Yesterday's financial convulsion is arguably the beginning of the end for a credit expansion of epic proportions that has underlain the economic boom of the last 25 years. It had its roots in the corruption of fractional reserve banking, as directly overseen and facilitated by the Federal Reserve. For those who look to the Fed now for a solution, perhaps it would be advisable to look instead at how the Fed created the current mess.

Fractional reserve banking was designed to provide a controlled credit expansion. However, in the early 1990s, the Fed began to find its rules too restrictve and acted to lower reserve ratios on some deposits and eliminate them for others. In addition, creative accounting implicitly condoned by the Fed allowed banks to circumvent even the limited remaining need to hold reserves. According to the Fed itself (PDF warning, see page 44), by using overnight retail sweep accounts, banks can transfer a proportion of deposits out of the category for which they must hold funds at the Fed (checking deposits), and use them to invest in interest-earning assets.

The lowering of reserve ratios and the acceptance of sweeps by the Fed over a period of many years demonstrates its attitude towards the need for reserves in the first place. How can the Fed claim to be concerned about the unsustainable expansion of the money supply (ie inflation), via the creation of essentially limitless amounts of credit, when it has been fully aware of the corruption of US fractional reserve banking all along? And how can the Fed be unaware of the eventual consequence of uncontrolled credit expansion - a debt crunch - when it has played out many times before?

Massive Surge in Sweeps

Logic? Who cares about logic? Banks are allowed to lend out checking account deposits even though they pay no interest on those accounts. Customers assume the risk and banks literally sweep up the profit. This is a sweet deal for the banks and is accomplished ironically enough via sweeps.

Sweeps are a mechanism by which "excess capital" is swept from some accounts into other buckets based on patterns of expected behavior (not all customers are going to demand all of their money all at once).

Money in the accounts where the money was swept is allowed to be lent out. In essence, the money sitting in your checking account right now is not really sitting there at all. It's lent out all over the place (in theory overnight but in practice for god knows how long or for what)....

....The study does not say it explicitly but I will. There are essentially no bank reserves. Wait a second, I take that back. The combination of fractional reserve lending and sweeps really means there are negative reserves. Far more money has been lent out than really exists.

_{Source: Board of Governors of the Federal Reserve System.}