Basic question on Fed working

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chankya2703's picture
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Basic question on Fed working

Hello

 

My name is sharma. I have a a basic question on Federal Reserve Bank Operations.

 

On last Wednesday fed decided to purchase 600 billion assets to increase the money supply. The question is Is Fed creating the money(priniting) or creating debt.

 

In eiter cases, how does it get accounted for. I looked at the fed reserve balance sheet. In the asset components what gets affected due to the purchase of the assets? If it is creating money out of thin air, what Journal of Entry is applied. Just wanted to be clear.

 

Thanks in advance

Sharma

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Re: Basic question on Fed working

Hi chankya2703 or Sharma!

Welcome to CM.

I'm sure there are others here that can do a much better job at answering your question but here is my take.

Money (fiat currency) is debt. I'm not being flippant. For example if you go to a bank for a loan and they give it to you they simple print you a check or add it to your account or whatever, and the money then exists. So in reality you created an increase in the money supply by simply taking a loan. It has been said that if every loan was paid off there would be no currency left to be found anywhere. Meaning ever time you see a bank note it literally represents someones debt.

The bank is charging you interest because they say they are at risk if you don't pay but the truth is they win either way. If you default on the loan the bank is out nothing because they created the money out of thin air. Then the bank takes your house, or car or whatever you took the loan out for. They have effectively gained real assets with no risk and no investment. And of course if you keep paying the loan then they still get paid for doing nothing.

The FED acts much the same way. If I'm correct in this I believe that the FED puts their investments in debt (treasuries) down as an asset. If Im wrong I am very sure I will be corrected Laughing

Essentially the FED is a private bank that is neither Federal (Not part of the government) nor a reserve (it only holds about 24hrs worth reserve currency). If you read what the FED claims is their responsibility you will see that they actually do the exact opposite of what they say they do. The FED is simply a private bank made for bankers by bankers with the sole purpose transfering wealth to the top 2% of the wealthy and powerful of the world taking profits and debasing the dollar by 94% since its inception.

 

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Re: Basic question on Fed working

 

 

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Re: Basic question on Fed working

Chankya2703

Kudos to Mr. Oxygen for helping a new member.  I’ll add what I can, and then we’ll see if the real experts come in and put me in the shade regarding the Federal Reserve.

The Federal Reserve – Here is my limited understanding.  The US Treasury issues bonds, which are a debt.  They are bought by a limited circle of designated banks called Primary Dealers.  The Federal Reserve bank buys the bonds from primary dealers and holds them.  The Fed pays the primary dealers for the bonds with digital money they create “out of thin air” via some computer keystrokes.  They are legally authorized to do this.  As long as the amount of new money is comparable to the growth in real wealth of the nation this is supposed to be a good thing to keep the money supply in balance with demand.  When they create huge sums of money without the offsetting growth, -- then we have problems.

Banks in general – It is a misinterpretation to say that ordinary banks create money out of thin air like the Federal Reserve.  In fact when they fund a loan (which is an asset on their balance sheet) they must always show a corresponding amount of deposits (which is a liability on their balance sheet) as the source of funds.  If they don’t have the deposits they can’t make the loans.  They give the depositor’s money to the person who got the loan, but they still tell the depositor the money is available for withdrawal.  They count the money twice.  Since they know from experience that most of the money will remain on deposit they just keep a ”fractional reserve”.  They have in effect created money backed by debt – the promise to repay the loan.  This money creation power is why banks have been so heavily regulated in the past.  If the loan is not paid the bank has to take money from their reserves or capital to offset that.  Too many bad loans and they are out of business.  With few exceptions, repossessing collateral is a money loser for the bank. 

This is over simplified in detail but is a standard explanation of the principles of banking.  Some other views have merit.  There are also some people who don’t have knowledge of how a bank operates in the real world who make statements that contradict observable facts, particularly the requirement for deposits to offset loans.

What I described is how small to medium sized banks have traditionally operated.  With the growth of giant national banks due to deregulation over the past 15 years they have entered a different realm.  Some of them have become so big and complex they don’t even know what they are doing.

I hope this helps, and welcome to the forums.

