How the Bank of Japan is Destroying Financial Markets

This week in horrible economic policy news, we learned that the central bank of Japan is top 10 shareholder in fully 90% of Japan's leading public companies. Admittedly, this probably sounds like an exceedingly mundane and boring fact if you aren't too familiar with how central banking works. But once you understand what's going here, you will recognize it for what it is--a scandalous economic policy that is destined to go down in flames, and take many innocent bystanders with it. In this post, we'll explain what this policy is, why it matters, and why this is another sign that the global economy is well on its way to the next collapse.

Central Banking and Monetary Policy*
The central bank can be thought of as the bank for banks. It is the institution where commercial and consumer banks store their extra cash, and it is well-known for serving as the lender of last resort to prevent bank runs. Individual banks never have enough money on hand to fulfill all the deposits that have been made with them. The reason for this is that some of the money stored by individual depositors has been given out in loans to other customers. This is where the name fractional-reserve banking comes from. At any given time, each bank only has a fraction of their total deposits on hand and ready to meet deposits. Though this fact is not commonly understood, there's actually nothing inherently underhanded or shady about it; it's just how the modern banking system works. And because modern banking works this way, all banks are always technically at risk for a bank run where many of their depositors come knocking all at once and demand more cash than the bank can provide. This can probably be viewed as the main reason that central banks came into being--to lend banks money when they are faced with a bank run.

In the aftermath of the Great Depression and with the steady rise of Keynesian economics, however, the US central bank, the Federal Reserve, eventually adopted a broader role. Now the Fed's mission is not only to serve as the lender of last resort, but to also manage the money supply (which is precisely what it sounds like, the amount of money in existence) in order to ensure a healthy economy. And in particular, the Fed's goal was to ensure both low inflation and low unemployment, often referred to as the dual mandate. And the basic way they go about pursuing this goal is by adding money to the economy (by lowering interest rates and/or directly injecting money into the system) when it is in a slump, and reducing money in the economy when it looks like it is overheating. In practice, the first part of that process, injecting more money, happens frequently, but the second part rarely does.

For our present purposes, the key thing to understand is that the central bank, in the US and elsewhere, literally has the power to create money out of nothing. When it wants to inject new money into the system, it will frequently buy US Treasury Bonds. And when it makes these purchases, it usually does so with money that, prior to the purchase, did not exist. It sounds strange, but it's the truth. The only difference between a counterfeiter and a central bank creating money is that it's illegal for the counterfeiter; if they were both using the money to purchase Treasury Bonds, the impact on the actual economy would be the same. Obviously, this is a very significant (and dangerous) power.

If the central bank does too much money creation, there's a risk of having massive inflation. In the current situation, however, with consumer spending down and oil prices down as well, most consumer prices are basically flat. Thus, most central banks have judged that the risk of inflation is limited, and that we might actually need more of it. You see, most mainstream economists view deflation (generally falling prices) as the supreme evil that must be avoided at all costs.** And to prevent this from occurring, they are pulling out all the stops to get more money into the economy and cause inflation.

What to Buy
We mentioned above that the Fed typically buys Treasury Bonds (US Government debt) when it wants to inject money into the economy. There's a good reason for this. Treasury Bonds are very heavily traded, which means they are easily bought and sold. It also means that the Fed's purchases or sales on any given day probably won't have a huge impact on the broader market; they're still a large player, but their presence is diluted by the actions of so many other investors. Another benefit is that the value of Treasury Bonds is relatively stable. And to the extent that the Fed profits off of the interest on US Government debt, that gets remitted back to the US Government at the end of the year anyway, just like all of the Fed's net profits. So, viewed in the most optimistic sense, this is sort of like one arm of the US government lending to another arm. (Yes, people pretend the Fed is independent, but we've previously explained how deeply silly this belief is.) In effect, the Fed's demand for US government debt, subsidizes the government's borrowing costs. And given that it's inevitable that the Fed's efforts to inject money will subsidize something, this is probably about the least distortionary effect. That doesn't mean it's a good thing, but it's probably the least bad.

