Has the Fed Lost Control Over Money?

Email Print


In my previous
article, “How
Bernanke Snookered Us All
,” I made the case that during a one-month
period, mid-August to mid-September, 2007, the Federal Reserve System
deflated the adjusted monetary base. As with Austrian economists
generally, I define “inflation” as “an increase of the money supply.”
I define “deflation” as “a decrease in the money supply.” The adjusted
monetary base is the only monetary aggregate that the FED controls
directly. I referred readers to the chart and table provided by
the Federal Reserve Bank of St. Louis which tracks this statistic.
do so again

I said that
this decrease in the monetary base was significant because this
was during a period in which the Federal Open Market Committee (FOMC)
of the Federal Reserve System was actively intervening in the market
known as the federal funds rate, i.e., overnight loans from banks
to other banks. This rate had been exceeding the target rate of
5.25% for over two months. The FED normally intervened once a day
to bring this rate back to about 5.25%. I offered a link to a page
where anyone may see the daily rate in the FedFunds market: high,
actual, and the FOMC’s target rate. Here
it is.

So far, we
know two facts: (1) during the month leading up to the September
18 announcement by the FED of a reduction in the target rate for
overnight bank loans to 4.75%, the FOMC was reducing the
one monetary aggregate that it controls directly; (2) the FOMC was
actively intervening daily to reduce the FedFunds rate to 5.25%.

Are you with
me so far?

My conclusion:
the FED was buying repos from the banking system (inflationary —
more money in circulation) while selling other assets (deflationary
— less money in circulation). The FOMC sold more assets than
it bought during this one-month period, which is the only way the
adjusted monetary base could fall.

Are you with
me so far?

I could be
wrong about the FED’s buy-and-sell techniques of this process. I
am always open to suggestions. If someone can show me from the statistics
how the adjusted monetary base could fall during a period in which
the FOMC was actively intervening to push the interday FedFunds
rate back to 5.25%, I want to hear it. I will certainly consider
it. But I do not see how I can be wrong about the overall effect
of this process: more FOMC sales of assets than purchases.

The adjusted
monetary base fell. If the FOMC increased its purchases of assets
in this period, this indicates that the FOMC has lost control over
the monetary base. The base went down, contrary to the action that
traditional central bank theory says must raise it: net purchases
of assets. If the base fell while net monetary base assets (Federal
Reserve credit) increased, this surely calls for an explanation.
I am open to suggestions.

There is a
second question: “Can the FOMC continue to do this, i.e., lower
the adjusted monetary base while also keeping the Fedfunds rate
to 4.75?” My guess is that it cannot — not for long, anyway.
But that is a guess. The FOMC did it for a month.

made this comment
with respect to long-term FOMC policy:
table at the bottom of the chart provides the important numbers:
the rate of increase from various dates until now. From mid-September,
2006, to mid-September, 2007, the increase was 1.8% per annum. This
is what it has been ever since Bernanke took over on February 1,

An increase
of 1.8% is tight money policy by previous FED standards. I have
been hammering on this point for a year. The FED has dramatically
reduced the rate of monetary inflation.

So, I made it
as clear as I could that the FED is not targeting deflation. It is
targeting an inflation of the monetary base at about 1.8% per annum.
To achieve this, it had to deflate after mid-August. Why? Because
it had increased the short-term rate of inflation prior to mid-August.
I quoted my August 28 article: While the FED is now pumping
in new reserves at a little under 6% per annum, and I expect it to
continue this policy for the foreseeable future, I don’t think this
will be enough to reverse the sagging economy in the next six months.
But if I am wrong, then we can expect a return of accelerating price

I do not see
how I could have been more clear. I did not say that the FOMC is
deflating long-term. It is disinflating, compared to what the FOMC
had done under Greenspan.


One criticism
I received from more than one source was this: the banking system
can create credit, which is money, independent of the Federal Reserve
System’s monetary base.

At this point,
the critics are breaking with what money and banking textbook authors
have written about central banking for a century. Let me briefly
review the argument of all economists — Austrian, Keynesian,
Chicago School, and supply-side.

