Who Controls the Money?

To the Editor:

“It Just Ain’t So!” by Richard Timberlake (December 1999) contains material errors that mislead readers. The Federal Reserve does not, as Professor Timberlake writes, have “monopoly power to increase or decrease the economy’s stock of money.” It is the banking system (of which the Fed is a component) that has that power. Most money is created by the banks, not the Fed.

Since 1950, of the approximately $6.4 trillion that has been created by the banking system, only about $500 billion was created by the Federal Reserve. People need to understand that the Congress has improperly delegated to the banks a power that the Congress does not have under our Constitution. We have, in effect, a statist monetary system that is at odds with the Constitution. To talk about the Fed having a money-creation monopoly clouds the issue.

Professor Timberlake is equally mistaken when he writes, “Federal Reserve policy is responsible for the quantity of money—cash and bank deposits—that all households and business firms have in their possession at any moment.” Without getting into a deep discussion about this, the Federal Reserve is an influencer, not a controller. Its essential function is to stand ready to bail out the banking system if and when it gets into trouble.

Since Professor Timberlake is mistaken in his premises, he is equally mistaken in his conclusion: “By controlling the basic stock of money in the U.S. economy, Fed policy determines the level of prices.” Simply put, “It just ain’t so.” This said, he is correct that the Fed does not control interest rates; it can only influence them.

—Larry Parks

Foundation for the Advancement of

Monetary Education

New York, N.Y.

Richard Timberlake responds:

When I wrote the “It Just Ain’t So” explaining that the Federal Reserve System—in practice, the Federal Open Market Committee (FOMC)—could not raise interest rates, I could not also take the space to write a text book on how commercial banks and the Federal Reserve System create money. I have already written that book.

First, the Fed is not “a component of the banking system.” The Fed is the central bank, and despite the label “bank” is an institution fundamentally different from the banks in the fractional-reserve commercial banking system. The latter consists of some thousands of individual banking firms that operate to make a profit. The industry cannot and does not set policy or dehberately create money. Indeed, commercial bankers are renowned for believing and claiming that they do not create money. All the demand deposits they create are an unintentional by-product of their lending operations. Just as important, they do not initiate the creation of money. Only the Fed’s FOMC can and does initiate changes in the monetary base that the commercial banks use to make new loans and investments. The FOMC carries out its policies deliberately, with an avowed policy goal.

Second, Congress has not “delegated powers to the banks.” It has delegated unlimited (and unconstitutional) powers of money creation to the Federal Reserve System, which is not “a bank” in any functional sense of the word. It is a governmentally controlled institution that operates primarily for the benefit of the federal government. Only the policy-making central bank part of “the monetary system” is statist. If the Fed and all its trappings were obliterated, the commercial banking system still in existence would have no policymaking powers and no organization to create additional money. The stock of bank-created demand deposits would be fixed.

Third, the Fed’s “essential function” is not “to bail out the banking system when it gets in trouble,” as Parks alleges. (To assert that the Fed still has this anachronistic function is to admit that the Fed and the commercial banks are indeed different animals.) Far from it. Even though the Fed continues to hold this propaganda goody in front of the media and the public, its essential function is the creation of new base money by monetizing outstanding government securities—securities that the U.S. Treasury has issued and sold previously to finance federal government excesses. From this base-money creation the Fed realizes huge seigniorage profits—about $30 billion per year—for its government owners. The commercial “member” banks also get a pittance, perhaps $1 billion, for their “membership.”

I will state my conclusion again in more detail in order to contradict the misinterpretations Parks introduces and to clarify my original statement: “By controlling [increases or decreases in] the basic stock of money in the U.S. economy, Fed policy determines the level of prices [and any change in direction the price level will take].” This statement does not deny that other real factors—production of goods and services, and the public’s demand for cash—also influence the price level. Nonetheless, the Fed’s control over the stock of money is of a magnitude and a means that can counteract or subordinate these other factors. The one thing lacking in Fed control over the monetary system is its ability to effect changes immediately. In other words, a substantial lag of months and even years exists between the Fed’s immediate policy actions and their results on the economy. But that problem is another story.

The conclusion here is that Parks’s criticism is a medley of conceptual and factual errors by someone who does not really understand the monetary system.

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