The Fed Already Has a Blank Check

In the interest of continuing the conversation, I want to argue a contrary position and push back a bit on Steve Waldman's post about allowing the Fed to pay interest on reserves, and his worry that this change will allow the Fed to put excessive amounts of public money at risk:

Let's not write the Fed a blank check, by Steve Waldman: Last week, the Fed decided to ask Congress for the right to pay interest on bank reserves. (Hat tip Barry Ritholtz, see also William Polley, Mark Thoma, Brad DeLong) This is a very big deal.

Don't be misled into thinking that the Fed's proposal is just some arcane, technocratic change. The Federal Reserve is asking taxpayers for a big pile of signed, blank checks. That's far too much power to put in the hands of a quasipublic organization with little democratic accountability. This authority should not be granted without some strong strings attached. ...

First, some background. There is a trend among central banks to move from old-fashioned, fractional-reserve banking to a system whereby interest rates are managed via a "channel" or "corridor", and under which fixed reserve requirements might be dispensed with entirely. The basic idea is simple. The Fed ... choose two interest rates, a "floor rate" at which the Fed would stand ready to borrow funds, and a "ceiling rate" at which the Fed would stand ready to lend. As long as there is no stigma attached to transacting with the Fed, banks would never lend for less than the floor rate or borrow for more than the ceiling rate. The interbank interest rate would necessarily lie within a "corridor" defined by these two interest rates. ...

A corridor system would represent a meaty change to how central banking is done in the US, but the approach seems to work okay in other countries. ...

As long as the Fed is conducting ordinary monetary policy, switching to a channel system offers modest benefits at a modest cost to taxpayers. But the Fed's monetary policy has not been ordinary at all lately. In fact, it's been quite extraordinary. It is in the context of this extraordinary policy that the Fed has asked Congress to accelerate its authority to implement a channel system...

The core of the Fed's new exuberance is a willingness to enter into asset swaps with banks. The Fed lends safe Treasury securities to banks, and accepts as collateral assets that private markets consider dodgy or difficult to value. (This is the direct effect of the Fed's TSLF program, and the net effect of TAF and other lending arrangements that the Fed sterilizes in order to hold its interest rate target.) In doing so, the Fed puts taxpayer funds at risk. If a bank that has borrowed from the Fed runs into trouble, the Fed would face an unappetizing choice: Orchestrate a bail-out, or permit a failure and accept collateral of questionable value instead of repayment. Either way, taxpayers are left holding the bag. ...

In December, the Fed had $775 worth of Treasury securities. That stock will soon have dwindled to $300B, give or take. The difference, about $475B, represents an investment by the central bank in risky assets of the US financial sector.

$475B is an extraordinary sum of money. It is as if the Fed borrowed more than $1500 from every man, woman, and child in the United States, and invested that money on our behalf in Wall Street banks that private financiers were afraid to touch. For bearing all this risk, if things work out well, taxpayers will earn about what they would have earned investing in safe government bonds. If things don't work out well, the scale of the losses is hard to predict. ...

If the Fed were to blow through the rest of its current stock of Treasuries, it would have invested more than $2500 for every man, woman, and child in America. Public investment in the financial sector would have exceeded the direct costs to date of the Iraq War by a wide margin. Would that that be enough? If not, how much more? Just how large a risk should taxpayers endure on behalf of companies that arguably deserve to fail, to prevent "collateral damage"? Have we considered other approaches to containing damage, approaches that shift costs and risks towards those who benefited from bad practices, rather onto the shoulders of taxpayers and nominal-dollar wage earners? Does this sort of policy choice belong within the purview of an independent central bank?

Now I don't actually mean to be too harsh. Putting aside the years of preventable foolishness that got us here, ... a crisis emerged that had to be managed and the Fed was the only organization capable of stepping up to the plate. I don't love the decisions that were made, but decisions did have to be made, and there weren't very good options. But now we have a moment to reflect. If the credit crisis flares hot and bright again, how much more citizen wealth should be put at risk before other policy options are considered? That's not a rhetorical question: We need to choose a number, a figure in dollars. My answer would be something north of zero, but not more than the roughly $300B stock of Treasuries that remains on the Fed's balance sheet. But this is a decision that Congress needs to make.

And what does all this have to do with the question that will soon be put before the Congress, whether the Fed should be permitted to pay interest on deposits?

