BUILDING THE MANDRAKE MECHANISM
From The Creature from Jekyll Island
by G. Edward Griffin
(the following is an excerpt from chapter 23, "The Great Duck Dinner" pages 477-481)
In Chapter Ten, we examined the three methods by which the Federal Reserve is able to create or extinguish money. Of the three, the purchase and sale of debt-related securities in the open market is the one that provides the greatest effect on the money supply. The purchase of securities by the Fed (with checks that have no money to back them) creates money; the sale of those securities extinguishes money.
Although the Fed is authorized to buy and sell almost any kind of security that exists in the world, it is obligated to show preference for bonds and notes of the federal government.
That is the way the monetary scientists discharge the commitment to create money for their partners, the political scientists. Without that service, the partnership would dissolve, and Congress would abolish the Fed.
When the system was created in 1913, it was anticipated that the primary way to manipulate the money supply would be to control the "reserve ratios" and the "discount window".
That is banker language for setting the level of mandatory bank reserves (as a percentage of deposits) and also setting the interest rate on loans made by the Fed to the banks themselves.
The reserve ratio under the old National Bank Act had been 25%. Under the Federal Reserve Act of 1913, it was reduced to 18% for the large New York banks, a drop of 28%. In 1917, just four years later, the reserve requirements for Central Reserve-City Banks were further dropped from 18% to 13% (with slightly lesser reductions for smaller banks). That was an additional 28% cut.(1)
It quickly became apparent that setting reserve ratios was an inefficient tool. The latitude of control was too small, and the amount of public attention too great.
The second method, influencing the interest rate on commercial loans, was more useful.
Here is how it works.
Under a fractional-reserve banking system, a bank can create new money merely by issuing a loan. The amount of new money it creates is limited by the reserve ratio or "fraction" it is required to maintain to cover its cash-flow needs.
If the reserve ratio is 10%, then each $10 it lends includes $9 that never existed before. A commercial bank, therefore, can create a sizable amount of money merely by making loans.
But, once the bank is "loaned up," that is to say, once the bank has already loaned $9 for every $1 it holds in reserve, it must stop and wait for some of the old loans to be paid back before it can issue new ones.
The only way to expand that process is to make the reserves larger. That can be accomplished in one of three ways:
1. use some of the bank's profits,
2. sell additional stock to investors, or
3. borrow money from the Fed.
WHEN BANKS BORROW MONEY FROM THE FED
The third option is the most popular and is called going to the "discount window."
When banks go to the Fed's discount window to obtain a loan, they are expected to put up collateral.
This can be almost any debt contract held by the bank, including government bonds, but it commonly consists of commercial loans.
The Fed then grants credit to the bank in an amount equal to those contracts. In essence, this allows the bank to convert its old loans into new "reserves."
Every dollar of those new reserves then can be used as the basis for lending nine more dollars in checkbook money!
The process does not stop there. Once the new loans are made, they, too, can be used as collateral at the Fed for still more reserves.
The music goes 'round and 'round, with each new level of debt becoming "reserves" for yet a higher level of loans, until it finally plays itself out at about twenty-eight times.(2)
That process is commonly called "discounting commercial paper." It was one of the means by which the Fed was able to flood the nation with new money prior to the Great Dam Rupture of 1929.
But, there is a problem with that method, at least as far as the Fed is concerned.
Even though interest rates at the discount window can be made so low that most bankers will line up like ducks looking for free corn, some of them--particularly those "hicks" in the country banks--have been known to resist the temptation.
There is no way to force the banks to participate. Furthermore, the banks themselves are dependent upon the whims of their customers who, for reasons known only to themselves, may not want to borrow as much as the banks want to lend.
If the customers stop borrowing, then the banks have no new loans to convert into further reserves.
That left the third mechanism as the preferred option: the purchase and sale of bonds and other debt obligations in the open market.
With the discount window, banks have to be enticed to borrow money which later must be repaid, and sometimes they are reluctant to do that.
But with the open market, all the Fed has to do is write a fiat check to pay for the securities.
