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Our Modern Banking System
Next, let us discuss some of the most critical problems with modern banking. We will start by developing a better understanding of how it works presently in the United States. While other countries differ in the details, they are very similar in general structure.
Many Americans don’t really understand what the Federal Reserve is. If they do, they probably just accept it as a given fact of life–just part of the way things are. Many people also think the Federal Reserve is somehow a part of the federal government. Neither assertion is true.
The Federal Reserve is not a part of the federal government at all. It is not exactly a private corporation either, but it is certainly not a government agency. Rather, it exists largely outside the control of government.
Legislators and presidents do not have the ability to audit its operations, they do not set its policies, nor can they hire or fire its employees. The primary link to government is a political one. The President appoints seven members of a board of governors, and the Senate confirms those appointments. The seven governors, together with the presidents of 12 regional central banks, form a committee who decide what our monetary policy will be. Such decisions are no longer in the hands of our elected representatives.
The Federal Reserve’s primary stated purpose is to regulate the size of the money supply. We have discussed the idea that if there is too much money, there will be inflation–the money will lose its value. If there is not enough money, the opposite will occur–deflation.
The theory of why deflation is bad is this: people can lose the incentive to spend their money because if they hang onto it, it will become more valuable later. There is also a disincentive to borrow because, as money becomes more valuable, wages fall, and it will be more difficult to pay off a loan in the future. We will discuss later some of the possible merits and flaws of this approach.
Most narratives on the subject also remind us, the Federal Reserve was created as a response to various financial panics and other economic crises that had occurred previously. The implication is, without a central bank, the normal economy will always be subject to periodic crashes. Those who have lost money in market corrections since 1913 wonder if the Federal Reserve has done much of anything to remedy this problem.
As a central bank, the Federal Reserve, or “Fed,” also serves as a lender to every private bank in the country. In order for a bank to do business, it is required to be a part of the Fed’s regulatory system. It must conform to Fed policies and maintain reserves according to Fed mandates. The theory is, no bank can fail due to a bank run, because the Fed can always make additional funds available in the case where depositors all demand their money at the same time. The result is, all banks can be thought of as a single banking system. They all succeed together, but they can also all fail together.
In order to regulate the size of the country’s money supply, the Fed has several methods at its disposal. First, it is able to set the official interest rate at which it will lend to all other banks. This assumes there is a certain natural demand in the market to borrow money. As we reviewed previously, money is debt and debt, created with a bank, is standardized money.
So the more people borrow money from banks, the more debt is created, and hence the more money there is in circulation. If you think about the money you borrowed to buy your house, you will see this is true. We have discussed how this money was not really borrowed from the bank, and that you really traded notes with the bank in order to guaranty your own private credit. If you accept this concept, you now understand that once your loan was closed, a bunch of new money came into being that hadn’t existed before.
You were able to give that money to the seller of your home in exchange for getting title to the home. Once the seller received your money, he probably began to spend it on something else. As he did, the money you created began to circulate around the economy in the exchange of goods and services.
To the degree your money got left in someone’s deposit account in a bank somewhere, that bank was then allowed to make more loans to other people, by a factor of 10. This created even more new money in the process. So as long as there are plenty of people lined up to borrow money, a single act of borrowing can cascade through multiple layers of additional borrowing, adding up to quite an impressive effect.
Lower interest rates are believed to stimulate more borrowing. And that makes sense. If the cost of borrowing is lower, more people should want to do it. If the cost is higher, borrowing is sure to slow down. So the theory is, by adjusting the interest rate down, the Fed can create an incentive for people to voluntarily enter into new borrowing agreements, creating new money at a predictable multiple. If they move the interest rate up, fewer people will be willing to take out new loans, so as old ones get paid off, the money supply will gradually contract.
The biggest problem with this type of control is that it really only works well in one direction. It is pretty easy to stop people from borrowing by making it too expensive. Raising interest rates is quite effective and they can be raised a lot if needed. But what if you begin to lower interest rates and people still decide not to borrow? What if they don’t want to borrow for other reasons?