Everything, as it turns out. Suppose the Fed decides it wants to swap more than the $300B in Treasury securities it currently has available in order to support the financial system. Given its current tools and practices, the Fed would have to print money in order to buy more Treasuries to swap. But if it did that, the extra cash would drive interest rates below the Fed's target level, quite likely provoking inflation. The Fed cannot simultaneously swap away more than its existing stock of Treasuries and satisfy its legal mandate to promote price stability, unless it resorts to something weird.

But suppose Congress gives the Fed the authority to pay interest on reserves. Suddenly the Fed can print cash to buy all the Treasuries it wants to swap for troubled assets. When banks find they have more cash than they need, they lend the money back to the Fed, collecting the "floor" interest rate and removing the currency from circulation. Since interest rates can be held to any level by adjusting the "corridor", the Fed would retain the flexibility to respond to inflation. At the same time, it would be able print cash in any amount that it pleases — "to infinity and beyond!" — in order to fund asset swaps (or outright purchases) at taxpayers' risk. This strikes me as a delegation of Congressional authority that would not only be undesirable, but arguably unconstitutional.

So, should we simply refuse the Fed's request? Probably not. Brad DeLong makes an excellent point:

The Fed may also want to raise the general level of interest rates in order to fight inflation--which requires that it sell its Treasuries for safe bank reserves rather than temporarily swap them for risky MBSs.

The Fed is already rubbing pretty close to its "balance sheet constraint". If, after exposure to gamma radiation from televised images of food riots, Ben Bernanke were suddenly transformed into The Incredible Volcker, he might lack the tools he'd need to jack rates up into the muscular high teens, unless he's given this new authority. So what should we do? James Hamilton has an answer:

Congress has a quite proper role in determining the magnitude of the fiscal risk that the Fed opts to assume... [A] statutory limit on the non-Treasury assets that the Fed is allowed to hold might make sense. Perhaps the outcome of a public debate on this issue would be a decision that the Fed needs the power to lend to private borrowers even more than the $800 billion or so limit that it would run into from completely swapping out its entire portfolio... Or perhaps after deliberations, Congress would decide that the business of swapping Treasury debt for private sector loans is one that is better run by the Treasury rather than the Federal Reserve.

I agree. I think that Congress should grant the Fed's request, but it should simultaneously impose constraints on the composition of the Fed's balance sheet that cannot be violated without express legislative consent. This will be a complicated exercise, unfortunately. Besides government debt, central banks quite ordinarily hold precious metals and foreign exchange, and limitations on non-Treasury assets will have to take this into account. Plus, restrictions would have to be written carefully to apply to off-balance sheet arrangements such as TSLF, and contingent liabilities like the insidious reverse MBS swap proposal. Finally, Congress must consider restrictions on the Fed's ability to enter into derivative positions, whether directly or indirectly via special purpose entities, including how the bank's existing derivative book should be managed and whether the bank should or should not guarantee the liabilities of current Fed-affiliated SPEs.

Congress might also limit the quantity of reserves on which the Fed will be permitted to pay interest.

The Fed can retain full independence for the purpose of conducting ordinary monetary policy, exchanging government debt for cash and vice-versa. But if the central bank wants to put ever greater quantities of public money at risk, it will have to accept a lot more public supervision. If the prospect of intrusive oversight is too much for the Fed, then, as James Hamilton hints, perhaps the roles of central bank and macroeconomic superhero should be moved to separate boxes on the organizational chart. If we are not careful, the next bank requiring a taxpayer bailout may be the Federal Reserve system itself.

This is an old problem - how much authority should be centralized thereby allowing quick and immediate response during a crisis, and how much should be retained in slower, deliberative bodies like the House and Senate? The War Powers Act reflects this compromise - we want the ability to respond quickly to an attack or other military developments, but we worry about the concentration of power in the hands of a single individual. Centralization has the benefit of allowing a quick response to a crisis, but it risks being out of step with the democratic process. In the case of financial market emergencies, however, I have more faith in the Fed than in congress to act quickly and correctly. That's partly because I have little faith in the ability of congress to quickly comprehend what the problem is and attack it directly and effectively - many of them admit to not having a clue about economics, and more worrisome are the ones who think they have a clue but don't - but congress should not give up its oversight role.

