Showing posts with label federal reserve. Show all posts
Showing posts with label federal reserve. Show all posts

Saturday 26 December 2020

The Truth about Money: Money Good; Money Bad

What is money?

Anything can be used as money:  paper, tokens, clay tablets, seashells, tree bark, pixels on a computer screen, strokes on a ledger somewhere, even people.  Historically, not just slaves and cumal were used as money.  The Bible tells us a man can beat his servant because "he is his money" (Exodus 21:20-22).  As Jacob Goldstein reiterates throughout Money:  The True Story of a Made-up Thing:    "money is money because we believe it’s money."

However, some things become like money (a soft way of saying they become money) even when people doubt, question or just don't notice.  Silver, data, Modigliani nudes, and, most importantly, "commercial paper" have all become forms of money despite doubts, questions and ignorance.

                        In 2008, the day after the Lehman bankruptcy, this Modigliani

                        sold for $150 million (USD). Someone was shifting

                        currency from the stock market to the art market.

Money Good

Goldstein quotes Marco Polo who wrote that his readers would not believe this but  "the Great Kaan [of the Mongol empire] causeth the bark of trees, made into something like paper, to pass for money all over his country."  The result of the Kaan's "bark of trees" money was a unified, stable and prosperous empire.  When the Ming Dynasty attempted to return to traditional (money-less) ways in China, the result was three hundred years of poverty, deprivation and starvation.  Even today, world-wide, getting food from farmers' fields to the shelves of your local grocery store is facilitated by; in fact, dependent upon money.

Money is infinite

In the context of the Covid-19 pandemic, one after another, representatives of the US Federal Reserve announced that they could provide a limitless supply of US dollars to support American businesses?  Of course, it's obvious that money is a product of our collective imaginations and is therefore infinite (or at least only limited by our collective imaginations), but it was unprecedented for the Fed to publicly confirm this fact.   

Wealth inequality versus poverty 

Steve Pinker was quite right to point out the difference between wealth inequality and poverty in his tome Enlightenment Now.  What Pinker calls the "lump fallacy" is the mistaken notion that the economy is a "zero-sum" game:  "that if some people end up with more, others must have less."  On the contrary, if history shows, as Pinker claims it does, that we have all prospered over time--even if unequally--we have nothing to complain about.

Pinker's point is well taken, but I suspect that in this argument he might be confusing wealth and money, the real economy and the financial markets.   Money is infinite but the planet itself is finite, and its wealth/resources are similarly limited.  The real economy becomes very much a game of winners and losers when the biggest winners are willing to sacrifice the planet for short-term gain through, for example, global warming (which, as Pinker later argues, is the real and most threatening problem of our time).

What every kid should know about money

Perhaps I need to remind you, dear Reader, and myself that this blog is about education.  I really don't know what is being taught in grade schools and high schools these days, but shouldn't every middle-schooler know how money is created? 

Goldstein concurs with every other source that I have consulted on the subject: "Most of the money in the world is not just stored in private banks; it is created by private banks."  I found it reassuring that Salman Khan, founder of the Khan Academy, has a very straightforward explanation, directed at high-school students, of how private banks create money.  Khan displays the mathematical formula which shows that for every $1000 which the Federal Reserve introduces into the monetary system, private banks, using the fractional reserve system, create $10,000.  

The Federal Reserve was created at a "secret meeting"

As long as farmers are getting paid and the grocery store is getting paid and I have enough money to pay for groceries, who cares how the money was created?  Is it a problem that private banks create money?  To answer this question we would, of course, first have to acknowledge that private banks do create money. 

According to the "History" section of the Federal Reserve website, the Fed began with a gathering which included a senator, his secretary, an economist and three private bankers who met in November, 1910, on Jekyll Island.  (The name sounds like something from a Gothic novel, but the place does exist.  I played golf there once and even slept in the famous Jekyll Island Clubhouse which was pretty run down by the time I stayed there.)  The secrecy of the meeting is emphasized in the "Federal Reserve History."  Senator Aldrich . . .

went to great lengths to keep the meeting secret, adopting the ruse of a duck hunting trip and instructing the men to come one at a time to a train terminal in New Jersey, where they could board his private train car. Once aboard, the men used only first names – Nelson, Harry, Frank, Paul, Piatt, and Arthur – to prevent the staff from learning their identities. For decades after, the group referred to themselves as the “First Name Club.”

