Will fractional reserve banking create hyperinflation?

[RonPaulGetsIt]

Everyone knows banks are in the business of taking money from savers and lending it out at a higher interest rate to borrowers. They make money from the difference in interest rates between the two parties. That's all right? Nothing else to see here. Wrong.

There is actually much more than meets the eye. People are becoming more aware every day that the Federal Reserve creates money out of thin air with the stroke of a keyboard to buy up Treasury bonds. This is called monetization or quantitative easing, but few appreciate the way banks create money as well. It is well disguised to the public. Banks create credit over and above the original amount of money deposited until the money and credit combined is 10 times the amount of money originally deposited.

Abe makes a deposit at his local bank of $100. According to current lending rules, the bank can lend out 90% of the money and must keep on hand $10 in its vault for day to day operations. The bank lends out $90 to Bill. Bill takes the money and buys a bicycle with it. The bike shop owner, Carl, deposits the $90 in his bank. Of that $90, $81 is lent out to Derek. He spends it with Ethan, who deposits it in his bank. They lend it out 90% or $72.90 to Frank. Frank buys something from George. George deposits the money and 90% of that, or $65.61 is re-lent. The process completes over and over again until the original $100 of bank deposits has resulted in an additional $900 of credit creation.

This money is created by the magic of credit creation. There is a certain amount of currency issued by the Federal Reserve, this is called base money. Fractional reserve banking then takes that money and converts it to 10 times its original amount.

Why is this important? Take a look at the following graph from the Federal Reserve's website:



The monetary base has more than doubled since the financial crisis of 2008. What does this mean in layman's terms. The Fed has created money out of thin air to buy all that undesirable junk mortgage debt and who knows what other toxic nonsense the Wall Street banks were holding.

Under normal circumstances this money would multiply 10 fold out into the economy and we would be looking at hyperinflation. Why have we not had hyperinflation given this astounding increase in the monetary base? Simple, The Fed is paying banks interest not to lend. Banks are logically choosing to keep their cash deposited at the Fed and collecting a risk free return as opposed to lending the money out to borrowers in the economy.

The rest continues here: [URL="http://freemarketeconomicsinastory.blogspot.com/"][URL="http://freemarketeconomicsinastory.blogspot.com/"][URL="http://freemarketeconomicsinastory.blogspot.com/"][url]http://freemarketeconomicsinastory.blogspot.com/[/URL][/URL][/URL][/URL]

 

[YumYum]

: "One thing is for certain, the Fed cannot simply sell off its reserves to shrink the monetary base. This is because they exchanged Treasury Bonds for junk assets at equal value. The process went like this. 1) Government bailout issued 100s of billions of dollars in new debt. 2) Fed bought the government bonds with newly created money. 3) The Fed exchanged those bonds to banks for their toxic bad assets. If they tried to sell those toxic assets into the market they would only fetch their market value which is far less than they paid for them."

Can the Fed print money backed by those toxic assets? Its kind of like taking out a third mortgage.

 

[RonPaulGetsIt]

: "One thing is for certain, the Fed cannot simply sell off its reserves to shrink the monetary base. This is because they exchanged Treasury Bonds for junk assets at equal value. The process went like this. 1) Government bailout issued 100s of billions of dollars in new debt. 2) Fed bought the government bonds with newly created money. 3) The Fed exchanged those bonds to banks for their toxic bad assets. If they tried to sell those toxic assets into the market they would only fetch their market value which is far less than they paid for them."

Can the Fed print money backed by those toxic assets? Its kind of like taking out a third mortgage.

The Fed creates checking accounts magically with dollars in them or it alternatively can print the actual Federal reserve notes, but in order to get this money into the hands of its friends it has to exchange them for something. That something ends up on the Feds balance sheet. Up until the 2008 banking fiasco it was always liquid Treasuries bonds it exchanged the Federal Reserve notes for. The Fed could always shrink the monetary base by selling off its Treasury bonds. Now we are in unchartered territory as it holds toxic junk for the first time which it cannot simply sell.

 

[DFF]

: "One thing is for certain, the Fed cannot simply sell off its reserves to shrink the monetary base. This is because they exchanged Treasury Bonds for junk assets at equal value. The process went like this. 1) Government bailout issued 100s of billions of dollars in new debt. 2) Fed bought the government bonds with newly created money. 3) The Fed exchanged those bonds to banks for their toxic bad assets. If they tried to sell those toxic assets into the market they would only fetch their market value which is far less than they paid for them."

Can the Fed print money backed by those toxic assets? Its kind of like taking out a third mortgage.

Given all these toxic assets they're holding, is there a viable exit strategy for the Fed and the US economy? Is there a chance the US may escape a brush with total economic oblivion and come out shining once again? Or, are we 100% screwed?

