The Modern Art of Printing Money
The Complicated Process of Federal Reserve Open Market Operations Made Simple
Since the invention of banking, banks and governments alike have been in the constant pursuit of loaning out money they do not have, or of paying off debts without actual responsibility. These problems spawned the art of printing money. In modern times, one such method is called fractional reserve banking. Although there are some merits to this practice, what we know for sure is that it is inherently less stable than 100% reserve banking, and we know that combined with the irresponsibility of politicians, it can devastate entire countries.
In modern times, extreme unsound banking is the standard practice and is made possible by central banks. Modern central banks also have the power to guide interest rates and control a large portion of the money supply. This article will be an in-depth explanation of the structural bastardization of sound banking principles and sound money.
A Quick Recap on Banking
The money that you hand to the bank teller is called a deposit. You would like to imagine this deposit is stored in some sort of vault, but a bank would never make a profit if all it did was store your money. It is implied that the money you hand over to the teller is no longer your money, it is now the bank’s money to do with what they please. You have a claim to that money.
This is not inherently wrong, but it’s certainly good to know. This has been the standard practice for centuries — there is even something called the “bagging rule,” an implied cultural understanding from ancient times. If you gave your gold to the bank in a closed bag or chest, it was implied that you did not want your money to be lent out, you simply wanted it stored. Coins deposited without a bag or a chest did not fall under the bagging rule and were quickly loaned out.
Such a rule does not exist today however, and banks almost immediately loan out your money to someone else, with interest. There is nothing inherently harmful about this practice of charging an interest rate. The lender is taking a risk by investing in this debtor person, and would like to see a return on his investment for taking such a risk. This rate of interest is a price, and just like all other prices it is influenced by the supply of money that is available for loans, along the demand of people wishing to obtain money now.
100% Reserve Banking
To keep this simple, let’s imagine there is a bank with only one depositor and only one debtor, and let’s imagine that this bank has $5 reserves in its vault. A bank’s reserves are like its personal savings, the money it has in the vault in case depositors want their money back.
The client comes and deposits $10. So now the banker has $15 total. If the bank has totally sound principles, it will only loan out $5 of its client’s money, still leaving the bank with $10 in reserves.
If the client were to come demand for his money back, the bank would be able to pay back the client’s $10 without issue and still receive the $5 plus interest from its loan. In this scenario, the bank kept a reserve ratio of 100%.
If the interest rate on that loan was 20%, the bank will make back $5 plus $1 in interest from the debtor, meaning it has earned a $1 profit for this lending endeavor. Under this scenario, all parties have benefited and the money supply remains the same.
As you can see, it is not necessarily easy to make a lot of money under this scenario of totally sound banking. This presents a conundrum in the financial world. A bank of this caliber would likely have to charge a decent fee for their services. So the reader is presented with a question, would you pay a fee to ensure that your money is completely safe under a bank’s care? In times of financial crisis, such a bank may be prosperous, but keep in mind no such banks exist in the world today.
One of the arguments for fractional reserve banking, as we will discuss in detail, is that banks are far more profitable when they don’t have to keep 100% reserves. This is not without its risks, and the risks can be extremely devastating in the hands of the fiscally irresponsible.
Fractional Reserve Banking
Now let’s consider this same scenario under modern circumstances.
Let’s say the bank has $0 in reserves, and the client deposits $10. The banker then takes $1, puts it in his vault and then proceeds to loan out $9 to someone else.
The client soon comes back and demands his money back. “Sure, give me just a second,” the banker says. Remember the banker only has $1 in his reserves, but his client wants $10 — he can’t actually pay back his client. So the banker walks into a backroom and proceeds to print $9. Under this scenario, the total money supply has increased by $9. So everyone gets the money they wanted, at the expense of the entire monetary system. In any other scenario, this would constitute as fraud and counterfeiting, but not under banking schemes.
This is a simple example of fractional reserve banking and the money multiplier effect. Variations of this practice have existed for hundreds, if not thousands of years. Paper dollars we use today stem from the bank notes that were once handed out to depositors after depositing their gold with the bank. These bank notes were redeemable in gold and were therefore worth just as much as gold. However, banks quickly realized they could simply loan out more of these bank notes regardless of their total reserves in gold. What started as a 1:1 ratio between bank notes and gold reserves quickly became unequal.
For instance in 1721, France was at the peak of the Mississippi Bubble, the fractional reserve ratio was raised to one-fifth, meaning there could have been five times the amount of paper notes in circulation than bullion reserves. People began to realize the financial system was unstable, and began to exchange their bank notes, (or Mississippi Company stock, which was also being used as a currency at the time. When the bubble finally burst and the bank runs ensued, 50 people were either crushed or trampled trying to scramble into the bank to redeem their notes for bullion.
Fractional reserve banking has always been inherently more risky than sound banking. The Federal Reserve was a creation that spawned from many large banks such the Morgans, the Rothchilds, the Vanderbilts, along with several more, who all came together to create a system in which fractional banking could be structurally solidified within the government and funded by the US Treasury. Since its invention, banking has been a quasi-government enterprise.
