What the F*D?! Part 1

Published on 09/24/19 | Saurav Sen | 3,405 Words

The BuyGist:

  • This is the first part of 4 articles that make up "The Buylyst Fed Papers." The papers cover: 
    • Why the Fed came into being.
    • How the Fed changed over time.
    • What is its current role?
    • How its alternatives like Cryptos and the MMT stack up against the current system?

Why this article?

I’m often shocked by how little people know about Central Banking, even in my industry – Investment Management. Most people I come across in my line of work have a superficial understanding of Central Banking, its mandate, and its importance. This is the second-most shocking revelation about my industry, after my realization that most investment managers hadn’t actually read all of Warren Buffett’s shareholder letters. That’s like an aspiring tennis player refusing to watch Federer’s matches.

Anyway, I don’t blame anyone – most people are busy with their daily duties and don’t find the time to step back to think deeply about the game they’re playing. I have been there myself. In investing, the bigger problem is “silo thinking”. In the name of specialization, many professionals miss the forest for the trees. Equity analysts don’t talk to bond analysts. Quants don’t talk to Fundamental Analysts. Economists don’t talk to Research Analysts. None of them talk to industry experts who actually build stuff in the real economy. I can go on and on. But Investing is a polymathic game. And the giants of investing are all polymaths. They have the ability to see the entirety of the game they’re playing, not just the 2-yard radius around their specific position on the field. They have what Charlie Munger calls “a latticework of mental models”.

Central Banking is a good place to see the entire game. Most of us think that this is the purview of some nerdy Macroeconomists, and we’d be forgiven for thinking that. But in reality, Central Banking both affects and is affected by the most “bottom-up” factors, such as you or me deciding to buy a home or even something as minuscule as adjusting our grocery expenditure. One of the central themes of this series of articles is going to be this: Central Banking is not as “macro” and “centralized ivory-tower magic” as most people think. It’s rooted in reality.

But there are other reasons why I bring up this age-old, oft-discussed topic now. Two reasons in particular are current and relevant:

  1. A growing skepticism (and even derision) of Central Banking amongst (mostly) right-wing rabble-rousers, led by President Trump.
  2. Connected to #1, the growing popularity of alternatives to Central Banking such as Cryptocurrencies and the Modern Monetary Theory (MMT) as ways to dissociate society from the evil, grubby hands of allegedly know-nothing economists in Central Banks.

At the heart of these arguments is anti-elitism. Fair enough – nobody likes a bunch of self-proclaimed know-it-alls calling the shots. But here’s my take: The Fed may have its flaws, but its merits far outweigh them. And to appreciate that, it’s important to understand:

  1. Why the Fed came into being.
  2. How the Fed changed over time.
  3. What is its current role?
  4. How its alternatives stack up against the current system?

For the sake of brevity and sanity, I will split up “The Buylyst Fed Papers” into 4 parts. This article is about how and why the Fed came into being and evolved into what it is today. In subsequent worldview articles, I will dig into how the Fed changed over the course of the 20th century, how it does things today and, finally, into alternative systems like Cryptocurrencies and the MMT.

Why have a Fed at all?

Libertarianism is an appealing concept. Minimal government involvement in our lives? Sure, most of us would sign up for that. Libertarianism also lies at the heart of the American story, set in motion with the Boston Tea Party. And more than a century later, it was at the heart of the big fight to form the Fed. The idea of a CENTRAL anything was abhorrent to most of the country. It still is in many parts. And the idea of CENTRAL BANKING was doubly abhorrent. Some unelected group of academic bookworms calling the shots when it comes to the value of my dollars?? No Sir! The skepticism isn’t crazy. But is isn’t well-informed.

The fight to form the Fed was ultimately resolved with a simple correction to this Libertarian mindset. The slow and painful realization that caused this correction was this: The irony of the Capitalistic system is that in order for a laissez-faire economy to function properly, some government oversight is necessary – just a fair game of football needs a referee. The key word here being “properly”, which is debatable. The word “properly” could be taken as – in one sentence – maintain an economic environment in which people are limited by nothing except their ability to produce and consume goods, based on their effort and willingness to do so. Capital should be available to whoever deserves it. That’s how an economy grows.

That is not an official Fed statement. It’s my layman summary of what they’re supposed to do – what their raison d’etre is. And if that statement sounds philosophical and utopian, it’s because it is. As you and I both know, reality is different. However, it’s the Fed’s job to bridge the gap between reality and that statement as best as they can.

The US was rather late in the game when it came to Central Banking. It’s libertarian inclinations, bolstered by PTSD from the Civil War, favored a banking system that was as regional and as decentralized as possible. Roger Lowenstein has written a fantastic book about this. In it, he delineates a constant occurrence of banking crises and credit crunches across the American heartland between throughout the 19th century, right up until the First World War. At the heart of these violent banking crises were 2 main factors:

  1. Too many disparate currencies issued by individual banks in different states.
  2. The close ties of local banks to farming.

