Banks themselves maintain accounts at the Federal Reserve Bank. This facilitates clearing drafts on one bank that have been deposited in another, and it makes it easier for banks to borrow money. Often if one bank’s reserves temporarily fall below the required amount, it can borrow the money to make up the shortfall via a short-term loan from another bank. The interest rate on overnight loans of this sort is known as the federal funds rate and is often used as the basis for setting other interest rates. Similarly the London Interbank Offered Rate (LIBOR) is the average rate charged by a number of London banks for loans to each other.

Banks can also borrow directly from the Federal Reserve via the “discount window.” The Federal discount rate is the charged for these loans and it is set by the Federal Reserve. One method of controlling the supply of money is by adjusting the interest rate which the Federal Reserve charges banks. In theory the “price” of money will affect the “demand” and therefore the “supply.” In the case of the Federal Reerve it seems to work better when they attempt to “tighten” money by raising the interest rates which they charge banks. Making it more costly to borrow funds reduces the incentive of banks to borrow money from the Fed to lend to its customers. Reducing the “price” of money does not always seem to have the desired effect and is often compared to pushing on a string. It may be easier for banks to borrow money, but that does not insure that they will in fact borrow money or that the borrowed money will be used in ways that increase the “supply” of money circulating in the economy.

Banks can of course also increase their cash reserves by selling securities they may hold. Another way in which the Federal Reserve attempts to affect the supply of money is by buying or selling treasury bonds held by banks through what are called “open market operations.”

In the current system when the government “prints money,” what it is doing is “monetizing debt” using the unique relationship between the U.S. Treasury and the Federal Reserve. The Treasury issues bonds, notes and bills which are essentially standardized loan contracts designed to be “securities” which can be traded in a market. Originally they were printed in a way to make them difficult to counterfeit, and, if the loans paid periodic interest, they would include coupons which were cut off and turned in to a bank for redemption when the payment was due. Bonds that pay all the interest in a lump sum at the maturity date are called “zero coupon” bonds. Zero coupon bonds are marketable, and the market price, which will obviously vary with the maturity date of the bond, is allowed to float. On maturity the bond will be worth its face value, but when bought and sold on the market prior to its due date, its price will determine the effective rate of return that the buyer will receive on the investment. This fluctuating rate of return on U.S. Treasury securities, especially on short term bills and notes, has a ripple effect on other interest rates in the financial market.

When the Treasury issues securities, it can transfer (i.e. sell) some of them to the Federal Reserve and its account at the Federal Reserve is credited with the purchase price. This is comparable to the way normal banks credit the account of a borrower with a loan agreement. The government is borrowing money from the Federal Reserve. The “cash” credited to the Treasury’s account is “created out of thin air.”

The Federal Reserve, although it operates as a profit making enterprise like other banks, is required to turn all of its net profits over to the government. If it holds a Treasury bill or note until its maturity, it simply returns any interest it has earned to the Treasury. The Treasury can choose to “pay back” the Federal Reserve for the principal amount (i.e. the face value of the bond or note or bill) by having its account debited or it can “roll it over” by issuing another security to cover the amount and “selling” it to the Federal Reserve. The net effect is that the Treasury can borrow money indefinitely from the Fed “for free.”

There is something weird about the government creating money by lending money to itself. It seems at first like a bit of sleight of hand or at least an unnecessarily circuitous route for “financing” government operations or investment. Why not just have the government create money by issuing checks to pay for things without pretending that it is borrowing the money from the Federal Reserve? This may be just a vestigial artifact from the evolution of money and finance. Regardless of how it came about, the monetization of debt in this way is an indication of how central interest is to finance and the economy.