The central
bank creates money when it purchases assets — any assets —
for its account. It spends this new money into circulation when
it buys an asset. This new money is deposited automatically in the
asset-seller’s account in a commercial bank. The fractional reserve
process then takes over. This new money is used by the bank to make
loans. The banks of the borrowers do the same, setting aside the
required non-interest-bearing reserves with the FED. When the process
ceases, the reserves deposited with the FED equal the initial purchase
of assets by the FED. This is the standard textbook account.

Let us get
this clear: the basis of all new credit created by the commercial
banking system is the new money issued by the central bank.

In textbooks
on money and banking, this process is described by the use of a
conceptual tool called a T-account. Step by step, the author shows
how the initial deposit of a check in a bank leads to the creation
of new credit. The FED makes this initial deposit.

The best textbook
I have seen on this process was written by Murray Rothbard: The
Mystery of Banking (1983). You
can download it for free here.

There are
newsletter writers who argue that the banking system as a whole
can create credit independently of an addition of Federal Reserve
fiat money, which is often called high-powered money. I am surely
willing to consider such an argument. What I need is evidence. I
need to be shown how the commercial banking system as a whole can
issue credit in a form that is not regulated by the central bank’s
legal reserve ratio.

As evidence,
I would like a reference to some position paper issued by the FED
which explains this. Also acceptable: a reference to a textbook
or an academic journal that shows how the traditional textbook discussion
of reserve requirements is incorrect.

Anyone who
argues that fractional reserve banks can create credit that is not
under the law regarding reserve requirements is making a very remarkable
argument. For one thing, he is making it difficult to understand
why the federal funds loan market even exists. The FedFunds market
is universally recognized as a market for a bank that has temporarily
exceeded its reserve requirement for the creation of new loans (credit)
to meet this requirement by borrowing from another bank. Here
is the description provided by the Federal Reserve Bank of New York.

funds are unsecured loans of reserve balances at Federal Reserve
Banks between depository institutions. Banks keep reserve balances
at the Federal Reserve Banks to meet their reserve requirements
and to clear financial transactions. Transactions in the fed funds
market enable depository institutions with reserve balances in excess
of reserve requirements to lend them, or “sell” as it is called
by market participants, to institutions with reserve deficiencies.
Fed funds transactions neither increase nor decrease total bank
reserves. Instead, they redistribute bank reserves and enable otherwise
idle funds to yield a return. Technical details on fed funds are
described in Regulation D.

Why would
any bank go to the FedFunds market or the FED’s discount window
to borrow money if it had not exceeded the FED’s reserve ratio requirement?
It must pay interest to borrow this money. Banks do not pay interest
for no good reason. The official reason is that some banks temporarily
have lent out more money than is legal, given the reserve requirement.

Are bankers
irrational? No. Are they in the habit of giving away money to other
bankers? No. Then why does any bank borrow overnight money in the
FedFunds market? The universal answer is: “To meet its reserve requirements
for the day.” If this answer is incorrect, then he who argues that
the banking system can issue more credit than is allowed by the
FED needs to show why this traditional argument is incorrect.

If the monetary
base does not set the limit for bank credit, then he who argues
this way needs to show why the entire academic field of money and
banking has been wrong for over a century. He has to show that Murray
Rothbard ignored something fundamental when he wrote The Mystery
of Banking and his earlier book, What Has Government Done
to Our Money? Because, if the private commercial banks can create
credit — money — independent of the government-licensed
monopoly of the national central bank, then government is not the
culprit that has destroyed our money; commercial banks are doing
this on their own.

You can download
Rothbard’s other book
, which I regard as the best introduction
to monetary theory despite being short, free of charge.

There are
lots of things about money and banking that I do not understand.
But I always thought I understood this: a central bank controls
a nation’s money supply by controlling (1) the reserve ratio and
(2) the monetary base. Anyone who argues that commercial banks can
and do issue credit independently of these two restraints is arguing
that traditional monetary theory is incorrect. Such an argument
requires considerable evidence.

Again, I am
not saying that such evidence does not exist. I am saying that,
so far, I have not seen anyone present it, especially those analysts
who say that the commercial banking system, as a system, can do
this any time it wants.