Some "off the cuff" thoughts:

1. Public money is always at risk when the Fed does open market operations. The amounts may not be as large, but the risk is always there. For example, suppose the Fed prints $100 and purchases a T-Bill for $100, and that while it is holding that T-Bill, the price falls to $75. The Fed has just taken a 25% loss - if it tries to sell the T-Bill back to the public, it will get less for it than it paid originally. The big difference is that with MBS and other risky securities there is default risk - the value could fall to zero - but this is about the magnitude of the loss, not the fact that the Fed is able to put taxpayer money at risk. In addition, every action the Fed takes can affect the public treasury. If monetary policy changes GDP, tax collections change and this affects the deficit. Similarly, when the Fed changes the interest rate, the amount of interest paid on the accumulated federal debt changes - and this can be quite a bit of money. So everything the Fed does has the potential to hit you in the pocketbook, and if it makes a big mistake, the hit could be fairly large (a 3% decline in GDP is more than 400 billion dollars). The fact that the Fed can impact your pocketbook is nothing new. [Update: the first comment makes me realize I should have been more careful here, this is only the Fed's part of the government balance sheet, and I should have noted this is not the main argument - that is in 3 and 7 - i.e. that the Fed already has the authority to put money at risk so that is not a reason to object to paying interest on reserves.].

2. The Fed's ability to purchase risky securities comes under emergency authority. When the emergency ends, the ability ends, so this criticism is only about extraordinary times in financial markets. There haven't been many of those.

3. The channel of corridor system does not alter the Fed's ability to put public money at risk, it can do that now. For example, the worry above is that the Fed will want to take risky securities off the market by trading them for safer government bonds, but it might run out of government bonds to trade. If it does, it can print money to purchase more risky assets, but this could be inflationary. To avoid the inflation, it buys the money back by offering to pay interest on reserves (notice what happens if the value of the risky assets the Fed is holding falls to zero - it gave out money for free, then buys it back by paying interest). But the Fed can already do this under existing authority - it can already purchase risky securities and avoid inflation even when its inventory of T-Bills is zero. Just do as above, print money to purchase the risky securities, then increase the required reserve ratio and make banks hold the extra reserves in the vault or at the Fed (at zero interest). This avoids the potential for inflation, and it does not require that the Fed pay interest on the extra reserves banks are forced to hold. The difference between the current procedure and a corridor system is that under the corridor system banks are compensated with interest for being forced to hold reserves idle, but they can be forced to hold the reserves at zero interest under existing authority.

4. The worry seems to be that the Fed will lose all $475 billion. If there are losses, it is likely to be a fraction of the total, not the full amount. If it is the full amount, we're in big trouble anyway, and the Fed was probably correct to try to prevent such a disaster. But we should probably value the loss as a probability times $475 billion, not as the whole amount.

5. Are there losses? If the Fed prints money and buys an asset, it has created an asset out of thin air - newly printed money - and purchased an asset from the private sector. Thus, by creating as asset out of thin air, the Fed was able to get something of value. If the asset the Fed bought - say an MBS - has its value fall to zero, then the effect is just as if the Fed printed money and gave it to the public - dropped it out of a car on the street, dropped it from a helicopter, something like that. But where is the loss? (That's a question, I need to think about the "seigniorage", etc. aspects a bit more.)

6. Steve says:

It is as if the Fed borrowed more than $1500 from every man, woman, and child in the United States, and invested that money on our behalf in Wall Street banks that private financiers were afraid to touch. For bearing all this risk, if things work out well, taxpayers will earn about what they would have earned investing in safe government bonds. If things don't work out well, the scale of the losses is hard to predict.

But isn't the return is larger than this? Shouldn't we include the (probabilistic) benefit from not having slipped into a major recession? If, say, $250 of the $1500 is lost, but by taking the action the Fed prevented a fall in GDP valued at, say, $500 per person, aren't we better off? As noted above, a 3% fall in GDP for one year is over $4oo billion.

7. The main thing to note is that the Fed already has a "blank check" through manipulation of reserve requirements as described above. If you are worried about the Fed putting public money at risk in an emergency, that risk already exists and the corridor or channel system does not change that. So I don't see this as a valid objection to the channel or corridor system.

Comments

[Bruce Wilder]

Mark Thoma: "For example, suppose the Fed prints $100 and purchases a T-Bill for $100, and that while it is holding that T-Bill, the price falls to $75. The Fed has just taken a 25% loss - if it tries to sell the T-Bill back to the public, it will get less for it than it paid originally. The big difference is that with MBS and other risky securities there is default risk - the value could fall to zero - but this is about the magnitude of the loss, not the fact that the Fed is able to put taxpayer money at risk."

