ZEN and the Art of the Federal Reserve System


I know nothing about motorcycles, and not much more about the U.S. Federal Reserve system—yet I feel compelled to dismantle, pick apart, and understand the latter for the simple reason that it seems to be a machine I’ve been riding on (and vaguely writing essays about) for some time now. So, it stands to reason I shouldn’t be ignorant of it. Not that I would get much help in this effort from American economists. Indeed, they seem intent on keeping the mechanism under wraps—as if it were a proprietary secret which they can only refer to in code. Or, perhaps, they are just the kind of bikers who leave it to their mechanic to know how the carburetor works. There are a few exceptions—one being Eric Tymoigne who saw fit to post a kind of on-line parts manual for anyone who wants to take the time, and make the mental effort, to figure the machine out. So, I have the parts spread out now on my workshop floor. Here’s my own interpretive consideration, thus far, of what I’m looking at:

Three Dollars

There are not just “U.S. dollars,” but three kinds of dollars—or, perhaps a better description: there are three “states of existence” a dollar jumps back and forth between. The most fundamental state of a U.S. dollar is as a “reserve” in the Federal Reserve banking system. “Reserves,” as they’re commonly referred to, are what you might think of as “real money”—the “actual thing” of which the other two states are what I’m perceiving to be “pre-reserve” and “post-reserve” variations.

Once upon a time, half a century or so ago, “reserves” were associated with gold specie that U.S. dollars were defined as being equivalent to. “Reserves” are no longer associated with gold—or any precious metal, or any other “thing”—but are simply “reserves” that are issued by the U.S. Federal Reserve as needed. (Since the Federal Reserve is uniquely authorized by the sovereign government to create “reserves,” they could rightly be called “fiat reserves” in that their authorization is created by a decree of the sovereign.)  Each bank in the Federal Reserve system maintains an account at the Federal Reserve which contains that bank’s “reserves.” Keep in mind that, in this form, these “reserves” are just numbers on a balance sheet.

The “post-reserve” state

The second “state” a U.S. dollar can jump to is a “bank-dollar” in a savings or checking account. It is crucial to see that a “bank-dollar” in a checking or savings account is not, itself, a “reserve” but, instead, is a claim on the “reserves” held by that bank. You can exercise that claim by withdrawing U.S. dollars from an ATM machine (printed U.S. dollars are “reserves” in a paper form). Most of the checking and savings account bank-dollars, however, are never converted to cash, but are, instead, exchanged back and forth within the Federal Reserve banking system in the form of check-writing and electronic payments and transfers. In other words, while they are a claim on the banking system’s “reserves,” the claim does not need to be exercised for the bank-dollar to be spent by the owner of the bank account.

When Bank A in the Federal Reserve system issues a loan, it makes a deposit in a Bank A checking or savings account. In other words, it increases the bank-dollar claims on the “reserves” that it holds. When a check is written, and then deposited in another account at the same Bank A, nothing much transpires: bank-dollar numbers are subtracted from one account and added to another. When a check is written and deposited in an account at another bank—Bank B—something else happens: Bank B, at the end of the business day, exercises a claim on the “reserves” of Bank A for the dollar amount of the check. To reconcile the transaction, Bank A must then transfer “reserves” from its account at the Federal Reserve, into the reserve-account of Bank B. This “clearing process” happens millions of times at the end of each business day at the Federal Reserve. For the system to work—for the “machine” to run—it is an absolute requirement that every check, and every electronic transfer, “clear.”

The banks in the Federal Reserve system decide how many claims they want to have against their “reserves” by controlling the number of loans they issue. If private commerce is in an expansive mood, and there is a lot of demand for loans to finance business ventures and consumer purchases, a bank may well decide to take advantage of the profit-potential and make a lot of loans, thereby increasing the claims on its “reserves.” Where this is the case, at the clearing process at the end of a business day, the bank may well find that claims against its “reserves” exceed their capacity to make good on the claims. (The bank is required by law to maintain a certain amount of “reserves”—so their capacity to fulfill claims is reached long before they’re drained to zero.) When this occurs, the bank must borrow “reserves” from another bank, or from the Federal Reserve itself.

