What is the Federal Reserve?
Congress created the Federal Reserve System (“the Fed”) in 1913. This Federal Reserve Act was the result of a secret meeting that occurred at the Jekyll Island Club in November, 1910, involving the most powerful banking interests in the United States.
The Federal Reserve is the head of America’s central banking system. The Federal Reserve is the head of a cartel that allows banks to uniformly loan out excess reserves (i.e., inflate the money supply) without having to worry about other banks in the cartel demanding redemption of the underlying deposits, which would force the inflating bank into insolvency. In plain English, the Federal Reserve is the enabler that allows banks to loan out more money and generate more interest income than would otherwise be possible under a sound market-based monetary system.
In addition, the Federal Reserve enables the federal government to finance expensive welfare programs at home and wars abroad without having to raise taxes to levels that would cripple the economy.
How the Banking System Used to Work
Back when the developed economies of the world were primarily based on real commodity monies, like gold and silver, individuals would generally deposit their gold and silver in a bank. The depositor would then decide whether to leave the deposit in the bank, or have the bank loan the monies out at interest.
Under “Deposit Banking,” the depositor pays a nominal fee for the bank to store the money and keep it safe. Under this arrangement, the bank would not be permitted to loan the deposited monies out at interest. Legally, a bailment would be created between the bank and the depositor.
Under “Loan Banking,” the bank would loan the deposited monies out at interest for a specified period, or term, to an individual or business. The bank’s income under Loan Banking would be based on the difference between the interest received from the borrower, and the interest paid to the depositor. What’s important to note here is that nobody has a simultaneous claim to the same money at the same time. In other words, this classical banking system makes it very difficult and risky for banks to attempt to inflate the money supply. If word got out that a bank was impermissibly loaning out Deposit Banking funds, there could be a run on the bank that could cause the bank to fail.
Today, most people believe “bank runs” are a bad thing. In reality, bank runs were the means by which depositors (i.e., the market) kept bankers honest and prevented them from impermissibly loaning deposits out at interest. Bankers at sound banks did not have to worry about bank runs since these banks were solvent and could meet the immediate demands of their depositors.
How the Banking System Works Today – Fractional Reserves
Deposit Banking and Loan Banking were merged into what we call Commercial Banking today. When someone deposits $100 in a bank, $90 of that $100 is loaned out the back window, assuming the Fed requires a 10% Reserve Requirement. This is what we call, “Fractional Reserve Banking.” As should be clear from this basic example, all Fractional Reserve Banks are inherently insolvent. If all depositors wanted their money immediately at one time, the bank would not be able to meet its obligations.
The Central Bank (the Federal Reserve), steps in to provide money for banks when they need quick, short-term money to meet unexpected depositor demands and/or to ensure the bank closes each day with at least the minimal 10% reserve requirement. In this way, the Fed can be viewed as the facilitator that allows banks to loan out more money than they would otherwise be able to, which allows the banks to earn more interest income. Is this a bad thing? Yes – because of the inflation and instability this system creates.
Inflation and Instability
Assuming $100 is deposited in a bank, $90 will be loaned out the back window assuming a 10% reserve requirement. That $90 will eventually be deposited by someone at a bank and the bank will loan $81 of the $90 out the back window to someone else. This process will continue until ultimately you have $1,000 pyramided on top of $100 of real deposits. This upside-down pyramid of debt creates a very unstable banking system, but it also increases the outstanding money supply. Inflation is an increase in the money supply. The eventual rise in consumer prices that eventually arrives is the effect of inflation.
Inflation is theft, plain and simple. Inflation is a stealth tax. Inflation destroys the purchasing power of the dollar. Thus, inflation punishes savings. Banks and the government benefit from inflation, but the average person does not benefit from inflation, and people who believe in saving and living within their means are punished for being prudent and responsible.
How Government Benefits from the Federal Reserve
Governments have three ways to raise money: (1) Taxing citizens; (2) Borrowing; and (3) Inflation. In reality, Inflation is a stealth tax and borrowed money must be repaid through taxation, so governments can really only tax. However, since Inflation (i.e., Federal Reserve money printing) does not involve direct confiscation of dollars or property, Inflation is not technically taxation. Inflation is counterfeiting. However, for purposes of simplicity, all three methods are discussed below.
1. Taxing Citizens
The government can and does tax its citizens. In the United States, the federal government imposes income taxes, estate taxes and a long list of excise taxes and other taxes to finance its operations. However, there are limits to which the federal government can tax before people begin to get angry.
