The Fed’s Superpowers

(updated 8/18/2020 9:40am PT)

How can we Structure the Financial System to be Compatible with a Shared Ownership Economy? (Part 3)

Part Three – The Fed’s Superpowers

The Federal Reserve is an interesting beast.

It is the key player of the money and banking system – it can issue the national currency, it facilitates the national payment system, it determines the level of interest rates and, at least on paper, it implements monetary policy and provides regulatory oversight of the banking sector (it has failed spectacularly in this last task in the run up to the financial crisis of 2007-2008 as I will show below).

It has an amount of power in shaping the US economy and the financial system scantly understood by the general public.

The name “Federal Reserve” might suggest it is a government entity. It is not.

The Federal Reserve system is a network of 12 private banks owned by the national member banks headquartered in their corresponding geographical jurisdiction (for example, JP Morgan Chase is a shareholder of the NY Fed while Wells Fargo is a shareholder of the SF Fed).

I will just mention that the Federal Reserve System also comprises two important Boards in part appointed by the US Government: the Federal Reserve Board setting the rules for the operation of the 12 Federal Reserve banks and the Federal Open Market Committee determining the levels of interest rates (the cost of money) and deciding when and how to intervene in financial markets by buying and selling securities.

And intervened they have!

As I write the S&P500 is trading higher than in January of this year and very close to an all time high. Now, can you imagine anything that happened since January which might make US stocks less valuable?  Perhaps a global pandemic raging through the US and the rest of the world having killed already more than 170,000 and infected more 5 million in the US? Perhaps the contraction of the US economy by 32.9% last quarter? Perhaps the more than 50 million jobs lost since March? Not to worry! Thanks in part to the Federal Reserve’s compassionate and timely implementation of the leave-no-billionaire-behind program  it has reflated financial markets and caused the net worth of billionaires like Jeff Bezos to increase by $584 Billion in the first quarter of 2020 alone while $6.5 Trillion of household wealth disappeared. Such is the power of an entity like the Fed with infinite buying power!

What would be important for all of us is understanding how such power could be harnessed to build a stronger economy and preserve our natural capital instead of enriching the financial elite in this country.

But let’s forge ahead.

The Fed sits at the top of the money hierarchy and can issue the highest form of money – the national currency. There is a physical form your are very familiar with – the dollar bills in your wallet. The Fed also issues Federal Funds Deposits – an electronic form of the currency exclusively used by banks.

You can think of the Fed as the banks’ bank. National member banks have a “checking account” at the Fed they use to settle their balances with other banks. If you write a check to someone banking with a different bank, your bank will need to transfer federal funds deposits from its checking account at the Fed to that of the payee’s bank. So, while commercial banks can create electronic money when they make loans (as I explained in part two) they cannot use the money they create to settle their own accounts but must use federal funds deposits, a higher form of money created by the Fed.

Banks are constrained in the amount of electronic money they can create by the availability of worthy borrowers (at least for the loans they have to keep on their books) and by capital and liquidity requirements. Without getting into the nitty gritty, banks need to hold an amount of federal funds deposits representing a certain percentage of their demand deposits (the electronic money in their clients’ checking accounts) and their equity capital need to be in proportion of their assets (mostly loans they made).

When the Federal Reserve goes shopping or makes loans it just creates the money needed for the transaction by simply typing numbers in a computer. Unlike the banks, the Fed has no limit to the amount of money it can create!

When the Fed was created in 1913 the U.S. Congress established three key objectives for monetary policy in the Federal Reserve Act: maximizing employment, stabilizing prices, and moderating long-term interest rates. Nowadays it looks like the primary objectives of the Fed is the profitability of the banks and extending the bubble in financial markets.

If you watched the movie The Big Short or read Michael Lewis book by the same title you have a sense for:

  1. Excessive money creation by banks issuing mortgages to anyone with a pulse
  2. The Fed’s dereliction of its duty to provide oversight of the banking sector (remember the NINJA loans? Mortgage loans very popular in 2006 and 2007 to people with no income, no job and no assets. Banks would originate and immediately sell them to Wall Street so that the shadow banking system could turn them into tradable securities which then collapsed like a Jenga tower taking the US economy with it in 2008).
  3. The ability of Wall Street to profit from the inflation of the US real estate bubble and from its implosion
  4. The disastrous economic consequences of an unregulated financial system (thank you Bill Clinton!)

There are two more things you need to understand about the Federal Reserve before I can bring this interminable preamble to an end and turn my attention to the solutions:

  1. The effects of 5 years of ultra low interest rates (see below) and
  2. The expansion of the Fed’s balance sheet since 2007 (next post)

The Federal Open Market Committee (FOMC) set the Federal Funds Rate – the interest (cost) paid by member banks for overnight borrowing of excess federal funds deposits from other banks to meet their mandatory liquidity requirements. The Federal Funds Rate influences all interest rates throughout the financial system (e.g. the prime rate, mortgage rates, interests paid on savings account, on student loans, on commercial loans, on credit cards balances etc.)

The picture above shows that in the aftermath of the financial collapse of 2007-2008 the Fed set the fed funds rates at near zero.

The effect has been a massive wealth transfer from the general public (especially older people living off their fixed income portfolios) to financial speculators on Wall Street and large publicly traded companies.

The financial speculators borrowed money almost at no cost and invested in higher yielding assets around the world (the so called “carry trade”). Large publicly traded companies instead used the super cheap money to acquire smaller competitors or to buy back their shares and boost their stock price linked to the compensation of their top managers.

When interest rates change, there are winner and losers yet the public has not say in these matters. To move towards economic democracy the FOMC needs to become more representative of the population at large.

For Part One please see What Does Finance do for Society?

For Part Two please see Money and Banking

Published by Marco Vangelisti

Marco Vangelisti is a 100% impact investors dedicated to shifting financial capital from Wall Street and the extractive economy towards building the world we want. He helps individual investors, family foundations and financial advisers move towards aware and no-harm investing.

2 thoughts on “The Fed’s Superpowers

  1. What strikes me as I read this post is my own conflation of “The Fed” with what we now colloquially associate with Alexander Hamilton — the “Central Bank”. Your help in untangling the Federal Reserve for me — and clarification that it is NOT a government entity is vital. I’m grateful for your preamble in helping us appreciate the power of the Fed as a vital component of our basic economic and financial literacy.

    You make some important claims in your last few sentences:

    “When interest rates change, there are winner and losers yet the public has no say in these matters. To move towards economic democracy the FOMC needs to become more representative of the population at large.”

    What might this transition look like? What’s a pathway to getting there? Who has the power to make that kind of change? What coalition with what amount of power would need to come together to enact that kind of change?

    Can you draw on Prompt 2 re: Power to help us begin to understand ( and perhaps quantify) in some regard just how much power might be needed?

    Like

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