Travlin 

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Re: Basic question on Fed working
Travlin wrote:

Banks in general – It is a misinterpretation to say that ordinary banks create money out of thin air like the Federal Reserve. 

Just shows how difficult these things are to understand. My understanding is different.

When a retail bank funds a secured loan they create the money out of thin air, give it to you as a credit in your bank account and record the same amount as a debit or liability on their balance sheet. This liability is balanced by the secured asset that they have entered as a claim on your purchase. In this way fractional reserve banking allows banks to loan far in excess of their working (tier 1) capital.

 The Fed does much the same, although as Travlin states, they don't act directly with Treasury but through the intermediary of Primary Dealers. The main reason seems to be to add smoke to the transaction as part of their smoke and mirrors obfuscation,

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Re: Basic question on Fed working

 Groucho examines the Federal Reserve Act...

 

 http://www.youtube.com/watch?v=KS2khYJZKwA

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Re: Basic question on Fed working
chankya2703 wrote:

The question is Is Fed creating the money(priniting) or creating debt.

My understanding is that the FED is creating money and it is the treasury that is creating debt.   The treasury creates bonds, which are a general obligation of the US citizens, to finance the government operations and generally sells these through its network of primary dealers.  However if an individual or normal institution buys these bonds, no new money is created.  In this case existing money is loaned to the US government at interest. 

If a bank is the purchaser, it also must use existing money to buy the bond but it can then use that bond as reserves for its fractional lending and therefore create ~ x10 the bond value in new loans.  The problem right now is that the banks have tons of excess reserves that are not being fractionally loaned out right now because in reality there are not enough good creditors to loan money too. 

The final option for purchasing of government bonds is the FED.  When the FED buys bonds, money is created out of thin air and the bonds are added to the FED balance sheet.  The FED is not constrained like a normal bank by fractional reserve or anything else except the possible fear of congress getting wise to their scam and starting to take a more careful look at their operations and balance sheet.

Because the whole system is based on growth, and can potentially collapse into a black hole of debt if the money system is not growing, the FED has decided that it is worth the risk and basically stated it will create $600 of new money to finance the governments operations and keep interest rates lower than they would otherwise be.  This could work in the short term, while money velocity is low, but it is hard to see how this creates anything but more problems in the long term.

I kind of wonder if Peter Schiff is right and this is all just a ruse to allow the FED to step in if/when an auction fails.  I also thought the person at zerohedge had it spot on when it discussed how the Democrats/Republicans are arguing about a few % change in the income tax, while the FED without any oversight, is doing actions that could potentially devalue EVERYONES income and savings by >10% seems completely crazy.  I guess it is just the morally bankrupt system we live under until we END THE FED!

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Re: Basic question on Fed working
Travlin wrote:

Banks in general – It is a misinterpretation to say that ordinary banks create money out of thin air like the Federal Reserve.  In fact when they fund a loan (which is an asset on their balance sheet) they must always show a corresponding amount of deposits (which is a liability on their balance sheet) as the source of funds.  If they don’t have the deposits they can’t make the loans.  They give the depositor’s money to the person who got the loan, but they still tell the depositor the money is available for withdrawal.  They count the money twice.  Since they know from experience that most of the money will remain on deposit they just keep a ”fractional reserve”.  They have in effect created money backed by debt – the promise to repay the loan.  This money creation power is why banks have been so heavily regulated in the past.  If the loan is not paid the bank has to take money from their reserves or capital to offset that.  Too many bad loans and they are out of business.  With few exceptions, repossessing collateral is a money loser for the bank. 

That does not completely agree with my understanding.  While banks certainly cannot create money unconstrained in the same way as the FED can, every new loan from a commercial banks is creating money out of thin air.  The difference is that the commercial bank does need to have reserves on deposit or else it cannot create the new loan (out of thin air).  This is not even as great of constraint as it appears because if banks are short reserves they can get loans in the interbank loan network from other banks that have excess reserves. The problem comes when there are very few credit worthy borrowers as there are now.  Banks don't make any loans and just sit on their reserves.

So in summary, my understanding is that banks do create money out of thin air and that often times these loans are made before the actual backing deposits are found.  Otherwise, I agree with the rest of what Travlin was saying.

