How the Federal Reserve Works

Economics Economics Questions
1

So, I understand that the US Government nearly always spends more than it takes in. I also understand that the government makes up the difference by borrowing from the Federal Reserve, who in turn may choose to sell the debt as US Government bonds.

The part I don’t understand is… where does printing money come into play. Does the US government print money to pay the interest on its debt?

How does the US government go about making new money. What is the check on the system that prevents the government from printing as much money as it wants?

Thanks for the help.

2

Banks have accounts with the fed and the fed can add zero’s to the money in those accounts

they can also add zeros to the money in their own accounts and go and buy stuff with that.

What is the check on the system that prevents the government from printing as much money as it wants?

Good question

3

This may help:

[url]Question about open market operations - #4 by Think_Blue]

4

Ok, let me know if I’ve got this right:

The Federal Reserve can create money ex nihilo (out of nothing) in order to loan it to the US Government or to loan it to member banks at a discount rate.

Member banks can borrow 10x the amount of money that they have in deposits from the Fed at very low interest.

So, the only thing limiting the creation of money is government spending or demand for loans - both of which are seemingly limitless…

5

@Chris: The details are a lot more complex than that but you have the basic idea. Importantly, the Fed is not the only customer of US government debt. This is an important part of the justifications that economists give for the Federal Reserve’s actions. Essentially, the reasoning is that if the Fed is buying government debt on the open market, then the market also judges the debt to be valuable. The term “quantitative easing” refers to the buying of government debt without the constraint of being purchased on the open market.

Clayton -

6

Chris,

The U.S. Government borrows money from the treasury market, ie, from the private sector, foreign governments and foreign central banks. It does not borrow directly from the U.S. central bank (Federal Reserve) under “normal” conditions.

(using “normal”, “central bank” and “U.S. Government” in the same sentence is hazardous.)

The central bank purchases short term U.S. Treasury notes, ie, with maturities less than 90 days in order to manipulate the amount of excess reserves in the banking system (The Federal Reserve System, the private banking cartel).

The amount of excess reserves determines the Fed funds rate (the rate banks charge each other for overnight loans). The Fed targets this rate. It keeps buying short term treasuries until this rate hits their targeted range. The larger the excess reserves in the system, the lower the Fed funds rate, the smaller the excess reserves, the higher the rate.

The central bank writes a check to buy the short term t-bills from those who hold them. This check is deposited into a commercial bank (usually one of the large money-center banks like JP Morgan). A demand deposit account is opened with money created from nothing. The bank has a “reserve” with the Fed (created from nothing), and the former holder of government debt has a demand deposit account that he can write checks on, to use as money.

Money created from debt. That’s how it works. Every penny of money in existence in the U.S. was created from debt using this mechanism.

Because of the Fed’s intervention, the banking system and the economy collapsed in Sept. 2008. Yes, the banking system actually collapsed. The TARP was needed to re-capitalize banks, and the TAG program was needed to guarantee all demand demand deposit accounts in the system (about $5 trillion, I believe, vs. the FDIC Fund of about $60 billion at the time).

(One of the large money market funds “broke the buck”, LIBOR rose to 6%, there was a run on the system, everyone wanted their “money” back all at once; the Fed would have had to print it all, causing a hyperinflationary collapse of the currency. Instead, promises were made to honor all accounts by the Central bank and U.S. Taxpayer; the market accepted this promise, and things calmed down, for now.)

Because the Fed funds rate is zero, the Fed now buys long term treasury notes in the open market using money created from nothing. For now, this has the effect of decreasing the yield on longer term bonds. This is called Quantitative Easing, a euphemism for money printing designed to prevent panic in the bond market, and keep excess reserves in the banking system increasing.

The U.S. Gov/t now runs $1.5 trillion annual deficits, with no end in sight. Buyers in the market place are insufficient to meet this demand. Without the Fed’s buying of these treasuries, yields would rise.

Higher bond yields would decrease the market value of the existing $13 trillion in treasury debt. This would cause a panic in the bond market as bond holders see the value of their investment drop. They might sell, causing yields to rise further, thus continuing the process of wealth destruction. The Fed would have to intervene to stop the process.

This is why the Fed is purchasing long term bonds.

The only “check” I can think of is the threat of a hyperinflationary melt down, caused by the Fed’s own printing. Paul Volker saw the beginnings of this process in the late '70’s, and actually tightened monetary policy to save the bond market. Fed funds peaked at about 20% in 1981, and I think treasuries rose to about 17%.

Sorry I used so many words, and maybe went beyond your question. But, there are many things going on when it comes to the Fed.

For an excellent explanation, read this: What Has Government Done to Our Money

7

The US government sells bonds. The bond dealers buy them and then subsequently sell some to the Federal Reserve Bank. The Fed creates the money from nothing to buy these bonds. So the Federal government does not create money, only the fractional reserve banks do that with the Federal Reserve Bank being the big kahuna of the fundamentally fraudulent fractional reserve banking system. There is no only one check that stops the Fed from printing all the money it wants and that is the deterioration in the value of the money as more and more is created. Every dollar created lessens the value of all dollars already in existence. Eventually the money will become worthless if the banking system creates too much of it.

