Understanding the Fed’s Primary Purpose
The NY Fed posted a short piece today about the history of banking and the Fed’s role. Now, there are a few roles the Fed plays in the economy. But it’s important to understand that the Fed exists primarily to serve as a stabilizing force for the US banking system.
The USA has always been based on a free market capitalist economic approach. Before the Fed, the banking capitalists didn’t just rule the monetary roost, they often times corrupted it. Before the Fed we had what was essentially rogue banking. Banks would issue loans and settle payments amongst themselves, but when a crisis broke out it turned into an “every man for himself” economy. Banks didn’t trust the solvency of other banks, payments were impossible to settle, the system froze up. The 1800′s saw repeated scenarios like 2008 due to this fragmented arrangement (in fact, there were SIX depressions in the 1800s). To create some stability in the system we created the Federal Reserve System.
Now, the Fed gets most of its press for its intervention in the economy via monetary policy. So we hear a lot about quantitative easing and manipulating interest rates. This is important policy and certainly has a huge impact on the economy, but what we hear a lot less about is the brilliance behind the design of the interbank payment system. The NY Fed briefly touched on this:
Seven minutes and forty seconds into the film, after the Miller Supply Company has received a check from Mr. Adams for business supplies, and after an employee has endorsed the check, the film turns to the topic of check clearing, where the Federal Reserve makes an appearance:
But instead of collecting the money direct from the Elmville National Bank, the company does it through its own bank where the check is arriving right now. This bank can collect $150 once it places its own endorsement on the check, as it is doing here. But, instead of collecting the money directly, it uses a more convenient method. Like many other banks, it sends its checks to the Federal Reserve Bank for collection. The Federal Reserve Bank is set up to handle thousands of checks from hundreds of banks in a single day. All these banks save themselves a great deal of trouble by collecting on checks through the reserve bank. The Federal Reserve Bank collects the money direct from the banks on which the checks are drawn and returns the checks to these banks.
While the narrator is describing the role of the Federal Reserve in check clearing, the film depicts checks being sorted by hand into a horizontal wooden structure, check amounts being tabulated with an adding machine,and checks being put into envelopes and sorted again in canvas bins.
To better understand this it’s useful to understand the forms of money in our economy. Banks issue what Monetary Realism refers to as “inside money”. It is created inside the private sector. This is the dominant form of money in our economy. The US economy is almost entirely electronic these days. And this electronic money is almost entirely bank deposits. Deposits are the result of the loan creation process. And those deposits allow us all to transact, invest, etc.
When the Federal Reserve was created a second form of money became more prominent. MR calls this “outside money”. It is money created outside the private sector. This includes cash, coins and bank reserves. Private banks do not create these forms of money. But they’re important in helping banks operate.
Banks in the USA are part of the Federal Reserve System. So they maintain deposit accounts with regional Fed banks. These deposit accounts are held in bank reserves or outside money. You and I cannot access this money and it’s held on deposit specifically for two purposes – to meet reserve requirements and help settle interbank payments. Ultimately, a banking system is all about being able to settle payments. And in a capitalist market like the one we have where the money supply has been privatized to an oligopoly of private entities, it’s crucial that payments be settled in an orderly fashion. This is one of the dominant and probably the most important roles of the Fed. The interbank system where deposits are held on “reserve” is where these payments settle. It’s kind of like having a nationalized banking system, but still maintaining private competitive banking.
It’s rather brilliant when you understand the design of it because it allows the money supply to be elastic and based almost entirely on a market based demand structure, but has elements of a nationalized banking system that help create oversight and order in a market that would otherwise be fragmented. Unfortunately, it’s all the other stuff the Fed does that gets all the negative press and takes the spotlight off this rather ingenious system design.
