By Dan Kervick
It is sometimes said that commercial banks in our modern monetary system create money “from thin air”. While there is truth in this metaphorical claim, the metaphor can also be seriously misleading, and leads some to attribute powers to commercial banks that are actually retained by the government alone under our system. It is worth trying to get clear about all this.
Suppose you have some debt to pay; or suppose that there is some good or service that you wish to purchase on the spot. How can you make the payment? Clearly you are going to have to hand over something of positive value. In order to pay off a debt you will have to possess some asset that you can transfer to your creditor in a way that discharges your obligation. Similarly, in order to purchase some good or service on the spot, you will need to possess some asset that the seller is willing to accept in exchange for the good or service that is sold to you. The asset you use might be a very specific, unique and particularized kind of thing, depending on the nature of whatever implicit or explicit contract you have with the creditor or seller. But more often than not, you will pay with a generic and widely accepted type of asset, once which in used routinely to buy things and discharge debts, and that seems to exist mainly or solely for those very purposes. Such payment assets have existed in many different forms historically, along with different kinds systems for generating, storing, transferring and regulating these assets. We customarily call these assets “money”.
Payment assets obviously possess value, for if they didn’t they would not be accepted in exchange for other things of value. As a result, it is rare that one can acquire these payment assets for nothing. Usually you need to give something up in return. The money you use to buy a car was most likely obtained either in exchange for some good you traded for the money, or for some labor service you provided to an employer. You can also obtain payment assets in exchange for promises – even for promises to hand over an even greater quantity of the very same kind of asset as some point in the future.
Among the most common ways of paying one’s own debts or paying for goods and services is to pay with the debt of a third party. For example, suppose I give a signed note to Pat Brown that says, “I agree to pay Pat Brown, or the bearer of this note, $100 on demand.” And suppose Pat has a $100 debt to the corner grocer. Pat might attempt to pay the grocery tab with that IOU. If the grocer accepts the note, then Pat has paid a debt with a debt.
Once I have issued and signed the note, and Pat has accepted it, I have a liability. And if that liability is of a kind that Pat is legally permitted to sign over or otherwise transfer to a third party, it is said to be “negotiable”. If Pat does whatever is legally required to convey the IOU to the grocer to pay the grocery tab, the grocer becomes a “holder in due course” of the negotiable liability. At that point, Pat no longer has a debt to the grocer. But I still have a debt. I previously had a debt to Pat; but now I have a debt to the grocer. That’s what it means for a debt liability to be negotiable: the creditor who holds that debt as an asset can transfer it to a third party, so that the debtor ends up owing the same debt to a new creditor.
Where did the IOU come from? Was it created from thin air? More or less. Yes, a certain amount of paper and ink and work might have been involved in producing it, so its production didn’t come with zero cost. But typically the cost of making the promise will be so low in proportion to the amount promised, that we don’t go far wrong in thinking of the promise as having been produced from thin air, created ex nihilo as it were. And it is not as though to make a promise I have to pull the promise out of my pre-existing promise stash. The promise doesn’t really come from anywhere. There is no effective limit on my ability to make promises beyond the length of my lifespan, and the number of people in the world to whom I might make them. But the fact that my ability to make promises is virtually unlimited does not mean that my ability to get my promises accepted is virtually unlimited. Some people and some commercial entities have a much easier time getting their promises accepted than do others. Making promises is a lot easier than making credible promises; and accepting a promise that you personally find credible might be a lot easier than trading such a promise to someone else. To trade away any promises you possess, you must be able to convince others that they should find the promise just as credible as you did when you first acquired it. Also, once I have made a promise and had it accepted, I am bound in a way I wasn’t before. The holder of the promise possesses a legally binding claim on my assets.
A bank deposit account is such a promise, and it therefore represents a debt or liability of a bank to the account holder. If you have a bank deposit account then you are in possession of a promise by the bank to pay you a defined amount. If it is a demand deposit account, then the promise is to pay on demand. The agreement you have made with the bank specifies the conditions under which you can demand payment on the debt or make use of that debt – and those specified conditions usually include the right to transfer part or all of that debt to a third party. Most banks have a good track record in paying the debts represented by their deposit accounts, and there are also reliable government guarantees in place to pay most of the deposit account debts that insolvent banks find themselves unable to pay. Thus bank debt functions as a fairly reliable and very widely accepted payment asset. Bank deposit liabilities are a form of money.
Of course, when you transfer the bank’s debt to a third party, you don’t literally transfer your bank account to that party. Instead you give the party some financial instrument, or send some electronic payment instruction, that ultimately results in your bank having a smaller debt to you, but a correspondingly larger debt to the payee. For example, you might have a demand deposit account with $10,000 in it and give someone a check drawn on that account for $1000. If the recipient has an account at that bank, they can present the check – your payment order – to the bank, following which your bank reduces the amount in your account by $1000 and increases the amount in the recipient’s account by $1000. In other words, the bank’s debt to you has been reduced by $1000 and its debt to the recipient has been increased by $1000. You have paid the recipient with a debt. However the debt you paid with was not your debt. Rather the debt you paid with was the debt of some other debtor – the bank – and is a debt obligation of which you were the initial creditor, not the debtor.
Note that the person who took your check to the bank might not have been willing to accept payment from the bank in the form of further bank debt, that is, in the form of an amount credited to their account at that bank. Instead they might have demanded cash. Generally speaking, that’s up to them. If they accept a deposit balance, then the bank still has a debt to them. If they are paid in cash, then the bank’s debt has been discharged, but the bank has had to surrender a payment asset in order to discharge it – in this case money from its vault.
Now this raises a question. As we have already seen, one way to pay a debt is with another debt – more specifically with a negotiable liability. But if I pay a debt with my bank’s debt, how does my bank pay that debt when they are required to pay it off? Or looked at slightly differently, given that my bank’s debt to me can serve as my payment asset, what kind of thing can serve as my bank’s payment asset? And when do banks pay the debts represented by their depositors’ account balances?
For most banks in the US banking system there are two fundamental types of payment assets banks use to pay their debts. But perhaps another way of putting it is that there are two main forms of one fundamental type of payment asset. That payment asset consists in the negotiable liabilities of the central bank, i.e. the Fed. These liabilities come in two forms: the deposit balances that commercial banks in the Fed system hold at the twelve Federal Reserve Banks, and the paper currency notes that the Fed also issues. Just as you and I possess payment assets in the form of commercial bank account balances, commercial banks possess payment assets in the form of central bank account balances. In each case, that balance is an asset of the holder of the account and a liability of the depository institution at which the account it is held. You and I can pay our debts with commercial bank debt; commercial banks pay their debts with central bank debt. Note, however, that one form of central bank debt is widely held by both commercial banks and the non-bank public: the currency notes that banks hold in their vaults and that you and I hold in our wallets.
But when do banks pay the debts represented by their depositors’ accounts? We have already considered one occasion: someone presents a check at a bank and receives either cash or a positive increment to their account balance at that bank. Another way in which bank’s pay their debts is by rolling them over into debts of the same kind or a different kind, as when the promise represented by a certificate of deposit is redeemed in the form of an increment of dollars to some demand account balance.
But banks also pay their debts when they are ordered by their depositors to pay someone who does not have an account at the same bank. Suppose you pay $300 to Bob’s Propane with a check or electronic check card, and Bob’s Propane holds its accounts at Maple Valley Bank, while your account is held at Ridge Bank. While the exact procedures for clearing and settling this payment differ according to the mechanisms used, the end result is the same. Bob will end up with $300 more in his Maple Valley Bank account, and you will end up with $300 less in your Ridge Bank account. But banks are not in the habit of giving away money for free, and Maple Valley Bank is not going to increase its deposit account liability to Bob’s Propane $300 without getting something in return. In addition, Ridge Bank does not receive the benefit of reducing its liability to you by $300 without giving something up in return. What Maple Valley Bank receives and Ridge Bank gives up is a $300 balance in their own deposit accounts at the Fed. You paid Bob with Ridge Bank’s negotiable liability; Maple Valley Bank then gave Bob its liability in the form of a deposit balance in exchange for Ridge Bank’s liability, and demanded payment from Ridge Bank. Finally, Ridge Bank paid by directing its bank, the Fed, to reduce its own account balance by $300 and increase Maple Valley Bank’s account balance by $300.
But we often hear that banks create money “from thin air”. Doesn’t that mean that a bank never has to obtain payment assets from some external source in order to pay its debts? Can’t the bank simply create its own payment assets out of the thinness of air, so to speak, and pay its debts with those newly-created assets? Aren’t banks in this sense self-funding?
No, banks are not self-funding, either individually or in the aggregate. The “out of thin air” language, while containing elements of truth, can be extremely misleading, and people using this language sometimes woefully under-represent the significance of central bank liabilities and the government in the US financial system. Banks can indeed create deposit account liabilities from thin air, just as you and I can create liabilities from thin air when we issue IOU’s and someone accepts them. But those deposit liabilities are debts of the bank, just as the IOUs that you and I issue are our debts. And these bank debts are not just so-called debts or pro forma debts. They are real debts which banks must and do routinely pay off in the course of doing everyday business; and the assets a bank uses to pay these debts come from sources external to the bank. A bank cannot simply manufacture its own payment assets from thin air.
Suppose our old friend Ridge Bank, for example, wishes to purchase a fleet of company cars. It might be able to pay for the cars by creating a deposit account for a car company and crediting that account with the total purchase price for the fleet. But that account balance is itself a debt of the bank. Yes, the bank can pay for the cars with this debt, but that is no different in principle than the fact that you and I can pay for a car with an IOU. These debts are liabilities that can and will be extinguished over time by surrendering assets that the issuer of the liability doesn’t create or control. It’s always possible that the car company will just allow the balance to sit in its account indefinitely. But more likely, the company will begin to spend the money. Some of the expenditures might be to people or companies who have accounts at the same bank, which means balances just move from one Ridge Bank account to another Ridge Bank account, without the deposit liability being discharged. But over time a large proportion of that balance will either be withdrawn in the form of cash or used to pay people who bank elsewhere, and in each case the bank will have to surrender some externally created asset to meet its obligation. And note that even if the liability just sits unredeemed in the car company’s account for an extended period of time, the existence of those liabilities reduces the bank’s equity, and thus reduces the degree to which the bank’s owners profit from the bank’s operations.
People who are fond of saying the banks create money “from thin air” often seem to suggest that banks are no different than the government in that regard, and can thus obtain valuable monetary assets simply by manufacturing them ex nihilo, in effect profiting from pure seigniorage in the way a currency-issuing government can. But this picture is wildly inadequate. If banks could simply summon their assets into existence out of the aether, then every bank in the country could be as rich as an Arabian Gulf emir, manufacturing money at will to purchase solid gold chandeliers, 100-story luxury high rises, Olympic swimming pools, indoor ski slopes, and a personal entourage of world-renowned chefs, attendants and masseuses. The sky would be the limit. But clearly this is clearly not the case. There is a lot to complain about with regard to banking; lots of people in the banking system are making completely unwarranted profits from a massively bloated and exploitative financial system. But the wrongness here comes from the banking system’s ability to suck, squeeze and swindle assets from others; not from its simply conjuring these assets out of nothing.
There are several features of the existing banking system that sometimes lead to confusion about the role of commercial banks liabilities in our existing system, and about their dependence on central bank liabilities. We have space to consider just two of them: netting and government deposits at commercial banks.
Netting. Suppose Cogswell Cogs owes $50,000 to Slate Quarry for a delivery of gravel, and Slate Quarry owes Cogswell Cogs $60,000 for a delivery of cogs. The two companies might each issue separate payments of $50,000 and $60,000 respectively to settle their obligations. A more efficient method of settling the obligations, however, would be for both companies to agree to use the Cogswell Cogs debt to reduce the Slate Quarry debt by $50,000. Slate then pays Cogswell the net $10,000 balance and their business is terminated.
Banks can do the same thing. In the US, registered banks can make use of CHIPS, the Clearing House Interbank Payment System. CHIPS has its own account at the Fed, which participating banks pre-fund at the beginning of every business day by transferring money from their own Fed account to the CHIPS account. Net daily payment balances are calculated as the resultant of all of the payment obligations the participating institutions owe to one another, and payments are made by CHIPS by the end of the day to banks that end up with a net positive closing position. If a bank has a negative closing position – that is, if the amount pre-funded is insufficient to cover that days payments – then the bank pays CHIPS what it owes by making another Fedwire transfer from its Fed account to the CHIPS Fed account. Because multiple payment obligations are incurred among those participating banks throughout the day, then just as in the case of Cogswell Cogs and Slate Quarry, the actual amount that needs to change hands in a given day is much less than it would be if each payment were processed separately by the gross settlement system Fedwire.
Notice, however, that the system is ultimately dependent on the Fedwire system, and CHIPS just inserts an efficiency-enhancing intermediary between the Fed and the banking system. Participating banks can settle some of their less time sensitive interbank payments on the books of CHIPS, but they have to settle with CHIPS via the Fed. And larger, more time-sensitive payments are still settled directly via Fedwire.
Also notice that even in the case of a netting system, financial debts are still settled with assets that are not internally manufactured from thin air by the debtor. Consider, once again, Cogswell Cogs and Slate Quarry. To settle their business, Slate paid Cogswell $10,000 and Cogswell paid nothing. But Cogswell began by owing $50,000. So does that mean that Cogswell somehow manufactured a $50,000 benefit out of nowhere? Of course not. Before they settled, Cogswell held a $60,000 debt from Slate, but at the end of the day it received only $10,000. Cogswell received a cancellation of its own $50,000 debt in exchange for cancelling $50,000 of Slate’s debt. In other words, it had to relinquish an asset.
Government deposits at commercial banks. It is sometimes argued that the US government must be dependent on commercial bank money to fund its various activities and public enterprises, because the US Treasury holds some deposit balances at commercial banks. But I believe this is a seriously misleading claim. The government is certainly dependent on private sector economic activity and finance in a more general sense: if there were less private sector economic activity, there would be correspondingly fewer goods and services produced by our society, and thus fewer real assets that the government could make obtain and make use of to carry out its own activities. But the government is not financially dependent in any fundamental way on commercial bank deposit liabilities to carry out government spending.
To see this, let’s first look at a simplified picture of Treasury taxing and spending, before moving to the more detailed and accurate picture. The US Treasury has an account at the Fed called the “general account,” and that is the account from which it spends. Suppose I have an account at Maple Valley Bank from which I pay a $2000 tax obligation to the US government. Here’s the simplified picture: I send a check to the government, and as a result of the check being cleared $2000 is transferred from Maple Valley Bank’s Fed account to the Treasury general account. At the same time, my deposit account balance at Maple Valley Bank is reduced by $2000 and so Maple Valley Bank’s debt to me is reduced by $2000. Thus, Maple Valley Bank has lost both a $2000 asset and a $2000 liability, and experiences no net loss or gain. But the US Treasury now has $2000 more and I have $2000 less. The Treasury then spends that $2000 by buying $2000 worth of sticky note pads from Acme Office Supplies, a company which banks at Old Union Bank. After the various payment operations are completed, Acme’s account at Old Union has $2000 more in it, and $2000 has been transferred from the Treasury general account to Old Union’s reserve account at the Fed.
Now here’s the more accurate picture: In practice it has been found that conducting government operations in the way just described results in undesirable volatility in bank reserve balances, which interferes with the central bank’s ability to implement its target rate for interbank lending: So the government has introduced Treasury Tax and Loan (TT&L) accounts. TT&L accounts are US Treasury accounts at commercial banks designated as TT&L depositories. Suppose Ridge Bank is such a depository. Then when I send my $2000 check to the government, it may deposit it in its TT&L account at Ridge Bank. As a result, $2000 is transferred from Maple Valley Bank’s Fed account to Ridge Bank’s Fed account. At that point, no reserves have left the banking system. But as the Treasury spends over time, it continually transfers money from its TT&L accounts to the general account, and then spends from the general account. As that happens, central bank liabilities first leave commercial bank reserve accounts and then go back into those accounts after the Treasury spends.
Clearly there is no fundamental difference between the simplified system and the more complex system that uses the TT&L accounts as monetary way stations. The TT&L accounts exist solely to smooth out the flow of central bank liabilities to and from the Treasury general account and commercial bank reserve accounts. There is no sense in which the Treasury needs the commercial banks to “create” money in those accounts to carry out its taxing and spending operations.
In a broader sense it should be clear that, far from needing to acquire commercial bank liabilities in order to spend, the government doesn’t even need to obtain Federal Reserve liabilities from commercial bank reserve accounts in order to spend, and could alter the existing system if it so chose. The central bank is itself an arm of the US government and thus liabilities of the Fed held as assets by the Treasury are just amounts owed by one government account to another government account. That the US government chooses to operate in such a way that payments from one arm of the government are processed on the books of another arm of the government is an administrative and policy choice, not a deep feature of the monetary system.
What is true in the “from thin air” metaphor is that commercial banks are able to initiate the process of expanding deposit balances via lending without first obtaining any additional assets that might be needed to handle the added payment obligations and withdrawal claims that the additional deposit liabilities might impose on the bank. It can expand the deposits first and acquire the additional assets, if necessary, afterwards. And, of course, if the bank already possesses excess payment assets, it might not be able to expand its deposit liabilities without acquiring any more payment assets. It is also important to recognize that while banks obtain some reserve payment assets by borrowing them – either from other banks or directly from the Fed – some of those reserve assets are acquired for “free”: as interest on loans the banks make to the Treasury and as interest on reserve balances they already hold.
But it is crucial to recognize that banks do not and cannot simply manufacture their own assets – whether from thin air or otherwise. What they manufacture are liabilities; that is, debts. And they obtain assets from external sources, mainly by trading debts for debts.
Great discussion. As a layman who is interested in such questions, I would appriciate a further discussion of the degree to which commerical banks do create new debt via reserve requirement ratios. My understanding of the “money from thin air” argument is that while the banks themselves have a corresponding debt liability on any new loan guarantees they issue, the aggregate effect of fractional banking is that the total money supply is increased simply by the promise to pay.
Of further interest to me is the corollary implication of the effect of interest collected by banks on the loans they issue through this system. Namely that while the loan guarantees in the form of bank credit increase the money supply by the amount of the loan principal, the interest due on the loans by the borrowers is never created – this seems to imply that the outstanding debt (principal + interest) is always larger than the existing money supply available to service the loans.
Yes, most of what we use as money in our society consists of a certain kind of negotiable bank debt. That’s all it is. Bank’s issue IOUs of a form such as:
IOU $10,000, payable on demand.
and they make a deal with someone that consists in exchanging that IOU for a different IOU of a form such as:
IOU $10,500, payable in equal monthly installments, terminating on June 1, 2015.
The first IOU – the bank’s debt – is widely accepted, and the person who possesses it can use it in a lump or in pieces as money to buy stuff.
Have you even read modern money mechanics? That pretty much explains how the banks can expand the money supply an infinite amount of times based on reverse requirement. That expansion of the money supply is in fact the creation of money out of thin air. Loans do not come out of the banks pockets but actually are the creation of money due to the demand for said money. Interest is also the creation of money (out of thin air) which never existed in the money supply. For example, if I am the bank and I loan you 10$ and tell you that you own me 15$ including interest, that 5$ to cover the interest does not exist in our money supply. I would have to loan it to you because at this time there is only 10$ in the money supply. You can only possibly pay back the principal on the loan, the interest must be created by the bank. That is how the bank literally creates money out of thin air.
Yeah I’ve read all that stuff. I’ve criticized some of the problems with the analysis in my piece on “Hyper-Endogeneity.”
You make a good snake oil salesman for the Banks Dan.
As far as I know, the restriction on the banks creating ‘money’ out of thin air, is the fractional reserve system. The BIS sets the fractional rate, which last I heard, was 12 to 1. So; for every dollar a bank has in its reserve account, it can create an additional 12 dollars. Calling them liabilities, debts ,negotiable instruments, whatever, doesn’t get away from the fact the commercial banks do have the government granted ability to create those extra dollars. The system works because, historically, every creditor doesn’t withdraw their deposits at the same time – EXCEPT OF COURSE – when we do have a run on a bank. The reason banks collapse is precisely because they have created more ‘money’ than they can ever have in reserve. While your explanation of the mechanics of banking operations thru the Central Banks is essentially correct, as soon as a run occurs, either the bank has to close its doors or the “government’ has to come to the rescue.
Right. Fractional reserve just means that banks are permitted to have deposit account liabilities far in access of their currently available central-bank-issued payment asset. However, there are also bank capital requirements. Total capital has to be at least 8% of risk-weighted assets. Since total capital is equal to total assets minus total liabilities, then that means:
Assets – Liabilities >= .08 * r(Assets).
If banks find themselves unable to pay depositors out of current reserves, they are supposed to have a large capital buffer out of which they can sell capital to acquire more reserves without borrowing them.
Guzzie, you question has always puzzled me as well. Particularly related to govt debt. The interest seems to never be created and put into circulation, and in case of govt debt, the discount amount as well. therefore there is never enough money in system to pay off full debt obligation.
Comment was for belshazar post. Sorry
The interest goes into bank profits and bank capital which is convertible back into money as dividends or capital to support new loans…
The banking system, with central bank accommodation, can continually loan new money into existence in sufficient amounts to pay off the previous rounds of loans. The total debt never needs to be “paid off”. In the aggregate it is just rolled over.
Also, the government is constantly spending more money into existence. It swaps Treasury securities for dollars, and the Fed then buys a lot of the Treasury securities at a price greater than the purchaser paid for them..
I think EJ’s point was that while new money is constantly loaned into existence (by banks) or spent into existence (by Feds) a “snapshot” of the aggregate ledger at any moment in time will reveal that there is always an excess liability (in the form of interest due) compared to demand deposits available to service the debt.
Your statement can then be recast in a somewhat less positive light:
“The banking system, with central bank accommodation, must continually loan new money into existence in sufficient amounts to pay off the previous rounds of loans.”
When external forces in the economy reduce the new money creation rate below the point necessary to meet aggregate interest obligations, the result is widespread default on loans because no matter how individual divvy the existing money supply there is simply not enough to go around.
A careful understanding of the debt-based system of money would show that you are correct.
Which is what happened in September ’08.
And which took a realigning of accounting rules and unprecedented CB action to prevent such cross-defaulting, basically by liquifying, spreading out those interest costs at zero-bound and revaluing assets in order to create a state of virtual solvency.
