, on September 21, 1931, Great Britain defaulted from the gold exchange standard, throwing the world into monetary chaos.  Foreign governments, along with businesses and private investors from the United States and around the world, began to fear that the U.S. might follow suit.

Suddenly, there was a dash for cash.

Within the U.S., banks were running out of gold coin, and at the same time tremendous outflows of gold began to leave the vaults of the Federal Reserve, destined for foreign countries.  (Its important to note back then that our currency was pegged to gold, so banks were required to have it on hand to pay out against the dollar.)

The pyramid scheme that was the gold exchange standard began to crumble.  To stop the bleeding, the Fed more than doubled the cost of currency in the U.S., raising interest rates from 1.5% to 3.5% in one week.  As a result, between August 1931 and January 1932, 1,860 banks with $1.4  million in deposits suspended their operations.

However, 1932 was an election year.  Three long years into the Depression, people were desperate for a change, and in November, Franklin Delano Roosevelt was elected president.

Even though his inauguration wouldn’t be until March, rumors started flying that he would devalue the dollar.  By devaluing the dollar, Roosevelt could offset the deflation that occurred with the currency contraction by causing inflation.  Again, gold flowed out of the vaults as foreign governments, foreign investors, and the American public lost even more faith in the dollar, and the most devastating bank run in American history began.

But this time the American public wouldn’t be fooled.

As Barron’s put it in its March 27, 1933 issue:

It has been aptly observed that the stages of deflation since 1929 have been the flight from property (chiefly securities) into bank deposits, next a flight from bank deposits into currency, and finally, a flight from currency to gold.

Incredibly, the currency supply of the United States was falling so fast that if it continued at that pace for a year only 22% of it would remain.  The U.S. economic outlook was dire, and it seemed as if the dollar would fall into oblivion.

Roosevelt Takes Action

On March 4, 1933, Roosevelt was inaugurated, and within days he signed executive proclamations closing all banks for a “bank holiday,” freezing foreign exchange, and preventing banks from paying out gold coin when they reopened.

A month later he signed an executive order requiring U.S. citizens to turn over their privately held gold to the Federal reserve, in exchange for Federal Reserve Notes (IOUs).

On April 20, he signed another executive order, ending the right of U.S. citizens to buy or trade in foreign currencies, and/or transfer currency to accounts outside the United States.

On the same day, the Thomas Amendment was sent to Congress, authorizing the president, at his discretion, to reduce the gold content of the dollar to as low as 50% of its former weight in gold. It was enacted into law on May 12, and then amended to give Federal reserve notes the full “lawful money” status.

But there was still one major hurdle to overcome before Roosevelt could devalue the dollar:  the infamous gold clause.

During the Civil War, President Abraham Lincoln had to come up with a way to pay the troops and introduced a second purely fiat currency to the country - the greenback dollar.  When it first appeared, the greenback was worth the same amount as gold notes.  But by the end of the Civil War, they had fallen to just one third of the value of the gold-backed dollar.

Many people who had made contracts or taken out loans before the war in gold notes paid them back in depreciated greenback dollars.  Of course this was cheating the creditors and many lawsuits were filed.

After the end of the Civil War, most contracts contained a “gold clause” to protect lenders and others from currency devaluation.  The gold clause required payment in either gold or an amount of currency equal to the “weight of gold” value when the contract was entered into.

The Government Steals From Its People

The big problem for Roosevelt was that most government contracts and obligation also had this clause written into them.  So devaluing the dollar would also increase the cost of government obligations by the same amount.

So at the behest of President Roosevelt, Congress passed a joint resolution on June 5 defaulting on the gold clause in all contracts, public and private, past, present, and future.

In essence, the government simply said to American citizens and businesses “We don’t have to pay you.”

Outraged by what he viewed as the government’s blatant disregard for American’s rights, Senator Carter Glass, chairman of the Senate Finance Committee, lamented:

“It’s dishonor, sir.  This great government,  strong in gold, is breaking its promises to pay gold to widows and orphans to whom it has sold government bonds with a pledge to pay gold coin of the present standard of value.  It’s dishonor, sir.”

But Senator Thomas Gore of Oklahoma put it even more succinctly when he said:

“Why, that’s just plain stealing, isn’t it, Mr. President?”

But these protest fell on deaf ears.  On August 28, 1933, Roosevelt signed Executive Order 6260, outlawing the constitutional right of U.S. citizens to own gold.  To keep from having to default on its commitments (i.e. declare bankruptcy), and to keep concealed the fraud of fractional reserve banking, the banking system’s only choice was to get the government to make gold (the legal money of our constitution) illegal for U.S. citizens to own.