A related point here is that it matters what the underlying assets are. Each time the Fed wants to inject money into the market, it acquires an interest in real assets. When it buys government debt, it gains an interest in the government's assets. If the US government were to default, then the central bank (again, effectively a different branch of the government) theoretically would gain some power over US government assets. Again, this isn't ideal, but you could do worse (as we'll see).

So to revisit, if a central bank is going to buy financial assets (and most, if not all, of them do it), the things it buys should have the following characteristics:

• Highly liquid
• Highly traded market (so the central bank doesn't make a big dent in the price)
• Stable value
• Limited subsidy impact
• Neutral ownership interest (owning other government assets)

The Case of Japan

Now that we've laid out some general principles about how central banking is supposed to work, we can observe how the central bank of Japan is blatantly violating them. The unoriginally named Bank of Japan (BoJ), has had a policy of buying Japanese government bonds just as the Fed buys US debt. However, the BoJ has actually implemented an even more aggressive form of Keynesianism over the years than the US has. Indeed, the BoJ has purchased so much of Japanese government debt that it was starting to harm the liquidity of the market--that is, it couldn't find enough sellers to buy from. But since the threat of deflation still looms large in their mind, the BoJ turned its attention to purchasing other assets besides government debt, all in the name of trying to stimulate the economy by adding more money.

One of the asset types it turned to is an ETF, or exchange-traded fund. This is effectively a mutual fund that is traded on the open market, so it's effectively a basket of major stocks. Thus, once we peel back the layers, the fact is that the BoJ has been purchasing stocks for some time now.

And all of that leads us to terrible headline from Zerohedge yesterday, "In Shocking Finding, The Bank Of Japan Is Now A Top 10 Holder In 90% Of Japanese Stocks". That is, the BoJ has purchased so many stocks that it's now one of the dominant shareholders in 90% of the major public Japanese companies, which are listed in the Nikkei index (effectively, Japan's version of the S&P or Nasdaq).

This fact is shocking and problematic for a whole host of reasons. Let's use our original criteria above to spot a few:

• Less liquid and less heavily traded - While the BoJ owns shares of large, highly traded companies, the fact is that stocks are much more prone to panic sell-offs than government debt. If the BoJ tried to sell off its stake, the value would likely decline rapidly.
• Unstable value - Obviously, stocks are not known for having a stable value over time
• Subsidy - The BoJ is now effectively subsidizing the shareholders of individual companies
• Ownership - The BoJ, which is to say the Japanese government, has now accidentally gained a large ownership share of major companies.

Another important fact is that this completely distorts stock market prices and deprives investors of the ability to make accurate decisions. As it stands, the Nikkei has dropped over 13% over the past year. Imagine how much more it should have dropped, if the BoJ had not been using its money creation power to artificially prop up the prices. Given the significant holdings the BoJ now has, the difference is likely to be considerable.

Of course, few people like the idea of falling stock prices. But it's more important for stock prices to reflect reality than it is for them to maintain a certain price level. Stock prices are used to help allocate scarce investment capital among different companies; if the prices are manipulated, then the allocation will eventually be wrong too. As an example, if a company starts losing money, its stock price needs to fall. This will likely have some adverse consequences for management and help motivate them to improve performance. Additionally, it helps prevent new investors from pouring more money into the company at high prices, when other companies might be a better value. If the prices get distorted, the entire market process is liable to break as well.

The problems get compounded further if we assume the central bank is deliberately trying to prop up stock market prices, which there is some evidence for in the case of Japan, as noted in the Zerohedge piece. If this is the case, the central bank has exactly the wrong incentives. A typical investor in the stock market is looking for companies that may currently be undervalued and likely to perform well in the future. By contrast, the central bank's only incentive is to prevent prices from falling, regardless of actual value. And since the companies that are performing the worst are likely to have the fastest falling stocks, it follows that the central bank will tend to give the most money on the worst performing companies.

If pressed on the rationale for this program, the BoJ would likely argue that their actions are necessary to stabilize the economy (by injecting money generally) and protect small investors from getting wiped out. But here we must remember that stock prices are not an end in themselves. If a company is failing, the BoJ's action to prop up its stock will not save it. Indeed, it might actually cause the company to behave more recklessly as the executives in charge feel no pressure to change. At best, the BoJ could delay a stock market collapse; it can't actually prevent it.

