Rooted in Reason: Nurturing the Seeds of Liberty

How the Federal Reserve System “Makes Money” by “Creating Money” by grassroothawaii
November 8, 2010, 9:44 am
Filed under: Uncategorized

By George Berish

The Federal Reserve System (“Fed”) is a group of 12 private, for-profit banks — not part of the Federal Government.  [If you know all the foreign and domestic owners who share its profits I’d love to know too.]

The “Fed” profits from an exclusive franchise, granted by the Federal Government, to manage the supply of “money” America’s economy uses to represent things of value (goods and services) produced by Americans.

Note: “Money” has no value. It represents value.  So when America’s silos are filled with valuable wheat in the fall, America needs more “money” to represent that value.  By spring the silos are depleted, so less “money” is needed to represent less value.

When Americans produce things of value, their bank account balances (which are “money”) track how much value they’ve produced and haven’t yet consumed.  We exchange things of value that “money” represents, using checks (for big amounts), and currency, like dollar bills (for small amounts).  “Dollar bills” are currency, not “money”.  They are just preprinted checks for small fixed amounts that are more efficient than writing a paper check for every tiny transaction.

The “Fed’s” franchise lets it create “money” in two ways: (1) “monetizing debt”, i.e. turn government I.O.U.s (treasuries) into “money”, and (2) turning “dimes into dollars” (the secular version of multiplying fishes and loaves).

Bernanke’s $600 billion is an example of “monetizing debt”.  Here’s how it works.

Start with about $12 trillion of existing interest-bearing IOUs (treasuries) already issued by the government to borrow and spend that much “money”.  They are held by “lenders” who earned that money, and to whom we owe it back along with about 2.5% interest ($300 billion annually).

Next the “Fed” buys $600 billion of the IOUs from those lenders.  It pays them with the literal equivalent of a mouse-click that increases their bank account balances $600 billion.  (Their franchise allows that.)  Since bank accounts balances are “money”, the amount of “money” increases by $600 billion.  The income line on the “Fed’s” profit & loss statement goes up $15 billion annually (2.5% interest on that $600 billion), because we pay it interest instead of the original “lenders”.

But the mouse-click “money” doesn’t add value to the economy, so now we have more “money” representing the same number of things, so each thing is represented by more “money”, i.e. costs more “money”.  Inflation.

But the “lenders” wanted to hold $600 billion of Treasuries, so they use the new money to buy replacements.  And the government issues another $600 billion of IOUs.  Just add it up.

The original $600 billion of government IOUs are now $1,200 billion ($600 billion each held by “lenders” and the “Fed”).  $15 billion of interest has become $30 billion ($15 billion each to “lenders” and the “Fed”).  America’s bank account balances (“money”) increase by $600 billion.  Banking magic turned new IOUs into new “money” – “monetization”.

Why does Bernanke need more inflation?  Because Americans have reversed the other method — “dimes into dollars”.  (The “Fed” can’t unilaterally control that as it does “monetization”.)  Reversing it means reducing the “money” supply.  That produces deflation.  And deflation rains pure hell down on borrowers, because it forces them to repay with “dollars” that are worth more “money”.  Note: The issuer of Bernanke’s franchise is the world’s largest borrower.  Here are more details.

“Dimes into dollars” works, because the franchise also permits other banks to lend a “mouse-click dollar” for every dime they hold as a real deposit (“reserve”) – honest.

They get away with that, because chances are when your car payment moves “money” out of your bank and into a different bank, someone with an account at the different bank is writing a check that will move “money” into an account at your bank.  So long as all the “money” stays in the banks, the transfers tend to wash out, and the dime of real deposits provides enough slack to keep anyone from noticing the “mouse-click-dollars” aren’t really all there.  It’s only a problem when everyone withdraws from a single bank, i.e. “runs” the bank.  Then everyone realizes all the “money” really isn’t there.  [E.g. about 100 days before the 2008 election Sen. Schumer denounced the IndyMacBank in a letter from his office.  Massive withdrawals “ran” the bank and, “fortuitously” for Schumer’s party,  triggered the Fannie Mae meltdown just before the election.]

Anyway, to increase “money” using this method, the “Fed” offers to lend dime’s worth of “money” to the other banks as a deposit (“reserve”).  Normally they borrow.  The “Fed” can offer a low interest rate, because it’s only lending mouse clicks.  And adding the dimes to their deposits lets them lend ten times that amount at a higher rate.  The new loans are made by mouse clicking an increase into someone’s bank account.  And that creates more “money”.  “Normally”!

But today Americans are afraid to borrow.  Many are repaying loans instead, and the “dime to dollar” sword cuts both ways, so our repayments reduce the “money” supply.  That produces deflation.  Left unchecked we would rain pure hell down on the world’s biggest borrower and issuer of the “Feds” franchise.  Hence, Bernanke “has to” force inflation.  And he has to use “monetization”, because the “Fed’s” “dimes to dollars” lending rate is near zero (less than 0.25%) and no one is taking the bait.  Simple as that.



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