 

[Libertydad88]

Given all these toxic assets they're holding, is there a viable exit strategy for the Fed and the US economy? Is there a chance the US may escape a brush with total economic oblivion and come out shining once again? Or, are we 100% screwed?

From a beginners perspective, it sounds like all the Fed needs to do is get a hold of some non-toxic assets(perhaps it'll be the next gubm'nt bail out) to sell to the banks. Crazier things have happened... and holding on to the toxic assets doesn't seem too destructive to the almighty Fed.

Does this scenario hold any water? And if the FedGov bails them out with treasury bonds, what would be the repercussions?

 

[Zippyjuan]

Early on in the crisis, the Fed did trade some of their secure holdings (Treasuries) for toxic assets like mortgage backed securities. The problem with the MBS was that they were all jubled up- qualityy loans mixed up with loans with high risks of default. They were so complicated (MBS contained other bundles of MBS inside of them and some had multiple layers of this) that it became impossible to give them a fair price based on the underlying asset values and the risks of default so nobody wanted them. There was no real market- even though they were worth trillions of dolalrs. Firms which did invest money in them found that they couldn't do anything with them and that tied up their money which might have gone into other investments. The entire financial markets began to freeze up and threaten to possibly collapse.

So the Fed stepped in and said they would take those assets off the hands of the banks. Rather than buy them, the Fed traded some of their Treasury holdings for them. Later on, the Fed commenced with buying MBS outright for cash- that program ended this spring. The Fed also purchased more Treasuries to help that market. They brought their treasury holdings to about what it was when the crisis started. But they also now hold all these other securities. What to do?

They are still concerned about the economy being weak and thus are not presently that concerned about inflation. They are more worried about the economy slipping back again. Within their portfolio of MBS, there are a variety of maturities and some are expiring as consumers with the original loans the securities are based on either pay off or refinance their mortgage. Some default. Anyhow, what this means is that the Fed is having some of their MBS holdings start to expire. What to do with that money? Simply collecting the money they get from the MBS would reduce the money supply and they are concerned about that being a further drag on the economy. But they also want some flexibility for the future for when they do decide they need to reel in what they can of all the money they put out there.

So what they are presently doing is basiclaly holding steady. As their security holdings mature, they are taking that money and converting it into more Treasuries. Since they are buying the Treasuries from dealers on the open market, this is neutral as far as the money supply is concerned. One dealer gives them the money they earned on the MBS and they take that money to another dealer and trade it for Treasuries.

Unwinding those in the future could be a challenge. Brian understands this better than I do but as I see it, if the Fed starts selling their Treasuries to try to take money out of the economy, that increases the supply of treasuries, driving down their price and raising the interest rates they pay. Rising interest rates increases costs for businesses who rely on borrowing and they may pass along this higher cost in the form of higher prices- so the very effort to keep prices from rising also has a counter force (probably smaller in scale) which wants to bump them up a bit again.

I don't really see hyperinflation (defined in most books as in the neighborhood of a 50% increase in prices every month) but do not see how we can avoid inflation once the economy gets going again (which could be another couple years or so- unemployment will take even longer than that to come down). But higher interest rates also reduce borrowing which acts as a damper on the economy- hopefully keeping it from getting overheated. Another problem the Fed will face will be timing. There is a delay between when they do something and the time it has its full effect on the market. This lag can be as long as two years. If the Fed hits the breaks too soon, the economy could stall again. Wait too long and inflation could get a strong foothold and be tougher to fight. At this time, they are content to wait and keep things as they are.

 

[Libertydad88]

I understood everything up until the end. If there was an increase of treasuries on the market, and their prices were driven down, why would that increase their interest rates? For some reason I thought that treasuries "matured", and the higher the interest rate, the more they were worth over time.

Argh, I'm tired and my brain isn't really working that well right now. Am I speaking nonsense?

 

[hugolp]

Early on in the crisis, the Fed did trade some of their secure holdings (Treasuries) for toxic assets like mortgage backed securities. The problem with the MBS was that they were all jubled up- qualityy loans mixed up with loans with high risks of default. They were so complicated (MBS contained other bundles of MBS inside of them and some had multiple layers of this) that it became impossible to give them a fair price based on the underlying asset values and the risks of default so nobody wanted them. There was no real market- even though they were worth trillions of dolalrs. Firms which did invest money in them found that they couldn't do anything with them and that tied up their money which might have gone into other investments. The entire financial markets began to freeze up and threaten to possibly collapse.

This is false. Its just the excuse of the Fed to buy the MBS.