There's also a strong corruption angle here. In a market environment where market prices are no longer based on the profitability and fundamentals of the underlying company, small investors don't have a chance. Even if they understand finance and economics, it's useless because the company's performance is no longer the key driver of the stock price. Instead, the key driver becomes central bank policy, and the only way for investors to make money is to guess (or quietly learn) the central bank's policy in advance. This opens up the opportunity for well-connected financiers to get tips, but the average small investor is going to be left out in the cold.

And all of this explains why this story is outrageous. The BoJ is printing new money to benefit public company shareholders. And in the process, it's massively distorting financial markets, subsidizing inefficient companies, denying small investors any chance at success, and, on top of it all, subtly nationalizing private companies. This policy is a clear act of desperation by the BoJ, and the unintended consequences are certain to be devastating. For now, it's barely keeping the Nikkei afloat. But when it finally crashes, the policy helps ensure the collapse will be as painful as possible.

*Before we get started, note that none of what follows should be taken as an endorsement of central banking. I share the view common among the Austrian School of economics that the net impact of central banks on the economy is decidedly negative. But that larger issue is not the subject of the present post. Thus, we're going to describe the central bank in a neutral way and describe the role that more conventional economists believe it should play in the economy.

**There are compelling reasons to reject this idea in general, but for our present purposes, we'll just stick with the mainstream view.

The Folly of Easy Monetary Policy and Negative Interest Rates

Last week, the European Central Bank announced new and aggressive efforts to try to stimulate the lagging economy of Europe. To this end, the ECB increased the rate of monetary stimulus (i.e. creating money) by 33% to 80 billion euros per month and further reduced the deposit rate to negative 0.40%. We'll explain how negative interest rates work in a minute, but know that all of it is done in the name of trying to increase economic activity. Central bankers around the world are pulling out all the stops to try and prevent the collapse of the latest financial bubble. In reality, the policies being implemented today only serve to delay the inevitable crash.

At the heart of the problem lies a deceptively simple view of the economy and what really matters. To see this in action, let's begin with the case of GDP. 

GDP is not the only thing that matters

Gross domestic product, or GDP, is one of the key metrics used to gauge economic health. The technical details of how it's measured are not critical, but it basically captures the value of all products and services produced by an economy. And since things that are produced must also be purchased / paid for, GDP is often thought of in demand terms--where the money is coming from. In particular, economists often focus on three major components: consumer spending, investment spending (spending by businesses), and government spending.

GDP is a useful measurement of economic activity. But that's all it is. It does not tell us whether the economic activity itself was productive, useless, or somewhere in the middle. For instance, the economy could have $10B of GDP related to the production of cars that provide value to customers. Alternatively, there could be $10B of GDP related to government spending on a fighter plane that can't fly through clouds. They'd get counted the same in GDP, but they clearly would not be equal in terms of benefits provided to the economy (and the people in it). One provides value; the other is just an acceptable form of graft.

You might think this would be an obvious point. But you would be wrong. To this day, it is very common for Keynesians (the dominant school of thought in economics) to claim that war is good for the economy. Which explains why New York Times columnist Paul Krugman could be found in recent years wishing for a credible threat of an alien invasion that would get the government to spend the money needed to get the economy going again. (And no, I didn't make that up.)

A related problem to this one is the idea of idle resources. If unemployment is high or factories are lying idle, you will sometimes hear people assume the solution is for the government to take action and get these resources and people back to work. Here again, there's often a confusion between mere economic activity and useful economic activity. Imagine a ski resort during the summer. Most ski resorts are largely vacant during the summer, for the obvious reason that there's no snow on which to ski. In some sense, the lodge, the chairlifts, restaurants on the mountain, etc. are idle during this period. But if the government somehow managed to pass a stimulus to get the ski lodge working year-round to create jobs, this would obviously not be preferable. There might be more jobs and activity in the short-run (and GDP would go up), but if no one wants to use the ski resort, then this is really a waste of resources.

