Enrico has probably been guilty of the excessive use of colorful language about the Fed’s printing press.
Of course, the Fed does not literally print currency. Only the US Treasury can do that.
As all conspiracy theorists know, the Fed is actually a private organization.
Well, the conspiracy theorists are full of crap. The Federal Reserve Bank is a government agency, authorized by an act of Congress, whose operation is controlled by federal law. The Fed typically makes a hell of a profit in its operations, but, before you grab your pitchfork and descend on the nearest convenient Greek Revival edifice, let me reassure you, the Fed turns all its profits over to the Treasury.
The conspiracy theorists base their claim that the Fed is a private organization on the fact that the banks own stock in it. This stock ownership is a vestigal remnant of the arrangement whereby banks are required to pony up capital to the Fed as part of reserve requirements imposed by law, delegated to the Fed. The stock ownership has nothing to do with actual ownership, much less control, of the Fed.
The Fed’s mission is to manipulate the money supply to maximize employment while keeping inflation under control. Its mission has nothing whatsoever to do with protecting the dollar, pumping up the dollar, or anything in the realm of dollar exchange rates vs other currencies.
“Money supply” is a little bit of a slippery concept. In the jargon, there are four categories of money. The first, called M0, is literally currency and coins. The second, called M1, is M0 plus balances in checking accounts. M2 is M1 plus savings accounts. M3 is M2 plus everything else, basically all dollar-denominated relatively liquid money instruments. This category includes things like eurodollar deposits, which are dollar-denominated accounts in European banks, accumulated by companies trading with the US, and repurchase agreements, which are kind of like money market funds for huge banks.
The Fed has two main tools for manipulating the money supply: the discount rate, and open market action.
The discount rate is the interest rate at which banks are permitted to borrow from the Fed. Banks borrow from the Fed to get the money they lend to their customers, and to meet their reserve requirements. Banks are required to actually have in their possession 10% of the demand deposits their customers have deposited with them. In other words, banks are permitted to lend out 90% of the money deposited with them as demand deposits. The reserve requirement for time deposits is zero–banks are permitted to lend 100% of their time deposits.
The spread between the discount rate and the prevailing rate charged to customers on loans is the basic gross profit margin for banks. So, right now, the discount rate is 2.5%, and let’s say the prevailing loan rate is somewhere around 5.25%, which happens to be the current prime rate. So, the bank’s basic gross profit margin in 2.75%. Small, you might say, but lordy lordy, do they ever make it up on volume!
So, what on earth does the discount rate have to do with the money supply? The answer: the real action in money creation is through the banks lending money. Bank lending is highly stimulated by a bigger spread between the discount rate and the prevailing market rate for loans. Let’s look at how bank loans create money.
Let’s say the Skank of America borrows $10k from the Fed at the discount window. Then the Skank of America lends $9k to the learned counselor. The learned counselor buys a car for $9k from Tilman Fertitta, yet another porsche in panties for the LC, and Tilman, who is a bit strapped for cash at the moment, deposits the $9k in a local branch of JP Mogen David. JP Mogen David lends $8.1k to Dr. Virus, who buys a shiny new theremin with the loan, from Paddy O’Reilly. Paddy O’Reilly deposits the $8.1k in DiscHoover Bank. DiscHoover Bank loans $7.3k to Enrico, to buy a BeerAVan, a mobile beer brewery built on the platform of a pink Winnebago.
So, the original $10k from the Fed’s discount window has now been used to buy $24.4k worth of goods. The daisy chain of bank loans and deposits has created $14.4k of new money out of thin air.
Open Market action is when the Fed buys or sells treasury securities from its member banks. If the Fed buys treasury securities, the selling bank gets more reserves, in payment for the securities, and therefore can lend more money, amping up the money supply through the mechanism described above. If the Fed sells treasury securities from its member banks, the buying bank has less reserves, reducing its ability to lend money.
Now here is the part of this that I know is going to be hard to believe: when the Fed buys treasury securities from a member bank, it makes an electronic CREDIT entry increasing the selling bank’s reserve balance by the appropriate amount. THERE IS NO CORRESPONDING DEBIT ENTRY ANYWHERE! Do you have the chills? The Fed just created money out of absolutely nothing.
The same principle holds when the Fed sells securities. The selling bank gets its reserve balanced DEBITED by the appropriate amount, and there is no corresponding CREDIT entry anywhere. The Fed just burned some money.
I know this is very hard to swallow. Read it for yourself, on page 7 of this document.
So, the Fed doesn’t need an actual printing press. The eventual recipient of the invented money is perfectly free to go to any bank and demand paper currency, and the US Treasury makes sure all the time that there is plenty of paper for all comers.
Look for a few more editions of this post, dealing with the late lamented Glass-Steagal Act, and the Fed’s recent actions regarding mortgage-backed securities, and the implications of this for the money supply, oh, and I guess I’d best pay homage to the quantity theory of money (everyone say “amen”).