Voluntary Society - Conditioning - Credit - Federal Reserve 2

In July of '92 a small article in the "Money" section of USA Today led me on an extensive research and analysis exercise. The article stated that for the first time in banking history more loans had been made by banks to the federal government than to private businesses. This surprised me because I, in my naiveté, thought banks were prohibited from making loans to the government because of their ability to borrow directly from the Fed. It seemed to me that banks could be borrowing from the Fed (or in effect from the mint) at the "discount rate" then turning around and lending the money back to the government at a higher rate of interest which would be a rather sweet deal for banks. I realized, however, that my knowledge of banking, operation of the Federal Reserve System and the monetary system in general was very superficial at best. To learn more I checked a book on money out of the local library. The book, entitled "Money, What it is and Where it Comes From" by John Kenneth Galbraith, was both amusing and informative, a good representation of Galbraith's writing style. The book answered many questions such as what money really is (per Galbraith, understanding what it really is does not make it any easier to obtain more!), how paper money was invented, the difference between "gold backed" money and un-backed money, how banks operate and how money gets from the mint into the economy.

I learned much from Galbraith's book but, as is so often the case with learning, it made me more conscious of the degree of my ignorance and motivated me to read more. I quickly digested Volcker's self-serving book, "Changing Fortunes", Robert Reich's insightful book "Work of Nations" and Greider's "Secrets of the Temple". The latter book is a tome, carefully researched, very informative and written with a noticeable but minimal degree of prejudicial opinions.

Then I discovered a gold mine quite accidentally. I was told that regional Federal Reserve banks allowed the public access to their research libraries. I made an appointment with the Regional Federal Reserve bank in Richmond in March of '93 and, before leaving, had been informed by the librarian of the immense quantity of excellent material available at no cost from the Federal Reserve. These materials, in the form of pamphlets, reports and books, exhibit professional authorship and impressive publication features. I availed myself of numerous publications from the Fed to enhance my understanding of the making and implementation of monetary policy. Additionally, I have followed and am able to more fully appreciate the sparse and very brief news items in the press which pertain to formation and implementation of monetary policy.

At this point in my studies I realize that when I read the news article in July of '92 I was totally ignorant of what was going on. I also realize now that monetary policy is as important, perhaps more important, than fiscal policy in solving the national budget, deficit and debt problems which often dominate political debate.

Armed with new-found knowledge and insight I have formed opinions on the current state of affairs of national fiscal and monetary policy. These conclusions which I have reached and the basis for them are the subject of this document.

Prior to launching into the body of this document the reader is due a brief personal note from the writer. I am by nature and, in the field of technology by profession, one who studies, digests, analyzes, identifies key issues and reaches conclusions on subjects of interest. The family was fed for many years doing this type chore in the high technology business of aerospace and defense systems. As a specialist in engineering and physical science I make no apologies for this intellectual foray into the area of economics, banking and monetary theory. I have found the narrowly defined concepts of money and monetary system management to be quite simple. In addition, their relationship to fiscal policy and the legislative and executive branches of government are well defined and easily grasped by any who care to undertake an examination of the subject.

Many Americans have been convinced by politicians and the media that the nation's fiscal problems are analogous to those of a family which spends more than it makes and has accumulated a large and burdensome debt load. Letters to the editors of newspapers and talk show callers illustrate the frustration of those who have been misled into believing this false premise of national fiscal affairs. It seems perfectly obvious that any housewife, any average housewife, whose family had the same fiscal problems as the government and had the resources of the government would solve the problem in a heartbeat. That's because the resources this average housewife would have would include a mint which prints legal dollars, real honest to goodness greenbacks, not funny money nor phoney money. This average housewife would hit the button, run off as many as she needed and smile as the debt gets paid and the annual shortfall in income gets fixed. Anyone who does not understand why the government does not do this, what would be necessary to allow the government to do it, who would be hurt and who would be helped by it being done simply does not understand the problem. People who complain about a balanced budget without understanding this point are just adding noise and confusion to the problem. For many, the quick answer to why the government doesn't do it is "inflation". But that's not the real answer. The real gut issue is who gets to issue money into the dollar denominated economy and to whose account it is issued. At the present time 9 out of each 10 new dollars are issued by and added to the assets of privately owned commercial banks. The other dollar is issued by the government through the Federal Reserve as a buy-down of the national debt. This one dollar in debt buy-down by the Fed seeds the issuance of the other nine by commercial banks by way of the 10% reserve requirement on demand deposits. I think this ratio is unfair to taxpaying citizens. People clamoring for a balanced budget and not understanding this real issue are supporting the status quo. People need to be better informed of the options available in the monetary policy domain to reach an informed position on this issue. Democracies do not function well except with informed electors.

