For that matter, what is the fear of a central bank? In some countries, banks are like utilities and post offices — public services provided by the government. The First and Second National Banks were killed because people did not trust the government with their money. Well, it seems like big commercial banks can be trusted even less. Also, it’s not like anything would function with just community banks. It’s not a country of farmers any more…

I mean, capital allocation decisions can still be locally made and subject to market forces, as they should, but banking infrastructural issues like described here (and regulatory ones, some say) should have no reason not to be national, am I wrong?

Who is the Federal Reserve, who owns the Federal Reserve

and this,

Where does the Federal Reserve get the money to fund its operations?

If that’s the case, then the Federal Reserve doesn’t really “creates money” when it uses open market operations to buy bonds. To presume that would put the Federal Reserve outside the economy.

Money is “created” at the moment that a newly originiated debt IOU (or any non-money, really) is accepted as money for the first time, that is, in exchange for actual money — e.g., individuals obtaining a new loan, companies or governments selling newly issued bonds, selling of newly created stock, etc.; and if I were a stickler, this should really only apply to the portion of the debt that is unsecured, as the exchange of money for the secured collateral is like a purchase by the lender who has rights on it. When the bond or debt is repaid, the reverse happens as money is destroyed. Interestingly, money expansion like this is only pseudo-permanent to the extent that the debt is either permanently revolving or replaced with new issues (Treasury notes in practice) or has an infinite time horizon (stocks).

In fact, bank loans can go a step further and continually (permanently) expand the money supply through fractional reserve lending, where new loans given out faster than the pace that old ones are repaid — if I get a loan today, I can put it into a savings account, but before I pay it back, it will be loaned out again. This is okay as long as banks have a reasonable value proposition for their loan, i.e. an expectation that whatever the loan is used for has or will have underlying value in the economy and hence an expectation of repayment. (If that’s not the case, then fractional reserve lending becomes but a pyramid scheme.)

In none of these cases is the money supply expanded top-down by the government. The money supply expands organically with the new value created in the economy (actually keeping slightly ahead of it, as they are tied to the expected value to be created from a capital venture — temporary asset bubbles excepted). The Federal Reserve is just a bank in this ecosystem with the objective not of profit but of being a sane participant (indeed to define “sane” through its market behavior); but it is still just a bank, and it has to balance its own checkbook, too.

(See here for another discussion. Interestingly, the Fed doesn’t have nearly sufficient net equity to conduct its operations, but it doesn’t matter because when the bonds it buys mature, the government, i.e. taxpayers, pays the Fed; or if the bonds roll over, then taxpayers in the indefinite future presumably will. If we look at this situation on a grand scale, if money supply in the economy grows in any permanent way it must be entirely due to growing private debt lent by banks plus growing debt incurred by the government, which of course is implicitly borne by the public as well. If that growth is in step with the economic productivity, meaning people will be increasingly able to pay their private debt, and government will get increasing tax revenue to pay bonds, then everything is okay.)

Here’s an excerpt

The growth in China’s reserves is driven by the rapid growth of its exports, which brings in dollars, euros and other foreign currency, and by the billions of investment dollars being poured into the country.

The surge in money flooding in from abroad forces the central bank to drain billions of dollars from the economy every month by selling bonds in order to reduce inflationary pressures.

The precise composition of China’s foreign currency reserves is a secret. But economists believe that as much as 75 percent is believed to be in U.S. dollar-denominated instruments, mostly Treasuries, with the rest in euros and a small amount in yen.

Stephen Green, chief economist at Standard Chartered Bank in Shanghai, calculated that last year the central bank made a $29 billion profit on its Treasury holdings after paying interest on its own bonds and other expenses.

But even that represents a return of less than 3 percent on the $1 trillion in holdings.

By contrast, Singapore’s Temasek says it has averaged an 18 percent annual return since it was created in 1974.

When a country sells more than it buys, and when other people make investment (gives the country a loan), the excess money ends up parked somewhere, in this case, at the central bank. According to this article, the central bank takes this money and invests it in US Treasury Bonds, but is looking for other investments. But it also mentions, as a separate matter, the central bank sells its own bonds (denominated in RMB, presumably) to absorb excess RMB. But the selling of bonds is not much different from offering a time deposit account, so all that the central bank does is to encourage more savings in it. The intention to remove excess money means the government has determined that the economy can’t bear any more production/investments so that investments should be made to external projects. But it’s strange that the central bank can pay its bonds and still get 3% additional return on behalf of the depositors (which it keeps). Why wouldn’t people just invest in US Treasury Bonds or whatever other external investments themselves? Is it due to the non-convertibility of the RMB? Or is it something else?

In fact, why does any country end up with a huge reserve, even ones with convertible currencies? Some reserve for safety is understandable, but a huge reserve must mean that its people just like to save save save. But why do they like to save? It must be because they have low risk tolerance as individuals — that makes them seek out the government as an investment fund? If so, then it only makes sense for the central bank to leverage its large funds to make risky but diversified investments to give its depositors a high return at a still tolerable risk. In that case, it makes sense that China is making adjustments to its reserves investment policy away from the completely safe US Treasuries, ahead of any further loosening of RMB convertibility. That way, when convertibility arrives, the reserves will be competitive enough to remain large enough for the government to still have its monetary levers on the economy.

In contrast, the US sells less than it buys. But the US Federal Reserve is still awash in money. It gets money from the rest of the world well in excess of what would be the usual investments in the US economy, due to the status of the dollar as the world’s preferred reserve currency. So even with large deficits and lack of savings, the Federal Reserve still can do what it needs to do — and this includes handing out cheap loans to the US government and banks (and indirectly, consumers). Nice.