What the Fed is doing to our money

There is no justification in history for the existing position of a government monopoly of issuing money. It has never been proposed on the ground that government will give us better money than anybody else could. It has always, since the privilege of issuing money was first explicitly represented as a royal prerogative, been advocated because the power to issue money was essential for the finance of the government — not in order to give us good money, but in order to give to the government access to the tap where it can draw the money it needs by manufacturing it. That, of course, is not a method by which we can hope ever to get sound money. To put it into the hands of an institution which is protected against competition, which can force us to accept the money, which is subject to incessant political pressures, such an authority will not ever again give us good money. — Friedrich A. Hayek  1977

The Monetary Policy Problem

When you talk to people at home or at work, you speak a common language with the people you meet.  You can understand what is said in books, articles, and memoranda, because the words have a standard, and fixed meaning.

But what would you do if every few months, the meanings changed without notice. When you say, “How are you” people understand you to mean “The boiler is about to blow up.” When you say “Can I have a cup of coffee”, it means to others, “French textile workers are on strike.” Intelligent communication would be very difficult.

This is what has been happening to our monetary system in the last 70 years. Without notice, the value of the dollar (and of major currencies in other countries throughout the world) is manipulated by central authorities in other countries and in our country by the Federal Reserve System.  Federal Reserve Discount Rates were set at 6.5% in 1978. Two years later, they were set at 13%. Two years after that they were 8.5%. In 2011 they are at less than 1%. These rates help to determine the value of the dollar. These drastic changes send confusing signals to people who are trying to conduct business. They cannot rely on the basic unit of trade — the dollar bill — to have a fixed value or meaning from one year to the next.  These changes affect our jobs, employment, prices, wages, production, and national stability.

The Federal Reserve System

Every country in the world today has a “central bank”; usually a government owned or controlled bank whose main job is to manipulate the money supply in the country. The Federal Reserve System is such a bank.

Established in 1913 in Woodrow Wilson’s Administration, the Fed (as it is called) is made up of 12 Federal Reserve Banks[1] each of whom is represented in the central Board of Governors of the system in Washington. All “national” banks are members (depositors in) one of the reserve banks, as are virtually all of the other large and medium sized banks in the country.

 

Each member bank must keep its “reserves” on deposit with the Federal Reserve Bank of which it is a member.  The Fed controls these banks in many ways. It determines the percentage of reserves that the banks have to keep on deposit. The average amount required is about 16% with larger banks having to keep more.  These reserve requirements can be changed by the Fed at any time, but in practice they are seldom shifted. There is a political component in the reserve requirements: small country banks have lower reserve requirements — not because they are sounder banks (they are not) –  but to give them a competitive edge against their larger competitors.

 

These reserve requirements are very important in determining the size of the total money supply. Deposits (D)  are inflated by the banking system based on the reserve requirements (RR) by the formula:

dM  =  D  *  1 / RR

 

Another Fed control is the “Discount Rate”, the interest rate charged on bank loans from the Fed. Up until 2008, few banks actually borrowed money from the Fed, so they did not use the discount rate. But the rate is used by the banking community, and others, as a signal for what the Fed thinks should happen to interest rates, and to borrowing. The discount rate, over time, is highly erratic.

Here are the interest rates as of 2011:

The most important control over banks, and the entire money supply, however, is provided by the Fed’s Open Market Operations.

The National Debt

The largest single borrower of funds anywhere in the world is the U. S. Federal government. By 2011, the debt was $14.5 trillion dollars, and growing at a rapid rate.

Here is the historical debt in constant dollars.

The bulk of this debt is in the form of long term bonds, and short term “bills” and “notes” which pay a fixed amount of money per year, and can be “redeemed” by their owner for a fixed amount of money when they “mature”.  A typical bond would be one which will pay $10,000 in 20 years, and in the meantime, pays the holder $372 per year.

About two thirds of these treasury securities are marketable, which means that the owner can sell them to anyone at any time. The remainder are non-marketable. The owner holds them until maturity without being able to sell or trade them.

Of the marketable securities, about 10% are held by commercial banks, and another 10% are owned by Federal Reserve Banks. The balance are held by non-bank investors including pension funds, insurance companies, individuals, other businesses and foreign banks, companies and governments.