The misleading of the American public by politicians and the media deflects attention, thought and energy from some of the real issues which the nation faces. The simple reality is that the U.S. Government does not need money. Contrary to what many conservatives are fond of saying, the U.S. government is the sole producer of money, discounting counterfeiters. Our government of the people, by the people and for the people owns the printing presses which print the legal tender called dollars. The government can print all of the money it requires. Money, quite literally, is just paper printed with green ink; it is nothing more and nothing less.

In a long by-gone era paper money could be exchanged for gold (and of course you can still buy gold with your dollars if you want to!) or other precious metals. For decades now, paper money has stood on its own, retaining its purchasing power as a medium of exchange. It has been learned, and the lesson has been put into practice, that it is the relative scarcity of a medium of exchange which causes it to maintain value. Nature did that for us when we used gold or other precious metals as a medium of exchange. Because of this simple reality of money, governments do not levy taxes because they require money; they levy taxes because they have an obligation to control the supply of money which they produce, maintaining a degree of scarcity which will cause its purchasing power to be maintained and, at the same time, insuring a sufficient supply to support the economic energies of the nation. If more is spent than is extracted by taxing, then the supply of money grows and the unit of exchange, the dollar, loses value. This is called inflation. On the other hand, if more money is taken by the government than it spends, then the money supply shrinks and dollars become more valuable, economic activity is hampered, widespread liquidation of assets is instigated and a depression or deflation occurs.

Management of its monetary system is a very real and very basic obligation of a government. If a government does not face up to this obligation it does a disservice to all of its citizens, rich and poor alike.

The U.S. constitution holds the Congress responsible for both fiscal affairs (taxing and spending) and for monetary affairs; the printing, distribution and control of the money supply. The Congress needs to face both of these responsibilities to solve the vexing budgetary problems now facing the nation.

Congress's responsibility to manage the monetary system dictates a need to generally increase on a continuous basis the supply of money in the dollar - denominated economy. In 1992 (the last year reported by the Fed.) the supply of money (M1) increased by about $150B or about 15%. Most would say management of the money supply is the responsibility of the independent Fed. This is a generally true statement, but the Fed was created by an act of Congress and in crucial areas the Fed is still controlled by the Congress. Additionally, independence of the Fed is a statement often heard but not referenced in any legislation relevant to the Fed.

Examples of congressional control of the Fed are the Humphrey-Hawkins Full Employment Act used by the Fed for policy guidance, the Monetary Control Act of 1980, the Banking Act of 1933, the Garn-St. Germain Depository Institutions Act of 1982 and the acts in 1935 which reformed the Fed and centralized power in Washington. Both history and the constitution relegate questions of monetary policy and actions to the congress. It is, therefore, proper and correct to examine the full range of options open to the congress to manage the more inclusive monetary budget. It is equally proper to demand examination of the fiscal budget only in context with this more inclusive monetary budget. The monetary budget consists of dollars placed into the economy and dollars extracted from the economy with the dollars placed into the economy exceeding the amount extracted by the money growth goal. The annual money growth goal is expounded by the Federal Reserve, aided by their very able economic analysts. The mechanisms used for extraction of dollars from the economy are:
1. Federal taxes, tariffs, fees, etc. (TX)
2. Sale of Treasury bonds (SB)
3. Fed. open market operations, sale of debt paper (FS)

The insertion mechanisms are:

1. Spending by the Federal Government


2. Fed. open market operations, purchase of debt paper


3. Money issued by commercial banks under fractional reserve banking rules.


Using the notations in parentheses after each item we see that the discussions are often concerned with reducing GS to allow a reduction in TX and SB. These limited scope discussions suppress the other items listed above. The usual budget arguments assume the following (annualized) fiscal budget expression must be held true:

(1) TX + SB = GS It is, however, the real responsibility of the congress to maintain the following (annualized) monetary relationship:

(2) TX + SB + FS = GS + FB + BI - DM, where the annual increase in the money supply is denoted by DM. The monetary expression, equation (2), quite obviously provides added options which do not exist in the simpler, less inclusive fiscal relationship, equation (1) The objective of those supporting a balanced budget and trying generally to reduce government spending is to effect a reduction in taxes and in borrowing by the government. This is a proper and commendable objective. However, much greater freedom to achieve these goals is available in the context of the monetary relationship, equation (2) In equation (2) it is equally obvious that the fiscal relationship, equation (1) is not a necessary constraint. The broader responsibilities of the Congress do not require balancing government spending against taxes and borrowing.