It's an extreme example, but the same logic can be applied to a factory that is idle because the product it produces is no longer in demand (or the prevailing price is too low for the factory to break-even). A healthy economy needs activity, but it needs activity that is sustainable and creates value. Activity alone is not enough.

Unfortunately, this is not the dominant view among mainstream economists. A recession is defined as a decline in GDP in two consecutive quarters, and they are determined to prevent a recession at all costs. And that's where the negative interest rates come into play.

How could negative interest rates help?
Negative interest rates should be viewed as an extension of the historically low interest rates that were initially embraced during 2008 Crisis. For US rates, this chart from the St. Louis Fed shows the progression of the key interest rate over time. This interest rate is known as the Federal Funds Rate, and it has a cascading effect on other interest rates in the economy. Here's the chart:



There is a slightly complicated technical definition of the Federal Funds Rate, but basically you can think of it as the interest rate banks earn for storing extra funds with the Federal Reserve. If you have extra money, you might put it in a savings account and earn a small interest rate on your deposit. If you're a bank and have extra money, you will likely deposit it at the Federal Reserve and earn interest at the Federal Funds Rate.

Based on this definition, you can see how it would have an impact on interest rates in the broader economy. Since the bank's deposits at the Federal Reserve are thought to be virtually risk-free, the rate they can earn on these deposits is essentially the floor for any interest rate they might charge a potential borrower. If the bank could earn a guaranteed 6% at the Fed with no risk, as was the case around 2000, then it would have to charge a borrower several percentage points higher to account for the risk of loss. (Again, though this might not be intuitive, considering a personal example makes it clear. If you could 6% interest on a savings account, you would have to be promised a much higher rate of return in, say, the stock market to be willing to accept the risk that goes with it.)

Thus, if you lower the Federal Funds Rate, you lower interest rates in the overall economy. And if you have lower interest rates, people will borrow more money, and spend more money. And if they spend more money, that means higher GDP in the short-run. In turn, this is why lowering interest rates is often the first tool deployed when a recession seems near; the central banks are doing whatever they can to get people borrowing again to drive up GDP.

The problem this time around is that the Federal Reserve, and many other central banks, already drove the interest rates to effectively zero in the last crisis. And during the much-hyped recovery, they were afraid raising interest rates would send the economy back into a downward spiral, so for the most part they didn't. The major exception to this is the Fed's rate increase in December 2015, which was promptly followed by a large decline in the stock markets during the first two months of the year. In other words, it appears that central banks were correct in their fears that raising rates could destroy the recovery--but one must question the robustness of a recovery if the prospect of raising interest rates by merely 0.25% is enough to derail the entire project.

Outside the US, other banks have not been showing nearly the level of optimism that was present at the Fed. Europe and Japan, especially, have been trying desperate measures to try to bolster lagging economies. And since they also drove their interest rates to zero during the previous crisis, sending interest rates negative was the only option left available. They now exist in several countries.

Unfortunately, this experiment is nearly certain to end in disaster. Because think about what it means. It effectively means punishing banks to keep excess reserves on-hand. If your savings account charged you a fee just for the privilege of depositing your money, you probably wouldn't do it. The same is true of banks. A negative interest rate, by design, makes them more eager to give out loans and will presumably lead some to lower their credit quality requirements towards meeting that end.

This could possibly achieve the narrow goal of increasing borrowing and spending in the short-run, but to do so, the banks are taking on more risky loans than they otherwise would. This, in turn, makes the banking system less stable overall.

That's not the only problem though. The fact that banks are also effectively punished for storing extra cash, means they will tend to keep less reserves on-hand, further reducing their stability. And since banks are not likely to charge their depositors a fee for saving money any time soon, they are going to tend to be less profitable overall. In accounting jargon, we would say their margins are being squeezed. Because while the interest rates they can charge borrowers will likely come down to say, 4.25% from 4.5%, the average interest they pay their depositors will stay the same, close to 0%. The fact that banks will be less profitable, all things equal, further destabilizes them.

