“End the Fed”? — Maybe Learn What the Fed Does First!

I was recently lurking on one of the online crypto forums where a bunch of ‘connectors’ and social media mavens use to bring developers and venture capitalists together with people who want to get involved in crypto but are not sure what they can do to help.

The topic turned (as it often does) to how we should ‘take down’ the fiat money system.  *sigh*. This is quite often the battlecry used by the crypto mavens to galvanize support from developers and armchair anarchists, as the anti-establishment theme seems to be able to rouse the most revolutionaries to action. (That, and free pizza seems to work equally as well).  The discussion spiraled into a lecture where I very calmly, coldly, explained how the Fed system of money works and why fiat money was already digital to people who didn’t understand how our money system works and was hell-bent on ‘fixing’ it with crypto money, because it was digital, and therefore, modern, new, and definitely what we want for Christmas. *sigh* (again).

The problem with the crypto space in general that has become very apparant to me is that people don’t really understand how the existing money system works, and yet, they proprose to have great solutions for it.  It’s likely listening to a fengshui guru try to design and architect your house for you.  He has neither the experience or qualifications to do any sort of structural engineering or design, but he thinks that this window definitely needs to face southwest otherwise your life will certainly suffer ruin and misfortune.

Making matters worse, a lot of the misinformation comes from people who have ostensibly worked in the financial sector, albeit likely were IT in a financial tech company like Bloomberg or some other ancillary industry to the finance sector.  Unfortunately, due to the speed at which the industry of crypto has grown, there are way too many instantly rich ‘lucky fools’ to who are the new breed of venture capitalists, and an even larger cohort of ‘lucky idiots’ who found themselves involved in crypto not because of their contributions to the art, but because they got into the space early enough to be seen as ‘experts’.

Take it from me, the ratio of true experts to charlatans in crypto is a very very small fraction.  Most of the experts in the field don’t have time to write blogs, lurk on forums and prostelitize on reddit.  (Which incidentally explains why the rate at which my blogs are updated these days has fallen drastically in recent months).  But I digress.  This blatent affront on the fiat system by charlatans which clearly did not understand anything about how the money system worked demanded that I rouse myself from my productive work to explain.  After I was done, I realized that perhaps it wasn’t all the fault of the mavens who speak as if they know but know not what the speak… maybe it was the simple fact that not many people know how banking and money really works. I thought back to how I learned about this, and it was through my own research while working at Goldman Sachs, coupled with a colleague who I worked with at JPM who worked as a treasury trader.  Certainly not the kind of information or experience that is easily digestable by laypeople.

So I thought, maybe it was high time that somebody explained, in SIMPLE terms, the basic misconceptions about our money system.

Firstly, know this: Although all its operations and structure of the Federal Reserve is public information, they don’t go out of their way to teach the general public about how money works.  This is, I believe, part of the design. If too many people knew how the money system works, then they would likely find fault and think it wasn’t totally fair to [some special interest group or demographic].  So when desiging a money system that is based on the general trust and belief that money is worth something of value, then it behooves the designers not to explain the details to everyone, as faith is much stronger a motivator than logic.

But you knew this already, otherwise you wouldn’t be a reader of my blog. You want the logical facts. You want to make up your own mind about things.  Good. So here comes the firehose. Brace yourself.

I will structure this lesson as a series of commonly misunderstood things about the fiat money system.

Misunderstanding #1 – The central banks (Fed) prints money. That is how fiat is created.

Truth: Not really. Well, that isn’t how most money is created anyhow.

Contrary to popular belief the Fed while actually creating the notes and bills that represent money, (literally printing the physical bills) they don’t actually CREATE the money it represents whenever they feel like it. Money is created by the Treasury Dept (government) selling bonds to the Fed, which creates money in order to buy them. So the government is the ones actually creating money from nothing (the hallmark of a fiat money system) when they decide to print and sell more bonds to the Fed. (usually because they need to fund government spending that taxes isn’t enough to cover).  The Fed actually makes a profit from the interest on these bonds, which is shared among the Fed’s shareholding banks. The Federal Reserve system (or simply central banking system for other countries) is that banks can have a lender of last resort, in case they find themselves in a shortfall for their liabilities.  This prevents economic downturns from making banks go bankcrupt, which may have a domino effect and cause more issues for other banks, causing a meltdown.

Misunderstanding #2 – The Fed is run by the Government

Truth: No. The Fed is actually a privately owned bank, which is owned by shareholder banks and some super secret entities (cue tin hat conspiracy theories here). They operate on a government mandate, but they are their own masters.  The only pull the gov has over the Fed is that the president gets to nominate the Chairman of the Board of the Fed. Effectively assigning its “CEO”.  But the shareholding parties also have their own governing board members and it acts very much like a bank.  Other central banks around the world may have different setups, but they are generally not directly controlled by the government.

Misunderstanding #3 – The government creates most of the money we use.

Truth: No. Actually your local bank that you get a loan or mortgage from is how most of the money in the system is created.

Both retail and commercial banks are the only ones that create money outside of the Gov issuing treasury bonds.  They do this by creating loans.  Every bank is allowed to have outstanding loans as a ratio to the actual cash reserves that they have on hand at their reserve bank accounts (an account which is held at a local Reserve Bank which is part of the Federal Reserve system). In accordance to this, e.g. if they accept $100 worth of deposits from customers they are allowed to create $900 of outstanding loans.  This 900 dollars is created from thin air, added as a cash credit to the borrowers account, and added as a loan asset on the banks balance sheet, balanced by a liability for the borrower.  This is how MOST money is created in the economy.  So the banks create money in response to the market’s demand for loans. This is a good thing, as it ensures that money is always ‘available’ to fund developments.  It is a bad thing, when too many banks given out loans to people to can’t actually repay them, which was the case in the financial crisis of 2007.

