One of the most important financial, but least understood, events of the 20th century was the creation of the Federal Reserve System. In the late 19th century and the early 20th century a series of financial panics promulgated a convention of thought that a banker's bank was required to avert such disasters in the future. On Jekyll Island, Georgia in 1913 the idea of a central bank was born. [Author's note: There is something ironically symbolic about the creation of this institution on an island by the name "Jekyll".]

The Federal Reserve System (FED), created in 1913, functions as a central bank. It is a private organization with twelve regional Federal Reserve Banks located in major cities. The term "private" is a bit of a misnomer since the President appoints the Board of Governors of the FED and ostensibly, there is some degree of Congressional oversight. There are also thousands of private banks that are also members of the FED (meaning they own stock in their associated FED bank). The FED is not part of the government however. The current FED chair is Janet Yellen.

The FED is supposed to mitigate the circumstances that led to the financial panics mentioned earlier. Unfortunately, 16 years after FED creation, a financial panic ensued that evolved into the Great Depression. The panic led President Roosevelt and Congress to take extraordinary measures in 1933 such as outlawing domestic gold ownership and domestic contracts denoted in gold. These directives meant that existing paper notes were not exchangeable for gold. The inability to exchange paper notes for gold provided the catalyst for future inflation. Why? Because now Federal Reserve Notes (FRN) could be created without regard to the supply of wealth. Furthermore, FRN became legal tender, which meant they had to be accepted by the public for debts both public and private. At this point, the FRN no longer represented wealth since they were not exchangeable for wealth. Though some notes were exchangeable for silver, this ceased in 1964.

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". Have you ever seen an establishment in the US with a sign saying, "Cash not accepted"? [Author's note: There are establishments that find it convenient to accept credit cards since they don't want to deal with cash. Some airlines only accept credit cards for in flight purchases. It would be interesting to see someone challenge that!]

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 flows into other parts of the banking system from which more loans occur. 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 backing for this money is the FED's ownership of government bonds.

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 to the public. The FRB 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 FRB'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 FRB has bonds and the Treasury has more 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. The Quantitative Easing (QE) term we hear in the news is the FED buying debt instruments to a) provide the government money and b) to hold down interest rates.

FED purchases naturally represent inflation since there are more money units artificially created. Another term for this is an increase in the money supply. When the FED purchases a government bond, the US Treasury receives the money, and now can spend this money in any authorized manner. The spending allowed by the newly created money places demands on existing wealth or other resources in the economy, thus driving up their "price". So any time the FED buys a financial instrument, the other party to the transaction has money that previously did not exist.

Despite the FED buying trillions in assets since 2008, we have not experienced a raging inflation for reasons I have stated in other articles. One thing is absolutely certain. If the FED had refrained from these multi-trillion dollar purchases, the price of these financial instruments would be much lower and interest rates much higher.

One final point about inflation. The US Mint produces one dollar silver coins (99.5% real silver content). The coins are legal tender since they represent the same currency value as a one dollar bill. If purchasing a soft drink for one dollar, which would you use, the one dollar silver coin or the one dollar paper bill? Consider the reason for your answer. You know intrinsically that the one dollar silver coin represents something besides what it says. In fact you can exchange the dollar silver coin for around 20 dollars of the paper variety. The example represents one of the most understandable examples of inflation.