The assets of the Federal Reserve Banks consist largely of two central items. One is the gold originally confiscated from the public and later amassed by the Fed. The other major asset possessed by the Fed is the total of U.S. government securities it has purchased and amassed over the decades.
On the liability side, there are also two major figures: Demand deposits held by the commercial banks, which constitute the reserves of those banks; and Federal Reserve Notes, cash emitted by the Fed.
At the base of the Fed pyramid, and therefore of the bank system’s creation of “money” in the sense of deposits, is the Fed’s power to print legal tender money. But the Fed tries its best not to print cash but rather to “print” or create demand deposits, out of thin air, since its demand deposits constitute the reserves on top of which the commercial banks can pyramid a multiple creation of bank deposits, or “checkbook money.”
Let us see how this process typically works. Suppose that the “money multiplier” — the multiple that commercial banks can pyramid on top of reserves, is 10:1. That multiple is the inverse of the Fed’s legally imposed minimum reserve requirement on different types of banks, a minimum which now approximates 10 percent. Almost always, if banks can expand 10:1 on top of their reserves, they will do so, since that is how they make their money. The counterfeiter, after all, will strongly tend to counterfeit as much as he can legally get away with.
Suppose that the Fed decides it wishes to expand the nation’s total money supply by $10 billion. If the multiplier is 10, then the Fed will choose to purchase $1 billion of assets, generally U.S. government securities, on the open market.
The process unfolds in two steps. In the first step, the Fed directs its Open Market Agent in New York City to purchase $1 billion of U.S. government bonds. To purchase those securities, the Fed writes out a check for $1 billion on itself, the Federal Reserve Bank of New York. It then transfers that check to a government bond dealer, say Goldman Sachs, in exchange for $1 billion of U.S. government bonds. Goldman Sachs goes to its commercial bank — say Chase Manhattan — deposits the check on the Fed, and in exchange increases its demand deposits at the Chase by $1 billion.
Where did the Fed get the money to pay for the bonds? It created the money out of thin air, by simply writing out a check on itself. Neat trick if you can get away with it!
Chase Manhattan, delighted to get a check on the Fed, rushes down to the Fed’s New York branch and deposits it in its account, increasing its reserves by $1 billion.
The nation’s total money supply at any one time is the total money (Federal Reserve Notes) plus deposits in the hands of the public. Note that the immediate resultof the Fed’s purchase of a $1 billion government bond in the open market is to increase the nation’s total money supply by $1 billion.
But this only the first, immediate step. Because we live under a system of fractional-reserve banking, other consequences quickly ensue. There are now $1 billion more in reserves in the banking system, and as a result, the banking system expands its money and credit, the expansion beginning with Chase and quickly spreading out to other banks in the financial system.
In a brief period of time, about a couple of weeks, the entire banking system will have expanded credit and the money supply by another $9 billion, up to an increased money stock of $10 billion. Hence, the leveraged, or “multiple,” effect of changes in bank reserves, and of the Fed’s purchases or sales of assets which determine those reserves.
It should be easy to see why the Fed pays for its assets with a check on itself rather than by printing Federal Reserve Notes. Only by using checks can it expand the money supply by ten-fold; it is the Fed’s demand deposits that serve as the base of the pyramiding by the commercial banks. The power to print money, on the other hand, is the essential base in which the Fed pledges to redeem its deposits. The Fed only issues paper money (Federal Reserve Notes) if the public demands cash for its bank accounts and the commercial banks then have to go to the Fed to draw down their deposits.
Thus, the major control instrument that the Fed exercises over the banks is “open market operations,” purchases or sale of assets, generally U.S. government bonds.
Another powerful control instrument is the changing of legal reserve minima. If the banks have to keep no less than 10 percent of their deposits in the form of reserves, and then the Fed suddenly lower that ratio to 5 percent, the nation’s money supply, that is of bank deposits, will suddenly and very rapidly double. And vice versa if the minimum ratio were suddenly raised to 20 percent; the nation’s money supply will be quickly cut in half.
Ever since the Fed, after having expanded bank reserves in the 1930s, panicked at the inflationary potential and doubled the minimum reserve requirements to 20 percent in 1938, sending the economy into a tailspin of credit liquidation, the Fed has been very cautious about the degree of changes in bank reserve requirements.
Thus, the Fed has the well-nigh absolute power to determine the money supply if it so wishes. Over the years, the thrust of its operations has been consistently inflationary. For not only has the trend in its reserve requirements on the banks been getting ever lower, but the amount of its amassed U.S. government bonds has consistently increased over the years, thereby imparting a continuing inflationary impetus to the economic system.
Note: Traditionally, money and banking textbooks list three forms of Fed control over the reserves, and hence the credit, of the commercial banks: in addition to reserve requirements and open market operations, there is the Fed’s “discount” rate, interest rate charged on its loans to the banks. Always of far more symbolic than substantive importance, this control instrument has become trivial, now that banks almost never borrow from the Fed. Instead, they borrow reserves from each other in the overnight “federal funds” market.
There is only one way to eliminate chronic inflation, as well as the booms and busts brought by that system of inflationary credit: and that is to eliminate the counterfeiting that constitutes and creates that inflation. And the only way to do that is to abolish legalized counterfeiting: that is, to abolish the Federal Reserve System, and return to the gold standard, to a monetary system where a market-produced metal, such as gold, serves as the standard money, and not paper tickets printed by the Federal Reserve.
Murray N. Rothbard, The Case Against the Fed