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Re: Basic question on Fed working

For me, it helps to look at the Federal Reserve's own H.4.1 statement, issued every Thursday evening. The latest one shows the following holdings:

U.S. Treasury securities ... $839.990 billion

Federal agency debt securities ... $149.681 billion

Mortgage backed securities ... $1,051.037 billion

http://federalreserve.gov/releases/h41/Current/

If the Fed buys $600 billion more of Treasuries, then their Treasury holdings should rise from $840 billion to $1.44 trillion.

However, the Fed also has said that as the principal of their mortgage backed securities is paid off, they will reinvest those payments into Treasuries too. This amount can only be estimated, not known exactly, since it depends on home sales and refi rates. But if $300 billion of MBS principal is paid off, then the Fed's MBS holdings would shrink to $750 billion, while the Treasury category could rise as high as $1.75 trillion.

All of these third-party debt securities add to the monetary base, which consists mainly of currency and banks' reserves with the Fed. As the Fed's H.3 report shows, banks already have $969 billion of excess reserves at the Fed. Presumably QE2 will increase their excess reserves to the $1.5 to 2.0 trillion level. But since reserves are not constraining bank lending now, it's unclear why even higher excess reserves would have any direct effect.

http://federalreserve.gov/releases/h3/Current/

Bensane Bernanke has stated that he wants to 'influence expectations.' Posing as a mad inflationist with a sorcerer's assistant printing press that won't stop has certainly changed perceptions, that's for sure.

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Re: Basic question on Fed working
goes211 - Post 7 wrote:

That does not completely agree with my understanding.  While banks certainly cannot create money unconstrained in the same way as the FED can, every new loan from a commercial banks is creating money out of thin air.  The difference is that the commercial bank does need to have reserves on deposit or else it cannot create the new loan (out of thin air)

Hi Goes

I think it depends on how you define “thin air”.  We agreed that commercial banks create money.  But since it must be matched by an equal amount of deposits (as we agreed) I don’t see this as “thin air” like the Fed.  The commercial banks have limits.  This gets into semantics and differing views may be valid depending on your perspective.  I’ve read other explanations that say the money isn’t created until the loan check is deposited in another bank.  I’m still trying to figure this out myself.

goes211 - Post 7 wrote:

This is not even as great of constraint as it appears because if banks are short reserves they can get loans in the interbank loan network from other banks that have excess reserves.

This is a good point.  I left it out to keep my explanation simple.  You are essentially correct with a technical quibble.  I think you are confusing reserves with deposits in both quotes.  I’ll define some terms as best I can to prevent confusion.

Deposits are the customers’ money in checking, savings, CDs, etc. 

Capital is the bank’s money that is set aside after expenses, dividends, etc. and is represented by shares of stock.  Ideally it should grow over time.

Reserves are the bank’s money that is set aside after expenses, dividends, etc., but not added to capital.  Reserves cover loan losses and will fluctuate with the amount of loss and profit.

If losses are low over time, some reserve money can be shifted to capital.  If losses are high more profit is diverted to reserves.  If a bank’s loan losses exceed its reserves then it dips into capital to cover the difference.  If its capital ratio (compared to assets) falls below approximately 7% then the regulators make the bankers very miserable.  If it falls too much lower they are liquidated.  (Unless they are too big to fail.)

Here is how I would re-write your statement: If banks are short of deposits they can get a loan from another bank with excess deposits, and use this to fund loans to their customers.

If a bank is “loaned out” and can’t get enough new deposit money to fund more loans, it may borrow as you said.  The regulators will give them the hairy eyeball, but if the bank is sound they will be okay.  I’m sure there are limits to how much they can borrow like this, but I don’t know the details.  I will point out that the rules say they must get the money before they make the loans.

It would be very helpful to have a practicing banker as a member of this community to get a clearer understanding of how they actually operate.  Maybe we do, but they are just too shy to reveal themselves.  Gee, I wonder why?  FACE  I’m not a banker, but I’m 90% confident that what I have said is accurate.  Meanwhile we’ll just have to puzzle it out together.

