Questions regarding FED's interest rate mechanism

So I've got this much...

The Federal Open Market Committee cannot “set” the fed funds rate by edict.  When it wants to lower the rate it directs the New York Fed to inject cash into the system. The New York Fed lends money to major dealers in government securities, taking Treasuries as collateral.

But here are my questions:  Is there not a finite quantity of said Treasuries for the FED to accept as collateral?  And if there is, shouldn't this fixed quantity limit how far the FED can drop rates?  What exists to ensure a sufficient supply of Treasuries is on hand at the precise moment that the FED decides to cut rates (particularly when the rates are cut unexpectedly)?  Are member banks required to keep a certain amount of Treasuries in their reserves in the event that the FED decides to unexpectedly inject liquidity into the system, a sort of "Treasury reserve requirement?"

anyone?  anyone?

Good question.

The New York Fed does not lend money to major securities dealers; it buys securities and pays for them with a check. These securities do not always have to be Treasuries. Last year, the Fed bought mortgage-backed securities.

If the number of securities remained constant, there would indeed be a limit to the Fed’s ability to manipulate the money supply. However, the Department of the Treasury regularly holds auctions in which they sell new treasury securities to the dealers. So, the Department of the Treasury creates new treasuries, which they sell to the securities dealers, which the Fed buys from the securities dealers using a check that is not backed by anything. This is how new money is created. The only limit is that the Fed, the securities dealers, and the Department of the Treasury all must cooperate in the process.

Jeffrey, when are you gonna have The Case Against The Fed in an online version?

Thanks for the response.  The specificity is much appreciated.  I presented Greg Mankiw (of blog and Harvard fame) the same question and he seemed not to have a clue what I was talking about.  His response left much to be desired: "...I think the answer is that the [FED] changes in quantity of bonds via open market operations."

Clarifying questions:  What backs these securities created by the Treasury Department?  Are these newly created securities backed by tangible, value-based assets or are they claims on future fiduciary inflows collected by the government?  In other words, are these "commodity-based" securities?  Or are they simply pieces of paper with promises from the government ("fiat securities," if you will) to repay a sum of X dollars at a future date? 

If they are the latter, it would then seem the Dept. of the Treasury is every bit as complicit in debasing our currency as is the FED.

Treasury securities are not asset based, and without new treasuries there would be limits on the Fed’s ability to increase the money supply through open market operations.

In fact, this is exactly what happened in the 1990’s when the Clinton administration supposedly “balanced” the budget. There was a reduction in the number of treasury securities and Fed watchers grew concerned that the Fed’s ability to control the money supply would be reduced.

If they are the latter, it would then seem the Dept. of the Treasury is every bit as complicit in debasing our currency as is the FED.

Bingo.  Why do you think this is such an untouchable area of American politics?!

The government uses the FED to monetize its debt.  Without them, the government would be subject to raising taxes, which is politically unfavorable, or requiring individuals to buy its debt, which is not as quick or complete of a process.  (recently, this is disputed with the swiftness China is willing to take our debt).  The FED is more than happy to take this debt, because it allows them to create up to 9 times the debt's value in loans of new money (over time - it can only lend 9/10 out at first, but when that 9/10 comes back into the banking system, it can lend out 9/10 of that, and so on...until you end up with 10 times the total original debt [9 times worth of new loans, 1 times the original debt]).

Too many people get locked in a ridiculous argument that the FED is too private, and that elected officials are more accountable to the American people in issuing money.  Rubbish.  Most to all of the private interest the regional FED banks earn is paid to the government, which it uses as general revenue.  Additionally, the FED is subject to Congress - Congress granted it the ability to monetize not only Congress's debt, but other governments, and now many forms of private debt.  Why would Congress do this if Congress wanted better control of the money supply?  If congress is so good with money, why can't they seem to follow a budget...year after year after year...