Maybe they lack confidence in the economy and are unsure about their ability to repay the loans in the future. What if people become quite prosperous and have a lot of the commodities they want so they really don’t need to borrow so much anymore? What happens if you lower the interest rate to zero and they still are not borrowing enough to keep the money supply at the size you deem to be appropriate? Then, the method of adjusting interest rates begins to break down and central bankers have to try something else.
One other available method for adjusting the money supply is to dictate the reserve requirements for banks. This is the multiple that tells them how much in total loans they can create, as a function of how much money they have to keep on hand in deposits. Again, if there is an appetite for voluntary borrowing, changing the reserve rate can have a dramatic effect on the amount of new money created. But if people still don’t want to borrow for other reasons, it doesn’t really do much at all.
When adjusting the reserve multiple or the prime interest rate doesn’t work, central bankers generally tend toward another method which doesn’t require the cooperation of free people voluntarily deciding to borrow. It only requires the cooperation of the federal government. In this system, the Fed chooses to buy or sell government bonds, or loans. When it buys a bond, this is the equivalent of lending money to the federal government so new money is created. When it sells a bond, it is like getting debt paid back by the federal government so money is destroyed.
When the federal government borrows money, you know what happens next: it spends it. The money flows out into the economy and the theory is, it will get deposited and may cause a cascade of other borrowing activity as previously discussed. If it does not, then it has still had a small effect in increasing the money supply–just not as much as if other people were to keep borrowing to magnify the effect.
Politicians seem to be willing to spend more money whenever they are given the chance. And they don’t seem to mind going into debt to do it. So there is a cozy relationship between the government and the Fed, even if it is an unconscious one. Any time the Fed wants to use public debt to increase the money supply, they will get no argument from Washington.
In 2008, the United States experienced a liquidity crisis. Among other factors, federal regulations had been put in place encouraging banks to give mortgages to people who were not sufficiently qualified to borrow. The banks would never have otherwise approved their loans. But federally supported mortgage companies such as Freddie Mac and Fannie Mae had agreed to buy up many of these questionable loans. Also, firms on Wall Street figured out how to help banks comply with federal requirements by packaging the questionable loans and selling them as securities into the stock market.
This caused the banks to write bad loans they would never want to own themselves, earn a bunch of fees in the process, and then profit by selling the bad contracts to someone else who either didn’t understand that they were unlikely to be paid back. By the time everyone figured out what was going on, the total amount of the bad loans was so big, it had a major impact on the rest of the economy. The biggest insurer of mortgages faced probable bankruptcy and many of the country’s biggest banks teetered on the edge of insolvency.
While this “sub-prime mortgage bubble” was not the only problem to cause the financial crisis, it had a huge effect. Remember, when new loans are made, it means more money in the system. When those loans disappear, the money disappears too. The collapse of the sub-prime loans was a massive deflationary hit to the economy. And the lack of liquidity cascaded through the system creating crises in other areas as well.
Those who were paying attention at the time will remember the response of the government. We were told we needed an instant and massive government spending program–a stimulus, they called it. The government had to borrow hundreds of billions dollars and spend it immediately, and it didn’t really seem to matter so much what they spent it on. So TARP, or the Troubled Asset Repurchase Program was born.
The Fed bought enough bonds to get the job done, and the money supply received a shot in the arm. But it was not enough. Over the coming years, government spending soared to new highs but private and corporate borrowing did not recover for years. Each time a new appropriations cycle came around, it seemed everything was again in crisis. If the money was not approved and spent immediately, the economy was said to be in peril.
Congress stopped even trying to budget. Each year, spending continued to rise at a pre-programmed rate. The Fed dropped interest rates essentially to zero. But the money supply seemed still to be inadequate. People just didn’t want to borrow. Finally, the Fed got desperate and began to employ what are politely called “unconventional monetary policies” such as quantitative easing, or QE.
