Liberty Maven

A step-by-step explanation of how the Federal Reserve, America’s Central Bank, can manipulate monetary policy.

by Jake, the Champion of the Constitution
Originally published November 17, 2008 at http://www.nolanchart.com/article5489.html

Part 5 covered the origins of fractional reserve banking.  In this article I will formally define fractional reserve banking and describe how it works. Next I will share how the Federal Reserve controls monetary policy and supply with its three major tools – “printing” or “de-printing” money (technically referred to as “open market operations” by the FED), bank reserve requirement ratios, and the infamous “Fed-rate.”

Fractional Reserve Banking – a banking system in which banks are supposed to maintain a quantity of reserves from its depositors that is a fixed fraction of the amount of new money the bank is then allowed to create.  This newly created money, or credit, is then loaned to the bank’s borrowers.

Fractional reserve banking has two major flaws in practice.  The first is that it is an arguably criminal act, which is a topic more suited for Part 7.  (See Rothbard’s “The Case Against the Fed” below, pages 40-45.)

The second flaw is insolvency.  This is generally known as a “bank run” and is easy enough to understand.  If the system’s depositors demand in excess of the reserve amount within a short enough time span, the entire system theoretically just runs out of printed cash and goes broke. Realistically in today’s world this would cause the government to begina a massive physical printing of dollars, resulting in massive currency devaluation and eventual worthlessless and death of the currency via hyperinflation.

For example, let’s suppose the entire banking system consisted of $100 at a 10% reserve ratio.  This means the banks would loan out $90 and keep $10 as its reserves to satisfy depositors.  However, if the depositors of $10.01 ask for their money back, the bank will NOT be able to satisfy the request and will need to close down all redemptions of deposits until it receives cash flow from its loan investments.  This is similar to the dilemna faced by those devious medieval goldsmiths from Part 5, except we are dealing with paper money instead of commodity money.

Here is how fractional reserve banking works in the United States, using the current approximate 10% fractional reserve ratio requirement:

1) A depositor deposits $100 with a bank.  (This depositor could be a citizen, or another bank, even a receiver of the FED’s open market operations which is described later.)

Total Reserves: $100, Total Loans: $0, Total Money Supply: $100

2) The bank holds $10 for its reserves and loans out the other $90 to other banks or citizens.  If it is a citizen, this money is temporarily held outside the banking system until he/she decides to deposit the money into a bank.

Total Reserves: $10, Total Loans: $90, Total Money Supply: $100

3) Next, the second bank takes the $90 in deposits, holds $9 for its reserves, and loans out the other $81.

Total Reserves: $19, Total Loans: $171, Total Money Supply: $190

4) Step 3 repeats.  The third bank takes the $81 as a deposit, holds $8.10 for its reserves, and then loans out $72.90.

Total Reserves: $27.10, Total Loans: $243.90, Total Money Supply: $271

5) Step 3 repeats again.  The fourth bank takes the $72.90 as a deposit, holds $7.29 for its reserves, and then loans out $65.61.

Total Reserves: $34.39, Total Loans: $309.51, Total Money Supply: $343.90

6) And so on.  The bulk of the money creation is done after 15 repeats, but what is eventually left after 40 or 50 repeats is pretty much:

Total Reserves: $100, Total Loans: $900, Total Money Supply: $1000

So you can see that within a very short period of time, banks transferring to other banks within the system can CREATE $900 from the initial $100 deposit.  In the source list below, I included a few more audio-visual examples.  For many, this process is such NONSENSE that it is indeed hard to grasp, which is why I used the numbered steps and tallies. If you still do not understand, please write to me below and I will do my best to reply.

Now we will move on to how the FED controls our monetary policy.  The FED uses three key technical powers in addition to the fractional reserve banking method, although the “propaganda tool” – verbal and written pronouncements to both describe and drive current and future expectations – should certainly NOT be overlooked.  These powers are Open Market Operations, Bank Reserve Requirement Ratios, and the infamous (although not nearly as powerful) FED Discount Rate.  Let’s look at each in turn.

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The FED’s Open Market Operations are the “principle tool for implementing monetary policy,” which is fancy-talk for saying they are the FED’s best way to swell or contract the money supply.

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The Federal Reserve writes here on page 36 (my italics) “In theory, the Federal Reserve could conduct open market operations by purchasing or selling any type of asset. In practice, however, most assets cannot be traded readily enough to accommodate open market operations. For open market operations to work effectively, the Federal Reserve must be able to buy and sell quickly, at its own convenience, in whatever volume may be needed to keep the federal funds rate at the target level. These conditions require that the instrument it buys or sells be traded in a broad, highly active market that can accommodate the transactions with­out distortions or disruptions to the market itself.”

