The Economic Superpower Of The U.S. Central Bank

Super Banking
By Melvin J. Howard

As I study more and more about banking the U.S. in particular I am amazed at where it started to where it is today. From a colony of rag tag farmers and merchants to the most competitive, creative and complicated financial and banking system in the world. Although there have been some bank failures in the past and some recently. The alternative would be 3 or 4 banks to choose from to do all your banking. Can you imagine America without choices? Let’s face it we want choices like 31 flavors it is in our blood. America's central bank (ie, government-controlled money banking system) was instituted purportedly to protect the public from the "anarchy" of free banking. Money and banking were the freest from 1936 (when President Andrew Jackson ended Federal involvement in banking) to 1862 (when Congress mandated that fiat greenbacks be accepted as legal tender to finance the Civil War -- but without prohibiting the use of gold or silver). The National Bank Act of 1863 required all banks to collateralize their bank notes with government securities. Private coinage was outlawed in 1864. Otherwise, from 1836 to 1913 banking remained under state jurisdiction, with over half of states allowing free banking. Prices remained stable during this period -- in sharp contrast to the steep inflation produced under central banking in the period after 1913.

Representatives for the American central bank say that there were bank failures in the United States prior to the Federal Reserve System. This is true where business is freely practiced, poorly run or poorly located businesses will fail. Free markets mean rapid progress through trial-and-error, rather than the stiflingly slow progress (or regress) of a controlled economy. But bank failures were far fewer under free (or semi-free) banking than under central banking. The ratio of capital to loans in American banks went from 40.5% in 1836 to 55.1% in 1842, falling to 41.3% in 1862, to 17% in 1913 and to 5.6% in 1989. In New York State, which had the largest, freest banking system, bank failures from 1838 to 1863 were less than one-third of 1% per year, on average (with customers receiving an average 75 cents on the dollar in the failures). By contrast, under central banking the rate of bank failures in the 1920s was in excess of 2% per year. And in the 1930-1933 period about one-third of all US banks failed. 

Depositors lost more money in the first 20 years of central banking than had been lost in the 75 years before central banking. Bank failure rate declined after 1934 when the institution of Federal deposit insurance effectively created a welfare system for bankers, allowing federal money to bail-out poorly managed banks thereby underwriting inefficiency and encouraging risk-taking.

The Federal Reserve Act of 1913 established the Federal Reserve System (headed by the Federal Reserve Board) as the central bank of the United States (affectionately known as "the Fed"). Of course, this move was touted as the creation of high-minded oversight for money and banking that would rise above the petty interest of the market place. Conveniently, the Fed doubled the money supply during World War I to finance the war effort.

The inflation wrought by wartime government spending in Europe was far more severe than that in the United States particularly in Germany, where a postage stamp for local delivery cost 100 billion marks in 1923. The inflationary crisis in Germany undoubtedly made people desperate for a New Deal from a "high-minded" leader like Hitler, who had no trouble rising above the petty interests of peoples who would be free. As has been mentioned, Roosevelt's New Deal made the possession of gold punishable by imprisonment for American citizens.

The Federal Reserve Act of 1913 forced all banks in the United States to become part of the Federal Reserve System. This meant that their reserves (for fractional reserve banking) had to be demand deposits at the Fed. US Dollars became Federal Reserve Notes, backed (fractionally) by gold. The fractional reserves of gold held by the Fed were "backing" for the fractional reserves of Federal Reserve notes (amount dictated by the Fed) for the member banks. The system was so "successful" that in the period from 1921 to 1933 more than half of the 30,000 US banks went out of business. In 1938 the Fed doubled the reserve requirements for member banks from 10% to 20%, an economic shock treatment that led to disastrous credit liquidation.

Outlawing gold for American citizens was only half the battle for a truly fiat currency, however. As long as dollars went abroad, foreign governments could demand gold for the dollars. But central bankers in foreign countries were all engaged in the same struggle for independence from the discipline of the gold standard that the Fed was attempting. Once freed from the gold standard in the 1970s, the Fed could back-up its reserves by printing as much money as it liked.

The Fed controls money supply not so much by the amount of money it prints, but by the amount of reserves created in the banking system and the fractional reserve requirement dictated by the Fed. After 1980 the fractional reserve requirement was gradually lowered from 14% to 10%, which increased the money supply considerably. Reserve requirements for nonpersonal time deposits and CDs were eliminated entirely in 1990.

The Fed is currently not changing reserve requirements as a means to implement monetary policy. Nor do changes in the discount rate have a significant impact on money supply. Currently, the key to the Fed's control of money supply and interest rates is through its open market operations, ie, buying and selling of US government debt instruments (bonds, T-bills, etc.) through Primary Dealers. (Just over 20 Primary Dealers are authorized to buy and sell with the Fed, including Goldman Sachs and Morgan Stanley.) The buying or selling can be either permanent or temporarily through repurchase agreements or reverse repurchase agreements. For example, the Fed could increase money supply by buying $1 billion of US government bonds. The Fed writes a check to a bond dealer for $1 billion from the Federal Reserve Bank of New York and then the bond dealer deposits the check from the Fed with a commercial bank.

