What the Federal Reserve Could Do to Help Hard-working Americans

Continued from previous page

The explanation lies in the distortion that Federal Reserve policy has inflicted on something most Americans have never heard of: “repos,” or repurchase agreements, which are part of the equally mysterious but vital “shadow banking system.”

The way money and credit are created in the economy has changed over the past 30 years. Throw away your textbook.

Fractional Reserve Lending Without the Reserves

The post-textbook form of money creation to which Kessler refers was explained in a July 2012 article by IMF researcher Manmohan Singh titled “The (Other) Deleveraging: What Economists Need to Know About the Modern Money Creation Process.” He wrote:

In the simple textbook view, savers deposit their money with banks and banks make loans to investors . . . . The textbook view, however, is no longer a sufficient description of the credit creation process. A great deal of credit is created through so-called “collateral chains.”

We start from two principles: credit creation is money creation, and short-term credit is generally extended by private agents against collateral. Money creation and collateral are thus joined at the hip, so to speak. In the traditional money creation process, collateral consists of central bank reserves; in the modern private money creation process, collateral is in the eye of the beholder.

Like the reserves in conventional fractional reserve lending, collateral can be re-used (or rehypothecated) several times over. Singh gives the example of a US Treasury bond used by a hedge fund to get financing from Goldman Sachs. The same collateral is used by Goldman to pay Credit Suisse on a derivative position. Then Credit Suisse passes the US Treasury bond to a money market fund that will hold it for a short time or until maturity.

Singh states that at the end of 2007, about $3.4 trillion in “primary source” collateral was turned into about $10 trillion in pledged collateral – a multiplier of about three. By comparison, the US M2 money supply (the credit-money created by banks via fractional reserve lending) was only about $7 trillion in 2007.  Thus credit-creation-via-collateral-chains is a major source of credit in today’s financial system.

Exiting Without Panicking the Markets

The shadow banking system is controversial. It funds derivatives and other speculative ventures that may harm the real, producing economy or put it at greater risk. But the shadow system is also a source of credit for many businesses that would otherwise be priced out of the credit market, and for such things as credit cards that we have come to rely on. And whether we approve of the shadow system or not, depriving it of collateral could create mayhem in the markets. According to the Treasury Borrowing Advisory Committee of the Securities and Financial Markets Association, the shadow system could be short as much as $11.2 trillion in collateral under stressed market conditions. That means that if every collateral claimant tried to grab its collateral in a Lehman-like run, the whole fragile Ponzi scheme could collapse.

That alone is reason for the Fed to prevent “taper tantrums” and keep the market pacified. But the Fed is under pressure from the Swiss-based Bank for International Settlements, which has been admonishing central banks to back off from their asset-buying ventures.

An Excuse to the Fed's Mandate of Full Employment

The BIS said in its annual report in June:

Six years have passed since the eruption of the global financial crisis, yet robust, self-sustaining, well balanced growth still eludes the global economy. . . .

Central banks cannot do more without compounding the risks they have already created. . . . [They must] encourage needed adjustments rather than retard them with near-zero interest rates and purchases of ever-larger quantities of government securities. . . .