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:
STEP 1
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?
STEP 2
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?
STEP 3
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.
STEP 4
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.
After reading this Part 2, I hope that readers are thoroughly disgusted with the current system. Anyone could come up with a more transparent, honest and efficient system than the nightmare described above.
I do want to point out the the above explanation directly conflicts with the MMT story that claims taxes do not fund spending. In addition, one can see that the explanation shows how the current Fed operations successfully obscure the reality – it took several pages to describe government borrowing!
The implication is that somehow, indirectly, the Fed is funding government spending – this is incorrect. Until recently with Quantitative Easing, the Fed held very few government bonds as assets and is not a significant funder of government spending. Congress explicitly did not want to give the central bank that power. Its operations, as MMT points out, are designed to smooth the interbank flow of reserves by providing a buffer and source of reserves to meet reserver requirements.
I really would suggest people step back to get a bigger picture on how money works and, more importantly, how it could work. For instance look at a very readable “Sovereign Money” by the economist Joseph Huber
https://www.amazon.com/Sovereign-Money-Beyond-Reserve-Banking/dp/3319421735
This wonkish fascination with the byzantine Fed system is interesting but offers no solutions.
Very well done but I think the explanation of Reserves can be simplified.
In my mind, the distinction between future reserves and current reserves is very confusing. There is a more direct way to explain, avoiding future reserves.
The more direct way is to let both private banks and the CB accept government bonds as collateral for reserves. By accepting this logic, private banks are found to lend existing reserves to government, in trade for a new bond that is as good as fiat money collateral can be. Government has just created new reserve collateral equal in value to the amount of reserves borrowed.
Still accepting this logic, the CB, when lending to government, takes a new government bond (new reserve collateral) and gives government new reserves. Logically, the single transaction has created TWO reserves units (the new bond AND the new reserve units).
Everything is done in real time without distinction between current reserves and future reserves.
Following this logic, I think we reach the same conclusions. Government, acting through the CB, can borrow reserves without limit. Limits from other aspects may be present, but obtaining more fiat money is always achievable.
I grant you understand the system, J.D., but what you don’t seem to understand (or don’t care about?) is how unjust it is:
1) The debt of a monetary sovereign, including account balances at the Central Bank (“reserves” when the account holder is a depository institution), is inherently risk-free and should return, at most, ZERO* percent. Otherwise we have welfare proportional to account balance. And forget an appeal to real interest rates or yields since the richer have no more right to be protected from price inflation than the poorer and, arguably, LESS.
2) So-called “private” bank money is backed by government privilege:
a) Only depository institutions may use the Nation’s fiat in account form at the Central Bank, not the non-bank private sector, including individual citizens
b) government guarantees on private, including privately created, bank deposits/liabilities for fiat
c) Central Bank lending to depository institutions.
d) Central Bank asset buying from depository institutions and the private sector.
Also, you might consider that all the problems you wish to solve with “the people’s money” have a single root cause which is economic injustice – a major part of which is the “money” system which is itself an obsolete relic of the corrupt Gold Standard.
*Actually NEGATIVE if overhead costs are subtracted with shorter maturities costing more (more negative interests or yields) with fiat account balances at the Central Bank costing the most, having zero maturity weight. But with this exception: Individual citizens have an inherent right to use their Nation’s fiat for FREE up to a reasonable account balance.
There is a third thing necessary to resolve the monetary and economic problem and that is to ask ourselves if the current monetary, financial and thus economic paradigm of Debt Only needs to be changed to Abundantly Direct and Reciprocal Monetary Gifting at the point of retail sale with a monetary policy of a 50% discount to consumers that is reciprocally rebated back to enterprise gifting it to the consumer.
MMT and all of the other leading edge heterodox reforms surround and analyze the current monetary paradigm, but lacking the new but centuries long hiding in plain sight insight of the significance and power of such a monetary policy at retail sale/the terminal ending point of the entire economic/productive process….fail to comprehend the above paradigm changing policy and the singular concept that characterizes any and every new paradigm. Strategically integrate sufficient direct and reciprocal monetary gifting into the economy at its terminal ending, summing and factor expressing point and you solve the economy’s deepest and most long standing problems of 1) individual income and systemic monetary austerity and 2) chronic price and asset inflation….and you resolve it for all economic agents individual and commercial.
