E Financial Bubbles (Part III)

So what do Federal Reserve Notes represent? We answer this question by looking at the FRN (that paper in your wallet with George Washington’s picture).  It clearly states,

This note is legal tender for all debts public and private.

Legal tender means the note must be accepted as payment of debt. For example, after eating a steak in a restaurant, the establishment must accept your FRN by law.  If you paid in cash and went home, the restaurant could not sue for non-payment – since you provided legal tender (FRN).  The restaurant, however, in the case of checks, credit card, debit card or other non-cash form of payment is not obligated to accept these instruments. Think of an establishment that has signs indicating, “Personal checks not accepted."  

[Note: The move towards credit/debit card payments has led some establishments to stop accepting cash. Even local governments have gotten into the act by accepting digital payments only at parking meters, for example.  It would be interesting to see a legal challenge towards establishments not accepting legal tender. This delves into the topic of the war on cash.]

The functions of the FED are several.  First and foremost they facilitate credit in the banking system.  The member banks of the FED are authorized to lend (provide credit) under a practice known as “fractional reserve.”  Banks can loan a large portion of their deposits.  Historically, 90% of a bank’s deposits became credit.  This credit flowed into other parts of the banking system from which more loans occur (more credit).  Additionally, banks have the ability to issue stock, bonds and other debt instruments and thus create a larger pool of funds for use as credit.  The only backing for this additional money is the FED’s ownership of government bonds purchased with bookkeeping entries. 

As just illustrated, another FED function is to purchase or alternately sell government bonds.  When the US Treasury needs to borrow money, they sell debt instruments (bonds) to the public.  The FED is one entity that buys these bonds from intermediaries (banks and financial institutions) and increases the value of the US Treasury’s checking account.  But where did the FED's money come from to buy the bonds?  The money was simply created.  It never existed.  At the conclusion of this transaction, called monetization the actual sellers are paid their transaction fee, the FED has bonds and the Treasury has money in their checking account.  Buying and selling government bonds constitutes what are called open market operations.  The FED has the ability to acquire many types of assets besides government bonds.  As an aside, Japan's central bank (Bank of Japan) is one of the primary players in the ETF market in that country.

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