Others argue that the government is what misdirects the FED into bad policy, and the FED should be completely independent.  It is true that the government's appointees do have a significant amount of control over the main parts of the system.  Yet you rarely see any FED members publicly denounce the government and leave the system.  They will not abandon such a huge privilege simply because they may disagree with some management decisions.  If the FED were truly independent, then it does not make sense to give them special privileges.  Should everyone be allowed to create money if they so choose?  Why shouldn't every bank issue their own money, partially backed up by the "common money"?  Why shouldn't every person issue their own currency?  As Rothbard says, this defeats the entire point of having money in the first place...and this is why free individuals chose gold and silver as their universal currency.

Make no mistake - the FED is pure and simple a collusion of big banking and big government.  Any arguments made by either side that deny or discredit this should be regarded as pure propaganda.

I've been told that this is a very good explanation of the tools the fed has, but I've never been interested enough to read all the way through.

@ meambobbo

Great post, just curious...

So... perhaps what might be ideal is a completely open, free-market competition in actual currency? Gold, silver, paper money (backed 100% by X Y or Z) or e-gold, diamonds, vintage cheeses (joke!) or whatever the free-market innovates and finds most convenient and stable for the consumers and economy. Is this feasible though? Surely the FED can only exist because the government protects and guarantees its monopoly anyway, so the root cause is not our monetary system or the FED per say, but the actual violent enforcement of that monopoly on currency... the state itself?

Let's say, hypothetically, the state doesn't exist anymore and anyone can print paper money or exchange whatever currency they like. How do we go about 'regulating' (voluntarily I hope?!) the free-market in money creation/supply? Wouldn't the free-market itself provide regulation enough? Might we innovate some kind of new standardised electronic money system (convenient and fast) backed by assets or a mixture of other currencies (e-gold, e-silver etc)? Might banks as we know them today become obsolete under this system... except perhaps as sub-contracted storage or security agents of some kind?!

Just playing with some ideas! I'm not an economist (could you tell?!)

fingolfin:

@ meambobbo

Great post, just curious...

So... perhaps what might be ideal is a completely open, free-market competition in actual currency? Gold, silver, paper money (backed 100% by X Y or Z) or e-gold, diamonds, vintage cheeses (joke!) or whatever the free-market innovates and finds most convenient and stable for the consumers and economy. Is this feasible though? Surely the FED can only exist because the government protects and guarantees its monopoly anyway, so the root cause is not our monetary system or the FED per say, but the actual violent enforcement of that monopoly on currency... the state itself?

But the state could exist in some form, clearly a different one, without a FED.  It did prior to 1913.

Point taken. However I'm not debating the form and makeup of a state, or indeed the virtues of anarchism! What I'm curious about is whether or not the core economic issue is the violent enforcement of a monopoly on currency (by the state).

Fine, get rid of the FED - let the state control money issuance - or sure let the FED do it, with or without governance in the matter. Whichever. As long as there is no violent enforcement of any monopoly by the state. What I'm talking about is totally open competition in money supply/currency in the free-market. Is it feasible, if so how would it work today? Would the new FED be subject to checks and balances by market competition and just become another private competitor rather than today's stinking pillar of corruption?! Same question for a (non-coersive, optional) government backed 'standard' currency?

They might have an advantage in the market because of their state or FED official backing, or just the opposite, people might flock to the newer (digital?) currencies. What might this open economy look like?

STARBucks?!!!

if you take a look at what has happened to e-gold and the liberty dollar, clearly the FED and its government backers sees no room for competition.  The secretary of the treasury told liberty dollar that it was a good, legitimate idea!  Years later the FBI suddenly disagrees?  This is in addition to the other obstacles, such as capital gains taxes.

