Tax protestors and their obsession with the Federal Reserve

[LightinDarkness]

I think the obsession with the federal reserve is because its an organization that is essential to our economy but functions in a way that is difficult for the average person to understand. That makes it an extremely easy conspiracy mongering target.

I have been struggling with a way to explain the federal reserve in as simplified a way as possible to conspiracy theorists. I don't even know if this is right, but - can someone tell me how this sounds for explaining to how money is created:

(1) The federal reserve sells a bond on the market. Lets say the bond was a 30 year 1% interest bond for $1 - the federal reserve now owes the bond holders $1.01 in 30 years, and for now has $1.00.
(2) The federal reserve member banks draw upon the $1 proceeds and loan it out to commercial banks at say 2%. Now the federal reserve can pay the bondholders back (eventually) and nets $0.01 profit, which is rebated to the US treasury. Commercial banks receive the $1 and now owe the federal reserve $1.02.
(3) The commercial banks loan that money to me the consumer at 5%, so now I have the $1 and will pay back $1.05, meaning that the bank has profited $0.03. Oh and it can only loan out that $1 it got from the federal reserve member bank if it already had at least $0.10 in other assets*.

Is this correct or do I have it totally wrong?

*I'd also like a way to clearly explain fractional reserve banking, as the CTers seem to go NUTS about that. They THINK it means that with $1 a bank can magically wave a wand and loan out $10. But in reality doesn't it just mean that with $1 in assets a bank can loan out $10 in obligations, but it still owes those obligations (still has to be paid back). The purpose of fractional reserve banking is to ensure that credit is liquid, because if we forced banks to only give out loans equal to the assets they had on hand, there would never be enough money to lend out.

I admit I dont know much about how the federal reserve works, I just know it doesn't work how the conspiracy theorists claim it does.

[Gregg]

I think the obsession with the federal reserve is because its an organization that is essential to our economy but functions in a way that is difficult for the average person to understand. That makes it an extremely easy conspiracy mongering target.

I have been struggling with a way to explain the federal reserve in as simplified a way as possible to conspiracy theorists. I don't even know if this is right, but - can someone tell me how this sounds for explaining to how money is created:

(1) The federal reserve sells a bond on the market.yes, so far Lets say the bond was a 30 year 1% interest bond for $1 - the federal reserve now owes the bond holders no, the treasury as issuer of the bond does$1.01 in 30 years, and for now has $1.00.
(2) The federal reserve member banks draw upon the $1 proceeds and loan it out to commercial banks at say 2%. Now the federal reserve can pay the bondholders back (eventually) and nets $0.01 profit, which is rebated to the US treasury. Commercial banks receive the $1 and now owe the federal reserve $1.02. no, not exactly
(3) The commercial banks loan that money to me the consumer at 5%, so now I have the $1 and will pay back $1.05, meaning that the bank has profited $0.03. Oh and it can only loan out that $1 it got from the federal reserve member bank if it already had at least $0.10 in other assets*.

Is this correct or do I have it totally wrong? see my earlier post about confusing even to the well meaning

*I'd also like a way to clearly explain fractional reserve banking, as the CTers seem to go NUTS about that. They THINK it means that with $1 a bank can magically wave a wand and loan out $10. But in reality doesn't it just mean that with $1 in assets a bank can loan out $10 in obligations, but it still owes those obligations (still has to be paid back). The purpose of fractional reserve banking is to ensure that credit is liquid, because if we forced banks to only give out loans equal to the assets they had on hand, there would never be enough money to lend out.

I admit I dont know much about how the federal reserve works, I just know it doesn't work how the conspiracy theorists claim it does.

The goal of monetary policy is to match the increase in actual wealth to a corresponding increase in money. And in very simplified terms, increase in wealth = value added to commodities or services.
When GM buys $1200 worth of steel, aluminum,plastic etc... pays $5000 in fixed costs for the factories and expenses and $900 worth of labor to build a car they then sell to a dealer for $12,000 who eventually sells it to a consumer for $15,000, the value added at steps along the way are increases in wealth. The dealer created $3,000 of wealth (minus their overhead etc...) the employees added the $900 worth of wealth for the work they did, etc... I can and have done this analysis of a car for every penny down the line including purchased parts, shipping costs, all the way. In the end, a $15,000 car assembled in the USA with a USA engine and transmission increases the wealth in the US economy buy about $3500. Trust me on that, the spreadsheet was about 200 pages.
So anyway, the Fed, will on the one consumer transaction need to increase the money supply by $3500. One of the reasons this simple calculation is so hard to make is GM doesn't tell the Federal Reserve about the $3500 until 3-6 months after the fact, and the action the Fed takes on that day doesn't really have effect until 3-6 months more afterwards. But all the drama of control of the money supply is adding up all those transactions for every company in the US economy, and they even have to estimate the black market, cash only economy, drug dealers and money launderers....all of these things need to be taken into account. I'm sure a congressional committee would be better at this
So, that's what they're trying to do. The mechanical levers they have are controlling the discount rate which in theory worked when it was a drastic step but not so much anymore. Because of the stuff I talked about before, controlling the rate now is much less effective and really has more of an effect on velocity than aggregate supply. Another step is they can dictate reserve requirements which does control the supply because it changes the amounts involved in all those discount window loans which indirectly influences corporate borrowing, and if corporations can't move commercial paper easily they issue more bond debt or equity, both of which behave differently in the ...hard to explain, they have different effects, mostly again on velocity which slows down the longer term the debt is. Finally, they have open market operations, currently the lever they use.