Despite the fact that the  Federal Reserve is a model for monetary systems all over the world (including in Canada, Russia and China), and there are widely available descriptions of how the system works, more than 100 years later, the shadow of secrecy still seems to hover over how the system works and how private banks create money. Consequently, as I outline in How Is Money Created, for conspiracy theorists, the Fed is part of a cabal of satanist bankers out to control the world while, for others, it is an altruistic gathering of civil servants.  Officially and perhaps most accurately, it is a mix of the private and the public.  However, which is the dog and which the tail, and who wags whom remains a matter of debate.

Commercial banks, investment banks and shadow banks

For most of us, a bank is a bank.  (However, if you googled "types of banks," you might be in for a surprise.)   As Alan Blinder explains in After the Music Stopped,

[ . . ] commercial banks do have deposits--that's why we call them banks.  Investment banks do not.  They fund themselves almost entirely by borrowing. Remember, with a 40-to1 leverage, capital constitutes a mere 2.5 percent of assets.  They must borrow the other 97.5 percent.
Blinder points out that "By most estimates, the shadow banking system was [in 2008]  far greater than the conventional banking system."  "The shadow banking system," as Blinder explains is "a complex latticework of financial institutions and capital markets that are heavily involved in various aspects of borrowing and lending."  The important takeaway here is that these shadow banks are non-banks and therefore not regulated as stringently as commercial banks.  Current estimates of the size of the shadow banking system put it at $1.2 trillion.

In a 2015 post, I reported estimates of the unregulated derivatives market as being between 710 trillion and 1.2 quadrillion US dollars.  At the time,  I remember thinking these numbers were too big to be believed.  How could there be an unregulated market that was 50 times greater than the GDP (the total value) of the US economy?  According to Investopedia the current (2019) value of the derivatives market is estimated to be over a quadrillion dollars or 10 times the GDP of the entire world.

Commercial paper is money

The mind boggles at the size of these numbers.  How are they possible?  What are the mechanics that allow such fantastically large amounts of money to be created? When I read that "financial institutions  . . . are heavily involved in various aspects of borrowing and lending,"  I interpret that they are creating money.   As Goldstein explains, the collapse of 2008 "is a story about money itself—a new kind of money that started flowing through a new kind of banking system that nobody quite knew was a banking system."  This new kind of money is "commercial paper."  It usually comes in denominations of $100,000  and is issued by commercial banks and investment banks on behalf of large companies seeking funding. 


About having private banks create money, Goldman comments, "For nearly a hundred years, some of the smartest economists in every generation have said this is a horrible way to do money."  One solution, as Goldman describes, is "dazzlingly simple":

The root of the issue is that basic banks do these two, very different things. (1) They hold our money and make it easier for us to get paid and make payments. (2) They make loans. The dazzlingly simple argument from all of these great economists comes down to this: split those into separate businesses. Variations on this idea are usually called “100% reserve banking” or “full-reserve banking” (as opposed to the current, fractional-reserve banking system)  [. . . .]
Another solution now being debated and seriously considered, as Goldstein reports, is called "Modern Monetary Theory or MMT, for short."  The underlying principle is that the government should take over control of the creation and distribution of money to ensure full employment and sustainable development of available resources, reducing the money supply to prevent inflation when these objectives are met.  Oddly, much of what has been happening in the context of the 2020 pandemic, with governments distributing money directly to businesses and individuals, seems in line with Modern Monetary Theory.  We are in the process of discovering how the theory works in practice.

Whatever the future holds, it is inevitable, as Goldstein concludes:

that money will change. The way we do money will look as strange to our great-great-grandchildren as a world where banks print their own paper money with pictures of Santa Claus.


In response to this post, one of my readers (Thanks D!) email a link to this Front Burner podcast on Modern Monetary Theory:  Never Mind the Deficit!

