If the Fed didn't manipulate reserves, how would interest be determined?

Pretty straight forward question…

The short answer is free market forces. In the first half of the 19th century the money supply was mostly made of privately issued bank notes. The quality of these notes was no better than the bank that issued them. Notes from banks that were strong traded for close to their face value. Weak banks traded at a discount, and notes from broken or fraudulent banks were worth nothing. Money from the Federal Government was limited to coins, which included gold and silver, which were “real money.” Copper cents and half cents were coins of convenience. They had no legal tender status. That was the supply side. Foreign coins, mostly from Spanish or formerly Spanish colonies had legal tender status and did add to the money supply.

The demand for money came from business that borrowed to cover their expenses and capital projects. Farmers were noted for borrowing money during the planting season and paying it back, if things went well, at harvest time. Many farmers and plantation owners were perpetually in debt.

One of Abraham Lincoln’s Civil War reforms was to pass a law that put a prohibitive tax on privately issued bank notes. From about 1865 on, all of the paper was supplied by the Federal Government. The National Bank notes that were issued with a local banks name on them made up a lot of money that was in circulation. The backing for these notes came from government securities that the National Banks deposited to the government back the national bank notes. Addition money was issued with the backing of gold and silver that was in the Federal Government vaults.

The Federal Reserve Act eventually replaced all of this. The Fed has the ability to increase and decrease the money supply. The most powerful weapon the Fed has is to buy and sell government bonds through open market operations. When the Fed buys bonds it pays the holders of those securities which increases the money supply. When it sells them, the Fed takes in money and decreases the money supply. Of late it’s all been buying because the Fed has been the chief buyer of our national debt. This is the so-called QE-1 and 2 plans.

The late conservative economist, Milton Freidman, called for the Fed to increase the money supply by the amount of growth in the economy. He argued that the continual tinkering by the Fed with the money supply caused more harm than good. There as certainly been evidence to support that.

Super long posts are not my thing to read or write so I’ll end here, and try to field questions if there are any.

Edited to answer your first question: Some government agency would need to issue paper or electronic money if the Fed was not there to do it. You don’t want to go back to the privately issued bank notes of the early 19th century. Would want to consult a bank rating service before you accepted each piece of money you received? Those who advocate the gold standard don’t comprehend how high the government fixed price of gold would have to be to provide a money supply at today’s prices. The short answer is there is not enough gold in the world to do it, and the gold standard didn’t work all that well when it was in its “golden age.”

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It was the railroads that prompted this. Trains crossed state lines and the states issued their own money. So the guy in Virginia bought a ticket with Virginia money, but when he arrived in Kansas his money was not good and banks were also not staying in business very long making the money sometimes worthless.

Hence the term: “Train Riding Dollars”. Train Riding Dollars was US money backed by gold and it was accepted everywhere…


Interesting bit of history I did not know about. There was some movie I watched recently where such a situation arose back in the old west where a fellow tried to cash in $300 dollars and found that the bank had gone bust

The Homesman (2014) - IMDb


Thanks for that, but it didn’t really answer my question.

You said; “The short answer is free market forces”.

But what does that mean? Explain to me, why, in the economy we have today, that interest rates would rise above zero if the Fed stopped manipulating rates. I mean, I accept your explanation for the history of the past, but things are different now and they operate under different rules.

When you say “market forces”, isn’t the “force” in this case the supply and demand of capital? If that’s true, how does the market for money run out of capital to lend if banks can create all the capital they need to make more loans? Of course there is a constraint on how much a bank can lend, but it’s hard to imagine that constraint ever being realized today.

That is, supply of credit is infinite and labor and resources are finite, the real constraint is actually labor and/ or resources and/ or perhaps credit worthy borrowers, right? If we ran out of labor, resources and/ or credit worthy borrowers, wouldn’t the demand for capital decline, not the supply?

Thus, under what circumstance would the rate ever rise above zero?

> You said; “The short answer is free market forces”.
> But what does that mean? Explain to me, why, in the economy we have today, that interest rates would rise above zero if the Fed stopped manipulating rates. I mean, I accept your explanation for the history of the past, but things are different now and they operate under different rules

Currently the Federal Reserve is flooding the economy with so much money that the banks don’t need to pay you much of anything on your saving account or CDs. In Europe some banks are charging customers to hold their money. In other words those banks are paying negative interest on savings accounts. Since the banks don’t have to pay much for money they can charge less for the loans they make. Since there is competition between banks, they are all going to keep the loan rates low. If they don’t, they won’t get any business. If the Fed were to tighten things up and make money less available, the banks would have more of a need for your savings and pay you more.

