22/11/2010 – Robert Prechter Explains The Fed, Part II

In Chapter 9 [of Conquer the Crash], I called the
dollar “money.” By
the definition given there, it is. I used that definition and
explanation because it makes the whole picture comprehensible.
But the truth is that since the dollar is backed by debt, it
is actually a credit, not money. It is a credit against what
the government owes, denoted in dollars and backed by nothing.
So although we may use the term “money” in referring
to dollars, there is no longer any real money in the U.S. financial
system; there is nothing but credit and debt.

As you can see, defining the dollar, and therefore the terms
money, credit, inflation and deflation, today is a challenge,
to say the least. Despite that challenge, we can still use
these terms because people’s minds have conferred meaning
and value upon these ethereal concepts.

Understanding this fact, we will now proceed with a discussion
of how money and credit expand in today’s financial system.

How the Federal Reserve System Manufactures Money

Over the years, the Federal Reserve Bank has transferred purchasing
power from all other dollar holders primarily to the U.S. Treasury
by a complex series of machinations. The U.S. Treasury borrows
money by selling bonds in the open market. The Fed is said
to “buy” the
Treasury’s bonds from banks and other financial institutions,
but in actuality, it is allowed by law simply to fabricate a
new checking account for the seller in exchange for the bonds.
It holds the Treasury’s bonds as assets against — as “backing” for
— that new money. Now the seller is whole (he was just a middleman),
the Fed has the bonds, and the Treasury has the new money.

This transactional train is a long route to a simple alchemy
(called “monetizing” the debt) in which the Fed turns
government bonds into money. The net result is as if the government
had simply fabricated its own checking account, although it pays
the Fed a portion of the bonds’ interest for providing
the service surreptitiously. To date (1st edition of Prechter’s Conquer
the Crash was published in 2002 — Ed.), the Fed has monetized
about $600 billion worth of Treasury obligations. This process
expands the supply of money.

In 1980, Congress gave the Fed the legal authority to monetize
any agency’s debt. In other words, it can exchange the
bonds of a government, bank or other institution for a checking
account denominated in dollars. This mechanism gives the President,
through the Treasury, a mechanism for “bailing out” debt-troubled
governments, banks or other institutions that can no longer
get financing anywhere else. Such decisions are made for political
reasons, and the Fed can go along or refuse, at least as the
relationship currently stands. Today, the Fed has about $36
billion worth of foreign debt on its books. The power to grant
or refuse such largesse is unprecedented.

Each new Fed account denominated in dollars is new money,
but contrary to common inference, it is not new value.
The new account has value, but that value comes from a reduction
in the value of all other outstanding accounts denominated
in dollars. That reduction takes place as the favored institution
spends the newly credited dollars, driving up the dollar-denominated
demand for goods and thus their prices. All other dollar
holders still hold the same number of dollars, but now there
are more dollars in circulation, and each one purchases
less in the way of goods and services. The old dollars lose
value to the extent that the new account gains value.

The net result is a transfer of value to the receiver’s
account from those of all other dollar holders. This fact is
not readily obvious because the unit of account throughout
the financial system does not change even though its value
changes.

It is important to understand exactly what the Fed has the power
to do in this context: It has legal permission to transfer wealth
from dollar savers to certain debtors without the permission
of the savers. The effect on the money supply is exactly the
same as if the money had been counterfeited and slipped into
circulation.

In the old days, governments would inflate the money supply
by diluting their coins with base metal or printing notes directly.
Now the same old game is much less obvious. On the other hand,
there is also far more to it. This section has described the
Fed’s secondary role. The Fed’s main occupation
is not creating money but facilitating credit. This crucial
difference will eventually bring us to why deflation is possible.

[Next: Prechter explains “how the Federal Reserve has
encouraged the growth of credit.”]

Come back later this week for Part III of the series “Robert
Prechter Explains The Fed.” Or, read more now in the
free Club EWI report, “Understanding
the Federal Reserve System.”