What really was happening is that there was a market for MBS, but at a lower price than what the banks were willing to sell. And why did banks not want to lower the price? Because if they sold their MBS at a lower price they would have a hole in their ballance sheet that their reserves would not be able to cover and they would be bankrupt.

This is why the government at the beginning of the crisis changed the accounting rules of the mark to market, and why the Fed had to buy the MBS: so the banks did not failed.

There were buyers, just at a lower price than the banks could sell without going bankrupt. Its great to have a business, make a lot of money recklessly during the boom, and then have the government rescue you when your short-term-gain investment go south.

 

[hugolp]

I don't really see hyperinflation (defined in most books as in the neighborhood of a 50% increase in prices every month) but do not see how we can avoid inflation once the economy gets going again (which could be another couple years or so- unemployment will take even longer than that to come down).

You can have a recessionary economy and high unemployment, and still have rising prices. This explains why in keynesian terms: http://www.pbs.org/nbr/blog/2010/08/idle_resources_-_they_dont_sto.html

I think we will start to see rising prices sooner, maybe in one year. We'll see.

 

[YumYum]

What really was happening is that there was a market for MBS, but at a lower price than what the banks were willing to sell. And why did banks not want to lower the price? Because if they sold their MBS at a lower price they would have a hole in their ballance sheet that their reserves would not be able to cover and they would be bankrupt.

The Fed traded some securities with the banks for the 1.3 trillion in toxic mortgages. A question I have is: how much of what the Fed paid to the banks was their Treasury holdings and how much of it was paid with money that was "printed out of thin air"?

Also, aren't the banks that the Fed bought the toxic assets from the same banks that "own" the Fed?

 

[YumYum]

Given all these toxic assets they're holding, is there a viable exit strategy for the Fed and the US economy? Is there a chance the US may escape a brush with total economic oblivion and come out shining once again? Or, are we 100% screwed?

"gonegolfin" (Brian), is a forum member who understands the mechanics of the Fed very well. From what he has said the Fed is caught between a rock and a hard place.

I personally do not believe the U.S. will come out of this because the national, state, city, county, business and personal debts are so large there is no way mathematically that they can continued to be paid on. What I believe to be the indicator that the game is finally over is when the government cannot pay the interest on the national debt. While the debt can never be paid back, it is the interest that must be paid, and when they cannot sell bonds to borrow more money to pay the interest, that will begin the crash.

If OPEC decides not to sell their oil for dollars, that would collapse the dollar internationally. If China dumps our bonds, that could collapse the dollar. There are so many different scenarios that could happen that would trigger the end that I believe 2 things will eventually happen:

1) our government will turn to a world banking system, just as Griffin predicted in his book,

2) the government will throw us into a world war to save itself from total collapse.

Otherwise, I see no hope, because as it stands right now, neither our president nor our congress have any plans to stop the deficit spending.

 

[hugolp]

The Fed traded some securities with the banks for the 1.3 trillion in toxic mortgages. A question I have is: how much of what the Fed paid to the banks was their Treasury holdings and how much of it was paid with money that was "printed out of thin air"?

You can see it yourself here: http://www.clevelandfed.org/research/data/credit_easing/index.cfm

Its a simplified balance sheet of the Fed made by the Cleveland Fed.

Also, aren't the banks that the Fed bought the toxic assets from the same banks that "own" the Fed?

The local Fed's are bank "owned" (and I use the brackets, because its a weird and special government regulated type of stock, f.e. it can not be sold). But this decisions are taken by the Board of Governors of the Federal Reserve (Bernanke and the rest of the gang) that is a federal government agency, and its members are nominated by the president and ratified by congress. So the decision is made by a government bureaucrat (and yes, the government is corrupt and plays for the special interests, but its not like direct ownership).

 

[YumYum]

Great website. It's easy to see we are finished. Is the "Liquidity to key credit markets" the money that was "printed out of thin air"?

 

[hugolp]

Great website. It's easy to see we are finished. Is the "Liquidity to key credit markets" the money that was "printed out of thin air"?

All those assets are bough by money "printed out of thin air". The other side of the balance sheet of the Fed is "money" although right now the big increase sits mainly as excess reserves.

The "Liquidity to key credit markets" is mainly currency swaps, but I am talking from memory so dont take my word on this. You have to think that is a simplified version of the Fed balance sheet, and they group together what they consider are "similar" assets. If you want a more detailed (and more complicated) graph of the fed balance sheet I always check it here: http://www.cumber.com/ . Its in pdf format at the middle of the page. In the pdf you also have the other side of the balance sheet and you can see that the big increase of money by the Fed has gone to excess reserves. Also, you might want to check the BoE balance sheet. They are even more fucked up than the USA.

