CHAPTER 7
We must protect the position of the American dollar as a pillar of monetary stability around the world.
President Richard Nixon1
The last link between money and gold was severed in 1971. The consequences were revolutionary. The parameters within which monetary – and fiscal – policy had traditionally operated expanded well beyond what earlier generations had imagined possible.
Once the Fed was no longer required to hold gold to back Federal Reserve Notes and the reserves that commercial banks held at the central bank, it was free to create as much credit as it wished, simply by making deposits into the commercial banks' reserve accounts at the Fed. That meant the Fed could engineer an extraordinary expansion of commercial bank credit as well as central bank credit, since when the Fed added to the reserves of the banking sector that enabled the banks to extend additional bank credit, while still meeting the statutory required reserve ratio.
Suddenly there seemed to be no limit as to how much credit the United States financial system could create. Soon, credit growth began to accelerate, not only when measured in dollars but also relative to the size of the economy. Before long, credit growth became the principal driver of economic growth. That theme will be developed in later chapters. First, this chapter will describe the transformation of the Fed's balance sheet once its golden fetters had been removed.2
Assets
Between 1971 and 2007, the Fed's total assets increased 10-fold from $95 billion to $950 billion, as shown in Chart 7.1.
The Fed's balance sheet shows which items were responsible for that growth.
The composition of the Fed's balance sheet became much simpler between 1971 and 2007, as shown in Chart 7.2. Government securities became the Fed's only major asset and Federal Reserve Notes became its only major liability. All the other items were relatively insignificant.
CHART 7.1 The Fed's Total Assets, 1914 to 2007
Source: Data from “The Federal Reserve System’s Weekly Balance Sheet Since 1914” and accompanying spreadsheet. Johns Hopkins University, SAE/No.115/July 2018. See Bibliography.
On the asset side, the Fed's holdings of government securities soared by $670 billion, from $70 billion in 1971 to $740 billion in 2007. On the liabilities side of the balance sheet, Federal Reserve Notes in circulation increased even more, skyrocketing by $720 billion from $54 billion in 1971 to $774 billion in 2007.
First, let's consider the reason behind the growth in the Fed's holdings of government securities. As mentioned in the previous chapter, after its 1951 Accord with the Treasury Department, the Fed's stated objective in carrying out monetary policy was to facilitate sustainable economic growth at low rates of inflation. To accomplish that objective the Fed would first determine what the appropriate amount of monetary accommodation should be. It then would add or, less frequently, remove reserves from the banking system using open market operations. Open market purchases of government securities would add to reserves, which would stimulate economic growth by making credit more available. Open market sales of government securities would remove reserves and tighten credit availability, which would slow the economy and dampen inflationary pressures.
CHART 7.2 A Breakdown of the Fed's Major Asset and Liabilities, 1940 to 2007
Source: Data from “The Federal Reserve System’s Weekly Balance Sheet Since 1914” and accompanying spreadsheet. Johns Hopkins University, SAE/No.115/July 2018. See Bibliography.
During the 1950s, when the government's budget was generally in balance, the Fed had little difficulty achieving its policy objectives. Its task became much more difficult once the government began running large and persistent budget deficits, however. Budget deficits became a problem during the 1960s. They then became much worse. By 1976, the budget deficit was larger than it had been at the peak of World War II. In 1983, the deficit had grown to four times the World War II peak; and by 2004, it was nearly eight times larger (see Chart 7.3).
CHART 7.3 US Budget Balance: Surplus or Deficit, 1940 to 2007
Source: Data from the Office of Management and Budget, Historical Tables, the White House
Increased government borrowing put upward pressure on interest rates, which the Fed countered by purchasing increasing amounts of government securities in order to support economic growth and employment. The Fed paid for the government securities it acquired by making deposits into the reserve accounts that commercial banks held at the Fed. In other words, the Fed created Federal Reserve Credit to finance its purchases of government debt.