* Addendum – it’s often noted that this system of private banking is not in keeping with public purpose. This is true to some degree. After all, private banks exist for private purpose to increase profits for their owners. So there is an interesting conflict in the existence of the Fed. The Fed is ultimately an act of Congress and so is designed to serve public purpose. But the Fed is subservient to the banks because it is private banking which it oversees and operates within. I am not here to be judge and jury of that design structure, but merely to help you better understand what we have today.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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31 Comments
AUDIT THE FED!!!111oneoneeleven
Sorry, couldn’t resist.
I do wonder what the “audit the fed” crowd hopes to find evidence of in an audit… I just cannot place myself in their position and see what they’re worried about. If they’re “worried” about finding evidence of money printing, reality has a nasty surprise in store for them.
It’s nice to see some balance here. Rarely do we read about the positive things the Fed does. And MR is such a breath of fresh air. What a clear explanation of the system it has become! Well done guys.
Just trying to better understand your thinking here. Couldn’t you say that outside money is more important? Cash and reserves because they play such a crucial role in settling and transacting business?
Important for what? The health of our economy? No. Bank’s ability to settle interbank payments? Yes. But if a big bank becomes reserve constrained, it gets new reserves in one way or another.
A modern banking system actually doesn’t need much outside money at all. Sweden is well on their way to a cashless society. That’s the direction of the entire electronic world. Cash is becoming extinct.
People have this obsession with money as a physical thing. So they think cash or gold are “real” money. That’s just not true. Technology is proving this entirely false.
Outside money is important for settling payments in the interbank market, but that’s a support feature to inside money. Saying that outside money is more important than inside money is like saying that a football player’s knee brace is more important than his knee.
I’ll have to remember that one about the knee brace
Very good piece indeed. And if the fed stick to this key responsibility – maintaining ordertly payment setllement, nobody would be requesting audit and dissolution.
Employment levels is absolutely not their business. And, honestly speaking, they should not meddle in interest rates either.
Are publicly traded securities outside or inside money? Are they money at all?
The Fed also:
1. Guarantees inside money for select institutions by buying back junk assets when necessary.
2. Procures inside money for the U.S. Treasury in exchange for real financial assets (T-notes).
3. Promotes price and asset inflation to generate rising income for the financial community.
I don’t see inflation as being all that bad myself. It ends up being a tax on idle money, which I see as good.
The problem is, of course, people being forced to save money for their retirement (god this is so stupid). If they can’t inflation-secure their savings, … yeah you know what happens.
When people, which I assume means the economy as a whole, cannot “inflation-secure”, it means the pie is shrinking and the economy is in a severe slump.
I meant the kind of inflation where prices and general wage levels are rising pretty much in tandem. Which requires an expanding supply of money in general circulation. Which is provided by ever-increasing house loans.
This would “work” if the economy didn’t have a big drain on it where profits levels are increasing faster than general inflation.
So what we get now instead is ever-decreasing interest rates to accommodate house prices rising FASTER than the general rate of inflation. And it is going to be very interesting to see how long that can continue.
This is indeed the way the system works, however, it makes the money supply far from elastic. If money is created only as debt and there is no demand for more debt from the private sector as is the case now then money supply is unlikely to grow. If there is no demand for debt even from the government sector as probably will be the case soon, then the money supply for sure will not grow. If the possibility to create money as an asset only (no debt) is taken away from the government completely (these are the physical paper notes and coins) then the money supply will start shrinking. The situation becomes even worse if the private sector or even the government sector decides to deleverage on top of all this as that automatically shrinks the money supply even further. So, you see, the way the monetary system is set up to create money as debt mostly by the private banks is not much different than the gold standard when taken to the extreme end of the debt supercycle as we are now. Under the gold standard the creation of money wad outsourced really to foreign powers who had the most natural deposits of gold, under the present system, money is outsourced to private entities who will always behave only in their own interests when the situation is taken to an extreme. Not saying it is not efficient this system in normal times, and i am not judging its fairness(the privelege to create money out of thin air at 0% interest and to lend at any positive % interest is the ultimate free lunch), but surely in a balance sheet recession this system is not working. We need to have the ability to balance the creation of money.