Travlin 

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Re: Basic question on Fed working

Plato, Thanks for putting that YouTube piece.  I already had a good idea the way things work, but Ron Paul does a great job of explaining the Fed.

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Re: Basic question on Fed working
Travlin wrote:

I think it depends on how you define “thin air”.  We agreed that commercial banks create money.  But since it must be matched by an equal amount of deposits (as we agreed) I don’t see this as “thin air” like the Fed.  The commercial banks have limits.  This gets into semantics and differing views may be valid depending on your perspective.  I’ve read other explanations that say the money isn’t created until the loan check is deposited in another bank.  I’m still trying to figure this out myself.

I still think we may still disagree about this so maybe someone more knowledgable about the mechanics of this can clairify.  It is my contention that loans are NOT all "matched by an equal amount of deposts".  If they were, I agree with you that they would not be really creating money "out of thin air", except for the way the money is in someones account at the same time it is loaned out. 

It is my contention that banks create money out of thin every time they make a loan.  The thin air money is created and added to the debtors account when they sign the loan papers.  What matches this debit on the banks balance sheet is a loan agreement which is now held as an asset.  You may be correct that sometimes deposits that are held at a bank are loaned out in the way you describe but banks also buy government bonds to use for reserves.  It is my understanding that these reserves are not loaned out fractionally but can actually be leveraged up immediately.  In otherwords if a bank has $1 million worth of treasuries in reserves, it can immediately create loans (out of thin air) for up to $10 million if the fractional reserve ratio is 10 to 1.

FULL DISCLOSURE -  I did work as a VP in a major US bank for a couple of years a few years ago but I had nothing to do with loans or money creation so my knowledge of this subject is not first hand.

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Re: Basic question on Fed working

 

goes211 – Post 11 wrote:

  It is my contention that loans are NOT all "matched by an equal amount of deposits" 

 Gee Goes.  I was just helping a lady with a question and now you’re going to make me work. Smile  That’s okay.  I know you study this issue seriously and you are rational and judicious in evaluating arguments and data.  Let’s focus on the primary issue and see what evidence I can provide for your consideration.

First a caveat.  I’ll qualify my statement to say that loans are primarily funded by deposits, and secondarily by borrowing from other institutions.  I am describing the classic principles of banking as still practiced by smaller banks.  No one really knows what the giant banks are doing anymore, including their own executives.  During our present period of near zero interest rates markets are seriously distorted and more anomalies appear.

Item 1Why do banks work so hard to attract deposits if they don’t need the money to fund loans?  You can be sure this is not just a public service.  Remember loans are the primary profit center for banks.  It is very expensive to build branches in every neighborhood, employee many people to handle small transactions, provide security for the cash, pay interest on deposit accounts and CDs, and process transactions in checking accounts.  Why don’t they charge you for keeping your deposits safely stored and electronically accessible?  Why do they pay you interest instead?

Item 2 – Look at the numbers.  Select any community bank where you live.  Their balance sheet should be publicly displayed in the lobby.  As for a copy.  At most banks you will find the total for loans is less than the total for deposits.  Even if they juice up their loan capacity by borrowing from other banks, it will be a small proportion compared to deposits.  You should ask for definitions of the line items so you can identify what numbers to use, but they are simple to add and compare.  The chief financial officer may be happy to help you, especially if you say you are looking for a safe bank to do business with in light of the financial crisis.  He can do this with a short phone call as you look at the balance sheet.  You don’t have to believe any propaganda.  The numbers are conclusive for our purposes.

All banks file standardized public reports quarterly that are available online at https://cdr.ffiec.gov/public/ManageFacsimiles.aspx  Select the Call\TFR report.  Here the balance sheet is deconstructed and itemized so it is hard to pick the relevant numbers, but knowledgeable people can analyze any bank in the nation from the comfort of their own home.  Maybe you know someone from your former employer or an accountant who could help.

Item 3 – Why don’t trees grow to the sky?  If loans are not limited by deposits then why can’t your community bank with one branch fund all the world’s credit?  I’m exaggerating here to make a point.  If bank loans are funded by borrowing then they should be able to write any amount of credit-worthy loans, because someone would be happy to supply the funds.

