November 22, 2010 - by Elliott Wave International
Robert Prechter Explains The Fed, Part II
world's foremost Elliott wave expert goes "behind the scenes" on the Federal Reserve
This is Part II of our three-part series "Robert Prechter Explains The Fed." You can read Part I here -- and come
back later this week for Part III.
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 [of Conquer the Crash], 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.
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
How the Federal Reserve System Manufactures Money
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 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 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 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 has monetized 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.
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 financial system does not change even though its
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.
read more now in the free Club EWI report, "
Understanding the Federal Reserve System."
This article was syndicated by Elliott Wave International and was originally published under the
headline Robert Prechter Explains The Fed, Part II. EWI is the world's largest market
forecasting firm. Its staff of full-time analysts led by Chartered Market Technician Robert
Prechter provides 24-hour-a-day market analysis to institutional and private investors around
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