Month: October 2020

Here when the Fed purchases a bond directly from a bank, there is no initial increase in demand deposits, or in total bank assets or liabilities. But the key point is that Citibank’s reserves have, once again, increased by the $1,000,000 of the Fed’s open market purchases, and the banking system can readily pyramid a multiple amount of loans and deposits on top of the new reserves.

And, indeed, under the Monetary Control Act of 1980, the Fed now has unlimited power to buy any asset it wishes and up to any amount–whether it be corporate stocks, bonds, or foreign currency.

Still, despite its relative unimportance, it should be pointed out that Federal Reserve rediscount rate policy has been basically inflationary since 1919. The older view was that the rediscount rate should be at a penalty rate, that is, that the rate should be so high that banks would clearly borrow only when in dire trouble and strive to repay very quickly. The older tradition was that the rediscount rate should be well above the prime rate to top customers of the banks.

One way for the Central Bank to inflate bank money and the money supply, then, is to lower the fractional reserve requirement.

In short, the Central Bank functions as a government cartelizing device to coordinate the banks so that they can evade the restrictions of free markets and free banking and inflate uniformly together. The banks do not chafe under central banking control; instead, they lobby for and welcome it. It is their passport to inflation and easy money.

The more the public is willing to hold checking accounts rather than cash, the greater the inflationary potential of the central bank system.

But couldn’t the banks within a country form a cartel, where each could support the others in holding checks or notes on other banks without redeeming them? In that way, if banks could agree not to redeem each other’s liabilities, all banks could inflate together, and act as if only one bank existed in a country.

There is therefore no day-to-day clientele limit from the existence of other banks, and the only limit to this bank’s expansion of inflationary credit is a general loss of confidence that it can pay in cash. For it, too, is subject to the overall constraint of fear of a bank run.

On the other hand, if there are only a few banks in a country, and the clientele of each is extensive, then the expansionary process could go on a long time, with clients shuffling notes and deposits to one another within the same bank, and the inflationary process continuing at great length. The more banks, and the fewer the clientele of each, then, the less room there will be for fractional reserve inflation under free banking.

A bank’s assets are always “longer” than its liabilities, which are instantaneous. Put another way, a bank is always inherently bankrupt, and would actually become so if its depositors all woke up to the fact that the money they believe to be available on demand is actually not there.