Of course it’s not working. When households can’t go further into debt, the state needs to go into debt instead, the then the deficit hawks start crowing.
But if anyone even breathes “print some money”, all hell breaks lose with cries of “Zimbabwe! Weimar Germany!” .. which is completely unfounded in this situation, but I never accused politicians & pundits of understanding macro economy.
Sorry fail – the CBs have guided and overseen this free banking crisis to rule them all.
This is much worse then the 19th century free banking crisis as at least they did not issue credit in the goverments unit of account.
It is becoming quite clear that they do not now value the “assets” they hold but the legal right to farm fiat via their asset conduits.
Whats important to them is not the value or productivity of their assets be it mortgages or fiscal debt but as Riche Boucher of the BoI has recently said its all about the “cash flow” as they are ” not a pawnbroking business”
This goes to the very heart of the problem on both sides of the Atlantic – obviously the media will not discuss the implications of what Riche had said as this will destroy the very foundations of the modern republican myth.
The bank assets were non – productive consumption sink holes because the assets serve as a mere conduit , they hold no real value to the banks – therefore whats the point in making the right investment when all these investments serve a different purpose from what is generally believed ?
What has value is the legal right to farm the fiat – sometimes through the very indirect mechanism of mortgage provision.
Hence you get a malinvestment crisis so big this time that they cannot create a fiction to hide the real truth.
1. You are conflating central banks with fractional reserve banking. They are two different things. Even with full reserve banking you would want a central bank as a clearinghouse and lender-of-last-resort.
2. What malinvestment? Are you talking about the insanity of citizens having to go into debt to keep the money supply stocked up? That I can agree with. But malinvestment? What malinvestment?
With, say, a requirement that banks hold reserves equal to at least 50% of deposits, the Fed could still fulfill the role of maintaining the payment system; and credit/debt money creation by private banks would still be elastic, within limits.
The Fed’s hand in “manipulating interest rates” might also be restrained by such a measure, but this might be a good thing.
But reserves are typically loaned from the Fed..?
The primary source would be inter-bank lending, with a true rate-setting market. Any lending from the Fed would be for emergencies, at a stiff enough penalty to discourage excessive credit/debt money creation.
One possibility would be for the government to run a regular deficit, covered by the Fed creating additional reserves in proportion to GDP growth over some prior period. Any additional (eg counter-cyclical) deficit could be covered by issuing Treasuries (borrowing), which could then be available to banks as collateral for borrowing reserves from the Fed, if necessary – thus forming a kind of reserve buffer pool. (The pool of outstanding Treasuries could be allowed to contract during expansionary periods. Note: I am not entirely sure I know what I am talking about here.)
@Mikael
I was thinking of going back to a 19th like century system of free banking with banks using their own units of account but without a private central bank such as the BoE to back them up.
With a treasury that issues 2% or something extra greenbacks a year to tax and spend on the commons.
At least the goverment would not be exposed to a leverage crisis under such circumstances.
When or if the free banking units collapse or implode people can pay back their worthless notes for their “assets”…therefore you get no existential crisis as in Ireland where they must pay back these valueless assets with goverments (taxable) units of account.
The banks would become a pawnbroking business again divorced somewhat from goverment although I imagine they would continue to use their albeit more limited money power to influence legal affairs and such.
Eh – The North sea is declining by 10 to 15 % a year now and what has the UK to show for it ..
One modern PWR…..
The free banks extracted capital from the system to express short term profits – the capital base of the UK and indeed Europe has been destroyed.
Within a few years its likely the lights will start going out.
PS Mikael
The claims on wealth within the UK is interesting.
