Happy Saint
Patrick’s Day. We won’t be wearing green
on the blog today, but we will be talking about it. Long green, that is: money. Admittedly, that’s a pretty clumsy way of
segueing into our subject, but they can’t all be smooth . . . which doesn’t
detract from the importance of what we’re talking about.
 |
| "Ich bin der Stat...I mean..." |
Ask most people
today what a central bank is supposed to do, and they’ll answer “to fund
government,” or words to that effect.
Oddly enough, however, that’s not why central banks were invented, nor
is it what they’re supposed to do. In
the preface to the original Federal Reserve Act of 1913, it states that the
system is being established to (and we quote),
. . . provide for the
establishment of federal reserve banks, to furnish an elastic currency, to
afford means of rediscounting commercial paper, to establish a more effective
supervision of banking in the United States, and for other purposes. (Ch. 6, 38 Stat. 251,
December 23, 1913, 12 U.S.C. ch. 3, § 1.)
 |
| One Dollar Treasury Note of 1890 |
Read that again and see if you can find where it says that
the primary purpose is to fund government.
Then dig out a copy of the original Act (it’s
on the internet), and give it a read through. The Act specifically prohibits dealing in
primary issuances of government securities, i.e.,
securities issued to monetize deficits.
Dealing in secondary issuances was allowed to retire that portion of the
national debt backing the National Bank Notes of 1863-1913, the Treasury Notes
of 1890, and the United States Notes of 1861-1963. In other words, part of the reason for
establishing the Federal Reserve in the first place was to get rid of the
national debt, not to make it grow to astronomical proportions.
 |
| Federal Reserve (Bank) Note Series 1914 |
You’d never know
that from the way the Federal Reserve operates today. Contrary to the original intent, new
money is created these days by the central bank to purchase Treasury paper, and
destroyed when the central bank sells its accumulation of government debt
(bills of credit). Thus, rather than a having a reserve currency backed by
productive assets (or any assets at all), America today has a reserve currency
backed by government debt — the very thing they were trying to get rid of in
1913. The reserve currency is still uniform and elastic, but it is far from
stable or asset-backed.
How was it supposed
to work? By rediscounting qualified
private sector commercial paper representing the present value of actual future
assets, not unqualified government debt representing the present value of
future possible taxes . . . that might never be collected. . . .
That’s a nice bit of
jargon, but what does it mean? It’s
actually pretty simple.
 |
| Tellers at the First National Bank of Columbia, PA, cir. 1890. |
Let’s talk “discount
window.” Although no actual teller’s
window exists where commercial banks stand in line to sell loan paper to the
Federal Reserve (although commercial banks used to have such things — the photo to the left is of the First National Bank of Columbia, Pennsylvania, now a museum, well worth a visit, which has a — pardon the expression — mint condition discount teller's window), the
transaction is described as taking place at “the discount window.” When the
discount window is “open,” commercial banks can sell their “qualified
industrial, commercial and agricultural paper” to the central bank, which creates
money by issuing promissory notes backed by the paper to purchase it.
When the discount
window is “closed,” commercial banks must go elsewhere to obtain reserves to
support their loans, or cease making loans. Important point: reserves do not
back bank-created money, but provide uniformity and confidence in the system by
supplying cash to satisfy daily transactions demand and allowing the
bank-issued money (promissory notes and demand deposits) to be converted on
demand into the reserve currency.
Thus (if operated
correctly) a central bank ensures that there is always enough money in the
economy, and that all the different types of money can be converted into a
reserve currency that is stable in value and asset-backed.
Of course, we know
that’s not what’s going on — but we’ll look at that tomorrow.