Earlier this year and for decades prior, the vast amount (as in 90-95%), of the FED’s balance sheet rested in US Treasury securities traded in New York City.  These securities are the US’s debt.  [Hence this is one reason for the phrase "all money is debt."]  However, this has all changed with the Great Panic of 2007, and the FED is now exercising its’ “In Theory” abilities.   The Atlanta FED published this truncated graph, and now foreign securities, AIG, illiquid mortgage debt have replaced, then ballooned the FED’s balance sheet.  Now Treasury securities account for only 32% of the FED’s balance sheet, which limits the effectiveness of this monetary weapon as buyers outside of the FED are necessary for the FED to sell, per the FED’s own admission above.

Here’s how it works, step-by-step, when the FED buys Treasuries, although it is the same process for whatever asset they wish to purchase.

1) The FED’s Open Market Committee (FOMC) decides expand the nation’s money supply and purchases, for example, $10 billion in Treasury bonds.

Monetary Supply Expansion: $0

2) The FED writes a check on itself for $10 billion.  Where did it get the money?  The answer is FROM NOWHERE!  You have just witnessed the act of money creation, which is far less subtle than the fractional reserve banking trick above.  So each time you hear that the FED is buying assets, like AIG or JP Morgan or GE, it is the same as if you could take bills from your Monopoly boardgame and then use them to pay for a Porsche.

Monetary Supply Expansion: $10 billion

3) This $10 billion FED check then goes to one of the select government bond dealers (such as Secretary Paulson’s Goldman Sachs) in exchange for the $10 billion Treasuries.

Monetary Supply Expansion: $10 billion

4) Then the bond dealer deposits its $10 billion FED check into a commercial bank.

Monetary Supply Expansion: $10 billion

5) Go to the fractional reserve loop above.  We just learned how this deposit will very quickly be “pyramided” and lead to $10 billion in deposits and $90 billion in loans within the banking system.

Monetary Supply Expansion: $100 billion

Now, the FED can very quickly CONTRACT the money supply in a similar fashion by SELLING its assets.  The process typically takes several weeks.  However, the key enabler to do this is that there must be a buyer outside of the FED so it is not quite as easy – Treasuries are (historically-speaking) a liquid market, but the AIG debt, for instance, is a lot harder to find a buyer for.

It should also be apparent by now that the FED and the banks does NOT want anyone to use cash and coin.  Every $1 you hold outside the banking system in your pocket erodes the bottom of this huge upside-down pyramid and takes away $9 from the rest of it.

And yes, the US government DOES pay interest on the Treasuries to the FED, which many harp on, since it can never be paid back since there are not enough dollars in the banking system to ever clear all of the debt owed.  Others love to point out that the privately-held FED stock pays a guaranteed 6% annual dividend to the (undisclosed) owners.   However, if these are compared to the raw power to create money with its open market operations and the power I will describe next, I want to point out that these are, monetarily-speaking, quite insignificant.

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The FED’s control over bank reserve requirements are an incredibly powerful backup punch to its open market operations power.

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Per the FED, the reserve requirement ratio is the ratio of “funds that a depository institution must hold in reserve against specified deposit liabilities.”  “Specified deposit liabilities” are traditionally limited to cash deposits from depositor, but the FED is technically free to redefine this as they wish.  A simpler (but slightly less precise) definition is the reserve requirement ratio is: the fraction of deposits at a bank that it is supposed to hold in cash for withdrawals.  I write “supposed to” since modern banks do not really have to do so.  (Like the thieving medieval goldsmith, good work if you can get it!)

The Federal Reserve writes here on page 41 (my italics): “The Federal Reserve can adjust reserve require­ments by changing required reserve ratios, the liabilities to which the ratios apply, or both. Changes in reserve requirements can have profound effects on the money stock and on the cost to banks of extending credit and are also costly to administer; therefore, reserve requirements are not adjusted frequently. Nonetheless, reserve requirements play a useful role in the con­duct of open market operations by helping to ensure a predictable demand for Federal Reserve balances and thus enhancing the Federal Reserve’s control over the federal funds rate.”

“Profound effects” is right!  The reserve requirement ratio has been more or less at 10% since the 1990s, falling from 14% in the 1970s.  Rothbard notes: “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.” (p. 144)

However, if the Federal Reserve Board of Governors have a  joint bad hair day and decide tomorrow to halve the reserve requirement ratio to 5%, the nation’s money supply will almost DOUBLE in a matter of weeks.  A $20,000 asset like a car or a small apartment would rapidly approach $40,000 in value.  In fact, just about everything would see 100% inflation, but salaries’ purchasing power would be halved until the inflationary tidal wave rips them upwards.  (The FED finds it far less painless to do this over a long period of time by utilizing open market operations.  In excess of what I just described was accomplished from 1985 to 2008.  Use this calculator for those years to track the worth of $1.)

With the weapons of “open market operations” and “reserve ratio requirements,” the FED has close to absolute monetary control over the American dollar, aka the Federal Reserve Note.  There is one last tool that is more or less a propaganda-type revolver that has run out of bullets recently, but since it is what most Americans associated with the FED before the Great Panic of 2007, so I will address it briefly.

