Wikinvest Wire

How the Fed gets its money

Tuesday, December 02, 2008

Axel Merk explains how the Federal Reserve can effortlessly increase its balance sheet by more than a trillion dollars, whereas, rescue money flowing from the Treasury is a much more labor-intensive process, one that is also politically charged as we all learned a couple months ago when the $700 billion rescue package was presented to Congress.

How does the Fed get its money? It doesn't need to borrow it; it merely creates an entry into its balance sheet. All the Fed requires to "print" money is a keyboard connected to a computer. The difference between the Fed and the Treasury issuing money is that the Treasury needs to get permission from Congress before selling bonds. In this context, it shall be mentioned that physical cash (coins, bank notes) are entered as liabilities on the Fed's balance sheets; they are rather unique liabilities, however, as you can never redeem your cash: if you went to a bank, the best you can hope for in return for your dollar bill is a piece of paper that states that the bank owes you one dollar. While it is possible for central banks to remove cash in circulation, they are not obliged to do so.

Until recently, the Fed would only temporarily park non-government securities on its balance sheet: a bank would typically receive a temporary, often overnight, loan for depositing top rated securities with the Fed; these "swap agreements" were traditionally intended for very short-term loans, but the crisis has led the Fed and other central banks around the world to engage in 60, 90 day or even longer agreements. Since late September, the idea of swap agreements has been supplemented by outright purchases.

When the Fed issues cash for debt securities it acquires, we talk about "monetizing the debt".
The entire article is worth a look.


Neutral observer said...

Someone recently posted here that any claim of a relationship between government debt and money supply is "spurious."

This article by Alex Merk is devoted to the relationship between government debt and money supply. It points out in great detail some of those relationships.

It notes, e.g., that when the Fed "prints" money, it increases the money supply. When the US Treasury issues government debt, it increases the debt. The author notes that the Fed can now print money to buy Treasury-issued debt. This increases the money supply AND the debt at the same time.

And that creates a DIRECT relationship for those who didn't see it before.

Finally, the author notes that this can lead to 'inflation' "depending on your definition of inflation."

This again points out the confusion on using the term 'inflation' since many people define it differently.

One definition is a growth in the money supply and that is one that the above-mentioned posted on this site seems to be offended by (for some unknown reason).

Despite this fact, it is a commonly used definition and, as long as the author notes it, there should not be a problem.

Arguing over the definition of a word ignore the real issue.

The real question is whether the Fed and Treasury's actions will improve or solve the current fiscal issues or lead to even bigger problems.

Many people (such as I) believe we are in for much bigger problems as a result of these actions.

In the short run, we'll probably see the effects of a deep recession as everything slows down drastically compared to the recent bubble-driven consumer spending.

In the long run, we may see rampant "inflation" as the value of the US dollar declines and things cost more due to the excessive money supply.

We're in uncharted territory, though, and it's anyone's guess.

joebhed said...

I really have to provide an alternative thought to that of the neutral observer.
I cannot say it more clearly than this - as this is my understanding of the relationships between debt and money supply growth.

ALL increases in the money supply are created as a debt.
All of the FED's machinations, regardless under which tree they may have dropped their works, ALL of it is new money and ALL of it is new debt.
ALL of the funding that is being provided from the FED to the banks is on the basis of a somewhat-collateralized loan, a.k.a., debt, which is in turn brought into existence as an increase in the money supply.
ALL of it.
With regard to the Treasuries and the $700 Extra-Large.
The biggest difference is that in this case the FED must await the government's permission to issue the bonds that will back the new debt.
This is not true of the FED's balance-sheet machinations.

A great American, Henry Ford, once said:
""It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.""

And famous monetary reformist Major Clifford Hugh Douglas once said it this way:
""As the situation stands at present, the banker is in a unique position. He is probably the only known instance of the possibility of lending something without parting with anything; and making a profit on the transaction, obtaining in the first instance his commodity free.""

Time to end the charade and bring back the Chicago Plan to the Congress.

Neutral observer said...

Hi, Joebhed

I was re-stating the gist of the article Tim referred to.

I think it was well written.

As I understand it, if the Fed 'prints' money, it doesn't go on their books as a loan that must be repaid someday. It's just flat created from thin air. There's no interest rate or maturity date. It's just paper with the backing of the USA. It's what we all have in our wallets.

If the Treasury department auctions bills, bonds or notes, however, those are actual obligations with a face value, interest rate and they must be repaid in some way at maturity. (Usually, they are refinanced.)

To me, that is a difference. But, in the end, it's all going to cause problems, one way or the other.

The excess money supply will result in 'inflation' (by the definition I learned in university as a finance major) and the debt will have to be repaid somehow.

Too much of either one is bad.

Did I miss something?

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