In open market operations, they simply control the ratio of different obligations in the total portfolio. The Fed doesn't pay the interest, it's US Treasury Debt and tax funds pay the interest, either to the private sector which increases the money supply at the same pace as the interest payed.
Taxes received = wealth created ---> interest paid on government debt ---> money supply created.
That is the ultimate way the Treasury creates new money, incoming tax funds that go towards paying interest is new money. In the real world, that is a minimal amount, but until the Federal Reserve Act, that and increase in specie (gold and silver) was the only way the money supply could expand. And since the needs of business and agriculture needed a more flexible money supply a central bank of some kind was needed. Remember, although pretty much every developed nation on earth had a central bank from at least the 17th century, the USA didn't have one in 1912. During the Civil War, the treasury began acting like one, but there are problems with that, and before that there was one that Andrew Jackson killed, and until they fought about slavery the politicians fought about banks so it was an on again off again thing. It ended up causing a panic or crash or recession or something else about every 20 years. This is why I say thank whoever you prey to every night for the Fed, they prevent that, more or less.

As I explained above, we have a more flexible system now. Treasury issues debt, which will increase the money supply at that rate, but to make it more flexible the Fed buys and sells some of that debt from the people who originally bought it from the Treasury or their successors, (never ever ever does the Fed buy new debt directly from the Treasury) or takes some of what they bought and hold as inventory and sells it.

When they buy, they issue new Federal Reserve Notes to pay for it and that increases the money supply. That new money is backed by the future payments they will receive in interest on the securities they now hold.

When they want to decrease the money supply, they SELL from their inventory and accept Federal Reserve Notes in payment, which they then retire, reducing the money supply.

This increase or decrease in the money supply is the basis for commercial banks to make new loans.

(continued)

[Gregg]

How banks create new money out of thin air!

Well, they don't. If I buy a new house lets say that in all that building a new house I created $10,000 in new wealth. Because of that, eventually, the money supply will increase $10,000, and that new money will be created when the Fed buys an existing government security from someone in the private sector, pays them cash for it, with a newly issued Federal Reserve Note.
The new money is created because of the new wealth created when I caused a house to be built, it is funded by a portion of tax revenue being used to pay the interest on a government bond, the taxes are paid by the guys who built the house etc... it's like the circle of life.

Now, if I get a loan the bank is going to create new money, sort of. They are going to leverage the new money created by the Fed, and that new money is still created by the creation of new wealth from building the house, but instead of being funded by taxes used to pay interest, it's funded by...
ME, as I pay interest on the mortgage for 15 years (do yourself a favor and never finance a house more than 15 years or a car more than 36 months)
The money from out of thin air is actually money I am going to earn, a portion of which I'm giving to the bank (plus the principal) over 15 years. The bank is not creating any money, I am, by doing something for an employer that causes an increase in wealth.


The concept is easiest to grasp when you equate new money with new wealth. And most new wealth eventually breaks down to labor. The countries with the most efficient economies are usually the ones with the most productive labor. A sudden surge in assets like the California Gold Rush can definitely goose it for a period, but long term economic performance will always correlate to labor productivity.

[Edgar]

So I guess this tendency can be partly chalked up to people not understanding how the Fed works.

What rather annoys me about all this conspiracy-mongering is that legitimate criticisms and suggestions regarding the Federal Reserve (e.g., whether they should take or not take particular actions; possible improvements to the organization's structure, oversight, or operations; etc.) seem to get lost in the vast sea of "OH MY GOD THEY'RE SAPPING OUR MONIEZ!!" (On the Internet, at least. Maybe in the realm of books and academic papers this isn't as true)

Thanks for the replies, by the way.

[notorial dissent]

The biggest problem, is that the Fed is very much a hybrid critter, a gov't controlled entity pretending to be independent, a bank that isn't really a bank, and that operates under rules totally separate from any other institution. For the most part, the Fed's actual banking functions are pretty much straightforward and comply with normal usage, if you squint real hard in some cases. The sticky parts come when they start carrying out Congressional or Treasury mandates that really are outside regular banking function, the big bailout for instance. Then we go from murky to absolutely Byzantine, and the ignoricenti, who can't wrap their minds around the way a regular checking account works are totally lost at this point, so it has to be a vast conspiracy. The fact that this probably includes a good portion of Congress as well is just more grist for the mill. The thing that really sends them over the edge is the fact that the Fed issues currency, and this is just more than they can cope with, since they can't/don't understand this function at all.

