Keywords: economics, finance, money, banking, FED, “Federal Reserve”, gold, silver, “fiat money”, inflation, savings, investment, taxes
Put a dollar bill in front of you and look at it. How much is it worth? In case you do not have one, here is a picture of a $100 bill. Notice that the face is not smiling.
It cost the Federal Reserve about 1.25 cents to make it and its average life span in circulation is about 6 months. At the top, it says “Federal Reserve Note.” A long time ago, it said “Silver Certificate.” So I ask again, how much is it worth?
In legal terms, a note is a promise to pay. That dollar bill is a promissory note to pay the bearer one US dollar. What is a US dollar? It is another Federal Reserve note. So I ask once again, how much is it worth?
The answer is (drum roll please): Money is worth what someone else thinks it is worth who has something you want and is willing to give it you in return for that dollar bill. It you think it is worth more than that dollar bill, you think you found a good bargain. If you find out later that someone else would have given you the same thing for less than a dollar, you feel like you were ripped off (cheated). Ergo, money only works when everybody you trade with for goods and services sincerely believes that piece of paper is a valuable substitute for barter goods. In other words, it is about collective faith.
When a whole crowd of people lose faith in the value of money, bad things happen. When money is a scarce commodity (e.g. job loss, banks stop lending, interest rates rise, taxes increase), bad things happen. When a whole lot of people compete for a scarce resource and bid up its price, bad things happen. When people collectively bargain for and get higher wages and benefits without adding an equivalent extra value for their services (increase productivity), bad things happen. When wealth is highly concentrated in a small elite segment of the population, businesses run out of customers that are able to buy their products or services. That affects the business’s ability to prosper and its ability to meet its payroll. Jobs are lost and more customers are lost. Ergo, monetary value is also about fairness, honesty, availability of basic resources, a stable balance between supply and demand, distribution of wealth, and balance of power.
How do banks really work?
When you deposit money in a bank, the bank must deposit in the Federal Reserve a percentage of the aggregate deposit balance specified by the Federal Reserve System. Some call this the “Federal Deposit Rate.” For illustration, suppose it is 10 percent and you just deposited $100 you received from a tourist from outside your local area. This means that the bank is free to loan out the other 90 percent, or $90. Let’s assume that the bank loaned 90 percent of its deposits, including $90 of your deposit. The person who received that loan most likely used it to pay for goods and services from others, who deposited it in their local bank. Their bank could loan out 90 percent of your $90 or $81. This process theoretically could repeat itself down to the last 9 cents. Ergo, your $100 deposit could theoretically generate an increase in the local money supply of $90 + $81 + $72 + $64.80 + . . . + $8.75 + $7.88 + $7.09 + $6.38 + $5.74 + $5.17 etc. for a grand total of $900. Your $100 deposit added another $900 to the money supply in circulation in your area. Economists call this the “money multiplier effect.” Did your $100 increase the money in circulation within the entire USA? It depends on where that $100 came from.
What if this deposit was a check?
The banks exchange check images electronically through the Federal Reserve Banks. This check image travels between Federal Reserve Banks until it reaches the local bank of the person or business that gave you the check. That other bank must deposit that $100 in your bank’s Federal Reserve account from its own Federal Reserve account. It used to take several days to pass all of that check paper around. The amount of money circulating within the Federal Reserve System to clear all of those checks is called “Federal Reserve Float” or “money float.” That is why the local bank flags a hold on your $100 deposit for one to three days by calling it “uncollected funds.” Once the check clears the Federal Reserve and lands in their account, the bank releases its hold on your $100 deposit and calls it “collected funds.”
What happens when a bank does not have enough money in its Federal Reserve account to cover its Federal Deposit Rate minimum balance?
It can borrow money from other banks that have a surplus balance in their account brokered by the Federal Reserve at a fixed daily interest rate set by the Federal Reserve. Some call this the “Federal Reserve Funds Rate” If the local bank cannot maintain its minimum Federal Reserve account balance; it must get it by selling off some of its loan portfolio, or borrow money from banks that specialize in banking customers. They are called “Investment Banks.” Another resource is insurance companies.