Just like in our scenario, modern US banks are legally required to hold 10% in reserves, so if you deposit $10 into a bank, that bank can loan out 9 of those dollars to someone else, while still meet your demand deposit of $10 at any time by simply printing money.
As we have discussed, there are some merits to fractional reserve, but with an increased risk of insolvency and systematic bank runs. If the banker exercises caution, things tend to run smoothly, but if a banker decides to print wantonly it can potentially lead to total economic disaster. Current reserve ratios, at 10%, are fairly low compared with most of history. As we saw in the Mississippi Bubble, they had a reserve ratio of 1:5. The financial system is about as unsound as feasibly possible, and it is constantly supported by the US Treasury or the tax payer. In 2008, the entire system almost came to an abrupt end, and this spawned the use of QE in the United States. We’ll look into this operation next.
Key Takeaways:
- Bank reserves are the money the bank has put away ‘in the vault,’ in case many depositors need their money all at once.
- 100% reserve banking is a banking system in which the bank always has enough money in reserves to pay 100% of its client’s deposits. This limits the bank’s profitability, but ensures it is able to pay back its depositors under stress.
- Fractional reserve banking is a banking scheme in which banks lend out far more of their clients money than they could pay back. This allows banks to profit far more than they normally would under 100% reserve, but with the increased risk of insolvency under stress.
- Interest rates are the price of borrowing money, and is effected by the supply of money in circulation. More money in circulation means lower interest rates and vice-versa.
Open Market Operations and Quantitative Easing
The Fed Funds Rate
With the basics down, now we can get into the more complicated processes of the modern art of printing money.
You may have seen a few news headlines that said something like: “the Federal Reserve (Fed) is raising [or lowering] rates.” Many times, it is simply stated as “the Fed is raising interest rates to x%.” This can be misleading as the Fed thankfully does not directly manipulate interest rates. They have the power to guide interest rates throughout the economy by printing or removing money from the system using various tools. One such tool is the Fed Funds Rate.
The Fed Funds Rate is the interest rate that banks charge to each other when they loan out their excess reserves to one other. Although this sounds like a rate that the Fed has direct control over, they don’t directly control this either. There’s many moving parts here, but here’s the general theory of how it all comes together:
In the United States, every bank must keep at least 10% in reserves, meaning if someone deposits $100, they have to keep at least $10 “in the vault”. But sometimes a bank’s reserve level runs low, and falls below that 10% threshold. When this happens, a bank can quickly borrow money from another bank who happens to have more than enough reserves.
If CitiBank’s reserve level drops to 8%, and Bank of America currently has a reserve level of 12%, CitiBank can ask to borrow enough to meet the 10% reserve ratio, and the interest rate that Bank of America charges on this loan is called Fed Funds Rate. This is the rate the Fed attempts to guide.
The way that the Fed guides this interest rate, is impressively clever. (although I personally believe it to be a harmful distortion in the economy). Here’s a scenario where the Fed lowers the Fed Funds Rate, and consequently, interest rates throughout the economy:
The Fed prints money (or technically the Treasury Department prints the money and gives it to the Fed). The Fed then buys government, or private assets on the open market.
But what does this mean, it buys assets on the open market?
The Fed literally buys assets the same way a normal person would, from normal people and businesses. The Fed generally buys certain assets, mortgage-backed securities and US treasuries. And the Fed does have limits on what it can buy.
It technically cannot buy stocks on the open market without Congressional approval, although in 2020 it’s possible they found a way around this rule. The Fed is now buying ETFs on the stock market. If the Fed buys an ETF that attempts to track stocks, for example if the Fed bought the ETF, SPY, (a fund designed to mimic the performance of the S&P 500), they would indirectly be buying stocks. Every time you buy a share of an ETF, the ETF fund will then buy shares of the stocks it is attempting to track.
Getting back to the Fed Funds Rate, imagine that the Fed buys assets from your grandfather, who happens to have government bonds. Let’s say he’s got a lot of 10Y US Treasuries, valued at $20 million dollars. Once the Fed buys this $20 million dollars worth of bonds from your grandfather, your grandfather now goes to deposit his profit into his bank account.
And here’s where it all comes back around. Because this new money will create an influx of new bank deposits from people like your grandfather, who are depositing this new money into their own bank accounts, these new deposits can now be used to fulfill their bank reserves. This new influx of money means that interest rates on loaning reserves will decrease. Remember, when money is freely available the price of borrowing decreases.
And what happens when the interest rates on reserves decreases? Banks begin to lend money to each other with a lower interest rate. That lower interest rate means that banks can loan each other excess reserves more frequently. This means banks have a greater leeway to lend to normal people without having to worry as much about keeping a 10% reserve ratio. If they accidentally go below $10, they can simply borrow excess reserves from another bank at a cheaper rate. So that very act of buying bonds from your grandfather with printed money creates a butterfly effect of lowering interest rates everywhere, including the rate that banks lend to each other, i.e. the Fed Funds Rate.
As banks begin to lend a little more carelessly, interest rates throughout the entire economy begin to decrease, as money is now more readily available for lending.