Wednesday 23 October 2019

Central Banks and the Bitcoin Experiment

Money has gone digital

Money has gone digital.  Less than 3% of currency these days is in the form of cash (coins or paper bills).  I still struggle to understand bitcoin, but I have slowly come to realize that what I don't fully understand are the technological aspects of bitcoin.  To understand bitcoin, you must first understand blockchain. To understand blockchain, you need to know about open-source coding, algorithms and cryptography, then you need to know about hashing and CPUs in order to understand what "mining for bitcoins" means (although I get that "mining" means solving a math puzzle and allowing transactions to use your computer).  However, these lacunae in our technological knowledge notwithstanding, bitcoin is just like any other digital currency (keeping in mind that the US dollar, for example, is already 97% digital) with only one truly significant difference.  Every example of money that we accept without much thought is managed and manipulated by a central bank--bitcoin is not.

Countries and companies preparing their own digital currency

Most countries have their own currencies--197 countries use 164 different national currencies worldwide--but there are only eight [small] countries without a central bank.  The Financial Post reported a few days ago that  last year Stephen Murchison did a presentation to the Bank of Canada on "whether or not the bank should issue its own digital money."  China is preparing the launch of its own digital currency.  Facebook is planning the release of Libra, its own digital money.  The FP article reports that :
 Switzerland’s central bank started exploring the use of digital currencies for trading. Sweden and Singapore both have research efforts underway. [ . . . .]  JPMorgan is already using a digital coin and Vanguard is testing a blockchain-based currency trading system.
Although these reports create the impression of a definite distinction between digital and non-digital currencies; to reiterate, most of the money we use today is already digital.  Since this currency must be encrypted in order to transit over the internet, it can also be described as cryptocurrency.  What distinguishes bitcoin from the crypto, digital money that we accept unquestioningly into our lives is that bitcoin has no central bank.

Facebook, China and even JPMorgan provide a central bank to manage their digital currencies.  We Canadians who have been accepting Canadian Tire money since the 1950s should be at ease with corporations' producing their own money, and recognize that a company (the Canadian Tire Corporation in this case) can be a central bank.  The question bitcoin raises is:  "Do we need central banks?"

Central Banks:  God or the Devil?

Central banks are either God or the Devil depending on your perspective.  Few issues are more likely to spur conspiracy theories than discussions of central banks.  The claim that the Rothchild family has slowly taken over the central banks of the world regularly gets viral play.  Depending on your perspective the US Federal Reserve (the US central bank) either saved the American economy from total collapse in 2008 with 100s of billions in bailouts, or it protected the interests of wealthy bankers at the expense of American sub-prime mortgage holders.  Central banks are either a cabal of fat-cat bankers taking care of themselves, or they are altruistic, public-spirited individuals dedicated to serving the interests and welfare of their countries' citizens.  Individuals with connections to a central bank have insider knowledge not only of monetary policy but of the financial systems and decisions of their home countries.  These financial gurus tend to be in the wealthiest 1% of the 1%--which arouses suspicion.  On the other hand, they help to control inflation and unemployment by decreasing or increasing the money supply, cooling down or heating up the economy.  We barely note their existence until there is a major screw up, as there was in 2008.

What's the difference between the new money and the old money?

The average citizen doesn't understand bitcoin because the average citizen doesn't understand money.  I speak from the perspective of an average citizen.  Even though I have done two posts on the subject (What Is Money?  & How Is Money Created)  and I am an accredited professional in understanding works of imagination, I still struggle to grasp that money, that thing which hard-core realists consider the bedrock of modern existence and survival, what we get up and go to work for, and worry about going to bed, can be such an airy-fairy, shrouded-in-mystery product of imagination.

How the Bank of Canada creates money

I credit this Parliament of Canada website with providing a clear and succinct description of "how the Bank of Canada creates money for the federal government." The article also provides "Information about how private commercial banks create money." The first step is perhaps the most confusing.  The Government of Canada produces bonds and treasury bills, which the Bank of Canada sells to private banks and other financial institutions, but the Bank of Canada also buys 20% of the bonds produced by the Government. This first step is confusing because to the uninitiated (like me) the assumption is that the Bank of Canada is part of the Government of Canada, so it sounds like Canada is buying and selling to itself.  The process would seem to make more sense if the Bank of Canada was a private company, separate from the Government.  In fact, the Royal Bank of Canada was first created as a private enterprise in 1934 but was nationalized in 1938.