It’s only accounting.
This endogenous money system, based on banks lending to ‘qualified’ borrowers to create money (or else we have no money) has been modeled by Japanese macro-economist Dr. Kaoru Yamaguchi and he comes to the same conclusion as stated.
It’s a debt-end money system.
Based primarily on unfunded compounding-interest monetary obligations for the users of the system.
But what’s your point ?
Belshazzar– Interest payments can be made without creation of any new money. They are just a transfer of money from one part of the economy to another, within the monetary system, for the services rendered by the bank. Interest payments increase the income and capital of the banks, as with other purchases of services. These are not the same as repayment of a loan, which eliminates money from the system as a whole.
At least that’s my understanding, based upon something JKH posted a year or two ago…
Yes, up to a point, and that point is when the non-bank sector runs out of financial assets. Without net exports, or government deficits, the non-bank sector’s financial assets are reduced by each interest payment (by the portion of it that goes to bank retained earnings), and they cannot create more by themselves. They can only trade their labor or real assets for them, and if they trade only with each other, there is no net increase with which to continue the interest payments to the bank sector. New loans can supply the money to pay the interest, until the amount of the loans exceeds the value of the collateral. The real economy creates new collateral (real assets), so that process could continue for quite a while depending on the interest rate and the rate of economic growth.
But the bank owners are members of the non-bank sector in their role as citizen/consumers. So the profits accrue to them for use in consumption or however they please, just like any other profits. Or the profits can be reinvested in the business, as with any other profits, buying supplies and hiring labor…
Only the retained earnings are removed from the non-bank sector. What the bank pays in salaries and executive bonuses is not profit, and returns to the private sector. What they pay in dividends also returns to the private sector, but what they retain as capital remains in the bank sector, removed from the non-bank sector. And if they were to hold it as interest-bearing assets, that would also remove income from the non-bank sector, the same as QE.
Belshazzar, u r correct as to the intent to my point. If us govt borrows $1b over 30 yrs. It must pay back say $1.8b. Oh and don’t forget the bond discount upon issuance. So the gov only received $990m to spend while it is supposed to pay back 990m received plus 810m in interest and discount. The 810m is paid back with more debt money. So it is a vicious debt snowball our govt can never hope to get out from under unless it takes joe firestones lead and begins to direct issue currency through hvpcs or just straight up issuance.
I believe if the govt borrow $1b, it should use sovereign prerogative to credit its account the full amount to be paid over time, the $1.8. Therefore u would have the govt at least putting the full amount of money to be paid, into circulation.
If us govt borrows $1b over 30 yrs. It must pay back say $1.8b. Oh and don’t forget the bond discount upon issuance. So the gov only received $990m to spend while it is supposed to pay back 990m received plus 810m in interest and discount. The 810m is paid back with more debt money. So it is a vicious debt snowball our govt can never hope to get out from under unless it takes joe firestones lead and begins to direct issue currency through hvpcs or just straight up issuance.
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The govt borrowing is NOT for spending in the first place, so this “vicious debt snowball” is a senseless analogy. The govt creates “debt” for kind of the same reason as a bank offers Certificate of Deposit accounts, except that the govt does it as a public service and for monetary policy reasons.
That is, the Govt does not need to borrow. Rich people and banks and institutions have the NEED for a SAFE NO-RISK account instrument in which to deposit their surplus savings for storage. Treasury Bonds are that “warehouse”. Therefore, the interest payments are essentially a GIFT. Also, since the CB and Treasury COULD swap debt instruments directly with each other, if Congress stopped forbidding that, then all the profits earned by Primary Dealers are a GIFT.
The rules and terms are tricky. The jargon is tricky. It’s hard for me to be accurate with the jargon, and it’s hard to be clear and accurate at the same time. There’s a difference between the broad conception of what’s going on, vs the mechanics of what actually happens, vs the specific details of operations, timing, the role of govt, etc.
Govt Spending can (for instance) be the net source of all the bulk of interest charges that private banks levy on private borrowers, since that’s “effectively” Demand Leakage due to wealth consolidation, though it’s true that most of that is covered because asset prices tend to rise slowly over time, and hopefully *wages* tend to rise over time too.
The SLOWLY snowballing effect of private debt growth — since most of that is based on real estate (land) prices — that seems to be not REALLY a problem.
People can debate morals and ethics of that in la-la land, but that system worked fine until the shift to Financialization and into early Ponzi Finance (in multiple ways) around 1980 and beyond, with loans going to partial LIQUIDATION of existing real tangible capital instead of creating new capital … Leveraged Buy0uts and associated looting.
Then the RAPID expansion of credit — due to banks’ pressure and greed, and govt changing rules to accommodate — is a different “snowballing” story.
If Treasury Debt is the instrument in which savers (banks) save surplus wealth — yes, China too — then the record levels of Wealth Concentration would seem to be the CAUSE of the rise in Treasury Debt. There’s just that much more wealth being socked away, so there’s that much more Govt Debt being created to store those Assets. (Right??)
The reserve requirement doesn’t affect the amount of lending because banks’ reserve balances are only used for payments among institutions belonging to the FRS and the Fed always provides reserve balances sufficient to clear these payments and meet reserves requirement by either purchasing tys to increase reserves available for interbank borrowing, er else lending to banks as needed through repo or at the discount window. Banks do not need to check their reserve position before making loans. The make loans and then obtain the required reserves if necessary either by attracting deposits or borrowing interbank, in the money market, or from the cb.
A reserve requirement just makes lending more expensive to the borrower, since the cost of banks’ borrowing reserves to meet their requirement adds to the spread. Thus, the reserve requirement acts as a tax, so to speak, rather than a brake on lending in a non-convertible flexible rate system such as is in existence now. Reserve requirements are not necessary under the present system, and Canada doesn’t have a reserve requirement, i.e., the requirement is zero %. That just means that the cost of lending is less expensive in Canada than the US, since Canadian banks don’t have to borrow to meet an RR.
I don’t think it matters much whether there is a formal non-zero reserve requirement or not. Both in Canada and the US, net interbank payments are ultimately settled on the books of the central bank. The level of the reserve requirements and collateral requirements just determines where the penalty rates for settlement set in, and what proportion of bank assets are held as liquid payment assets vs. other kinds of capital assets. If there is a lower reserve requirement, the banks have to pledge more collateral to the central bank. No matter what, bank deposits are liabilities of the banks, and hence represent claims against the bank’s assets.
I think the banker’s old claim that reserve requirements represent a “tax” is dubious. Preventing a bank from making as much money as they would like to make by being free to invest all of their assets in riskier, interest-bearing financial instruments is not the same thing as taking money away from them. Safe banking operations require a liquidity buffer. The smaller the liquidity buffer, the bigger the size of the eventual liquidity bailout during a financial crisis.
“I think the banker’s old claim that reserve requirements represent a “tax” is dubious.”
Reserve requirements also result in an implicit tax on banks because reserves held at the Fed do not earn interest. Therefore, reserve requirements reduce the revenues of the member banks. The burden of a given level of reserve requirement depends heavily on the level of nominal interest rates: the higher the rates the greater the earnings foregone. The magnitude of the reserve tax has varied considerably over the last several years. When the nominal interest rate soared to over 10 percent in the early 1980s foregone interest reached $4 billion per year. In the fourth quarter of 1992 the effective tax was at a rate of $700 million per year. Although the amount of the reserve tax has declined in recent years as nominal interest rates have fallen the impact of the reserve tax depends on the effective rate of taxation rather than the total amount. The higher the effective tax rate on banks the lower the net return on loans.
As implied by basic tax theory, the higher the rate of taxation on the production of any product the greater will be the price paid by the demanders of that product and the lower will be the price received by the suppliers of that product. Taxes introduce a wedge between prices paid and prices received. Borrowers pay more and banks receive less for loans. A simple way in which the Fed could eliminate the reserve tax on banks is to pay interest on the reserves. If the Fed paid a market- based rate of interest on required reserve balances, the reserve tax would essentially be eliminated as would the distortion of the tax on resource allocation. In the past, proposals to pay interest on required reserve balances have encountered resistance because they would reduce the earnings remitted by the Fed to the Treasury.
The reserve tax has always discouraged membership in the Federal Reserve System. To reduce the burden of the tax, legislation was enacted to allow banks to use vault cash to satisfy their reserve requirements. This change was phased-in beginning December 1959. At the end of 1992, 56 percent of required reserve balances were in the form of vault cash. Despite the efforts of the Federal Reserve System the membership declined steadily. In 1959 approximately 85 percent of all transaction deposits were at member banks. By 1980 the portion of transaction deposits at member banks had fallen to less than 65 percent.
In response to declining membership the Fed sought changes, other than the elimination of the reserve tax, to prevent membership attrition from further undermining the efficacy of monetary policy. In 1980 Congress adopted legislation to reform the reserve requirement rules. The Monetary Control Act of 1980 mandated universal reserve requirements to be set by the Federal Reserve for all depository institutions, regardless of their membership status. The act also simplified the reserve requirement schedule.
Warren Mosler, “Soft Currency Economics”
With due respect to Warren, I think calling the reserve requirement a “tax” is a bit of bankers’ free market hyperbole. We should reserve the term “taxing” for the act of government taking of some asset. Regulating the use of an asset in ways that require the owner not to be able to use the asset to make as much money as they might like is not a tax. For example, suppose that in some jurisdiction the government has a law that the foundation area of any building built on a lot of private property can be no larger than 75% of the total area of the property. And suppose that you are not permitted to rent any undeveloped property in the lot. It’s still your property. Even if you have built out to the 75% limit, you can still sell the land and the buildings, even at a great profit. And if you dismantle part of the house and sell it’s pieces to reduce the foundation area, you can even sell off subdivided parts of the lot. The government hasn’t taken any of these assets away from you. They have just set some regulatory limits on the ways in which you can exploit them. A capital requirement just means that a chartered, functioning bank is required to maintain solvency, and a reserve requirement just means that banks are required to hold a certain portion of their assets in the form of liquid central bank liabilities. They are not a tax.
But isn’t Mosler’s tax-theory made irrelevant by the facts that not only is cash providing most required reserves, but the banks are also receiving interest on not only their required reserves, but much higher excess reserve balances?
And if the payment for required reserves is a tax on the banks, then should not a payment of interest on excess reserves received BY the banks from the Fed, reducing the Fed’s Treasury transfer, being ultimately FROM the taxpayer, properly be called ‘a taxpayer subsidy TO the banks’, again under prevailing tax theory?
Thanks.
One of the arguments for instituting interest on reserves in the first place was the claim that reserve requirements were a tax on the banks. So yes you are right that argument has now gone by the boards somewhat, although I imagine that some banks still find the reserve requirement with current 0.25% rate to be a tax since they think they might be able to make more elsewhere.
I think interest on reserves might have been be a good step as an interest rate management tool. But I regard the idea that the reserve requirement is a tax to be a bit of a public relations sob story.
On a purely economic basis, what Warren said about the reserve requirement being an implicit tax is equivalent to saying that it functions economically like a tax, not that it meets any other technical requirements to legally qualify as a tax, an issue like the Supreme Court dealt with in the Obamacare case.
A recent post on Warren’s site compared 4 steps the Fed might take, including something like:
1) Increase QE so as to reduce Treasury interest rates by 20 basis points
…
4) Impose a 20 basis point tax on interest income from newly issued Treasuries
They are identical in their effect on the economy. That doesn’t make #1 a tax, but #1 does function in the economy exactly the same way that #4 does.
It was Warren who introduced the notion of using today’s tax theory. As quoted by Mr. Hickey.
I’ve just explained how paying interest on reserves, and not the reserve requirement itself, is a tax on the taxpayer due to there being taxpayer funded interest payments to the banks for their excess reserves.
As in a CB-to-bank funded subsidy paid for by taxes.
Are you saying that this tax payment, being countable on a daily basis, is a public relations sob story?
For who?
The taxpayer doesn’t have to “fund” the interest payment. The Fed doesn’t have to acquire money first from the private sector before paying it out. It can expand its balance sheet indefinitely if it decides that monetary policy is advanced in that way.
Dan,
Interesting construct.
Funny things happen when monetary science is absorbed by technology (keystrokes) and accounting.
This involves the financial statements of the CB.
One statement is its balance sheet, on which the CB never, under any monetary policy guise, creates reserves except as an asset-liability transaction.
The other is the CB’s statement of operations.(sort of)
Here revenues are measured against accounting expenses to determine the annual ‘profit’ or net income of the entity – yes, even the CB in its super-special method.
The tool for determining ‘excess income’ that might get returned to the Treasury is not the balance sheet – it is operations. Gains from operations go the balance sheet. As do losses(*).
So, while its true that the Fed can increase its balance sheet any time there is an asset to be acquired from a willing seller, this has NOTHING to do with what happens with the Fed operating payments of IOER.
As I said, the CB’s revenues come from interest payments, etc. received from the holding of those assets.
Obviously taxpayers directly pay the interest on TSY’s held by the Fed.
And the Fed uses that, and ‘other’, income to pay the IOER interest.
While the source of MBS interest may be ‘other’, the reason the taxpayers pay, and therefore subsidize substantially, the private banks, is because those IOER interest payments are ALL deducted from the Fed’s revenues in order to determine the amount, if any, that goes as a net-income ‘internal transfer’ to the Treasury.
Were there no IOER payments deducted from the Fed’s revenues, the transfer amount would be larger, reducing the annual taxpayer’s burden required to meet the government’s budgeting constraint.
I can’t see how the taxpayers do not have to fund the IOER payments in this situation.
(*) We’re all waiting for any explanation of what will happen when the MBS’s acquired from the willing sellers thereof must be returned in an OMO sale.
Gerry,
The point about the taxpayer not funding these interest payments is central to MMT.
Fiat money is created by government fiat. Government doesn’t need to tax or borrow, it can simply create all the fiat money it needs. The purpose of taxing is not to raise revenue for spending, it is to control aggregate demand so as to prevent inflation.
If that is unfamiliar, I recommend reading the 7 Deadly Innocent Frauds on Warren’s web site.
If government spending were funded by taxes, then IOR might be a subsidy. If a State government were to do it, for instance, it might be a subsidy from State taxpayers to the banks. For a monetary sovereign, though, such considerations do not apply.
> Tom Hickey:
For the past few years the average actual federal funds rate has been about half of the interest rate paid on reserves by the Fed, so this is a negative tax, i.e., a gift paid by the Fed to the banks. As Randy Wray’s students showed from analysis of the data dumped by the Fed (thanks to Bloomberg’s court case), the Fed (and Treasury) bailouts have, in effect, provided the banks with many more (net) gifts. Has the benefit of these gifts been passed on to borrowers? Or have these gifts gone into building up the banks’ capital buffers (net worth), for free?
Why would a bank lend to another bank at 1/2 the rate they could lend to the Fed?
It seems unaccountable. But I seem to recall reading some stuff over the past couple of years that indicated that the Fed Funds rate tends to dip below the IOR floor, and that this is considered a bit of a mystery.
> Golfer,
No, I’m asking why would a bank lend to another bank at 1/2 the rate they are getting from the Fed for holding reserves (i.e., for not lending)?
Also, the interest rates on T-bills and Commercial Paper have been about 1/2 the rate the Fed is paying banks for holding reserves (i.e., for not buying T-bills and Commercial Paper) – see Fed release H.15. But what is the justification for this?
Dan is correct that the Fed has put out some papers examining this, e.g., this one: http://www.federalreserve.gov/pubs/feds/2010/201007/201007pap.pdf – but the reasons and justifications for paying interest on reserves at the top of the target rate aren’t really there. Note that the Fed doesn’t pay any interest on balances held by government/governmental agencies, but only on the balances held by private member banks. This is why I ask: Is this nothing more than the Fed giving gifts to its private member banks (and indirectly, their stockholders)?
Guggzie,
You are absolutely right. Unfortunately Dan and most of his MMT colleagues are trapped in a delusional world were they are convinced their prescriptions for how the monetary system should operate are reality. The FED is only a quasi-arm of the Government. The FED is 12 private banks that facilitate private banking operations and more importantly the needs of private banking and finance. Considering that those operating the FIRE sector have bribed our politicians and president into creating legislation which benefits themselves rather than the common good it is all that can be expected. Dan, take a few minutes and read Cullen Roche’s Monetary Realism website, you might take a step back toward the real side?
It’s a public-private partnership, but monetary policy is determined from the top.
Governance
Fed Board of Governors: all 7 members appointed by the President of the United States.
Fed Open Market Committee: 12 members, 7 of which are the Board of Governors, 5 rotating members elected from among the Federal Reserve Bank presidents.
How are those presidents chosen? By the Federal Reserve Bank boards of directors.
How are those boards of directors chosen? Each board has nine members, 3 each of class A, class B and class C. Class A directors are appointed by the Board of Governors. The other 6 are elected by the member banks.
So roughly, 1/3rd of the power to elect the 5 rotating members of the FOMC rests with the government appointed BOG. 2/3rd comes from the member banks. But all 7 non-rotating members of the FOMC are the Presidentially appointed appointed Board of Governors. So it looks to me like the total government input into the FOMC is (1/3)*5 + 7 = 8.67; while the total non-government, member bank input is (2/3)*5 = 3.33.
Charles Fasola–
Cullen Roche seems to have gone seriously wrong. Here’s Cullen:
“Monetary Realism starts with the understanding that there are two forms of money in our monetary system. The most important kind of money is the kind we all primarily use – credit money. MR calls this ‘inside money’ because it is created inside the private sector through banks. Banks create this money by extending loans… the dominant form of money in our monetary system…”
He misses the point that government expenditure contributes more money to the economy than does private credit. All money — publicly and privately created — is subject to taxes, but only privately created money is subject to repayment…
Either he misses the point.
Or there is no point.
Have you informed Cullen of his error?
I haven’t yet broached this with Cullen. I guess I’ll wait until he brings it up again on his site, since that seems to happen fairly often. Or perhaps I’ll mention it in a slightly off topic comment sometime…
government expenditure contributes more _NET_ money to the economy than does private credit
because private credit contributes ZERO _net_ financial assets
but on the other hand, as Keen points out
private credit contributes over 90% of financial instruments (deposits) in circulation at a given time
which seems to me to be because (Hudson) bank credit is lent on existing collateral, not on “great ideas”, and 80% or more of credit is lent on real estate (land) (hence FDR securitizing the entire land mass of the USA rolling on in perpetuity via Fannie Mae, to add solvency and liquidity during the GD), and those Real Estate loans create principle that tends to “hang around” for 2o years on a typical 30-yr mortgage, as monthly payments gradually shift more to principle instead of mostly interest at the beginning, so that liquidity is like an OCEAN of long-term credit that is “money-like”
and likewise, the ENTIRE interest load on a loan is not payable up-front, and by the future time that the interest payment is required, the entire economic system has probably inflated enough to cover the interest
addendum,
the average person ‘gets it’ that when they are listing their assets for whatever purposes, even for sale on Craigslist or Ebay, they may overstate or understate the “value” of their house or car or other assets, depending on whether they are applying for a credit card vs. applying for a Pell Grant or Medicaid, and banks and corporations also have similar leeway and fudging on assets and taxable income, but the job of regulators is to keep that fudging within realistic limits.
I probably screwed up the technical jargon in the previous paragraph, but hopefully painted a picture that’s useful for non-technical discussants.
Gary– Can you refer me to Keen’s work claiming that “private credit contributes over 90% of financial instruments (deposits) in circulation at a given time”?
Here is a link to a post showing that government spending contributes more than private credit — http://economicsrantsnmusings.blogspot.com/2013/06/does-credit-drive-economy.html.
Note that taxes equally to all money, regardless of source. Also, government bond sales are financed from the general money supply, not just the money created by government spending. So gross govt expenditures should be compared to net private credit creation (total private credit created minus payback of loans).
I agree that net financial assets is a key concept, and that private loans create no new net financial assets…
Guggzie,
As I understand it, the “fractional RESERVE” story is false. That is, a balance in a bank’s RESERVE account at the CB is not the actual source of the bank loan at all, nor is the 10x or 12x multiplier.
The new loan proceeds or deposit is literally created on the bank’s balance sheet (of assets & liabilities) out of the new asset, the signed loan agreement.
BIS sets or suggests a policy that banks should or must maintain a certain level of capital assets vs outstanding risk and liabilities. The role of regulators like Black’s former role comes in because banks have to ESTIMATE the value of their assets, because much of their assets consists of receivables — loans they have issued.
A recent William Black article on the New York Times went into detail on this:
If they estimate that the outstanding loans are all rock-solid, when they aren’t — like in the mortgage bubble when banks were issuing or purchasing loans to borrowers who didn’t have income, and paying appraisers to over-estimate the value of the collateral — or the quality vs risk of other deals they have made, then they can purposely over-state their assets and thus allow themselves to take on more and more risk, which is the source of profits. When all the banks do this in unison, and it’s not just one “bad bank” but a different regulatory playing field that permits stretching risk to greater or insane limits, and functionally permits no-holds-barred LYING about assets, then banks can appear to maintain a sound capital vs risk ratio which is fictional.
A bank’s assets would also include govt T-Bonds account into which the bank transferred some of their reserves, but which carry ZERO or infinitesimal risk, by law and by fact.
This is not the same thing as a non-estimated ACCOUNT BALANCE held in Reserve Acct at the Fed. Big difference. Not only is the Reserve Acct NOT used as a source of loans,
1) the rules for Reserves do not apply at all to commercial accounts (liabilities) the bank holds
2) the rules for Reserves only apply to household accounts
3) the “sweeps” rule allows banks to “sweep” (like borrow, but not formally) customer’s checking account balances into reserves for a few hours overnight to clear payments, then “sweep” those balances back into checking
4) reserve requirements are computed two weeks in arrears
5) some country’s banking systems like Canada (per Mosler) literally do not have ANY “reserve requirement”, no requirement to keep a certain balance in reserves acct (usually not interest-paying) at the Central Bank; they are required to report and maintain sufficient capital assets to be considered ‘solvent’ … which is a stretchy figure.
Insolvency and govt bailouts after 2008 did not arise as the result of depositors coming to withdraw gold or cash en masse, like that Christmas Story movie “It’s a Wonderful Life”, due to rumor and panic. The problem in 2008 was that bank’s CAPITAL base was stretched fraudulently thin in several ways and from borrowing from and lending to other banks to create “Ponzi” ASSETS many of which were arguably not actually structured to stay “good” for the long term but were (as Black explains) guaranteed to collapse and cause record LOSSES in the longer term, after generating record GAINS in the short-term.