Assume the money growth goal, DM, is a given in the equation. It literally is given to the Congress each year by the Federal Reserve and published in April in the Fed's "Annual Report". Equation (2) can be rearranged and simplified as follows:

(3) DM = GS + FN + BI - (TX + SB) where taxes and borrowing, the items to be reduced, have been grouped and the very large open market operations items of the Fed, FB and FS (near $3T in '92) have been replaced by the net "high power" dollar input by the Fed to the economy, FN,

(4) FN = FB - FS : Net Fed input dollars into economy (Note: FB & FS must also include buying and selling of Treasury bonds and certificates by the public).

From this it can be seen that the monetary relationship can be maintained and taxes and borrowing reduced by reducing the issuance of money by banks as well as by reduction of government spending. The value of BI is, of course, controlled by FN, the fractional reserve banking rules and, if they were not constrained to a zero sum, by GS - (TX + SB). Denoting the fractional reserve requirement by fr,

(5) BI = (1/fr - 1 ) * (FN + GS - (TX + SB))

This expression defines the license for banks to issue money into the economy. A small value of fr provides great latitude for issuing new money. If fr were unity banks would lose their license to issue new money. The current nominal value of fr is 0.1, giving a multiplier value of 9.

Using relationship (5) in equation (3),

(6) DM = (1/fr) * (GS + FN - (TX + SB))

This expression between the primary monetary variables carries many messages. For example:

  1. To produce a given increase in money government spending plus pay down of the national debt (FN) must exceed the sum of taxes and borrowing.
  2. The extent of the imbalance which can be tolerated between spending plus debt pay-down and taxes plus borrowing is controlled by the reserve requirement, fr. A small fr tolerates a small imbalance while a larger value will allow larger imbalances.
  3. Looking at present values of these parameters it will be seen that the monetary budget would essentially balance with FN and SB equal to zero if fr were equal to unity.

Analysis of the equation also exposes the truly "dirty little secret" of monetary and fiscal policy. Government borrowing and the buildup of the national debt over the past decade and a half has been necessary, in effect, to "make room" in the economy for commercial banks to issue money for the aggrandizement of their assets. The reserve requirement was reduced in the Monetary Control Act of 1980 and again in the Garn-St.-Germain Depository Institutions Act of 1982. This reduction in reserve requirements has allowed banks to issue more money, increasing their assets while government borrowing had to increase to make room for the money created by banks. The negative image of the national debt is the assets of commercial banks.

The "in effect" phrase used above is important. This is not a promulgation of a conspiracy theory but rather a statement of the effect of policy which was not necessarily foreseen by those who established the policies. Low reserve requirements are, of course, desirable for banks and banks can be expected to lobby for the lowest rates attainable. The effect of operating the banking system with very low reserve requirements while maintaining a non-inflationary growth in the money supply has been to accumulate a large national debt while bank assets have enlarged. Examination of the monetary budget variables shows that the two events are not unrelated.

There is no law of economics nor any god-given right for commercial banks to operate with a low reserve requirement. New money in the economy could and should be issued by the government itself rather than "enabled" as presently done by "high-powered" dollars from Fed open market operations.

The origin of fractional reserve banking has been described by Galbraith in his book on Money. He relates, as a tutorial, the situation when gold was the medium of exchange but people found the heavy metal inconvenient to transport for commerce and difficult to safeguard. The practice developed of storing the gold with goldsmiths who had safe storage facilities. The goldsmiths would give paper receipts for the gold stored with them. (Paper money backed by gold!) These goldsmiths discovered an interesting and profitable fact when people came to them to borrow gold receipts.

The goldsmiths found they could issue more receipts than they had gold because all the people with receipts never came at the same time to redeem their gold! Thus, according to the story, fractional reserve banking was born from an essentially fraudulent action of lending non-existent money. It is submitted that no other basis for the practice of fractional reserve banking exists other than that people do not normally all want their money at the same time.