The government can and does borrow from its citizens and from foreigners and foreign central banks. The United States is in the fortunate position of having the world’s Reserve Currency. Reserve Currency status means most countries around the world conducting international business transactions will use US Dollars to execute these transactions. As such, there is a worldwide demand for the Dollar. Demand for the Dollar keeps the Dollar strong.
Because of the Dollar’s status, people, governments, and central banks all around the world generally park their excess dollars in US Treasuries. Treasuries are US government bonds. These bonds pay interest to the people who purchase them. But the money these people put into bonds goes to the US government, who proceeds to spend the borrowed money on government expenditures, which include welfare programs and wars around the world. These operations are very expensive. Often taxing and borrowing are insufficient to cover the costs of operating government. That is where the Federal Reserve steps in.
Here’s a simple cartoonish example of how the government benefits from inflation:
Let’s say the government plans on spending $3 Trillion in a given year. The government projects tax revenues of $1 Trillion, and plans on borrowing the remaining $2 Trillion. However, let’s say the sale of bonds is not projected to cover the $2 Trillion without potentially requiring a higher rate of interest on the bonds being sold. If the government is able to sell $1 Trillion of US Treasuries, where will the government find the additional $1 Trillion to cover its expenses?
The Federal Reserve “Open Market Committee” will step in, create money out of thin air and purchase government bonds from “Primary Dealers.” These Primary Dealers consist of privileged banks and securities broker-dealers. These firms include the likes of Goldman Sachs, UBS, Morgan Stanley, Credit Suisse, etc… These Primary Dealers will then purchase more US Treasuries directly from the Treasury at auction. This is all part of an end-around process whereby the Federal Reserve is ultimately purchasing US Treasuries by using the Primary Dealers as a conduit. Boiled down to its simplest terms, the Federal Reserve is printing money and buying federal debt, thus allowing the federal government to spend money with impunity. The privileged Primary Dealers make money on the spread under this arrangement for doing nothing that provides any sort of economic value. Not a bad gig.
The Federal Reserve Causes the Boom and Bust Business Cycle by Manipulating Interest Rates
Interest rates in a free market are determined by the amount of available savings in an economy.
High Savings equals Low Interest Rates: If Americans in the aggregate saved lots of money and did not overindulge on consumption spending, there would be large pools of savings available to be loaned out to other individuals and businesses. If savings were plentiful and available, competition between banks would drive down interest rates. These lower rates would incentivize spending and investment in long term projects since the available pool of savings would be able to sustain the viability of these projects in the long term.
Low Savings equals High Interest Rates: If Americans in the aggregate did nothing but spend and did not save much money, there would be small pools of savings available to be loaned out to other individuals and businesses. In this low savings environment, interest rates would be high since borrowers would have difficulty shopping around at various banks for lower interest rates. In other words, if savings were in short supply, banks would charge higher rates of interest. If banks were charging higher rates of interest, people would be incentivized to save money to reap a healthy return on their savings. These higher interest rates would also encourage the economy as a whole to rebuild its savings in order to sustain the eventual viability of long-term investments.
The Federal Reserve has created an environment where there is a small pool of available savings in the aggregate, but interest rates are low. How does the Federal Reserve artificially lower interest rates? The Federal Reserve Open Market Committee goes to its Primary Dealers and purchases significant amounts of US Treasuries. The idea here is to have the Primary Dealers put the money into their banks, thus flooding the banking system with new high-powered money. Flooding the banking system with money makes it so banks will lend to each other at lower interest rates. This, in theory, will make it so banks will lend to individuals and businesses at lower interest rates. This, the Federal Reserve hopes, will encourage spending and investment.
There are many problems with this arrangement, but the most notable problem is that an economy without a solid pool of savings cannot grow in a sustainable manner. The Federal Reserve, through its artificially low interest rate policy, is creating a temporary economic boom that will inevitably end in a collapse since the available pool of savings in the economy cannot sustain the boom. During the boom, all that occurs are rises in prices and an increase in indebtedness across the economy. Resources are diverted to unsustainable businesses and lines of production. When the bust arrives, these unsustainable ventures (i.e., “malinvestments“) must be liquidated so resources can be freed up and diverted to more sustainable businesses and lines of production.
For more on the Federal Reserve System, we recommend, The Creature from Jekyll Island: A Second Look at the Federal Reserve, and The Mystery of Banking.