The securities owned by the Federal Reserve are particularly important for monetary policy, since they are the method whereby open market operations work.

The Bond Market

There is a very active bond market in New York (as well as in other cities). Every business day, billions of dollars’ worth of marketable U. S. Treasury bonds change hands. The rate at which the bond sells determines the effective yield of the bond.

For example, if a long term bond sells for $10,000 and pays $361 per year, its yield is 3.61%.

Yield = Annual payment / purchase price

If the market shifts, and this same bond sells for only $9,000, the effective yield changes to 4.01%  If the bond sells for $11,000, the yield becomes 3.28%. In this way, the selling price of the bonds affects the interest rates in the bond market.

Suppose that the Federal Reserve feels that interest rates in the economy are too high. Business is bad, there is much unemployment. A lowering of the interest rates, the Fed economists reason, might get the housing industry going again, and pick up other industries as well.

To do this, the Fed goes in to the bond market and buys many billions of dollars of Treasury securities. The effect of the Fed’s actions tends to raise the price of securities in the market.

The Fed’s purchasing power is so large, that it can make the interest rates move to whatever level it believes is appropriate — up or down — by buying or selling bonds.

The yield of treasury securities affects the yield of all other securities and stocks in the market. The reason is obvious: if Treasury bonds are paying 4%, while other bonds are paying 6%, people will sell their Treasury bonds and buy the higher paying commercial or state government bonds. The effect of this will be that the price of Treasury bonds will go down (as people dump them on the market) and their effective yield will rise (as a result). The price of other bonds will go up (as people scramble to buy them) and their effective yield will be reduced (as a result). In a short time, the final yield of all bonds will be roughly equal. Treasury bond yields will be higher than they were, and other bonds will be lower in yield.

In this way, changing the yield of Treasury bonds affects the yields of all other similar marketable bonds throughout the country. But the effect goes further. The bond market affects other interest paying instruments such as home mortgages. Mortgages are bought and sold in car-load lots by banks and institutions. If interest rates in the bond market go down, home mortgage interest rates will go down also, as bond owners dump them to buy higher yielding home mortgages.

The Fed thus has a terribly powerful tool available to it through “open market operations”: the buying and selling of Treasury bonds in the open market. It can control and set interest rates throughout the country at any rate that it wants.

How the Fed Pays for the Bonds

The Fed’s power depends on its ability to come up with plenty of cash whenever it needs it. For the Fed, that is no problem at all. To buy bonds, the Fed places an order with a New York brokerage house (or rather, a dozen brokerage houses at once in secret orders) for purchase of the bonds on the New York bond market at the market price. When the bonds are purchased, the Fed pays for them with a check. It makes the check good by increasing the reserves of the bank presenting the check. How does it increase the reserves? Just a bookkeeping entry is all that it takes.

When the Fed increases a bank’s reserves, the bank, of course, will be able to loan out some of that money. The loaned out money will increase deposits wherever it goes, so the money supply expands by a multiplied amount, using the familiar formula:

dM = D * (1/RR)

Where D = the new reserves created by the Fed’s purchase of bonds.  The effect of buying the bonds really does two things: it reduces the interest rate in the market, and it expands the money supply. Open market operations, therefore, can make the money supply grow or contract, and interest rates go down or go up.

The Role of the Fed

The Fed has several functions:

  • Management of the money supply, currency, credit and interest rates.
  • Creation of an efficient and smoothly running banking system
  • Clearance and collection of checks
  • Acting as the fiscal agent for the Treasury.

The fiscal responsibilities for the Treasury include acting as the U.S. government’s banker. Supervision of the banking system it shares with the Federal Deposit Insurance Corporation which, in fact, does more to supervise the banks than the Fed can possibly do.

It is the first function, management of the money supply, which is the heart of national monetary policy.

Dollar Bills

As a part of this role, the Fed issues all the dollar bills. At the top of each one, you see the words Federal Reserve Note. Dollar bills are carried on the books of the Fed as a liability. The idea is that some day some holder of a dollar bill might come back to the Fed and say, “I don’t want this bill. Please give me some real money.” If someone should do this, the Fed would just give him another dollar bill, because that is all they have to offer. They don’t exchange dollar bills for gold any more as they used to do before 1934.