But the “reserve” accounts of the Federal Reserve banks are always growing, as well. This is because when the U.S. government authorizes its Treasury to spend dollars for any purpose—say, to make a Social Security payment—the Treasury’s spending results in two deposits: the first deposit is in the bank-dollar account of the person receiving the SS check; the second, equal, deposit is in that bank’s “reserve” account. Federal spending, then, increases the claims on bank “reserves”—but also increases the “reserves” themselves by an equal amount.

The “pre-reserve” state

The third “state” a U.S. dollar can exist in is as a “future reserve” embodied in a U.S. treasury bond. Treasury bonds with short maturities are called treasury “notes” or “bills”—but they’re all the same thing: a container of “reserves” which can be opened at some specific date in the future. Treasury bonds are not issued by the Federal Reserve, but by the U.S. Treasury, which is uniquely authorized by the sovereign government to issue them. Why would the Treasury issue a treasury bond? Why are they necessary?

A primary reason is because very often the Treasury is directed by Congress to spend more dollars than are tallied to exist in the Treasury’s spending account (which consists, basically, of the “tax-dollars” which have been credited to it). To keep its checks from “bouncing,” the Treasury adds to its spending account by issuing treasury bonds. This happens through a coordinated effort with the Federal Reserve system, as follows:

The Federal Reserve arranges for a bank in its system to trade some of its “reserves” in exchange for the treasury bond. After the exchange is made, the Treasury now has the dollars it needs to spend, and the bank has the “future reserves” (the treasury bond) in its reserve-account at the Federal Reserve. Next, the Federal Reserve—which is the only entity authorized to create “reserves” out of thin air—creates and trades new reserves to the bank in exchange for the treasury bond. What is the end result of these operations?

  1. The Treasury spends more dollars than it collects in taxes.
  2. The Federal Reserve bank system has the same number of “reserves” it started with.
  3. The Federal Reserve has a treasury bond on its balance sheet.

Is that “printing money”? Has the federal government “borrowed” money from somebody? Has the United States gone into “debt”? I’ll let you decide. I’m still parsing all these parts on my workshop floor before I put the machine back together to go riding again. I’m open, of course, to assistance and suggestions. There’s a pile of parts, I’m noticing now, that I haven’t even considered yet.

21 responses to “ZEN and the Art of the Federal Reserve System

  1. The first step in understanding the monetary system is to kick the bookkeepers out of the room. They do not have the tools to deal with an entity that creates money. They are needed and do a valuable job for entities that use money but are disruptive and cloak the actual facts with an entity that creates money. I’ll quote a simple example. In 2016 the quarter dollar coins minted by the US Treasury had a face value of about 400 M$ in excess of the cost of minting them. That 400M$ was “real money” and it was spent into the economy but it was not borrowed nor covered by tax “revenue.” I would challenge you to find that 400M$ on the 2016 books. It is there but cloaked and hidden. The greatest misdeed committed by bookkeeps is identifying taxes as revenue. Beardsley Ruml nailed it in 1946; taxes are not revenue since FDR put us on fiat money. Labeling taxes as revenue distracts us from the actual function of taxes as well as the governments capability to create money. The recent proposal for a 70% marginal tax on incomes in excess of 10M$ is an example. As has been pointed out, the taxes raised by the tax are not that significant but what the tax will do is essentially cap wages, a much needed action to restore a semblance of equality in our nation.

    • Since the federal government was unlikely to have spent quarters, were the quarters not delivered in exchange for reserves to commercial banks for public distribution ? This would indicate these funds are not new money spent into the economy.

      • Sure. In that case the quarters have been spent to buy reserves. The treasury does not give away coins like they give away Fed Reserve Notes. Coins are real money. Remember the discussions about Joe Firestone’s proposal to mint T$ coins?