Investment banks used borrowed money to make loans and risky investments.  They were not regulated because they didn’t have retail deposit operations so people’s savings were not at risk.  They leveraged themselves to insane levels until they blew up.  However they grew to gigantic size  first. Commercial banks before the repeal of Glass-Steagall where very staid in comparison.  After the repeal in 1999 the lines blurred and after the crisis of 2008 (a wholly predictable result) the remaining investment banks were allowed to convert to commercial charters.  The was the only way to “save” them by allowing access to the Fed and numerous benefits they didn’t deserve.  But I digress.

Item 4 – Deposits are cheaper than borrowing from another bank.  Despite the costs outlined above, a well run bank can accumulate deposits for less cost than borrowing from another bank.  That is another reason why they borrow after they have exhausted deposits as a source of funds, and the amount borrowed is a small proportion compared to deposits.  If they just borrowed to fund loans they would be a finance company which is a different animal.  Deposits are in effect a lot of very small loans to the bank by individual customers.  The customers can "call the loan" for payment in full at any time.  I’m sure you’re aware that interest on savings is always less than interest on loans.  This “spread” is a bank’s primary source of profits.

Thoughts – I have serious doubts about banking as an institution.  Its social utility may be outweighed by its costs.  We all need to know more about this.  However, I think it is important to be objective and factual.  Before we can honestly criticize the results of banking we first have to understand how they actually work.  Flawed premises can lead to some wild conclusions that are not supported by observable events.  I just try to keep the debate sound to the best of my knowledge, which is incomplete.  I’m open to persuasion by good evidence.

I know you’re doing your own research and I’m interested in your conclusions or questions Goes.  Hope this helps.  It should give you plenty to think about.

Travlin

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Re: Basic question on Fed working
Travlin wrote:

First a caveat.  I’ll qualify my statement to say that loans are primarily funded by deposits, and secondarily by borrowing from other institutions.  I am describing the classic principles of banking as still practiced by smaller banks.  No one really knows what the giant banks are doing anymore, including their own executives.  During our present period of near zero interest rates markets are seriously distorted and more anomalies appear.

We are in agreement then because I did not realize you were only describing the traditional fractional reserve process currently practiced by small banks.  I was thinking more in terms of FED banks and might have been a bit speculative.

Cheers!

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Re: Basic question on Fed working

Goes

With all the attention to the nefarious practices of the mega banks it is easy to forget that probably the majority of banks still plod along using traditional practices.  Nowadays when we hear the word “bank” we immediately think of the un-indicted criminal enterprises that have captured our government.  I think there is good reason to debate the social utility of traditional fractional reserve banking.  I just try to help people keep the facts straight. 

Thanks for making me work.  It was good exercise for my mind.

Travlin

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Re: Basic question on Fed working

How about bank loans being funded by time deposits under a contract with savers with full discosure?  Or from the banks own capital borrowed from capital markets.   Demand deposits being off limits for funding loans could eliminate some of the risk banks pose by having their assets and liabilities  match better,   not unlike some of the strong insurance companies out there.

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Re: Basic question on Fed working
Carl Veritas wrote:

How about bank loans being funded by time deposits under a contract with savers with full discosure?  Or from the banks own capital borrowed from capital markets.   Demand deposits being off limits for funding loans could eliminate some of the risk banks pose by having their assets and liabilities  match better,   not unlike some of the strong insurance companies out there.

Hi Carl

What you say is correct except for one technicality.  Capital is the money the bank owns free and clear.  Borrowed money can be used to fund loans, but the bank will have to pay it back so it is not capital.  Capital is used to fund loans in some circumstances.

I just thought of another quibble regarding CDs (time deposits).  What you say is logical, but in practice the demand accounts, which include checking accounts, are actually more stable.  The aggregate average balances are pretty predictable and people are very reluctant to go through the headache of changing their checking to another bank.  The CDs are the “hot money” as people chase higher yields.  With the advent of the internet they are easy to find and buy.

This is another example of the difference between theory and reality I have mentioned before.  You are catching onto the mechanics and applying them well.

I hope this was helpful.

Travlin 

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Re: Basic question on Fed working

John99 just posted this.

http://themoneyscam.blip.tv/

 

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