The larger the budget deficits became, the more government securities the Fed bought. This can be seen by comparing Chart 7.4, which shows the annual change in Federal Reserve Credit outstanding, with Chart 7.3, which shows the growth in the government's annual budget deficits.
It was noted in the previous chapter that Federal Reserve Credit expanded more in 1971 than it did at the peak of World War II. After 1971, it did so nearly every year. Altogether, between 1971 and 2007, the Fed created $825 billion of Federal Reserve Credit and acquired $672 billion of government securities.3 That amounted to 8% of the increase in government debt during that period.
CHART 7.4 Federal Reserve Credit, Annual $ Change, 1940 to 2007
Source: Data from Board of Governors of the Federal Reserve System, The Fed's 2017 Annual Report Tables 6A and 6B
Had the Fed not bought so much government debt, either other investors would have had to buy those bonds, or the government would have had to run smaller budget deficits. If other investors had bought the bonds, then they would have had less money to invest in other bonds or in equities, meaning that bond prices would have been lower and that interest rates would have been higher, while stock prices would have risen less or fallen. If the government had run smaller deficits, there would have been less economic growth. Either way, the public would have been far worse off.
Despite monetizing an additional $672 billion of government debt during this period, the share of government debt owned by the Fed still declined. At the peak, in 1971, the Fed owned 17% of all government debt. In 2007, its ownership share had fallen to 8% (see Chart 7.5). However, as Chapter 10 will show, by then, other central banks had monetized even more US government debt than the Fed. When central banks outside the United States began financing US government debt, the Fed was no longer compelled to finance as much.
CHART 7.5 The Fed's Holdings of Treasury Securities, as a Percentage of Gross Federal Debt, 1945 to 2007
Source: Data from Board of Governors of the Federal Reserve System, The Fed's Annual Reports 1945 to 2007
By 2007, Federal Reserve Credit accounted for nearly all of the Fed's total assets; and Federal Reserve Credit was comprised almost entirely of credit extended to the government by the Fed's acquisition of US government securities, as shown in Chart 7.6 and Chart 7.7.
Liabilities
As mentioned above, when the Fed bought government securities, it paid for them by making deposits into the reserve accounts that commercial banks hold at the Fed. Those deposits did not remain in the commercial banks' reserve accounts, however. Chart 7.2 shows that despite the surge in the Fed's holdings of government securities during this period, its reserve account liabilities hardly increased. The number of Federal Reserve Notes in circulation expanded instead – by $720 billion, from $54 billion in 1971 to $774 billion in 2007.
CHART 7.6 The Fed's Total Assets: Gold vs. Assets Acquired with Federal Reserve Credit, 1914 to 2007
Source: Data from “The Federal Reserve System’s Weekly Balance Sheet Since 1914” and accompanying spreadsheet. Johns Hopkins University, SAE/No.115/July 2018. See Bibliography
CHART 7.7 Federal Reserve Credit and Its Components, 1940 to 2007
Source: Data from “The Federal Reserve System’s Weekly Balance Sheet Since 1914” and accompanying spreadsheet. Johns Hopkins University, SAE/No.115/July 2018. See Bibliography.
Before going any further, it is important to emphasize that the explosion of Federal Reserve Notes in circulation after 1971 would have been entirely impossible if the Fed had still been required to hold 25% gold backing for the Federal Reserve Notes it issued, as had been the case up until 1968. In 2007, the Fed would have had to have held $193 billion worth of gold certificates to back $774 billion of Federal Reserve Notes. It held only $11 billion worth. Its holdings of gold certificates had not changed since 1971.
Increased demand for cash drains Bank Reserves. That is because the Fed debits the reserve accounts of the commercial bank in exchange for the Federal Reserve Notes it provides them. Chart 7.2 shows that increased public demand for cash was so great that it completely offset all of the reserves the Fed injected into the commercial banking system to pay for the $620 billion of government securities it bought during those years.
