Pursuant to its essence as a
post-Peel Act Central Bank, the Federal Reserve enjoys a monopoly of the issue
of all bank notes. The U. S. Treasury, which issued paper money as Greenbacks
during the Civil War, continued to issue one-dollar "Silver
Certificates" redeemable in silver bullion or coin at the Treasury until
August 16, 1968. The Treasury has now abandoned any note issue, leaving all the
country's paper notes, or "cash," to be emitted by the Federal
Reserve. Not only that; since the U.S. abandonment of the gold standard in
1933, Federal Reserve Notes have been legal tender for all monetary debts,
public or private.
Federal Reserve Notes, the
legal monopoly of cash or "standard," money, now serves as the base
of two inverted pyramids determining the supply of money in the country. More
precisely, the assets of the Federal Reserve Banks consist largely of two
central items. One is the gold originally confiscated from the public and later
amassed by the Fed. Interestingly enough, while Fed liabilities are no longer
redeemable in gold, the Fed safeguards its gold by depositing it in the
Treasury, which issues "gold certificates" guaranteed to be backed by
no less than 100 percent in gold bullion buried in Fort Knox and other Treasury
depositories. It is surely fitting that the only honest warehousing left in the
monetary system is between two different agencies of the federal government:
the Fed makes sure that its receipts at
the Treasury are backed 100 percent in the Treasury vaults, whereas the Fed
does not accord any of its creditors
that high privilege.
The other major asset
possessed by the Fed is the total of U.S. government securities it has
purchased and amassed over the decades. [Editor's note: Now,
mortgage-backed securities also comprise a significant portion of the Fed's
holdings.] On the liability side, there are also two major
figures: Demand deposits held by the commercial banks, which constitute the
reserves of those banks; and Federal Reserve Notes, cash emitted by the Fed.
The Fed is in the rare and enviable position of having its liabilities in the
form of Federal Reserve Notes constitute the legal tender of the country. In
short, its liabilities — Federal Reserve Notes — are standard money. Moreover, its other form of
liability — demand deposits — are redeemable by deposit-holders (i.e., banks,
who constitute the depositors, or "customers," of the Fed) in these
Notes, which, of course, the Fed can print at will. Unlike the days of the gold
standard, it is impossible for the Federal Reserve to go bankrupt; it holds the
legal monopoly of counterfeiting (of creating money out of thin air) in the
entire country.
The American banking system
now comprises two sets of inverted pyramids, the commercial banks pyramiding
loans and deposits on top of the base of reserves, which are mainly their
demand deposits at the Federal Reserve. The Federal Reserve itself determines
its own liabilities very simply: by buying or selling assets, which in turn
increases or decreases bank reserves by the same amount.
At the base of the Fed
pyramid, and therefore of the bank system's creation of "money" in
the sense of deposits, is the Fed's power to print legal tender money. But the
Fed tries its best not to print cash but rather to "print" or create
demand deposits, checking deposits, out of thin air, since itsdemand deposits constitute the reserves on top of
which the commercial banks can pyramid a multiple creation of bank deposits, or
"checkbook money."
Let us see how this process
typically works. Suppose that the "money multiplier" — the multiple
that commercial banks can pyramid on top of reserves, is 10:1. That multiple is
the inverse of the Fed's legally imposed minimum reserve requirement on different
types of banks, a minimum which now approximates 10 percent. Almost always, if
banks can expand 10:1 on top of their reserves, they
will do so, since that is how they make their money. The counterfeiter, after
all, will strongly tend to counterfeit as much as he can legally get away with.
Suppose that the Fed decides it wishes to expand the nation's total money
supply by $10 billion. If the money multiplier is 10, then the Fed will choose
to purchase $1 billion of assets, generally U.S. government securities, on the
open market.
Figure 10 and 11 below
demonstrates this process, which occurs in two steps. In the first step, the
Fed directs its Open Market Agent in New York City to purchase $1 billion of
U.S. government bonds. To purchase those securities, the Fed writes out a check
for $1 billion on itself, the Federal Reserve Bank of New York. It then
transfers that check to a government bond dealer, say Goldman, Sachs, in
exchange
for $1 billion of U.S.
government bonds. Goldman, Sachs goes to its commercial bank — say Chase
Manhattan — deposits the check on the Fed, and in exchange increases its demand
deposits at the Chase by $1 billion.
Where did the Fed get the
money to pay for the bonds? It created the money out of thin air, by simply
writing out a check on itself. Neat trick if you can get away with it!
