AP photo courtesy VOA News
AP photo courtesy VOA News

In Bernanke: Fed Prepared to Act, published September 29, 2011 in the Wall Street Journal, Luca Di Leo writes “Federal Reserve Chairman Ben Bernanke … is prepared to take more unconventional policy steps …’because we don’t want deflation.’ …”

Part I – my first essay on this subject – addressed “Money”.  It represents the abstract concept of “Value” the way Temperature represents “Warmth”.  It requires “Tokens” (the equivalent of “Degrees”) to show us how much “Value” exists and who owns it.  The “Value” of all “Money” (“Tokens”) in the economy must be kept equal to the “Value” of all the unconsumed stuff that can be bought with it.  And that means “someone” must be legally empowered to create and destroy “Money” to maintain that equality.

In America, that “someone” is a collection of 12 Banks known as the Federal Reserve (“The Fed”) and how they manipulate “Money” is often called “Money Mechanics”.

Like regular banks, The Fed’s banks are owned by stockholders — not by the federal government.  Unlike regular banks, it’s as impossible to trace their ownership, as it is to trace the ownership of a drug cartel.  All we know for sure is all nations have Reserve Banks, and all Reserve Banks seem to own each other.

But that’s exactly like being told GM & Honda own Audi, Honda & Audi own GM, and Audi & GM own Honda — Nice to know, but you still have no idea which human beings are calling the shots.  [Note:  According to The Fed’s web site it paid stockholders $990 million in dividends in 2007.  I can’t find any disclosure for years after the 2008 elections.]

Regardless, The Fed has an exclusive charter from Congress to supply America’s economy with “Money” that has a stable “Value”.  To permit The Fed to do that, Congress gave The Fed legal authority to maintain accounts for regular banks whose account balances The Fed may quite literally increase or decrease with a “Mouse-Click”.

That is very different from regular banks that are only legally allowed to increase or decrease the balance in a customer’s account when the customer deposits or withdraws “Money” that already exists.  (Otherwise those accounts would be useless as the primary “Tokens” used in America’s economy to tell us how much “Money” exists and who owns it.)

Just as obviously, such unlimited power requires some constraint, so (at least before 2008) The Fed constrained its use of that power to two methods.

One method involves buying and selling U.S. Treasuries.  I believe that’s best described by the purpose to which The Fed most frequently applies that method today:  “Monetizing Government Debt”.  The other method is universally referred to as “Fractional Reserve Banking”.

Method 1: Monetizing Government Debt:

This is simple.  To create “Money” the Fed finds a regular bank that already owns say a Billion of U.S. Debt, i.e. owns a Billion of U.S. Treasuries, and buys them.  It pays for them by simply “Mouse-Clicking” an increase in that bank’s account balance at the Fed a Billion higher.  Account balances are “Tokens” for “Money”.  Therefore that creates a Billion of new “Money” – from nowhere.

[The Fed destroys “Money” by selling Treasuries and “collecting” the purchase price by “Mouse-Clicking” the bank’s account balance lower, i.e. “Mouse-Clicks” “Money” back into nowhere.]

Note: Regular banks have reasons for owning Treasuries in the first place, so they invariably use the new “Money” to buy replacements.  Sometimes they buy them from people who then spend the new “Money”.  However, today America’s insanely indebted federal government is more likely to uses the existence of a new Billion of “Money” to issue a new Billion of Treasuries it sells to the bank, i.e. so it gets to borrow and spend another Billion.

Hence the term Monetizing Government Debt — A Billion of new debt shows up as a Billion of new “Money”.

[Note: In 2008-2009 The Fed assumed the power to use “Mouse-Click” “Money” to buy a Trillion of Fannie Mae Junk from foreign banks and some (favored) Wall Street investors – at full price even though no one else would give a “plugged nickel” for them.  And subsequently Bernanke’s been reported to say The Fed even has the power to use “Mouse-Click” “Money” to buy furniture and store it in warehouses to create the illusion of economic activity.  FYI:  The Fed’s net purchases of Treasuries and Fannie Mae Junk to date is approaching 3 Trillion.]