The balance sheet of the Federal Reserve System looks like this:

Look at what has happened to this balance sheet since the summer of 2008. Federal agency debt, previously zero has become immense.  Lending to banks, previously almost zero has become very large.

What is the Fed Trying to Accomplish?

The role of the Fed in managing the money supply has grown and changed significantly over the years. During World War II, they took their responsibility as the government’s banker very seriously. We had a major war to win, and the Fed helped the government finance it, encouraging banks and others to buy Treasury bonds.

The Fed itself, of course, owns a lot of Treasury securities. The Treasury pays interest on these bonds, the same as it does on all of its interest bearing obligations. There is a difference, however. At the end of each year, the Fed returns to the Treasury all of the interest payments that it has left over after meeting its administrative expenses.

From 1946 until 2008, the Fed saw its role as helping finance the government by keeping interest rates low. The higher the rates are, the more the Treasury has to pay out on the national debt. One third of all the Treasury securities mature (fall due) every year. The Treasury has to pay out more than a trillion dollars each year redeeming bonds. Where does it get the money?  You guessed it. It just prints more bonds, and sells them.

Since the 1970′s the Fed has seen its role more as a manager of the U. S. economy, rather than as the Treasury’s banker. The reason for the shift is central to the policy role of the Fed.

Runaway Inflation

1969 was the last year that the Federal government balanced its budget. It was also the year that, more than any other, marked beginning of the U. S. welfare state. The war on poverty, and the Great Society programs of Lyndon Johnson, resulted in a vast expansion of Social Security, Medicare, Medicaid, Welfare, Food Stamps, Education, and other programs. The Vietnam War, at the same time, was draining significant federal resources into military spending. With all of these new programs, there was no corresponding increase in tax revenue.

The result was a major increase in the Federal deficit — one of the first major peacetime deficit increases since World War II.

Government policymakers at the time relied on Keynesian economic theories. Government deficits were supposed to be the cure for a sick economy — and the economy was sick in the 1970′s. A serious recession took place in 1974 and 1975 with unemployment over 8%. But the deficits didn’t seem to help. After 1978, despite massive government deficit spending, the gross domestic product headed straight down for the next four years, as unemployment mounted.

The worst problem, however, was the rise in prices. The 1970′s was the heyday of the COLAs – cost of living adjustments — which labor unions had successfully built into virtually all employee wage agreements. A COLA means that if consumer prices go up by 6%, then wages will automatically go up by 6% — plus an additional percentage for “productivity gains”.  Some wages during the 1970′s, as a result, increased by more than 10% per year. The problem with a COLA is that as a result, employers have to increase the price of their product (to be able to afford the higher wages), so the COLA next year is higher still. There was a widespread feeling that the economy had gotten seriously out of hand, and existing theory did not hold a solution. President Carter spent many months conferring with advisors throughout the land seeking a solution. He emerged from his seclusion to announce that America was suffering from a “malaise”. His diagnosis did not seem to offer much of a solution.

In the fall of 1979, the Fed took what in retrospect appears to be a very courageous step. They stopped trying to keep the interest rates on Treasury bonds low. They stopped inflating the money supply at the previous rate, and let interest rates rise to their natural level. The effect was dramatic:

A change in open market operations led to a dramatic rise in the prime lending rate. The result was a major recession in 1982. Unemployment increased, and price rises were brought to a halt. Serious price rises, in fact, were ended for almost a decade.

The result surprised just about everyone. There were many observers in 1979 — including many economists — who believed that the United States economy was in very serious trouble, and in danger of massive hyper-inflation of the sort that ruined the economy of Germany in the 1920′s, and has done the same with many Latin American countries since World War II.

The Fed’s action showed how powerful a reduction in the money supply can be at a time of price inflation. Unfortunately, people were so glad to see the crisis averted — even though it took a serious recession to do it — that they didn’t think to ask why the crisis came about in the first place. The real story is that the Fed in 1970 – 1982 was like the arsonist who became a local celebrity by heroically putting out a major fire. It was only discovered later that he was the one that had set the fire in the first place.