A paradigm is a SINGLE concept that transforms and creates an entirely new PATTERN. Thus it, itself, is the phenomenon of the integration of the opposites of singular and plaural, part and whole. Think integratively/paradigmatically and study the signatures of all historical paradigm changes.
I’m a virtual illiterate in these money matters, but if I’m reading you right, Mr. Alt, the process by which the Fed creates the money needed for public spending is a gift to private banking. It could simply deposit Reserves in the Treasury, but instead it goes through a byzantine process which must have been designed to fatten the profits of the bankers. Am I right?
Eugene –
Its all “inside baseball”. Please understand that, by law, the Fed does not fund government spending. Funding is accomplished by taxing and borrowing (selling Treasury bonds to the wealthy, institutions, foreign governments, retirement funds, etc). The interest paid on these bonds must be paid either via taxes or by rolling over debt just to pay interest. It is a sick system that doesn’t require literacy in the byzantine workings to see. Your gut is right on.
Nowhere in this explanation are presented the solutions that many leading economists have proposed over the last century to fundamentally change the monetary system to be transparent, fair, democratic and beneficial to society. I wish Mr. Alt would devote his writing skills to that.
Paul –
Your claim on the Fed’s funding of the Treasury is not accurate.
The following is a breakdown of publicly held debt (the additional debt is intergovernmental);
“The most recent complete breakdown from the U.S. Treasury is as of June 2018. The public debt was $15.6 trillion. It’s in the Treasury Bulletin, Ownership of Federal Securities, Table OFS-2. Here is the breakdown:”
Foreign – $6.2 trillion. In June 2018, China owned $1.18 trillion of U.S. debt and Japan owned $1.03 trillion. That’s more than one-third of foreign holdings.
Federal Reserve – $2.46 trillion.
Mutual funds – $1.8 trillion.
State and local government, including their pension funds – $984 billion.
Private pension funds – $600 billion.
Banks – $674 billion.
Insurance companies – $226 billion.
U.S. savings bonds – $158 billion.
Other holders such as individuals, government-sponsored enterprises, brokers and dealers, bank personal trusts and estates, corporate and non-corporate businesses, and other investors – $2.4 trillion.”
( from ‘Who owns the US National Debt’ https://www.thebalance.com/who-owns-the-u-s-national-debt-3306124 )
Then too, from Investopedia:
“The Federal Reserve and the Department of the Treasury are linked in another way. The Federal Reserve is a nonprofit company (see “Who Controls the Federal Reserve Bank?”) After its expenses are paid, any remaining profits are paid to the Department of the Treasury. The Department of the Treasury then uses that money to fund government spending. It’s a relationship that produces a considerable amount. The Federal Reserve System contributed over $80 billion to the Treasury in 2017, according to the Federal Reserve Board (FRB). So, the Federal Reserve not only helps to make and implement policies, but it also serves as the government’s bank and generates a portion of the revenue used to fund the country’s activities.”
The Federal Reserve System contributed over $80 billion to the Treasury in 2017, according to the Federal Reserve Board (FRB). So, the Federal Reserve not only helps to make and implement policies, but it also serves as the government’s bank and generates a portion of the revenue used to fund the country’s activities.” Ray Love [bold added]
If the Fed owns $2.6 trillion in US Treasuries then an average yield of just 3% means the Treasury pays the Fed $78 billion/yr which is quite close to the ~$80 billion/yr the Fed pays the Treasury.
So it appears to me that the net contribution of the Fed to the US Treasury is a mere $2 billion/yr or so. Am I wrong?
This is not to say the Fed does not fund the Treasury indirectly (but in the process providing welfare for private interests such as primary dealers, the banks and the rich) by buying US Treasuries from the private sector.
Ray –
Appreciate your reply. Don’t confuse the $2.4T which was created by the Fed during Quantitative Easing with funding the government. They were created specifically to bolster bank reserves. Look at the historical bond holdings of the Fed prior to the global financial crisis of 2008 – very little. Congress specifically wrote the legislation to prohibit direct Fed funding of government spending. You are misreading the Investopedia article, they are referring to profits obtained by the Fed go to the Treasury. In addition, the Treasury Bills that the Fed holds are part of the government debt and have to be repaid – its not free money.