This act of decreasing the Fed Funds Rate literally acts to inject more money into the system, and conversely when the Fed increases the Fed Funds Rate, this will literally remove money from the system. The Fed will decrease the Fed Funds Rate by buying assets on the open market and will increase the Fed Funds Rate by selling off its assets on the open market.
Key Takeaways:
- The Fed does not directly control any rate or price, but guides them by printing money or removing money from the system.
- The Fed can buy assets on the open market just like any person can buy a bond or a stock, but the Fed buys these assets with printed money, increasing the total money supply.
- When the Fed sells those assets, it literally acts to remove money from the system.
- When the Fed buys an asset, they are buying from a real person or business who has a bank account. The seller will receive this new money from the Fed and deposit this money into their bank account — giving banks more money to lend with.
Quantitative Easing & The Fed’s Balance Sheet
After understanding the Fed Funds Rate and how the Fed can buy assets on the open market, it will be much easier to understand Quantitative Easing. Quantitative Easing (QE), was the name the Fed gave to their experiment where they mass-purchased assets on the open market after the financial collapse of 2007.
The goal of the operation was not just to decrease interest rates, but to simply increase the supply of money.
At first, QE was split up into 3 rounds of purchases, and the Fed bought 4 trillion dollars in assets. You may often hear the phrase, “the Fed increased its balance sheet,” and this is what they’re talking about here. Their balance sheet contains the value of all the assets they have purchased on the open market. All of this information is public, you can view their balance sheet here.
QE was first pitched as a temporary operation, but as QE2, and then QE3 came to pass, it became clear that QE would never leave. In September 2019, the Fed began a new operation in the repo markets. The only real difference in this operation was that the Fed specifically purchased short-term bonds, but the principle was the same as previous QEs. Instead of being dubbed QE4, this operation was dubbed by the finance community as NotQE. This name was clearly a joke at the expense of Fed Chairman Jerome Powell, who persistently claimed that they were not doing QE.
In 2020, QE was solidified as a permanent banking structure with what the finance community is calling QE Infinity, an unlimited purchasing of bonds, junk bonds, and ETFs. As of this writing, its disrupting effects are still taking place.
Key Takeaways:
- Quantitative Easing (QE) was an act to increase the money supply after the Great Recession. The Fed initially bought 4 trillion in assets on the open market and therefore increased the money supply by 4 trillion. As of this writing, the Fed’s balance sheet sits a little over 6 trillion and will likely see 10 trillion before year’s end.
Fed Interest on Reserves and Non-Textbook Ways of Tightening
Around 2015, the Fed started its “tightening” cycle. You may hear this stated in several different ways. Tightening, Contracting, which contrast with Easing or Expanding. These terms simply mean either removing money from the system (tightening) or printing money (easing).
Normally, as economic textbooks would describe it, this process of tightening would entail selling off its assets on the open market, but this is not what happened. This was a whole different kind of tightening, and arguably, not really tightening at all. They began raising the Fed Funds Rate without selling off their assets.
As we discussed previously, the Fed should only be able to raise the Fed Funds Rate if it sold its assets, because this money given to the Fed in exchange for assets would be removed from the system. So how were they able to raise the Fed Funds Rate while still keeping their assets?
As it turns out, the process was mostly smoke and mirrors. They were not adjusting the traditional Fed Funds rate, and many finance journalists made the mistake of writing stories about this particular rate. What they were actually adjusting was a rate not as many people know about. They were increasing the interest on reserve rate.
Many banks, and all large banks, have an account with the Fed. In the same way that you have a bank account with Bank of America, BoA has a bank account with the Federal Reserve. Instead of having an actual vault where they keep all their reserves, many banks actually keep their reserves in an account at the Federal Reserve.
In 2008, the Fed essentially told the banks: “If you keep your reserves parked at the Fed, we will pay you an interest rate on those reserves nearly equal to the Fed Funds Target Rate.” Since then, the Fed has been paying banks as an incentive NOT to lend their customers money.
If a bank can make, say 1.5% by simply keeping their reserves at the Fed, that’s a guaranteed 1.5% and it is far more preferable to keep more money parked at the Fed than to lend to one of their customers who might possibly default. There’s far less risk keeping money parked at the Fed than there is lending, so this works to discourage lending and potentially raise interest rates.
In 2015, when the Fed began to ‘raise rates’, they were trying to do that by simply increasing interest on reserves rate, which theoretically discourages lending, and evidence suggests that it does.
Up until 2018, the Fed’s balance sheet remained the same. In early 2018, the Fed finally started to actually sell off its assets. They sold about half a trillion dollars worth of bonds in 2018. At the end of 2018, the stock market collapsed nearly 10% and the Fed immediately stopped selling off its assets.
This was likely not a coincidence. It’s evidence that the Fed has created an economy dependent on easy money and monetary stimulus, and the events of 2020’s QE Infinity adds more water to that argument.
Key Takeaways:
- In 2015 the Fed began to raise the Fed Funds Target Rate without selling off its assets, but instead by increasing the rate at which they paid banks for keeping their reserves parked at the Fed.