Roosevelt gladly obliged.

First under threat of publishing the “gold hoarders” names in the newspaper, and then under threat of fines and imprisonment, the United States of America, land of the free and home of the brave, ordered its citizens to turn over their private property (the money in their pockets) to any Federal Reserve Bank.  The government was no longer a government of the people, by the people, and for the people.  Instead it was a government of the bankers, by the bankers, and for the bankers.

But it wasn’t over yet.

On January 31, 1934, Roosevelt signed an executive proclamation effectively devaluing the dollar.  Before this proclamation it took $20.67 to buy one troy ounce of gold.  But now, since the dollar instantly had 40.09% less purchasing power, it took $35 to buy the same amount of gold.

This also meant that, with regards to international trade, the government had just stolen 40.09% of the purchasing power for the entire currency supply of the people of the United States - all with the stroke of a pen.

By devaluing the dollar, the value of the gold held by the U.S. Treasury now exactly matched the value of the monetary base.  This mean the dollar was once again fully backed by gold.  To halt the implosion of the U.S. banking system and to regain the trust of our international trading partners, gold had forced government to devalue the currency by stealing from its citizens, and accounted for all the excess currency the banking system had created.

Climbing Out Of The Depression

What got us out of the Great Depression wasn’t the government spending and work programs of the Roosevelt administration, or even World War II, as most people think.

What got us out of the Great Depression was the tremendous influx of gold from Europe.

When the Untied States raised the price of gold by nearly 70% to $35 per ounce, prices of goods and services in the United States didn’t immediately jump by the same 70%.

Remember, thanks to the Roosevelt administration, the dollar was devalued by over 40%.  So its purchasing power overseas fell by the same amount, slowing our imports dramatically.

But countries buying from the U.S. now found their currency purchased 70% more U.S.  goods than it used to.

Also - when a country fixes its currency to gold, it has to buy or sell as much gold as is offered or demanded to maintain that currency price.  Suddenly, all of the gold mining companies around the world were selling their gold to one buyer - the U.S. government.

So this, plus a tremendous trade surplus, accounted for most of the gold inflows from 1934 through 1937.

But in 1938, a new dimension was added.  When Germany’s Adolf Hitler annexed Austria, the rest of Europe panicked, fearing the looming threat of war.  And there was a transfer of wealth from European investments to U.S. investments as Europe braced for the ravages of World War II.

European consumer goods factories were used to produce guns, ammunition, airplanes, and tanks.  Thus, most Europeans had to obtain everyday items from the U.S.  So in reality, gold inflows, foreign investment, and war profiteering - not social programs - were what lifted the U.S. out of the Great Depression.

Barack Obama And The New Depression

Some of what you just read might seem eerily similar to what’s going on right now with the current housing crisis.

Many Democrats have been recalling the name of President Roosevelt, claiming that more social programs, public works, and government regulation are the answer to our economic downturn.  This includes Barack Obama.

However, as you can see in the history of the Great Depression, Roosevelt’s growing of government is not what delivered the U.S. out of that economic crisis.  Free market economics - supply and demand - and America’s manufacturing and export power are what made this country wealthy and healthy again.

All President Roosevelt seemed to achieve from an economic standpoint was robbing Americans of their rightful currency and having government control it.

Now that the government is buying up banks, it has an even easier time for controlling currency than Roosevelt did.  But what they plan on doing with it will most likely make our economic situation worse.

Barack Obama wants to make credit easier to get.  The problem there is that easy credit is what creates the bubble in the first place.  The housing market took a nosedive because credit was too easy to get, and people couldn’t pay off what they owed, causing deflation of the currency, and then causing banks to fold.

By artificially pumping credit back up like Obama wants to do, we are just setting ourselves up for an even bigger deflationary event than the one we just experienced.

Increasing public works and social programs, as Obama has proposed to create jobs, also will not help the economy, because again, they require the government to increase taxes and create more currency to pay for them.

Obama also plans to re-negotiate free trade agreements.  Barack Obama sides with the labor unions against free trade, because the Unions look at free trade as a threat to jobs.  Obama has made his view clear that free trade with developing countries, and with China in particular, is a kind of scam perpetrated by the wealthy, who reap the benefits while ordinary Americans bear the cost.

It’s an understandable view: how, after all, can it be a good thing for American workers to have to compete with people who get paid seventy cents an hour?