100% reserves is a stupid and clumsy kind of regulation that would be like hog-tying capitalism, credit, and genuine growth.
Requiring a SOLID and SANE base of capital assets — and utilizing accounting regulators with the knowledge, skills, and toughness to regulate — to tell banks “NO!” or “STOP” when they start drifting into fantasy-land — is the way to prevent the Crash and Bailouts of 2008.
What’s more, it’s also connected to preventing banks from creating Asset Bubbles in the Market in the first place, en masse, where a whole Market of real estate or other assets is bid up to fictional levels by a flood of credit competing to buy (and driven by the expectation that the credit-driven rise will continue to push prices upwards).
The latter is explained by Steve Keen explaining Hyman Minsky’s Instability Hypothesis, how “low-risk” finance over time evolves into “higher risk” finance and continues to evolve into “Ponzi finance”, where the max loan payments are insufficient to either pay down the principle OR all the interest due, the interest is deferred (balloon payment terms, etc.) and the source of the funds for repayment come from the expectation of refinancing the newly found Equity (caused by asset inflation) in 3-5 years. There is no mechanism in the Market to dampen or discourage that process … the Market players drive it. ONLY the referees — the Govt — holds a position that has the capacity to put up roadblocks on this evolution into ridiculous risk.
Guzzie, addendum from previous post, When all the banks inflate their assets in unison, under the argument that risks were reduced en masse by securitization, while banks were borrowing and lending to each other using securitized “pre-toxic” assets as collateral, that’s what critics were calling a mountain of SYSTEMIC risk. It wasn’t one bank taking on high and fraudulent risks, it was all of them at once.
A very good description of a complicated process in my humble opinion.
I often find that people have issues with how commercial banks initiate and account for client loans. The creation of the deposit and liability irrespective of reserves seems to cause confusion.
Yes, I think it adds clarity to understand the financial system as a system of debt relations. A debt is an asset of the creditor and liability of the debtor. Some of these liabilities are transferable or negotiable, and the negotiable liabilities that are the most universally accepted are the ones we call “money”.
When I go to a bank to take a loan, where does the bank have the money from?
Do they lend me someone else’s money? Do they create it? Do they get it from the Fed/Bank of England?
No. Many people, thinking of money as of something with inherent value, have problems with thinking that banks simply create money “out of thin air”. However, with our definition of money as contracts for labour (http://allweneedismoney.blogspot.com.br/2012/06/what-is-money.html), then it is very easy to see what is happening.
The magic happens here
When I walk into a bank, I take a loan and I sign a piece of paper pledging part of my labour to the bank. I am creating contracts for labour with the bank’s help – and the bank can give me money/bearer contracts now in exchange, because they know that I will work for them to cover those contracts.
So it is I, the guy who will do the labour, that creates the money out of thin air, by declaring that I exist and that I can back the labour contract that I sign with my labour. What the bank creates from thin air is the printouts of the contracts for labour, once as the loan agreement, which then promptly exchanges for bearer contracts emitted by the government (the dollar bills).
You don’t pledge any labor to the bank. You just pledge money. You might then obtain the money you need to pay your debt with your labor. But you might not. You might be a capitalist who profits from your whole or partial ownership of the capital stock of some productive business. Or you might get it by selling some other asset you already owned.
well, I know that you pledge money. But if you explain it that to get money you pledge money, the argument becomes very circular… So we must get to the root of it – you pledge your personal capacity to make money back to pay it. Yes, you can steal it, inherit it, find it in the street, and many other ways in order to pay it back to the bank – but if we are trying to explain fundamental things, best to stick to the Occam’s razor kind of explanations, I thought…
And yes, I know that I can be something else than a worker, but even as a capitalist ultimately I am still pledging my capacity to produce things, whether directly with my hands or indirectly through my enterprise, but this clouds the issue again a bit.
If the government said it would insure all the IOUs I make, then my capacity to make new IOUs is far greater than my credibility alone would allow. Sure, I still need to pay those IOUs back, but the profit I can earn in the meantime is how I turn those IOUs into free money. The limitation is my ability to use the money profitably.
Yes, the guarantee is definitely a big plus for you resulting in the widespread easy acceptability – or “moneyness” – of your IOUs, and getting one’s credit accepted is always a big plus in any plan to make a profit. But notice that a government guarantee to pay your creditors is not necessarily the same thing as a government guarantee to make you whole in the case of insolvency. The deal might be that if you go insolvent, your creditors get paid but your assets are seized and then re-sold. That’s how it’s supposed to work with the government guarantee, and usually does work that way for all but the lucky few TBTF institutions.
“It is sometimes said that commercial banks in our modern monetary system create money “from thin air”. ………..It is worth trying to get clear about all this.”
“But it is crucial to recognize that banks do not and cannot simply manufacture their own assets – whether from thin air or otherwise.”
Dan Kervick
“”This transactions concept of money is the one designated as M1 in the Federal Reserve’s money stock statistics.”
“”The actual process of money creation takes place primarily in banks.’ As noted earlier, checkable liabilities of banks are money. These liabilities are customers’ accounts. They increase when …….. the proceeds of loans made by the banks are credited to borrowers’ accounts. “”
Modern Money Mechanics
Federal Reserve System
Money is created when banks make loans according to the Fed. Banks create loans ‘out of thin air’.
The security agreement and PNs are printed BY the banks -which ARE their assets .
WHY the confounding explanations about money creation and issuance?
It is worth trying to get clear about all this.
Thanks.
When you pay that loan to the bank, you need to have some payment asset to do it. If the asset is simply the balance in your own demand deposit account at the very same bank, then the net effect is just a reduction in the bank’s ultimate liability to you: no net money creation, just a temporary expansion and then contraction of the bank’s balance sheet. If, however, you draw on deposits at other banks to pay the loan, the payment will require a transfer of some of that other bank’s reserve assets.
There is no process that results in a net increase in Fed liabilities in the system that does not involve the Fed issuing those liabilities.
Banks can create money, because money is just a bank liability to its depositors, and banks can always issue liabilites if they have sufficient capital. But they are liabilities. The monetary system is not simple a closed, self-contained circle of commercial bank liabilities, because the creation of these liabilities generates obligations that banks cannot meet in the aggregate simply with drafts on their own and other banks’ deposits.
When you pay that loan to the bank, you need to have some payment asset to do it. If the asset is simply the balance in your own demand deposit account at the very same bank, then the net effect is just a reduction in the bank’s ultimate liability to you: no net money creation, just a temporary expansion and then contraction of the bank’s balance sheet. If, however, you draw on deposits at other banks to pay the loan, the payment will require a transfer of some of that other bank’s reserve assets.
There is no process that results in a net increase in Fed liabilities in the system that does not involve the Fed issuing those liabilities.
Banks can create money, because money is just a bank liability to its depositors, and banks can always issue liabilities if they have sufficient capital. But they are liabilities. The monetary system is not simple a closed, self-contained circle of commercial bank liabilities, because the creation of these liabilities generates obligations that banks cannot meet in the aggregate simply with drafts on their own and other banks’ deposits.
Thats not correct at all, even though it is a common misconception.
For a bank to loan money, it has to either have the money on hand, or be able to acquire it overnight. Thus, when a bank loans money, it is not creating new money, it is simply either putting excess reserves back into circulation, or it is acting as a broker and borrowing the money that it lends from another source. With the exception of when the Fed is the source, the act of obtaining this money reducing the amount of money that someone else is holding, thus there is an offsetting transaction.
Banks, other than the Federal Reserve Bank, do not create money, they just increase the velocity of money by maximizing it’s efficiency.
They don’t always have to acquire the full amount loaned. Yes, if the borrower asks the bank just to cut a check or take the whole amount in cash, then the bank has to have the assets necessary to meet that immediate obligation. But if the borrower just asks to have the borrowed amount put on deposit, the new deposit balance just becomes a portion of the bank’s entire balance of demand deposit liabilities, only a fraction of which are matched by payment assets currently in the bank’s possession.
When a bank loan officer decides to make a loan to a credit worthy borrower, then after the paperwork is completed, the borrowers account it marked up in the amount of the loan (less charges). That is, a demand deposit account at the bank is credited, meaning that the bank book a liability and the borrower has an asset. Correspondingly, the customer books a a liability (the loan) and an asset (the deposit, spendable on demand). That’s “money” and the bank just created it.
The bank loan officer has already notified the asset and liability management (ALM) department of the loan and it is their job to make sure that reserve balances are available to meet the RR and clear payments, as well the capital requirement. They also ensure that the loans is properly funded on the liability side so that the LHS and RHS balance.
The key point is that banks don’t lend out reserves or lend against reserves, nor do they lend out savings or lend against savings. They make loans and then ensure that all requirements are met. Banks lend against capital and the are leveraging equity to make a profit through the spread they charge as the different between what it costs to make the loans and what they make from loan.
So the point of “bank’s lend out of thin air” is meant to correct the incorrect belief that banks first take in savings and them lend them out (financial intermediation). That is only true of depository institutions without access to the central bank, i.e., where loans must be pre-funded. Banks with access to the central bank don’t pre-fund loans. They make loans first, adding to the asset side of the balance sheet, and then ensure that they are funded on the liability side iaw prevailing requirements.
What banks cannot do is create reserves (reserve balances (rb) at the central bank plus vault cash in the form of notes and coin). Banks have to obtain rb to clear their obligations in the payments system and meet RR (after netting), and also to obtain cash in order to meet window demand by exchanging rb for notes and coin at the cb.
When banks create bank money by crediting bank accounts (loans create deposits), the bank is creating a promise to settle in the government’s unit of account. There is no “money” in the customer’s account other than the entry on the bank’s books. If the customer demands cash at the window, the bank has to obtain it ultimately through the cb, and if the customer makes a withdrawal by check or electronic draft, then the bank has to settle in rb in the payments system if required after intra-bank and interbank netting.
In this way the primary purpose of a bank is to act as an agent of the government to handle the risk management aspect involved in creating money denominated in the unit of account, chiefly to fund capital investment and facilitate capital formation. As public private partnerships, chartered banks act as a legally established bridge between the public and private sectors, that is, between the (federal) govt as currency issuer (in the US) and currency issuers — households, firms, non-federal govt (state and local govts in the US), and the external sector using the currency.
So the point of “bank’s lend out of thin air” is meant to correct the incorrect belief that banks first take in savings and them lend them out (financial intermediation).
Exactly Tom. That’s the aspect of the metaphor in which there is some truth. The misleading dimension of the metaphor is the idea, which you have also rebutted, that banks create their own assets from thin air. I frequently run into suggestion that bank deposit balances are akin to the government’s fiat currency, and that banks therefore profit from pure seignorage. (In other words, that the bank in my example can obtain a valuable fleet of automobiles simply by conjuring up a kind of fiat payment asset from nowhere.) They definitely can create the deposit account from nowhere, but that account is a genuine, full-blooded liability of the bank, and hence a claim against their other assets.
“The misleading dimension of the metaphor is the idea, which you have also rebutted, that banks create their own assets from thin air.” Dan Kervick
“Money is created when banks make loans according to the Fed(MMM). Banks create loans ‘out of thin air’.
The security agreement and PNs are printed BY the banks -which ARE their assets .” Gerry Spaulding
Why, given double-entry accounting, is the claim made that the bank does not ‘create out of thin air’ its own ASSET. Of course it does. Yes, it requires a printer and a little ink, but the rest is thin air. The IOU of the borrower is created by the bank – and IS the bank’s asset after the loan transaction, without other consideration being brought by the bank. Forget the back office stuff.
The part debunked by Mr. Hickey is the notion of imagep above – that the bank had ‘something’ to lend.
View again The Credit River Decision – in that the bank brought forward NO CONSIDERATION when it created the obligation of the borrower to repay the loan.
Judgment for the defendant and against the bank.
In a financial transaction, each party effects changes to both sides of ITS balance sheet.
The bank creates additional liability in the (bank-credit money) amount of the loan and additional its asset booking the PN and security agreement.
Why deny that banks create their assets?
Thanks.
The IOU of the borrower is created by the bank – and IS the bank’s asset after the loan transaction, without other consideration being brought by the bank. Forget the back office stuff.
I don’t get this part. The bank might draw up the paperwork, but the borrower and his credit-worthiness and his assets and his willingness to pledge a portion of those assets aren’t created by the bank. A bank could draw up a $500,000 promissory note for Lothar the Imaginary, but it wouldn’t be worth anything because Lothar doesn’t exist. It could also draw up a $500,000 promissory note for Meth Head Mary, the indigent beachcomber, and get her to sign it, but that would also be worth nothing because Mary doesn’t have assets worth $500,000.
Promissory notes are only assets because they are credible conditional claims against other assets. If a bank is willing to create a demand deposit liability, which is a claim against the bank’s assets, and exchange it with a borrower for the borrower’s promissory note, that is only because the promissory note is actually worth something. The bank doesn’t just cook the value of that note up out of nowhere, and they can only get a credible promise from someone if the promiser is willing to give that promise.
You stole my thunder, except that the PN has value only because it has been signed by the borrower. Absent a signature, its value is what a paper recycler would pay for it. Banks can’t print up PNs and sell them without signatures on the secondary market. (Although, maybe they did? Only they would know.)
Since it is the borrower’s signature that counts, not the paper and ink, I would say that the borrower, not the bank, created the bank’s asset.
> Golfer:
Remember the NINJA 125% liars loans? They may have had some sort of signature scrawled on them by Meth Head Mary (or maybe even Lothar the Imaginary), but not wittingly. And yes, they were sold (as AAA-rated assets). Could Meth Head or Lothar have done this without the banks? I don’t think so.
Those who forget history are doomed to see it repeated…
I think we were talking more theoretically. Fraud, of course, need not observe any normal rules, as it doesn’t have the normal motivations.
So, you don’t get the part that the loan-issuing bank creates the asset on its own books that BALANCES the liability of the ‘credit’ in the borrower’s account ?
Is that right?
You don’t get the part that the ‘loan’ is the asset, and the bank-credit is the liability of the issuing bank?
The asset created is colloquially, the loan, securitized and promised to pay.
Properly done, the issuing bank has created a monetary asset in the amount of the loan residing on the books of said bank.
Of course, if not collateralized and agreed by the borrower, it has no value – but in such a case, neither would the borrower get the credit to his or her account.
There is a financial transaction that must be completed in order to create ‘money’.
Both sides have a new balance sheet.
That’s the transaction.
Yeah, banks make loans to creditworthy borrowers.
And when they do so, they create money as denominated exchange media, and monetary assets.
Yes, they create the monetary assets for themselves.
The loan doesn’t necessarily “balance” the liability. The loan, which is the asset, has interest attached to it, and so the value of the asset exceeds the value of the liability. That’s the whole point. Banks are in business to make a profit and so they are trying to build a situation in which their assets are consistently greater than their liabilities. They are not trying to balance their assets and liabilities.
They don’t create the asset. They obtain the asset by trading something for it. It’s no different than if I barter a bushel of carrots with you a gallon of honey. I start with some asset that is of value to me, the carrots; and you start with some asset that is of value to you, the honey. Then we trade.
Now imagine that instead of bartering the goods, I give you a signed promise to deliver to you carrots on demand, up until the time you have drawn from me a bushel of carrots. In exchange you give me a signed promise to deliver to me a gallon and a half of honey exactly one year from now. My signed promise is my liability and your asset. Your signed promise is your liability and my asset. The asset I now possess, your promise to me of a gallon and a half of honey, is obviously not something I created – from thin air or any other kind of air – no matter whose paper it was written up on.
The same is true when what we promise each other is certain amounts of dollars, rather than agricultural products.
“necessarily”?
The principal amount of the loan is what is booked as the bank’s offsetting asset to its bank-credit liability.
The interest obligation is NOT a liability that affects the BANK’s balance sheet, as it is the liability of the borrower.
Yes, the loan amount ‘necessarily’ balances the bank’s liability.
This is the essence of the bank’s balance sheet transaction, though of course the additional debt burden from the PN is incurred by the borrower for ITS balance sheet, that of the principal plus all interest and other charges.
Each principal payment received reduces both sides of the bank’s BS, and that money expires.
Interest payments received affect the bank’s own operating statement and have absolutely nothing to do whether or not the bank creates its monetary asset in the loan transaction.
They do.
The interest obligation is NOT a liability that affects the BANK’s balance sheet, as it is the liability of the borrower.
Of course not. Where did I say anything differently?
I have no idea what you mean by, “the bank creates its asset”. Again, this is prima facie absurd. People, banks, businesses whatever can’t just go around issuing liabilities while at the same time magically conjuring up the assets to pay them. An IOU is an IOU. It’s a claim against the issuers assets. If you are the issuer and you are fortunate enough to get some other guy to issue his IOU giving you a claim against his assets, then that’s great. But you haven’t “created” that asset. It is the other guy’s decision to issue that IOU and exchange it for your IOU that gave you the asset.
It is not fundamentally different from a situation in which you issue a $10,000 IOU to a sculptor, and the sculptor manufactures a piece of sculpture in his workshop that you get in return. After you give the sculptor the IOU, you have a new financial liability of $10,000 and the sculptor has a new financial asset of $10,000. And once you have the piece of sculpture in hand you have a new real asset, an asset that used to belong to the sculptor but now belongs to you.
Let me ask you this: Suppose your assets are currently exactly equal to your liabilities, and then you lend your neighbor – a very reliable debtor – $10,000 at 200% interest. You take $10,000 from your safe and give it to him. He gives you his signed promissory note for ultimate payment of $30,000. Are your assets now greater than your liabilities or aren’t they?
“Let me ask you this: Suppose your assets are currently exactly equal to your liabilities, and then you lend your neighbor – a very reliable debtor – $10,000 at 200% interest. You take $10,000 from your safe and give it to him. He gives you his signed promissory note for ultimate payment of $30,000. Are your assets now greater than your liabilities or aren’t they?”
If you’re Enron, then maybe you’ve just made a $20,000 profit. Otherwise, I think you don’t account for the interest unless and until it is received. The promissory note may have a prepayment clause, and you might receive very little interest if he paid it back in a week instead of in a year.
The way I understand it, interest that is owed to a firm but hasn’t been paid yet is accounted for as interest receivable. When the interest is paid, the interest receivable column is debited and the cash column is credited. Both of these types of entries are on the asset side of the balance sheet. If some interest receivable is due within one year, then it is a current asset. But if it is due at some time exceeding one year it is a non-current asset. The firm’s current assets are supposed to be its most liquid and cash-like assets.
But with banks I suppose we also have to bear in mind the ways in which some loan assets might be written off or written down over time, if the bank doesn’t expect to be paid in full.
” interest that is owed to a firm but hasn’t been paid yet is accounted for as interest receivable.”
Yes, I should have said accrued rather than received. Each quarter, when it closes the books, is when the bank books an asset for interest earned but not yet received, perhaps “accrued interest income”. For instance, if the borrower makes payments on the 15th of the month, then when the books close on the 30th the bank adds 15 days of interest to its assets and retained earnings. But only as time passes is the interest actually due to the bank, not all at once up front.
> Dan:
1. Interest is not counted as part of the loan asset when the loan is booked, only the principal is, so at the time of the loan, the loan asset and deposit liability does balance.
2. You say an IOU is a claim against the issuer’s assets, but Tom Hickey says banks don’t lend against reserves, so which is it? (You and Tom can’t have it both way, so please sort it out.)
3. Don’t forget that you still have to pay the sculptor $10,000 at some stage.
I think a better way to put it is that banks don’t primarily lend out of their reserves. When a bank lends it doesn’t typically reduce its reserves by the amount loaned and give those reserves to the borrower. It instead issues a negotiable liability to the borrower, leaving the reserve balance intact.
But that liability doesn’t definitely represent a claim against the bank’s assets, and when the depositor asserts that claim by ordering the bank to make payments on the depositor’s behalf, the bank will at that time experience a reduction in reserves as it completes an interbank payment to pay the payee’s bank.
In general, this process of expanding liabilities through lending does not lead to a net reduction in aggregate bank reserves, since these asserted claims on bank reserves result in reserves moving from bank to bank. And if the banks were not already carrying excess reserves, the expansion in lending would likely result in Fed accommodation in ways that increase the aggregate volume of reserves.
However, some loans do increase the aggregate volume of reserves. Bank vault cash is a portion of the banks’ total reserves, and in some cases the loan doesn’t take the shape of an increment in the deposit balance, but a handover of cash from the vault. In that case, the individual bank’s reserves and the aggregate reserves of all banks have been reduced.
“2. You say an IOU is a claim against the issuer’s assets, but Tom Hickey says banks don’t lend against reserves, so which is it? (You and Tom can’t have it both way, so please sort it out.)”
I don’t see the conflict. The IOU issued by the borrower as part of the loan is a claim against the borrower’s assets, not the bank’s assets or reserves.
The IOU of the bank (the deposit) is indeed a claim against the bank’s assets, but the bank has more assets than just its reserves, and the claim is not for any specific asset. All the bank’s deposits, whether or not created by lending, are claims on the bank’s assets.
It has nothing to do with the fact that bank lending is not reserve-constrained.
“the loan-issuing bank creates the asset on its own books”
The bank records the asset on its books. It does not create it. It trades for it.
If the bank buys a check sorter, it records that asset on its books in the same way it records a loan. It does not create check sorters, it buys them, just like it buys promissory notes.
As I said, recording the asset on its book requires some ‘virtual’ paper and ink.
The rest is thin air.
So, what, pray tell, has the bank traded for the monetary asset of the loan?
Again, read the Credit River Decision – Minneapolis Fed.
The answer is “no consideration’.
“So, what, pray tell, has the bank traded for the monetary asset of the loan?”
Um … money? Doesn’t the borrower walk away with a pocketful of cash, or a check or a bank account balance that is the equivalent?
Thanks Dan and Golfer:
Dan, I agree with what you say above, except I think you mean “But that liability >does< definitely represent a claim against the bank’s assets" instead of "But that liability doesn’t definitely represent a claim against the bank’s assets" otherwise the rest doesn't really follow.
Golfer, I thought when Dan was referring to an IOU, he was referring to the bank's IOU to a depositor, not a borrowers IOU to the bank. Perhaps I misinterpreted Dan there, Dan?