However, in the current Canadian case:

Since the Bank of Canada is a Crown corporation wholly owned by the federal government, the Bank's purchase of newly issued securities from the federal government can be considered an internal transaction. By recording new and equal amounts on the asset and liability sides of its balance sheet, the Bank of Canada creates money through a few keystrokes. The federal government can spend the newly created bank deposits in the Canadian economy if it wishes.
The entire process seems like a game of "let's pretend."  "Let's pretend" you are a bank and I borrow some money from you, then I deposit the money I borrowed from you in your bank.  There is no limit to how much money I can borrow from you, and it doesn't matter if you think I'm a good, reliable client or not.  When I spend the money I have deposited in your bank, you take the money out of my account.  Of course, you will never ask me to repay the money I've borrowed from your bank. Later, when I have depleted my account, I will just borrow some more money from you.  In more adult language:

 . . . the Bank of Canada's purchase of government securities at auction means that the Bank records the value of the securities as a new asset on its balance sheet, and it simultaneously records the proceeds of sale of the securities as a deposit in the Government of Canada's account at the Bank [. . . ]. No paper evidence of a bond, treasury bill or cash is exchanged between the Government of Canada and the Bank of Canada in these transactions. Rather, the transactions consist entirely of digital accounting entries.

Most of the Money in the Economy is Created by Private Banks

In the game of "let's pretend," the Bank of Canada only buys 20% of the Canadian government's loans, the other 80% is purchased by private banks and investment firms.

Private commercial banks also create money – when they purchase newly issued government securities as primary dealers at auctions – by making digital accounting entries on their own balance sheets. The asset side is augmented to reflect the purchase of new securities, and the liability side is augmented to reflect a new deposit in the federal government's account with the bank. However, it is important to note that money is also created within the private banking system every time the banks extend a new loan, such as a home mortgage or a business loan. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money [. . .]. Most of the money in the economy is, in fact, created within the private banking system.

As just described, with a click of the mouse, private banks have an asset (money in their accounts) and an equal debt owed to the Bank of Canada.  Why do private banks buy or even want Canadian government debt?  The answer has many names (some of which I have dealt with in What Is Money?  & How Is Money Created) such as "leverage" or "the fractal banking system."  The parliamentary website describes the system as "[t]he limiting rules, known as 'capital constraints,' [ . . .]."  What each of these expressions is telling us is that when you go to a bank to take out a mortgage, or a car loan, or an education loan, or if you use your bank's credit card to buy a cup of coffee, you are creating money.  The money does not exist until you spend it, and when you spend it you have created an asset--money in the bank's bank account.

The Ontology of money

What we are talking about here, in big words, is the ontology of money.  With most things that are borrowed, there is an assumption that they must exist in order to be borrowed--not so with money.  It's as if you go to the bank to borrow a cup of sugar, the bank has sugar, but the sugar they lend you doesn't exist--except that you still owe the bank a cup of sugar.  Guess what?  Now the bank is considered to have even more sugar because the sugar you borrowed is added to the bank's supply. What "leverage," "the fractal banking system," and "capital constraints" all indicate is that the bank is allowed to lend you 10, 25 or even 40 times the amount of money it actually has, depending on the "limiting rules" in place.  For a period of time, the banks in Iceland had no limit on the amount they could lend out and thereby created so much money for themselves that they had more money on their books than the entire GDP of the country.  Imagine you were a bank and the "capital constraint" leverage ratio was 4% and you had a hundred dollars in your pocket.  You could lend your friend $2500 (without touching the $100 in your pocket).  Once you had your first friend's IOU for $2500, you could lend a second friend 25 X 2500 = $625,000.  If you could find a third friend, you could lend him $625,000 X 25!  You'd be a multimillionaire.  Kinda makes you want to be a banker, doesn't it?