Under QE, the Federal Reserve purchases certain financial assets such as stocks or bonds from commercial banks or from other institutions in the private market. The idea is a two-fold approach: artificially raise the demand for the securities in order to keep market prices higher, and feed the market with additional money at the same time. In light of our assertion that money is debt, it might be confusing how this new money qualifies. But it is just like the goldsmiths who took in an asset of gold and replaced it with a certificate.
The Fed receives an asset such as a stock, or ownership in a company. It then issues Federal Reserve notes in payment. And those notes go into circulation in the economy. The hope is, eventually the securities can be sold back into the private market.
If that ever happens, the money will be extinguished and the stock will be owned by someone else. But QE is inherently risky because a stock or bond can lose some or all of its value. It is not nearly as dependable as gold, or a house or the promise of a hard-working American citizen. If the underlying business goes bankrupt, the stocks can become worthless. Yet the Fed notes are still in circulation. That leaves us back in the position of the unethical goldsmiths who printed phony certificates backed by nothing.
The ultimate result of unbacked money is a lack of confidence which can cause the equivalent of a “run on the bank.” Today when all banks are joined together in a single monolithic system, one has to wonder what form that will take. Even if it doesn’t result in a catastrophic breakdown, the issuance of this new money is bound to devalue the other, more legitimately created money in the system. Whether by gradual inflation and wage stagnation, or by a sudden economic meltdown, one way or another, the American worker is going to foot the bill.
The Fed went through three rounds of QE in which it bought, among other things, hundreds of billions of dollars of mortgage backed securities. The effect was to pull the stock market gradually back out of the slump it had fallen into as a result of the 2008 crash and to supply needed liquidity to the market, stabilizing the size of the money supply. But what will this cost in the long term? Because we can not audit the Fed, it is impossible to know the quality of the assets it holds to back our money supply. We may never know until it is too late.
In order to estimate the potential impact to the money supply, we can just look to the balance sheet of the Federal Reserve. Prior to 2007, it had assets valued on the order of about $700 billion dollars. As you will remember, the way fractional banking works, the total money created by loans can be much bigger than what the bank actually has on deposit. To keep it simple, imagine the $700 billion represents total commercial bank deposits on reserve with the central bank. Because of this multiplying effect, the Fed’s balance sheet was producing a total money supply of about $7 trillion dollars.
In the following 7 years, as a result of Quantitative Easing, the Fed’s assets would soar to over $3.5 trillion, or roughly 5 times larger. And the debt of the federal government would roughly double from $9 trillion to $18 trillion over the same time period. That debt is guaranteed by the taxes collected from the American people.
It is an obligation we must repay, but one which we never agreed to. We will have to work for decades to service a debt incurred because of the decisions made by an unelected, private banking monopoly. It is, in the true sense of the phrase, involuntary servitude.
As of this writing, the Fed has discontinued QE, hoping the economy can get strong enough to start managing the money supply on its own without such unconventional stimulus. But just as with the removal of any artificial force, internal feedback mechanisms sent shock waves through the system. The markets entered a new phase of volatility and investors became less confident.
No one is quite sure how the Fed policy will work out. And no one is sure what will happen with such a bloated Fed balance sheet when people and companies begin again to borrow at historical rates. Will we see inflation again, and how much? Will interest rates have to be raised, and by how much? And what will the effect be on economic production?
Several things seem sure: The quality and dependability of the US Dollar has been severely damaged. The debt of the US government has increased dramatically and there is no reason to trust it ever will be diminished. Eventually the debt will become unsustainable and unrepayable. Then people will lose whatever is left of their confidence in the United States dollar.
More and more people are beginning to ask questions about the Federal Reserve:
- Does it really have the ability to prevent financial crises or might it create as many as it avoids?
- Can a multi-trillion dollar monetary supply really be managed by a board of 12 bankers?
- If a central bank is so critical, how did we manage in America for 135 years without it?
- Is it possible our monetary system is just as fatally flawed as that of Zimbabwe and it is only a matter of time until it will fail in a similar way?