The most dramatic change in Fed policy, however, occurred in 2008 when the Fed stepped in to solve the recession of that year.  They dropped interest rates to less than 1% hoping that at these low rates, people and businesses would borrow money, spend it, and put people back to work. Three years later, by 2011, the process had not worked.

 

Why The Fed Boosts the Money Supply

There is never one single answer for public policy questions. The Fed economists thought that what they were doing was in the public interest. No one has ever suggested irresponsible or corrupt decision making. What the Fed did was in keeping with the teachings of a majority of the economists at the time: Keynesians. The overall reasoning went like this:

  • The Fed’s job is to help the Treasury finance the government. A low rate of interest on government bonds keeps the expenses down. High money supply increases will keep interest rates down.
  • “Easy money” enables consumers and businesses to borrow more than “tight money”. Borrowing and spending creates jobs, and puts idle resources to work. Inflation of the money supply will boost the GNP.
  • The quantity theory of money says M = GNP/V. If V is constant (as it was) then increased M means a higher GNP. It was as simple as that.

For these, and other reasons, the Fed built up the supply of dollars by a massive amount during 1971-79  — an average of 10.2% per year for the period.  At the same time, the real supply of goods and services during this period increased by an average of only 3.2% per year. When you have 10% more money every year, and only 3% more goods to spend it on, price inflation is inevitable: not just price inflation, but massive price inflation. Does the story of the arsonist begin to ring true now?

What Should the Fed Do?

When there are millions of unemployed, the political pressures on the Fed to do “something” are immense. Lower interest rates, it is pointed out to them, will get the housing industry going again. They will help sell automobiles, and they will jump start the higher stage industries that depend on borrowed money for their financing. If, at the same time, Keynesian economists are saying that inflation is good for the economy, it takes a tough Fed economist to resist.

But, resist they must. Every increase in the money supply beyond the growth in real GNP will raise prices. Worse, it will cause unemployment. What happens is that the inflation sends false signals to various parts of the economy.  Investments are made based on the cheap interest rates resulting from the Fed’s actions. These investments no sooner get going — with millions employed in them — when the price rises caused by the inflation cause the Fed to get frightened. They stop inflating the money supply. Interest rates shoot up. The false investments are left high and dry. The businesses based on these false investments go bankrupt, putting millions out of work.

This cycle keeps happening over and over again. In 1992 there were millions out of work in an extended recession. What is the Fed doing? Massive increases in the money supply to bring interest rates down to 20 year lows.

So what should they do? Simply keep the money supply increases down to a level consistent with the growth in real GNP. For the past 20 years, that growth has been about 3%. If the money supply increase were held to that level, the following would happen:

  • Price rises would end. Some prices, due to shortages would occur, of course, but these are a natural part of the market process, and tend to even themselves out, sending signals to producers to produce more, and to buyers to buy less.
  • Interest rates would be consistent with the rate of saving, rather than being based on government decisions. We will be discussing interest rates later in this chapter.
  • The business cycle (periodic booms and recessions) would be greatly reduced. The reason for the recessions, after all, is the inflation. Stop the inflation, and there would be few recessions.
  • There would be greater capital formation.  Capital is formed by investment of savings. When inflation sends false signals to businesses which invest as a result, much of the capital created is wasted. Copper mines that are not needed (for example) are expanded. When the crash comes, the mines are abandoned, and the hundreds of millions invested are wasted.  If industry would put money only into sound investments, more valuable capital would be created, and less worthless capital would be constructed.

The Role of Interest Rates

Interest comes about through saving and investment. In a primitive society, a farmer, for example, takes time out from his production of food to build a barn, a fence, or a pond. The result of this work is that — temporarily — his consumption of food goes down because he is spending his time on non-final goods production. In the long run, his production of food will go up, because the barn, or fence, or pond will enable him to store hay and grain in the winter, keep the animals out of his fields, and irrigate in dry weather.