The bankers
always want to maximize their revenues. They do this by creating
credit, which is based on their banks’ deposits. They do this at
all times. They do not leave a penny on the books in a deposit that
is not lent out at all times. Bank credit is always maximized.

Remember this:
bank credit is money. Whatever a bank lends is money. This money
buys things, which is why borrowers borrow it. They repay in money.
Bankers want to be repaid in money. Credit is issued in the form
of entries into borrowers’ accounts. There is no bank credit that
is not in the form of a deposit in a bank account. So, if anyone
is increasing the supply of credit, this credit is in the form of
an entry into a bank account. Bank accounts are regulated by the
FED: reserve requirements.

What we need
to understand from those analysts who argue that the monetary base
does not set monetary policy for the nation is exactly how the commercial
banking system in the aggregate can issue credit independently of
the FED’s monetary base and its reserve requirements (which rarely

Is this too
much to ask? So, you had better ask it. If someone tells you that
the FED has lost control over the monetary system, and that banks
can issue credit independently of the FED, ask him to explain why
the standard textbook account is wrong, why T-account analysis is
wrong, and how on earth Murray Rothbard got it wrong. The person
who shows this may even win the Nobel Prize in economics, which
is now over a million dollars. It seems like easy money to me for
someone who argues that bank credit is independent of deposits in
bank accounts.


In my previous
report, I wrote this about M-3.

I don’t
think my message has penetrated the thinking of most hard-money
contrarians. They keep citing M-3, which was canceled by the FED
a year ago, and which was always the most misleading of all monetary
statistics. Year after year, the M-3 statistic was four times
higher than the CPI. The M-3 statistic was worthless from day
one. Anyone who used it to make investments lost most (or all)
of his money. I have written a report on this, which provides
the evidence: “Monetary Statistics.”

I wrote my
report on monetary statistics for my Remnant Review subscribers
earlier this year. Because so many well-intentioned people have
been taken in by M-3, and because so many people claim that there
was something sinister in the decision in 2006 of the Federal Reserve
to cease publishing M-3 data, I have posted my full report on my
GaryNorth.com website. Normally, I do not do this with Remnant
Review issues. Download
it here.

The main purpose
of following the monetary statistics is to estimate what effect
this will have on two things: (1) the price level; (2) the business
cycle. Point #1 raises the question: Which statistics of prices?

The theoretical
question of constructing a price index is amazingly complex. The
best book on the question of price indexes was written in 1950 by
economist Oskar Morgenstern, On the Accuracy of Economic Observations.
Morgenstern was one of the few men smart enough to be invited by
Ludwig von Mises to attend his private seminars in Austria. There
is a good presentation of the implications of this
book posted on the Mises Institute’s site

I use the
Median CPI figures — and other figures — to see the trend
of past prices. I want to have some sense of how rapidly prices
are trending upward. The statistics of the Median CPI go back 40
years. They
are posted here
(this week, anyway; they constantly change its
address, which is very annoying).

I update the
link whenever the Cleveland FED updates it. It is always on-line
at my free department, “Price
" (U.S.A.), here.

I have subscribers
who tell me in no uncertain terms that all consumer price index
statistics are fake. My response: as long as they are consistently
fake, I can still use them to see the trend of prices. Only when
the statisticians change their assumptions do the statistics become
useless for assessing past periods that were not updated in terms
of the revised assumptions. Even jiggered figures are useful if
the statisticians retroactively revise previous figures. I can still
see the trend.


maintain that a nation’s central bank controls the nation’s money
supply. It does so with two tools: (1) the legal reserve requirement
and (2) the purchase (inflationary) or sale (deflationary) of assets
in its possession — the monetary base.

If someone
says that a central bank does not control the nation’s money supply
in this way, then he owes it to his readers to explain either: (1)
other ways that the central bank controls money; or (2) the ways
that the commercial banks escape the controls set by the central
bank. Either of these assertions requires a textbook. Saying that
the central bank has lost control does not prove that it in fact
has lost control.

26, 2007

North [send him mail]
is the author of Mises
on Money
. Visit http://www.garynorth.com.
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible

North Archives

Email Print