If you think about it, if the Fed could just create money to fund the government, why would we need to borrow in the first place?
Having said this, many leading economists want legislation to allow a governmental agency to have the power to create money for spending (see 2012 HR 2990 https://www.congress.gov/bill/112th-congress/house-bill/2990) often referred to as “sovereign monetary reform”. This would vest the power to create money with the people. Currently all money in circulation is created by banks when they lend (see for instance the Federal Reserve pamphlet “Modern Money Mechanics” – https://upload.wikimedia.org/wikipedia/commons/4/4a/Modern_Money_Mechanics.pdf)
TO: C. EUGENE LAYMAN: It certainly looks that way, doesn’t it? So, what is our response to this apparent “irrationality” that history has bestowed on us? Many of the commentators here want to march on Washington and change the monetary system operations. From my perspective, it’s like the house is on fire, we have an operational system to put the fire out—but instead of making that fire-fighting operation clear and understandable (and politically safe), we’d rather argue about whether the firefighters are making a windfall (and probably corrupt) profit in doing so. I don’t like corruption either. I’m just trying to make the point we have the capability of putting the fire out—FIRST. Then we can talk about the corruption. Bill Black here at NEP has much to say about that side of the equation.
“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.”
I think there’s an important point missing out in this analysis: Where does the Treasury’s deficit spending go? Wouldn’t these banks be the receipients of nearly the entire government deficit spending and, thus, the reserves being “loaned out” to the Treasury end up right back into these bank’s balance sheets? If so, there’s no need for the repos to be settled in Treasuries. The Fed just trades the collateral for the Reserves that are proportional to the Treasury’s deficit spending, a process which, as you point out, “cancels” Reserves (liabilities) in the Fed’s balance sheet. It’s a wash.
The Federal Reserve does NOT fund government spending. No where in Mr. Alt’s analysis is the Fed funding the government demonstrated.
Mr. Alt –
So where is this fire fighting “capability” codified?
When rational legislation to modify the dysfuctional money system is introduced, it is characterized as a silly radical ” march on Washington”. How centrist can one be!?
Where is it claimed that the “firefighters” (whomever they are) are making a windfall? (Its an oft repeated canard to subtly associate reform for a just money system as somehow tied to conspiracy theories) Its not individuals who are the problem but rather it is the system that enables them.
The system, like a house built on a poor concrete mix, is incapable of putting any “fire out”. Instead of ignoring and even dismissing what many leading economists have been proposing for over a century, maybe some of your energy should go into standing behind a democratic and just monetary system.
Paul,
Again… your claim is inaccurate according to this:
“Why the Federal Reserve Owns Treasurys”
“As the nation’s central bank, the Federal Reserve is in charge of the country’s credit. It doesn’t have a financial reason to own Treasury notes. So why did it double its holdings between 2007 and 2014?”
“The Fed needed to fight the 2008 financial crisis. In 2007, it ramped up its open market operations by purchasing $2 trillion in Treasurys. This quantitative easing stimulated the economy by keeping interest rates low. It helped the United States escape the grips of the recession.”
“Did the Fed monetize the debt?In a way, yes. The Fed purchased Treasurys from its member banks, using credit that it created out of thin air. It had the same effect as printing money. By keeping interest rates low, the Fed helped the government avoid the high-interest rate penalty it would incur for excessive debt.”
https://www.thebalance.com/who-owns-the-u-s-national-debt-3306124
So, the Fed held nearly half of the Treasuries ‘before’ 2007.
Then too, do you have any evidence that the Treasury has “repaid” the Fed for any treasuries on the Fed’s balance sheet?
I’m just trying to make the point we have the capability of putting the fire out—FIRST. Then we can talk about the corruption. J.D. Alt
Actually, de-privileging the banks and the rich, besides being the right* thing to do, would INCREASE the demand for fiat by decreasing the demand for bank deposits and thus would allow MORE sovereign spending for the public welfare for a given amount of price inflation risk.