#1 and #2 put together created some violent credit crises. Back then – before the First World War – a large chunk of bank loans was made to farmers to fund farm equipment. These loans were made in one of the hundreds of local-bank-issued notes, which were generally accepted across the US when things were good. But here’s a problem that occurred time and time again: If a drought or tornado occurred in, say, Kansas, and destroyed farms, it also bankrupted farmers who wouldn’t be able to pay back loans. Others with deposits in that Kansas bank would rush to withdraw funds from the bank because such a drought would cause enough panic to want cash on hand. But during such a time, a bank would not have enough funds to meet those obligations. To make matters worse, the bank wouldn’t be able to borrow from other banks to meet its obligations – because 1) the bank’s own currency was no longer acceptable, because 2) the bank wasn’t credit-worthy any more in the eyes of banks in neighboring states. The bank, the farmers, and the regular bank depositors would all be stranded.

The history of the US Dollar is messy because the history of US banking is messy – a sharp contrast to the steady trustworthiness to which the dollar is associated these days. A big reason for this transformation is the formation of the Fed. Regular occurrences of bank runs like the Panic of 1907 led bankers like J.P. Morgan and Paul Warburg to lobby hard for a Central Bank that would, at the very least, serves as a “lender of last resort” or be the “banks’ bank”. In 1913, after years of lobbying, they finally got Congress to pass the 1913 Federal Reserve Act, which was ultimately signed into law by President Woodrow Wilson. Thus the Federal Reserve – in its first incarnation – was formed.

Finally, the US had a “lender of last resort” and a central body to oversee money supply and the banking industry. The Fed’s responsibility was to make sure that banks didn’t become insolvent leading to mass panic and to sudden, violent swings towards economic recessions. The Fed was created to smooth things out in an effort to…as I tried summarizing earlier…“maintain an economic environment in which people are limited by nothing except their ability to produce and consume goods, based on their effort and willingness to do so. Capital should be available to whoever deserves it..

The Fed was put in place to ensure – in one word – STABILITY of the monetary system. A worthy pursuit. But this was just the beginning. The Fed was a work-in-progress. It still is.

Money is created by Commercial Banks.

Before we get into the evolution of the Fed since the First World War to today, it’s important that we’re on the same page with Money.

You know what money is. It’s a unit of account and store of value. But how is it created? Here’s a shocker: The Government does NOT create money. The real economy – via commercial banks – creates money. Most people don’t realize this.

Every time a bank makes a loan it creates money. This doesn’t seem intuitive but if you think about a bank’s business, it makes more sense. Banks profit by borrowing at a lower rate and lending at a higher rate. They MUST lend to make money. And the real economy – people setting up businesses, running businesses, buying homes & cars – needs the money that banks want to lend. Here’s how the system flows (simplified for our purposes):

  1. Farmer Joe wants to buy land, seeds and a Combine. He needs to borrow.
  2. He goes to Farmer’s Bank & Co. to borrow.
  3. The Bank does it’s “credit analysis” and decides to lend Joe the money.
  4. The funny thing is that the Bank has just lent Joe money that it doesn’t have. It doesn’t matter. The Bank just needs to record the entry in Joe’s account. He has the money. He’s happy.
  5. The Bank has many ways to fund this loan. They can borrow from other banks, or they can issue bonds or issue stock. Or the Bank can hope for other farmers depositing money with them.
  6. The loan the Bank made to Joe is an Asset – it’s their money-maker because they will charge Joe an interest on this loan.
  7. If some other farmer (say Farmer Jane) deposits money with the Bank, that’s a liability for the Bank. The money belongs to the other farmer. Because the Bank really appreciates the deposit, it pays Jane a small interest on her deposit. The Bank is essentially telling Jane that they’re borrowing her savings until she wants to withdraw all of it.
  8. Now the Bank’s Assets and Liabilities are matched. Now, over time, the Bank’s Asset will be worth more than their Liability. That’s because the Bank earns a higher interest from Joe than the amount it pays to Jane. This is called Net Interest Income.

Farmer’s Bank & Co. has created money in the economy – new money. The loan to Joe is money that didn’t exist before. They made it up. So far, the Central Bank had nothing to do with it. If things pan out as the Bank planned, then Joe would build his farm and return the bank’s money with interest. Jane would earn a little something on her savings. Hey, Joe may get rich and open a savings account at the same bank. This is more money the bank can lend out and create more money in the economy. D c

Money is created with credit, by commercial banks. If things go well, the banks fuel the real economy and that creates money in the system. This concept is sometimes hard to grasp fully. But the important thing to remember is that the only involvement of the Fed is to ensure that banks and people have access to a system that channels credit towards deserving parties. The Fed is there to make sure the laissez-faire system of decentralized decision-making (by individual banks) runs smoothly.