Summing Up
What we have then is a perfect storm of sorts. Amongst other priorities, central banks have two key goals: mitigating economic recessions (primarily by managing the interest rates) and ensuring that the banking system is stable. But as we have seen, negative interest rates bring these two goals into direct conflict. Central banks can temporarily prop up consumer spending and GDP by cutting interest rates into the negative; but in doing so, they have to make the banking system as a whole more unstable. The GDP effects will show up in the short-run; the instability will only be apparent in the longer term. History clearly suggests that short-term priorities are likely to carry the day.

This means we should expect the Federal Reserve to back away from its previous plans of raising interest rates multiple times this year. Raising rates would probably throw the market into utter turmoil, and that's the last thing they want. Indeed, by the end of the year, it seems likely the Federal Reserve will be considering lowering rates again and contemplating negative rates in the US.

That said, we should also recognize that there are no easy solutions here. At this point, the Fed is choosing between two bad options: short-term economic collapse that will be very painful, or a longer term collapse that will be even worse.

And while no one can predict exactly when the next collapse will strike, there are many different reasons to think that day is quickly approaching.

*Full disclosure: I work for a bank (not one of the infamous ones), but the views expressed here are entirely my own and in no way reflect the public or private views of decision-makers at my institution.

Democratic Hypocrisy Blocks Efforts to Audit the Fed

The Federal Reserve Transparency Act, better known as the Audit the Fed bill, failed in the Senate last week by a vote of 53 in favor and 44 against. (Note that the rules of the Senate effectively make 60 votes required to pass anything.) It is not surprising that the bill failed, but it is surprising how it failed. The vote fell almost entirely along party lines, with all but one present Republican voting in favor and virtually all Democrats voting against it. On its face, this seems confusing. The Republican party that gave us the legendary secrecy of the Cheney-Bush years voted in favor of transparency. Meanwhile, the Democratic party that talks ceaselessly about Wall Street's depravity and income inequality voted to shield an institution in the Fed that contributes directly to both. What can possibly account for this?

It's a obviously a bit depressing that a good bill like this cannot succeed, when horrible things get passed into law all the time. But there is a silver lining here, because it reveals how preposterous it is to be loyal to either political party. Neither Republicans nor Democrats have a consistent set of principles that guide their political positions. So if you happen to have consistent principles that matter to you--civil liberties, helping those in poverty, opposing war, etc.--chances are you'll wind up with strange bedfellows from time to time. The Audit the Fed bill is a perfect example of this. In order to see this and understand the full hypocrisy of the Democrats on this issue, let's take a deeper look at this issue.

Exposing Fed Monetary Policy
Critics of the Audit the Fed legislation correctly point out that the Fed already gets audited like any other institution. This is technically true, but it's also beside the point. The Department of Defense receives a financial statement audit too, but obviously that does not mean that Congress and the public shouldn't have some oversight of their activities. We don't apply that reasoning to any other aspect of the government; why should we apply it to the Fed?

Despite its name, this bill isn't really about conducting a financial statement audit of the Fed; it's about shining a light on the Fed's secretive monetary policy discussions and decisions. The Fed and its supporters have warned that making such discussions more transparent would harm the economy. But of course they're going to say that. Shadowy institutions will always fight to remain in the dark; otherwise they wouldn't be shadowy institutions.  Think of it this way. If everything is above board, then obviously releasing the details won't cause any harm. But if there is something sketchy going on that would outrage the public, well, then that's probably the exact sort of thing that needs to be public--such as the trillions of dollars made available to well-connected banks during the 2008 crisis.

Damaging Independence
When confronted with the straightforward arguments offered above, critics, such as Senator Elizabeth Warren (D), will argue that making monetary policy public risks jeopardizing the Fed's independence. You see, the Fed is technically a private entity that is supposed to be immune from the political mood of the day. In theory, this would allow the diligent economists at the Fed to make the monetary policy decisions they need to without worrying about the timing of the next election. Thus, according to mainstream economic thinking, this means that the Fed should expand the money supply* during depressions to stabilize the economy, and contract the money supply* during booms to prevent the economy from creating bubbles and collapsing. The much-hyped independence of the Fed is supposed to make this utopia possible.