In a modern economy, this savings and investment process is roundabout, and involves financial intermediaries like banks, insurance companies, or pension funds. The saver is a person who has no immediate personal investment opportunities like the barn, fence or pond.  He gives his saving to a bank. The bank goes out and finds the investors who borrow the money and invest it in profitable long run capital activities. In the typical scenario the investment process works like this:

The saver can be paid his 5% because the bank has earned 10% on the $20,000 by loaning it out. The bank earns 10% because the business it loans the money to makes 15%; they keep 5% for themselves and pay 10% on their loan. Everyone wins. Nobody loses.

The process works because of two things:

  • Savers are willing to wait for interest on their money, rather than spending it now on consumer goods.
  • Entrepreneurs can find projects that pay them enough (in this case 15%) so that they can pay interest on the loan and still make money.

The result of the process is that national productivity and production goes up.  Solid jobs are created that are based on the willingness of savers to wait for their return. Savers can count on a solid return without the nuisance of seeking out entrepreneurs, measuring their soundness, worrying about the safety of their saving.

The interest rate in the market is a complicated combination of several factors:

  • Savers willingness to wait for a return on their money.
  • Bankers’ ability to find sound investments, and realize a reasonable return in the process.
  • Entrepreneurs’ ability to come up with projects that pay enough to satisfy the banks, the savers, and themselves.

If savers are doing well, they will save more. The increased saving affects interest rates, and sends a signal that activates the entire economy.  Banks, flooded with deposits, will be unable to find enough high-paying borrowers, so interest on savings will fall to 4%. Entrepreneurs will find that they can borrow at 9% or 8%. At these lower interest rates, they will discover many more profitable investment opportunities (that were not possible when loans were at 10%).  Investment will expand. Capital will be created. Productivity and production will expand. Savers (who are the workers in the economy) now have more money than before. Savings expand and the cycle begins all over again.

In this process, prices do not rise excessively, because when entrepreneurs spend the borrowed money (on labor and materials which do rise in price as a result) it eventually finds its way into the hands of savers who put a substantial percentage back into banks as savings, rather than spending it all on consumer goods.

The Fed Enters the Picture

Now introduce the Federal Reserve into this picture: raising and lowering interest rates by artificially lowering and raising the money supply. When they lower interest rates, entrepreneurs think that it is as a result of increased saving — they can’t tell the difference — loan rates come down.  They borrow more, and invest.

But the amount of saving has not gone up. When the borrowed money is spent, it finds its way to consumers who spend it right away (increasing the price of consumer goods), rather than putting a substantial percentage into the bank as savings.

Prices begin to rise everywhere: not just in producers inputs (labor and materials in the entrepreneur’s projects) but consumer goods as well. As prices rise, the value of the dollar goes down. The Federal Reserve begins to worry about the effect of their money supply increases. Eventually, prices go so high, that the Fed turns off the spigot. Money supply increases are stopped. Money for investment dries up. Interest rates shoot up. Many projects, based on low rates of borrowed money are cancelled. Many are scrapped, and the capital is wasted. Millions lose their jobs.

Why Interest Rates are not Toys

Interest rates, like prices, send vital signals to a market economy. When government artificially controls prices (such as in rent control, or gasoline prices) the result is blighted inner cities and long lines at the gas pump. When government artificially raises and lowers interest rates the effects are just as devastating — but harder to see, because the effects are more indirect.  Ruined investments and lost jobs are seldom blamed on the artificially low interest rates that created them. They are blamed on some other cause (business cycles, or the lowering of interest rates) rather than the fundamental problem: tinkering with interest rates as if they were public toys.

In 2008 there was a major economic crisis caused by the housing market.  For years the government had been urging banks to make adjustable rate sub-prime housing loans to people who did not have sufficient income or down payments on the theory that millions owning homes is important to the economy, and will help minorities and the poor to join the middle class. To keep these mortgages flowing, they were purchased by two mortgage buying giants:  Fannie Mae and Freddy Mac.  These publicly backed private corporations bought millions of private bank mortgages – usually without worrying about their credit worthiness.  They then put the mortgages into securities and sold them to unwitting investors. Approximately 80% of U.S. mortgages issued to subprime borrowers were adjustable-rate mortgages which meant that the monthly payments went up with interest rate increases.