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The FED Discount Rate, or “Fed Rate,” is the interest rate the FED charges to banks to borrow from the FED. Sometimes this is used for banks in trouble (like now) or can just be another way to set off the fractional reserve cascade described above.  For instance, a bank borrows $1 million from the FED at the discount rate (currently 0.5%), keeps $100,000 as reserves (or sometimes just to pay its depositors/meet its reserve requirements), and could then loan out $900,000, setting off another flurry of money creation.  However, borrowed reserves are not as satisfactory to the banks as reserves that are wholly theirs, as they now have to pay it back with interest.

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Per the FED, the discount rate “is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility – the discount window. The Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All discount window loans are fully secured.”

However, the Federal Reserve also notes “the volume of discount window borrowing is rela­tively small.”  Besides being infamous in the pre-Panic days for dramatically shifting the stock market’s ebb and flow within minutes of its announcement, it is merely an ordinary wave in monetary policy compared with the other two powers.  An open market operation could be construed as a double-overhead (for surfer’s), and a sizeable shift in the reserve requirement ratio could be construed as a monster rogue at a certain magical place in California called Maverick’s.

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The power to create these waves is the key reason why the FED must be driven out of existence.  There will be more to follow on the FED in Part 7.

In Liberty!

Jake, the Champion of the Constitution               [Reach the Author Here!]

www.CampaignForLiberty.com

www.ENDtheFED.us

END THE FED! Protest to take place on Saturday, 11/22/08
Published: November 16, 2008
“Scenes are now to take place as will open the eyes of credulity and of insanity itself, to the dangers of a paper medium abandoned to the discretion of avarice and of swindlers.” -Thomas Jefferson to Thomas Cooper, 1814

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We the People of the United States, in Order to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defence, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity, do ordain and establish this Constitution for the United States of America.

As always, unlike the NFL, the author grants full permission to allow any accounts of, rebroadcasts, retransmissions, repostings in part or full of this article to your blog or anywhere else in order to promote the Restoration of our Republic.

Veritas numquam perit. Veritas odit moras. Veritas vincit. Truth never perishes. Truth hates delay. Truth conquers.

“Whenever the legislators endeavor to take away and destroy the property of the people, or reduce them to slavery under an arbitrary power, they put themselves into a state of war with the people, who are thereupon absolved from further obedience, and are left to the common refuge which god hath provided for all men against force and violence.” – John Locke

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The Money Matrix Series

1. America, Were Michael Phelps’ Eight Olympic Gold Medals Worth Winning?
2. The Money Matrix – Prelude (PART 1/15)
3. The Money Matrix – What is a Dollar Bill Worth? (PART 2/15)
4. The Money Matrix – What Makes Money Money? (PART 3/15)
5. The Money Matrix – If You Don’t Know Who the Sucker Is, Then It’s You! (PART 4/15)
6. The Money Matrix Explores Seigniorage – Do not give in to evil, but proceed ever more boldly against it. (PART 5/15)
7. Save Ron Paul’s Voice – A Money Matrix Addendum
8. A Money Matrix Addendum: Citigroup and GATA Call for an End to the Suppression of the Gold Market
9. MY PROPHECY – The Federal Reserve Will End! A Money Matrix Addendum

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Source List and Recommended for Further Research on the FED (see also Part 1 above)  (Photos 1)  (Photos 2) (Photos 3) (license)

Rothbard, Murray N. “The Case Against the Fed.“  1994.  Pages 137-145.

Board of Governors of the Federal Reserve System. “Purposes and Functions.”  2005.  Pages 27-50.

Martenson, Chris. While I do not agree with a lot of what Dr. Martenson says,  this 4 minute and this 7 minute video are great visuals for understanding money creation.

Mises Institute. “Money, Banking, and the Federal Reserve.“  41 minute video, highly recommended.

TheMoneyMasters.com. “The Money Masters – How International Bankers Gained Control of America.”  A much longer but quite interesting viewpoint.

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Although I want to end their organization, I want to express my thanks to the members of the FED who have answered my emails over the past several months.  The one that wasn’t answered was errr… a little emotional, so I would have done the same in his shoes.  It is a little weird how anxious they are to share everything and reply, although I have never received a reply (no matter how respectful I am) from my Congresswoman and Senators.

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- Lyrics from StainD’s “Cross to Bear”

“We do not come as individuals… We come to speak for this broader class of businessmen… We beg no longer; we entreat no more; we petition no more. We defy them!… If they dare to come out in the open field and defend the gold standard as a good thing, we shall fight them to the uttermost, having behind us the producing masses of the nation and the world. Having behind us the commercial interests and the laboring interests and all the toiling masses, we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold.”

- William Jennings Bryan, 1896 Democratic National Convention, Chicago, Illinois, excerpts from the famous “Cross of Gold” speech.   This poison was far more cunning at achieving its political purpose for the bankers than even the best efforts from  President-Elect Obama.  Will Obama realize that gold is not a “cross”?  That it is the only way to free the world from its Crown of Debt?  Doubt it.  The world must learn to free itself.