But in practice, the Fed has not followed through on this strategy. During recessions, the Fed indeed expands the monetary supply to revitalize the economy. But during booms, the Fed pursues the exact same strategy, further expanding the money supply and exaggerating the boom. This, coincidentally, is precisely what the politicians would want the Fed to do. Pumping more money into the system during a boom perpetuates the appearance of a very strong economy, and incumbents perform well in elections under these circumstances. Of course, no one ever worries about the crash that invariably comes later.

If you don't find this policy trend compelling, perhaps it is useful to recall the political battle that took place when it came time for a Obama to pick a new chairperson of the Fed. Progressive Democrats supported and eventually nominated Janet Yellen, while many in the establishment preferred economist Larry Summers instead. But if the Fed is an independent organization that is immune from political considerations, why should it matter who leads it? Of course it shouldn't. So why was this such a row?

It turns out that Yellen and Summers had hinted that they would support different monetary policies. And ultimately, the candidate that succeeded was the one that wanted to implement a more expansionary monetary policy (the kind that helps the economy in the short-run).

Upon reading these details, a cynic might almost think the Fed is already politicized. Yet some specifically opposed Senator Rand Paul's Audit the Fed proposal on the grounds that it might lead politicians to try to influence monetary policy, an activity that already openly occurs.

Why Expansionary Monetary Policy Hurts the Poor
This fact is not widely understood, but it is intuitive once you understand the full effects of an expansionary monetary policy. We'll attempt to follow this through the full process to show the impact.

Expansionary Monetary Policy and Inflation
First things first. Expansionary monetary policy simply refers to a policy that causes more money to be added to the financial system. The mechanisms for how this occurs are not critical to understand.

Expansionary monetary policy has many effects, but one of the most direct effects is inflation. Adding to the amount of money to the system, does not add to the amount of goods available in the system as a whole. Thus, if more money represents the same amount of stuff in the economy, all else equal, it follows that prices will go up. These changes don't happen instantaneously and there are many other factors that may accelerate or delay the effect. But the end result is that prices will ultimately be higher.**

Ever since the Fed's came into being in 1913, we have seen a gradual decline in the value of the US dollar over time, or what is the same thing, a rise in the level of prices. At some point in your life, you've probably heard a crotchety old relative say they used to be able to buy a candy bar with a nickel. In fact, depending on how old they are, they might not be lying. Due to the impact of inflation, $0.05 in 1913 would be equivalent to $1.20 in the year 2015. Even if they're not centenarians, the disparity is still likely to be pretty shocking. And this is according to the US government's own inflation statistics.

One response to this might be who cares? We don't really want to carry around a bunch of coins all day. And who knows how much harder it would be to split a tab with friends if every nickel mattered? But if we set those issues aside, we realize this actually does create real problems.

Winners and Losers from Inflation
One problem with inflation is that it doesn't impact everyone equally. The new money that exists in the economy doesn't fall from the sky, giving everyone an equal shot to get some. Rather, it enters the economy primarily through the financial sector--banks and investment banks.

This matters because the people who get the new money first are the ones who benefit most from inflation. They get to spend the new money before prices have adjusted to account for the extra money. So let's say the investment bankers (group A) earn 50% extra profits in January based on the new money and can now spend more at their favorite restaurants, spas, and golf courses before any of their prices have changed. The owners of these restaurants, etc. (group B) have earned 30% extra profits based on the new money, and now in February, they can spend on their favorite grocery stores, movie theaters, etc (group C). Since some time has passed, prices for group B will be a little higher than they were in January (say, 15%), but the group is still better off. Group C starts earning extra profits (say 5%) thanks to extra business from B, but now it's April and other prices in the economy have already risen by 50%. Thus, even though Group C is technically "earning more money" on paper, they're actually worse off in reality.

The above numbers and time frames were made up, but that is ultimately how the process works. There's a kind of trickle down effect, where the people that get the new money last lose the most. And since poor people don't tend to have a lot of connections to the high-powered financial sector, they're usually the ones that get hit by inflation. In this way, the Fed's official policy goal of causing a steady increase in inflation tends to transfer wealth toward the financial sector and away from the poor.

Punishing Saving
The other problem with inflation is that it can create a powerful disincentive for individuals to save. And the higher the inflation, the stronger the disincentive. If I know a dollar I have today is going to be worth only 95 cents tomorrow, I'm less likely to save that dollar. I want to spend it today instead, when it's worth more.