Method 2: Fractional Reserve Banking (“FRB”):

This is more complex, more powerful and more dangerous than Monetizing Debt.  That’s because it involves The Fed leveraging its “Money” creating power by sharing some of it with regular banks.

The amount of power the Fed shares fluctuates, but it generally hovers around 90%.  However by convention everyone describes FRB in terms of the amount it doesn’t share.  That means sharing 90% is described as a 10% “Reserve Requirement” (RR), sharing 80% as a 20% RR, and sharing 0% as a 100% RR.

You and I have a 100% RR, i.e. 0% ability to “Mouse-Click” “Money” into existence – from nowhere.  So to loan you $1,000 I must already have the entire $1,000.

Regular banks are different.  They have a 10% RR.  That means to loan $1,000 all they need to have on hand is 10%, or $100.  Under FRB, they can “Mouse-Click” the other $900 (90%) into existence — from nowhere.

I know that offends common sense, but it works.  Just remember that when the regular bank system loans the public say $300 Million for mortgages, we don’t walk out of the banks with $300 Million in our pockets.  We leave it in the system as $300 Million of new checking account balances somewhere.

Thereafter, we mostly buy and sell things by decreasing a buyer’s checking account, and increasing a seller’s account by the same amount, i.e. without anyone withdrawing any “Money” from the system.  Therefore, no one cares if the total of all loans is 10 times the amount of “Money” actually deposited in regular banks until a large number of depositors withdraw their “Money” at one time.  Then it “Runs” the bank into ruin.

Mechanically here’s how The Fed uses FRB to create say 10 Billion more “Money”.  First it induces regular banks to borrow say 1 Billion from the Fed by offering them an “irresistibly” low rate of interest.  The Fed makes the loan by simply “Mouse-Clicking” a 1 Billion increase into the borrowing banks’ account balances at the Fed.  Under FRB those banks can now relend 10 Billion, i.e. the 1 Billion (10%) now on hand from The Fed, plus another 9 Billion (90%) they are allowed to “Mouse-Click” into existence – from nowhere – by themselves.

For purists: A single bank doesn’t produce the 10 Billion directly.  The Fed’s loan lets bank 1 re-loan 90% to create a new account balance at bank 2.  That permits bank 2 to re-loan 90% to create a new account balance at bank 3, and so forth.  The result is a “monotonically decreasing convergent series” of new account balances – 100%, 90%, 81%, 72.9%, 65.6% … 0% — that eventually adds up to 1000%, i.e. 10.

Regardless, the important point is that FRB applies a 10 to 1 multiplier to The Fed’s loan.  And that means FRB also applies a 10 to 1 multiplier to borrowers’ repayments.

Note carefully:  FRB is dramatically less controllable than “Monetizing Government Debt”.

That’s because The Fed doesn’t need to earn the money it uses to buy and sell Treasuries, so it can always overbid any other buyer when it wants to buy, and undersell any other seller when it wants to sell.  However, Fractional Reserve Banking only works if people are willing to borrow.  E.g. although The Fed is offering to loan banks “Money” at near Zero interest rates banks are not borrowing much.  In fact, not so long ago, Japan’s desperate Reserve Banks had to offer negative interest to get its regular banks to borrow – yes that means paid them to take the “Money”.

And that means borrowers can thwart The Fed’s ability to create “Money”, or even override and reverse it.  Space doesn’t permit a full demonstration, but if America’s borrowers collectively embarked on paying down their debt, with as little as a steady 3% – 5% annual reduction, FRB’s 10 to 1 multiplier (in reverse) could set off runaway deflation The Fed literally could not stop.

I will allow others to argue whether that would only be “God Awful” or “Un-survivable”, but it seems clear that fear of it being “Damn Near To Happening” has made Bernanke’s and The Fed’s actions ever more ill-conceived, if not reckless.

And fear it they should.  Deflation crushes debtors and rewards lenders: The U.S. is the world’s biggest debtor, and some of its sworn enemies are its biggest lenders. Enough said.

Part III will apply the foundation laid in Part 1 (“Money”) and this Part 2 (“Money Mechanics”) to explain what silly Fed euphemisms like “Twisting” and “QE2” means, and what they could mean for America’s future.

George L. Berish is a Honolulu resident who is with The American Political Party