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Copyright (c) 1999 Commodity Systems Inc. (CSI). All rights are reserved.
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Topics discussed in this month's journal.
Bob Pelletier is taking a brief sabbatical from writing new articles for the CSI Technical Journal while he devotes more of his energies to engineering and implementing CSI's enhancements to our data delivery system. This article is an updated version of an essay that appeared in the August, 1996 issue. It is the first installment in a two-part series on the Federal Reserve. An Essay - Part I The enormous economic power wielded by the U.S. Federal Reserve System has a very great impact on the lives of every American. Even our overseas trading partners are not exempt from its mind-boggling influence. Knowledge of how the Federal Reserve operates has supported the efforts of many successful traders. This first installment of our series about the Federal Reserve Board explores two economic views that have influenced this country. Through these views, we hope to explain how the Federal Reserve System works. Next month we will dig into the mechanics and consequences of controlling U.S. monetary policy by the Federal Reserve and we will address the political connection of this arm of government. The basic responsibility of the U.S. Federal Reserve System is to control the credit and the supply of money within the system itself. This includes just about every money depository institution in the United States. The Federal Reserve System was created with the passage of the Federal Reserve Act of 1913. The Act created twelve Federal Reserve Banks distributed around the country, which are supervised by the Federal Reserve Board and the Federal Open Market Committee (FOMC). The intent of the legislation was to give the Federal Reserve Board in Washington the authority to stabilize the credit and money markets so that inflationary and deflationary pressures could be controlled. The express objectives included stabilizing the dollar, maintaining high employment, fostering economic growth, achieving balance of payments equilibrium and maintaining a rising level of consumption. The Fiscalists and the Monetarists The emphasis on consumption, rather than production can be attributed to John Maynard Keynes. Keynes, a British economist known for his economic theory circa 1919, advanced the fiscal view. His theory involved controlling the economy with tax rates and government spending. Keynes authored Indian Currency and Finance and The Economic Consequences of Peace, which were very popular works in their day. Keynes' view that peace is a deterrent to prosperity has outlasted him. My recollection following World War II was that the Keynesian "beware of peace" position was well entrenched in the minds of all well-educated people. My own money and banking professors of the '50s believed that only through "prudent fiscal policy" could we avoid another depression. I don't think I'm being unkind or inaccurate when I recall my professors saying, "We can always tax our way out of a jam or start a war somewhere to keep the economy on track." Keynes, in attempting to apply his own economic theory to the currency markets, made substantial profits speculating on the strength of the dollar versus European currencies. However, in 1920 he suffered bankruptcy when speculating on a bearish posture for the German Mark. After replenishing his capital and reputation through his writings, he successfully speculated in commodities, accumulating over one-half million pounds. In spite of his later wealth, he was known for offering his guests meager meals and sending them away hungry. In one report, he paid native boys in Algiers such a pittance for shining his shoes that he was stoned in return. His reaction: "I will not be a party to debasing the currency." Keynes' theory has had its trials as applied to the American economy, but the later monetarist view on monetary control represents the flavor of the official policy adopted today. The monetarists control the economy by manipulating the money supply and rates of credit. Milton Friedman advanced the monetarist view that the quantity of money, prices, national income, and velocity of money interact to keep our economy in check. Mr. Friedman was born in 1912, some 22 years after John Maynard Keynes and one year before the enactment of the Federal Reserve Act. He was short in stature (five feet five inches), but a giant in his contribution to economic theory. He was not
the first to advance monetaristic views concerning the supply of money, but he
was an avid lecturer and probably the most consistent advocate of monetary
policy. He believed that control of the money supply, not government fiscal
policy, should be the primary means to manage the economy. He also believed
that an insufficient money supply was the major contributor to the Great
Depression.
The Great Debate CNN pundits have noted the similarity between the current mid-west drought and the dust bowl days of the Great Depression, hinting that an impending repeat of deflationary forces may be in store. When debating the cause of the Great Depression, a fairly significant event to consider is the stock market's strength in the late 1920s. Just prior to the DJIA's peak in 1929, the market showed amazing strength, going from a low of 65 in mid 1921 to a high of 382 on September 12th 1929, a nearly 600% rise. This was the result of great technological advances in radio communications, cinematography and aeronautics, plus advances in the phonograph, lighting, electricity, etc. The DJIA had
a dizzying drop of nearly 50% from 382.0 on September 12 1929, to a low of
224.7 on November 18, 1929. A 33% recovery rally in the winter of 1929 was met
with further drops to a low of 43.9 by July 14, 1932. There were signs at that
time that the depression had seen its worst days. The total drop from the late
1929 highs measured nearly 90% before the final carnage was over. From there
the market has demonstrated a gradual rise that carries forward to today. See
the chart showing the Dow Industrials from October 4, 1928 to August 7, 1936.
