24/11/2010 – Robert Prechter Explains The Fed, Part III

Money, Credit and the Federal Reserve Banking System
Conquer the Crash, Chapter 10
By Robert Prechter

How the Federal Reserve Has Encouraged the Growth of
Credit

Congress authorized the Fed not only to create money for
the government but also to “smooth out” the economy
by manipulating credit (which also happens to be a re-election
tool for incumbents). Politics being what they are, this
manipulation has been almost exclusively in the direction
of making credit easy to obtain. The Fed used to make more
credit available to the banking system by monetizing federal
debt, that is, by creating money. Under the structure of
our “fractional reserve” system, banks were
authorized to employ that new money as “reserves” against
which they could make new loans. Thus, new money meant new
credit.

It meant a lot of new credit because banks were allowed
by regulation to lend out 90 percent of their deposits, which
meant that banks had to keep 10 percent of deposits on hand
(“in reserve”) to cover withdrawals. When the
Fed increased a bank’s reserves, that bank could lend
90 percent of those new dollars. Those dollars, in turn,
would make their way to other banks as new deposits. Those
other banks could lend 90 percent of those deposits, and
so on. The expansion of reserves and deposits throughout
the banking system this way is called the “multiplier
effect.” This process expanded the supply of credit
well beyond the supply of money.

Because of competition from money market funds, banks began
using fancy financial manipulation to get around reserve
requirements. In the early 1990s, the Federal Reserve Board
under Chairman Alan Greenspan took a controversial step and
removed banks’ reserve requirements almost entirely.
To do so, it first lowered to zero the reserve requirement
on all accounts other than checking accounts. Then it let
banks pretend that they have almost no checking account balances
by allowing them to “sweep” those deposits into
various savings accounts and money market funds at the end
of each business day. Magically, when monitors check the
banks’ balances at night, they find the value of checking
accounts artificially understated by hundreds of billions
of dollars. The net result is that banks today conveniently
meet their nominally required reserves (currently about $45b.)
with the cash in their vaults that they need to hold for
everyday transactions anyway. [1st edition of Prechter’s Conquer
the Crash was published in 2002 — Ed.]

By this change in regulation, the Fed essentially removed
itself from the businesses of requiring banks to hold reserves
and of manipulating the level of those reserves. This move
took place during a recession and while S&P earnings
per share were undergoing their biggest drop since the 1940s.
The temporary cure for that economic contraction was the
ultimate in “easy money.”

We still have a fractional reserve system on the books,
but we do not have one in actuality. Now banks can lend out
virtually all of their deposits. In fact, they can lend out
more than all of their deposits, because banks’ parent
companies can issue stock, bonds, commercial paper or any
financial instrument and lend the proceeds to their subsidiary
banks, upon which assets the banks can make new loans. In
other words, to a limited degree, banks can arrange to create
their own new money for lending purposes.

Today, U.S. banks have extended 25 percent more total credit
than they have in total deposits ($5.4 trillion vs. $4.3
trillion). Since all banks do not engage in this practice,
others must be quite aggressive at it. For more on this theme,
see Chapter 19 [of Conquer the Crash].

Recall that when banks lend money, it gets deposited in
other banks, which can lend it out again. Without a reserve
requirement, the multiplier effect is no longer restricted
to ten times deposits; it is virtually unlimited. Every new
dollar deposited can be lent over and over throughout the
system: A deposit becomes a loan becomes a deposit becomes
a loan, and so on.

As you can see, the fiat money system has encouraged inflation
via both money creation and the expansion of credit. This
dual growth has been the monetary engine of the historic
uptrend of stock prices in wave (V) from 1932. The stupendous
growth in bank credit since 1975 (see graphs in Chapter 11)
has provided the monetary fuel for its final advance, wave
V. The effective elimination of reserve requirements a decade
ago extended that trend to one of historic proportion.

The Net Effect of Monetization

Although the Fed has almost wholly withdrawn from the role
of holding book-entry reserves for banks, it has not retired
its holdings of Treasury bonds. Because the Fed is legally
bound to back its notes (greenback currency) with government
securities, today almost all of the Fed’s Treasury
bond assets are held as reserves against a nearly equal dollar
value of Federal Reserve notes in circulation around the
world. Thus, the net result of the Fed’s 89 years of
money inflating is that the Fed has turned $600 billion worth
of U.S. Treasury and foreign obligations into Federal Reserve
notes.

Today the Fed’s production of currency is passive,
in response to orders from domestic and foreign banks, which
in turn respond to demand from the public. Under current
policy, banks must pay for that currency with any remaining
reserve balances. If they don’t have any, they borrow
to cover the cost and pay back that loan as they collect
interest on their own loans. Thus, as things stand, the Fed
no longer considers itself in the business of “printing
money” for the government. Rather, it facilitates the
expansion of credit to satisfy the lending policies of government
and banks.

If banks and the Treasury were to become strapped for cash
in a monetary crisis, policies could change. The unencumbered
production of banknotes could become deliberate Fed or government
policy, as we have seen happen in other countries throughout
history. At this point, there is no indication that the Fed
has entertained any such policy. Nevertheless, Chapters 13
and 22 address this possibility.