The Fed was instituted in the US in 1913 following the panics in the late 19th and early 20th century caused when too many people descended on banks at the same time demanding their money. The Federal Reserve, as the lender of last resort, guarantees banks immunity to failure while they make loans with money they do not possess. The most basic reason for the Fed's existence is to "back up" banks practicing fractional reserve banking.

Goodfriend and Hargraves of the Federal Reserve Bank of Richmond have written an excellent review article on reserve requirements. ("A Historical Assessment of the Rationales and Functions of Reserve Requirements", 1983.) The article is, however, as blind to the broader aspects in fiscal policy as current congressional debates on balancing the budget are on monetary policy. The publication is free from the Richmond Fed in a booklet entitled "Monetary Policy in Practice".

There is surely waste in government spending. The portion of the national expenses devoted to interest on the debt is excessive. The core problem, however, is one of monetary policy, not fiscal policy. The Congress needs to explore and debate the full spectrum of problems and solutions available to them and, in fact, address the full range of their responsibilities.

It is time, perhaps, to restructure the Federal Reserve System and commercial banks as completely as they were changed in the early to mid 30's. Also, it may be time to infuse those two great American attributes, democracy and free markets, into our banking system which has none of either at the present time.

The reserve requirement for U.S. commercial banks has been changed many times since being first established at 25% by the National Bank Act of 1863. At the time of the establishment of the Federal Reserve by Congress in 1913 reserve requirements ranged from 12 to 18%. At present the reserve requirement varies from a maximum of 10% down to 3% on the first $46.8 million of transaction accounts and to 0% for loans to the government. Many of these reductions in reserve requirements have been legislated recently by the Congress. Suffice to say that low reserve requirements benefit banks and, as noted below, account for many of the current money problems facing the nation.

The advantage of a low reserve requirement for banks can be seen from the example of someone cashing a government bond for $1000 and depositing the cash in his checking account. The bank would be required to maintain just $100 of the deposit and could use the remaining $900 as the basis for $9000 in loans. Thus, using the $1000 deposit, the bank has created an additional $9000 on which it will collect interest. Also, the $9000 will be paid back to the bank and it definitely will not be given to the original depositor of the $1000 which was the basis of the creation of the new $9000.

Fractional reserve banking is allowed by statutes passed by the U.S. Congress. Congress could increase the reserve requirements under which banks operate, thereby reducing the deficit pressure on the fiscal budget.

How would an increased reserve requirement help solve the current national deficit problem without increasing taxes or reducing spending? It would do it in two ways. First it would allow paying off a significant part of the national debt without risking inflation and second it could allow the government to spend a significant amount of money directly into the economy to provide the needed growth in the money supply. The first action would reduce interest payments on the national debt and the second would allow the government to spend money into the economy without borrowing it or gathering it by taxes.

Banks currently (4/93) hold about 239B$ in government debt on which they are paid, assuming a nominal 6% rate, 14B$ per year. This government debt holding is to limit the loans which banks can make, not because the government needs the money. The 14B$ interest is payments to banks to not make loans, just like payments to farmers to not grow crops. The Federal Reserve, Congress's agent for monetary policy, could pay off these loans with a keyboard entry converting the loans to bank reserves. The inflationary effect of this action would be avoided if the reserve requirement on demand deposits were increased. An additional benefit of converting government debt to bank reserves will be the interest which the Fed earns on these reserves which is turned over to the US Treasury. If the Fed earns 4.5% on these reserves, the net savings from this monetary action would be 25B$ per year.

Government spending of money which was not raised by borrowing nor by taxes would be declared a no-no by some but it has to happen in some fashion to provide the money supply growth needed by the economy. In 1992 the basic money supply, M1, grew by over $150 billion. This happened by the Fed putting, effectively, an additional $15 billion into the reserve accounts of banks by buying government debt. Banks then, based on these added reserves and the fractional reserve requirements, generated an additional $135 billion in loans. This $135 billion was essentially given to the banks by the government. If the reserve requirement were 100% then the government could have spent the full $150 billion into the economy directly without either borrowing it nor raising it as taxes. Based on 1992, a 100% reserve requirement on banks would have relieved the budget deficit of about $175 billion or over one-half of the total deficit before any new taxes or spending cuts were made.

(Copyrighted 1994, Charles R. Layne)
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