Wikipedia sez:
“Because the Credit River decision was nullified, the case has no value as precedent. A U.S. District Court decision in Utah in 2008 mentioned half a dozen such citations, noting that similar arguments have “repeatedly been dismissed by the courts as baseless” and that “courts around the country have repeatedly dismissed efforts to void loans based on similar assertions.”
You are speaking of money, not assets and leverage. Your explanation about the process may be correct. Your assertion that banks do not create money is false. They create almost all of the money in circulation. The FED is a cadre of private banks. If you cannot accept that fact I’m sorry. Sorry Dan, you can’t be partially pregnant just as you can’t be partially right.
It’s amazing that these “private” banks remitted $89 billion in profits to the US Treasury in 2012.
Dan.
The private banks that create all the money retain all their profits.
The reserve banks, that hold Treasury’s mostly as collateral and gain taxpayer interest payments, merely repay to the Treasury a portion of the monies that they have received.
It’s all a net cost to the taxpayers.
The Fed retains whatever it needs, including for surplus.
There is no legal requirement to pay to Treasury.
Again those banks that create the money, and profit therefrom, are not the banks that return their excess earnings to the taxpayers.
The private banks that create all the money retain all their profits.
Sure. That’s true of every business. That falls out of the definition of “profit”. However, the profit they book in a given time period is only what is left over from their income in that time period after they have paid the obligations due in that time period. Among those obligations are debts to the central bank. If they have been required to borrow from the central bank then they owe the central bank money.
The reserve banks can and do profit in various ways. They lend to the member banks at interest, and the member banks then repay the loans and the interest. The reserve banks can make money on the transaction. Also the reserve banks buy securities of various maturities from the public via auction. As the securities pay off, the reserve bank may receive more than they paid. The Fed shows a profit on its balance sheet as a result, and after paying off its other obligations to the member bank stockholders is required by law to remit the rest of the profit to the US Treasury.
Whether this happens or not is purely a question of monetary policy. In my view it would probably be better for the public, as a matter of fact, if the Fed fails to profit and maintained permanent and gradually increasing negative equity on its balance sheet.
“Sure. That’s true of every business.”
Dan. no other business gets to create its assets that it rents out to the people using their assets – which, in case you haven’t noticed is – everybody else.
Everybody else has to acquire or produce assets from which to gain profits.
This is where the Austrians are correct.
No other business creates and issues ‘purchasing-power’ needed by the national economy.
Take that power away, have the banks only use their deposits (for which they pay interest) to make loans, and the banks work like The Restofus.
And people would never begrudge their ‘earnings’.
Because they earned them.
So, great idea.
What happens when the Fed has gradually increasing net equity (from booking operating losses I presume) that would make the public better off?
The bank doesn’t create its assets. It trades for them.
“Your assertion that banks do not create money is false.”
I don’t see that assertion in this article. Instead, I see that Dan wrote:
“Banks can create money”
What Dan writes over and over is that banks cannot create their own assets. The money they create is their liability, not their asset.
Most of the money we use is indeed “bank money”, i.e. demand deposits. The critical part of the money in our economy is the government money, because government money, unlike bank money, is not a liability of the private sector.
Most of the Coca-Cola you drink is water. That doesn’t mean that water is the ingredient in the secret formula that is responsible for increasing sales of Coca-Cola.
Tom Hickey gets my respect for being able to state clearly and accurately what I attempt to state, for the newly developing field of study which I shall dub “Kindergarten MMT”.
“That’s not correct at all, even though it is a common misconception.”
Sorry, but everything you wrote after that IS a common misconception, and not correct at all.
Sorry.
Everything.
Have you read the Fed’s Modern Money Mechanics publication?
Please do.
Thanks.
I know this is off-topic but did anyone else catch Warren Mosler’s debate with an Austrian last night? It was truly a wonderful smackdown. I don’t know whether it was an intentional debating technique or not but his agreeing with his opponent completely disarmed him. Of course, at every step, he would add “Yes I agree with you, that is exactly the way the system works….under a gold standard and we haven’t been on that for 50 years” and then point out the difference between a currency issuer and a currency user. Add to that his mild mannered way of explaining things. It was a thing of beauty to see him so thoroughly destroy the Austrian’s arguments.
Is that going to be available to watch again, for those of us who missed it?
I suppose it’s going up to modern money and public purpose -youtube channel when it is edited and processed:
http://www.youtube.com/user/ModMonPubPurpose/videos?flow=grid&view=0
Lots of good lectures there already, from introductory to truly wonky stuff. I think this was 8th seminar on the topic.
The central bank is itself an arm of the US government and thus liabilities of the Fed held as assets by the Treasury are just amounts owed by one government account to another government account. That the US government chooses to operate in such a way that payments from one arm of the government are processed on the books of another arm of the government is an administrative and policy choice, not a deep feature of the monetary system. @Dan Kervick
The Treasury Bonds held by the Federal Reserve are not owned by the Board of Governors or the Federal Open Market Committee. They are owned by the regional Fed banks. Those banks are privately owned and the bonds are among their assets. Privately owned companies will not sacrifice their assets forgiving the Government’s debts. Nor should they! The Government is obligated to pay those debts by the Constitution!
@Joe Firestone,
I think it is misleading to view the regional banks as privately owned. The regional banks do have “stockholders”, so-called. But when the Fed books a profit, those stockholders only get 6% of the take, and the rest does to the US Treasury. So it seems to me that it is more accurate to see the Fed regional banks as public-private partnerships, with the government as, by far, the dominant partner. The government also dominates the managerial processes through which those banks are governed.
It’s not even 6% of the profit. It’s 6% of the commercial bank’s investment in the regional bank. “A member bank is a privately owned bank that must buy an amount equal to 3% of its combined capital and surplus of stock in the Reserve Bank within its region of the Federal Reserve System.” “…statutory dividend of 6% on their capital investment is paid to member banks…” (Wikipedia quotes) It sounds more like preferred shares with fixed dividends regardless of profit or loss.
I think it’s fair to say that the Fed is “politically” controlled or strongly-influenced by the private financial sector, but “operationally” and “legally” it is an arm of President, Treasury, and Congress … and tied into a slew of other private-public systems, like Fannie and Freddie.
How’s that?
The Fed is certainly strongly influenced by the private financial sector. But most of its top governance consists in government appointees. At the very top of the pyramid, the governance is all government appointees. The further down the pyramid you go, the more private ownership dominates the structure.
Of course, since the government itself is owned and controlled by the corporate and financial sector, maybe the fact that the top governance of the Fed is appointed by government that doesn’t matter all that much.
“Ownership” is itself a mixed concept. It has to do both with how control of an enterprises is exercised and who is entitled to profits. Fed income is distributed both to member banks and to the Treasury. So it’s mixed. And governing control is mixed – but the closer you are to the top, the clearer it is that the state is in control.
People seem to have terrible mental conflicts about accepting the fact that our banking system is a centralized hierarchy at the top of which sits a state-run bank. It flies in the face of all the stereotypes people have – for good or ill – about the American economic order.
Personally, I think its a good thing that the banking sector is organized under a state run central bank. Now if only the democratic elements of American society can re-establish some measure of control over the state, we would be in business.
See Bill Woolsey, Who Owns the Fed?
Conclusion:
Who owns the Fed? The owners of a business typically have ultimate authority over operations and serve as residual claimant. Stockholders elect directors, who appoint top management. Stockholders receive the profits — excess revenues after all other claims on funds are paid.
For the Fed, final authority is in the hands of the politicians. They appoint the Board of Governors, who dominate the Federal Reserve banks. Further, any earnings of the Federal Reserve banks beyond expenses, including the 6% dividend to the member banks, goes to the U.S. Treasury. Since the U.S. government has final authority and serves as residual claimant, the most reasonable view is that the Federal Reserve system is government-owned.
The conspiracy theorists’ claim that private owners of the Fed are making bundles of money is false. The conventional view among economists (including libertarian ones) that the Fed is a government operation that partially finances fiscal deficits by money creation is fundamentally correct. The live question among libertarians is how to get the government out of the banking system — perhaps by truly privatizing the Fed’s operations — in a way that prevents inflation and macroeconomic instability.
Bill Woolsey is a Libertarian office holder and an econ prof.
See also 406 F3D 532 Scott V. Federal Reserve Bank Of Kansas City
21. In light of the definition of agency in Title 28, the Hoag analysis, and the fact that the purpose of Rule 4 is not particularly well-served by declaring the banks to be federal agencies, we conclude that the Federal Reserve Bank of Kansas City is not a federal agency. Accordingly, the motion to dismiss the appeal is granted.
Great cite. I guess libertarians aren’t all bad 🙂
I resemble that remark! Besides, I don’t see you blogging in favor of Nazis, Communists, or other totalitarian dictators 🙂
If you think filling our prisons with recreational drug users is a bad idea … YOU may be a libertarian!
no such thing as a libertarian Golfer John…..that word doesn’t even have a real meaning……
“If you think filling our prisons with recreational drug users is a bad idea … YOU may be a LIBERAL”
Libertarian = Anarchy
“that word doesn’t even have a real meaning …… Libertarian = Anarchy”
It may be a case of trying to compete with self-parody, but do you not see the contradiction in your statement?
Libertarians (and libertarians) believe in a proper role for government, one mostly the same as the Founding Fathers believed. Just not as much of one as liberals and conservatives believe in. Most liberals believe that eliminating drug laws is anarchy, not Liberalism.
> Dan, I presume you were referring to the first citation, since the second citation (the court case) says Fed banks are not federal agencies, which contradicts the first citation.
The 12 individual Federal reserve Banks might not be government agencies for the purposes of whatever piece of legislation that court was interpreting, but:
1. The boards of directors of those banks are 1/3 federal government appointees;
2. The US Treasury has a claim on a substantial portion of the net earnings of the banks;
3. Those individual banks are part of a centralized federal system, and the entire system is governed by a board of governors that consists 100% of presidential appointees; and
4. the implementation of the monetary policy is decided by the board of governors is carried out by a committee that is 7/12th made up of that board of governors itself. The other 5 members come from the reserve bank presidents that are selected by the boards of directors that are 1/3rd government appointees.
It’s nice to believe in a clear, clean distinction between the private sector and the public sector. But we have a central bank and centralized banking system in the United States. It is pyramid-shaped in its organization; and is all government at the top, almost all private at the bottom, with varying degrees of public-private fusion in between.
With the Fed and private banking system complexity, to a certain degree the definitions are more CONCEPTUAL, with a factual base about operational and legal parameters. A ‘spread’ exists between conceptual vs operational, like the ‘spread’ between micro vs macro.
Wouldn’t you say that the Fed’s open market operations are government operations? The Fed
creates money out of thin air or ex nihilo to buy securities from banks in order to introduce new
money into the banking system. In the process (I believe) buying the securities redeems the
government’s debt to the banks in the securities. A government agency uses government powers to
create the money for the purchase. The Fed will then either sell that security to someone else, if it is
still immature, or swap it for a new security with a later redemption date, to the Treasury. At that
point the Treasury should extinguish the mature security since it has been paid for by government money by a government agency. Furthermore, once the Treasury has it back, neither the Fed possesses it nor any bank, and so it is an extinguishable security. This is how the government retires its debts to
the banks all the time. Now how do we get the Treasury and Fed to agree that this is what they do?
One final question. When the Fed gets a new security in the swap, and it does not have a buyer yet
of it, who is the government owing for the security, or is it only a potential liability? If so, then
why is it counted in the national debt limit? Most securities held by the Fed are of this kind, waiting to
be sold to banks during inflationary times to drain the banks’ reserves. Similarly are dollars locked up in bank vault savings only potential liabilities, but with a bank liability to return to depositor?
You might still be known by the company you keep.
The purpose of Woolsey’s piece is to MAKE the Federal Reserve Banks part of the government.
It is a fail.
No proof, really.
Much more anecdotal stuff like the GUVMINT is the residual claimant.
Which raises the question of what happens with losses.
Will they reduce shareholder stock, or be paid by the Treasury?
It is said here that ownership implies authority over operations.
The Court cases, includng that of Scott, have found no such authority with the government.
And none is shown.
Is there a law requiring the Fed to transfer its excess earnings to the Treasury? Such as might enjoin the issue of residual losses responsibility. I think not.
The perfunctory assent to Directors who govern does not an agency make.
Each Fed Bank IS a private corporation.
But why is this an issue?
Thanks.
Is there a law requiring the Fed to transfer its excess earnings to the Treasury? Such as might enjoin the issue of residual losses responsibility. I think not.
Yes. It pays out the required amount to the member banks, covers its own operating expenses, and then all the rest is by law returned to the Treasury.
“”Is there a law requiring the Fed to transfer its excess earnings to the Treasury? Such as might enjoin the issue of residual losses responsibility. I think not.””
“Yes. It pays out the required amount to the member banks, covers its own operating expenses, and then all the rest is by law returned to the Treasury.”
What law would that be, Dan?
(Don’t spend too much time on this.)
12 USC § 290 – Use of earnings transferred to the Treasury
The net earnings derived by the United States from Federal reserve banks shall, in the discretion of the Secretary, be used to supplement the gold reserve held against outstanding United States notes, or shall be applied to the reduction of the outstanding bonded indebtedness of the United States under regulations to be prescribed by the Secretary of the Treasury. Should a Federal reserve bank be dissolved or go into liquidation, any surplus remaining, after the payment of all debts, dividend requirements as hereinbefore provided, and the par value of the stock, shall be paid to and become the property of the United States and shall be similarly applied.
Fed- FAQs
Fed Distributions to the Treasury
http://www.federalreserve.gov/newsevents/press/other/other20120110a1.pdf
The Federal Reserve does not receive funding through the congressional budgetary process. The Fed’s income comes primarily from the interest on government securities that it has acquired through open market operations. Other sources of income are the interest on foreign currency investments held by the Federal Reserve System; fees received for services provided to depository institutions, such as check clearing, funds transfers, and automated clearinghouse operations; and interest on loans to depository institutions. After paying its expenses, the Federal Reserve turns the rest of its earnings over to the U.S. Treasury.
JUNE 4
1910 BIRTH OF ROBERT B. ANDERSON, SECRETARY OF THE TREASURY UNDER PRESIDENT DWIGHT D. EISENHOWER
“When a bank makes a loan it simply adds to the borrowers deposit account in the bank by the amount of the loan. The money is not taken from anyone else’s deposit; it was not previously paid in to the bank by anyone. It’s new money, created by the bank for the use of the borrower.”
Happy Birthday, Mr. Anderson.
That’s all true. But the money is a liability of the bank.
We could also say this:
“When Gerry Spaulding issues an IOU, the IOU is not taken from Gerry’s IOU to someone else. Nor did Gerry have to possess IOUs from others equal or greater in value to the IOU he just issued. It’s a new IOU, and if it’s negotiable than Gerry’s creditor can use it to obtain other things.”
Would it not be more accurate to say that the ‘bank credit’ is a liability to the bank?
Or, are you saying that bank-credit IS money?
Thanks.
Depends what you mean by “bank credit” Gerry. In a typical loan agreement, there is an exchange of debt for debt, and credit for credit. The bank gives the depositor a demand deposit balance, which is a debt of the bank. In return, the borrower gives the bank a promissory note, which is a debt of the depositor. The depositor is the creditor with respect to the demand deposit; the bank is the creditor with respect to the promissory note.
Demand deposit balances can be confirmed in authoritative ways, and banks are reputable debtors with debts insured by government guarantees, so those balances are honored almost everywhere, and so the holder of a demand deposit account can issue various kinds of negotiable drafts on those accounts and use them almost anywhere to buy stuff. They therefore function as money.
And demand deposits can be exchanged for currency at par, at the bank or ATM. They are money.
But if a bank goes insolvent, and you have deposits in excess of the guaranteed $250,000, you might not recover the whole excess right? So not quite money as good as a Federal Reserve Note?
Right, there is a hierarchy. Bank money is better than my IOU, but not as good as Uncle Sam’s IOU.
Randall Wray’s concept of a pyramid of liabilities is an excellent way to think of the monetary system…
Yes, that was my source (or one of them). I didn’t make it up.
Only because you’re last here g1j.
There is a ‘qualified’ consensus here – as always – that bank-credit is money, somewhere in the money-ness hierarchy.
All this in reference to my question: “Or, are you saying that bank-credit IS money? .”
They function as money.
They are money.
They are not quite money.
A little surprising then for any sentiment that banks do not create money, as they obviously create the bank-credit that serves and functions as money in the real-world economy.
Thanks.
Whose sentiment is it that banks do not create money? Not MMT, and nobody else that I know of.
Joe Firestone has correctly made the distinction between the Federal Reserve Board, a US Government agency that participates in Reserve Bank policy, and the Federal Reserve Banks, a private bank consortium whose own debt is the US’s folding money and the commercial banks’ reserves. The FRB’s debt is a promise to pay the sovereign coin of the US, and the FRBs own 1.88 $T in U.S. debt, should they run low on those coins.
“The Treasury Bonds held by the Federal Reserve are not owned by the Board of Governors or the Federal Open Market Committee. They are owned by the regional Fed banks. Those banks are privately owned and the bonds are among their assets. Privately owned companies will not sacrifice their assets forgiving the Government’s debts. Nor should they! The Government is obligated to pay those debts by the Constitution!”
http://www.aei-ideas.org/2012/12/how-could-washington-avoid-a-debt-ceiling-default-mint-a-few-trillion-dollar-platinum-coins-seriously/comment-page-1/
The straw man is the notion that by “creating money”, i.e., making a loan, the bank is adding to its own assets. It is not. The money created is not an asset of the bank, it is a liability of the bank, and an asset of the non-banking sector. The significance of the creation of the money lies in what it does to the real macro economy, the non-banking sector. More money leads to more economic activity, more production, more employment.
It is also true, though, that the interest paid over the life of the loan IS an asset of the bank, and that asset of the bank can be said to have been created by the bank for itself by making the loan, arguably out of “thin air” as far as the bank is concerned. Of course, it is physically not created by the loan but is a transfer of an existing asset from the non-banking sector to the banking sector.
It is further true that the bank must be founded on capital, which was an asset of the owners of the bank. In return for their capital, the owners expect to make a profit. In that sense, the interest paid to the bank over the course of a loan is not an asset created by the bank for itself out of thin air, it is the result of the investment of capital by the owners of the bank. Just as the profits of Cogswell Cogs is the result of the investment of capital by Mr. Cogswell.
The important point is that absent an infusion of money from a source external to the banking system, because of the interest, banks would eventually end up with all the net financial assets, and non-banks with nothing (liabilities greater than assets). Net exports could be such a source, and government deficits are the only other possible source.
The straw man is the notion that by “creating money”, i.e., making a loan, the bank is adding to its own assets. It is not.
Yes, this is probably the one central error that I was most interested in rebutting golfer. I see people making flawed claims along these lines continually.
On the interest question, I’m not sure I would agree that the interest is mainly a transfer from the non-banking sector to the banking sector. Some of it might be, to the extent that the interest payments result in a net reflux of physical cash from private wallets and safes to bank vaults. But I don’t think this is a significant component. When people repay their loans with the interest, they draw on deposit accounts, often at a variety of other banks. As they make those payments dollars move from some banks to other banks. The fact that banks in the aggregate are able to grow both their total financial assets and their total deposit liabilities through lending at interest in this way, in the context of a growing economy, is only possible because the central bank is continuing to accommodate the economic growth with an ongoing injection of central bank liabilities. If it stopped doing this there would be a combination of deflation and default as the aggregate financial assets of debtors proved increasingly too small to meet their aggregate nominal debt obligations.
“I see people making flawed claims along these lines continually.”
I have never seen such claims. I often see the statement that banks create money by lending, but it is always in the context of the money being the bank’s liability, not its asset.
What I do see often that needs to be rebutted is the claim that only banks can create money, under our current system and laws. If that were true there would be, as you say, a downward spiral of deflation and defaults.
I have never seen such claims.
You haven’t read as many crazy blog comments by the armies of monetary cranks. 🙂
I guess not. Not sure I want to.
Once upon a time, it used to be that the biggest problem out there was the people who believed in the loanable funds model, a fixed money multiplier, and the idea that the Fed drove and controlled lending in accordance with that fixed money multiplier by increasing or decreasing the quantity of reserves. It was a 100% exogenous picture of monetary economics. But increasingly I find misunderstandings at the other extreme: people defending a kind of “hyper-endogeneity” according to which banks function as a kind of government-in-themselves manufacturing their own sort of fiat money, and reaping massive seigniorage profits from every dollar they create.
BINGO. Well stated. Difficult to refute and clarify:
Once upon a time, it used to be that the biggest problem out there was the people who believed in the loanable funds model, a fixed money multiplier, and the idea that the Fed drove and controlled lending in accordance with that fixed money multiplier by increasing or decreasing the quantity of reserves. It was a 100% exogenous picture of monetary economics. But increasingly I find misunderstandings at the other extreme: people defending a kind of “hyper-endogeneity” according to which banks function as a kind of government-in-themselves manufacturing their own sort of fiat money, and reaping massive seigniorage profits from every dollar they create.
Thanks, Dan.
It is the interest question that also concerns me. To take the case of a typical mortgage loan over, say, 25 years, the borrower will pay back something in the order of 200% more than the original loan. While the original borrower may or may not take out additional loans, somebody down the track will do so. Without knowing any figures, I believe it is safe to say the larger proportion of the interest paid to the banks actually comes from additional loans created by the banks. What this system is doing is to create a perpetual round of debt obligations for the general public for the benefit of the banking sector.
On another point that you have raised, if the banking system works they way you describe, how can a bank become insolvent? Of course, the TBTF banks can’t become insolvent, but virtually no smaller banks can sustain a run, irrespective of whether they have practiced prudent banking, let alone mismanagement and exorbitant risk taking.
On the way out the door now, so have to be quick. But if depositors begin withdrawing much more money than expected from a bank, then the bank might have to borrow more reserves, either from other banks or from the Fed directly. If it is well-capitalized and has plenty of healthy, performing loans, then it has the collateral it needs to borrow, as well as securities it can sell. The bank can fail if so many of its assets (especially its loans) turn out to be crappy and overvalued that it can no longer meet its capital requirements, and/or no longer meet its obligations to depositors, and if no one is willing to re-capitalize it.