Chase Manhattan, delighted to
get a check on the Fed, rushes down to the Fed's New York branch and deposits
it in its account, increasing its reserves by $1 billion. Figure 10 shows what
has happened at the end of this Step One.
The nation's total money
supply at any one time is the total standard money (Federal Reserve Notes) plus
deposits in the hands of the public. Note that the immediate result of the Fed's purchase of a $1
billion government bond in the open market is to increase the nation's total
money supply by $1 billion.
But this is only the first,
immediate step. Because we live under a system of fractional-reserve banking,
other consequences quickly ensue. There are now $1 billion more in reserves in
the banking system, and as a result, the banking system expands its money and
credit, the expansion beginning with Chase and quickly spreading out to other
banks in the financial system. In a brief period of time, about a couple of
weeks, the entire banking system will have expanded credit and the money supply
another $9 billion, up to an increased money stock of $10 billion. Hence, the
leveraged, or "multiple," effect of changes in bank reserves, and of
the Fed's purchases or sales of assets which determine those reserves. Figure
11, then, shows the consequences of the Fed purchase of $1 billion of
government bonds after a few weeks.
Note that the Federal Reserve
balance sheet after a few weeks is unchanged in the aggregate (even though the
specific banks owning the bank deposits will change as individual banks expand
credit, and reserves shift to other banks who then join in the common
expansion.) The change in totals has taken place among the commercial banks,
who
have pyramided credits and
deposits on top of their initial burst of reserves, to increase the nation's
total money supply by $10 billion.
It should be easy to see why
the Fed pays for its assets with a check on itself rather than by printing
Federal Reserve Notes. Only by using checks can it expand the money supply by
ten-fold; it is the Fed's demand deposits that serve as the base of the
pyramiding by the commercial banks. The power to print money, on the other
hand, is the essential base in which the Fed pledges to redeem its deposits.
The Fed only issues paper money (Federal Reserve Notes) if the public demands
cash for its bank accounts and the commercial banks then have to go to the Fed
to draw down their deposits. The Fed wants people to use checks rather than
cash as far as possible, so that it can generate bank credit inflation at a
pace that it can control.
If the Fed purchases any
asset, therefore, it will increase the nation's money supply immediately by
that amount; and, in a few weeks, by whatever multiple of that amount the banks
are allowed to pyramid on top of their new reserves. f I it sells any asset (again, generally U.S. government
bonds), the sale will have the symmetrically reverse effect. At first, the
nation's money supply will decrease by the precise amount of the sale of bonds;
and in a few weeks, it will decline by a multiple, say ten times, that amount.
Thus, the major control
instrument that the Fed exercises over the banks is "open market operations,"
purchases or sale of assets, generally U.S. government bonds. Another powerful
control instrument is the changing of legal reserve minima. If the banks have
to keep no less than 10 percent of their deposits in the form of reserves, and
then the Fed suddenly lowers that ratio to 5 percent, the nation's money
supply, that is of bank deposits, will suddenly and very rapidly double. And
vice versa if the minimum ratio were suddenly raised to 20 percent; the
nation's money supply will be quickly cut in half. Ever since the Fed, after
having expanded bank reserves in the 1930s, panicked at the inflationary
potential and doubled the minimum reserve requirements to 20 percent in 1938,
sending the economy into a tailspin of credit liquidation, the Fed has been
very cautious about the degree of its
changes in bank reserve requirements. The Fed, ever since that period, has
changed bank reserve requirements fairly often, but in very small steps, by
fractions of one percent. It should come as no surprise that the trend of the
Fed's change has been downward: ever lowering bank reserve requirements, and
thereby increasing the multiples of bank credit inflation. Thus, before 1980,
the average minimum reserve requirement was about 14 percent, then it was
lowered to 10 percent and less, and the Fed now has the power to lower it to
zero if it so wishes.
Thus, the Fed has the
well-nigh absolute power to determine the money supply if it so wishes.[1] Over the years, the thrust of its operations has
been consistently inflationary. For not only has the trend of its reserve
requirements on the banks been getting ever lower, but the amount of its
amassed U.S. government bonds has consistently increased over the years,
thereby imparting a continuing inflationary impetus to the economic system.
Thus, the Federal Reserve, beginning with zero government bonds, had acquired
about $400 million worth by 1921, and $2.4 billion by 1934. By the end of 1981
the Federal Reserve had amassed no less than $140 billion of U.S. government
securities; by the middle of 1992, the total had reached $280 billion. [Editor's Note: Now, the total exceeds $1.6 trillion.] There
is no clearer portrayal of the inflationary impetus that the Federal Reserve
has consistently given, and continues to give, to our economy.
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