The eighth wonder of the world
By Chris Cook

I recently questioned conventional wisdom as to the relationship between the US Treasury and the Federal Reserve Bank, and indeed the very basis of the dollar itself. (See A very secret agent (Asia Times Online, July 27, 2011). Comments poured in, and the subsequent discussion and debate has been both intense and detailed.

Having peeled away all the layers of the onion, the debate reached the bizarro world of the Federal Reserve Bank's balance sheet. Manoj Singh explains the Fed's Looking Glass World in an Investopedia article. [1]

"Taking a look at the balance sheet of the Federal Reserve Bank, or for that matter, any central bank, is like seeing the eighth wonder of the world. Unlike any other business enterprise the Fed

 
can expand its balance sheet by printing as many dollar bills as it wants. It's like creating winds merely by waving your hands."

So we are asked to believe that the accounting definitions and rules of double entry book-keeping which apply to every other business entity are suspended at the Fed.

There are assets and liabilities...
For any business enterprise - and the Fed is no exception - there are two types of financial claim. There is the claim of the owner, generally known as equity, and there is the claim of a third party against the business, generally known as debt.

In the days when gold coins were used as money, they began to be taken in by goldsmiths and held for safe-keeping on benches or bancs in the goldsmiths' vaults. The goldsmith as custodian would issue a receipt which was a document of title to the gold coins. Note that the obligation of the goldsmith was not a debt to the owner, but was an obligation to deliver the gold coins to him upon presentation of the title document.

These convenient paper receipts rapidly came to be used instead of gold coins in exchange transactions while the gold coins, as the goldsmiths were not slow to observe, remained sitting indefinitely on their bancs. So goldsmiths began to create more receipts than they actually held in gold and by lending them to borrowers - creating interest-bearing debt obligations by the borrower - became the first generation of proto-banks.

These early private banks were always susceptible to a loss of confidence by depositors, who could demand the return of their deposited gold at any time, whereas the loans the banks made based upon their gold deposits were for defined periods of time. Over the centuries this mismatch led to a series of banking crises and collapses, which in turn resulted in the evolution of state-owned or state-controlled central banks. The first modern example was John Law's Banque Royale in France in 1719, accompanied, appropriately enough, by the first modern bubble fuelled by such manufactured bank credit - the Mississippi Bubble.

….and Fed assets and liabilities
The last vestiges of gold backing for US credit creation disappeared in 1971. When the Fed now creates credit as the agent of the Treasury it is still creating an ownership claim as before, but this ownership claim is now in respect of a different, and virtual, monetary object which is inserted into the Fed credit creation process almost by magic.

What in reality happens when the Fed creates credit as an agent of the Treasury is that it manufactures a facsimile or look-alike Treasury bill of credit: this is the virtual equivalent of a United States Note or "greenback". Such Treasury bills of credit are redeemable in payment of taxes, in precisely the same way that a Frequent Flyer Mile is redeemable in payment for flights. These are by definition not liabilities of the Fed, but are non interest-bearing liabilities of the Treasury, whereas dated Treasury Bonds and Treasury Bills bear interest directly or implicitly.

These undated Treasury bills of credit - generally known as cash - are then deposited by the recipient bank with the Fed as custodian. These reserve deposits are described by the Fed as liabilities, but this description is misleading at best and deceptive at worst, since the Fed is not in debt to depositors. It is the Treasury which has the debt obligation to depositors. The Fed's obligation to depositors as credit creating agent of the Treasury is that of a custodian, but this reality has been obscured.

Doublethink - believing two contradictory thoughts at the same time. (1984 - George Orwell)

Statement One: when the Fed creates credit it acts as the fiscal agent of the Treasury.
Statement Two: the Fed has a conventional banking counter-party and checking relationship with the Treasury.

In a principal/agency relationship a credit issued by the agent is equivalent to a credit issued by the principal.

But in a banking counter-party relationship - as anyone with a checking account will know - a debit entry in the Treasury's books is reflected by a credit entry in the Fed's books and vice versa. So a Fed account receivable mirrors a Treasury account payable and vice versa: a Fed term-loan asset mirrors a Treasury term-loan liability and vice versa.

It is not possible for both statements to be true because these two accounting relationships are mutually exclusive. In respect of a particular transaction you can be a counter-party or an agent, but you can't be both.

The reality is that Statement One is true, and the proof is that a Federal Reserve Note emitted by the Fed is accepted in exchange in exactly the same way as a United States Note emitted by the Treasury, of which a few still remain in circulation in the US.

Therefore Statement Two is false, because the Fed's balance sheet does not reflect reality, and distorts the true nature of the obligations between the Treasury, the Fed and the people.

What has vanished with a wave of Fed chairman Ben Bernanke's hand are the virtual undated Treasury bills of credit which are created by the Fed on the Treasury's behalf and deposited with the Fed as custodian.

Esoteric though it may be, this accounting smoke and mirrors - which completely invalidates almost the entire body of conventional economics built upon the misconceived understanding of money which results - is indeed the Eighth Wonder of the World.

Note
1. For Manoj Singh's article, "Understanding The Federal Reserve Balance Sheet", see here.

Chris Cook is a former director of the International Petroleum Exchange. He is now a strategic market consultant, entrepreneur and commentator.

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