        • I wish someone would give me Federal Reserve Notes, but they won’t, even if I was a bank. If you want Federal Reserve Notes (or quarters, as Larry K notes above) you have to pay for them with reserves.

      • Neither the Treausy nor the Federal Reserve give away Federal Reserve Notes. When the government spends into the economy, it is buying goods and services (for the most part). Nickels are no more real money than Federal Reserve Notes. Try recycling the material in a nickel. You won’t get 5 cents.

  2. Thanks for a simple and direct explanation of fundamental aspects of the federal reserve system. Now that we’re off the gold standard and well into the territory of fiat money, do you see the entire federal reserve system as anything other than a cumbersome and obfuscating accounting system? The MMT economists I’m most familiar with tend to view it somewhat in this manner, as best I can understand them. Are you suggesting that the federal reserve system actually enhances the appropriate flow of fiat money through the economy, unduly constricts it, or operates in both ways simultaneously? I look forward to your follow-up analysis, which I hope will get into such questions. We may well have to live with the federal reserve system pre-revolution, so to speak, but it’s best to know the true nature of the beast we’re forced to live with, its good points (if any) along with the bad.

  3. I like your little story. So don’t construe my following comments as an attack on your story.

    However, I don’t think I should keep quiet about problems I see just so I won’t hurt your feelings. I judge that you are adult enough to take a little criticism, and put it in perspective.

    The Federal Reserve buys only a fraction of the Treasury securities that the Treasury issues. Your description leaves out the Treasury Securities actually bought by the private sector. When you make a too facile explanation of something like this, you leave yourself open to a rebuttal. Then you have to admit that you left a little something out. Once you made a little fudge, you leave yourself open to the usual attorney’s ploy in trying to discredit a witness, “Were you lying then, or are you lying now?” For a little temporary gain, you have put your whole argument under a cloud. I wish people wouldn’t do that. With just a little thought you could have put in a few words to cover the whole picture.

  4. What happens when the T bond matures?

    • At the level of an individual bond, when a bond matures the bondholder’s asset (credit) and the Government’s corresponding liability (debt) are moved out of a bond account and into a reserve account. This just reverses what happened when the bond was sold: the buyer’s assets (and the Government’s liability) moved out of a reserve account and into a bond account.

      It’s like what happens when a commercial bank CD matures. Your bank transfers money from your CD account to your checking account, just reversing what happened when you bought the CD. (Wanna guess what happens when the bank sells you a CD? Often it just turns around and buys a T-bond with the money. Easy profit for the bank, because the Treasury pays the bank more than the bank pays you.)

      Looked at from the level of bonds in the aggregate, the Treasury rolls maturing bonds over into new bonds.

  5. I tend to prefer Ellis Winningham’s framing of a dollar as just a unit of measure.

    I also tend to like to explain that there is functionally no difference between creating dollars and creating bonds except the interest, and that the interest rate is a policy variable that the fed can control. Like the BOJ has been doing for the last few years with “QQE with Yield Curve Control” https://www.boj.or.jp/en/mopo/outline/qqe.htm/

  6. The Federal Reserve Bank is a bank: it does what all banks do, which is swap promissory notes. For example, you sign a note promising to pay your bank so many dollars a month for some time, and in return your bank creates a deposit to your credit which enables you to purchase a car or a house. (A deposit is not a pile of money in a vault somewhere, it’s a promissory note from the bank. Both the bank’s promissory notes and yours are payable in Government dollars or with another bank’s promissory note.)

    The Federal Reserve Bank mostly swaps US Government promissory notes. It swaps its own promissory notes (reserves, or paper notes if desired) for Treasury promissory notes (Treasury bonds) held by the commercial banking system, and sometimes it does the reverse; it swaps Treasury bonds it holds for reserves held by the banking system. The purpose of the Fed’s swaps is to adjust the amount of reserves held by the banking system up or down, in pursuit of its money supply and interest rate policies. By law, the Fed is not permitted to swap its promissory notes directly with the Treasury, it must conduct these swaps on the open market.