As it happens, the negative effect of trade on American wages isn’t that easy to document. The economist Paul Krugman, for instance, believes that the effect is significant, though in a recent academic paper he concluded that it was impossible to quantify.

But it’s safe to say that the main burden of trade-related job losses and wage declines has fallen on middle- and lower-income Americans. So standing up to China seems like a logical way to help ordinary Americans do better. But there’s a problem with this approach - the very people who suffer most from free trade are often, paradoxically, among its biggest beneficiaries.

The reason for this is simple: free trade with poorer countries has a huge positive impact on the buying power of middle- and lower-income consumers—a much bigger impact than it does on the buying power of wealthier consumers.

The less you make, the bigger the percentage of your spending that goes to manufactured goods—clothes, shoes, and the like—whose prices are often directly affected by free trade.

The wealthier you are, the more you tend to spend on services—education, leisure, and so on—that are less subject to competition from abroad.

In a recent paper on the effect of trade with China, the University of Chicago economists Christian Broda and John Romalis estimate that poor Americans devote around forty percent more of their spending to “non-durable goods” than rich Americans do. That means that lower-income Americans get a much bigger benefit from the lower prices that trade with China has brought.

Then, too, the specific products that middle- and lower-income Americans buy are much more likely to originate in places like China than the products that wealthier Americans buy. Despite a huge increase in imports from China—they sextupled as a percentage of U.S. imports between 1990 and 2006—Chinese products are still concentrated mostly in lower-price markets. (By some estimates, Wal-Mart alone has accounted for nearly a tenth of all imports from China in recent years.)

By contrast, much of what wealthier Americans buy is made in the U.S. or in high-wage countries like Germany and Switzerland. This is obvious when it comes to luxury goods—Louis Vuitton bags, Patek Philippe watches, and so on—but it’s also true of many other goods, like electronics, kitchen appliances, and furniture, categories in which American and European manufacturers have continued to thrive by selling to the high-end market.

According to the Yale economist Peter K. Schott, machinery and electronics products made in developed countries sell in the U.S. for four times the average price of Chinese products. And, since the late nineteen-eighties, that price gap has widened by almost forty percent.

Broda and Romalis, in their recent paper, calculate that between 1999 and 2005 alone the inflation rate for lower-income Americans was almost seven points lower than it was for the wealthiest Americans. That means that free trade with China has made average Americans, at least as consumers, much better off—in the sense that it’s made their dollars go further than they otherwise would have.

Now, there’s a lot that’s left out of this equation, such as the fact that free trade may help richer Americans by increasing corporate profits by outsourcing manufacturing to China. And cheap DVD players may not, on balance, make up for lost jobs.

But the reality is that if we toughen our trade relations with China the benefits will be enjoyed by a few, since only a small percentage of Americans now work for companies that compete directly with Chinese manufacturers, while average Americans will feel the pain—in the form of higher prices—far more quickly and more directly than rich Americans will. Obama in his desire to help working Americans—and gain their votes—is pushing for policies that will also hurt them.

The way to get out of any financial crisis is not to increase spending and reduce free trade.  It is to lower taxes, lower spending, and allow as much free trade as possible until the markets correct themselves.  This has always been the case throughout history, and it is still the case today.

Barack Obama has proposed an increase in spending on Public Works to create more jobs, and an increase in social programs, such as free healthcare.  Historically, these two strategies are credited to helping the United States recover from economic downturns, including the Great Depression.

However, this is not really the case.  Historically, more spending on public works projects and social programs in a time of economic crisis only serves to deepen the crisis by debasing (lowering) the value of the currency due to more deficit spending.  To illustrate this point, we turn to a historical example which brought about the Fall of the Roman Empire.

The Fall Of Rome

During its centuries of dominance, the Romans had ample time to perfect the art of currency debasement.  Just as with every empire in history, Rome never learned from the mistakes of past empires, and therefore they were doomed to repeat them.

Over 750 years, various leaders inflated the Roman currency supply by debasing the coinage to pay for war, which would lead to staggering price inflation.

Coins were made smaller, or a small portion of the edge of gold coins would be clipped off as a tax when entering a government building.  These would be clipped off as a tax when entering a government building.  These clippings would then be melted down to make more coins.  And of course, they mixed lesser metals such as copper into their gold and silver.

And last but not least, they invented the not so subtle art of revaluation, meaning they simply minted the same coins but with a higher face value on them.