Much of the “wealth” is in the form of house “assets” which is really a claim on external wealth as nothing much happens within the UK.
http://www.ons.gov.uk/ons/dcp171778_238758.pdf
See the striking graph near the bottom ……….the wealth of Europe was to a large extent the North Sea which the city exported from the UK jurisdiction in the early 80s as it closed down domestic industry during the Big bang period.
The above UK asset prices are a result of the external productivity of Europe which is now failing as the oil is running out.
To maintain UK asset prices it must destroy these PIg economies even to the point of getting negative yields from the rest of the world as is now showing on the UK current account Q2 2012.
The UK is choosing real good imports over income……….this is striking as the UK has always earned net income from the rest of the world.
Kyle Bass on MMT:
The fallacy of the belief that countries that print their own currency and years. Those that treat this belief as axiomatic will most likely be the biggest losers. A handful of investors and asset managers have recently discussed an emerging school of thought, which postulates are immune to sovereign crisis will be disproven in the coming months that countries, as the sole manufacturer of their currency, can never become insolvent, and in this sense, governments are not dependent on credit markets to remain fiscally operational. It is precisely this line of thinking which will ultimately lead the sheep to slaughter.
Amen.
http://www.zerohedge.com/news/2012-11-17/kyle-bass-falacies-such-mmt-are-leading-sheep-slaughter-and-we-believe-war-inevitabl
The only slaughtering is of Kyle Bass as he has tried to short Japanese Bonds and keeps running up against the Japanese Central bank and floating exchange rates.
Bass is right about a few things. Obviously, I don’t think MMT is right. Also, he’s right to claim that a current account imbalance can cause problems for an economy. But his analysis is still wrong. Japan can’t “run out of money”. So he’s betting on mythical bond vigilantes.
Cullen,
Can you expand on your comments (in relation to Bass) that “obviously I don’t feel MMT is right”. I thought your main objection to MMT is the jobs guarantee but that has nothing to do with the Bass issue. What else is it about MMT that you disagree with here?
The JG debates exposed bigger problems many of us had with MMT. Specifically, their idea that the govt is the “monopoly supplier of money”. The reality of our monetary system is that banks issue most of our money and the Fed system serves as a facilitating feature. Therefore, the money supply is actually privatized to an oligopoly of private banks. To call this a govt monopoly is just patently false. In the end, I think the main difference between MR and MMT is that MR builds the understanding of the monetary system around the private sector. We start with banks as the primary issuers of money and view the monetary system as primarily serving private purpose. MMT builds a govt centric view of the world claiming the govt issues the money and that the monetary system exists for the purpose of moving resources from private to public domain.
Frankly, I don’t think the MMT govt centric view is an accurate portrayal.
My expansive MMT critique is here. http://pragcap.com/mmt-critique
The grain of truth would be that banks are given the right to create money from the govt. And that could – in theory – change. But MR describes today’s reality.
“Interesting” and conflicting from Bass. He is right of course that money printing “destroys wealth” if you define “wealth” as “excessive money hoarding”. If “wealth” is defined as things you own it’s another story entirely. What’s new there?
And then he goes on to describe the Eurozone woes as the fault of Euro printing.. hello? What’s happening in Europe is austerity austerity austerity. How the hell does he go from austerity to blaming Magic Money Trees? What happened was just lots of lending from some countries to others, and then the lending stopped and demands were made for large scale repayment. And nothing fully replaced it. Big surprise what shrinking money supply means?!
debt/credit/entitlement bubble expands until it can’t
japan will be the dominoe that tips the US over………..having been tipped by italy.
house of cards goes down after the bond vigilantes realize there is not enough toilet paper in the world to fund the CDI on west+japan debt.
The BOJ is already talking about outright monetization, where the BOJ simply buys Japanese Treasury Debt and tears it up. The BOE is openly talking about the same thing. The only constraint on Japan is inflation. Are you saying that Japan will suddenly switch over from deflation to inflation?
Well, the Manhattan Project was funded by monetization, so the bond vigilantes are sort of right it CAN destroy an economy.
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