An Explanation of the Federal Reserve Money system and what it means for the potential accomplishments of American Democracy
By J.D. ALT
Let’s begin by restating what I think was the main insight of PART 1: The overarching purpose of the Federal Reserve Act was to enable “money” to be created, as necessary, to support the scale of commerce that American Enterprise decides to undertake and accomplish. If the labor, materials, energy, technology, and ingenuity exist to do something—and it is desirable that it should be done—it is illogical to say it can’t be done because there isn’t enough “money” in the system to pay for the doing of it.
The only questions to be asked, then, are two: (1) Who will create the “money” when it’s needed, and (2) Who will decide when the creation of additional “money” is justified?
Regarding the first question, since the Reserves used today are “fiat money,” their only source is a sovereign government. In our case, the authorized agent of the U.S. government, for this purpose, is the Federal Reserve. The FED, then, creates all Reserve fiat dollars (with keystrokes to an electronic balance sheet) no matter for what purpose. No one else is authorized to do so.
Regarding question No. 2, there are two answers, depending on whether the new Reserves are needed for private enterprise or public enterprise. What we’ll explore now are these two very different rooms under the roof of our Federal Reserve edifice. While they have connecting hallways, and many of the occupants wear two hats, they serve two distinctly different needs of our collective society.
Private and Public Enterprise—An American Partnership
The distinguishing thing about private enterprise is that its guiding principle is to make a financial profit. In the process of doing so, it provides a great diversity of goods and services that people really need, enjoy, and benefit from. But those beneficial goods and services, wonderfully important as they are, constitute a by-product of private enterprise’s underlying motive. This fact becomes apparent when you consider that if a good or service cannot be produced profitably (even if it is arguably beneficial or desirable) private enterprise will not produce it. Or, if a produced good or service proves to be unexpectedly unprofitable (even though beneficial) private enterprise will cease producing it. This is not because private enterprise is “greedy” or uncaring—it’s simply an implicit structure of private enterprise’s nature.
This implicit structure of private enterprise gives rise to the need for public enterprise—the undertaking of things that are beneficial (even existentially essential) for the collective good, but which do not, or cannot, produce financial profits. This includes goods and services which, to be profitable, demand prices that large segments of society cannot afford to pay. Public enterprise also undertakes beneficial things which may, someday in the future, become a profitable enterprise, but which, in their exploratory or start-up stages, involve too much financial risk for private enterprise to undertake.
Private and public enterprise share certain things in common. First, they share access to the real resources necessary to provide goods and services: labor, technology, materiel, energy, specialized skills, etc. Each of the enterprises pays money to marshal these resources to achieve its goals. Private enterprise hires American workers to build things and do things—and public enterprise does the same.
The two enterprises also share the same source of money used for the paying—the Reserve fiat dollars issued by the Federal Reserve. Private enterprise creates claims on those Reserves with bank-dollars (please see PART 1), while public enterprise spends the Reserves directly. (When public enterprise spends directly, the U.S. Treasury—the spending arm of the federal government—causes Reserves to be credited to the Reserve account of the bank associated with the spending recipient; in turn, the recipient’s bank credits bank-dollars to the recipient’s checking account.) Private and public enterprise, then, both depend on Reserves for their spending; each, however, has a different process by which it “calls for” the Reserve dollars it requires.
How private enterprise accesses Reserves
If private enterprise sees a lot of opportunities to spend money for profit-making ventures, and the banks agree the opportunities look good (meaning they will likely make profits as well), the banks create bank-dollars and loan them to private enterprise to undertake the ventures. The banks don’t calculate, first, whether they have enough Reserves to support the claims those new bank-dollars will make on their Reserve account at the FED. They make the loan first, and then later (if necessary) borrow any additional Reserves necessary to cover the claims.
In aggregate, then, the private banks decide how many bank-dollars are issued (based on their calculations for potential profits) and the FED responds by creating any new Reserve fiat dollars necessary to cover the resulting “clearing” processes in the system. The new Reserves are issued by the FED in exchange for collateral from the private banks. The collateral is held by the FED on what is known as its “balance sheet.” If it “expands its balance sheet,” it is creating new Reserves. If it “winds down” its balance sheet, it is trading collateral for existing Reserves—which it then simply “cancels,” erasing them from the system. (We’ll take a closer look at this odd-seeming cancelation of Reserves later.)