An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. Additionally, the economic incentives provided to the originators of subprime mortgages, along with outright fraud, increased the number of subprime mortgages provided to consumers who would have otherwise qualified for conforming loans. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Falling prices also resulted in 23% of U.S. homes worth less than the mortgage loan by September 2010, providing a financial incentive for borrowers to enter foreclosure The ongoing foreclosure epidemic, of which subprime loans were a part, began in late 2006 in the U.S. and continued to be a key factor in the global economic crisis for the following five years. It drained wealth from consumers and eroded the financial strength of banking institutions.

As adjustable-rate mortgages began to reset at higher interest rates, mortgage delinquencies soared. Securities backed with mortgages, including subprime mortgages, widely held by financial firms, lost most of their value. Global investors also drastically reduced purchases of mortgage-backed debt and other securities as part of a decline in the capacity and willingness of the private financial system to support lending. Concerns about the soundness of U.S. credit and financial markets led to tightening credit around the world and slowing economic growth in the U.S. and Europe.

External Pressures on the Money Supply

The U.S. dollar is a reserve currency in most of the countries in the world. This means that most countries hold dollars, rather than gold or SDR’s as their foreign exchange reserves which they use for international transactions.  If Hungary wants to conduct business with Mexico, the transaction will probably involve dollar bank accounts in New York at some point.

The effect of this situation is to complicate the U.S. money supply management considerably.  When interest rates are forced up here by Fed policies, foreign investors compete to buy U. S. Treasury bonds and other U.S. investments. The result of this competition is an increase in the international value of the dollar.  High dollar values mean that U.S. exports are made more expensive, and exports decline. Imports become less expensive, and begin to increase.

When interest rates are artificially lowered, the international exchange value of the dollar also falls, exports rise, and imports decline.

What Should Fed Monetary Policies Be?

There are several conflicting goals that the Fed has pursued since its inception in 1913:

  • Helping to finance the U.S. Debt.   This means low interest rates at all times. The Fed abandoned this idea in 1979, but went back into it in a big way after 2008.
  • Controlling the business cycle. This means raising interest rates in boom times, lowering them in hard times. This is the Fed’s current policy. It results in making the business cycle worse.
  • Maintaining the domestic value of the dollar at a stable level.  This means worrying about price levels (rather than unemployment and production), and manipulating the money supply with that as an objective. This was the Fed’s policy up to 2008, although it often conflicted with their business cycle activities.
  • Maintaining the international value of the dollar at a stable level. This can mean the opposite of other policies: worrying about the U. S. trade deficit. To accomplish this, the Fed goes into the international money markets and buys and sells dollars, yen, pounds and other currencies.
  • Maintaining the U. S. banking system. This task has almost been conceded to the Federal Deposit Insurance Corporation, which has to oversee the bankruptcy of thousands of federally insured banks..

The only policy that will work in the long term is the one that the Fed has never tried:

Keep the money supply growth at a fixed and stable level (such as 3% or 4%) which is consistent with long term growth of real goods and services — and leave it there. The result would be an end to the business cycle, and an end to price inflation.

Why can’t the Fed do this today? For the simple reason that they are trapped by their own policies.

The consolidated balance sheet of the combined U.S. Federal Reserve Banks (FRB or Fed) more than doubled during 2008 to $2.2 trillion. By some measures the Fed is now the largest bank in the United States. Its response to the financial market crisis has transformed it from a key, though small, U.S. money market participant into the largest actor and fundamental linchpin of that market and, indirectly, of the world financial system.

Summary

1. The Federal Reserve System, founded in 1913, is the U. S. central bank. Composed of 12 Federal Reserve Banks throughout the country, it has as members all national banks, and most large state banks. It sees its main function as manipulating the money supply.

2. Each member bank must keep its reserves on deposit with the Fed. The Fed controls the banking system by setting the reserve requirements for banks. These requirements are seldom changed. They help to determine the size of the money supply through the formula:  dM  = D  *  1 / RR

3. Another Fed control is the rate it charges on inter-bank loans, called the Discount Rate. This is often changed, and serves as a signal of Fed desires for interest rates.

4. The most important Fed control is its Open Market Operations (buying the selling of Treasury Bonds to influence the money supply and interest rates.