8

What is the check on the system that prevents the government from printing as much money as it wants?

There is none.

9

At the end of the day, somebody has to get paid in actual folding green. I understand that money is actually printed at the Buearu of Printing and Engraving, but how does it make its way to the Fed?

How is the money created by the Fed through it’s fancy checkbook tricks realized as actual cash?

I figure… at the end of the day, people have to get paid in actual cash (or something else valuable)… checkbook money only gets you so far.

10

Chris,

You are focusing on the “folding green”, but that is an insignificant part of the money creation process. And, actual currency (“folding green”) is not a significant part of the overall money supply. It is the creation of demand deposits that is the key.

But, to address your question: A bank has a reserve balance at the Fed. The bank orders up cash when its decides its cash balance is low. Armored car services move cash from one bank to another. Adjustments are made the bank’s reserve account balance at the Fed; Decrease the reserve balance, increase the cash on had balance (vault cash). The bank could also sell assets such as treasury securities.

I’m not sure exactly how “folding green” moves from the Bureau of Printing an Engraving to the Fed Reserve System (private banking cartel), but it is very likely only a matter of accounting entries between the Fed and banks, then getting armored cars involved.

11

I’ve been out of this thread for a while, but I wanted to thank everyone for their great responses. Per chloe732’s remark, I did some reading about demand deposits, and I think that I have a better understanding. It seems as though the actual cash kept on hand at the banks is merely a fraction of their “checkbook money” (fractional reserve?). If, for example, their books show that they have $100 million dollars, they only need to have a fraction of that in cash. So the cash that is printed is merely a fraction of the increase in the money supply - which is adjusted accordingly by the Buearu of Printing and Engraving.

So, how did this whole process work under the gold standard (1913-1944) and the Bretton-Woods system (1944-1971). My guess would be that under the gold standard, the fractional reserve was gold, rather than dollars, and a fraction of the money created needed ot be used to buy the gold to back it (i.e. creating $100 in checkbook money would require $30 worth of gold, and hence $30 worth of reserve notes). If that is the case, it still works out to be a pretty good deal for the banks.

Prior to the creation of the Federal Reserve, I suppose individual banks ordered cash from the department of the treasury to balance out their books (by sending them gold).

I’m slowly but surely wrapping my brain around this whole business. I think that it’s complicated on purpose - like taxes. It’s harder to complain about a thing if you don’t understand it fully.

I’ve been meaning to read Milton Friedman’s “A Monitary History of the United States” and Murray Rothbard’s “What Has the Government Done to Our Money” because I find the subject intriguing. However, life’s gotten in the way lately. Thanks for all of your insight.

12

Chris,

It took several months for me to really get my mind around this subject. I can tell you’ve made progress, keep working at it.

I would recommend reading Friedman’s Monetary History of the United States only after you’ve had some additional grounding in the economics of the Austrian school. Read What Has Government Done to Our Money first. It is easy reading, and is an introduction to the concepts. Then read The Mystery of Banking by Rothbard (both of these are free under the Literature tab on the home page).

When studying how the central banking system works (“Federal Reserve System”), I recommend expunging the concept of “cash” from your mind. Little green paper tickets and nickel plated copper tokens are irrelevant to the essence of the process of money creation. You can disregard the Bureau of Printing and Engraving from your analysis.

In fractional reserve banking (under the fiat system) it is not the “cash” that matters, it is the “reserves”. But the concept of a “reserve” is quite bizarre because it is so unlike anything we deal with in the real world. I think you focus on “cash” because you can visualize it, you can visualize packs of $100 bills, and you can exchange these tickets for goods.

Under the fiat system, the “reserve” is an accounting entry, nothing more. The bank can exchange the reserve balance for a cash balance. But that just muddles up the concept.

You will need some basic accounting, ie, the idea that Assets = Liabilities + Equity (or net worth). This is an accounting identity.

The reserve is an asset (an asset created from nothing, again we are discussing the bizarre world of central banking and fiat money).

The other side of the entry is a demand deposit (liability).

When the Fed creates a reserve (by writing a check on itself, when it buys treasuries), the ledger entry on the books of the commercial bank is: INCREASE Reserve (Asset) | INCREASE Demand Deposit (Liability).

This is great for the bank (as you alluded) because it now can loan out part the reserve! A reserve created from nothing! What a deal.

If the reserve = 10 and the demand deposit = 100, the fractional reserve is 10%. It is the ratio between the reserve and the demand deposit. Cash (tickets and coins) just muddles things up. The missing 90 = loans (an asset, unless it becomes uncollectible, but that’s what taxpayers are for)

Then, the banking multiplier kicks in, but I won’t go there right now.

There are some concepts and dates that will need straightening out. Reading Rothbard will help you out on this.

You got it! That is why you must boil it down to the essence, filter out the noise.

The essence is money created from nothing, at the whim of those given the power to do so. Once who’ve grasped this, you can move on to Austrian Business Cycle Theory, the hidden tax of money creation (inflation), and the way all of this impacts that little known idea called…Liberty.