When the Federal Reserve was created in 1913, the stated goal was “to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.” In 1933 this was amended to include promoting “effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Elasticity of money refers to the ability to have the supply of currency or credit expand and contract in response to the needs of business. The rediscounting of commercial paper refers to the ability of banks to use their loans to customers as collateral for borrowing money from the Federal Reserve. Obviously the Federal Reserve is intended to be more than a way of facilitating transfers between banks. It is tasked with keeping the economy running smoothly, and it has attempted to do this primarily by influencing interest rates in the hope of controlling the amount of money in circulation. It also deals with issues related to foreign exchange rates which can have an impact on our own economy.

So part of what the Federal Reserve is about is making sure that credit is available for investment in private enterprise as well as for financing government. The best way it has found for encouraging investment is through the influence it can have on interest rates.

Theoretically if the economy is slow or in a recession, lowering the interest rate will encourage businesses to invest. Conversely if inflation is the problem, “tightening” money by raising interest rates will make businesses less able to expand and will slow things down. It doesn’t always work this way. In the 70s there were periods of high inflation even though interest rates were extremely high. Also low interest rates alone may not entice business to invest in ways that increase output. Business investment decisions are influenced by a host of other things, and inflation may be caused by things like the manipulation of international oil prices by OPEC that occurred in the 70s. Nonetheless influencing interest rates seems to be the best tool available to the Federal Reserve for keeping the economy on track.

The Federal Reserve cannot just mandate interest rates for the entire financial market. It can only set the interest rate at which it lends money to banks and influence the price of Treasury bonds by buying or selling large amounts so that the supply available to investors will cause their prices to rise or fall. The effective interest rate on short term Treasury bills should theoretically have an effect on the rates on other bonds competing for investor’s dollars. In theory it should even affect the expectations for the return on other types of investment. Again reality does not always conform to the theory because there may be other factors determining investment decisions. In recent decades many businesses have sought short term profits by strategies other than investing in long term plans for growth or sustainability.

Banks are essentially businesses making a profit by borrowing money at one interest rate and lending it at a higher interest rate. Making a profit from lending in this way may seem like a fairly innocuous and even boring business plan. It is, however, a business model with plenty of room for abuse. The abuse may have catastrophic consequences as in the case of Penn Square Bank in Oklahoma and its role in the failure of Continental Illinois in 1984.

Penn Square was notorious in its wishful thinking. Its executives were the classic freebooters – entrepreneurial bankers who hustled new loans for oil drillers based on the most generous assumptions about the prospects for finding oil and gas, about the future price of oil, about the borrowers’ ability to repay. The federal examiners found a general recklessness and even fraud in the loan portfolio.

But the hustlers from Penn Square could not have done this by themselves. Their modest-sized bank simply did not have the capacity. A bank’s assets, its loans, were supposed to balance with its liabilities, its deposits. A shopping-center bank with less than $500 million in deposits could not carry $2 billion in loans on its books. So Penn Square simply sold the loans – “upstream,” as bankers say – to the larger banks that wished to share in the bonanza.

Continental Illinois, largest bank in the Midwest and seventh largest in the nation, picked up more than $1 billion of loan participations with Penn Square. Lesser amounts, but still in the hundreds of millions, were absorbed by Chase Manhattan and the others. They gave Penn Square the capacity to lend more and more and take greater and greater risks. …

Penn Square, in effect, acted as a business scout in the “oil patch” for Continental and the others. When Penn Square booked loans and reached its lending capacity, it simply offered a share of the action to the larger banks, collected the equivalent of a finder’s fee, then turned around and went out to find more oil prospectors who needed money. This was very profitable for everyone, while it lasted, and Continental Illinois’s stock climbed from $25 to $40 a share in less than two years. The largest and most admired banks in America were, it developed, as inattentive to the question of loan quality – the prudential rules of banking – as the hustlers in cowboy boots from a shopping center in Oklahoma. [see Greider]

The failure of Continental Illinois was the largest bank failure in history at the time. Its operations required it to borrow $8 billion every day. Its rescue by the Fed, the Federal Deposit Insurance Corporation, the Treasury and other regulators gave rise to the phrase “too big to fail.”

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