In other words, banks buy money wholesale and sell it retail. If prudence requires it, they may also resell high-yield loans at a discount. Their money source is deposits, loans from other banks, loans from investment banks, and resale of part of its loan portfolio to other banks, investment banks, insurance companies, hedge funds, investment funds, and now the US Treasury. Federal, State and local government can assist the local bank by leaving unspent tax collections in a demand deposit account at the local bank.
What causes banks to fail?
A bank’s income stream is inherently highly interest-rate sensitive because it mostly consists of demand deposits and demand savings accounts. Even certificates of deposit used to have a two-year maximum term. Now they go out five years or more. However, a bank’s loan portfolio has a longer-term maturity and is by nature less sensitive to interest rate behavior.
Suppose you crunch the numbers of a theoretical bank’s loan portfolio, and come up with a weighted average maturity and a weighted-average yield of the entire portfolio. If our theoretical bank’s portfolio is all mortgages, the weighted average maturity could be ten years out with a yield of 6 percent. Automobile loans could have a weighted average maturity of about 18 months and a yield of 9.5 percent. Lines of credit to commercial borrowers have a weighted average maturity of about 6 months and a yield of 5 percent. Credit card debt has about a 20-day weighted average maturity or less with a net yield of 12 percent. Let us say for example that our theoretical bank has a $1 billion loan portfolio with a weighted average maturity of 5 years and a weighted average yield of 7 percent.
Now let us look at the banks weighted average maturity of its money source and the weighted average yield of its cost of that money. Would you believe less than two weeks weighted average maturity with a weighted average cost of 3 percent? Let us go with that for our example.
Oh my, there is trouble brewing in the financial market. Congress lowered taxes, but did not reduce spending, creating a deficit. The Fed is trying to mop up their mess to control the money supply by increasing the Federal Funds rate and the Deposit rate. The Chair of the Fed mumbles something about irrational-exuberance and gets everyone excited. The news media is in a feeding frenzy. The interest rate has soared. The cost of money is now 8 percent and climbing.
The bank’s weighted average cost of borrowing shifts from 3 percent to 8 percent in less than two weeks. However, its loan portfolio is yielding only 7 percent and it is going to take the bank five years to shift only half of its loan portfolio to a higher rate. To make matters worse, people are using their demand deposits to invest in other bank CDs, the stock market, gold and silver, and US Treasuries with a principal value protected by cost of living adjustments. The Federal Reserve minimum balance is not enough to cover the size of their loan portfolio and they have to increase their deposit balance in their Fed account. In addition, the bank is experiencing unusually high bad debt losses in its loan portfolio because people invested in adjustable rate mortgages and now can no longer afford them. Now the Federal regulators (not from the Fed) are insisting that the bank increase its loss reserves.
This situation actually happened during and after the Reagan administration. You already know what the Democrats did to Fanny Mae and Freddie Mac, so I will not elaborate on that aspect of the story.
The bank is under new ownership and new management. Moody’s rates the bank as “stable.” The bank declares a dividend of 1 cent per share and its stock price dives accordingly. The bank’s CEO needs to sell off as much of its long-term portfolio as possible to get the weighted average maturity of the loan portfolio closer to the weighted average maturity of its deposit portfolio. It issues commercial paper and CDs because they have a longer maturity than deposits, and he can buy money from sources outside the Fed jurisdiction. He cannot sell bank stock because the stock market hammered its price.
Who has long-term money with deferred payout obligations and wants to invest it? Insurance companies, trust funds, endowment funds, investor pools through investment banks, and brokerage firms all fit the bill. They are willing to buy investments, but do not want the collection hassle. The bank creates a security package backed by the longest-term mortgages in its portfolio. The rate on the security is shorter term and a fixed rate. Ergo, he just reduced the weighted average maturity of his bank’s loan portfolio and partially hedged the bank against interest-rate fluctuation.
Life is good, so now he can play golf again and look forward to an annual bonus. Right? No, wrong again. Those mortgages that backed up those securities turned sour and the investment bankers want retribution. Well, who are the bad guys? We have to blame somebody because it just human nature and the natural order.
Let us blame the US Government. The US Government:
- Spent more than they received,
- Borrowed against the Country’s future,
- Increased the National Debt and the cost of its debt service, which
- Reduced the net yield of its tax revenue to pay for operating expenses.