The Bitcoin experiment

I call bitcoin an experiment because it attempts to test (prove or disprove) a hypothesis in an empirical fashion.  The hypothesis is that it is possible to create money without a central bank, without a private banking system, in fact, without any of the middlemen who run the financial system.  The mere fact that bitcoin still exists (despite constant rumours of its demise) is proof that it is possible to have a monetary system, to buy and sell, lend and borrow, carry out transactions of every sort on a person-to-person basis, without a central bank and accompanying private banking system.

What's wrong with bitcoin?

As I have taken note, here and there, of what is said to be wrong with bitcoin, I have found the only substantially negative feature of bitcoin relative to other currencies is its volatility.  The value of a bitcoin can change dramatically because its price is based entirely on supply and demand.  The total supply of bitcoins has, by design, been limited to 21 million.  Bitcoin is comparable to gold in terms of its limited supply and consequent fluctuating value. Fluctuations in the value of bitcoins can be unnerving as you are trying to decide if you should save, spend or exchange them.  This forex volatility calculator rates bitcoin (BTC) at least four times more volatile than most currencies.  Today's financial news is full of references to bitcoin's dramatic fall to below $10,000 Canadian.  Of course, if you bought, mined or were paid in bitcoins six years ago, you would still be up over $9000 per coin.  Central banks generally work to reduce the volatility of their countries' currencies, but they can also manipulate them to serve national economic interests in the global market place.

Much is made of the potential use of bitcoin to avoid taxes or for criminal activity.  As such bitcoin is a more technological, efficient replacement for cash, gold, jewelry, and artwork--all common currencies for tax-evading criminal activity (not to mention offshore banking, of course).  The real risk to and of bitcoins is that countries will and have been moving to protect their own central banks and banking systems by banning the use of bitcoin.  China is a leading example.  The second bitcoin risk, and perhaps this is the greatest one, is the competition from countries--like Canada, as the Murchison presentation suggests--when they create their own versions of bitcoin using the blockchain technology which would allow the government to track how every Canadian digital dollar is spent. 


Tuesday 19 December 2017

How Is Money Created?

Money isn't just pixel dust! 

In an earlier post I described money as “pixel dust.” I was being cute—way too cute! Sometimes an analogy can hide much more than it reveals. Money is not created by Tinker Bell, though I did feel a bit smug upon realizing that the writers of the Zeitgeist film series repeated my observation that when you take out a bank loan you create that debt out of nothing.

Banks have the right to create money, but they need your help

The bank does not have the money it is lending you. Stop and think about that for a moment, because it is the answer to the question “how is money created?” As more and more people struggle to understand bitcoin, the fact that money is just a way of recording debt is starting to sink in. When I googled the question “how is money created?” I was surprised by the number of sites covering the question—the number of people who knew the answer. I found myself asking, as I often do, how could I not know this? Shouldn’t every ten-year-old know the answer to this question?  Every time you take out a loan for a house or a car or an education, or buy a cheeseburger with a credit card, you create money--those pixels on a computer screen somewhere that are the reason you work and save and struggle.

The Federal Reserve gives banks the right to create money

In the USA the Treasury prints the money, but the amount of printed money is less than three percent of the total money supply in the system. Actually no-one really knows how much digital debt (i.e. money) there is floating around on the internet and in the intranet systems of all the banks and financial institutions in the world. We know, as I pointed out in my earlier post, there are 1.35 trillion US dollars in circulation (i.e., paper money), but the US debt is 18 trillion dollars. The unregulated derivatives market (the one that caused the crash of 2008) is believed to be worth between 710 trillion and 1.2 quadrillion dollars. To answer the question how much US money exists in the world today (remember money is just a measurement of debt), you need to add up all these numbers: 1.35 trillion plus 18 trillion plus (to be conservative) 710 trillion.  In total, a conservative estimate is that there are  729.35 trillion US dollars in circulation right now. How was all this money created?