By the time Diocletian ascended to the throne in A.D. 284, the Roman coins were nothing more than tin-plated copper or bronze, and inflation (not to mention the Roman populace) was raging.

In 301, Diocletian issued his infamous Edict on Prices, which imposed the death penalty on anyone selling goods for more than the government-mandated price and also froze wages.

To Diocletian’s surprise, however, prices just kept rising.  Merchants could no longer sell their wares at a profit, so they closed up shop.  People either left their chosen careers to seek one where wages weren’t fixed, or just gave up and accepted welfare from the state.  Yes, the Romans actually were the first to invent welfare.  Rome had a population of about one million, and at this period of time, the government was doling out free wheat to approximately 200,000 citizens.  That equaled out to 20 percent of the population on welfare.

Because the economy was so poor, Diocletian adopted a guns and butter policy, putting people to work by hiring thousands of new soldiers and funding numerous public works projects.  This effectively doubled the size of the government and the military, and probably increased deficit spending by many multiples.

When you add the cost of paying all these troops to the swelling masses of the unemployed poor receiving welfare and the rising costs of new public work projects, the numbers were staggering.  Deficit spending went into overdrive.  When he ran short of funds, Diocletian simply minted vast quantities of new copper and bronze coins and began, once again, debasing the gold and silver coins.

All this resulted in the world’s first documented hyperinflation.  In Diocletian’s Edict on Prices, a pound of gold was worth 50,000 denari in the year A.D. 301, but by mid-century was worth 2.12 billion denari.  That means the price of gold rose 42,400 times in fifty years or so.  This resulted in all currency-based trade coming to a virtual standstill, and the economic system reverted to a barter system.

To put this in perspective, fifty years ago the price of gold was 35% per ounce in the United States.  If it rose 42,400 times, the price today would be just under $1.5 million per ounce.  In terms of purchasing power, that means if an average new car sold for about $2,000 fifty years ago, which they did, the average car today would sell for $85 million.

In the end, it was currency debasement and pure deficit spending to fund public works, social programs, and war that brought down the Roman Empire.  Just as with every empire throughout history, it thought it was immune to the universal laws of economics.

Debasing the currency to pay for public works, social programs, and war is a pattern that repeats throughout history.  It is a pattern that always ends badly, and a problem that will explode under an Obama presidency.

Social Security and Medicare

Barack Obama is looking to expand social programs like Social Security and Medicare.  These are what are known as “unfunded liabilities.”  In other words, they are expenses that the government has no idea how to pay.

Former U.S. Comptroller General David Walker says that U.S. unfunded liabilities grew from $20 trillion in 2000, to $50 trillion in 2006.  In 2000, the U.S. gross domestic product (GDP), a measurement of all the goods and services produced in the country in one year, was about $10 trillion, and in 2006 it was about $12.5 trillion.

That means our unfunded liabilities were two times our GDP in 2000, but FOUR TIMES our GDP just six years later.

So the economy grew 25% over this time period between 2000 and 2006, but the unfunded liabilities grew by 150%!!!!

This means that the United State’s unfunded liabilities (i.e. cost of social programs) is growing a whopping six times faster than the economy.

It now totals more than 95% of the entire household net worth of the United States and is expected to exceed household net worth within just a few short years.  Social Programs and government debt are now a $117 trillion problem and growing at a daily rate that far exceeds the growth of the U.S. economy.

That’s over one million dollars per family.

It means every man, woman, and child in the United States owes $370,000.  That even includes newborn babies.

$117 trillion dollars in debt is a mind-boggling figure, and that number is still growing.  This means that because of social programs, our government is digging itself into a hole it will never be able to climb out of.

The Problem With Social Programs

The problem is that in the coming decades, there simply aren’t going to be enough full-time workers to promote strong economic growth or sustain existing entitlement programs.  Like most industrialized nations, the United States will have fewer full-time workers paying taxes and contributing to federal social insurance programs.

At the same time, growing numbers of retirees will be claiming their Social Security, Medicare, and Medicaid benefits.

Unless we reform programs like Social Security, Medicare, and Medicaid, these programs will eventually crowd out all other government spending.  Otherwise, by 2040 our government could be doing little more than sending out Social Security checks and paying interest on our massive nation debt.

(You can find more information about these statistics at the Government Accountability Office’s website.)

How Did The Debt Get So Big If Clinton Had A Surplus?

Many Democrats like to point out that our debt is due to the “failed policies of the Bush administration” and that he inherited a budget surplus thanks to President Bill Clinton.