The imbalance in the age of the population (caused by World War II, the Korean War, and the Vietnam War) is stressing the entitlements because they were not actuarially sound. The US Corps of Engineers WPA project was supposed to keep New Orleans out of high water. A gulf tornado named Katrina just shredded the seawall, and nailed many other cities along the coast.
I could go on and on with this scenario, but I think you get the picture. We need remedial action now that will not make the situation worse than it is already, and will not bite us in our backside later.
Summary so far
The Federal Reserve (FED) has some tools to control the amount of money in circulation and the cost of money borrowed and saved. One tool is the Federal Reserve Deposit Rate imposed upon the banks. Another tool is the Federal Reserve (loan to member banks) Rate, which indirectly pegs the prime lending rates banks charge to their largest loan customers. The interest rate that banks charge to their best customers is called the “Prime Rate.”
A Nasty FED Obligation Few People Know About
If the US Treasury has to pay out more than than it receives, the US Treasury has to borrow the difference. If it sells US Government Bonds to its citizens, it extracts money from circulation equal to the money it over-spends, avoiding the money multiplier effect. If it sells bonds to foreign investors, that action may or may not affect the supply of money in circulation. If the US Treasury cannot sell bonds because nobody wants them, the FED becomes the lender of last resort. In other words, the FED MUST BUY THE UNSOLD BONDS. If the FED wants to expand the money supply, it can voluntarily buy US Government obligations. This action totally kicks in the money multiplier effect, described above. This inflates the currency, a tax on savings. This is why a loaf of bread that cost 39 cents in 1960 now costs over $2.25 on sale. The FED wouldn’t dare call this behavior “inflation”, so they invented another term to describe their behavior: “Quantitative Easing.” The last I looked, the FED owns over $4.7 trillion US dollars in US Government debt.
Who financially benefits from quantitative easing? Who pays for the consequences of quantitative easing?
Why is the money supply so important?
If the US Government prints money that stays in your wallet, or in a business merchant’s cash drawer, or in a bank teller’s cash drawer, or in a bank vault, the US Government effectively has an interest-free loan, compliments of its citizens. If the US dollar is revered throughout the international banking community as a reserve currency, the US Government gets an interest-free loan from its trading partners. If it overdoes the size of the money supply, there is too much money chasing limited supplies of goods and services. This breeds inflation and makes the money worth less as an exchange unit for goods and services. That is bad because that action also devalues long-term savings.
The private sector alone cannot directly increase or decrease the money supply because a payer (sending) bank’s loss is a payee (receiving) bank’s gain. One positive money multiplier balances out an equal and opposite negative money multiplier balance. However, the private sector can influence the distribution of the money supply. Indirectly, the private sector can influence the money supply. The purchasing habits of US citizens (buy more imported goods than it sells to them) can force the US Government and/or our Federal Reserve System to do things they would not want to do.
The Role of Government
Ok, so who can affect the value of money and the size of the money supply?
Government has a dramatic effect on the supply of money. The US Treasury taxes its citizens directly through personal taxes, licenses and fees. The US Treasury indirectly taxes its citizens through corporate taxes. The Federal Government also taxes the savings of its citizens through the worst tax it can administer . . . inflation and devaluation of its money.
If the Federal Government spends more than it receives through tax revenue, it must borrow the difference. The cumulative net sum of unpaid US Government borrowing is called the “National Debt.” If you stacked enough $100 bills on top of each other to pay off the US National Debt, the stack could collide with satellites.
A high national debt hurts our economy in several ways. The interest required to service the debt reduces the amount of revenue collected by the US Government to pay for operating expenses. That debt cost increases if interest rates rise when expiring debt is refinanced. The only way to reduce the cost of debt servce is to pay down the national debt, lower interest rates, or both. Our government’s ability to do that action diminishes as our government continues to spend more than their revenue. Did you know that our government owes other economies over 55% of all other debtor nations combined?
Another Pop Quiz
If you could spend $1,000 per second, 24 hours per day, 7 days per week, including holidays, how long would it take to spend $1 trillion US dollars?
. If the US Treasury cannot sell enough bonds to the private sector, it must sell bonds to foreign investors. Where do they get US dollars to buy these bonds?
