November 24, 2010 - by Elliott Wave International
Robert Prechter Explains The Fed, Part III
world's foremost Elliott wave expert goes "behind the scenes" on the Federal Reserve
This is Part III, the final part of our series "Robert Prechter Explains The Fed." (Here are Part I and Part II.)
Money, Credit and the Federal Reserve Banking System
Conquer the Crash, Chapter 10
By Robert Prechter
How the Federal Reserve Has Encouraged the Growth of Credit
Congress authorized the Fed not only to create money for the government but also to “smooth out” the economy by
manipulating credit (which also happens to be a re-election tool for incumbents). Politics being what they are,
this manipulation has been almost exclusively in the direction of making credit easy to obtain. The Fed used to
make more credit available to the banking system by monetizing federal debt, that is, by creating money. Under the
structure of our “fractional reserve” system, banks were authorized to employ that new money as “reserves” against
which they could make new loans. Thus, new money meant new credit.
It meant a lot of new credit because banks were allowed by regulation to lend out 90 percent of their deposits,
which meant that banks had to keep 10 percent of deposits on hand (“in reserve”) to cover withdrawals. When the Fed
increased a bank’s reserves, that bank could lend 90 percent of those new dollars. Those dollars, in turn, would
make their way to other banks as new deposits. Those other banks could lend 90 percent of those deposits, and so
on. The expansion of reserves and deposits throughout the banking system this way is called the “multiplier
effect.” This process expanded the supply of credit well beyond the supply of money.
Because of competition from money market funds, banks began using fancy financial manipulation to get around
reserve requirements. In the early 1990s, the Federal Reserve Board under Chairman Alan Greenspan took a
controversial step and removed banks’ reserve requirements almost entirely. To do so, it first lowered to zero the
reserve requirement on all accounts other than checking accounts. Then it let banks pretend that they have almost
no checking account balances by allowing them to “sweep” those deposits into various savings accounts and money
market funds at the end of each business day. Magically, when monitors check the banks’ balances at night, they
find the value of checking accounts artificially understated by hundreds of billions of dollars. The net result is
that banks today conveniently meet their nominally required reserves (currently about $45b.) with the cash in their
vaults that they need to hold for everyday transactions anyway. [1st edition of Prechter's Conquer the Crash was
published in 2002 -- Ed.]
By this change in regulation, the Fed essentially removed itself from the businesses of requiring banks to hold
reserves and of manipulating the level of those reserves. This move took place during a recession and while S&P
earnings per share were undergoing their biggest drop since the 1940s. The temporary cure for that economic
contraction was the ultimate in “easy money.”
We still have a fractional reserve system on the books, but we do not have one in actuality. Now banks can lend out
virtually all of their deposits. In fact, they can lend out more than all of their deposits, because banks’ parent
companies can issue stock, bonds, commercial paper or any financial instrument and lend the proceeds to their
subsidiary banks, upon which assets the banks can make new loans. In other words, to a limited degree, banks can
arrange to create their own new money for lending purposes.
Today, U.S. banks have extended 25 percent more total credit than they have in total deposits ($5.4 trillion vs.
$4.3 trillion). Since all banks do not engage in this practice, others must be quite aggressive at it. For more on
this theme, see Chapter 19 [of Conquer the Crash].
Recall that when banks lend money, it gets deposited in other banks, which can lend it out again. Without a reserve
requirement, the multiplier effect is no longer restricted to ten times deposits; it is virtually unlimited. Every
new dollar deposited can be lent over and over throughout the system: A deposit becomes a loan becomes a deposit
becomes a loan, and so on.
As you can see, the fiat money system has encouraged inflation via both money creation and the expansion of credit.
This dual growth has been the monetary engine of the historic uptrend of stock prices in wave (V) from 1932. The
stupendous growth in bank credit since 1975 (see graphs in Chapter 11) has provided the monetary fuel for its final
advance, wave V. The effective elimination of reserve requirements a decade ago extended that trend to one of
The Net Effect of Monetization
Although the Fed has almost wholly withdrawn from the role of holding book-entry reserves for banks, it has not
retired its holdings of Treasury bonds. Because the Fed is legally bound to back its notes (greenback currency)
with government securities, today almost all of the Fed’s Treasury bond assets are held as reserves against a
nearly equal dollar value of Federal Reserve notes in circulation around the world. Thus, the net result of the
Fed’s 89 years of money inflating is that the Fed has turned $600 billion worth of U.S. Treasury and foreign
obligations into Federal Reserve notes.
Today the Fed’s production of currency is passive, in response to orders from domestic and foreign banks, which in
turn respond to demand from the public. Under current policy, banks must pay for that currency with any remaining
reserve balances. If they don’t have any, they borrow to cover the cost and pay back that loan as they collect
interest on their own loans. Thus, as things stand, the Fed no longer considers itself in the business of “printing
money” for the government. Rather, it facilitates the expansion of credit to satisfy the lending policies of
government and banks.
If banks and the Treasury were to become strapped for cash in a monetary crisis, policies could change. The
unencumbered production of banknotes could become deliberate Fed or government policy, as we have seen happen in
other countries throughout history. At this point, there is no indication that the Fed has entertained any such
policy. Nevertheless, Chapters 13 and 22 address this possibility.
Do you want to really understand the Fed? Then keep reading this free eBook, "Understanding the
Fed", as soon as you become a free member of Club EWI.
This article was syndicated by Elliott Wave International and was originally published under the
headline Robert Prechter Explains The Fed, Part III. 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 the world.
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