    The Money & Banking tab at the top of the home page has a lot more details.

  7. financial matters

    As you state ‘as if it were a proprietary secret which they can only refer to in code.’ there is unnecessary obfuscation.

    I think it’s important to understand the parts but I think one of the triumphs of MMT is to state that the Fed and Treasury essentially act as one body. As you state ‘To keep its checks from “bouncing,” the Treasury adds to its spending account by issuing treasury bonds. This happens through a coordinated effort with the Federal Reserve system’

    And the Fed was created by or in other words is a ‘creature of Congress’.

    Now if only campaigns weren’t financed by the financial and corporate sector.

    Which takes us back to one of the main points of MMT. The government ‘creates’ money and can use it for the public good (the real economy) just as easily as it can use it to fund wars, bail out the financial sector and pump up the real estate market and the stock market.

  8. I tend to prefer Ellis Winningham’s framing of a dollar as just a unit of measure.

    It is that and more. It is not just a unit of measure. How many loaves of bread can you buy with another unit of measure like the inch?

  9. I downloaded a pdf of Mr. Tymoigne’s book last week and have been reading the first five chapters, which I want to fully understand before I get into the next section on Leverage. Your post was good, and shows another way of entering this material.
    I have a question about your statement at the end, “the Federal Reserve bank system has the same number of ‘reserves’ it started with.” In the paragraph just before that you say, “the Federal Reserve . . . creates and trades new reserves to the bank in exchange for the treasury bond.” It seems to me that there would be more reserves in the system, not the same number as before the bond sale and exchange. What happened to the new reserves the Fed created?

  10. Craigh, yes, but the Fed pays the BEP the cost of printing only for Federal Reserve Notes. A 100$ bill costs the Fed about 15 cents and they can buy more with what is left over. It is just a continuation of what they did from 1913 to 1933 when gold was money. The Treasury printed the gold certificates for banks for free. After all, they were only paper; the gold backing them was the money.

    • A $100 Federal Reserve Note is worth $100 because if you return it to the Treasury they will knock $100 off from what you owe in taxes. But the note has no intrinsic value, and what it costs to print is irrelevant. The Treasury for its part is as like as not to then just throw it in the shredder. And gold or any other commodity is no longer involved in any of this.

      If you don’t need it to pay taxes you can trade it to someone else. The value of what you trade it for is strictly between you and the other person.

  11. Looked at from the level of bonds in the aggregate, the Treasury rolls maturing bonds over into new bonds.

    Rolling over bonds is what the Treasury does in the current environment. This is not a law of economics. Think about what could happen if the Treasury couldn’t roll over its bonds. Think about what might cause this problem of no longer being able to rollover. This is a good exercise for stretching the imagination.

  12. I see little chance of that happening for a very simple reason. The deficit spending requiring the sale of treasuries creates more idle cash and treasuries are the home of choice for idle cash

  13. The deficit spending requiring the sale of treasuries creates more idle cash and treasuries are the home of choice for idle cash

    That depends entirely on how the deficit is created. If the government has a deficit because it buys stuff from people that become employed to produce what the government wants, it is not idle cash for at least one round of spending. If the government runs a deficit because it cuts taxes to the wealthy, then, yes, it goes mostly to idle cash which the rich give right back to the government in the form of buying government bonds.

  14. Creigh, you are trying to deny the existence of seigniorage and it is real. Lincoln’s greenbacks, US Notes, coins (dimes and quarters) all had seigniorage and the budget could be balanced with seigniorage in addition to taxes and borrowing.

    • Charles, I’m not denying that seigniorage is real, I’m denying that it is relevant. If the money issued by the US was backed by a commodity of intrinsic value, then we could talk about seigniorage being relevant, as in a coin containing metal of less value than its face value. But the US government’s money isn’t backed by any physically existing substance. The government’s money is backed only by a requirement that its own money be remitted as payment of taxes–under threat of force, if it comes to that.