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Thursday, August 23, 2007

Federal Reserve Thoughts - How it Works

I originally wrote this article for the Ron Paul wiki, and I broke it up into several pieces and copied it here.

How Deficit Spending Works

Suppose the government needs $1B. Before the Federal Reserve Act, the government could have just printed the $1B directly and spent it itself. This was what President Lincoln did with his greenbacks.

Under the Federal Reserve System, the government prints a bond with face amount $1B. The government prints $1B in physical currency. The government sells the $1B of physical currency to the Federal Reserve at the printing cost, say $10,000. The government then gives the $1B bond to the Federal Reserve and takes back the $1B of currency as payment.

Physical bonds and bills do not need to be printed. It can be done purely electronically, via a bookkeeping trick.

That seems kind of silly, doesn't it? Why doesn't the government just print the money and spend it directly? The superficial reason is that the government has ceded its money printing authority to the Federal Reserve. The actual reason is that if Congress directly printed and spent its own money, this would run contrary to the Federal Reserve's goal of fixing interest rates at an artificially low level. More details are given below and in my next post "Reasons for Abolishing the Federal Reserve".

There is an interesting exception. For paper money, the government gets reimbursed only for its printing costs. For coin money, the government gets credited for the face amount of the coin. Maybe that's the reason for resistance to the use of a $1 coin; that increases seignorage revenue for the government at the expense of seignorage revenue for the financial industry. In theory, the government could mint a $100 trillion coin and deposit it in its account at the Federal Reserve.

Did you ever notice that? A Federal Reserve Note says "This note is legal tender". Treasury-minted coins do *NOT* say "this is legal tender". Federal Reserve Notes and Treasury-minted coins have different legal status. Coins still have a face amount greater than their metal value, except for pennies and nickels. Ironically, pennies and nickels have a face amount close to their metal value. Pennies and nickels are the only true money currently in circulation. The government can't abandon minting pennies and nickels, because that would be tantamount to an admission that inflation exists.

There is another reason why the government can't be allowed to directly print and spend money itself. Money counts as reserves for fractional reserve banking, whereas government bonds do not. Fractional reserve banking would cause any money directly printed and spent by the government to be multiplied by the reserve ratio factor, causing inflation. That's why government deficit spending is preferable to directly printing and spending money. The real culprit is the fractional reserve banking system combined with government-subsidized artificially low interest rates. If either of these were removed, there would be no difference between government debt and directly printing and spending money.

How the Federal Reserve Increases the Money Supply

Suppose the Federal Reserve decides that it wants to increase the money supply. It buys Treasury bonds that are nearly expired, and the cash paid for them has the effect of increasing the money supply. However, the Federal Reserve just creates the money it used to buy the bonds. Suppose that $1B of Treasury bonds need to be bought. Since these bonds are nearly expired, their face amount is $1B and their market value is something like $999M. The Federal Reserve creates a credit of $999M in the account of whoever sold it the bond. The Federal Reserve has a debit of $999M in its own account. The Federal Reserve now has bonds with a market value of $999M in its account.

A few days later, the bonds expire, and the Federal Reserve redeems them with the government for $1B, the face amount. The $999M debit cancels out, leaving a $1M credit. The Federal Reserve made a profit of $1M. However, it didn't do any work at all. The Federal Reserve was guaranteed a profit as long as interest rates are positive.

This trick is called "monetizing the debt".

Notice that this trick allows the Federal Reserve to subsidize artificially low interest rates and show a bookkeeping profit at the same time. The fallacy is that the Federal Reserve has no cost of capital. It just created the $999M it used to buy the bonds out of thin air. Nobody notices, because the $999M it created disappears when it redeems the bonds.

The Federal Reserve is exchanging bonds for cash. The reason this trick increases the money supply is that government bonds don't count as bank reserves, but cash does. Due to the Federal Reserve's market manipulations, banks have more reserves. This means they have a greater ability to issue loans. The reserve ratio, typically 10x, can be used to amplify this new money by a factor of 10x. With a 10x reserve ratio, each dollar put into circulation this way leads to ten more dollars of actual money after fractional reserve banking. Government bonds don't count as reserves and don't have the multiplicative money effect. Since interest rates are held at an artificially low level, banks are always able to loan out all the extra reserves they have.

If fractional reserve banking were forbidden, this trick would have no effect on the money supply. With fractional reserve banking, the cash can be lent out up to 10 times.

There is a cost to the Federal Reserve's market manipulations. They are paid by everyone else in the form of inflation.

This "monetizing the debt" trick is one of the dirtiest financial scams ever invented. The word "monetizing" means "profiting off". When the Federal Reserve "monetizes the debt", it is simultaneously showing a profit and subsidizing artificially low interest rates. The Federal Reserve itself shows a bookkeeping profit. The financial industry profits from government-subsidized artificially low interest rates.

The Federal Reserve repurchases enough debt so that the Fed Funds rate equals its target.

The Compound Interest Paradox

In the Federal Reserve System, whenever money is created, an equal debt is simultaneously created. However, the money required to pay that interest is not also simultaneously created. This insures that the total debt in the economy increases exponentially over time.

For example, the government borrows $1B from the Federal Reserve. Suppose it issues a 1 year bond at 5% interest. The government receives $1B, which is put into circulation when the government spends it. However, that bond needs to be repaid with $1.05 billion a year from now. The $50 million needed to pay the interest was never created or put into circulation. A similar process is followed when the Federal Reserve loans money to banks.

Under the Federal Reserve System, the total debt in the economy can only increase exponentially over time. The scam has been running for so long that the amount of the total debt is starting to reach ridiculous proportions.

The Federal Reserve is not a Check on Federal Budget Deficits

Even though the government ceded its money printing authority to the Federal Reserve, it does not effectively prevent the government from deficit spending. All the government has to do is ask and it gets a loan. Due to the Compound Interest Paradox, a federal budget deficit is necessary in order to allow anyone else to have any money at all. The current state of affairs is kind of silly. The accumulated federal deficit is larger than the M2 money supply. How can the Federal government be in debt by more money than actually is in circulation? That's because of the Compound Interest Paradox.

Federal Budget Deficits and Inflation

When the Federal government runs a deficit, it prints more bonds to raise money for its deficit spending. These additional bonds are sold to the public. The presence of more government debt means that the price of government debt falls. The supply has increased, so the price drops. A drop in the price of a bond means that the interest rate goes up. In other words, deficit spending by the government via debt causes interest rates to rise.

The Federal Reserve's goal is artificially low interest rates. As the supply of government debt increases, the Federal Reserve must repurchase more bonds to achieve its target interest rate. The act of repurchasing government debt is inflationary, because it increases the amount of reserves banks have available for fractional-reserve banking.

Notice that if the government directly printed and spent money, it would have the opposite effect on interest rates. There would be more money in circulation, so it would be easier for banks to acquire reserves to lend out. Interest rates would drop.

The regulated fractional reserve banking system is the primary culprit. It is the primary reason for the distinction between government deficit spending via debt and government deficit spending via directly printing and spending money.

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