As for the demand side, businesses access what they can make for a project or their ongoing activities. If they can make 10% on their money, they might be willing to pay 4 or 5 percent to borrow it. Those numbers are just out of the air, but you get the idea. Weather or not you can afford a mortage depends upon the interest rates, the duration of the loan and the down payment requirements.

The kicker in all of this is government regulations. My sister-inlaw is a senior loan officer at a large south Florida bank. She says that the Dodd-Frank banking law has made their jobs a lot harder. Loans are not a easy to get because of it. That could be a good or bad thing. When the goernment was passing anti-red lining laws and people were getting mortages who had no hope of paying them off, that was a bad thing. When people take a mortage with little or no down payment, that is a bad thing, in my opinion. When people took mortages and didn’t have to pay the principle and only paid interest, that was a ROTTEN THING in my opinion.

> When you say “market forces”, isn’t the “force” in this case the supply and demand of capital? If that’s true, how does the market for money run out of capital to lend if banks can create all the capital they need to make more loans? Of course there is a constraint on how much a bank can lend, but it’s hard to imagine that constraint ever being realized today.

The banks cannot create all of the capital they need or want to make more loans. They have reserve requirements which limit them as to amount they can loan. Let’s say the reserve requirement is 25%. That means if a bank has $100 in vault cash and deposits with the Federal Reserve, they can make $400 in loans, but no more. In The United States the reserve requirements generally don’t change very much because the reserve requirement is a very powerful tool. Let’s say that the Fed raised the reserve requirement to 50%. That means that the bank would have to get down to $200 in loans overnight which cause a huge liquidity crisis. They would have call in their loans very quickly, and if the borrowers can’t pay them, you are looking at bankruptcy all over the economic system.

All of this gets very complicated when you apply it to the entire economy, and there are significant delays between when a policy implemented and when it takes effect in the economy. Then when you add politics to the situation it gets worse. No body wants the Fed to put the breaks on, but when the economy is roaring out of control, or banks are making dumb loans that are going to go belly up, you have to slow things down. The dumb housing loans made in the 2000s helped get us to where we were in 2008-9 when Bush was on his way out and Obama was on his way in.

> Thus, under what circumstance would the rate ever rise above zero?

When the Fed stops flooding the economy with money as it has been doing for much of the Bush and Obama administrations, interest rates will rise. The Federal Reserve has funded irresponsible government spending with its policies, and yet has not been able to stimulate the economy the way some people thought it should have. The reason is the business climate that Obama has created, but now I’m getting into politics, so I’ll back off.

Market forces generally drive the market, but as rules, regs get dumped on companies at lower and lower levels the market forces no longer work, which is where we are now.

Small business is starting to be crushed so the reaction is to keep you business so small that you fly under the regulatory radar. Last I checked the threshold for employees was 25 FTE’s.

The capital markets for business have changed a lot, most small businesses are self funded, when at another time you would go to the market for startup funding, today you leverage your own assets such as ReFi your home, credit cards etc to get your seed money and then at some point in time you may go to capital funding for expansion. But I can tell you many are just deciding to cap their business below the thresholds of govt regs.

As for today’s rates and why they go above where they are at. Its all phony junk. The Feds depressed % rates in order to support their $1Trillion overspending every year. The Govt has to pay % on the money it borrows and since they are setting the rate they pay it becomes a sweet deal. In addition by capping growth at about 1% you also hold down inflation. They have also caused the reduction in household income for the middle class, again, holding down inflation and allowing the govt to spend like a drunk on payday.

What Obama has done is set America up for a fall and a big one. The current debt per taxpayer is $162,500! All this begs the question, what will HildaBeast do because Obama has left her with $20 TRILLION in Debt, that is going to be a burden that will need to be dealt with. At some point in time the $1 T + the govt has been spending that came from borrowing not from tax revenue must end…either by the govt reducing spending by $1T or by increasing revenue by $1T, our glide path will sooner rather than later run out of air under its wings.

The free market forces are no longer the driving force in our country, everything you see it manipulation by the Govt to redistribute income, that is what is driving the capital markets.

Heavy regulation by the govt from the EPA to the Treasury does not let the free market work and no govt has EVER successfully managed its economy…

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I remember that movie too, but I can’t recall the title. “The Shootist,” John Wayne’s last film comes to mind, but I don’t think that’s right.

I thought States lost the ability to circulate money with the adoption of the Constitution.

The trains loaded with currency, IIRC, was the result of not having a Central (sovereign) Bank able to move currency by ledger from one point to another. In the early 1800s it was not a major issue. With the discovery of gold in California; and with the railroad industry having vast payrolls out in the middle of nowhere…and with no way for checks, drafts or scrip to be redeemed in the Territories…payrolls had to be met with railcars full of money. Likewise, gold was sold and shipped out East the same way.

