This is Part II of our three-part series "Robert Prechter Explains The Fed.” You can read Part I here.
Money, Credit and the Federal Reserve Banking System
Conquer the Crash, Chapter 10
By Robert Prechter
... Let’s attempt to define what gives the dollar objective value. As we will see in the next section, the dollar is “backed” primarily by government bonds, which are promises to pay dollars. So today, the dollar is a promise backed by a promise to pay an identical promise. What is the nature of each promise? If the Treasury will not give you anything tangible for your dollar, then the dollar is a promise to pay nothing. The Treasury should have no trouble keeping this promise.
In Chapter 9, I called the dollar “money.” By the definition given there, it is. I used that definition and explanation because it makes the whole picture comprehensible. But the truth is that since the dollar is backed by debt, it is actually a credit, not money. It is a credit against what the government owes, denoted in dollars and backed by nothing. So although we may use the term “money” in referring to dollars, there is no longer any real money in the U.S. financial system; there is nothing but credit and debt.
How the Federal Reserve System Manufactures Dollars
Over the years, the Federal Reserve Bank has transferred purchasing power from all other dollar holders primarily to the U.S. Treasury by a complex series of machinations. The U.S. Treasury borrows dollars by selling bonds in the open market. The Fed is said to “buy” the Treasury’s bonds from banks and other financial institutions, but in actuality, it is allowed by law simply to fabricate a new checking account for the seller in exchange for the bonds. It holds the Treasury’s bonds as assets against -- as “backing” for -- those new dollars. Now the seller is whole (he was just a middleman), the Fed has the bonds, and the Treasury has the new money.
This transactional train is a long route to a simple alchemy (called “monetizing” the debt) in which the Fed turns government bonds into new dollars. The net result is as if the government had simply fabricated its own checking account, although it pays the Fed a portion of the bonds’ interest for providing the service surreptitiously. To date (as of 2002), the Fed has monetized about $600 billion worth of Treasury obligations. This process expands the supply of dollars.
In 1980, Congress gave the Fed the legal authority to monetize any agency’s debt. In other words, it can exchange the bonds of a government, bank or other institution for a checking account denominated in dollars. This mechanism gives the President, through the Treasury, a mechanism for “bailing out” debt-troubled governments, banks or other institutions that can no longer get financing anywhere else. Such decisions are made for political reasons, and the Fed can go along or refuse, at least as the relationship currently stands. Today, the Fed has about $36 billion worth of foreign debt on its books. The power to grant or refuse such largesse is unprecedented.
Each new Fed account denominated in dollars, contrary to common inference, is not new value. The new account has value, but that value comes from a reduction in the value of all other outstanding accounts denominated in dollars. That reduction takes place as the favored institution spends the newly credited dollars, driving up the dollar-denominated demand for goods and thus their prices. All other dollar holders still hold the same number of dollars, but now there are more dollars in circulation, and each one purchases less in the way of goods and services. The old dollars lose value to the extent that the new account gains value.
The net result is a transfer of value to the receiver’s account from those of all other dollar holders. This fact is not readily obvious because the unit of account throughout the financial system does not change even though its value changes.
It is important to understand exactly what the Fed has the power to do in this context: It has legal permission to transfer wealth from dollar savers to certain debtors without the permission of the savers. The effect on the "money supply" is exactly the same as if the money had been counterfeited and slipped into circulation.
In the old days, governments would inflate the money supply by diluting their coins with base metal or printing notes directly. Now the same old game is much less obvious. On the other hand, there is also far more to it. This section has described the Fed’s secondary role. The Fed’s main occupation is not creating new dollars but facilitating credit. This crucial difference will eventually bring us to why deflation is possible. ...