Wednesday, April 03, 2013

The Federal Reserve: Making Money From Nothing

At its core, money is a medium of exchange, a unit of account and a store of value. A currency with a commonly recognized value can be used to buy the goods and services we want and need. Like all other things, the value of money is determined by its quantity and availability.

For centuries, people used gold as money. In order to buy something, they had to carry around pieces of the heavy, yellow metal. But that was impractical, especially if someone needed to make a large purchase requiring a significant amount of gold. So people decided to leave their gold in a bank and instead use pieces of paper that would represent their gold. That paper could then be taken to a bank and exchanged for gold.

Gold is a form of commodity money, a currency thats value is based on the value of an underlying commodity. Gold is durable, portable, easily stored, highly recognizable and difficult to counterfeit, which made it an ideal commodity money throughout the world over many centuries.

But, beginning in 1933, the U.S. government decided that we could no longer exchange our dollar bills for gold. From that point forward, dollar bills have merely represented the concept of money.

However, until 1971, U.S. currency was still backed by gold. Foreign governments were able to take their U.S. currency and exchange it for gold with the U.S. Federal Reserve. That changed when President Nixon effectively took the U.S. off the gold standard by ending the convertibility of the dollar to gold in August of 1971.

Since that time, our money has been fiat money, meaning its value has been declared by the government to be legal tender. In essence, it must be accepted as a form of payment within the boundaries of this country, for "all debts, public and private."

Fiat money has value because the government says it does.

Not only is there no longer any gold backing our money, there aren't even bills for most of the money that exists. Most money is simply an idea. Banks don't even have all the money that's allegedly in the accounts of their depositors.

Most money isn't physical; it is merely created electronically. Think about what happens when you pay your mortgage, rent, utility bills, car payment or monthly insurance. No cash — no physical money — ever changes hands.

M2, the broadest measure of our money supply, had increased to $9.61 trillion in October 2011, the latest month for which data is available. However, as of December 2010, only $915.7 billion (about 10%) consisted of physical coins and paper money.

The other 90% is just numbers in bank databases, on computer screens.

The truth is, our money is created out of nothing. It is merely loaned into existence.

Every six weeks, the Federal Reserve's Open Market Committee convenes in Washington D.C. to discuss the health and performance of the economy. By controlling the amount of money in our economy, the Fed can influence interest rates. More money usually results in lower rates, while less money typically has the opposite effect.

More money (or lower rates) generally makes it easier for businesses and individuals to get loans. This allows businesses to expand or new businesses to start up. That ultimately translates into more jobs and a stronger economy.

But, more money can also result in inflation. For example, if there's a hundred dollars in an economy and you create a hundred more, every dollar is suddenly worth half as much. That's inflation.

Money must correlate to the amount goods and services produced in an economy, particularly the things that people want. If there is too much money chasing too few goods and services, money loses value. It's not so much that prices are going up. Rather, the purchasing power of money is going down.

That is why simply printing new money will not create wealth for a country. Money must be in balance with the supply of goods and services in the economy for it to maintain its value, or purchasing power. If the Fed issues too much money, its value will go down, as is the case with anything that has a higher supply than demand.

Over the thirty-year period from 1981 to 2009, the U.S. dollar lost over half its value. This is because the Federal Reserve has intentionally targeted a low, stable rate of inflation.

On January 25th, 2012, Fed Chairman Ben Bernanke announced a 2 percent target inflation rate. Bernanke had previously stated that central banks seek an inflation rate between 1 and 3 percent per year.

Between 1987 and 1997, the rate of inflation was approximately 3.5 percent and between 1997 and 2007 it was approximately 2 percent.

Yet, even at an annual inflation rate of 2 percent per year, the dollar would lose 20 percent of its value in just one decade.

But that doesn't deter the Federal Reserve.

The Fed injects billion of dollars into the economy via the banking system. It does this by purchasing government bonds from the banks. Big banks typically have billions of dollars in Treasury bonds just sitting around on their books because these bonds have long been viewed as the safest, surest investment.

But having billions of dollars just sitting around on their books doesn't suit the banks. At least the bonds they sell to the Fed earn interest. So, the banks are inclined to loan out this new money to make even more money. After all, that's what banks do. And that's how all of this new money enters the economy.

But a large supply of new money doesn't create demand. To create demand, the banks need to lower their lending rate to encourage businesses and individuals to borrow. The hope is that an increased level of borrowing will create an economic expansion. But, as we've recently seen, that doesn't always work as planned.

When the financial crisis was in full swing in the fall of 2008 and the economy appeared poised to crater, the Fed ramped up its money printing to unprecedented levels.

Since that time, the Fed has done things it had never done before. And it's done them on a scale that has dwarfed anything ever attempted before in its history.

NPR's Planet Money put it this way:

The sheer amount of new money that the Fed created was unprecedented. From the time we went off the gold standard of 1933 until 2008, the Fed had created a net total of $800 billion. In the months after the financial crisis, that number nearly tripled to almost $2.4 trillion.

[The Fed was] spending more newly created money in just 15 months than [it] had created in its entire history up until 2008.

However, getting all these trillions of dollars into the economy required more than just buying Treasuries. The Fed decided to buy home mortgages as well, in the form of mortgage backed securities. The intention was to prop us the plummeting housing market.

The danger of this extraordinary and historic Fed intervention is that it will result in debilitating inflation, resulting in the dollar losing significantly more of its purchasing power.

At some point, the Fed will have to find a way to get all those trillions of dollars out of the economy before serious inflation takes hold. Instead of buying bonds, the Fed will begin selling them, which it will attempt to do in an orderly fashion without flooding the market and driving down their value. Again, think supply and demand.

The Fed is able to create trillions of dollars out of thin air on its own authority. Congress doesn't debate it or vote on it. The president doesn't approve it. There's no public input. The Fed is independent and is able to act of its own accord.

Though the Federal Reserve is subject to Congressional oversight, its chairman is appointed by the president, and its name includes the word "federal," it is not actually part the federal government.

It's important to understand that the Federal Reserve isn't federal at all. It is an independent institution comprised by 12 regional banks, all owned by big private banks. Yes, the Fed is privately owned and actually has stockholders.

As the long-time Chairman of the House Banking and Currency Committee Charles McFadden said on June 10, 1932: “Some people think that the Federal Reserve Banks are United States Government institutions. They are private monopolies.”

Consider that when you're evaluating or scrutinizing any decision made by the Fed.

We should never forget that the Fed started the financial crisis that tanked the economy. By keeping interest rates too low for too long, the Fed inflated the housing bubble. And it now appears that it has initiated a bond bubble and a stock market bubble as well, which is an odd occurrence.

Money usually shifts between bonds and equities, typically favoring one or the other, given the particular economic circumstances or appetite for risk. But, right now, there is so much money flooding into the financial system that it is flowing freely to both the bond and equities markets.

At this point, it's pretty clear that the Fed is again blowing yet more massive bubbles that could once again tank the U.S. economy — except that next time will likely be even worse since the economy is still on such weak legs.

The Fed cannot print this economy back to health. At this point, that should be clear. To the contrary, this massive monetary expansion could have some horrible consequences.

As history repeatedly shows, printing money is the road to ruin. It devalues money and causes a loss of confidence. If everyone stops believing in their currency, it has disastrous results. The whole monetary system is built on trust. Once that trust is gone, the value of money goes away with it.

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