Note that even during the 2008 crisis there wasn’t a problem with commercial bank runs. The problem was at higher levels of the financial system with a collapse in products that some financial institutions sold to other financial institutions. The FDIC firewall evidently works and now gives ordinary depositors confidence that the safest place for their money during a crisis is in the bank. Also, right now there are so many excess reserves in the banking system that it is a moot point.
What Dan said.
Also, many of the big banks were insolvent, and only because they used a “mark to model” methodology instead of “mark to market”, were they able to appear solvent. That is why they needed to be bailed out, not because of any run. The bailouts, and passage of time, restored their solvency, some people think.
I need to save this page and comments because my economic vocabulary is weak. Thanks:
Also, many of the big banks were insolvent, and only because they used a “mark to model” methodology instead of “mark to market”, were they able to appear solvent. That is why they needed to be bailed out, not because of any run. The bailouts, and passage of time, restored their solvency, some people think.
——
And “mark to model” which is ostensibly ‘ok’ evolved to increasingly fictional over a few years. And a sudden shift by BIS and Fed away from “mark to model” towards “to market” was claimed by some to have been a contributing factor to sudden collapse, i.e., the tightening up of ‘fictional’ assets … which I think is mostly a bullshit excuse for blaming bank criminality on the govt, but also MAY have been more true for smaller banks that followed the TBTF to a lesser degree, but nevertheless got ‘caught’ in the trap when credit markets began to crumble.
This is for Dan and golfer1
“The straw man is the notion that by “creating money”, i.e., making a loan, the bank is adding to its own assets. It is not.” g1j
“Yes, this is probably the one central error that I was most interested in rebutting golfer. I see people making flawed claims along these lines continually.” Dan
OK. No flawed argument. No straw man. No central error, in my view.
When banks make loans, they create their own assets.
Awaiting rebuffing in clear, concise financial-accounting terms.
Already explained above – with acknowledgement that neither the explanation nor the issue deserves the ink.
It’s NOT the bank-credit balance of the borrower, which is the bank’s liability.
It IS the loan agreement and Promissory Note that make up the bank’s asset.
Why do you focus on one side of the balance sheet?
Are the outstanding loan balances NOT the assets of the banks that issue and hold them?
If anyone thinks that a Loan agreement and Promissory Note are not monetary assets, then please explain the entire hierarchy of monetary assets that sit upon the mortgages issued by banks, the entire hierarchy of which are also monetary assets.
And the mortgages that provide the footing for it all are nothing more than money-created loans documents.
The market in bundled PNs – also as a form of monetary asset – should really seal the discussion.
Any loan agreement and Promissory Note is an asset to the bank.
So there. Either the collateralized loan agreement and promissory notes ARE assets of the bank or they are not.
They are, and they are created by the issuing bank when they create money.
The bigger question is WHY is Dan trying to refute this truth?
What is the connection to monetary theory?
Are the outstanding loan balances NOT the assets of the banks that issue and hold them?
Of course they are. And the banks did not “create” these assets from thin air. Those assets are promises of the borrower, issued by the borrower, against assets owned by the borrower and exchanged with the bank for either cash or a bank deposit balance. The bank creates a deposit for the borrower, which thereby becomes a liability of the bank and asset of the depositor, and in return the borrower issues an IOU to the bank, which thereby becomes an asset of the bank and liability of the borrower. How much clearer can this be made?
“How much clearer can this be made?”
None, I would say. The problem is with the listener.
Dan and g1j
Really interesting.
What you describe would be true with full reserve banking, and where the bank did not, in fact, create the money, loan and deposit.
The bank would need to FIRST acquire the asset against which it would make the loan.
But with fractional lending of money BASED upon the debt being created, it is not true at all.
It is clearly a fiction.
Because this is a debt-based, fractional-lending money and banking system, banks create money by making loans and when they do the banks create a liability of the deposit-credit and there is also created an asset on the books of the banks that we call – the loan. It is ALL one transaction.
So the money-created equals the debt issued(loan) and credit issued(deposit) – all done by the bank.
However, it is claimed that the banks do NOT create their asset, which is again the loan – being a monetary asset introduced to the books of the bank upon completing the money-creation transaction – even though the bank issues both the loans proceeds and the note and attached PN.
And the gist of denial that the bank is creating its own asset – again the loan – is that because the borrower signs the loan documents, the bank does not create the assets.
Which not only takes monetary economic shoe-horning to another level, it completely contradicts the claim made in the article .
“” it is crucial to recognize that banks do not and cannot simply manufacture their own assets – whether from thin air or otherwise…… they obtain assets from external sources, mainly by trading debts for debts.””
The truth is that banks create their own assets when they create money.
They create the loan, and they enter the loan amount on their own books as an asset.
That is eminently clear.
The bank does not issue the promissory note. It accepts it. The borrower is the one who issued the promissory note.
The fact that the actual form or paper on which the note is filled out is originally owned by the bank is neither here nor there. Suppose I’m a billionaire and I decide to give my house, my businesses, my entire estate to a hitchhiker I met. The hitchhiker pulls a candy bar wrapper out of his pocket, and I write upon that wrapper:
“I, J. Farnsworth Moneybags, cede my entire estate to Ernie Thumber, effective July 1, 2013.”
We fill it out at a lunch counter, and a waitress who is there witnesses the document with her signature.
Ernie Thumber now has an asset worth a billion dollars. Did Ernie create that asset from thin air?
Well, then, they have no need of borrowers. Whenever they want more assets, they can just print off another promissory note. What a great business! How could they lose? If the borrower defaults, like lots of them did in 2008, then the bank can simply create another asset to replace it, right? No harm, no foul.
Well, that’s not how it works. The bank’s asset is a promise by someone else. The bank cannot manufacture that promise, only the borrower can do it.
I tire of this nonsense.
“The important point is that absent an infusion of money from a source external to the banking system, because of the interest, banks would eventually end up with all the net financial assets, and non-banks with nothing (liabilities greater than assets). Net exports could be such a source, and government deficits are the only other possible source.”
Or, assuming the absurdity of our economy these past couple decades, a third source could be ever-increasing asset prices – such as stocks or the value of your house (a.k.a. ponzi scheme).
Increasing real asset prices might encourage the owners to borrow more against them, but that does not increase their net financial assets, it decreases them as soon as they make the first interest payment, or if they paid points or fees for the loan.
Stocks may be good substitutes, if they are very liquid, for financial assets, but strictly speaking, I think they are not financial assets. Financial assets are not only denominated in the unit of account, they represent a fixed quantity of it. Stocks are real assets, ownership of companies, land, buildings, factories. Selling them only transfers financial assets from one owner to another, it does not change the net financial assets of the private sector. Borrowing against them, like borrowing against your house, decreases (not increases) your financial assets.
Yea I guess you are right.. I was thinking in the case of buying a house or stocks, you hold for some period of time, then sell at a profit. But if someone else has to purchase that asset from you it would net to zero; there’s always got to be a buyer and a seller. We can’t all just collectively sell our houses or stocks at the same time at a profit (unless government or foreign sector is buying).
> Golfer:
“Stocks are real assets, ownership of companies, land, buildings, factories. Selling them only transfers financial assets from one owner to another, it does not change the net financial assets of the private sector.”
Did you mean to write “… only transfers real assets from one owner to another,” since you were defining stocks as real assets?
That, too. When A buys stocks from B, real assets transfer from B to A, and financial assets transfer from A to B.
The point is that the net financial assets of the sector (an important concept in MMT) do not change.
Thanks Golfer,
So in your definition, “real” doesn’t have to be physical, in which case, what are the “financial” assets that transfer from A to B? Where does “real” end and “financial” begin?
Really appreciate your input and knowledge on this, as definitions are very important and instructive.
Cheers, Jamie
“Where does “real” end and “financial” begin?”
It’s blurry, and common stocks nowadays – ETFs even more so – act a lot like financial assets. For me, the key is that the value is variable. Bonds are worth their face value at maturity, especially those issued by monetarily sovereign governments. Stock has no predictable future value. Also, if you look at the transfer of the entire ownership of a small company, especially one that consists mostly of tangible things, it is evident that the stock certificate represents ownership of the real assets of the company. For a publicly-held internet bank, it’s not as clear, since most of their assets are themselves financial (cash, loans).
As for macroeconomics, I think the key issue is that sale of stock does not create money like a loan does. Ordinary corporations, unlike banks, cannot create money from nothing.
“what are the “financial” assets that transfer from A to B?”
Money. Usually the cash balance in a brokerage account.
“you will have to possess some asset that you can transfer to your creditor”………..let’s imagine a person standing in the middle of a desert….how does this person acquire an asset in the first place…..
A financial asset? They can’t unless they have something to sell. If they are literally in the middle of a desert where there is no money and/or no opportunity for money-earning employment, then no one is going to lend them money in exchange for a promise of more money in the future.
If I can be a bit off topic here, I was fascinated by a recent post by Paul Meli entitled “Does Credit Drive the Economy?”. There was considerable discussion on this at MNE, but no consensus.
My take on Paul’s post is that people such as Cullen Roche have dramatically overstated the significance of privately created money (bank loans) in comparison to publicly create money. Here’s Cullen:
My view is that Cullen misses the point that all money — publicly and privately created — is subject to taxes, but only privately created money is subject to repayment. When this is factored in, government expenditure contributes more money to the economy than does private credit.
I would be interested in others thoughts on the relative importance of government spending and taxation v private credit in the monetary system. As Paul notes, we should be able to determine this from facts and data…
“When this is factored in, government expenditure contributes more money to the economy than does private credit.”
And, lately, as consumers and businesses have been deleveraging, the contribution of private credit creation has been negative, while the contribution by government has been much larger than usual. In the late 1990’s, the situation was the reverse: government contribution was negative (budget surplus) while private credit creation was exploding.
The important point is that since private credit creation is endogenous, the only policy lever is government.
follow up: To determine the impact of government vs private bank money creation, just compare gross federal govt expenditure per year with net bank credit creation (new loans – payback of previous loans). For example, the current U.S. government spending is about $3.8T per year. Where can we find the net private bank credit creation per year for comparison purposes?
Paul Meli did this at the cumulative level (all years up to present) and found that government expenditure accounts for about 60% of money creation, compared to 40% from private bank loans…
But the relevant government number is net spending, i.e. deficit spending, not total. Taxation must be subtracted, just as loan repayment has been subtracted from the bank numbers.
No, golfer1john, I believe that gross federal spending should be compared to net private credit creation. The reason is simple– all monetary income is subject to taxation, whether the result of government spending or private sector credit.
Money created by private debt is subject to taxation and repayment. Money created by government spending is subject to taxation but not repayment.
I don’t follow you. When I take out a loan, I don’t pay taxes, and neither does the bank. When I repay it, I don’t pay taxes, and neither does the bank. The only tax is on the interest, and not even all of that because the bank deducts its ordinary and necessary expenses and pays tax only on the remainder.
Depending on what the borrower does with the money, it may generate taxable income for someone else, or not. Borrowing by a business to finance inventory, for instance, creates no additional income and no additional taxes. Borrowing to establish a non-profit institution creates no taxes.
All government spending is income to someone, and thus is taxed. The amount taxed away is not net money created by government.
It makes no sense to net out the repayment of principal and not to net out the removal of income by taxation. That would be like saying the government could increase social security payments by $1T, and at the same time raise taxes on SS recipients by $1T, and money would be created. It would not be. It’s a zero.
But when the loan is spent into the economy, the recipients of the income must pay taxes, just like the recipients of government expenditures. Until the loan is spent, it is not doing anything.
If a business borrows money and buys some goods for inventory, then this is income for the seller of the goods and subject to tax, right? Just the same as if the government buys the inventory. Governments can provide funds to non-profits just as well as banks can lend to non-profits, correct?
The point is taxes apply to all money, not just government expenditures. In this example, the increased payroll taxes would hit money created by private loans to the extent that these loans funded labor, directly or indirectly. So it would not be correct to attribute all of the increased taxes to increased government spending.
The change in the stock of money would be zero in your example, but the proportion of money in the economy attributable to government would increase. Government spending would increase the money supply by $1T . Taxes would decrease the money supply by $1T. But not all the taxes would be on money created by government expenditures.
If you think about it, this is obvious, but this can also be verified empirically. See http://economicsrantsnmusings.blogspot.com/2013/06/does-credit-drive-economy.html.
“The change in the stock of money would be zero in your example”
Thank you. So, if government spends $3.8T, it matters whether they collect taxes of $3.8T or $2.8T or $4.8T. The deficit matters.
So, if they spend $3.8T and collect taxes of $2.8T, how is that different from spending $5T and collecting $4T, or spending $3T and collecting $2T? By your logic, there is only a very marginal difference, and it depends on the assumption that any difference in taxing is spread across the economy without discrimination as to the source of funds. That may not be a good assumption. If one is to believe everything written here about inequality, government spending goes disproportionately to people who are net lenders (the 1%), upon whom the incidence of income taxation falls more heavily as well, whereas lending goes disproportionately to those who pay no income taxes, further indebting them to the 1%.
“the increased payroll taxes would hit money created by private loans to the extent that these loans funded labor, directly or indirectly”
I didn’t say payroll taxes. I said increased taxes on SS recipients. For instance, they could lower the threshold limit on other income that determines when SS becomes taxable, or eliminate the extra exemption for over 65. Or, it wouldn’t have to be an income tax at all, it could be all sorts of other laws that only affect people over 65.
I get the part about taxes reducing the spending either way, but I still think the size of the deficit, not the size of the spending, is what affects the money supply.
“I didn’t say payroll taxes. I said increased taxes on SS recipients. ”
Which gives me an idea. They want to “save” Social Security by, basically, reducing future benefit levels (chained CPI, or whatever). OK, so do it. And at the same time, make seniors whole by increasing other subsidies to the over-65 crowd. Raise the threshold for taxation of SS benefits, and have a refundable tax credit equal to the right % of SS benefit income, for those whose taxable income is below the threshold. It essentially transfers part of SS support for seniors to the general fund, where there are already other forms of support for seniors, thus “saving” the SS Trust Fund.
The unfortunate thing is that it would reinforce the myth of the trust fund, and all the rest of the malarkey surrounding it.
To me this seems a very relevant policy issue; i.e. to what extent do government spending, taxes, and private credit creation affect economic activity?
Obviously the government deficit matters. But to compare the government deficit to net credit creation in turns of economic impact, as you did, is obviously wrong. You’ve now thrown in a bunch of qualifications and side issues that I agree with, but are mostly irrelevant to the point I was making.
Here’s a quick example for an example year:
Govt Expenditures: $4T
Taxes: $3.5T
Net private credit creation: $2T
Deficit: 0.5T
Net money created: $2.5T
We’ve always agreed on the above, I believe.
The point that I’ve been trying to make is the impact on the money supply. How much is attributable to government and how much to bank loans? Sorry if I was not clear in spelling this out. This seems like an important thing to know in formulating policy, or predicting the economic consequences of various policy choices.
If we look at things as you originally claimed then 80% of new money created is attributable to private bank loans. (2.5T new money = 2.oT private loans + 0.5T govt deficit)
If we look at taxes as being spread across all money created, then we get the following:
New money = government expenditure + net private credit creation – minus taxes = 4T + 2T – 3.5T = 2.5T. and the result is that 2/3 of the new money creation is due to government expenditure.
The difference in the 2 scenarios is huge in terms of the relative impacts of govt spending vs private bank loans.
You can argue that taxes are not evenly distributed across govt spending and spending from private sector bank loans, and I agree that there could be some systematic differences. But the 2 you suggested (inventory financing and non-profit financing) didn’t seem to hold up. If you want to make an argument as to the relative impact of taxes on government spending vs private sector loans, that would be wonderful. But, as you say, it’s too simplistic to just assume that the impact is the same, or that 100% of taxes fall on government expenditure and 0% on money created by private loans.
So this would seem to me be a fertile area for further discussion, and that’s why I’ve taken the time to broach the subject here. I’d love to see a post here on this subject by Dan K…
One more point– Paul Meli has already taken an empirical analysis of the issue we are discussing — see http://economicsrantsnmusings.blogspot.com/2013/06/does-credit-drive-economy.html. He compares public and private debt, figuring that private debt corresponds to private money outstanding, and public debt to public money outstanding. I haven’t thought his arguments through thoroughly, but they seemed to hold up well in the comments. Dan K, for example, seemed to get over his initial reservations when Paul better explained his rationale…
One more thought…
The vast majority of taxes each year are paid from previously existing money. So it doesn’t make much sense to worry about how the money to pay taxes was originally created. In considering how new money is created, then, taxes can be ignored as they come out of an undifferentiated pool of existing money.
Money is created by federal expenditures and net private bank loans. In the example above, gross money creation was $4.0T govt expenditure and $2.0T private loans. 2/3 of the new money was created by government expenditure. Taxes were taken mostly from the undifferentiated pool of previously existing money.
Government deficits are important in determining the amount of money created in a year. But the deficit is irrelevant in determination of who created the money. Only the expenditure component is significant for that purpose…
Loans on housing fall on the 99% mostly, but I think it’s notable that a Very Big Corporation or Very Wealthy Person can borrow more and at significantly lower interest rates than a typical middle class or poor person taking out a car payment or financing purchases on a credit card.
Even with all the QE reserves, the rate on a used car loan today can be from 8-15% (I think), a new car loan is less, a leased car has credit built in to the lease rate, and credit card rates can run from 12% or so up to around 30% with a single late payment (and the terms can be also be very disadvantageous too).
Point being that the shift to MONETARY policy to “control inflation” via more credit or less credit puts more burden of interest on lower income people, while higher incomes and LBO deals like Bain Capital and others get juicy near-prime rates. And many low-income people don’t qualify at all, or have to go for 200% Payday loans (often owned by the same TBTF banks as subsidiaries) to meet emergency costs.
On the other hand, FISCAL policy to “control inflation” via more or less govt spending CAN go to Soc Security recipients and college grant recipients and other low-income people (or to landlords or retail stores that service them), and such spending is often “qualified” by low-income. Plus of course those juicy Pentagon contracts and DoE (nuclear energy/weapons) that rival or exceed the “social welfare state” spending.
In other words, FISCAL policy is more POTENTIALLY democratic and egalitarian than MONETARY policy which seems inherently anti-democratic and anti-egalitarian. Wonder why the Elites don’t like fiscal policy?
Another update: I see that Paul posted the following annual figures:
Year…Public spending…private debt…ratio of private to total (public and private totals are billions of dollars)
1970…201.60…94.14…31.8%
1971…220.60…109.81…33.3%
1972…245.20…149.20…37.8%
…
…
2010…3703.40…-1883.32…N/A (can’t calculate the ratio between a positive and negative number)
2011…3757.00…-69.13…N/A
2012…3757.70…203.05…5.1%
See above: the relevant government number is net spending, i.e. deficit spending, not total. Taxation must be subtracted, just as loan repayment has been subtracted from the bank numbers.
Money created by private debt is subject to taxation and repayment. Money created by government spending is subject to taxation but not repayment.
Can’t the private sector create (or extinguish) debt prior to any federal spending (or taxation)?
Perhaps you can give an example of what you mean?
A private sector loan does nothing if the money is never spent. Once the money is spent, it becomes someone’s income just like any other expenditure and just like any federal expenditure. Money is money and income is income regardless of whether the source of the money is government spending or a private loan.
Well, suppose its spent. Right now the banking system is carrying reserves far, far in excess of the reserve requirement. They already have far more asssets than they need to meet their current deposit liability obligations. I think the banks could expand the M1 money supply by almost 15 trillion dollars in the aggregate before bumping into the reserve requirement.
They have reserves of 1.58 trillion, of which only .098 trillion are required reserves:
http://www.federalreserve.gov/releases/h3/current/
Those required reserves are sufficient for the demand deposits that have been moving between about 900 billion and a trillion dollars lately. But that leaves almost 1.5 trillion in additional reserves! Of course, if bank lending increased dramatically, by even a fraction of that amount, the Fed would begin draining reserves like mad. But clearly the banks have tremendous room to expand the money supply at this point without the need to acquire any more payment assets than they already have.
Hmmm. I’m not following. I don’t think I said anything about banks needing to acquire more payment assets. I just said that all money is subject to the same tax laws, whether created by government or by banks.
Here’s an example of what I have in mind:
The Federal government spends $100 million on some project, say federal housing projects. They deal with a bunch of contractors and pay the contractors who in turn pay sub-contractors who in turn buy materials and hire employees who in turn spend their paychecks and pay income taxes. The $100 million circulates in the economy creating perhaps $250 million of income in a year due to the fiscal multiplier. Some percentage of this income is collected in federal taxes — say $35 million. So the federal government has created a net $215 million of income via their $100 million expenditure. This money continues to circulate in years 2 and beyond, subject to normal leakages to taxes, imports, and savings.
Now say that a bank lends $100 million to a real estate developer. The developer hires contractors who in turn pay sub-contractors who in turn buy materials and hire employees who in turn spend their paychecks and pay income taxes. The $100 million circulates in the economy creating perhaps $250 million of income in a year due to the spending multiplier. Some percentage of this income is collected in federal taxes — say $35 million. Also, the borrower begins paying off the loan, so the net money creation resulting from the loan is less than $215 million in year 1. More of the loan is paid back to the bank (extinguished) in each subsequent year throughout the life of the loan. So as time goes buy, the stimulative effect of the private loan is repeatedly offset by the payments to extinguish the initial loan amount.
The net effect on the money supply of the money created by the government expenditure is equal to the initial expenditure times the fiscal multiplier minus taxes. The net effect on the money supply of the money created by the private loan is the initial loan amount times the fiscal multiplier minus taxes minus repayment of the loan principal. Taxes effect all money equally, regardless of how it was created, but only the private loan must be repaid.
Does this make sense?
> Detroit Dan:
Are you assuming that 100% of the interest component of the bank loan repayments is spent or distributed back into the economy instead of being retained or reinvested as another round of interest-bearing debt?
Yes. Do you believe that interest payments retained in bank capital represent the destruction of money? At any rate, I am talking about net money creation as a result of private bank loans. Loan repayments represent money destroyed, but I think interest payments increase bank capital and those which are retained by the banks are similar to retained earning in other corporations…
Interest payments retained in bank capital are not destruction of money, just transfer of it from the non-bank sector to the bank sector. Thus requiring an infusion of money from outside in order to sustain and grow the non-bank sector. Could be net new lending or exports or government.