What? You mean banks can just create money they need to lend to people? But what about inter-bank loans? Overnight swaps? LIBOR swaps? And the whole FX market of derivatives? How can they just create all this ‘fake’ money? This leads us to the next one…

Misunderstanding #4 – Investment Banks and Commercial Banks are the same

Truth: False. Ever since the Glass Steagall act, they cannot be the same company. In fact, they were only licensed equally because of the obvious benefits of being the lender of money and also the facilitator of fund raising for companies.  Investment Banks cannot create money. Commercial Banks can.  Investment banks (the guys like Goldmans) who engage in the securities market activities have their primary purpose hedge risk, raise funds, and to do M&A and IPOs, acting as a ‘facilitator’ for businesses who need capital. Even though some of Glass Steagall has been since repealed, and the same company can be both a commercial bank and an investment bank, the point is still that the commercial banks are the parts that can create money via loans. Not the investment bank businesses. So banks cannot create money to pay for their debts to other banks.  They have to borrow money from other banks in order to fufill their daily cash settlement demands. This is one of the reasons why an overnight swap, spot, and forward markets exist (among others). Because if any bank (or company for that matter) cannot settle their daily liablitities, then they are technically in insolvancy. Not a fun place to be if you are a bank. (or any entity for that matter).

Misunderstanding #5 – Fiat money isn’t digital

This is actually how the debate on the online forum started.  Some person was adament that fiat money wasn’t digital.  They likely took an old Economist magazine front page headline a bit too literally. (and didn’t have the wherewithal to realize it).
Actually this is even where most people who you would think know better (even ones that worked in the industry) get it wrong.  Fiat money is >90% digital.  M0, which is the classification of money that is in the form of notes and coins, makes up for less than 10%.  And of that M0, 2/3 lives outside of the US.  All other forms of USD, live in bank account balances, which is reconciled up to the the top level Fed accounts.  Therefore, fiat currency is very much digital.  It’s just not cryptographically secured, nor is the supply of it metered by some algorithmic process as is the case with cryptos such as Bitcoin.  Instead the Fed system uses a hierarchical tree of double entry accounting books to reconcile from your bank account at your local bank all the way up to the accounts at the Fed and other central banks around the world.  The way this is structured is that each bank in addition to keeping the books for their clients must keep accounts for other banks they have dealings with.  This is the system of NOSTRO and VOSTRO accounts and it is necessary that each bank in order to have a banking license in a country must have a NOSTRO account at a bank further up the chain, ending with a bank that has an account with the Fed (central bank) itself.  Normally this layering is only 2 levels deep for the big banks, but smaller regional banks may have to bank with a larger bank who in turn will have a NOSTRO account with a bank which is directly part of the Federal Reserve network.  This is how all daily reconciliations are done, so that every penny is counted and the system is ties out. The only potential source of error to this balanced accounting system is due to the paper notes and coins that could be counterfeit or lost to the system.  Which is the reason why banks want to reduce the use of physical bearer instruments such as notes and coins as much as they can.  You can go look up the Fed’s balance sheet which is public and see for yourself, but knowing you are likely too lazy to click on the link and find it I’ll put it here for your convenience. You see that number under liabilities labelled “Federal Reserve notes in circulation”? that is the exact number of M0 money of USD that exists in the world, (excluding the exceptions mentioned). Yep. You read right. That is 1.6 trillion dollars in cash floating around in the system.  How can the fed possibly come up with this number in a reliable fashion if it were not reported back up to the Fed by the Reserve banks who have their master accounts at the Fed themselves?

Which leads us to the last one…

Misunderstanding #6 – Banks are evil because they can create money when they want to make loans, while at the same time when they need money they can always borrow from the Fed

Well, this is somewhat true.  Banks which are part of the Fed system that have accounts with the Fed directly CAN borrow money from the Fed through what is called the Discount Window.  This is supposed to be the lender of last resort. As such, the discount rate (interest charged) is not attractive nor meant to be.  Instead banks borrow from each other through what is called the Fedfunds rate. This is somewhat controlled (through a market process) by the Fed board of governors, but in practice this is just the average rate that depository institutions will lend to each other.  If too much or too little lending is happening at a given rate, then the Fed will step in with open market operations (buying or selling of treasury bonds or other instruments) to reduce or increase the amount of money in the system so that the Fedfunds rate move closer to what is targeted by the Fed’s board of governors.  What is borrowed needs to be repaid with interest, so it isn’t in a banks best interest to borrow more than they need, or to hoard cash and not lend.  Banks that borrow too much, or make too many bad loans and end up not being to meet their obligations will go bust.  (or should go bust).

The last point is really the main problem with the central banking system.  Banks need to be allowed to go bust if they, through the process of making too many bad business decisions, end up not being able to make their interest payments.  That, and simply the fact that by centralizing the management of money, a single failure in a system of highly inter-dependant banks, stands to have large scale systematic effects if any bank large enough (thus having many liabilities owed to other banks) were to fail.

Crypto may have some part to play in improving the system.  But I believe it will be more on the aspect of making financial transactions transparent, and accountable. Not simply from the fact that it will make things digital or more readily reconciliable.  The current system is already pretty good at accounting and keeping balances straight.  All that is needed is to make the system more transparent, and perhaps reintroducing the notion that banks should once more be in the business of raising capital, instead of simply creating it when needed.

/EOL

Update:

It works now!

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