As we noted in PART 1, banks are able to leverage the creation of many more bank-dollars than they have Reserves to back them up. The FED, then, is only required to issue new Reserves if that leverage changes. One thing that would change the leverage is if private enterprise in America decided to expand its profit-making ventures—and the banks obliged by creating new bank-dollars exceeding the Reserve capacity of the aggregate “clearing” process. When that happens, the FED, as a matter of course, issues the new Reserves that are necessary.
How public enterprise accesses Reserves
In the same way that private enterprise can “call upon” the FED to issue new Reserves to accomplish its goals, public enterprise can do the same. It goes about doing this, however, in a different way.
The public enterprise process begins with the U.S. Congress—representing the democratic will of the American public—voting to undertake the production of some specified goods or services which benefit the whole society. (By implication, as already noted, these are goods or services which private enterprise deems unprofitable to produce.) Congress “appropriates” new dollars to be spent for the stated purpose. As the spending agent for Congress, the U.S. Treasury then sets about acquiring the new dollars that Congress has directed it to spend. It does this in coordinated partnership with the Federal Reserve system.
This is one of the most labyrinthine parts of our edifice’s corridor system—and one of the most interesting. So, now we’ll slow down to appreciate it. (Hold tight to your brain-handles again!)
As we’ve noted, just like each of the private banks in the Reserve system, the U.S. Treasury has a Reserve account at the FED. This is the federal government’s spending account. Where do the Reserves in the Treasury’s spending account come from?
As we all know from personal experience, some of the Reserves in the Treasury’s account come from our payments of federal taxes. In PART 1, we saw how writing your check to the IRS enables you to make claims on your bank’s Reserve account at the FED, causing some of your bank’s Reserves to be debited from its account and, in turn, credited to the Treasury’s Reserve account. So that’s how the Treasury gets some of the spending money it needs when Congress gives it the order to buy goods and services for a specified goal of public enterprise.
But Congress, as we all know, typically asks the Treasury to spend a great many more Reserves than it has collected in taxes. (This, it turns out, is a necessity entailed by the unique evolution of the needs of modern society—a topic which will be a primary focus of PART 3 of this essay.) For now, we’ll just focus on the fact that, by virtue of Congress’ appropriations, the Treasury is compelled to acquire a substantial amount of additional Reserves—beyond what it has collected in taxes—in its spending account at the FED. The Treasury doesn’t say to Congress, “Oh, sorry, we don’t have enough dollars to pay for that!”—just like the private bank doesn’t say to a well-heeled loan applicant, “That’s a great business proposition and resume, but we’re simply out of money at the moment!” (If you’ll notice, the Treasury only claims it’s about to run out of dollars when small-minded politicians play small-minded games to gain some small-minded advantage on the political stage.)
Instead, when the Treasury is directed to spend more dollars than it has collected in taxes, it simply instigates its own unique process within the Federal Reserve System which compels additional Reserves to be credited to its spending account. Here’s how it works:
The Treasury issues something which it uniquely has the capability of creating: a believable certificate of future Reserves called a “treasury bond.” This action commands a few moments of our attention: Anyone can create a “bond”—a written promise to pay a certain amount of dollars at some point in the future. But, for obvious reasons, not everyone’s such promise is equally believable. A corporate bond, for example, depends on the corporation’s ability to generate future profits to keep its promise. “Junk bonds” are promises made by businesses who pose a substantial risk that they won’t be able to produce those profits necessary to redeem the bond.
A treasury bond, in contrast, is not a promise that depends on future profits at all, but only on the legal authority of the FED to issue new Reserves. But how are the future Reserves of the treasury bond converted into present Reserves in the Treasury’s spending account?
The Treasury, working in tandem with the Federal Reserve system, trades its future Reserve bonds for present Reserves, which are then credited to its spending account. This “trading” occurs on what is called an “open market”—which simply means (a) the entities are doing the trading voluntarily, and (b) the FED is not participating directly in the trading (bypassing the voluntary participants). Some of the present Reserves the Treasury receives in trade are new Reserves, created by the FED, and some of them are existing Reserves that were residing in the various banks’ Reserve accounts.
Again, this requires a moment of our attention on two fronts: (1) Why would private banks want to trade their existing Reserves for future Reserves? (2) If the FED is not allowed to participate directly, by what process do the FED’s new Reserves make their way into the spending account of the Treasury?
To answer these questions, lets observe a treasury bond issue operation from where we now stand—at this particular intersection of corridors in the Federal Reserve edifice. This is an important moment, so get your camera out if you want to take pictures.