> Detroit Dan, Golfer has answered your question to me (below) for me (below that), except that I would like to point out that bank capital is not counted as part of the money supply, so, for as long as those interest payments are retained in bank capital, that amount of money has been removed from the money supply.
Detroit Dan: On your process – well that’s why Hyman Philip Minsky called gubmint money “High Powered Money” or HPM. OF course there might have been another reason.
Taxation is just the repayment (reflux) of government money. There really is no ultimate distinction between the two. Both government “fiat” money and bank money are types of credit money, because “money is credit, and nothing but credit.”
Great post Dan, thanks.
1 ) Only the Government (FED) can create reserves or base money.
Reserves are a liability (iou) of the central bank
Are bank reserves money?
2) Bank deposits are a promise to pay reserves on demand. Not reserves themselves.
Bank deposits are a liability (iou) of the bank.
Are Bank deposits money?
3) A treasure is a promise to pay reserves ( + interest) upon maturity. It is a liability (iou) created by the U.S. treasury.
Is a treasury money?
4) a cooperate bond is a promise to pay reserves (ultimately) upon maturity. A cooperate bond is a liability of the issuing corp.
5) A personally written ( signed and legally binding) IOU is a promise to reserves ( eventually). A personal IOU is a liability of the issuer.
is a personal IOU money?
for those of you claiming banks create money. Do you also claim treasuries are money?, what about #4 and # 5?. Do I create money when I promise to pay? Is it a question of how liquid the liability is? Is it the access to unlimited reserves at the fed window that banks can borrow, that separates bank IOU’s from every one else’s?
MMR claims it’s two different money creation mechanisms, If this is the case, why not add treasuries as a third and so on.
As Stephanie K., golfer, Randy Wray, Detroit Dan and others have all said, I think, there is a hierarchy. The greater the degree of acceptability and liquidity of a negotiable liability, the greater its degree of “moneyness”. And for any debt, there are some assets that are eligible for the debtor to use to discharge the debt, no matter what the creditor says, and others that won’t discharge the debt unless the creditor chooses to accept it. There has been an endless debate about what kinds of things in the hierarchy constitute “money”, and economists and the Fed have given a variety of different answers and provided different ways off counting the aggregate “money supply”. But at some level there is a continuum, with no sharp distinction between money and non-money.
If money is as money does, then reserves wouldn’t qualify, even though they are counted in M1. That’s why enormous amounts of excess reserves have not had any impact on the economy, while government deficit spending and bank lending do have an impact.
Sometimes economists get so wrapped up in definitions and technicalities that they lose their ability to communicate, especially with each other.
M1 doesn’t include reserves balances; and it also doesn’t include commercial bank vault cash reserves or any currency held by the Treasury or Federal Reserve Banks. It’s basically just money “in circulation”: cash held by the public, plus travelers’ checks, demand deposits and other checkable deposits.
But I would say reserve balances and vault cash are a kind of money. They are just a kind of money possessed by banks alone. If I’m a bank, and I owe a million dollars to another bank, and I can pay them with my reserve deposit at the Fed, then that’s good enough for me to call those reserves “money”.
My bad. Reserves are part of the Monetary Base, not part of M1.
Steve–
Randall Wary (a founder of MMT) describes this as the pyramid of liabilities. See MMP (sic) Blog #15: Clearing and the Pyramid of Liabilities
Randall *Wray*
Let’s do the accounting of starting a new bank.
Assume the capital requirement for mortgages is 5% (10% times .5).
Sell bank stock for demand deposits and central bank reserves and then buy treasuries:
Assets = $100,000 in treasuries
Liabilities = $0
Equity = $100,000 in bank stock
Now make 20 mortgage loans for $100,000 each.
Assets = $100,000 in treasuries plus $2,000,000 in mortgages
Liabilities = $2,000,000 in demand deposits
Equity = $100,000 in bank stock
The 20 people use the demand deposits to buy 20 homes for $100,000 each from 1 home builder.
The home builder sets up a checking account at the new bank. So 20 checking accounts at the new bank were marked up and then marked down by $100,000 each, while the home builder’s checking account was marked up by the $2,000,000.
The home builder allocates as follows:
$2,000,000 in a savings account. The reserve requirement for savings accounts is zero so that takes care of a positive reserve requirement.
Let’s stop here.
1) $100,000 in demand deposits became $2,000,000 in demand deposits
2) When the bank made the mortgages, it had zero vault cash and zero central bank reserves. It stayed that way when the home builder allocated to the savings account. The home builder accepted demand deposits in exchange for the 20 homes. No monetary base was involved.
The balance sheet of the bank looks like this:
Assets = $100,000 in treasuries plus $2,000,000 in mortgages
Liabilities = $2,000,000 in savings account
Equity = $100,000 in bank stock
Now crank up the capital requirement to 100%.
The bank sells $100,000 in bank stock and can only make $100,000 in mortgage loans.
It seems to me a lot of economies have a fractional reserve system and a fractional capital system.
“why enormous amounts of excess reserves have not had any impact on the economy, while government deficit spending and bank lending do have an impact.” [golfer1john]
Taxes affect bank-created money as well as government created money. As I phrased it before–
Money created by private debt is subject to taxation and repayment. Money created by government spending is subject to taxation but not repayment.
So you might say that gross government spending, net private credit creation, and taxes all have an impact on the economy. Or you could say that (government deficit spending) and (private credit creation minus taxes and repayments) each have an impact on the economy.
Does this make sense?
Correction to my post above– One should not say that (government deficit spending) and (private credit creation minus taxes and repayments) each have an impact on the economy. While technically correct, this is misleading if the purpose is to describe the impact of government spending, taxation, and private bank loans. The government deficit includes taxes on private bank loans and thus overlaps with the effect of private bank lending.
Here is a better statement of how the money supply changes:
The money supply is increased through government spending and private credit creation.
The money supply is reduced by taxation and private credit payback.
Taxation applies to all money, not just government spending.
Private credit payback only applies to money created by private credit in the first place.
Hope this makes sense.
I’m beginning to think this is a significant point, since it is evidently not understood by many MMTers and seems to have led Cullen Roche and his band of MMR followers way off course. Taxes apply to money created through bank loans. This seems pretty straightforward, but people can’t seem to wrap their heads around it => a learning opportunity…
The methodology is too simplistic.
Taxes are not levied on money, or on all spending equally. They are levied on transactions, and levied differently or sometimes not at all depending on the type of transaction. Spending on labor is taxed in a way that spending on technology as a substitute for labor is not taxed. Income taxation of individuals depends on the level of income, so spending on high-wage, high-skill workers is taxed more than spending on low-wage, low-skill workers. I see no reason to believe that the distribution of spending by government is exactly the same as the distribution of spending by bank borrowers, in respect to these and many other factors. And some argue that there are big differences, that government spending is heavily skewed toward the rich.
In the bigger picture, the whole argument about which one created more money than the other seems like nothing more than a testosterone contest, with no relevance to policy.
I guess we’ll have to agree to disagree…
Dan,
you said above that: “when the Fed books a profit, those stockholders only get 6% of the take”
Fed member banks (stockholders) receive a 6% dividend on their paid-in capital (i.e. on the amount of stock they own). The amount of stock a member bank must own is equal to 3% of its total combined capital and surplus.
Yes, you’re right. I misspoke. It’s not that 6% of Fed earnings go to dividends, but that there is a mandatory 6% dividend on paid-in capital.
This article from Steve Keen covers some of this, from a different angle, which compliments this article well:
http://www.businessspectator.com.au/article/2012/10/22/commodities/myth-money-multiplier
Particularly, the tables in that article, clarify the money/debt transfers much well.
I wonder what peoples opinion is, on framing money creation as a ‘democratic’ issue?
Money creation by private banks (even if it is more ‘liability creation’), to me seems to be a seriously undemocratic power, which gives banks unique profit-making privileges, and power over politics/economics/society.
By contrast, money creation by government (through public spending), and/or through a public bank, seem to be the only truly democratic ways to create money, as there is accountability to the public, and policy decisions are influenced by the public.
This seems to be a very powerful way of building a moral framework around MMT, based upon promoting democracy, which could go up against conservative economists moral arguments.
Are there any mistakes or downsides, to my moral framing of money creation like this?
Banks do have unique privileges, but they also have unique regulation and oversight that other businesses do not have. As long as government does its job and is not corrupt, banks cannot harm society any more than other businesses. Repealing Glass-Steagall was a great failure on the part of government. I cannot imagine a government-run commercial banking system that would offer the same level of choice and innovation that the current system offers. It is not the fact that the banking system is privately owned that is causing our current economic problems, it is poorly conceived and poorly executed government policy.
MMT does not, and should not take a position on public vs. private ownership of banks. MMT explains how the system works today, and what policy options are open to government, most especially those that were not available under the gold standard. To stray from that can only reduce its effectiveness in promoting proper economic policy.
MMT appeals very much to Progressives, who find its policy options very compatible with their own policy preferences, whereas traditional economics offers them no help. I think it would be a mistake for MMT to become mostly a tool to bolster Progressive policy arguments. MMT has a moral framework that, explained properly, will appeal to people of any political stripe. That is one of its great strengths, beyond the correctness of its theory and analysis. It should not be diluted by taking sides in political arguments.
golfer1john
“MT has a moral framework that, explained properly, will appeal to people of any political stripe. That is one of its great strengths, beyond the correctness of its theory and analysis. It should not be diluted by taking sides in political arguments.”
I couldn’t agree more.
I find many people in business & finance, who tend to be conservative, very open to MMT’s operational description of the monetary system.
What surprised me the most was how open many were to the idea of a permanent Job Guarantee Program.
Once they understood the concept & application of buffer stocks, how an Employed BS differs from an Unemployed BS, they were in almost total agreement as to the vast superiority of an Employed Buffer Stock.
To them it was good for business.
Vilhelmo, you’ve made my day. I always thought that would be true, but have not tested it except on my brother, who is an IT worker bee, very political, very conservative, very aware of the economic issues but not a business and finance guy. He likes MMT, too.
The moral argument I make about the employed buffer stock is that since government is the sponsor of our economic system, it has the responsibility to mitigate the harm inherent in that system, even though the good inherent in it is greater. This argument should appeal to anybody engaging in good faith, regardless of their politics. It is not a Progressive-only issue.
But JG is also good for sales, and should appeal on that ground to a selfish interest as well.
MMT should do more to sell itself to those outside the Progressive movement, instead of trying (as some seem to do) to alienate them.
Like Vilhelmo, I couldn’t agree with you more.
Fair enough, these are good points on trying to keep MMT politically-neutral (or, well…seeing as economics is inherently highly political, at least having it be amenable to both progressives/conservatives), but what do you make of my moral argument, about the undemocratic nature of private control over money creation (whatever it’s form), even if it were to be a moral arguments applied separately to MMT?
I’d be curious to know how well that moral position stands up.
I don’t see a moral issue. I know Jesus threw the money-lenders out of the temple and all, but I think that whatever laws you pass there will always be people who want to borrow and others who want to lend, outside of whatever government-run system you might set up. It will have rules and qualifications, and there will be some who would prefer different rules and qualifications. So, as a practical matter, I don’t think you can do away with privately-controlled lending, any more than you could do away with alcohol or marijuana use, moral arguments notwithstanding. And I don’t see value in tilting at those windmills.
I do think that there is a need for more conscious control of economic policy by government, as that is part of their responsibility, and it needs to be informed by a true understanding of the nature of fiat money, that is, by MMT. Maybe that means ending (most) Treasury borrowing, and creating money directly by spending, maybe it means a publicly-owned banking system alongside the private one (I gather one of the Dakotas has established state-run banks, maybe it should be states and not federal), or maybe it means greatly increased capital requirements so that banks really do lend mostly from their own assets. I would judge each of those things mainly on the basis of the safety and efficiency of the system (clearly the present system needs some safety adjustments).
As for which is more undemocratic, as a matter of principal I think control by the sovereign is undemocratic, and dispersed control among the population is more democratic. There are problems with systemically dangerous institutions, the so-called Too Big to Fail, but those same problems go away when there are lots more banks, of much smaller size, along with competent regulation. Or just when you separate the risky investment banking activities from the more staid commercial banking. Let the big investment banks do their thing, and if they fail, they fail by themselves. Primarily local banking is, I think, the most democratic solution, as it promotes choice and competition, and gives the most power to the consumer of banking services, even in the age of the Internet.
The moral issue isn’t the lending or borrowing though, it is the ability to create money, and private banks having pretty exclusive privilege in being able to do this (which nobody else in private society can do, only government also having this privilege, though in different form).
This seems quite immoral, given the unusual profitmaking powers it bestows them, and the unsual control over society/economics and, to a degree, politics, it provides those in banking/finance, which is sourced (in some cases directly, in others indirectly) through the ability to create money.
If the banks were forced to be full-reserve (or as you say, have much more stringent capital requirements), or to act as investment brokers instead (both with no ability to create money) I would have no problem with that, but it is the ability to create money I see a moral issue with.
I too, think viewing things in terms of optimal safety/efficiency of the system is best, but I also think this moral perspective is potentially very important, and perhaps is even a politically useful distinction (if my framing of it can hold up to scrutiny).
Well, anyone can create and issue an IOU. The trick is getting them accepted. If people resent the general and easy acceptability of bank IOUs, why do they accept them so readily?
If I could create IOU’s and call what I lend US dollars and those IOU could be converted into fed notes im pretty sure I could get these accepted.
Those bank IOUs can be converted into Federal Reserve notes because the bank guarantees to so convert them. If you want to convert your bank deposit balance into Federal Reserve notes, you have to go to the bank, where the bank wipes out the deposit balance (it’s IOU) and gives you some of the Federal Reserve notes the bank has in its possession. That’s no different than if you redeemed an IOU you issued for Federal Reserve notes you possess.
I agree, so the source of the power of banks to create IOU’s which many people use as money is because of fractional reserve lending. If banks are forced to hold all their deposits as reserves and you modify the fed so it deals directly with the public not banks, that will force banks to source money from businesses and households first before lending onwards which is the ultimate regulation because they wont lend to banks that engage in excessive risky lending as they will also stand to lose.
Warren proposed some policy options short of what you describe for “Narrow banking”. If I understand correctly, it’s that ordinary banks as a quasi-private arm of the govt’s money supply system, should be entitled to issue credit (subject to profits and losses, and expenses) but NOT play with their credit creation powers to “bet” alongside hedge funds and investment (stock) banks.
Someone mentioned that the Fed was forced to sweeten the pot in some ways to encourage investors to create commercial banks that operate as part of the Fed system. This is probably more the case after laws, tax laws, and policies were stretched to allow more latitude to hedge funds and investment banks to reap super-profits at the expense of the general economy … commodity futures and other speculation.
The movie “Inside Job” compares Wall Street and stock brokers of the 60s or 70s compared to today, Merill-Lynch as I recall was one example. Being a stock broker was a 2nd job, and the executive decision makers could fit around a single conference table.
Also, when Volker pushed prime rates up to 22% to “cool inflation” that was really caused by the 1973 Oil Spike, I think that probably made existing Usury limits useless. (I don’t know if usury laws on credit set that at a % over prime or just a hard number.) So this opened the legal gateway for super-high commercial interest rates, compared to before this period, and the explosion of consumer credit. Otherwise, Congress COULD tell the banks (or pass new laws) that 12-30% consumer interest on credit cards or collateralized by cars, now during ZIRP, is illegal.
I think a lot of THAT stuff, and stuff I haven’t thought of, is a bigger factor in “outsized” or “immoral” bank profits.
I also believe that too much moralizing about how many economic angels should be allowed to dance on the head of a pin, can become circuitous for even the wisest philosophers, and can lead to extremes of ideology from total State-Communism to total Anti-Communist Neoliberalism (and Austrian Econ extremism). On one hand, the total elimination of “immoral” profits, on the other hand, total elimination of “immoral” govt interference, taxes, or redistribution of “just” profits.
I think MMT with JG leans towards the ideals of various socialisms including Marx — without excessive controls along those lines — by attempting to bring the fruits of Labor for the 99% closer UP to the full profits of production and sales (or however Marx & Engels said that) instead of a too-large unemployed buffer and desperation and FEAR used to push down wages to below “par”, such that the consuming public requires levels and expansion of credit that becomes harmful — and the number of private govt-protected monopoly sectors that could be serving the whole economy (political economy) better if partly in the public domain … like health care.
MMT and Post-Keynesian econ seems to address and recognize both Supply AND Demand of goods and services (and the role of money/credit in that), whereas I think Marx was heavily weighted on the Demand (labor & income) side, while those pointing to the simplicity of Say’s Law were arguing almost exclusively for Supply-Side economics, and to ignore both demand and “social justice”, let people struggle “naturally” argument, in a system of supposedly-automatic Neoclassical equilibrium and “fairness” of the Market.
MMT seems aimed at improving outcomes NOW without difficult and uncertain revolutionary systemic changes. Which is pretty much what FDR was aiming at, IMO.
JohnB
“but what do you make of my moral argument, about the undemocratic nature of private control over money creation”
As far as the government is democratic, money creation is democratic when in the hands of government.
I see private control over money as profoundly undemocratic. Private institutions are by their very nature undemocratic, unaccountable tyrannies.
I guess we’re misunderstanding each other about what is “democratic”. Pure democracy is tyranny of the majority. That isn’t our system, we have a representative government (republic), and a Constitution that limits government and protects the rights of the minority.
Power vested solely in government is autocracy, not democracy. Power vested in the people is democratic, and that involves freedom to act as long as the action does not infringe on the rights of others. Since nobody is forced to deal with banks (there are credit unions), I don’t see what is “undemocratic” about someone being allowed to operate a private bank.
Private institutions cannot be “tyrannies” under our government, and all are accountable to the law. Nobody has the right to control anyone else against their will. Everyone has the right to control themselves. If banks are making excessive profits due to their ability to create money, then perhaps they should be taxed differently than other businesses. Under Glass-Steagall, though, I think commercial banking was a pretty boring business, and profits were pretty ordinary.
Under Glass-Steagall, though, I think commercial banking was a pretty boring business, and profits were pretty ordinary.
——
Yeah, what I said above about “Inside Job”, banks were fairly “pedestrian” before that Financialization exploded in the 80s and 90s. M.Moore’s Capitalism has that clip of Don Regan of M-L ordering Reagan around. That clip alone says a lot about that era, and the era we’re in now since Reagan’s “Great Moderation” has run its course to collapse.
I know this. There is a well known case of the Federal Reserve or a member bank (don’t recall which) being sued in a tort case under the US Tort Claims Act. The Federal Reserve (or member bank) defended the case on the grounds it was not part of the government and thus not subject to the US Tort Claims act. The Plaintiff’s case was dismissed, the court finding that the Federal Reserve or member bank was not part of the Federal Government. The Federal Reserve Bank of Kansas City, cited above, has held the same thing because neither the banks nor the “system” are considered to be agencies.
Only the board of governors is an agency of the government but not in any true sense of an agency because it is “independent” of the executive, legislative and judicial branches of government. A true agency has a principal but the board of governors, being independent, has no such thing. It is a scam agency. When the Federal Reserve or its board can’t even be audited by the government, calling it part of the government is a sick joke on the people.
Legally, one can get into some “hall of mirrors” funhouse stuff. When one is talking about quasi-public or quasi-private institutions, there’s plenty of ambiguity. I know about that Tort case, but I no longer believe that it’s sensible to use that case alone as “proof” about the entire Fed system.
Unlike a private corp, Fed’s net profits DO go to Treasury … which really doesn’t NEED that money, except under the non-MMT understanding of taxes and revenue. The WaPo a few years ago had that article (public relations fluff, imo) about how profitable the Fed was in that fiscal year (ign0ring the “toxic assets” mortgage securities that it bought from banks and is keeping in deep freeze so as to not count the losses), and how the Fed paid some $40 Billion to the Govt. “Yay for Fed!” the article said. Point being not that “paying into Treasury” doesn’t help the economy, in MMT, but that if the Fed were operationally a private corp, rather than a quasi-private facilitator corp with a public purpose, it would KEEP all those profits. The Fed is structured differently from Walmart, Exxon, or JPMC, or other private for-profit corps.
I’m now satisfied that Congress COULD change laws and rules to manage the Central Bank they created, if they were willing to return this Financialization Bubble Economy back to some sound basis for an economy, and IF they understood the implications of MMT and Post-Keynesian empiricism.
I’m now satisfied that while it may be seen as a largely “captured” agency and regulator, the Fed is operationally more like the Treasury’s lending institution … since Treasury is permitted by the 1700’s Constitution to only “coin” or “borrow” … or spend out of taxation. It is probably possible to somehow change laws and merge some or all Fed duties with Treasury, with or without a Constitutional Amendment, with or without some beneficial anti-Plutocracy outcomes, but the changes that we need most badly NOW are possible NOW under the current system.
Another great post Dan, you deserve a medal for explaining these operations so well, and for the robust discussion it generates.
Just to clarify, in the second-to-last paragraph you say:
“And, of course, if the bank already possesses excess payment assets, it might not be able to expand its deposit liabilities without acquiring any more payment assets.”
Should the “not” between “might” and “be” be taken out? (I think that’s what you meant to say, correct?)
It sounds from this discussion that banks do create money or credit ( which is used just like money). The three problems I see with this. The first is the issue of where the extra money comes from of the interest. I believe you discussed this . 2) That banks receive interest often reaching twice the cost of the house or whatever you’re purchasing. Huge cost on a loan of money that didn’t exist before they typed it in . And 3) there is the issue of collateral. If I do not pay my debt, the bank gets my house ( business etc). Who does that really hurt? Not a depositor. This process drains the small businessman/woman and the middle class generally and concentrates money into the hands of the bankers who at the end of every recession/depression own more and more capital as they foreclose on property. Allot of our laws are predicated on the myth that bankers lend out the money they get from depositors. As we become educated about where banks get the money they lend, we should change our laws to offset the concentration of wealth.
Say the bank has a million dollars of deposits in it. Now I borrow a hundred thousand and the cheque is deposited in the bank. The bank now has $1,100,000 dollars in deposits after this transaction. And I can go and spend my $100,000.00 anytime I want without reducing any other account in the bank. So the bank has now “magically” created a hundred thousand dollars I can spend.
In that sense we might say the bank has created this money out of “nothing”.