* And if there is a God who cares about justice we could hope for His help too. Besides which, some problems are beyond man’s ability to solve anyway such as the Yellowstone super volcano erupting.
I’m not sure what is “inaccurate” about my claim. What you wrote completely supports my contention that QE was implimented to support the failed banking system and stimulate the failing economy.
First look at the Fed’s own stats on Treasury bond holdings:
https://fred.stlouisfed.org/series/TREAST
Does this look like the Fed is set up to fund government spending? If so, why were Fed holding so low pre 2008?
Are you actually claiming that the Treasury doesn’t need to repay the Fed when Fed’s bond holdings mature?!!! Where is you evidence for that?
If as you claim, the Fed just creates money and gives it to the Treasury to spend, why is the Treasury borrowing in the first place? The answer is that the Fed is legally not authorized to do that.
Finally, why is it so important to you to insist that the Fed gifts money to the Treasury? If its true, why are we in such an economic mess?
TO LOBO CAMPO: Your question, “Where does the Treasury’s deficit spending go?” is, of course, the heart of the matter at hand—and one which I’ll try to focus on in PART 3 of the essay. It’s true the Reserves the Treasury receives in exchange for its future Reserve treasury bonds “end up right back” in the bank’s Reserve accounts—but framing it like that overlooks what is of central importance: the PROCESS by which the Reserves make their way back to the bank’s Reserve accounts (government spending) is the process by which American citizens and businesses are paid “money” to undertake and accomplish the goals of public enterprise. As you state it, it sounds like the Reserves that end up in the bank’s Reserve account are the bank’s windfall “profit.” But they are not. They represent the dollars American citizens and businesses have been paid for their work in pursuit of the collective interest. From a very limited perspective it is, indeed, “a wash,” but the larger perspective is to see and evaluate what that “wash” accomplishes: real health-care services, real child-care services, real infrastructure construction, real weather forecasting, real court systems, real basic research in health and science, real air-traffic control systems, etc. etc.
TO PAUL LEBOW: “So where is this fire-fighting ‘capability’ codified?”
It is “codified,” I would say, in every beneficial accomplishment of public enterprise—which is paid for by the Treasury’s direct spending of Reserves—as, for example (to make the metaphor real) the fire-fighting efforts to control the devastating wild-fires in California, as well as the forest-management efforts to limit their threat. What I have described as the U.S. monetary system is, I believe, an accurate representation of what is. You can characterize it as unfair, rife with corruption, badly in need of restructuring, and I would not disagree with you. What you cannot do is claim that the sovereign U.S. government is in “debt” for the very thing which it, exclusively, has the power and authority to produce.
The banks create bank-dollars and the FED creates Reserves to back them up. It doesn’t do this because the banks require it to be done—it accommodates the banks because it chooses to, and the reason it so chooses is because doing so is in the interest of the American Enterprise (both private and public). It’s a system set up to enable real, concrete things to get accomplished. There’s a lot of people who unfairly, and corruptly, profit from it financially. There’s a lot of people whose real needs are ignored by what the system chooses to undertake and accomplish. In my view, these problems and failings are not endemic in the system itself but proceed from our political misunderstanding of what the system is capable of—specifically with respect to the public enterprise side of the equation. As I write, Elizabeth Warren is preparing her “explanation” of how to “pay for” Medicare-for-all. God knows what she will say, but I’ll wager she’ll find it politically impossible to say the Federal Reserve System, itself, enables us to pay ourselves wages and salaries to provide, to our own selves and families, health services and whatever pharmaceuticals American ingenuity can produce.
[I am certainly not an expert in Fed financing. On the other hand, I claim that money is mechanical and that all of the framework gizmos must mesh logically. I can’t quite make gizmos mesh using your narrative.]
“Step 3
4. 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.”
I’ve read and re-read Part 2, and come to the conclusion that this is where the narrative missteps. The actual mechanical failure is that the Fed, in your narrative, does not seem to end up with more Treasure bonds on inventory when new reserves are issued. In the real world, the Fed balance sheet is increasing.
I think that, in reality, the Primary Dealer Banks have an inventory of Treasury bonds that are sold to the Fed when the Reserves in private ownership fall short. New reserves are issued by the Fed (to the Primary Dealer banks) to cover this purchase. The Fed does not sell this increase in Treasury Bond inventory unless, sometime in the future, the Fed wants to reduce Reserves in private ownership.