But Farmer’s Bank & Co. could face some problems:

  1. What if Joe and Jane come in to withdraw all their money on the same day? The Bank won’t have the funds.
  2. What if Farmer Joe spent all the money and there was a tornado that destroyed everything? And what if Jane comes to the bank the same day because there her home is also destroyed, and she needs here savings?

In these types of scenarios, the Bank, Joe, and Jane’s savings would be toast. And it would create panic. That’s why they need a Fed.

The Fed is like a Clearinghouse for Banks.

With the formation of the Fed in 1913, the immediate effect was that a sort of clearinghouse was formed for banks to deal with each other. This was important. In our example of the failure of the Kansas Bank, it now had the ability to borrow from other banks through a central clearinghouse.

How does this clearinghouse operation work? Let me introduce you to something called Fractional Reserve Banking (FRB). It sounds nerdy but it’s actually a cool concept. The Fed requires all banks in the US to keep about 10% of its deposits at the Fed. These are called Reserves. Now you know why the Fed is called the Federal Reserve. Why do they have this requirement? It serves 3 purposes:

  1. It’s an insurance – a forced insurance – against panic-driven bank runs.
  2. It serves as a clearinghouse for banks to borrow and lend amongst themselves.
  3. It puts an upper limit to the total volume of money creation to 9X. You’ll see below.

The FRB system works like magic. The Fed keeps 10% of all the combined Banks’ deposits. The rest – 90% - is for lending, for growing the real economy. Banks are incentivized to lend out all that 90%. Remember from our Farmer Joe example, when a bank lends out money it is an asset in the Bank’s balance sheet – it’s a potential money-maker for the bank. So, let’s say Bank A lends out 90% of its deposits. The group of people who got those loans will deposit them in another bank or spend it. The people they spend it on will deposit it in some other bank. Ultimately, the loaned amount finds its way into another bank’s deposit. But this new bank just needs to keep 10% with the Fed and can loan out the rest. Repeat the cycle. This can keep on going. At the end of all the repeated cycles, a, say, $1,000 deposit creates $9,000 in loans. On a combined basis – the entire banking sector combined – the $9,000 in loans are matched by $9,000 in deposits. The Fed can see this from the top.

At this point, I’d like to introduce 2 more concepts to describe what it is that Fed does:

  1. Outside Money and Inside Money.
  2. Fed Funds Rate.

The Reserves that the Fed safeguards are usually called Outside Money. The deposits – the 90% of Bank deposits – are called Inside Money. Think of it as “outside the real economy” and “inside the real economy”. Outside Money – the reserves – are used to ensure smooth functioning of the banking sector. Banks can borrow from each other to meet their obligations so that there are no ugly bank runs like in the 19th century. I bring up the concept of Inside and Outside money to make a point: The Fed has control only on Outside money. It has no say in how Inside Money is lent out, where it’s lent or at what interest rate it’s lent – not directly at least.

The Fed Funds Rate is a target overnight interest rate set by the Fed that banks charge each other when they borrow/lend money. This – the Fed Funds Rate – is the Fed’s main monetary policy tool. It dials it up or down depending on its assessment of economic condition. The connection between the Fed Funds Rate and the real economy will be discussed in the 3rd paper of the series. For now, we’re more interested in the main reason why the Fed was formed in the first place: to prevent bank runs and credit crises.

The Fractional Reserve Banking system and the Fed Funds Rate gave the Fed 2 main levers:

  1. It allowed the Fed some leverage over the economy – just one (sometimes) effective lever to… maintain an economic environment in which people are limited by nothing except their ability to produce and consume goods, based on their effort and willingness to do so.
  2. It allowed it to become a “lender of last resort”, in case banks were unwilling to lend to each other.

It’s all about Credibility.

The creation of the Fed meant that loans were given out more easily. It greased the wheels of the US economy for more than a decade. Money was freely available for people to set up business and employ people, which meant the money was available to buy goods and services that were being created. Supply was good and demand was good, which is the environment you need for a growing economy.

While the FRB system and the Fed Funds Rate were operational details, the Fed’s main effect was psychological. It meant that banks were more confident about lending. People were more confident in their banks. And the end result was the people were more confident of the value of their dollar.

The last point is important. If there is no credibility in the currency, it’s very hard for people to make business or consumption decisions. Before the Fed was formed, bank runs in one part of the country devalued its currency if that bank lost credibility. With the “pooling of risk” and “pooling of the currency”, so to speak, at the Fed with the FRB system, regional banks didn’t lose credibility because they had access to Reserves at all times.

Over time the credibility of the US Dollar became more strongly associated with the credibility of the Fed. And then the Great Depression happened. Things changed. It was no longer enough for the Fed to just be a “lender of last resort”. Suddenly, it needed to be more.

Coming Up…

Over the next 3 papers, I will get into:

  1. How the Fed evolved through the 20th century, starting with the Great Depression.
  2. How it functions today.
  3. How it stacks up against the Cryptocurrency and MMT alternatives.

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