grants credit to the bank in an amount equal to those contracts. In essence, this allows the bank to convert its old loans into new
'reserves.' Every dollar of those new reserves then can be used as the basis for lending
The process does not stop there. Once the new loans are made, they, too, can be used as collateral at the Fed for still
The music goes 'round and 'round, with each new level of debt 1. In 1980, statutory limits on reserve ratios were eliminated altogether. The Federal Reserve Board now has the option to lower the ratio to
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becoming 'reserves' for yet a higher level of loans, until it finally plays itself out at about twenty-eight times. That process is commonly called 'discounting commercial paper.' It was one of the means by which the Fed was able to flood the nation with new money prior to the Great Dam Rupture of 1929.
But, there is a problem with that method, at least as far as the Fed is concerned. Even though interest rates at the discount window can be made so low that most bankers will line up like ducks looking for free corn, some of them—particularly those
'hicks' in the country banks—have been known to resist the temptation. There is no way to force the banks to participate.
Furthermore, the banks themselves are dependent upon the whims of their customers who, for reasons known only to themselves, may not want to borrow as much as the bank wants to lend. If the customers stop borrowing, then the banks have no new loans to convert into further reserves.
That left the third mechanism as the preferred option: the purchase and sale of bonds and other debt obligations in the open market. With the discount window, banks have to be enticed to borrow money which later must be repaid, and sometimes they are reluctant to do that. But with the open market, all the Fed has to do is write a fiat check to pay for the securities. When that check is cashed, the new money it created moves directly into the economy without any concurrence required from the recalcitrant banks.
But, there was a problem with this method also. Before World War I, there were few government bonds available on the open market. Even after the war, the supply was limited. Which means the vast inflation that preceded the Crash of 1929 was not caused by deficit spending. In each year from 1920 through 1930 there was a surplus of government revenue over expenses. Surprising as it be, on the eve of the depression, America was getting out of debt.
As a consequence, there were few government bonds for the Fed to buy. Without government bonds, the open-market engine was constantly running out of gas.
The solution to all these problems was to create a new market tailor-made to the Fed's needs, a kind of half- way house between 1- See chapter ten for details.
2. See Robert T. Patterson, The Great Boom and Panic; 1921-1929 (Chicago: Henry Regnery Company, 1965), p. 223.
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THE CREATURE FROM JEKYLL ISLAND
the discount window and the open market. It was called the
'acceptance window,' and it was through that imagery that the System purchased a unique type of debt-related security called banker's acceptances.
b a n k e r ' s a c c e p t a n c e s
Banker's acceptances are contracts promising payment for
commercial goods scheduled for later delivery. They usually involve international trade where delays of three to six months are common. They are a means by which a seller in one country can ship goods to an unknown buyer in another country with confidence that he will be paid upon delivery. That is accomplished through guarantees made by the banks of both buyer and seller.
First, the buyer's bank issues a letter of credit guaranteeing payment for the goods, even if the buyer should default. When the seller's bank receives this, one of its officers writes the word
'accepted' on the contract and pays the seller the amount of the sale. The accepting bank, therefore, advances the money to the seller in expectation of receiving future payment from the buyer's bank. For this service, both banks charge a fee expressed as a percentage of the contract. Thus, the buyer pays a little more than the amount of the sales contract, and the seller receives a little less.
Historically, these contracts have been safe, because the banks are careful to guarantee payment only for financially sound firms.
But, in times of economic panic, even sound firms may be unable to honor their contracts. It was underwriting that kind of business that nearly bankrupted George Peabody and J.P. Morgan in London during the panic of 1857, and would have done so had they not been bailed out by the Bank of England.
Acceptances, like commercial loan contracts, are negotiable instruments that can be traded in the securities market. The accepting banks have a choice of holding them until maturity or selling them. If they hold them, their profit will be realized when the underlying contract is eventually paid off and it will be equal to the amount of its 'discount,' which is banker language for its fee.
Acceptances are said to be 'rediscounted' when they are sold by the original discounter, the underwriter. The advantage of doing that is that they do not have to wait three to six months for their profit. They can acquire immediate capital which can be invested to earn interest.
THE GREAT DUCK DINNER