One reason given for the Federal Reserve, was that it would serve as a clearinghouse. Paymasters for the Union Pacific Railroad in Omaha, could order their bankers in New York to have money deposited with the Fed or Fed-allied banks for withdrawal in Reno or San Francisco. The Fed could then credit a branch of the Western bank the railroad was using, via telegraph confirmation, and checks drawn or paper currency created to pay the workers.

No more Great Train Robberies.

There are many good reasons for the Fed. But I didn’t believe its charter allows it to act as a Central Bank; and if it does, that charter should be redrawn to STOP this currency manipulation!

Banks are paying nothing on interest and like so many others I had hoped the money from interest would supplement my income but it does not and we all know everything keeps rising. Gas is on the rise again for one thing.

Everybody except the Federal Government knows that there is inflation. The contents of boxes at the food store get smaller while the prices remain the same. Medical care prices are going though the roof because of Obama care. The government has come up with an inventive way to measure inflation which allows it not to increase transfer payments like social security benefits.

Get ready for huge increases in inflation whne Hillary takes office. With her tax increases combined with her carbon tax, she will become the poverty queen. Everyone will beg her for money, and the main people who will benefit from her programs will be the illegal aliens whom she will quickly makes voters so that they will vote for her and the rest of Democrats. She’ll tell us about how “I’ve made the system fairer.”

It was actually Bank notes IIRC this went on into the early 1900’s. What you had was Federally chartered banks printing and issueing their own Bank notes and they were backed by the govt (but not at full face value), then there were OTHER banks also printing their own banknotes and these often were not backed by the Feds but by the bank itself…you can guess how that worked out.

While this worked well enough going back to the late 1700’s, when the rails came along and folks began doing business outside of the city or state you have some problems…

[ATTACH]2807[/ATTACH] New Orleans

[ATTACH]2808[/ATTACH] National bank of San Diego 1913

[ATTACH]2809[/ATTACH] National Bank of Honolulu

And if currency were private and/or disconnected from public policy? To which, I respond with a question.

If the federal government didn’t manipulate the corn market, how would the price of corn be determined?

What is the demand for corn at various prices / how much corn have the farmers produced + what might be imported from foreign countries.

Government purchases are supposed shift the demand curve up so that farmers get higher prices.

Agreed, excess reserves sit at $2.2 trillion today, down from a high of about $2.6 trillion a year ago. At the rate we are going interest rates won’t rise for at least another 4 years regarless of where the Fed sets it’s target rate.

Yes in a misguided attempt to spur demand by discouraging savings. Ridiculous.

The Fed is “tightening things up”. The problem is QE made things so loose it will be years before the Fed can sell off enough bonds to soak up enough excess reserves to cause rates to rise.

Even if I concede that the government made banks, not only approve loans to unqualified buyers, the government didn’t tell banks they had to charge low rates of interest to those people. The government didn’t tell banks to obscure risk to investors, and the government didn’t make the ratings agencies (created, funded and owned (in a manner of speaking) by the very industry they are supposed to be rating).

But I digress…That’s not really apropos to the topic.

You are correct, banks cannot create capital. The bank requires investors to increase it’s capital account. A bank can also shift it’s profits into it’s capital account to increase it’s capital and it’s capacity to lend. Also, since loans are assets, there are capital adequacy requirements that allow low risk loans to be counted as capital.

This is where you’re mistaken. A bank is in no way functionally limited by reserves. Reserves are, as you correctly note, simply a mechnisim for setting interest rates. When the quantity of reserves are high, rates are low. When the Fed sell bonds it trades cash today for cash at some point in the future, until that future arrives, the amount of reserves in the system declines and rates rise as a result.

Banks can lend beyond the amount they have in reserve until the end of each day. When the day is over, a bank that has exceeded it’s reserve requirement must borrow reserves from another bank (reserves that will always exist somewhere in the system). The market set’s the rate here and determines what one bank will charge another bank to borrow reserves. This, as I’m sure you know, is the “overnight window” and the rate that banks borrow reserves from each other is the floor for many rates in the consumer market. Right now, as you’re pointed out. Banks have lots of reserves so there is no demand for them between banks, thus the rate is almost zero.

Actually, Banks would turn to the Fed as the “lender of last resort” and the Fed would be obliged to create the cash necessary to meet the new requirement. Since the Fed’s rate is not determined by market forces, the Fed could set a higher rate than is currently seen in the market thus, using this tactic, the Fed could cause rates to rise overnight, though I suspect that would have a ripple affect throughout the market causing lots of unintended consequences not the least of which would be to implode the stock market and squash demand sending the economy into a nose dive.

