Friday, June 11, 2010

So, Who Runs the Fed?

I'd like to comment today on the organization of the Federal Reserve System, and whether it is truly a function of the Federal Government and under democratic purview as is commonly understood—or whether it is a quasi-governmental intermediary that enables the interests of private banks to be enacted into law. As it turns out, it is a mix of the two, split nearly evenly down the middle.

Federal Reserve operations are handled by 12 regional banks, with 25 branches, across the United States. These operate the discount window and monitor the overall economy within their regions. Each regional bank is run like a private bank, independently incorporated, with shares held by member banks. Each has a 9-member board of directors: 6 elected by the shareholders, and 3 appointed by the Board of Governors (explained below). They are like private banks in how they are organized, except profits are relinquished to the Treasury Department, rather than shareholders.

At the federal level of policy-making, decisions that affect the whole of the economy and money supply are made by the Federal Open Market Committee (FOMC), comprised of 12 members. Five of the 12 are chosen out of the presidents of the 12 regional banks, who are elected by the shareholders (private banks). The remaining seven are the Board of Governors, each of which are selected by the President of the United States and confirmed by the Senate in staggered 14-year terms.

So the Fed is an independent government institution that has private aspects. Its everyday operations are run by, essentially, private banks. Broad policy decisions are made by a committee of 12, five of whom come from private industry, and seven who are appointed by the President and approved by the Senate. While seven versus five shifts the FOMC in favor of democratic control, any democratic influence is mitigated by the lengthy terms, and it would be surprising if the banking lobby didn't have a lot of say on the canditates submitted for the position. In the end, it is rare for the FOMC to have a dissenting vote.

Now it is fine with me to have restricted democratic influence over money supply. If it were possible, the democratic majority would vote themselves massive pay raises. For a society heavily in debt, as ours is, its willingness to forgive all debt through hyperinflation would be practically unstoppable. Paper money originated from private banks as gold notes, and within the private sector money creation should probably stay.

The problem with private interests running central banks is this: not all citizens will have the same opportunity to access the discount window for cheap capital. Those who do will have a carry trade advantage over those of us unable to tap into the easy money available from Federal Reserve printing presses.

Tuesday, June 1, 2010

An Endless Money Supply

I've been wondering lately: can the Fed print or electrically create money and then spend it, or give it away to somebody else for personal or government spending? My answer to that from reviewing Fed policy and open market actions is that it cannot. The only way for the Fed to let loose newly-created currency would be to lend it out. It can lend it directly through the discount window to banks, with Treasury Bonds as collateral, or it can buy bonds directly, and then either sell them or hold them until the bond matures. In any case, releasing newly created money acts as a loan. No money can be released from the Fed without an expectation it will be paid back. Money dispersed in this way will sooner or later make its way back to the vaults of the Fed.

Now there is a way to game the system: if the Fed knowingly buys a junk bond that is obviously going to be defaulted on, without recourse, then newly minted money has been let loose in the system and is there to stay. Otherwise, all other money minted and lent by the Fed eventually disappears when it is paid back. The only way to achieve a stable money supply is where debt issuance equals the rate it is paid back.

The essence of our money supply is the willingness of people to take on debt. We know this is the case with fractional reserve banking, where loans in this way account for the creation of most of America's money supply. But it looks like a similar principle applies to base money as well. All dollars originate from loans. Whatever the total money supply is, that entire amount is owed back to the banks. If people, corporations, and governments were to stop borrowing, money supply eventually would dwindle to nothing as loans are paid off.

Maintaining a stable money supply depends on regulating the flow of credit. Inflation can be contained if the Fed increases the prime lending rate. Higher borrowing costs would discourage new loans. In a deflationary environment, to maintain stable prices, interest rates can be lowered and borrowing encouraged. We have seen a lot of that lately. But in a society mostly exhausted of credit, lending cannot be forced.

If people cannot take on as much credit as before, then there is no way to expand the money supply. Without a fundamental change in Fed policy enacted by Congress, deflation is the only legal option in America. There is no way now for the Fed to hyperinflate the economy (unless the exception I mentioned in the second paragraph becomes rampant).

We see this already in a recent expansion of base money starting in September of 2008. This base money expansion has been matched exactly by money sitting in bank reserves. The new money isn't being lent—it isn't finding any outlet into the general economy, and it is not creating inflation.

The point here is that the Fed is sitting on a virtual money supply that is infinite. From a supply perspective, the Fed cannot expand money beyond what it already is, because that amount is unlimited. What contains money supply from skyrocketing to infinity is demand for credit. If prices destabilize through expansions or contractions of credit, the Fed can attempt to maintain price stability by regulating interest rates or purchasing bonds. Unlike a gold standard where money is limited by the quantity of gold, our economy has no fixed limit for credit and is constrained only by peoples willingness to borrow from banks, and banks willingness to lend.