Monday, April 7, 2014

Focus on the Fed, I: How the Federal Reserve Creates Money


This piece is intended to orient the reader and frame the discussion presented in “A New Look at Prices and Money” by Norman G. Kurland.  “Prices and Money” was first published in The Journal of Socio-Economics (Vol. 30, pp 495-515), and is available online from the CESJ website.

This piece is not intended to be comprehensive or in-depth, present all possible ramifications, or answer objections.  Its purpose is only to outline the “banking principle” paradigm on which binary economics is based, and within which Norman Kurland’s paper is written.

The banking principle is based on both “past savings” and “future savings.”  Past savings is the present value of past reductions in consumption.  Future savings is the present value of future increases in production.

The banking principle is in contrast to the prevalent “currency principle” that underpins today’s “mainstream” schools of economics.  The currency principle is based on “past savings.”

What is “Banking”?

 

Jean-Baptiste Say
The Federal Reserve System is the central bank of the United States.  Understanding its function and role is sometimes difficult due to the preponderance of what can only be called “myth-information” about money and credit, finance, commercial banking, and central banking.

There are two basic types of institutions that we call “banks.”  These are “banks of deposit,” and “banks of issue,” also called “banks of circulation.”

A bank of deposit is a financial institution that takes deposits and makes loans.  The most common types of deposit banks are investment banks, savings and loans, and credit unions.

A bank of issue is a financial institution that takes deposits, makes loans, and issues promissory notes.  The most common types of issue banks are commercial banks and central banks.

Our concern is commercial and central banks.

Commercial banks are in the business of turning the present value of existing and future marketable goods and services into media of exchange to facilitate commerce and industry.  They do this by accepting mortgages and bills of exchange offered by businesses and private individuals, and issuing promissory notes to purchase mortgages and discount bills of exchange.

A mortgage is a financial instrument representing the present value of an existing marketable good or service (“past savings”).  Most people today think of mortgages as referring only to personal home mortgages.  In this discussion the meaning is restricted to financial instruments representing existing marketable goods and services, i.e., “existing inventories.”

Adam Smith
A bill of exchange is a financial instrument representing the present value of a future marketable good or service (“future savings”).  A promissory note is a financial instrument conveying the promise of the issuer to pay a certain sum on demand or on maturity of the note.

A central bank is, essentially, a bank of issue for banks of issue.  It is analogous to reinsurance.  A central bank issues promissory notes to rediscount bills of exchange offered by its member banks and purchase bills of exchange and mortgages on the open market.

Commercial and central banking are based on the principle stated by Adam Smith in The Wealth of Nations (1776): “Consumption is the sole end and purpose of all production.” (“Part III, Ch. 8, “Conclusion of the Mercantile System.”)  Smith was not the first to make this observation, of course.  It is the basis of “Say’s Law of Markets.”

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