However, this is not true.  The fact is that Clinton did not create a surplus, and the debt problem actually can be traced back to the Presidency of Ronald Regan.

The notion that there was a surplus at the end of the Clinton years just simply is not true.  There was no real surplus because the federal government uses a cash accounting that allows a little room for monetary magic.  (Remember the scandal with Enron’s creative accounting?  Well, the government actually does something very similar with its own bookkeeping.)

The last year Clinton was in office the national debt grew by $68.6 billion, so the “real” deficit was $68.6 billion.  Clinton misled us when he said there was actually a surplus, and when George W Bush came into office, that deficit was his to inherit because under President Clinton, the U.S. debt grew.

So President George W. Bush started off the year 2000 with a budget that was nowhere near being balanced.

Then, the Bush Tax Cuts put us in the hole by about 9%, causing the deficit to explode again because the lowering of taxes was not accompanied by a decrease in spending.  By 2005, the debt reported by the creative accountants in the government was $318.6 billion, yet the debt actually grew by $760.2 billion - eleven times greater than when Bush took office.

This is not to impune the Bush tax cuts.  Had President George W. Bush practiced spending discipline along with the tax cuts, things would have been fine.  Instead, under President Bush, we saw an added $8 trillion Medicare prescription drug benefits package.  With one stroke of the pen, Congress and George W. Bush increased existing Medicare obligations nearly 40%.

If we trace back to 1981, President Reagan signed the Kemp-Roth tax cut, increasing the deficit by more than two and a half times in just two years, from $79 billion to $208 billion.

Then, in 1982, projections were made showing that the Social Security Trust Fund would be insolvent by the following year.  So a commission was appointed to study the insolvency problem, and in 1983, Ronald Reagan signed an amendment to “save” Social Security.

Then, in 1884, Social Security expenditures crept up at their normal pace, while revenues started to skyrocket.

Now that the Social Security Trust Fund had “excess” assets, the U.S. Treasury began borrowing the assets and replacing them with bonds, which are essentially government IOUs.  The borrowed assets were added to the general fund and spent.  Basically, our government took from one cookie jar to stock another.

Within a few years there was an extra $20 billion to $30 billion per year for the government to pillage.  So the federal masters of illusion cut our income tax, increased our social security tax, then stole the assets to help make up for the deficit caused by the tax cut.

But don’t worry - the government says this doesn’t count as debt because we owe it to ourselves.

The amendment Ronald Regan signed was also the act that made Social Security benefits (which are nothing more than a tax that you have paid being returned to you) taxable.  That is a form of “double taxation,” and it was signed into effect by a conservative icon.

And that’s just social security.  There are many, many other social programs on the books that say we owe even more money to ourselves.

Remember: tax cuts must always be accompanied by cuts in spending.  Presidents Reagan, George H.W. Bush, Clinton, and George W. Bush all spent a great deal of money, and we’ve seen a large increase in government over the years.

And under Barack Obama, government just get bigger.

Barack Obama Wants To Expand Social Programs

Part of Barack Obama’s campaign is his promise to cut wasteful spending.

Obama wants to stop funding wasteful, obsolete federal government programs that make no financial sense. He has called for an end to subsidies for oil and gas companies that are enjoying record profits, as well as the elimination of subsidies to the private student loan industry which has repeatedly used “unethical” business practices.

However, when it comes to the real drain on the economy - entitlement programs like Social Security, Medicare, Welfare, etc. - Obama has either said nothing of cutbacks, or a desire to decrease government spending on these programs, which already equate to such a large part of the national debt.

Barack Obama’s plan for free health care is also a huge social program that will be funded by the government, further increase the U.S. debt.

He also has ambitious plans to create public works projects to start rebuilding the infrastructure of the United States.  His belief is that this creates jobs and will help the economy.  The Roman emperor Diocletian believed this as well.  But because he did nothing to control spending, inflation occurred, the currency became devalued, and the Roman Empire crumbled under the economic burden.

Should Barack Obama go through with his plans to increase government spending, history may very well repeat itself.

What is the solution?  We need to cut as many social programs as we can, stop adding new ones, prevent additional spending by the government, and open up opportunities for business to fill the need for the people who want the services the government now provides.

If we were to further lower taxes on business, then the private sector would be able to afford to create the new jobs that Barack Obama wants the government to fund.

This is the only sensible solution to a problem which continues to grow, unchecked.  We need a President who can deliver fiscal responsibility when it comes to spending.

Unfortunately, Barack Obama is apparently not that President.