The rules for creating money

There is an exchange of paper but, basically, the US Treasury gives it to the Federal Reserve. The Federal Reserve then distributes the money to 12 Reserve Banks across the country which in turn pass the money onto private banks. So how does so much money get produced?  We've been here before: leverage.  It's all about the leverage ratio.  

This graphic (above), which I found online, does a nice job of showing how the money flows in what is known as the "fractal reserve banking" system.  "Fractal" (aka "fractional") means that the banks get a fraction of the amount that they are allowed to lend out, so it really boils down to leverage. Descriptions of the "fractal system" make it sound as if the amount of leverage in the system is quite modest, but as Blinder (who you might remember was a VP in the Federal Reserve) points out, in After the Music Stopped, financial institutions figured out ways to create synthetic leverage ratios of up to 40%.  Let me remind you of what a 40% leverage ratio means.  A 4% leverage ratio means a bank with $1 can lend out $25,  a 40% leverage ratio means that a bank with $1 can lend out $250--250 times more than it actually has.

What is the US Federal Reserve? 

The Federal Reserve is the moolah machine, the institution that creates money and runs the monetary system.  It is the model for and has tentacles into just about every central bank in every country in the world.  The cynical, conspiratorial answer to the question is that the Fed is a bunch of bankers, a cabal of the CEOs from the biggest banks and financial institutions in the world. According to the Zeitgeist movement, all the ways that we might imagine the world is being run--politics, religion, economics--are distractions, cover-ups, window dressing.  The only real power is the monetary system which remains hidden behind the activities of governments, religions, and all movement of goods and services.  If you ask why the USA is constantly at war with someone or something, the Zeitgeist answer is that nothing feeds the monetary system better, profiting and empowering those closest to the system, than warfare. Even conservatives acknowledge that money is the life-blood of the economic system, and nothing pumps more spending, borrowing and debt (i.e., money) into the system than a war.

graphic of Federal Reserve System

Who owns the Federal Reserve?

This may seem like a strange, dumb, childlike question, but as I have attempted to get a handle on how the system works, I understand perfectly how we end up at this question.  The pervasive suspicion that the Fed is owned and run by self-serving financial titans is hard to dismiss.  In her book Plutocrats, Chrystia Freeland notes a study on the incomes of Harvard University graduates showing a "split between bankers and everyone else, with financiers earning 195 percent more than their classmates." Harvard grads aspiring to become part of the 1% of the 1% have figured out that being connected to the monetary system is the way to do it. Certainly Jamie Dimon, a card-carrying member of the .1%, CEO of Morgan Chase, the largest bank in the USA, being a member of the board of the New York Federal Reserve has got to have the average wage-earner wondering "what the fuck! how is that possible?"

The official answer is that the Federal Reserve is “a blend of public and private characteristics.” Historically the network of "reserve banks" was created in 1910 at a meeting of private bankers on Jekyll Island (yes, it's a real place; I played golf there once in the 60s).  The idea that the entire monetary system would be run by unsupervised private bankers was unacceptable to Democrats; consequently, it was eventually agreed that the Chair of the Federal Reserve and the seven members of the Board would be chosen by the President of the USA and ratified by Congress. They all inevitably have strong connections to the world of banking and finance. As you work your way through the layers of administration, through the lip service and platitudes, the Federal Reserve does seem to be more and more a system run by banks for banks—despite repeated claims that the objective of the system is “to promote the effective operation of the U.S. economy and, more generally, the public interest.”

There are three kinds of answer to the question "Who owns the Federal Reserve?"

  1. The historical, conspiracy-inclined answer is that the Federal Reserve is owned by eight families:

  1. The official answer is “The Federal Reserve System is not 'owned' by anyone. Although parts of the Federal Reserve System share some characteristics with private-sector entities, the Federal Reserve was established to serve the public interest.”

  1. The third answer, on the other hand, is “The Fed is privately owned. Its shareholders are private banks.”

Whatever answer you accept, it seems clear that the much mocked concept of "trickle-down economics" is beside the point. We live, without much question, in a trickle-down monetary system.

What Does Article Five of the North Atlantic Treaty Actually Say?

In The Room Where It Happened , John Bolton points out that "This provision [article 5] is actually less binding than its reputation [....