Credit and the Federal
Reserve Banking System
the Crash, Chapter 10
By Robert Prechter
... Let's attempt to define
what gives the dollar
As we will see in the next
section, the dollar is "backed" primarily by government bonds,
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
the Crash], I called the dollar "money." By the definition
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.
As you can see, defining the
dollar, and therefore the terms money, credit, inflation and deflation,
today is a challenge, to say the least. Despite that challenge, we can
still use these terms because people's minds have conferred meaning and
value upon these ethereal concepts.
Understanding this fact, we
will now proceed with a discussion of how money and credit expand in
today's financial system.
System Manufactures Money
Over the years, the Federal
Reserve Bank has transferred purchasing power from all
holders primarily to the U.S. Treasury by a complex series of
machinations. The U.S.
Treasury borrows money 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 -- that new money. Now the seller is whole (he was
just a middleman), the Fed has the bonds, and the Treasury has the
This transactional train is a
long route to a simple alchemy (called "monetizing" the debt) in which
the Fed turns government bonds into money. 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 (1st edition of Prechter's Conquer
the Crash was published in 2002 -- Ed.), the Fed
about $600 billion worth of Treasury obligations. This process expands
the supply of money.
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.
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Each new Fed account denominated in
dollars is new money, but contrary to common inference, it 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
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
money but facilitating credit. This crucial difference will eventually
bring us to why deflation is possible.
[Next: Prechter explains "how the Federal
Reserve has encouraged the growth of credit."