During a recent address to Congress, Federal Reserve Chairman Ben Bernanke assured lawmakers that the Federal Reserve is ready to act as needed to safeguard the U.S. financial system and economy, especially amid rising financial tensions.
However, his reassurances seemed to fall flat, as evidenced by a sharp dip in the stock market. The DOW dropped by 145 points from its intraday peak immediately following his statement, signaling that Wall Street demands more than mere words.
What investors are longing for is definitive action: they desire QE3—the Federal Reserve’s third round of quantitative easing. This expectation reflects what the Fed has conditioned Wall Street to anticipate; under the leadership of both Greenspan and Bernanke, the central bank has consistently flooded the markets with liquidity to keep stock prices soaring.
At the Economic Prism, we believe that eventually, the Federal Reserve will not let Wall Street down. Nevertheless, it seems that Wall Street must exercise patience for now—the DOW may need to drop by another 2,000 points before Bernanke decides to open the floodgates.
What is concerning, however, is the extent to which expectation and speculation on Fed monetary policy can distract from larger issues. While Bernanke’s assurance that the Federal Reserve is ready and able to provide financial support sounds reassuring, it raises important questions about what this truly entails.
To understand the implications, let’s delve into a brief exploration of the Federal Reserve and its money creation processes.
A Brief Look at the Federal Reserve
Established by Congress through the Federal Reserve Act of 1913, the Federal Reserve serves as the central bank of the United States. This Act assigned the Federal Reserve three primary monetary policy objectives: achieving maximum employment, maintaining stable prices, and ensuring moderate long-term interest rates.
Monetary theorists at the time believed that a scientifically managed currency could achieve these goals. While this idea may have held some validity in theory, the reality is that the Federal Reserve has often prioritized economic growth over price stability throughout its century-long existence.
Even if the dollar hadn’t lost 95 percent of its value under the Federal Reserve’s watch, the methods employed by the Fed to pursue its objectives are quite remarkable. It attempts to strike a balance between economic growth and price control by managing the nation’s money supply—either expanding or contracting it depending on circumstances.
However, to grasp how the Federal Reserve manages money supply, one must first understand the nature of money in today’s economy. Currently, money is not backed by anything of intrinsic value; there are no commodities or precious metals, like gold or silver, supporting it, nor are there reserves upon which it is founded.
Ultimately, the Federal Reserve operates through a mechanism of illusion…
The Greatest Fraud of All
In reality, the Federal Reserve does not possess any reserves, unless we consider Treasury Notes—a form of debt certificate—to be reserves. Consequently, today’s money effectively represents debt. In fact, in the U.S. and many other countries, the total money supply is underpinned by nothing more than debt: without debt, there would be no money.
The Fed generates money by first creating debt; this debt is then transformed into money. Here’s how it works:
The Federal Reserve writes a check to the Treasury in exchange for U.S. Treasury Notes that haven’t been purchased on the open market. This process may seem straightforward but there’s a crucial detail: the Federal Reserve lacks the actual money to write that check. Instead, this fiat money is generated instantaneously through a simple ledger entry.
Once these notes are issued, the Federal Reserve employs the principles of fractional reserve banking to create an additional nine dollars for every dollar linked to the notes. The government spends the money originally created, while the subsequent funds generated form the backbone of bank loans offered to businesses and individuals.
This can only be described as a remarkable feat of accounting trickery—arguably the most significant fraud in history. But this situation is further complicated…
It is crucial to remember that the Federal Reserve charges interest on each dollar it creates from nothing. Consequently, the government enjoys a virtually limitless funding source, provided that the populace—meaning you—can continue generating enough value to pay off interest indefinitely.
This is the basic framework for how the Federal Reserve creates money. Keep this in mind the next time you hear the Fed proclaim its readiness to act. When they do take that action, you can appreciate the true implications.
Sincerely,
MN Gordon
for Economic Prism