Returning to your narrative, with additional Reserves in hand, Primary Dealer banks buy and hold what you call “ future Reserves. There is no need for the Primary Dealer Banks to perform additional collateral exchanges.
The same process can repeat the next time Treasury wants more Reserves than the private inventory of Reserves will support.
To me, this mechanical framework works better but it is consistent with real time bonds rather than your “ future Reserves. Sorry that I cannot fully agree with your narrative.
To J.D. Alt
While I look forward to your part 3, it may be more efficient just to cut to the chase. One of the MMT propents I respect is Joe Firestone who flat out says that the government can continuously borrow to pay for government programs and forever rollover that debt with new debt and NEVER have to actually repay. This is the core of the MMT message.
Neither Elizabeth nor Bernie will come up with a payment plan that is palatable to US public. For better or worse, indebtedness is viewed as antithetical to our core values, Joe Firestone notwithstanding.
Yes, true, the Fed creates reserves because, under the current convoluted system, that is the only way to impliment what is needed. The system designated banks as the primary decision maker on where money goes and the Fed is bound to those decision with the hope that some of that bank credit money will find its way to the public purpose. Its rare that this happens directly so the government relies on a trickle down through taxes and borrowing to scavange what it can politically.
The “direct spending of Reserves” is certainly an artifact and illusion. Reserves are keystroked only in response to the collection of taxes or borrowed money through bond sales. Its like claiming a car’s tires power the car since that’s where one senses the energy generated. The real engine is the banking system which provides the bank-credit money that the Fed only responds to with Reserves, just as the tires respond to the chemical ignition in the engine’s cyllinders.
Why not promote an honest, democratic and transparent system that doesn’t take a three-part course to unpack? I guarantee that after people digest your explanation, they still will not, in their guts, “get it”. The concept of codifying the direct creation of sovereign money by government is so refreshingly intuitive without all the b.s. that we now endure, people just “get it”.
As I write, Elizabeth Warren is preparing her “explanation” of how to “pay for” Medicare-for-all. God knows what she will say, but I’ll wager she’ll find it politically impossible to say the Federal Reserve System, itself, enables us to pay ourselves wages and salaries to provide, to our own selves and families, health services and whatever pharmaceuticals American ingenuity can produce. J.D. Alt [bold added]
Except:
1) Via a risk-free sovereign debt carry-trade from the US Treasury thru the private sector (primary dealers, the banks and the rich), i.e. welfare proportional to account balance – a moral disgrace and a violation of equal protection under the law- to the Federal Reserve.
2) And then sovereign spending has to compete for real resources in the same politically acceptable price inflation space with what is, in essence, a government privileged usury cartel producing new purchasing power for private interests.
3) And then via continued wage slavery to either the private sector or to government.
The problem with MMT is not that it is bold but that it is not bold enough – having mere pragmatism as its base and not ethics.
TO ROGER SPARKS: I appreciate your thinking and comments. I believe we are not really differing in essence, but perhaps mostly in narrative terminology. In your first comment you say:
“The more direct way is to let both private banks and the CB accept government bonds as collateral for reserves. By accepting this logic, private banks are found to lend existing reserves to government, in trade for a new bond that is as good as fiat money collateral can be. Government has just created new reserve collateral equal in value to the amount of reserves borrowed.”
I would argue that your framing is essentially the same as mine—except I am intentionally and carefully trying to AVOID the suggestion that the private banks are “lending” Reserves to the government. It is exactly this perception that lies at the heart of our political confusion that is constantly struggling with how to “pay for things.” Your own words demonstrate why this confusion is unnecessary: If the bank is “trading for a new bond that is as good as fiat money collateral can be,” then, in fact, it is not “lending” anything at all to the government, but merely trading one thing for another of equal (and, in fact, greater value). Your use of the term “collateral” is precisely the same as my use of the term “future Reserves”—because the “collateral” only has value as collateral BECAUSE it is future Reserves.