CHART 7.8 Federal Reserve Notes per Capita, 1945 to 2019
Source: Data from Board of Governors of the Federal Reserve System (U.S.), The Fed's Annual Reports 1945 to 2019
The unprecedented growth in the number of Federal Reserve Notes that began in the early 1960s was mentioned in the previous chapter, as was the mystery surrounding the reasons behind it. Yet the public's desire to hold cash became even more voracious during the decades following the collapse of the Bretton Woods system, for reasons that are difficult to identify.
The number of Federal Reserve Notes per capita surged from $160 in 1960 to $260 in 1971 and then to $2,600 in 2007 – and to $5,350 in 2019. That is $5,350 of cash for every man, woman, and child in the United States (see Chart 7.8).
The demand for cash soared even though credit card use became widespread during the 1970s and should have lowered the demand for cash. Why?
Some of the increase can be attributed to inflation. A higher price level requires more currency to conduct transactions. However, inflationary pressures abated after 1980, when Federal Reserve Notes per capita amounted to just $550. Therefore, inflation can account for only part of the increase in the demand for physical dollars.
A more important factor is that a growing number of Federal Reserve Notes began to be accumulated outside the United States due to the widespread international acceptance of dollars as a store of value and a medium of exchange. For instance, Panama, Ecuador, and El Salvador have adopted the dollar as their currency; and many other countries are partially “dollarized.” Drug lords are known to stockpile $100 bills. And it is very likely that dollar bills are used for a variety of other criminal transactions around the world, as well.
No one knows how many dollars are held abroad, but estimates range from between 40% and 70% of the total. In 2007, there were $800 billion Federal Reserve Notes in circulation. In 2019, there were $1.8 trillion. If 40% of those $1.8 trillion of Federal Reserve Notes were held overseas, the per capita amount remaining in the United States would be $3,300. If 70% were held abroad, US per capita holdings would be $1,650. Either of those figures would still represent a very large and difficult to explain surge in cash holding per capita within the United States relative to the level of 1980, which was $550.
The author is unable to find a satisfactory explanation for why, at the time of writing, more than 2 trillion non-interest bearing physical Federal Reserve notes are currently in circulation.
Conclusion
In 2007, the Fed had little in common with the institution created by the Federal Reserve Act of 1913. No one doubted that it was a central bank. Gold had become irrelevant to its operations. It had gained the power to create an infinite amount of credit. It could control interest rates at any level it chose. It was free to monetize some or all of the government's debt. And, it could even create wealth by extending Federal Reserve Credit and pushing up the price of property and stocks.
The following chapters will show that during the years after dollars ceased to be backed by gold, the Fed oversaw a phenomenal expansion of credit in the United States that supercharged the global economy and pulled hundreds of millions of people out of poverty. Unfortunately, the credit structure that existed in 2007 was built on weak foundations. In 2008, it began to collapse. If it had, it would have decimated the entire US financial sector and destroyed most of the country's savings and wealth.
That did not happen because in 2008 the Fed created and extended more Federal Reserve Credit in one year than it had during its near-century of existence prior to 2008, as shown in Chart 7.9.
And that was only the beginning. Fed policy ensured there would be no replay of the Great Depression.
CHART 7.9 Federal Reserve Credit, 1940 to 2008
Source: Data from Board of Governors of the Federal Reserve System (U.S.), The Fed's 2018 Annual Report
Notes
1. Office of the Federal Register (Ed.), Richard Nixon, containing the public messages, speeches and statements of the president - 1971, Washington: US Government Printing Office, 1972, 1362 p. (Public Papers of the Presidents of the United States), pp. 886–890. https://www.cvce.eu/content/publication/1999/1/1/168eed17-f28b-487b-9cd2-6d668e42e63a/publishable_en.pdf
2. This is a reference to Barry Eichengreen's influential book, Golden Fetters: The Gold Standard and the Great Depression (Oxford University Press, 1992).
3. The 2017 Annual Report of the Board of Governors of the Federal Reserve System, Tables 6A and 6B.