This is not the most coherent argument you've ever made. The Fed bought the T-bill with money it created, and it is a T-bill, a debt security for which the taxpayers are on the hook, regardless of its market price. And, strictly speaking, the Treasury Department issued the T-bill and printed the $100 bill, fully subject to express Congressional authority. Any change in the market value of T-bills is something the Fed controls (if it wants to), and doesn't alter the nominal obligations of the taxpayer to pay interest and principal, in any case. All that this example really shows is the Fed is powerful enough to affect the economy, and I think we knew that; it does not really address Waldmann's concerns about "putting taxpayer money at risk", which is really a constitutional concern about the Fed effectively taking over the Congress's exclusive authority to appropriate funds and levy taxes.

[JKH]

Re Number 5:

If the Fed prints money and buys an asset, it increases central bank revenue by the amount of income from the asset.

This becomes a net increase in central bank earnings and government revenue if the Fed finances this with free funding by increasing bank reserve requirements (non-interest paying).

If the asset value falls to zero, the Fed incurs an economic opportunity cost in the amount of income foregone on the asset.

If the asset value falls to zero, the Fed also incurs an equity accounting loss when the asset is written off.

Regardless of the performance of the asset at the Fed, the net interest margin of the banks declines by the amount of interest paid on funding to finance the increased reserve requirements.

This is a real economic cost to the banks.

This economic cost will be offset, risk adjusted, if the asset at the Fed performs.

It will be a net cost to the economy if the asset value falls to zero.

[Mark Thoma]

The main argument is in 3 and 7. I'm saying that paying on reserves doesn't change anything, the Fed already has the authority to put money at risk. The point of 1, whatever the details (I am talking just about the Fed's balance sheet, not the combined balance sheet, and I should have noted that), is that the Fed already has the ability to change tax collections, etc., i.e. to effectively levy taxes in the sense you mean.

[JKH]

Increasing either required or excess reserves, and paying interest on them, keeps the banks whole, more or less. The Fed’s expected seignorage due to a risky asset is the risk premium in excess of this interest cost.

Increasing required reserves, and not paying interest on them, shifts the interest cost to the banks. The Fed’s expected seignorage due to a risky asset is the full expected revenue on the asset, which equals the risk premium plus the avoided interest cost.

[kthomas]

Thanks, JKH. I just learned something, now my head's about to explode.

[Mark Thoma]

Yes: I think another way to say this is that the reserves banks hold have an opportunity cost, and if banks are forced to hold them, they forgo the opportunity - so that is the cost. Paying interest "keeps the banks whole, more or less."

On revenue, agree again - if the fed creates $100 and buys an asset, then pays 10% on the deposits (assume the bank keeps the $100 as reserves for simplicity), it is out $10. But if the asset it purchased earns $8, it is only out the difference, i.e. the $2 or 2% that is paid.

But if it pays zero on the deposits, it keeps the whole $8, i.e. earns 8%.

In a steady state, seigniorage is (inf/(1+inf))*(high powered money). This arises becasue inflation erodes real money balances. As it does so, the private sector increases its demand for nominal money (to keep real balances constant). By supplying this demand, i.e. printing more money, the government is able to either purchase goods and services, or offset other taxes.

Another view of seigniorage is that it's equal to (int rate/(1+inf))*(high powered money). This includes another term, the saving to the government when it shifts from interest bearing to non-interest bearing debt as it issues money (this doesn't apply when it purchases risky securities). Interestingly, under the proposal to pay on deposits, which makes high-powered money interest bearing, these two measures of seigniorage begin to converge. If the interest rate on bonds and reserves is the same, there is no saving at all from moving from bonds to high powered money.

[crack]

So your saying if I put my $100 in a savings account a bank can take that $100 and save it with the Fed. The bank can then pay me less than the rate they get with the Fed, and I still have all the catastrophic risk. Awesome. Where do I sign up?

[ampersand]

But isn't the return is larger than this? Shouldn't we include the (probabilistic) benefit from not having slipped into a major recession? If, say, $250 of the $1500 is lost, but by taking the action the Fed prevented a fall in GDP valued at, say, $500 per person, aren't we better off? As noted above, a 3% fall in GDP for one year is over $4oo billion.

Obviously, economists have forgotten all about efficiency vs distribution.

Having a secure, tenured, inflation proof income does funny things to the brain.

[Regressive]

Good plan. Everyone is forced to work overtime, but no one can afford to buy anything because the borrowers have already bid the prices up to the moon with newly created money. Those too old/disabled to work more overtime eat cat food due to high prices.

If you want to encourage borrowers to consume more, tax the rich, and loan that out at low rates. Enough with extracting resources via the regressive inflation tax which disproportionately harms society's most vulnerable members.

