Understanding the Monetary System in America

Matt Taibbi has a good description of the monetary system under the Federal Reserve tucked away in a chapter from his book Griftopia on the gigantic folly of Alan Greenspan. He writes:

“A person can go crazy trying to understand everything the Fed does, so in the interest of sanity it’s probably best to skip the long version and focus on its magical money-creating powers, the key to the whole bubble scam. The bank has a great many functions – among other things, it enforces banking regulations and maintains and standardizes the currency – but its most important job has to do with regulating the money supply.
The basic idea behind the Fed’s regulation of the money supply is to keep the economy as healthy as possible by limiting inflation on the one hand and preventing recession on the other. It achieves this by continually expanding and contracting the amount of money in the economy, theoretically tightening when there is too much buying and inflation and loosening when credit goes slack and the lack of lending and business stimulation threatens recession.
The Fed gets its pseudo-religious aura from its magical ability to create money out of nothing, or to contract the money supply as it sees fit. As a former Boston Fed chief named Richard Syron has pointed out, the banks has even fashioned its personnel structure to resemble that of the Catholic Church, with a pope (the chairman), cardinals (the regional governors), and a curia (the senior staff).
One way that money is created is through new issuance of private credit; when private banks issue new loans, they essentially create money out of thin air. The Fed supervises this process and theoretically monitors the amount of new loans issued by the banks. It can raise or lower the amount of new loans by raising or lowering margin requirements, i.e., the number of hard dollars each bank has to keep on hand every time it makes a loan. If the margin requirement is 10 percent, banks have to keep one dollar parked at the Fed for every ten they lend out. If the Fed feels like increasing the amount of money in circulation, it can lower the margin rate to, say, 9 percent, allowing banks to lend out about eleven dollars for every one kept in reserve at the Fed.”

Having a small reserve requirement from which banks can lend out many times more money that it actually is also called fractional-reserve lending. This supposedly allows money to flow more freely where it is needed, although it is done specifically by private bank loans.

“The bank can also inject money into the system directly, mainly through two avenues. One is by lending money directly to banks at a thing called the discount window, which allows commercial banks to borrow from the Fed at relatively low rates to cover short term-financial problems.
The other avenue is for the Fed to buy Treasury bills or bonds from banks or brokers. It works like this: The government, i.e., the Treasury, decides to borrow money. One of a small group of private banks called primary dealers is contracted to raise that money for the Treasury by selling T-bills or bonds or notes on the open market. Those primary dealers (as of writing there are eighteen of them, all major institutions, including Goldman Sachs, Morgan Stanley, and Deutche Bank) on occasion selling those T-bills to the Fed, which simply credits that dealer’s account when it buys the securities. Through this circular process the government prints money to lend to itself, adding to the overall money supply in the process.”

The Fed’s primary and most often used tools for regulating the money supply is through manipulating interest rates:

“When a bank falls short of the cash it needs to meet its reserve requirement, it can borrow cash either from the Fed or from the reserve accounts of other banks. The interest rate that the bank has to pay to borrow that money is called the federal funds rate, and the Fed can manipulate it. When rates go up, borrowers are discouraged from taking out loans, and banks end up rolling back their lending. But when the Fed cuts the funds rate, banks are suddenly easily able to borrow the cash they need to meet their reserve requirements, which in turn dramatically impacts the amount of new loans they can issue, vastly increasing the money in the system.
The upshot of all of this is that the Fed has enormous power to create money by injecting it directly into the system and by allowing private banks to create their own new loans.. If you have a productive economy and an efficient financial services industry that rapidly marries money to solid, job-creating business opportunities, that stimulative power of a central bank can be a great thing. But if the national economy is a casino and the financial services industry is turning one market after another into a Ponzi scheme, then frantically pumping money new money into such a destructive system is madness, no different from lending money to wild-eyed gambling addicts on the Vegas strip-and that’s exactly what Alan Greenspan did, over and over again.”

The power that the Fed has to manipulate the amount of money coursing through the economy at any given time is enormous. The function of such an institution is stability and easing financial hardship, but when factions and class interests are factored in, the misused of the power to control how much money gets pumped into the people’s pockets (all by loans with attached interest from banks and, therefore, an increasing debt burden) is epic. Remember: private banks create new money when they issue loans. This means that when the Fed lowers interest rates: the federal funds rate (meaning the banks can now borrow from each other or the Fed to meet its reserve requirements), the freedom of banks to lend is increased dramatically. More money is extended to people (often referred to as households – it is the economy remember) but as loans or as credit. This loan will theoretically be paid off eventually, but until then, people remain holding a debt that will gradually increase due to interest rates the bank sets on its own (besides the rates the Fed sets).

The U.S. government itself (in the form of the Treasury) also must borrow money from the Fed to finance its expenditures and pay out its dollars. Recall from above that the Treasury must contract out to banks the selling of its Treasury bonds and bills, then receives its (the Treasury’s) own money that it printed after the sale. Since these are bond and bill purchases that must take place before the money is allowed to enter existence as currency, the government must go into debt and pay back the investors who bought those bonds and bills eventually and with interest. Hence the skyrocketing U.S. national debt.

From both the perspective of the people and the government, debt is built into money from the start. But it doesn’t have to be.

Some will point to the Federal Reserve and say: “there is the problem. End the Fed or nationalize it, we can create money debt-free and end the national debt.” A number of people have wised up to this parasite on the money supply and have a similar idea: a national currency of “Greenbacks” the likes of which were seen in Lincoln’s Civil War era and Benjamin Franklin’s colonial Pennsylvannia. The currency would then be be created by publicly and not by private banks siphoning off interest right from the start. Here is a list of people who have more-or-less come to the same conclusion:

Ellen Brown
Stephen Zarlenga:
Bill Still:

The UK’s Positive Money:

A good blog post was put out on Washington’s Blog about the prospects of a nationalized, public central bank and public banking in general as a panacea: http://www.washingtonsblog.com/2010/03/7-questions-about-public-banking.html

Be sure to read this whole post. They bring on Steve Keen at the end to say that Public Banks are not enough because of the speculative gambling that takes place on Wall Street and the financial trickery that allows money to be multiplied many times over will not be stopped by the public issuance of money. Getting at the source is important, but not sufficient in creating lasting solutions to fictional bubble economies. Regulation of finance is crucial: as long as bankers and financiers are allowed to bid-up asset prices like land, housing, and commodities, the bubbles and an unstable currency will continue despite a tighter control of the money supply. Keen’s key is to stop the debt-leveraging of asset prices.

Very heavy financial reform and regulation is required to stop gigantic crises that spread misery throughout the Earth. These financial technologies like derivatives, mortgage-backed securities, and naked short selling were cooked up by the smartest people the academies produced (many of the brightest minds in physics left the field to work on Wall Street in the past few decades) and are difficult for regulators to stay on top of. Class interests prevent legislation from being passed on Capitol Hill due to banker capture and unlimited campaign financing. The way out of this mess is hard to see.

The decision makers in politics and finance will move when their power is threatened however. A few quick outlets:

People have been pointing to a far-left/far-right alliance of end-the-Fed Libertarians and progressive Socialists. If they stay away from falling in with the large Corporate backers and Banker class of ultra-wealthy and become popular, they could make radical legislative changes. See Ralph Nader here

The specter of a very unpopular war with Russia and perhaps China (which would mainly be caused by currency and oil control around the globe) could propel a mass movement to change what is in essence an imperial financial system. See here

A debt strike or jubilee would immediately make banks insolvent and provide the open space for alternative solutions formerly considered “too radical.” See Andrew Ross here

Revolution (early reports are unclear about how this would happen).


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