[Gregg]

Over the years, and to its credit, the Fed has alienated both political parties. One thing they are very good at is not making policy decisions based upon politics and that's why I feel so strongly that after BOG members are appointed by the President and approved by the Senate, they should be accountable to no one. It's also very fortunate that so far no Fed appointment has ever been of someone that people outside of banking or academics has ever heard of, they don't have big fights like Judges and cabinet appointments.

One other thing most people don't recognize, but people in finance most assuredly do is that the decisions they vote on are almost always unanimous. While they may not agree during the debate, for the sake of appearances it is expected for members to in the end vote for with the majority and for one of the Governors to vote differently is a sign of a pretty big disagreement. I wish the Congress could do the same.

[LPC]

The biggest problem, is that the Fed is very much a hybrid critter, a gov't controlled entity pretending to be independent, a bank that isn't really a bank, and that operates under rules totally separate from any other institution.

When you say "problem," are you talking about the issues that tax protesters have with the Fed? Or something that you think is a problem with the structure and operation of the Fed?

If the former, I agree.

If the latter, then you say "bug" and I say "feature."

As far as "bailouts" are concerned, I've read several economists express the view that central banks have traditionally acted (and should act) as "lenders of last resort" when an important part of the economy is about to fail. See, for example, this piece by economist J. Bradford DeLong, which addresses non-actions of the European Central Bank (not the Fed).

[fortinbras]

One of the reasons that the sovruns and others hate the Federal Reserve System is simply that they don't understand or know how it works; nor its history and the development of its various policies and functions. I have to admit this is not an easy topic; I didn't do at all well in banking class when I made an attempt at getting an MBA. There are no mass market paperbacks that explain the Fed, with the result that this vacuum is filled with stuff churned out by the cranks.

[notorial dissent]

When you say "problem," are you talking about the issues that tax protesters have with the Fed? Or something that you think is a problem with the structure and operation of the Fed?
Sorry, I could have been clearer here, the "problem" is on the TP side.

As far as "bailouts" are concerned, I've read several economists express the view that central banks have traditionally acted (and should act) as "lenders of last resort" when an important part of the economy is about to fail.
I agree, and have no problem with the bailouts either, as traditionally it has been a function of a/the Central Bank to do that sort of thing, and as long as they do so under some kind of Congressional oversight and with authorization I see no problem with it, and to my mind is the only sensible solution. Although it certainly confused and upset some members of Congress, as I recall, even though they had in fact authorized it.

I think what set them off, from what I can gather, was that the loans were in effect off the books and were treated differently, and that they were accounted for differently than the regular Fed operations, and this got them all in a lather, although I really don't think they knew why.

[Number Six]

As a coin and currency dealer (ebay handle "coinethics") you might think I would have a strong bias against the Federal Reserve and have the attitude of a raving anti-government wacko. Personally I have no problems with the banks or various federal entities which are just trying to do their jobs of maintaining a fair and honest playing field. As such there is quite a bit of good and intelligent feedback on this thread, especially by "notorial dissent". The important principle is one of accountability without which you have anarchy and disaster in every field. My guess is that the long history leading up to the creation of the Federal Reserve with the robber barons and other economic predators spurred reasonable government controls; subsequently other controls developed to address many other needs and frauds.

[notorial dissent]

Number Six, very well, and aptly put.

As I said previously, the biggest "problem" with the Fed, at least from/for those on the outside is that bank accounting does not make a lot/great deal/any sense to people who think they still have money in their account because they still have checks, and for real, that isn't a made up joke. Over the course of my mis-spent career, I worked with a great many of those, whose interest on their net worth would have swallowed me whole and left room for any number of other people as well, and who fervently believed that. Their trick was that they had lots more money, somehwere else, and just hadn't gotten around to spending it yet.

If you're really interested in how the Fed came in to being, there are several books out about the good/bad old days before the Fed when infamous old J P Morgan, who actually had, or controlled enough money to actually bail the country out of a depression, or beginnings of one, not once, but twice. Part of where the Fed came from, was the absolute bile that the establishment in DC felt at having to ask/beg him to bail them out, and the fact that not only did he , but that he could do it. I am thoroughly convinced that this was the beginnings of the Fed, whether he actually got credit for it or not, since he was effectively doing what a central bank could and should do. At any rate, between 1907 and 1913 the Fed came in to existence, and supplanted the likes of J P Morgan.

One of the things I have always wondered about, was what he could have/would have done about the impending depression of the 1930's. I am quite sure he would have seen it coming, and always wondered what his reaction would have been.