If the US Treasury can sell bonds to the US public (called the private sector) and spend it all in the USA for goods and services, does it affect the money supply? Does it cause inflation of the currency? Does it affect the quality of life of its citizens?
A Few Pop Quiz Answers
People who benefit the most from inflation are:
- The people in debt,
- With salable hard assets (gold, silver, etc.),
- Little or no personal cash or cash-equivalent savings,
- Little or no fixed-income investments such as bonds or long-term loans,
- Have inflation-protected defined-benefit pensions, and/or
- Receive earned-income credit or low or no income tax liability.
People who suffer the most are:
- Retired and/or disabled people living off of fixed income retirement savings,
- Who invested in the reverse of the above,
- With high and under-insured medical bills, and
- High tax liability.
It would require about 31 years and 8 months to spend $1 trillion dollars at $1,000 per second without pause or rest.
Foreigners have a boatload of our cash because we bought more stuff from their citizens than we sold to them. Now foreigners are investing US money in US assets such as mineral rights, land, real estate, and stock in its corporations. These investments yield profits that go to the foreign investors, not US investors.
When the US Government spends money for goods and services in competition with its private sector, that action reduces supply but not demand. This situation creates an inbalance until higher prices or expanded supply restore balance. If the government extracts money from the private sector to pay for these goods and services, the private sector must reduce demand to the level they can collectively afford, draw down savings, or go into debt. This behavior enables the full effect of the money multiplier.
Private sector quality of life is reduced when government spends money for goods and services that the private sector receives no tangible benefit. Examples are military weaponry, foreign aid, congressional junkets,.UN dues, foreign wars and insurgencies, diplomatic services, and the like.
Federal Government purchases can compete with the private sector for limited resources. This action affects the balance between supply and demand for these goods and services. That competition can bid up the prices for these goods and services. The result is a decline in the value of the dollarin international commerce.
Federa Government plicy toward employers can affect the value f our currency if:
- Frivolous government regulation, licenses, fees and taxes increase the cost of doing business,
- Employees are denied the right to work,
- Businesses are hamstrung by work rules to remain inefficient,
- Organized labor unions disrupt employee services through slowdowns, property damage, employee intimidation, frivolous lawsuits, featherbedding and strikes, and/or
- Business cannot compete in the world marketplace
Business iss compelled to charge more for the same thing because costs outpace productivity. Alternately, they can utsource their production to foreign shores, thereby causing unemployment. The obvious result is inflation of the curreny.
Ok, but how do entitlements affect the economy?
Entitlements are US Government commitments to pay people in the future. The best examples are Social Security and Federal retirement benefits. If the entitlements are funded through a balanced tax policy, nothing happens long-term. If the entitlements are under-funded, the US Government must borrow or tax money from non-beneficiaries to cover the payouts as they occur. If the entitlements are over-funded, the trust fund invests the surplus in US Government securities, thereby lowering the National Debt.
How the US Government GETS that money to cover the revenue shortfall determines whether or not it increases the money supply. How the US Government INVESTS that money to cover future commitments affects the money supply. If the entitlement’s reserves are invested in US Government bonds, it is not a real investment. Instead, it is just financing part of the National Debt with money from the Social Security Trust fund. It is like having two wallets, one in each hip pocket. If the right wallet is empty, transfer money from the left wallet and call it a loan.
How do imports and exports affect the US economy?
If the USA citizens buy goods and services from foreign countries that exceed the value of goods and services foreigners buy from the USA private sector, that creates what economists call a “Balance of Payments Deficit.” If the foreigners use that money to invest in USA assets, the private sector is selling our country piecemeal to foreign ownership and using our money to do it. That is one way national corporations have become international corporations. Foreigners already own about 35 percent of USA assets in land, real estate, and ownership of USA corporations (and their assets).
A farmer would describe this conduct as “eating your seed corn.”
 Contrary to popular belief, corporations do not PAY taxes. Corporations COLLECT taxes. If they cannot raise prices to cover their tax liability, the rest goes to the bottom line on their income statement “Total Net Income.” Therefore a corporate income tax and the employer portion of payroll taxes are really a combination of a hidden consumption tax paid by its customers and a hidden investment tax paid by its shareholders. How many politicians realize this fact? Probably zero.