When that check is cashed, the new money it created moves directly into the economy without any concurrence required from the recalcitrant banks.
But, there was a problem with this method also. Before World War I, there were few government bonds available on the open market.
Even after the war, the supply was limited. Which means the vast inflation that preceded the Crash of 1929 was not caused by deficit spending.
In each year from 1920 through 1930 there was a surplus of government revenue over expenses. Surprising as it may be, on the eve of the depression, America was getting out of debt.(3)
As a consequence, there were few government bonds for the Fed to buy. Without government bonds, the open-market engine was constantly running out of gas.
The solution to all these problems was to create a new market tailor-made to the Fed's needs, a kind of half-way house between the discount window and the open market.
It was called the "acceptance window," and it was through that imagery that the System purchased a unique type of debt-related security called banker's acceptances.
BANKER'S ACCEPTANCES
Banker's acceptances are contracts promising payment for commercial goods scheduled for later delivery. They usually involve international trade where delays of three to six months are common.
They are a means by which a seller in one country can ship goods to an unknown buyer in another country with confidence that he will be paid upon delivery.
That is accomplished through guarantees made by the banks of both buyer and seller. First, the buyer's bank issues a letter of credit guaranteeing payment for the goods, even if the buyer should default.
When the seller's bank receives this, one of its officers writes the word "accepted" on the contract and pays the seller the amount of the sale.
The accepting bank, therefore, advances the money to the seller in expectation of receiving future payment from the buyer's bank.
For this service, both banks charge a fee expressed as a percentage of the contract. Thus, the buyer pays a little more than the amount of the sales contract, and the seller receives a little less.
Historically, these contracts have been safe, because the banks are careful to guarantee payment only for financially sound firms. But, in times of economic panic, even sound firms may be unable to honor their contracts.
It was underwriting that kind of business that nearly bankrupted George Peabody and J.P. Morgan in London during the panic of 1857, and would have done so had they not been bailed out by the Bank of England.
Acceptances, like commercial loan contracts, are negotiable instruments that can be traded in the securities market. The accepting banks have a choice of holding them until maturity or selling them.
If they hold them, their profit will be realized when the underlying contract is eventually paid off and it will be equal to the amount of its "discount," which is banker language for its fee.
Acceptances are said to be "rediscounted" when they are sold by the original discounter, the underwriter.
The advantage of doing that is that they do not have to wait three to six months for their profit. They can acquire immediate capital which can be invested to earn interest.
The sale price of an acceptance is always less than the value of the underlying contracts; otherwise no one would buy them. The difference represents the potential profit to the buyer.
It is expressed as a percentage and is called the "rate" of discount--or, in this case, rediscount. But the rate given by the seller must be lower than what he expects to earn with the money he receives, otherwise he will be better off not selling.
Although bankers' acceptances were commonly traded in Europe, they were not popular in the United States.
Before the Federal Reserve Act was passed, national banks had been prohibited from purchasing them. A market, therefore, had to be created.
The Fed accomplished this by setting the discount rate on acceptances so low that underwriters would have been foolish not to take advantage of it.
At a very low discount, they could acquire short-term funds which then could be invested at a higher rate of return.
Thus, acceptances quickly became plentiful on the open market in the United States.
But who would want to buy them at a low return?
No one, of course.
So, to create that market, not only did the Federal Reserve set the discount rate artificially low, it also pledged to buy all of the acceptances that were offered.
The Fed, therefore, became the principal buyer of these securities.
Banks also came into the market as buyers, but only because they knew that, at any time they wanted to sell, the Fed was pledged to buy.
Since the money was being created out of nothing, the cost did not really matter, nor did the low profit potential. The Fed's goal was not to make a profit on investment. It was to increase the nation's money supply..
1. In 1980, statutory limits on reserve ratios were eliminated altogether. The Federal Reserve Board now has the option to lower the ratio to zero, which means the power to create unlimited quantities of money. It is the ultimate dream of central bankers.
2. See post this is in response to for more details.
3. See Robert T. Patterson, The Great Boom and Panic; 1921-1929 (Chicago: Henry Regnery Company, 1965), p. 223.