But a check from the Fed does not "clear" the way other checks do. The check creates a deposit at the Federal Reserve Bank, increasing the commercial bank's reserves by $1 billion. The Fed has spent no money it has simply written a check creating $1 billion in new money. But with a fractional reserve policy of 10%, the commercial bank is now able to make $9 billion in new loans. 

Thus, the $1 billion purchase by the Fed has increased money supply in the economy while helping supporting the market price of the government's bonds. Unlike the obvious inflation of printing money -- which only enriches the Treasury Department inflation through credit-expansion (lowering interest rates) enriches the Treasury from the $1 billion from the bond sale, enriches the Fed by the interest collected on the bonds, and enriches the commercial bank by the interest collected on the additional loanable funds. 

The purchase also ensures that the government benefits disproportionately from the new money, while others (such as pensioner's living on fixed income) are harmed disproportionately by being the last to experience the inflationary effects.

The main tools the Fed has for control of money supply and interest rates are the fed funds rate and the discount rate. In a free market, interest rates are determined by the supply & demand for savings. In contemporary regulated economies, central bankers have considerable influence on interest rate through control of money & banking. 

When the Fed sells government securities it decreases the supply of money (loanable reserves), which increases interest rates (the fed funds rate). When the Fed buys government securities it increases the supply of money (loanable reserves), which decreases interest rates. 

The Fed indirectly controls the fed funds rate by buying or selling bonds to achieve the desired rate. Fed funds is another name money loaned or borrowed to maintain the Fed's mandated level of bank reserves, the deposits a bank has with its regional Federal Reserve Bank plus cash in the vault. The fed funds rate is the rate at which banks make short-term (usually only overnight) loans to each other to meet reserve requirements. The loans are made on a private financial market called the federal funds market.

On any given day a bank may have more or less reserves than its required amount. Banks with excess reserves can loan to banks having a deficiency (fed funds are exempt from reserve requirements). The lending bank instructs the Federal Reserve Bank to charge its own account and credit the account of the borrowing bank a transaction to be reversed the next day. No physical delivery occurs, the exchange is made through the Fed's electronic network, the "Fed Wire".

The fed funds rate is the shortest of short-term interest rates and is the US short-term benchmark. The most common fed funds instrument is an overnight, unsecured load between two financial institutions (commercial banks, savings banks, savings & loan associations or credit unions) on the basis of an oral agreement. 

When banks borrow heavily on the fed funds market, the fed funds rate will rise unless the Fed adds new reserves. The Fed tries to keep the fed funds rate within a narrow band (50 basis-points or less) through buying & selling of government securities. The Fed will continue buying or selling in a trial-and-error fashion until its desired fed funds rate is achieved.

The discount rate is the rate the Fed charges banks to borrow money from the Fed. The Fed can directly control discount rate. When rates are changed, the fed funds rate and the discount rate are almost invariably both increased or decreased by the same amount at the same time. [The Fed sets a new discount rate and targets a new fed funds rate -- the latter typically being 50 basis points (ie, 0.5%) higher.] The Fed discourages banks from direct borrowing by imposing costly and time-consuming procedures, including scrutinization of the bank's creditworthiness offsetting the cost advantage of direct borrowing and making the Fed the "lender of last resort".

Unlike fed funds, reserves borrowed through the discount window require collateral, and the borrowing can only be done for "approved" reasons. Attempts to use the discount window frequently will cause the Fed discount officer to refuse the loans.

The open market policies of the Fed are decided by the Federal Open Market Committee (FOMC), which includes all 7 members of the Board of Governors plus five of the twelve Presidents of the district Feds who serve one-year terms on a rotating basis. 

The Governors are appointed by the US President for a 14-year term (subject to US Senate confirmation). Because open market operations are administered through the Federal Reserve Board of New York, the President of that district bank is a permanent FOMC member, with the title of Vice-Chairman. The FOMC meets 8 times per year under the Chairman to decide on interest rates. Banks will invariably increase or decrease their prime interest rates (ie, interest rates charged by commercial banks to their most credit-worthy customers) in lockstep with increases or decreases in fed funds rate & discount rate. Mortgage rates, bond interest and other forms of interest charge follow -- although long-term interest rates tend to be more independent and subject to market forces.

The control of interest rates and money supply are powerful tools of economic regulation in a purportedly free economy. In a free economy interest rates are the "price of money" -- and that price is determined by market forces (supply and demand). Price-fixing of interest rates by autocrats invariably results dislocation from the market price -- and shocks the economy every time the change is made or anticipated. The autocrats on the FOMC undoubtedly enjoy the fawning attention of the media hanging on their every word in an attempt to second-guess the next action -- but price-fixing always misallocates market resources. The tentacles of the U.S. financial system are found all over the world including debtor nations through the IMF.

The FOMC meets in secret and only issues vague summaries of its meetings six weeks after they occur. When Alan Greenspan was Chairman his disdain for market forces has been immortalized in his description of stock market activity as "irrational exuberance". However, Mr. Greenspan may well be the least autocratic (and most pro-market) member of the Fed at the time.