[Bruce Wilder]

Waldman's argument, if I understand it correctly, is that the Fed is making this otherwise sensible proposal now, in large part because its emergency asset-side operations have left it standing the breeze with no pants. Or, to put it less poetically, because the Fed has no good way to expand asset-side operations, without appreciably adding to inflation. Waldman surmises that the Fed wants this change to restore its flexibility.

And, he sees that that this proposal, coming at this moment, paves the way for making traditional fractional reserve requirements obsolete.

There's an element of the wastecan theory of political decision-making at work, here. Waldman really wants to regularize this highly irregular business of "rescuing" or "dismantling" Bear Stearns. There's no obviously good way of initiating such a reform, without calling into question the legitimacy of what has been done. But, the present proposal suggests a tenuous connection. So, into the wastecan goes the rescue of Bear, Stearns and right behind it, in the next wad, is the problem of derivatives:

"Congress must consider restrictions on the Fed's ability to enter into derivative positions, whether directly or indirectly via special purpose entities, including how the bank's existing derivative book should be managed and whether the bank should or should not guarantee the liabilities of current Fed-affiliated SPEs."

If the thesis is simply that Congress ought to address all of these things -- how, and by whom, investment banks will be declared insolvent; how derivatives and the liabilities banks acquire as a result should be handled; as well as the corridor -- in omnibus reform legislation, I'm inclined to agree. If there is any urgency to the corridor proposal, then that urgency only reinforces that connection Waldman draws to the current irregular asset-side operations and venturesome oversight of investment banking.

[paine]

interest on reserves ????
why pay for what you can get for free ???

my guess
a far more activist fed on the way to macro aims
may want to pay for its micro impact
on the various privately held banks' bottom line

btw
i'm a channel guy from way back

go for it gentle ben go for it

as to congo oversight

whats in this but mechanics
nothing to it that would prevent
congo control long term

then again
i'd like mark's very apt
war powers analogue
if that particular re assertion of congo control
had worked out the way
its post nam drafters had intended

[James]

Liberals are drawn to the concept of a centralized intellgentsia making the key decisions like moths to a flame.

[Winslow R.]

"All that this example really shows is the Fed is powerful enough to affect the economy, and I think we knew that; it does not really address Waldmann's concerns about "putting taxpayer money at risk", which is really a constitutional concern about the Fed effectively taking over the Congress's exclusive authority to appropriate funds and levy taxes."

Right. The Fed shouldn't be buying anything but treasury securities, or the 'people's debt'. If there isn't enough public debt, then we need more deficits not bank bailouts.

In terms of the channeling, I see two benefits...
1) It removes the need for the interbank market leads to BW's dissolution of the fractional banking system.

2) It removes the need for the open market desk and leads to the Treasury no longer needing to issue long-term debt.

As to James, it is important to create a system where the 'centralized intelligentsia' are running an optimal system, not making key decisions on who wins and loses.

[a]

Haven't read it all, stopped here:
"The big difference is that with MBS and other risky securities there is default risk - the value could fall to zero - but this is about the magnitude of the loss, not the fact that the Fed is able to put taxpayer money at risk."

Well it's much better to be holding TBills, because their value is likely to increase in the event that a bank defaults, while the value of MBS and other risky securities is likely to go down. That is, TBills and other extremely safe assets will benefit when there's flight-to-safety, and that's exactly what would happen should Citi or some such default.

[swells]

It is difficult for me to understand this situation. Yes, I do get that banks don't make any money on the amounts they hold as reserves. Um, the non-profit I work for doesn't make any money on the building it occupies either. It's an item that is integral to being able to do the work it does.

Why should a bank be making money on an item that is integral to it doing the work it does? It seems to me that a whole lot of the money banks would be lending to the fed would be money that they do not pay interest on in the first place, non-interest bearing money people deposited in checking accounts, etc.

Wouldn't this plan just amount to a further leveraging? Is more leverage what we need?

[Lawrence K]

Dear Mark

You ask "If the Fed prints money and buys an asset ... (and) its value falls to zero ... where is the loss?"

The answer lies with Inflation Tax. When the Fed prints money, it devalues the money the public holds - it is essentially a real tax on the holders of money. If they use it to buy worthless security from an investment bank, this is equivalent to taxing the general public to give a grant to the shareholders the investment bank.

We should object if the Fed uses an inefficient tax (inflation) to subsidize the wealthy.

[Winslow R.]

swells wrote:"Wouldn't this plan just amount to a further leveraging? Is more leverage what we need?"

It should do the opposite.