5. The biggest borrower in the world is the U. S. Government. $4.5 trillion in 1992, and growing at 9% per year. Two thirds of the bonds are marketable, and are actively traded. The Fed owns billions of them.

6. Bonds pay a fixed dollar amount per year. When their price goes up, their effective yield goes down by the formula:

Yield = Annual payment / Purchase Price

7. The Fed can raise or lower interest rates on government bonds by selling or buying bonds in the open market. Selling bonds reduces member bank reserves, reduces the money supply (by a multiplied amount) and raises interest rates.

8. The interest rate on Treasury securities, as a result, affects the interest rates on all other traded stocks, bonds, and mortgages in the market.

9. The Fed has unlimited powers to buy and sell, because it can buy through simply increasing member bank reserves — creating money.

10. The Feds functions are: a)  Management of the money supply, currency, credit and interest rates. b) Creation of an efficient and smoothly running banking system c)  Clearance and collection of checks  d) Acting as the fiscal agent for the Treasury.  Since 1979, the money supply management has been the Fed’s main policy preoccupation.

11. The Fed issues all the dollar bills, which are carried on their books as a liability. The own billions of Treasury securities, and pay back most of the interest earned every year.

12. The shift in the Fed’s role from Treasury fiscal agent, to money manager came about because of the events of the 1970′s. Runaway inflation in those years was caused by very high federal deficits, and excessive money supply creation. Economists, in those days, believed in Keynesian principles, that government deficits and inflation was good for the economy. By 1976-70 the inflation was at double digit levels, and no one knew what to do. The Fed stepped in in 1979, letting interest rates rise to unprecented level, bringing on the recession of 1982. The effect, however, was to end the inflation, and put the Fed into the business cycle stablization business.

13. People were so grateful for what the Fed had done to curb the price rises that they failed to see that the Fed had actually caused the price rises by its previous inflation of the money supply. The Fed was the hero of its own tragedy.

14. The cycle keeps getting repeated. To solve the recession of 1980-1982, the Fed raised the money supply by an average of 9.6% for the next six years. Then they dropped it to a 4% annual level after 1986, leading to the recession of 1990-1992, during which they pumped the money supply up again.

15. Interest rates come about from saving and investment. Financial intermediaries, such as banks, insurance companies, and pension funds, loan saver’s deposits to entrepreneurs who invest in capital projects. The success of the projects makes the entrepreneurs rich, creates jobs, boosts productivity, and pays interest on the loans, which gets back to the savers that created the whole process by putting their savings into the banks.

16. The process works because savers are willing to wait for a return, rather than buying consumer goods.  If savers do well, they save more. This lowers interest rates — sending a signal through the banks to entrepreneurs to create more projects.

17. Capital investment increases prices of the factors used in them, but does not increase consumer prices as much, because the savers (who started the process) continue to save a portion of their increased income, rather than spending it.

18. When the Fed expands the money supply and lowers interest rates, it sends false signals to the entrepreneurs. They create their capital projects which survive only until prices begin to rise (which they do because there are no large group of savers out there, but only consumers.) Then the Fed cuts down on the money supply growth, and the false capital projects are ruined and abandoned. Millions are thrown out of work.

19. Interest rates, like prices, send vital signals to the market economy. When government manipulates those signals (as in rent control, or gasoline price control) the result is blighted inner cities, and long lines at the gas pump. In the case of interest rate manipulation, the results are more serious: millions thrown out of work, wasted capital projects.

20. The Fed has several conflicting policy goals: a) helping to finance the national debt b) controlling the business cycle  c) maintaining the value of the dollar  d) protecting the banking system  e) maintaining the international value of the dollar. None of these goals is working. A preferable goal would be to keep the money supply growth at a fixed and stable level.


[1][1]  Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, San Francisco.

About Arthur Middleton Hughes

Arthur is currently Vice President of The Database Marketing Institute based in Fort Lauderdale, FL. Arthur is the author of 11 books, the latest of which is Strategic Database Marketing 4th Edition (McGraw-Hill 2012). A BA graduate of Princeton with an MPA in Economics and Public Affairs, Arthur taught economics at he University of Maryland for 32 years. He is an Austrian Economist.
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