Re: Let's understand how money is created ... and how the Fed works

On Thu, 18 Dec 2008 10:40:33 -0800 (PST), Saggy <gurfinkle@xxxxxxxxx>
wrote:

Thanks for your response .....

...No, again the Fed does not buy bonds from the Treasury. That is
called "monetizing the debt" and it is entirely illegal.

...The Fed buys and sells assets in dealings with the public.

Are you sure about this? It doesn't make any difference if the Fed
buys directly from the government, or from the public.

It makes a tremendous difference.

See "hyperinflation and the Weimar Republic"

That's why it's illegal.

The Fed holds
the bond, the government or the public has new money created by the
Fed. The debt is monetized either way. Bonds held by the Fed
represented monetized debt because they are paid for with new money
created by the Fed.

Nope.

The Fed buys and sellls to control the money supply to keep the price
level stable.

The Treasury sells bonds to finance government operations.

Those are two entirely independent operations -- one does not
determine the other.

The Fed has a independent governors largely to assure they stay
indepedent.

"Monetizing debt" means that effectively or literally the goverrnment
is printing currency to pay its bills -- adding "high power money" to
the base of the multiplier, in the amount of its deficit -- which then
gets multiplied and goes straiight into inlfation then hyperinflation.
Weimar, Zimbabwe today, etc.

If the Fed monetized the US debt, you'd see the credit rating of the
US plunge fast.

The Treasury issues and sells bonds to finance the govt, and this has
no effect on the money supply -- the deficit adds nothing to the money
supply.

The Fed buys and sells to control the money supply, regardless of what
the Treasury is doing.

Two different, independent processes.

.... Historically, in normal times, these have almost always been T-
Bills bought froim selected "dealer" banks.

Yes this part I understand.

....>What types of loans to banks does the Fed make?
...Changing by the minute!
....>Does it require security? Does it expect to be repaid?
...Until now and so far, yes and yes.

This is what is confusing me. What type of security is
'traditional'?

For the last few decades the Fed didn't make many loans to banks.

It has a "discount window" to which banks can go when short of funds.

In the early days of the Fed this was a major operation, as the Fed
gave short-term loans to small local banks with seasonal cash flows,
such as those in agricultural areas.

The loans would be secured by the bank's assets, its loan receivables,
whatever.

In recent decades with the nationalization of the financial system
that pretty much stopped since it became very easy for solvent banks
to borrow from each other and other financial institutions.

So if a bank showed up at the discount window asking for money the Fed
would ask, "What the hell is wrong with you that nobody else in world
will lend to you?" and the bank would get swarmed over with auditors,
maybe get closed down. Banks didn't like that so they stoppped going
there.

Of couse today, with nobody lending to anybody, the discount window is
whide open and they've punched through the wall to make it larger.


Apparently now I read the Fed is loaning money and
taking various suspect 'assets' as security. Does it take physical
possession? .

That's not necessary, a legal claim is fine.

If you have a mortgage the bank doesn't need to take physical
possession of your home to have it secure yoiur loan.

Is this precedented? Is is controlled by law?

Sure and yup.

If
it is loaning against toxic assets at face value, why would it expect
to be repaid?

"Toxic" doesn't mean worthless.

What it really means is "illiquid" not convertable into cash, not
readily salable at a market price today.

If and when the markets return to normal they could become perfectly
marketable and liquid again -- but in the meantime they are clogging
up the banks' balance sheets and inhibiting their ability to operate.

The original plan of the "$700 billion bailout" was for the Treasury
(not the Fed) to buy them and hold them until the crisis passed and
they became marketable again. Because the Treasury wouldn't care if
they were marketable in the short-term. Meanswhile banks, that do
care, would get cash.

But that plan was dropped -- in part because of the great difficulty
in setting the right price for the Treasury to buy them at when there
is no market price. Set too high a price, the Treasury and taxpayers
take a big loss. Set too low a price, the banks take a big loss --
which doesn't help them but only further damages their balance sheets.

Time to move on to Plans B, C, D...

Are the Fed loans long term or short term? Are there restrictions?

This is the crux of what I don't understand at present.

All this is changing as things move along.

You know, the web sites of the Fed and its reguonal banks have a whole
lot of educational and news material, that answer most of your
questions.

You should go look there. The information is a lot more reliable than
you'll get from a usenet news group like this. A LOT.


....>Now, if a loan defaults, the money is still in circulation. I've
read
....>that this money is somehow effectively removed from the money
supply
....>because the bank has to decrease it's asset base by the amount of
the
....>default, but I don't understand the reasoning for this.

....Loans are not money.

Correct. But the money loaned was deposited in an account. There is
the new money. When the loan defaults the money is still there.

No, the deposit is the money. (The money is not "in" a deposit account
-- the deposit, which is just a liability noted on a balance ***,
*is* the money).

And it would seem that if a borrower defaults on a loan he no longer
owns bank deposits, because if he did he'd still have money with which
to pay back the loan. So the deposit he made with the loan proceeds
is gone, it ain't still there. He's consumed all his deposits and
still owes on the loan.

Now with the loan in default the bank that made the loan has suffered
a loss. This impairs its ability to make further loans. If it wants to
stay in business it must use its cash income to cover its loss and pay
its own bills, instead of to make loans. When current loans are paid
off the bank uses the money it receives to pay its own mortgage,
electric bills and salary costs etc., instead of re-lending it out. It
may also call in loans to do same.

If this happens on a large scale across the banking system the money
multiplier goes into reverse, contracting the money supply.

If you looked at the charts I noted in my prior post, you see that
this is in fact what has happened.

Yet
I have read that when the bank balances its books, or does whatever it
does to account for the default, this money is somehow subtracted from
the money supply.
.