FED privileges include a practice that pre-dates their existence which was equally distorting the monetary market by allowing a fraudulent fractional reserve banking system.  Rothbard particularly lashes out at this, saying that banks can serve two functions, but not both at the same time.  Either they serve as a preservation device, like a guarded warehouse; or they serve as an investment broker.  One would have a agreed upon cost, the other having a cost of the risk involved, and part of the rewards possibly gained.  Our current system serves neither purpose.  Debasement through inflation allows the system to insure itself while earning money on investments with your money, but destroys the savings aspect of banking.  With either a checking or savings account paying interest, you are losing money in real terms, while exposed to a risky system - it is unsure exactly how much you are losing.  If the whole system collapses, you will be left with nothing, no matter what government assurances there are.  the FDIC couldn't handle a bank run similar to the panic of 1907, from what i understand.  and that's just to get paper money out of the banks.  that paper can still crash in value, even without hyperinflation, so long as the majority of the market finds another currency more favorable, even with government restrictions.

the problem w/ fractional reserve banking is more than the risk, which is usually only discovered during the one true audit - a bank run.  when the bank says they have your money and they can't produce it for you, that is fraud, a form of theft.  the problem is deeper, as artificial credit distorts the market and leads to countless decisions in error, many indirectly linked to the bank's credit inflation.  it is nearly impossible to assign accurate liability and secure justice.  should we regulate the banking industry then?  no, the market just needs to demand audits of ACTUAL money that the bank possesses and the market can regulate itself.  When people see banks collapse without a central bank to bail them out, and bank customers actually lose their money, the market will certainly demand audits and a government that enforces fraud.

other privileges are legal tender laws (clearly unconstitutional) and the requirement for national banks to be FED members.  The FED doesn't have the privilege of minting, however, it does have the privilege of being the only entity able to distribute into circulation the money that the government mint creates.

The FED is not just backed by government force, however.  it is a cartel.  while that cartel is forced to exist through government and would at least partially dissolve, cartels can still trump the market, if the market finds the cost of fighting the cartel less than the cost of compliance.  i think removing the privileges from this cartel will force its eventual dissolution or at least its compliance with lawful banking.

Not all of these obstacles must be struck down to have competing currencies.  And yes, you are correct.  Currencies don't have to be gold or silver, especially physical.  it can be electronic or other forms of accounts, backed or unbacked by any commodity, or good, or even debt.  consider the central banks of the world - their assets include other paper currencies, government debt, commercial debt, and even gold.  similarly, individuals could hedge their wealth in multiple currencies, in addition to non-monetary commodities and shares of businesses.  currencies backed by gold work well, because exchange rates should be fixed between them (if they differ it either means one of the suppliers has unbacked currency, or one supplier is exceptionally difficult at settling account balances).  This is why the classical gold standard worked well between nations, even while "protective tariffs" were encouraged.  WWI f'ed this all up.

what is the most important is that the government cannot engage in price fixing.  no gold to silver ratios. no paper to gold ratios, etc.  the market must decide these ratios based upon supply and demand.  it is the only means to find out what the best currency actually is.  when price fixing is engaged (or any other artificial over-valuation of one currency to another), the lesser valued currency becomes the most circulated, which is the opposite of what the best economic situation should be.  currently, federal reserve money is artificially over-valued compared to gold, thus you see many people save in gold, but they do not transact in gold.

competing currencies may seem like a distortion of what money is, and i would say they are.  the purpose of money is to have a common medium of exchange, so only the exchange ratio between a good and money tells you the exchange ratio of that good to the rest of the economy's goods.  one currency is much easier upon business, only required to price everything in a single unit.  (an interesting point on this is that monetary inflation on banking has little cost.  while banks must calculate inflation into their interest rates, this cost is negligible compared to the businesses who must change their displayed prices, such as on menu's, in advertisements, etc.  this is one reason why businesses often cut quality or quantity before raising prices.  thus, another goal of a good currency could be considered relatively stable prices [which is ironically a stated goal of the FED.])

yet, like all things that seemingly have one ideal solution, human societies cannot appear to create a lasting idealistic solution.  this is simply because all goods must have suppliers, and suppliers tend to want to have advantages over the market, especially when they have a monopoly.  the more powerful the industry, the more power they will attempt to seize or deceptively take.  to believe that one currency will ever be the perfect money is probably idealism.  thus, we must take the anarchist approach - privilege none and see what the people like, through the market.  anarchists don't believe in lawlessness (at least not the ones here), only that the law should be established by the uncoerced will of individuals, expressed through their relative productivity offered through the market.