Although today's conditions, which have yet to precipitate a disastrous effect,
exhibit haunting similarities to the rapid stock market advance that preceded
the Great Depression, I do not believe that a repeat is in store.
Banks, the Money Supply and the Fed Banks represent one mechanism through which the U.S. government exercises the monetarist's view espoused by Friedman. To a large extent, the banks themselves implement Fed-directed changes in the nation's money supply. Increases in the money supply are facilitated by commercial banks when they loan money or purchase securities. The Federal Reserve regulates the amount of money a bank can loan by requiring the bank to maintain a percentage of its assets on deposit at the commercial bank's regional Federal Reserve Bank. This percentage is known as the reserve requirement. If a commercial bank, for example, has $1,000 on deposit in the Federal Reserve Bank and the Federal Reserve is currently imposing a reserve requirement percentage of 10%, then the bank can grant loans totaling $1000/0.10 or $10,000 and effect a $10,000 increase in the nation's money supply. If the Federal Reserve wants to increase the money supply, it might buy U.S. Government Securities (T. Notes, for example) on the open market with a check drawn on the U.S. government. (The only cost to this transaction is the ink used to write the check because the money is created out of thin air.) When the seller of the securities deposits the government check in his commercial bank, the bank's deposits (reserves) at the commercial bank's Federal Reserve regional bank increase. With these increased reserves, the commercial bank can now increase the money supply (at a multiple of 10 times the amount of the government check, using the above example) by making new loans based upon the increased reserves from the seller's deposit. In reverse sequence, the Federal Reserve can decrease the money supply and commercial bank reserves by simply selling government securities out of its own inventory. The check received from the buyer that is drawn on a commercial bank is paid by the commercial bank. This transaction serves to decrease the commercial bank's reserves and the commercial bank is then forced to trim its loan portfolio by calling in loans. In lieu of calling in a portion of their loan portfolio, other alternatives for the commercial bank would be to borrow excess reserves from some other commercial bank at the Fed Funds rate or to borrow the necessary funds at the Federal Reserve discount window. This latter alternative, although less expensive for the borrower, is taken by the Fed as a sign that the borrower is overextended. Therefore, to keep the Fed from imposing an audit, banks usually get their needed funds from other banks that are operating below the Federal Reserve's reserve requirement. Such loan transactions are usually temporary measures by banks, which keep them from having to abruptly disturb their loan portfolios. The Fed is not responsible for the spread between the prime rate and the federal funds rate (the interest rate commercial banks charge each other) or the spread between the prime rate and the federal discount rate (the rate of interest charged by the Federal Reserve District Banks of commercial banks). But this spread represents the minimum gross total margin a bank earns for arranging a loan to a favored business. The spread represents an enormously lucrative opportunity for banks in general. It is no wonder that current Federal Reserve Chairman, Alan Greenspan, is known to be a close friend to the banker. The rate banks charge, if you think about it, is realistically a form of government sanctioned price fixing. A major bank, noting a Fed sanctioned discount rate hike, will announce a change in their prime rate. Other banks in the U. S. will then follow suit by imposing the exact same rate change on their books. Obviously, banks are insulated from any illegalities for price fixing. General Electric and Westinghouse management officials spent considerable time in jail for fixing the prices of heavy electrical equipment in the early 1960s. It is difficult to understand how banks all over the U.S. can not be cited for price fixing when nearly every commercial bank in the country can adopt a fixed pricing policy for loans pegged to an arbitrarily large spread above the federal discount rate. This
Technical Journal's introductory installment hints at the enormous power and
influence exerted on each of us by the Federal Reserve. I hope that we have
helped to heighten your awareness of the Federal Reserve Board and the
repercussions of its actions. Next month's installment delves into flaws in the
Federal Reserve's procedures for money management and suggests a solution to
the overall problem.
(Signed) Bob Pelletier
Bibliography: American Economic
Review, March 1968, "The role of Monetary Policy," p. 1-17.
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