Ah, but I have to pay the money back with interest and when I have done that, this money will, equally “magically” disappear.
It’s all rather like virtual particles in quantum physics where particles can be created as particle/antiparticle pairs so long as they then come together and annihilate themselves before anyone could possibly measure them. We know these particles do appear and disappear even though we can’t observe them directly because, among other things, of the Casimir effect, which we can and do observe.
So maybe we should call what the banks create “virtual money” by analogy. But we must certainly be careful not to push such analogies too far.
It’s all rather like virtual particles in quantum physics where particles can be created as particle/antiparticle pairs so long as they then come together and annihilate themselves before anyone could possibly measure them.
Not a bad analogy, but in this case we can measure them.
What the bank gave you is a claim on its assets. What you gave the bank is a claim on your assets. You can spend the claim the bank gave you by exchanging part of it for goods and services, because people willingly and eagerly accept these valuable bank claims.
Methinks most of the class was absent without leave when banking was discussed after reading just some of the comments above. Nary a grasp nor even a handle on the functioning of the banking system is displayed above, rather some drug induced dreams form the basis of opinions held by usually the most persistent commentors and seldom do the answers given satisfy the vacuum of ignorance. Another post also displayed the same ignorance of how the world works:
http://neweconomicperspectives.org/2013/05/reserve-balance-misconceptions.html
Both Karl Marx and John Maynard Keynes used the device of “scientific” explanation to base their arguments, knowing that such presentation was accessible and understandable to their readers. Given the state of education and aversion to intellect that rages in today’s public, there is little probability of a like outcome. As the extended trails of comments in both postings indicate, there is little chance filling the void of ignorance with countlessly repeated offerings of fact or knowledge that will avail; the hull built upon education has been holed and bailing is no longer sufficient to keep the ship of civilization afloat. Maybe it is possible to create an economic dictionary of definitions to arrive at something more universal than private opinion or understanding of economics. Without such recourse closing the breech of ignorance is not likely to produce result. It is not the duty of the author to assure the competence of the reader, the only duty is that the author’s product is competently given. Suffer fools at risk or be prepared to forever be defining what is is.
Well this is an entertaining comment. But you decline to actually provide any of the factual information you claim is missing here. So so far it looks like all you have to contribute is wind.
You have spent an amazing amount of time explaining Banking 101 as well as Accounting 101 above. For instance: How well has the principle been understood that interest income for one is a cost of using money assets for another? Why are you still working through these things. If my comment above is occupying valuable space, do please delete. If the use of certain words is offensive to the readers here, ignorance is merely the lack of knowledge. Learning is the traditional remedy for that condition. Learning rarely affects those who know everything a priori; which was the thrust of the original windy contribution.
T-Bear : Many of us know well how little we understand anything. But we might be helped if you could say more exactly what is wrong and what is right with the posts and comments, so we could get a grasp on the functioning of the banking system, rather than dream as if induced by drugs. Your readers may be incompetent (or not) and of course you are right that that is not the author’s responsibility. But can there be any readers if the author, however competent, refrains from giving them his product?
There is more confusion about the forms of money than there is confusion among physics students in quantum mechanics. Not joking–I’ve lived it.
I like to think of it like this:
The only real money in the US is high-powered money–Cash and Reserves.
Deposits are EFFECTIVELY money. Only existing as money when necessary (when deposits are spent), as Reserves move about.
I have no problem with anyone saying “banks create money” because they create deposits which are effectively money. As Steve Keen has mathematically proven, Aggregate Demand = GDP + Change in Private Debt. Private Debt –> think Deposits (not exactly the same, but…). So increasing deposits/debt has real effects the economy but these deposits are only effectively money when spent, never “real” money themselves.
Banks can create assets, when they create a loan they create an asset.
“But it is crucial to recognize that banks do not and cannot simply manufacture their own assets – whether from thin air or otherwise”
Banks can manufacture assets. When they create a loan they manufacture an asset.
What does “create a loan” mean?
Making a loan and creating a loan are the same thing arent they? I understand the nuance that banks dont create assets when they lend, but the debitor creates it when it writes the IOU so dont worry about that one anymore.
Could the accounting look like this?
Start a new bank and buy treasuries.
Assets: $100,000 in treasuries
Liabilities: $0
Equity: $100,000 in bank stock
Limited 20 borrower’s balance sheet (bs)
Assets: $0
Liabilities: $0
Now apply for mortgages.
Assets: $100,000 in treasuries plus $2,000,000 DD in its own account
Liabilities: $2,000,000 in DD
Equity: $100,000 in bank stock
Each of 20 borrower’s balance sheets
Assets: $100,000 mortgage loan
Liabilities: $100,000 mortgage loan
Approve the loans and “barter” DD for loans.
Assets: $100,000 in treasuries plus $2,000,000 loans
Liabilities: $2,000,000 in DD
Equity: $100,000 in bank stock
Each of 20 borrower’s balance sheets
Assets: $100,000 in DD’s
Liabilities: $100,000 mortgage loan
Thanks Jamie. What you say about paid interest retained as bank capital makes sense. It disappears from the money supply, it seems…
Detroit Dan,
Principal balance repayment equals money supply decrease. Interest payment is just a money transfer from borrower to lender.
-Kyle
Not a chance. A payment to a bank from a deposit account, whatever the mix of principal and interest, represents a reduction in aggregate M1, checkable bank debt. And, if the lending and checking banks are not the same, a lateral transfer of reserves (M0), leaving aggregate reserves unchanged.
Destructi0n of M1 through debt service (not “debt repayment”) is the very engine of debt deflation.
The bank’s interest earnings are its top line revenue. Out of those receipts it pays all its expenses, including interest on the money it borrows (including deposits), the salaries of employees, rent on the buildings it occupies, taxes, dividends, and all the other ordinary expenses that every business has. Most of that interest received, then, is recycled to the economy in the form of deposits, just as most of the receipts of any business or the wages of any employee are recycled. Only the portion that goes to retained earnings is removed from circulation.
It’s different from a principal payment, which removes deposits (M1) from the economy. They vanish, the reverse of when they appeared from nowhere when the loan was made. If, in the aggregate, there is more repayment than new lending, the effect would be deflationary. That just recently happened, for a few years.
Kyle– When an interest payment is make to a bank, how is that transfer made? What bank account is credited?
The account credited is a revenue account on the bank’s books. Out of that money, the bank debits its various expense accounts (salaries, rent, etc,) and credits the bank accounts of the recipients (employees, landlord, etc.)
Thanks golfer1john…
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I think this debate amazing. Keep in mind that the Federal Reserve is a Private Bank, run by 12 private banks. In the 100 years of the Federal Reserve must discover the truth of this fact. We must know the origins of the Federal Reserve, everything that happened on Jekyll Island, and the role played by banks in England. Who actually owns the Federal Reserve?
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What about real goods? We are always too busy focusing on the notion that “Banks create money when they make loans”. However, they also create money when they buy goods or equipments or whatever they desire. They buy goods or equipments and pay for it by crediting the borrowers’ transaction accounts. If the seller banks with another bank, the bank then simply sends the money to another bank which in turn, then, credits the account of the seller. In both cases, a new deposit, hence money, is created. Is this correct?
No, it’s not correct. The bank also debits its own asset account, “cash”. When a bank buys goods and services it spends its own money just like a hardware store buying goods and services does.
golfer1john: ‘The bank also debits its own asset account, “cash”. ‘
The bank just bought a vehicle for $20,000. The dealer deposited the check in its own bank. 20K in reserves are conveyed bank to bank, to clear. Aggregate reserves are thus unchanged. Doesn’t aggregate M1 increase by $20,000, the amount of the dealer’s deposit?
EconCCX, I also think the same way you do! In my opinion, what golfer1john said would be true only when bank pays for the vehicle or whatever that it is it purchased by paying in “cash”. So, goods come and cash is out. But, if the payment is made to seller’s transaction account, no matter whom seller banks with, there “must” be an increase in the aggregate M1 balance in the form of Demand Deposits. Also there is no change in the level of aggregate reserves at all as the change in reserves is fully and strictly determined by FED’s own decisions.
It seems wrong to me, but I can see how it might be true. If spending by the bank is an increase in M1 (or some other M, depending where the seller puts it), then a receipt by the bank of an interest payment must also be a decrease in Mx, just like the repayment of principal is a decrease in Mx. If banks in the aggregate are profitable, then the net of all such transactions must mean a constant conversion of Mx to reserves. If M1 is currency in circulation, the banks’ vault cash must be excluded from M1? Else cash transactions would cause different flows than checks, and that seems unlikely. But the volume of such transactions would be dwarfed by the volume of lending and principal repayment, so it probably doesn’t matter much.
Maybe some of the experts here can help me out.
Adjustment-However, they also create money when they buy goods or equipments or whatever they desire. They buy goods or equipments and pay for it by crediting the Sellers’*** transaction accounts
MONEY EX NIHOLO – NOT AS PER US CONSTITUTION
“Banks lend by simultaneously creating a loan asset and a deposit liability on their balance sheet. That is why it is called credit “creation” – credit is created literally out of thin air (or with the stroke of a keyboard).”
Paul Sheard, Chief Global Economic & Head of Global Economics and Research, Standard and Poors
http://2joz611prdme3eogq61h5p3gr08.wpengine.netdna-cdn.com/wp-content/uploads/2013/08/SP-Banks-Cannot-And-Do-Not-Lend-Out-Reserves-aug-2013.pdf
There is no evidence that either the monetary base or M1 leads the [credit] cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the [credit] cycle slightly.
Nobel prize winners Finn Kydland and Ed Prescott , Federal Reserve bank of Minneapolis (1990)
http://www.minneapolisfed.org/research/qr/qr1421.pdf
Under the present system banks do not have to wait for depositors to appear and make funds available before they can on-lend, or intermediate, those funds. Rather, they create their own funds, deposits, in the act of lending. This fact can be verified in the description of the money creation system in many central bank statements, and it is obvious to anybody who has ever lent money and created the resulting book entries.
IMF Working Paper Chicago Plan Revisited, p9
http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf
The key function of banks is money creation, not intermediation.
Michael Kumhof, Deputy Division Chief, Modeling Unit, Research Department, International Monetary Fund
Fractional Reserve Lending is much like having copyright laws extinguish to an exclusive group of businesses. Note this analogy. If video stores were allowed to make a copy from an original and rent that copy to another Video Rental store, and rent the original to the public. The second video store similarly was allowed to make one copy to rent to a third video store while renting the other to the public. Soon everyone who cared to watch the DVD would have done so, and the video stores would have made a killing renting out cheaply priced copies. The effect is that once a person watches the film that person has fulfilled his/her need, but the DVD did not get expended (like gasoline or food) but would have continue to circulate in the community. But then who looses? The production team who labored to produce the film.
Similarly money circulates in the economy from one person to another having an effect. If you have two conflicting conracts…one that maintains that you can have the money back when it is due, and the other where the money is loaned, then that is plain and simple FRAUD. To clarify this fraudulent claim lets look at what happened during the great depression.
There were rumors of an economic downturn so people decided to exchange their paper money for gold. The funny thing is that the paper money was a receipt for the gold as it read: “This note is legal tender for all debts, public and private, and is redeemable in lawful money at the United States Treasury, or at any Federal Reserve Bank”; and “PAY BEARER ON DEMAND”. BUT… When the public lined up to exchange their receipts they found out that the banking system/treasury/government had counterfeited these receipts so that there was a total of $71.8 billion of such receipts but only 3 Billion dollars worth of gold … See Banking and Monetary Statistics (Washington, D.C.: Federal Reserve System, 1943), pp. 544-45, 409, and 346-48.
I believe Dan needs to revise this blog if he is truly interested in educating the lay public like myself. First – it explains more than is necessary – TMI. Second, he stops short of revealing the true source of money creation – my take is that it appears to be the Fed through the approval of congress to raise the debt ceiling. By that act, it would be congress who creates the money, the Fed “monetizes” it and the commercial banks borrow it at low interest and then loan it out at higher. So, as Dan points out, banks are a burden, not because they create money but because they skim money as profits through a Byzantine maze of transactions. Correct me if I am wrong but needing to explain this concept in more than a sentence or two sends the message that the premise is weak.
Dan did describe the “shell game” but ultimately there is still a “nut” being shuffled around. I need to know the source of that nut.
MONEY EX NIHOLO – NOT AS PER US CONSTITUTION – CREDIT MONEY AB INITIO
February 1, 2014 at 11:15am
“In the real world banks extend credit, creating deposits in the process, and look for the reserves later” (Moore (1979, p. 539)—quoting Fed economist)
“In the real world, banks extend credit, creating deposits in the process , and look for the reserves later.”
Alan Holmes, then Senior Vice President, Federal Reserve Bank of New York (1969)
http://www.bostonfed.org/economic/conf/conf1/conf1i.pdf
“the difference of m2-m1 leads the cycle by even more than m2 with the lead being about three quarters” kydland and prescott Pg 14
https://minneapolisfed.org/research/prescott/papers/prescott-et91.pdf
“Banks lend by simultaneously creating a loan asset and a deposit liability on their balance sheet. That is why it is called credit “creation” – credit is created literally out of thin air (or with the stroke of a keyboard).”
Paul Sheard, Chief Global Economic & Head of Global Economics and Research, Standard and Poors
http://2joz611prdme3eogq61h5p3gr08.wpengine.netdna-cdn.com/wp-content/uploads/2013/08/SP-Banks-Cannot-And-Do-Not-Lend-Out-Reserves-aug-2013.pdf
There is no evidence that either the monetary base or M1 leads the [credit] cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the [credit] cycle slightly.
Nobel prize winners Finn Kydland and Ed Prescott , Federal Reserve bank of Minneapolis (1990)
http://www.minneapolisfed.org/research/qr/qr1421.pdf
Under the present system banks do not have to wait for depositors to appear and make funds available before they can on-lend, or intermediate, those funds. Rather, they create their own funds, deposits, in the act of lending. This fact can be verified in the description of the money creation system in many central bank statements, and it is obvious to anybody who has ever lent money and created the resulting book entries.
IMF Working Paper Chicago Plan Revisited, p9
http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf
The key function of banks is money creation, not intermediation.
Michael Kumhof, Deputy Division Chief, Modeling Unit, Research Department, International Monetary Fund
Are these cites responding somehow to my piece?
I’ve run across some of pmelli’s posts elsewhere, pmelli (paul), and I’m getting a better feel for his position.
What bothers me is that he describe things in our nation’s monetary system in a way that doesn’t reflect the reality of it. You describe a system like Lincoln’s with greenbacks. It wasn’t until the civil war under Abraham Lincoln that the Treasury was given explicit power to create money in the form of US Treasury Notes (known as ‘greenbacks’). The banks wanted 25% and 36% interest to lend the US for fighting the civil war. So, Lincoln explicitly resurrected the idea of fiat money (issued by the various colonies and praised by Benjamin Franklin) in the creation of the greenbacks. At this point it was correct to say that the Treasury creates money for Congress’ appropriations and spends it. This cut the banks out of the loop because the greenbacks were not borrowed for which interest had to be paid. They were just created out of thin air. But after the civil war the banks began lobbying to make the government borrow money from them. They also lobbied and achieved the gold standard for the dollar. In 1913 the Federal Reserve was created as a Central Bank with control over private banks. In 1917 the Treasury was required by Congress to borrow money from private banks. And as time passed the Federal Reserve assumed more power over the money supply. We did not have fiat money. Although the Fed was limited by the gold supply in what money it could create, the gold standard was weakened in 1933 under the depression. But it continued until 1971 when President Nixon found the French were draining our gold by exchanging dollars for gold and there was not enough gold to fight the war in Viet Nam, and on the home front, the War on Poverty and build the Great Society, mandated by Congress. So, we returned to a purely fiat money system. But now, the Fed implicitly had the power to spend money it created out of thin air when it bought securities. All that was needed was a monetary act that gave the Fed the power to buy and sell securities in the open market. Nothing in the law said where the Fed got its money and under a fiat money system, now without gold backing, it was sufficient that a government entity created by Congress had the power of Congress to create the money.
I go through this detail because I think it is important in the money creation account to note that the Treasury no longer was creating money and spending it, but borrowing it from banks and paying interest on the debt.
I am a scientist and I work with quantitative models involving many variables. In that modeling I focus on testing models to see if they fit data and accurately represent reality. Pmelli’s description of our monetary system is like the simple one with Treasury both creator and spender of the money. You say:
“When the Treasury spends it always increases the number of net dollars in the non-government. When it issues bonds, it is an asset swap…bonds for dollars…so that operation affects no change in NFA.”
But under the system we have, only the Fed as government agent increases the number of net dollars in the nongovernment sector when it creates the money out of thin air. The Tsy is only spending what it gets from issuing bonds to banks, so there is at the Tsy only an asset swap. And there is as yet a debt to the banks to repay. It isn’t until the banks take their tsy bonds and securities and put them up for public auction where the Fed buys them with new money it creates out of thin air, that new money is created and added to the money supply. And that redeems the govt.’s debt to the banks.
But the debt can also be handled by the Tsy indefinitely swapping new securities for mature ones with the banks. So, there are several possible outcomes depending on different actions of the entities in the model.
So, in explaining to the public how our monetary system actually works we have to describe it accurately. Otherwise they don’t know what we are talking about.
Every one of the transactions you describe is a swap. Sometimes one financial asset is swapped for another, or an asset is used to extinguish a liability.
And sometimes a financial asset is exchanged for a real asset. Like when you buy something at the grocery store.
When Treasury gives a bond to a primary dealer and receives money in return, it is a swap of financial assets, and the net financial assets of the private sector are unchanged. Likewise, when the Fed buys a bond from a private sector holder, net financial assets are unchanged.
When Treasury buys an aircraft carrier, or pays a Congressman’s salary, the net financial assets of the private sector go up.
It is spending, not bond selling or bond buying, that increases the net financial assets of the private sector. And taxing that decreases them.
““The Treasury Bonds held by the Federal Reserve are not owned by the Board of Governors or the Federal Open Market Committee. They are owned by the regional Fed banks. Those banks are privately owned and the bonds are among their assets. Privately owned companies will not sacrifice their assets forgiving the Government’s debts. Nor should they! The Government is obligated to pay those debts by the Constitution!”
But the FOMC buys securities with money it creates out of thin air and not with assets from the member banks of the Federal Reserve. So, whether they are the depository or not doesn’t matter. The Federal government owns them, because they were bought with federal government money. The member banks of the FRB don’t get a free gift for something they did not create. The open market operations of the Fed are government operations.
I am a scientist, a physicist – i.e., simple-minded. The gyrations and epicentral explanations I see here are beyond my ability to comprehend. It is as if the MMT folks are mesmerized by the concepts and the intense pleasure they receive by turning them over and over and marveling at the wonderful self-consistancy. The ultimate nerd wet dream. Meanwhile, policy makers are left with the existing lexicon. Callers to talk-shows regurgitate the same incorrect but oh so intuitive arguments over and over. Until you guys start talking their language, my language, you will forever be contemplating you navels. I listen for hours to the likes of Wray, Keen and Mosler – so compelling, so matter-of-fact, yet so ineffective in reaching the public -where it really counts. You can set up your new schools of economics, your enclaves of bright minds – the battles to save our society will not be won there.
Saying money is created out of thin-air – may or may not be true – but say that to the average Joe and you will, at best, get a blank stare. So much for changing the world.
So back to the simple-minded physics. We live in a closed system with fixed resources – human and natural. The goal should be to maximize the use of those resources for the good of society and humankind. Money is just particles of exchange to channel those resources in the most beneficial way. Politics, huge income disparities, the powerful, monopolize and misdirect those resources. From what I see, the Fed creates the reserves and congress, the wealthy and the powerful thwart the application of resources, leaving millions unemployed, not taking care of the elderly, the children, the sick – not discovering the scientific breakthroughs we desperately need, not protecting the planet. This is all possible due to the obfuscation of a complex and twisted conduit, the banking system, a hyper dimensional shell game which hides the fact that our resources are used instead to satisfy greed.
So what do I tell the average Joe? Just saying the US budget is not like a household budget – is another unhelpful phrase. What do I tell the average Joe about the interest on the debt? How do I tell him that the “debt” is not really debt and the “deficit” is not really a deficit in a way that will sink in? When Bernie Sanders can’t even appreciate the “elegance” of MMT, isn’t it time to start overhauling the message?
“isn’t it time to start overhauling the message?”
There are many different presentations of “the message”. My girlfriend, who has never studied economics and pays little attention to politics, just read J.D. Alt’s latest book and immediately saw the light. I think the problem is not the format of the message, it is the power of the megaphone. MMT just doesn’t have much of one. CNBC is very nice, but they need to get on This Week and Fox News Sunday, on a regular basis, where the mainstream economists and politicians live, and where the people watch.
It’s MSNBC, isn’t it, not CNBC.
Paul Lebow– To answer your last question, no, not necessarily. I wouldn’t use any one person as a litmus test for whether or not the message needs overhauling. Also, I do think it’s helpful to tell people that the US budget is not like a household budget, because the US can create money to pay its bills. Tell people that the “debt” is more like money than it is like private debt.
I know people will have trouble accepting these things, but over time the message will sink in. There are many concepts in physics that also take some getting used to for lay people. That doesn’t mean we should telling the truth about the matters under discussion…
Wow, MMTdebtkiller – you’ve made my point better than I could have! Thanks for walking through the securities process but one can see how intentionally opaque it is and how easily a phony right-wing talking point can be made by focusing on only a piece of the picture.
When you say “It buys them with newly created unbacked debt-free money (created out of thin air).” this seems to be a bizarre singularity – where the rules of double-entry accounting are suspended. How can this occur without the consent of congress? And if it is truly creating money out of thin air, why do we need taxes at all? Something is missing in this explanation.
I thoroughly agree with John B. (who agreed with me 🙂 that there is a game that we will continue to lose unless we play by the rules and use the same equipment as the right-wing. There is the belief by some on the left that change can only occur through major social movements. That’s one way, if one is willing to wait until things get so horrid in this country. In some ways that is precisely the libertarian approach. On the other hand, the genius of the right-wing strategy is to keep us happy with the illusion of affluence with trinkets from China so that complacence keeps the “movement” at bay. Despite the dire predictions for the economy, the 1% are immune and the 99% are irrelevant. MSNBC, left-wing podcasts and youTubes just preach to the choir – few minds are changed. We do have our deep-pockets too. Unless they are willing to break into the media and play with the big boys.