However, this scenario is extremely unlikely. Even if the Fed were to raise the reserve requirement, it would do so slowly over time and even then, it would find banks looking to the Fed to supply the market for reserves.

The Fed has stopped as of September of last year. The Fed has reeled in $500 billion in excess reserves since September of last year.

However, it’s interesting. You seem very knowledgeable, however, with all due respect, there is one thing that seems to have completely alluded you.

You say “when the Fed stops flooding the economy”…But that’s just it. In order for rates to rise, the Fed has to take an action. That is, when rates rise, it’s because the Fed is manipulating the market. The Fed Sells bonds and that decreases the amount of money available in the market and rates rise as a result. This isn’t “market forces”, this is Fed manipulation.

If the Fed did nothing, rates would fall to zero because every single loan a bank makes ends up as a deposit somewhere else in the system as a deposit, as reserves. Since only 10% is needed, than every single loan made creates 9 times more reserves than is necessary to cover that loan and since a bank can borrow the reserves it need after it’s made it’s loans for the day, then interest rates wouldn’t rise as there would always be money in the system to create new loans. Even if you account for the money that does not find it’s way back into the Federal reserve system, there is still many time the reserves created than is needed.

As I explained, and you may know, capital is what constrains banks, but loans are graded according to risk and higher quality loans can count towards a banks capital requirement under the Basal II rules. So more loans can mean increased capital which means increased capacity to lend.

Wrapping this up…

In today’s fiat economy, rates ABOVE zero are the result of Fed manipulation, not market forces. The system as you’ve tried to explain it hasn’t been true since 1971.

Having said that, I want to make it clear, that I’m simply explaining the system as it is. You may believe the system prior to 1971 is a better system where reserves did constrain banks, that’s not the argument I’m making here.

The point I’m making in this thread, is that in the system we have today, there are no “market forces” when it comes to interest rates. They are 100% determined by Fed manipulation, whether rates are low or high and if the Fed stopped manipulating rates, they would fall to zero.

To your question, if the Fed didn’t manipulate the corn market, how would the price of corn be determined?

Prices are determined in a free market economy through the interactions of supply and demand in the marketplace.

However, if your question is supposed to imply that the same is true of the price of renting money, then, as I said, no, manipulation means zero, or almost zero % interest as we have today.

Well, I tried.:noclue:

BTW a couple of economists in the 1990s agreed with you that that Federal Reserve often bails out over extended banks which makes the “the college undergraduate economics courses” invalid. And yea I got my BS in 1971.

There is inflation in some places and not as much in others and in some cases there is a decline in costs.


Yes, the corn market is manipulated. Assuming that it isn’t, the answer, the interaction of supply and demand in a marketplace, is an easy answer to figure out. That would be my answer to what I think CS is asking – but it’s not always obvious to some folks that money is also affected by supply and demand. Then again, if that’s not what he’s asking, it seems like a silly question.

The same is true of renting money. If the Fed and the government are not manipulating it, the price would be set through the interactions of supply and demand in the marketplace.

You’re correct. Money is not free market. Were you attempting to ask what would happen if it were, or were you just asking what happened if one public policy manipulation were ended? If the latter, what’s the point of asking the question?

As always my point is simply explaining the system we have. When someone says that the “free market” should determine rates, (I think) most believe that in the system we have now that rates would rise to some point above 1% if the Fed did nothing.

Take a period like the mid 1980’s where the Fed pushed rates really high to combat inflation. Inflation eventually fell because the Fed supplied (via manipulation) more reserves to the market. In that situation, the Fed is manipulating it’s previous manipulation. It’s kind of like a balloon. If you blow it up and then release it so the air can come out, it will naturally get smaller, but you can manipulate how fast it get’s smaller by squeezing it. The “natural state” of the balloon is to be deflated, but we’ve become accustomed to the Fed manipulating reserves in both directions, I think a lot of people assume that if the Fed stopped it’s manipulation that rates would fine some “natural point” above zero. I’m saying the system we have is similar to the balloon. It’s natural state is at or near zero.

And indeed Robert Murphy, Ph.D of the Austrian school of economics in a debate with Warren Mosler took the position that the Fed should stop manipulating rates. In the language he used he described the Fed as “artificially pushing rates down”, when in fact, if the Fed takes any action at all it’s to move rates up, unless as I stated it’s manipulating previous manipulations that caused rates to rise. QE didn’t artificially depress rates, it created a situation where the Fed cannot in the near term cause rates to rise though its manipulation. Once this was pointed out to Dr. Murphy he re-evaluated the question as I think most people are doing here in that the fiat system as a whole needs to change over to a system where the amount of money in the system is finite so that free market forces can drive rates.

Would you agree?