The first thing we notice, over in the direction of private enterprise, is that there are a lot of bank-dollars in private checking accounts that aren’t needed for rent, or car-payments, or groceries. They’re surplus bank-dollars that are looking for a safe investment to hide in until, someday in the future, they need to be spent for something. Where are those bank-dollars going to hide?
Some of them will hide in the stock-market, but that’s a bit scary. A lot of them, in fact, will want to hide in the future Reserve treasury bonds the Treasury is getting ready to issue. When the Treasury issues its bonds, then, there is typically a substantial interest over in private enterprise to trade some of its bank-dollars for treasury bonds. As we know from PART 1, these bank-dollars are claims on existing Reserves at the FED. When the trade is made then, the claimed Reserves, represented by the traded bank-dollars, are credited to the Treasury’s spending account.
It’s important here to note three things: (1) This is a completely voluntary action on the part of private enterprise. It is done purely out of self-interest, for the purpose of putting its surplus bank-dollars in a super-safe hiding place. (2) While the action is done out of self-interest, however, there’s an unnoticed “elephant in the corridor” as a result: By the act of trading existing Reserves for future Reserves, private enterprise is, in fact, INVESTING in the goals and undertakings of public enterprise. This “elephant,” I think, is something you want for sure to snap a picture of! (3) In the bond-issue operation we’re now observing, the Treasury is needing to trade $30 billion in future Reserves for $30 billion in present Reserves—but private enterprise has only ponied up $10 billion. Where will the additional $20 billion come from?
The FED has a group of its largest private banks—called “Primary Dealers”—with which it has a special set of arrangements. Specifically, the Primary Dealer banks are the ones who manage the trades between the future Reserve treasury bonds and the existing bank Reserves. As part of the “arrangement,” it is understood that if all the Treasury’s bonds are not spoken for, some further trading is instigated, which the Primary Dealers participate in. Namely, the following:
- The Primary Dealers trade collateral to the FED for new Reserves the FED issues specifically for the purpose. (In the operation we’re presently observing, the FED issues $20 billion in new Reserves in exchange for the collateral.)
- The FED now has on its balance sheet the Primary Dealers’ collateral, and the Dealers have in their Reserve accounts $20 billion new Reserves.
- The Primary Dealers then trade the $20 billion new Reserves to the Treasury for the remaining $20 billion in future Reserve treasury bonds that have not been claimed by private enterprise—thus crediting the Treasury’s spending account with the balance of the $30 billion it needs to meet Congress’ spending directive.
- The Primary Dealers then trade the newly acquired $20 billion in future Reserve treasury bonds to the FED—in exchange for the collateral they initially posted to start the operation.
There’s one final thing to get your camera ready for: The FED now has on its balance sheet not the collateral of the Primary Dealers, but the $20 billion in future Reserve bonds issued by the Treasury. The FED holds these future Reserves on its balance sheet until the bonds mature—at which point the future Reserves must be made into present Reserves. What does the FED do then?
It ought to do something that, on its face, seems rather silly: It ought to issue $20 billion in new Reserves and pay them to itself (since it is holding the bonds that just matured). But the FED has no need for Reserves because it is not a “spender” of Reserves, but only the “issuer” of Reserves. The FED doesn’t even have an account to keep Reserves in—for the simple reason that when the system calls for new Reserves, it is authorized to issue them by pushing buttons on an electronic keyboard. To keep from looking silly, then, trying to deal with something it has no need for, nor any place to keep, the FED simply cancels the treasury bonds it is holding—and the $20 billion in future Reserves are never made “real.”
The same thing happens when the FED “winds-down” its balance sheet (as we observed earlier)—trading collateral it has received in exchange for Reserves in the private banking system: The FED simply makes the trade, then cancels the Reserves it has received—essentially “reincorporating” them into its mandate to create Reserves as necessity (and either private or public enterprise) calls for.
End of tour
There’s not anything further we really need to see on our tour of the Federal Reserve money system. We’ve observed all that’s necessary, I think, to now have (in PART 3 of this essay) a meaningful discussion of what’s REALLY important: why we can, in fact, as a collective society, “afford” to pay ourselves to undertake and accomplish what’s necessary to actually address the five, money-intensive, life-defining dilemmas America now confronts: (1) climate change (2) healthcare (3) student debt (4) early child-hood care and development (5) affordable housing. Please feel free, by the way, to add to this list—but before we argue priorities, let’s understand and agree that we unequivocally DO have the financial resources, as a democratic society, to confront them.