First of all, ask yourself, where does money come from?
There are no magical helicopters dropping $10 bills on everyone. No storks.
While banks create new money it is debt. The Federal Reserve on the other hand, when it buys Treasury securities from banks creates new money that is debt free which ultimately gets into the economy via deficit spending money (now debt free and equal to the money initially borrowed). All money is are tokens, quantitative representations of debt-obligations in a unit of account (e.g. dollars) in the exchange between parties in the economy of goods and services. The value of goods in terms of money is always something negotiated between parties, who have a relative feel for the value of things by making comparisons between them. You can’t have a modern economy without money. You can’t play Monopoly without money. It is not a good idea to back money by a single commodity because its supply may always run out as gold has many times in history. The money supply has to grow as the need to grow the economy grows. Our Central Government has to create new money as it is needed. During deflations and higher deficit spending, new money has to be created, and the Fed has the day-to-day job to do that in its open market operations where it buys and sells marketable US securities and bonds.
If Congress hadn’t delegated to the Fed the power to create money, then our money supply would have remained fixed and constant throughout the Fed’s history. I’m sure it had the power even under the gold standard, because it just had to match any new money to any gold in its possession not already matched to money. When the dollar was taken off of Gold by
Pres. Nixon (R) the Fed still retained the power to create money. Only the money created was not backed by anything other than the full faith and credit of the United States.
So when the Fed spends with money it creates it is debt-free money. Unlike private banks who create debt when they loan, the Fed creates debt-free credit when it spends.
As for double entry bookkeeping, I’m not expert on that. But it seems to me you can always create a new entry as asset for new money and match that to liabilities. For example every dollar has the liability that the government must accept taxes paid in it, payment for services in it, and even that one must exchange a dollar for another dollar at the Treasury.
I was referring to double-entry bookkeeping in a very general sense. I may be misinterpreting but it seems that the Fed has the ability to create entries (assets) into its reserve account which then allows it to lend that to banks short term so that the commercial banks can meet their daily obligations. I don’t see a counterbalancing “liability” being created when the Fed creates these assets. Can or does the Fed also have the ability to just transfer this newly created money into the Treasury account at the Fed so the government can then spend fiscally? If so, why go through the charade of Treasury bonds? Makes my head spin.
In 1917 Congress required the Treasury to stop creating money to spend, as it had with
Lincoln’s greenbacks. Treasury had to borrow. That gave the banks a sacred cow from which
they could extract endless interest.
So, Treasury had to borrow from banks, and the means for this was US Treasury securities.
The Fed is actually prohibited by law from buying or giving money to the Treasury (just
to keep the Fed independent from the politicians). One exception is that the Fed can
swap mature securities for new ones from the Treasury. So, when we need to create
new money, we have to do this indirect method jusing the banks as intermediaries.
When the Fed creates new money to buy the securities, it adds the amount into the
reserves of the banks selling it the securities. Not being an accountant, I don’t know
what the Fed does with its bookkeeping. But all dollars carry a governmental liability.
If you take a dollar to the Treasury for something of equal value, you get back
another dollar. If you pay the government taxes with its dollars, the government is
liable to accept them as payment. If you buy services like at a national Park, you
have to pay with dollars and the government must allow you in. So, how do you
represent such liabilities on the books
So, no, the Fed never gives Treasury money directly. It always is what I call an
immaculate creation. The Treasury borrows from banks; the Fed buys the securities
from the banks with money created ex nihilo. That makes the money Treasury
borrowed debt-free.
In bookkeeping, suppose your rich uncle leaves you $1 million in his will. How do you
put that on your books? Suppose you could create money. How would you represent that
in book keeping? Do you just have an account that you add new money to and draw upon?
What are its liabilities? Or is there some special trick used for this special case. Accountants
rarely have to deal with creating money. Maybe those at the Fed do. So, what do they do?
The Fed is so secretive that it is hard to know what is going on there. My account has taken
months of research, indirect inference from certain things said here and there and an
idea of what is both reasonable and feasible. I think the Fed is afraid to tell the public that
it creates new money all the time; that then they would shut them down. So they use all
kinds of indirect expressions, like “draws upon itself”, “makes digital entries in spreadsheets”,
but from to time someone comes out and tells it like it is, like Marriner Eccles a one time head
of the Fed during Roosevelt’s administration. I’ve heard that Janet Yellen wants to create
more transparency, and I hope they explain this and clear up the nonsense about the
national debt.
Actually, United States Notes – Lincoln’s Greenbacks – were issued continuously through 1971 (http://en.wikipedia.org/wiki/United_States_Notes) for 14 series total. They were our longest-lasting form of currency, not removed by Treasury until 1996. Since then, two bills were introduced to return, and increase greatly, them to circulation, by Rep Ray LaHood (before he became Transportation Secretary) and Rep Dennis Kucinich. Predictably, the banks quashed both of these before they could make it out of committee.
Still, Congress can instruct Treasury to issue debt/interest-free U.S. Notes anytime, for any reason, in any amount (the old $360m restriction no longer applies, since the 100+ year old authorization in that amount went away with the 1996 burning of the last U.S. Notes by Treasury – BTW, the U.S. Account was never credited with the last $250M burned either, specifically because U.S. Notes were not allowed to be applied to the debt, from the very beginning in 1862. This then, is money that simply went up in flames!). You can buy U.S. Notes for about twice face value on eBay – they’ve held their value far better than FRNs, proving it is the private banking sector that over-produces money, not government.
I agree with Paul; I (after much reading/effort initially) understand the message, and gain a greater understanding of the topic every day, because I am interested in it.
To win the public debate though, you have to punch-home your message to the general public, and:
The general public doesn’t give a toss about economics.
If your message can’t be reduced to simple soundbites, you lose the public debate; I’m increasingly of the impression, that you have to throw gobloads of money at refining your narrative, and hundreds of times more on pumping it through as many media outlets, at the highest volume level, as you can manage – and then the public, who don’t give a toss about economics, will learn through osmosis/repetition.
This is what ‘the right’ does, and this is why they utterly dominate all economic discourse, and they dominate the public psyche as well, because of it.
So, MMT needs to be taken out of academia, and put into massive-investor-funded think-tanks/lobby-groups, who refine the narrative and then blast it out to the public, on a scale big enough to compete/fight with the narrative of the right.
I despise the network of right-wing propaganda think-tanks, but I’m coming around to the idea that there’s a Greshams Dynamic there, where if you don’t compete at a same level with them, then you lose – and society loses too, by never seeing the necessary reforms – I’d sign up to work on something like that, to see the message properly spread.
Thanks for the comments. It is difficult to contain my deep frustration at hearing supposed “progressives” mouthing the same incorrect interpretations of how the economy works as the tea-partiers. Its a matter of who gets to define the context. I’m not a public relations expert but it seems that unless the message can be put on a bumper sticker, it won’t penetrate. If indeed the federal budget is not like a household budget, maybe using terms that refer to household budgets should downplayed. “debt”, “deficit”, “borrowing” really don’t describe the true nature of things. A “deficit” is really an “investment”, the result of a political decision to create the money needed to accomplish the goals of the country. After reading many of the MMT discussion it seems that even the word “tax” has misleading implications in the context of the US Treasury. Tax is used for the purpose of controlling the private sector, not enabling or funding the public sector, through wealth redistribution and tempering inflation. Saying “deficits don’t matter” is provocative, but it provokes the wrong reaction. “Investments DO matter”.
I find the most convincing thing we can say is that 1/2 of the national debt is like CDs at a bank. People know about those. They know that they are time deposits and the CD is just the certificate that represents the bank’s IOU to pay back the holder when the CD matures. Well, a security is a CD, but the time deposit is not at an ordinary bank but the Federal Reserve Bank. And the time-deposit is in an account at the Fed, the government’s bank.
So, they should readily understand that when the securities mature, the holder can demand payment of his money back plus interest. The Fed will create a checking account at the Fed for the holder and will transfer
the contents of his/her/its time deposit account to the checking account along with some interest the Fed creates (out of thin air, unbacked by anything, anew). That covers private and foreign holders of the securities counted in the national debt by the debt-ceiling law.
It’s obvious that these do not represent debts due to government borrowing money. So right there half of the debt-ceiling debt amount is bogus. These are investor’s money invested in the Federal Reserve Bank. They take money out of circulation that otherwise might cause inflation if allowed to circulate chasing goods and services. China and Japan are the biggest foreign investors in these securities/CDs. They have obtained at least a combined $4 Trillion from importing goods into our country to be sold at such places as WalMart and Target.
Perhaps a more complex case is deficit spending and the requirement that the Treasury borrow money instead of creating it to cover the deficit.
So, the Treasury creates securities and sells them at a public auction to large banks. The banks buy at discount, so that the interest is the difference between the face value of the security at maturity and the initial selling price of the bank.
The Treasury takes the money which has been deposited in its general account at the Fed and spends it. It is important to see that the Treasury does not spend until it has the money from the banks. It also owes the banks the full value of the securities when they mature.
When the securities mature the banks have two options: (1) go to the Treasury and ask that the debt be rolled over by swapping new securities for the mature securities. (That’s like rolling over a CD at a bank when it matures). So, this is a way the Treasury can put off redemption of the debt indefinitely. All it has to be concerned with is paying interest each time. If the Secy of Tsy is smart, he will create a fund of dollars for payment of interest by issuing other securities sold to the banks for that purpose. No taxpayers are needed.
Still that creates more debt to the banks. But the resolution follows: (2) The banks might go to the Treasury and ask that it pay back the dollars in exchange for the mature securities. But if the Treasury already had all those dollars it wouldn’t have had to do deficit spending. So, I suppose the Treasury says, “Put your securities up for public auction. We don’t have all that money now.”
(Boy, are we not going deeper into debt? Read on).
So, the banks take their mature securities to the public auction, and the Fed buys them at full face value. It buys them with newly created unbacked debt-free money (created out of thin air). And it might not buy them unless there is a recession or depression or threat of one. But I suppose the Fed cannot allow debts to go unhonored, so it buys them.
That purchase by the Fed redeems the debt of the gov’t to the banks. The banks no longer have the securities and the Fed now has them. But there is still a liability obligation in the securities the Fed now holds as a result of the exchange. The name of the holder of a security is never on the security. So, the liability at this point is only potential and not actual. The Fed can at this point swap the mature securities for new ones at the Treasury. (I don’t know what the Treasury does with the mature securities it gets back). The Fed will sell these to banks during inflations to drain their bank reserves.
But if the liability of the govt to pay the holder face value of the security at maturity is only potential since there is no eligible holder to be paid, why are these securities counted by the debt-ceiling law?
Is the Fed eligible for repayment for buying the security? Is it owed the full value of the security? No! The Fed is acting as an agent of the government here in these transactions involving government (newly created) money. It has no claim to be reimbursed for what it paid with newly created unbacked, debt-free money (made out of thin air). That would be like a bank clerk’s claim to be reimbursed for the securities it/she/he bought from a bank customer with bank money for the bank. Such a clerk would either be reprimanded or fired for such a claim.
But the Fed is owed now a transaction fee for the purchase of 6% of the interest on the security. Transaction fees are the way the Fed funds its operations. It keeps the Fed independent of political influence from Congress in its actions, because Congress does not provide it appropriations for the Fed’s operations.
(Well, since the Fed is a creation of Congress it still fears a more drastic action by Congress than simply withholding an appropriation. So it behaves in a manner that shows it knows its place. And if push comes to shove, it acquiesces to the Secretary of the Treasury).
But now note that with the gov’t’s debt to the banks for deficit spending money no longer exists. So the deficit spending money is debt free, as if the Treasury had made the money itself out of thin air with debt-free money. And with the fungible nature of money, the deficit spending money is equal to the money the Fed created out of thin air and deposited in the reserves of the banks that held the securities for the deficit spending. Can we now consider that the deficit spending money is like money created out of thin air, since it is equivalent to money so created and restored to the reserves of the banks by the Fed? (I need others to comment here). If so, why is there no inflation? Or is there? Why is there no inflation from QE2? All those gov’t securities were likely issued for some earlier deficit spending. Is deficit spending always irrelevant to inflation or deflation? It doesn’t seem plausible. But I leave that to others to ponder.
The third case is intragovernmental debt figured in the national debt. This pertains to government series bonds issued to government Trusts, like the Social Security Trust, for idle money it has collected that could be put into the general fund (and take the Congress off the hook for deficit spending). So, the Trusts take their money to the Treasury and get them exchanged for these government series bonds. They are unmarketable. Which means, the Fed cannot buy them directly. So, how does Treasury deal with them?. Well, it can issue and sell new marketable securities to the banks at public auction to cover the cost of paying the Trust Funds cash for their gov’t series securities. Oh, oh, more debt, you say, to the banks. Well, at this point the Fed can simply buy those securities with money it creates out of thin air and redeem that debt. But of course the securities so bought still have potential liabilities of the government, should these securities be put up for sale and sold. Or they can be swapped for new securities that could be sold. But currently sitting idle at the Fed, they do not constitute an active debt to anyone who has lent money to the government. So why are these securities counted in the debt-ceiling law?
The simplest thing we can do to resolve these questions is have the courts declare the debt-ceiling law unconstitutional because it limits and constrains an absolute power granted to Congress in the Constitution. If Congress can create limits on these powers it can do the same on any others in the Constitution and the Constitution is without teeth.
What a web! So it seems from what you say, the Fed is the creator of actual money. This money can be lent to the banks to keep their daily obligations solvent, correct? I’m assuming a commercial bank can lend money it does not have in reserves by borrowing “created” money from the Fed and this is how the money supply increases. The spigot is the Fed and the drain are loans to the private sector.
When the Treasury needs money beyond what is collected in taxes it just borrows from the private sector by issuing a bond, the private party’s “CD account” at the Fed – is that correct?
Trying to make sense out of such a twisted, opaque and failed system is only important if the goal is to understand how to, and to make the case to, dismantle it.
Yes, the Fed truly creates new money. Some will say that Congress does that by deficit spending, but in the end, because the Treasury has to borrow and cannot create money on its own, it uses securities, and banks buy them as the way to lend money to the Treasury for deficits. Yes, I think the Fed can create any money it needs to lend to banks who are short on their reserve requirements. But that is debt money. The Fed creates money without debt to anyone for it when it buys securities back from the banks with new money (created ex nihilo, from nothing). There is always the implicit debt of the government to its citizens who use the money to accept the money in payment of taxes, fines and fees for services. Deficit spending money ultimately does not vanish from the economy, although it may from circulation. When paid for by Fed creating the money, that cancels the debt of the government for the loan on the deficit.
Don’t confuse investors who buy US securities as safe, very low risk investments with banks that buy them to give Treasury money for deficit spending. They are two different things. So, in that case they are not like CD accounts, because the money could not be there to pay back the loan for deficit spending, unless the Fed creates the money to buy back the securities. The investors’ CD-like time deposit investments in securities always have their money in those accounts. These deposits are not used by the government for deficit spending. The government can get its own money for deficit spending, by issuing securities separately, and it can only get it for debts authorized by Congress. The money supply only grows temporarily when it is issued by banks as debt, because ultimately, when the debt is repaid the money vanishes. The money supply grows when the Fed adds money into bank reserve accounts at the Fed (that is where they are kept) for securities. But it can’t create inflation until that money leads to new bank lending to businesses.
Questions: So, from your description, if “the buck stops at the Fed” when they buy gov’t securities held by banks, and if the Fed never knocks on the Treasury’s door to cash them in, then there exists no debt to the government in practice?
Interest and security redemption is then never payed from the Treasury’s account at the Fed???
The only way the Gov’t can issue securities is through a spending bill mandating that the money be found through taxes or securities?
So if the tea party’s nightmare of us reaching the point where no one wants to lend to us were to come to pass, this would unveil the wizard behind the curtain, the Fed, who would then have to show its hand by directly depositing new money into the Treasury account without the charade shell game using securities?
Fed and Treasury coordinate their actions so as to maintain stable markets and a functioning banking system clearing operation. Beyond that, they do keep the books as if they were separate. When a bond held by the Fed matures, Treasury has to redeem it, just like one held by anyone else. Then, in order to maintain their interest rate target, the Fed probably has to buy another bond just like it.
And, at the end of the year, the Fed remits its profits (in excess of its statutory 6%) to Treasury, so on that day they do act like members of the same family: what’s mine is yours.
The only way Treasury can spend – and must spend – is by act of Congress. They must issue securities when they are required by Congress to spend in excess of tax receipts.
The Primary Dealers are obligated to make a market for new Treasury issues, so whatever Treasury needs to sell will be sold. The only question is the price / interest rate. If no one else wanted to buy short-term Treasuries, the Fed would buy them as necessary to maintain the overnight interest rate, the Fed Funds rate. Longer-term securities would find their own levels in the market, since the Fed doesn’t target their rates as such. If the yield curve were to become too steep, which is unlikely because it would present such a huge arbitrage opportunity, there is nothing to prevent the Fed from flattening it by buying longer-term bonds and notes.
Paul Lebow: “Questions: So, from your description, if “the buck stops at the Fed” when they buy gov’t securities held by banks, and if the Fed never knocks on the Treasury’s door to cash them in, then there exists no debt to the government in practice?”
The Fed is a government agency created by Congress with powers extended to it by Congress. It is unusual in that it is supposed to be independent of Congress and the Administration. It does not receive appropriations from Congress. Fed gets its funding from transaction fees, 6% of the interest on each security it buys. Terms of officers at the Fed are longer than those of the President. The Fed cannot buy securities directly from the Treasury. (It can swap mature securities for new with the Treasury. This may be how ultimately the government’s debt gets cancelled on the books). The Treasury cannot have an overdraft from its account at the Fed. To say that the Fed is owed for the value of the securities (the debt) is like saying that a bank clerk is owed the full price of the securities it has bought from bank customers with bank money. The Fed wants new securities to sell to banks during inflations to drain their reserves. The Fed is also a joint venture with private banks. But I think what they do privately is separate from what they do as government agents.
Lebow: “Interest and security redemption is then never payed from the Treasury’s account at the Fed???”
Why would the Fed be deficit spending if it already had the money in taxes and fees and fines to spend as authorized by Congress? The Treasury can always create marketable securities to raise money to pay interest on mature securities presented to it. But the Fed would be used to buy the securities used for this purpose when they mature. If it doesn’t they are being stupid. Something like that is what it would have to do to redeem the government series securities of the Social Security Trust Fund. The Fed cannot buy these directly (by law). But it can buy any marketable securities issued issued by Treasury and bought by banks, from the banks.
The Treasury often rolls-over the debt by swapping new securities for the banks’ mature ones. But each time there would interest to pay. The Treasury can always create an account at the Fed for interest payments. It can borrow money from banks with marketable securities for this and the Fed could buy back these securities from the banks when they mature again with money created out of nothing.
But the securities held by foreign investors are sold to them by the Fed, if I am not mistaken. So the Fed is directly in a position to create the interest when it returns the principal on their time deposits. (Some have said that the Fed destroys the investors dollars to avoid problems of storage. The Fed has a record of the deposit and can just recreate it when the time comes).
@”The only way the Gov’t can issue securities is through a spending bill mandating that the money be found through taxes or securities?”
Ultimately there will be some Congressional appropriation which justifies the Treasury spending money on it. I’m sure that there are routine debts that arise in the course of government operations that have a general authorization to be paid. If it’s a legitimate government debt the Treasury will seek to pay it.
Lebow: “So if the tea party’s nightmare of us reaching the point where no one wants to lend to us were to come to pass, this would unveil the wizard behind the curtain, the Fed, who would then have to show its hand by directly depositing new money into the Treasury account without the charade shell game using securities?”
It would help if the Fed would say as much about their operations. They use circumlocutions that disguise to some extent their creation of money out of thin air. When asked where the Fed gets the money to buy securities, Chairman Bernanke said, “the Fed just draws on itself,” or it “just makes digital entries into spreadsheets of reserves ” I think they are fearful of saying that they make money out of thin air and redeem the government’s debts for the government. That’s too stark. But there have been those individuals at the Fed who did say the Fed creates money out of nothing (ex nihilo). Congress ultimately might have some fools who would take that power away from them and immasculate the government. There would always need to be some agency of government which can create any needed money. If they take it away from the Fed, then Treasury would have to be restored the power to create money. Otherwise it would take a Constitutional Amendment because the power to create (coin) money is in Art. 1 Sec. 8 of the Constitution. And there is another power, to provide for the punishment of counterfeiting the Securities and coin of the United States. If coin has not been interpreted as all forms of money of the United States, then a lot of counterfeiters of $20 bills would not be prosecutable and thousands have been, and I’m sure someone tested the law to avoid going to jail, and they went to jail.
I think when the Fed swaps the mature securities it has for new ones with the Treasury, the Treasury gets back the mature securities and can extinguish formally the debt on the books. But effectively the debt to the banks has been cancelled when the Fed as government agent bought the securities from the banks. We now have fiat money. No gold backs the dollar. So the Fed does not have to look over its shoulder to see if the dollars it creates are backed by some unmonetarized gold in its vaults.
We don’t need to borrow from foreigners. We go to international money exchanges and bring dollars needed to pay for things in other countries’ monies. The exchange rate floats. It is not pegged to any foreign money. We can always create the money we need to exchange for foreign money at whatever the rate requires to buy their goods. Congress just has to authorize enough, if needs be.
Our government’s borrowing is different from our government’s offering the privilege of buying US T securities as investments in time deposits. The Investors’ dollars are being taken out of circulation in these time deposit accounts. That prevents their potentially creating inflation if they were being used to buy everything here.
It would be even neater if Treasury was given back the power to create money needed for deficit spending. But the banks want to get interest. And they would fight to the death, I think, if we tried to cut them out of the loop by no longer making it necessary for government to borrow money.
Right now, we have something like the Treasury being able to create the money. When the Fed buys the securities, the money they generated from the banks becomes debt-free. This money is also equal to the money the Fed created and deposited in the banks’ reserve accounts. So, in a way by the fungibility of money (money can be freely exchanged for other money) we can treat the Treasury’s money as if it is the new money created by the Fed. The banks are back to the way they were before they lent to the Treasury. The deficit money is now being spent and is debt-free. That’s what would occur with the Treasury issuing instead of Federal Reserve Note dollars, Treasury Note dollars.