Your second comment is a bit confusing to me. When the FED trades new Reserves for a treasury bond, it expands its balance sheet. When the FED trades a bond on its balance sheet for Reserves, it cancels the Reserves it receives. When the FED holds a treasury bond to maturity, it cancels the future Reserves the bond represented. It’s true the primary dealers may choose to not take the final step in my narrative—they may choose to hold the treasury bond instead of trading it back to the FED for the original collateral they posted. And it’s true that the held treasury bond may become the collateral the bank posts to the FED in the next go-around. But I’m not clear how any of that changes the fundamental structure my essay is trying to make visible to a non-economist thinker about how the Federal Reserve system creates “money” for both private AND public enterprise.
Pity J.D.Alt didn’t mention that private bank created dollars are, at least in the view of the Nobel economist Maurice Allais, COUNTERFIET dollars. Plus several other leading or Nobel economists have argued that privately created money should be abolished, e.g.: Milton Friedman, James Tobin, Joseph Huber, Josiah Stamp (director of the Bank of England in the 1920s), and Martin Wolf (chief economics commentator at the Financial Times).
Plus several other leading or Nobel economists have argued that privately created money should be abolished, Sanjay Mittal
But that’s not ethical either and it would be impossible, imo, to police anyway.
Besides that, endogenous money creation certainly has a valuable role in an economy (e.g. common stock) and there’s nothing inherently wrong with banks creating deposits (IOU’s for fiat) but only if they:
1) are 100% private with no government privileges
AND
2) with 100% voluntary depositors.
Sanjay – So far I have not seen any concrete solutions proposed in Mr. Alt’s essays. The ambiguity of the argument is striking. On one hand there is the acknowledgement that banks create the money you and I use in the economy and on the other, there is the unsubstantiated claim that the central bank, the Fed, initiates and creates the money we use and can legally create all that is needed. I am surprised that this story often goes unchallenged.
It reminds me of any type of “buff” where there is such a fascination with the workings and mechanics of a subject, that it becomes the reality for them. Hence we see Civil War reenactments and groups who focus on steam engines. The story here is just another “reenactment” of an antiquated process that needs to be replaced.
Thanks for your thoughtful reply. I much appreciate both your effort and your goals. I try to forge my comments into helpful contributions (while knowing that I will usually fail).
This reply does indeed seem to find full agreement between us. Here is where I think useful additional mechanical insight can be found:
You (correctly) write “When the FED holds a treasury bond to maturity, it cancels the future Reserves the bond represented.” Unsaid is the important observation that the Fed reduces Reserves-owned-by-the-Treasury (in account) at the same time.
This observation highlights the mechanical link always present between Reserves and ownership. We can follow the links: Fed creates reserves and issues to Treasury; Treasury issues to government payees; payees transfer to other payees and all pay taxes; savers and pension funds lend Reserves to Treasury.
At all times, so long as Reserves exist, an owners name can be found attached. This, to me, is a mechanical link.
This formulation leaves open (the question of) what is it that private banks are lending? Private banks must be lending Reserves, thereby placing an additional claim(s) on those few Reserves that the Fed has created.
[It helps me to see the St. Louis Fed Monetary Base chart (BOGMBAS) which reasonable well matches the assets held by the Federal Reserve. Add mortgage backed securities as well as Treasury bonds (and other assets) to find this reasonable match.]
So what is private bank money? Well, if you add up all the money on account at private banks, you would have the number of claims on the few Reserves that the Fed as created.
There is hell to pay if everyone wants their reserves at one time! The Fed could cover it but only if it (the Fed) took every private bank asset as collateral. Following that event, privately owned Reserves would have replaced collateral completely.
I’ll stop here. My mechanical formulation seems (to me) to be similar to yours, yet different. I am not sure which is more easily understood by the novice economist.
Like Paul Lebow above, I am looking forward to Part 3.
I’m pretty sure that private banks don’t create dollars. That would indeed be counterfeiting. What banks create–out of thin air–are deposits. And a deposit is not a pile of dollars in a vault somewhere with your name on it, it is a promissory note from the bank that is payable in government dollars.
Banks could, would, and traditionally have created deposits (privately created promissory notes denominated in units of currency, aka “bank money’) out of thin air with or without government involvement. Because that’s what banks do, and have always done.