 

[RonPaulGetsIt]

I understood everything up until the end. If there was an increase of treasuries on the market, and their prices were driven down, why would that increase their interest rates? For some reason I thought that treasuries "matured", and the higher the interest rate, the more they were worth over time.

Argh, I'm tired and my brain isn't really working that well right now. Am I speaking nonsense?

Bond prices and interest rates move inversely.

Consider this example: a $100 bond is issued with a 5% interest rate - earning $5 a year interest. It has to always trade in the market at the same yield as other bonds of similar maturities.

Suppose overnight something happens to make the market demand a 10% interest rate and a new batch of bonds are issued with that rate.

In order for the first bonds to yield the current rate of 10% the bond price will have to fall to $50. The $5 a year interest they earn will be a 10% yield with their new $50 value.

So rates rise, bond prices fall. The same inverse relationship applies in reverse as well as rates fall, bond prices rise.

When the Federal Reserve is buying bonds with newly created money...ie quantitative easing or monetization they are artificially lowering rates. This sets the stage for the boom bust cycle that occurs when interest rates are held below their natural free market rate.

 

[DamianTV]

Everyone knows banks are in the business of taking money from savers and lending it out at a higher interest rate to borrowers. They make money from the difference in interest rates between the two parties. That's all right? Nothing else to see here. Wrong.

There is actually much more than meets the eye. People are becoming more aware every day that the Federal Reserve creates money out of thin air with the stroke of a keyboard to buy up Treasury bonds. This is called monetization or quantitative easing, but few appreciate the way banks create money as well. It is well disguised to the public. Banks create credit over and above the original amount of money deposited until the money and credit combined is 10 times the amount of money originally deposited.

Abe makes a deposit at his local bank of $100. According to current lending rules, the bank can lend out 90% of the money and must keep on hand $10 in its vault for day to day operations. The bank lends out $90 to Bill. Bill takes the money and buys a bicycle with it. The bike shop owner, Carl, deposits the $90 in his bank. Of that $90, $81 is lent out to Derek. He spends it with Ethan, who deposits it in his bank. They lend it out 90% or $72.90 to Frank. Frank buys something from George. George deposits the money and 90% of that, or $65.61 is re-lent. The process completes over and over again until the original $100 of bank deposits has resulted in an additional $900 of credit creation.

This money is created by the magic of credit creation. There is a certain amount of currency issued by the Federal Reserve, this is called base money. Fractional reserve banking then takes that money and converts it to 10 times its original amount.

Why is this important? Take a look at the following graph from the Federal Reserve's website:



The monetary base has more than doubled since the financial crisis of 2008. What does this mean in layman's terms. The Fed has created money out of thin air to buy all that undesirable junk mortgage debt and who knows what other toxic nonsense the Wall Street banks were holding.

Under normal circumstances this money would multiply 10 fold out into the economy and we would be looking at hyperinflation. Why have we not had hyperinflation given this astounding increase in the monetary base? Simple, The Fed is paying banks interest not to lend. Banks are logically choosing to keep their cash deposited at the Fed and collecting a risk free return as opposed to lending the money out to borrowers in the economy.

The rest continues here: [URL="http://freemarketeconomicsinastory.blogspot.com/"][URL="http://freemarketeconomicsinastory.blogspot.com/"][URL="http://freemarketeconomicsinastory.blogspot.com/"][url]http://freemarketeconomicsinastory.blogspot.com/[/URL][/URL][/URL][/URL]

Simple answer. YES. Fractional Reserve Banking Will Create Hyperinflation.

Long answer, but it isnt the only contributing factor.

 

[RonPaulGetsIt]

Also, aren't the banks that the Fed bought the toxic assets from the same banks that "own" the Fed?

Great question...Yes id say. [URL="http://www.globalresearch.ca/index.php?context=va&aid=10489"][url]http://www.globalresearch.ca/index.php?context=va&aid=10489[/URL][/URL]

 

[hugolp]

Great question...Yes id say. [URL="http://www.globalresearch.ca/index.php?context=va&aid=10489"][url]http://www.globalresearch.ca/index.php?context=va&aid=10489[/URL][/URL]

This is bullshit. See my post above.

 

[Zippyjuan]

Great question...Yes id say. [URL="http://www.globalresearch.ca/index.php?context=va&aid=10489"][url]http://www.globalresearch.ca/index.php?context=va&aid=10489[/URL][/URL]

That article has a lot of erroneous information in it.
http://www.federalreserve.gov/generalinfo/faq/faqfrs.htm

 

[hugolp]

That article has a lot of erroneous information in it.
http://www.federalreserve.gov/generalinfo/faq/faqfrs.htm

Am I agreeing with you? Guess that article had so much bullshit and its so obvious that even you and I agree on this one...