If you define leverage as the amount of loans/reserves and define reserves as Fed/gov issued currency then leverage should be reduced as banks will be more willing to hold reserves as they will now pay interest just as other bank capital does.

The importance of holding reserves has been reduced, in the past, through various banking methods (securitization) allowing for a reduction of bank capital that is held in the form of reserves.

Capital adequacy ratio
Bank capital is calculated by risk weighting assets (public and private securities) with the reserves (public securities) portion of that capital carrying no risk. Increasing the proportion of bank capital composed of reserves should provide added stability to the system and reduce the effect of risk weighted capital (private securities) evaporating.

At some point, in order to meet additional loan demand, the choice to allow a decrease in the capital ratio will once again be be an issue.

Will we once again fall into the trap of allowing the system to overleverage/undercapitalize in order to meet increased loan demand or is there a better way? I say yes but somehow we aren't there yet.

Economists seem to think the best way meet additional loan demand is to allow banks to create loans based on inflated asset values and then allow these inflated private assets to be included in bank capital. Once the value of the private assets collapse, then have government recapitalize the banking sector with reserves (public money).

Screwy.

[flow5]

(1) Winslow R" "At some point, in order to meet additional loan demand, the choice to allow a decrease in the capital ratio will once again be be an issue." The Financial Services Regulatory Relief Act of 2006 already provides for the reduction of bank capital.
(2) you can't peg currencies & you can't peg interest rates.
(3) The effect of tying open market policy to a fed. funds bracket or rate is to supply additional (and excessive legal reserves ) to the banking system when loan demand increases.
(4) New Zealand pioneered this procedure & their interest rates went to 8% + (zero-bound & zero-reserve banking)
(5) all 10 countries operating under this procedure report M3 (our means-of-payment money will eventually approximate this figure)
(6) the effect of Fed operations on all other interest rates is INDIRECT, and varies WIDELY over time, and in MAGNITUDE.
(7) Since the expansion coefficient has been emasculated (1996), what the net expansion of the money supply will be, won’t be known until long after the fact.
(8)Governor Meyer: "enhance the COMPETITIVENESS of depository institutions" could consider reducing or even eliminating reserve requirements, thereby REDUCING a regulatory burden for all depository institutions" I think not:
From a systems viewpoint, member commercial banks as contrasted to financial intermediaries, never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing demand-deposits, or time-deposits nor the owner’s equity or any liability item.

When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions) and every person, except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money-DDs.

I.e., the lending capacity of the member commercial banks of the Federal Reserve System is limited by the volume of legal reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities as fixed by the Board of Governors of the Federal Reserve System.

Contrary to Meyer, if there is any competition, it is soley between the individual (member) commercial banks within the Federal Reserve system (not the non-banks).

A brief “run down” will indicate just how costless, indeed how profitable – to the participants, is the creation of new money. If the Fed puts through buy orders in the open market, the Federal Reserve Banks acquire earning assets by initially creating new inter-bank demand deposits. The U.S. Treasury recaptures about 95% of the net income from these assets. The commercial banks acquire free legal reserves, yet the bankers complain that they are not earning any interest on their balances in the Federal Reserve Banks.

On the basis of these newly acquired reserves, the commercial banks can, and do, create a multiple volume of credit and money. And, through this money, they acquire a concomitant volume of additional earnings assets.

The process can be started by bankers who have over-extended their lines of credit, or for what ever reason impels them. They go into the federal funds market, the FFR is bid up and the Fed (as is its wont in the past 44 years) jumps in with open market purchases to accommodate. Thus the Fed laid the legal basis for a multiple expansion of money credit and bank earning assets.

How much is this multiple expansion of money, credit, and bank earning assets? Thanks to fractional reserve banking (an essential characteristic of commercial banking) for every dollar of legal reserves pumped into the member banks by the Fed, the banking system can, and does, acquire about 100+ dollars in earning assets through credit creation.

Initially, all credit creation involving dealing with the non-bank public results in a concomitant expansion of means-of-payment money. Over time, due principally to the trend increase in the public’s hold of currency, and the diversion of saved demand deposits into time and savings deposits, the multiplier for money declines to xx. That is for every dollar of open market purchases by the Fed $xx are added to the means-of-payment money supply.

Unfortunately for the rest of us, this money creation does not provide the remotest assurance or possibility that the dollars created will be matched in the marketplace by an offsetting addition to the volume of goods and services offered.

(10) There is no tax and there is no competition from outside the member money creating depository institutions.

[flow5]

The banks did just fine when legal reserves reached 91.1% in 1941.