A possible savings solution to the inflation problem is the interest-bearing savings account. As long as the bank pays an interest rate equal to or greater than the rate of inflation, I may be inclined to save again. Even if I'm not making much money, I can at least keep it safe from losing value.

But what if the Fed sets interest rates very low, as they have for the past several years? Now, if I want to save, I don't have any option that even keeps pace with inflation. Dissatisfied with the idea of knowingly losing money in a conventional savings account, therefore, I have to look for other ways to save money that can give a better return. I may get drawn into investing in the volatile stock market, hoping to ride the wave of stock price increases. Alternatively, I may decide to not save at all and just focus on consumption.

Notice how different this is from an economy that doesn't have new money entering the system to cause inflation. When there's no inflation, the average person can effectively save for the future by literally just saving money, either in a savings account or in physical form. There is virtually no risk of loss, short of robbery or their bank failing outright. And since, all things equal, production processes tend to get more efficient over time, this means that prices actually fall over time. The same amount of money in the economy, but with more stuff to buy, would tend to produce declining prices. This offers a reliable and safe option that encourages saving and discourages speculation in risky assets.

In an inflationary environment, however, the average person is likely to save less and put what savings they do have into more speculative investments like real estate or the stock market to avoid losing money to inflation. Ironically, since many people share this same problem, this forces more money into the investment market and drives prices higher than they otherwise would be. This in turn creates a bubble, and makes the market more unstable and prone to crashing. Thus, not only is it more likely that the average person will put money into speculative investments, it is also more likely these markets will crash hard when the boom ends, taking almost everyone's money down with it.

I say almost everyone, because very wealthy investors have a way to avoid the worst consequences. Wealthy investors can afford to hire sophisticated teams to ensure their investments are well-protected against risk. If they are wealthy and well-connected enough, they also have the opportunity to be bailed out by the government, as has happened numerous times in the past. All of this helps prevent rich individuals from getting wiped out to the same degree as everyone else when the next crash comes.

Finally, since the entire system encourages people to invest in stocks, bonds, and other investments that are sold by brokers, this artificially increases the amount of business received by those brokers. This is yet another benefit provided to the financial sector by expansionary policies.

Thus, we see that the general outcome of the Fed's expansionary monetary policy is to hurt the poor. Poor people's efforts to move upward are frustrated by the lack of reliable ways to save and the incentive to just consume. Meanwhile, the wealthy have unique abilities to protect themselves against instability of the markets that the average investor will not. And at each step of the process the financial sector is directly enriched.

It's tough to imagine a proposal that is more directly opposed to the purported priorities of the Democratic Party than the Fed's expansionary monetary policy. It benefits Wall Street at the expense of middle- and working-class. And the Democrats just voted to protect it from any scrutiny.

Summing Up
In the final analysis, one finds it difficult to exaggerate the hypocrisy of the Democrats on the Audit the Fed bill. Two members of the left, Senator Bernie Sanders and Senator Tammy Baldwin, were admirably willing to break with the President and support the bill. And they should absolutely be commended for doing so.

But for the rest of the Democrats, there's simply no excuse. Voting against Audit the Fed was a vote against governmental transparency, against social mobility, and in favor of more income inequality. So if you care about any of those issues, it turns out the Republicans were actually on your side on this one.

Of course, if you consider yourself a progressive, this doesn't mean you should run out to change your affiliation tomorrow or, so help me, pledge your support for Trump or Cruz. But it does mean you should reconsider being loyal to either party.

*The Fed has a few different tools to expand or contract the money supply, but the details of those mechanisms aren't necessary critical to understand. For the purposes of this article, just know that expanding and contracting the money supply mean exactly what they sound like they mean--increasing the amount of money in the economy or decreasing it.

**Technically, all we can say for sure about the nature of inflation is that prices will be higher than they otherwise would be. How much prices rise depends on how much and how quickly new money is added and how quickly the economy is growing. In recent US history, the net effect has been a small absolute rise in consumer prices. To simplify our discussion, we're assuming an absolute increase as well.