Jul. 13 2011 – 8:16 am
In the past year the Federal Reserve System has done $600 billion of quantitative easing. QEII, the second round of this kind of stimulus, is officially over, but we could get another dose of it. In his July 13 report to Congress Chairman Ben S. Bernanke mentions QEIII as an option for the woebegone economy.
Easing means having the 12 banks in the system buy Treasury bonds and Treasury-backed mortgage securities. Payment is with money created by the Federal Reserve.
What’s going on here? Investing, as when JP Morgan buys a Treasury bond? Or something more like money printing?
Defenders of big government and of expansionary money policies (they tend to be the same people) have a fit when you equate quantitative easing to the printing of dollar bills.
But look closely at this merry-go-round. The government wants to spend $1,000 it doesn’t have. So it sells a bond. The buyer is the Federal Reserve. The Fed pays for the bond with some folding money. The Treasury spends the $1,000 on farm subsidies or whatever.
The Fed makes a show of treating the $1,000 bond as an investment. It collects $40 in interest from the Treasury. But this is a charade. The Fed declares the $40 (after some overhead costs) as profit and sends the profit right back to Treasury. In reality, the interest payment never left the Treasury building.
When the dust settles, this is what has happened. The farmer has $1,000 of cash. The government did not get this cash by collecting taxes. It got the cash by creating it.
Senator Ron Paul has seized on the absurdity of the bond-issuing ritual with his recent proposal to end-run the debt ceiling. He says the Fed should just tear up the $1.6 trillion of Treasury bonds it owns.
Bad enough that the government is living beyond its means and borrowing money to do so. That’s what got Greece into trouble. But when the “buyer” of a bond is the government itself, there is no real borrowing going on, just the printing of currency. The Fed’s economic model is not so much Greece as Zimbabwe.
The U.S. does sell some of its bonds to lenders (like the ever-helpful Chinese). But in the past two years the Federal Reserve has been a big buyer, more than doubling the size of its balance sheet.
This was not supposed to happen. At the Federal Reserve System’s creation in 1913 its 12 banks were semi-public, semi-autonomous institutions that raised their own capital by selling shares of stock to commercial banks. Each Fed bank issued its own banknotes, much the way commercial banks did in the previous century.
Those banknotes from the New York Fed or the Philadelphia Fed or the other ten banks had to be backed by solid collateral: gold and commercial paper. Commercial banks would put up gold or commercial paper and get cash in return. The cash took the form of either banknotes or a credit balance at the Federal Reserve bank that held the collateral.
In those days U.S. Treasury bills and bonds were not acceptable as collateral at the reserve banks. It wasn’t that the creators of the Fed were worried about defaults on Treasury paper. The restriction had another purpose: making it impossible for the federal government to finance its activities with a printing press.
Federal Reserve banknotes were to be tied not to the spending habits of politicians but to the demands of commercial activity. If a lumber merchant in Philadelphia financed his inventory with a short-term loan, that loan would enter the banking system as an asset and somewhere down the line occasion the issuance of banknotes used to pay the lumberjacks in Wisconsin. The lumber dealer would sell off the inventory, taking in banknotes and using them to liquidate the loan.
It was called the real bills theory of how money should be created. A Federal Reserve banknote was real because it was backed by a bar of gold or a quickly liquidated loan. The loan was real because it was backed by the lumber.
Real money didn’t last long. In 1932 Federal Reserve banks got permission to buy Treasury paper. Thus began the modern era of debt monetization.
There’s still a vestige of the old world in which each reserve bank had its own collateral and its own note issue. You’ll find it on a dollar bill, which recites, in a seal above the serial number on the left, which bank issued it.
The larger bills have been artfully redesigned to erase this bit of history. Their value emanates not from a bank but from the System.
Blog Note: Should the Fed option into a third round of Quantitative Easing now is the time to look hard at backing your investments with gold & silver. Even though the banks do not want to back currency with a real asset doesn’t mean you must follow the same path to financial ruin. Add gold & silver to your Tangible Asset Portfolio today.