ps - i am no economist either - i am a computer programmer.  my advice is to read Rothbard's What Has Government Done to our Money, which you can find on this site.  read that, and you will read more...and then you might be smarter than half the professional economists out there. ;-)

methods of market regulation of currency:

profitability - buying the currency that most suits your economic needs - saving, risk factors, acceptance rate, portability, durability, performance compared to similar currencies.  the best currencies will be the most profitable, as they will be the demanded in exchange for more or higher quality goods and services than other currencies.  the basic principles of good currency are acceptance, durability, portability, divisibility, ease of measurement, ease of verification of identity, and difficulty of counterfeit.

demand audits, if paper is claimed to be backed by some commodity, or some similar claim.  make the "authorities" enforce fraud.  in any case, the market will enforce it through profitability, although this does not establish justice.  consider the situation where one established currency supplier decides to create quadruple its entire current supply overnight without backing it in what it claims to be backed in, in order to buy up gold.  they will succeed in getting the gold for a lower price than they should, as their currency will subsequently sharply decline in value.  They will shortly go out of business; however, they are already rich from their fraud.  There must be some form of justice to correct this.  not even audits can stop such a practice.  this is one of the reasons government has declared itself essential in regulating money, although it is directly its fault for not demanding justice when fraud is exposed, but simply legitimizing it.

bad currencies will become apparent.  their exchange rates with other currencies will diminish in purchasing power.  similar to how a bank run happens, or a stock dumping, a "currency run" might ensue.  but part of this may simply be speculation.  in any case, speculation leads to the quickest revaluations of the true market price.  there are no guarantees of crashes (unless fraud becomes apparent).

...of course, the only true exchange rates that are important are the ones you find when you attempt to transact.  whether it's the ratio to exchange at a currency exchange store, or simply ratio of prices for real goods expressed in different currencies.  for example, one store may set a 40:1 ratio between silver and gold prices, while another has 42:1.  a store doesn't have to abide with the spot prices in some large exchange market.  in effect, there is doubtfully a pricing authority as such.  (the only reason the public stock exchanges or commodities exchange markets are used to give "official" spot prices are because government requires such exchanges to be made in such artificially required institutions).  with such an extreme degree of speculation going on and no centralized "looking glass", it is likely that major shifts will not occur overnight, unless there are significant reasons for such, like poor audit results for a backed currency, or public knowledge of the decision to flood the market with new unbacked currency, or a major vendor's decision to no longer accept some form of currency.

even in the case that one currency seems to be dominant, the market may demand another simply as a hedge against the dominant one.  in this case, that currency probably wouldn't actually function as such in transactions until the other lost its crown.

it is very important to note that many electronic gold currency suppliers were completely fraudulent and simply ran off with people's money.  e-gold, on the other hand, is audited, although not by an independent agency.  e-gold was forced to ban many of its users, which was akin to a massive bank run, and it was able to deliver physical gold without any problems, which is evidence that its auditing is at least mostly accurate.

of course, having physical gold is probably the least risky, unless you live in an unsafe neighborhood.  for a little more cost, you can use a bank's safety deposit box, but this requires confidence that the bank won't crash and steal your gold in the process.  plus that method requires more effort to make a transaction.  so even in a single currency, you have market choices that correspond to intended use.

@ meambobbo

What a fantastic and highly detailed response. Thank you kindly, your time and knowledge is very much appreciated.

There is a lot to 'chew over' in those replies! Allow me some time to crunch up those points in my mind and I'll get back to you with some more questions if need be. I'll certainly endeavour to obtain a copy of Rothbard's 'What Has Government Done to our Money', as suggested, and read through it at the weekend if not before.

Even though as a layperson I had no idea of the intricacies of these arguments, something just 'felt right' about the anarchist approach to currency, seeing as how money is really just a commodity like any other - albeit with special significance in relation to all other commodities. As a side note: I have often wondered about Paypal and Ebay's mechanism of using reputation and feedback to encourage fair transactions, and whether that could be adopted as a kind of futuristic currency - a currency formed of or just backed by; market 'reputation' itself.

Anyway I'll think about what you said and let you know how I get on. Thanks again.