5.17 The Federal Reserve

In the old days when people put money in the bank they did it for two reasons.  One was to have a safe place to keep their money.  Keeping your money at home was dangerous, a thief could steal it or if there was a fire, your home and your money could burn up.  Another reason for putting money in the bank was the bank paid interest on the money.  The second reason is not true for checking and savings accounts anymore because the interest rate in 2021 is zero. 

Where did the banks get the money to pay people interest?  The banks loaned the money out to businesses.  The businesses used the money to buy equipment or land of buildings that they needed.  Then when the businesses made money they paid back the money and paid the bank extra for having loaned them the money.

You might ask, why didn't people give the businesses money directly instead of giving it to the bank?  Some people did, by buying stocks.  They could make more money that way but they could also lose more money that way.  Banks were thought of as safer investments.  Supposedly the experts running the bank would be sure keep the money people deposited there safe and make good investments with the money.  When you put your money in a bank the hope was that if one of the businesses the bank invested in failed, they still had a lot of other investments that were doing well so they would be able to pay you back your money.

What would happen if everyone who put their money in the bank wanted it back at the same time?  That's called a rush on the bank.  The bank wouldn't be able to pay them immediately since the bank invested a lot of that money in businesses that invested that money in new machinery, buildings etc..  The bank would have to declare bankruptcy.

What if a bank or owners of the bank made bad investments and lost money.  They might never be able to pay back the people who put their money in the bank.  What if natural disasters led to bank money being used for reconstruction of homes and buildings.  There would be even less money in the banks to pay back people who wanted their money.  In 1906 there was an earthquake in San Francisco.  A lot of money from New York banks was used to help rebuild San Francisco.  The following year, Otto Heinze, a wealthy investor, came up with a risky scheme to make money.  He convinced other wealthy investors to take part in his scheme which involved buying stocks of the United Copper company.  The scheme failed and led to the collapse of the United Copper Company.  People rushed on banks that had invested in United Copper or that were connected to Otto Heinze in any way.  Several banks couldn't pay and went bankrupt.

A wealthy banker, J.P. Morgan summoned the presidents of the city's banks to his office. They started to arrive at 2 p.m.; Morgan informed them that as many as 50 stock exchange houses would fail unless $25 million was raised in 10 minutes. By 2:16 p.m., 14 bank presidents had pledged $23.6 million to keep the stock exchange afloat. The money reached the market at 2:30 p.m., in time to finish the day's trading, and by the 3 o'clock market close, $19 million had been loaned out. Disaster was averted.

The panic of 1907 was one of many that had happened previously.  Many were the result of bad investments because of financial bubbles.  The lesson previous to this one discusses financial bubbles.  Something had to be done to stop runs on banks from happening again.  That is discussed in the video below. 


The way to prevent further panics that was chosen was to create a system of 12 Federal Reserve banks that could loan money to banks that didn't have enough to pay off their customers.  That leaves the question of where the Federal Reserve banks would get the money to lend the other banks. 

The way the Fed gets the money nowadays is it simply credits the money to the banks.  Then what happens is the Bureau of Engraving and Printing, under the U.S. Department of Treasury, does the actual printing of the cash.

It is very dangerous when an institution can create money out of nothing.  If it loans the money to banks that are making bad investments they'll keep on making those risky investments.  If it gives money to the U.S. government that is spending too much, the U.S. government will continue to spend too much.  As the Federal Reserve prints money the purchasing power of the money goes down.  That is dangerous as is explained here and here.

The Federal Reserve lends money to the U.S. government by buying U.S. government treasury notes with the money it creates.  A treasury note gets paid back to the buyer, in this case the Fed, by the U.S. government, with interest after a fixed amount of time.  When the Fed buys the treasury notes the U.S. government gets the money and the fed gets the note.  What happens when the treasury note comes due?  How does the government pay it back with interest? Currently the Federal reserve is not charging any interest which makes it easier for our government to borrow money.  Unfortunately the U.S. government often pays the money back by borrowing more money.  The debt of the U.S. government grows and grows and becomes a giant bubble as money becomes worth less and less.  Zero interest rates also make it easier for everyone to borrow money and so more people will borrow money for risky investments and won't be able to pay them back. 

The U.S. government collects a lot of taxes.  Why does it need to borrow if it collects so much tax?  The reason is that the U.S. government spends more money than the taxes bring in.  Politicians who promise to spend money to give people benefits, are more likely to be elected than politicans who don't.  What is going to happen if the Federal Reserve keeps printing money?  Money will lose its purchasing power.  That is known as inflation and is happening now.  Everyone will become poorer.  Peter Schiff spoke at Hillsdale college about this.  You can see a small part of his talk in the video below.  In his talk he mentions the debt ceiling.  A debt ceiling is the amount of money beyond which the U.S. government is now allowed to borrow.



In the video below Mr. Schiff talks about the danger of the Federal Reserve to our economy.

This web site has lessons about Black Lives Matter.  What do you think Black Lives Matter would think of the Federal Reserve?  Would they like the Federal Reserve to print money and keep interest rates at zero?  Of course they would because the government spends that money on social programs like theirs and a zero interest rate means its less expensive for them to borrow money.  Peter Schiff ran into a protest of Black Lives Matter and explains why they are mistaken.


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