The Federal Reserve and the Magic of Imaginary Money

The Federal Reserve and the Magic of Imaginary Money- by Larry DeWitt
Okay, this business about the Fed and the government and who owns the government debt, always drives me crazy. Every time it comes up I study the matter again, understand it a little, then forget what I thought I learned. So I am writing it down! Anyway . . . here is how I think it works.

The Fed is a private corporation, owed by its member banks. The Fed sells stock ownership in itself. The stock cannot be resold or transferred. Only member banks can hold ownership of the Fed. About 34% of the private banks in the U.S. are members of the Fed. Of course the fact that these are U.S. banks does not mean they are necessarily U.S. owned. Whoever owns the banks is the stockholder in the Fed.
In addition to the private banks themselves, there are 12 Regional Fed banks. These are kind of holding companies. This is where all the money is actually on deposit, and it from these 12 banks that the money is borrowed between banks.
There is also the Federal Reserve Board in Washington, which has oversight authority over the 12 Regional banks. Government control of the Fed consists principally in the power to appoint the members of the Reserve Board. (The executives of the Regional banks are appointed by their member banks.)
Since the Fed is a quasi-government, quasi-private, entity, it is a moneymaking concern. The Fed makes its money by lending money to member banks and charging them interest, and by providing other services to the financial system (the Fed is the clearinghouse for all checks in the economy, among other things).
The Fed religiously asserts that it is a non-profit institution. Like some others of that genre, the Fed nevertheless manages to accrue a considerable amount of not-profit each year. The Fed is guaranteed by law a 6% return on the money invested in it by its member banks. So if there is net income from the Fed’s activities, it goes first to pay dividends to the Fed’s owners. After the dividend is paid, the Fed can retain additional monies by placing them in its own reserve account. Anything left after this is paid to the government as the government’s profit on the Fed’s activities. Hence the idea that the Fed retains no profits.
In 2009, the Fed had a gross income of $54.4 billion. It paid itself a billion dollars for its operating costs, leaving net income of $53.4 billion in not-profits. It paid $1.4 billion in dividends to its owners; it put $4.5 billion in its reserve; and it remitted $47.4 billion to the U.S. government.


The Fed plays three roles in our political economy:
1) It is the government’s banker. That is, there is no treasury in the Treasury Dept. All the government’s money flows into the Fed and all government payments are paid out of the Fed. (All of the government’s accounts and transactions are processed through the New York Federal Reserve Bank.)
2) It controls the money supply (see below)
3) It set the rates of interest that it charges it member banks when they borrow money from the Regional banks (this is how they control interest rates). This interest-rate setting then cascades throughout the economy in the form of secondary interest rates and in this way the Fed can influence the whole economy through monetary policy.
The U.S. Treasury cannot create money. Nobody in the government can. Only the Fed can create money (that’s why our paper money is called Federal Reserve Notes). The Treasury prints the paper and mints the coins, but it cannot issue money. What happens is that the Treasury prints paper money and sells it to the Fed for the cost of printing. It also sells to the Fed coins at their face value. The Fed then distributes this paper and these coins through its 12 Regional banks as money. That’s how money gets created and circulated in the economy. (Note that this is an “in principle” discussion. In practice, only about 3% of the money in the U.S. economy is actual cash, the rest is just computer entries—but the principle is the same.)
Now, the way the Fed (as a private concern) creates money is by buying securities from the Treasury. So if the Fed wants to put more money into the economy it orders up some new cash from the Treasury, who prints the money and gives it to the Fed, who circulates this money into the economy. (Again, usually no real money is printed; the Fed just asks the Treasury to give it credit for more government bonds on its computer spreadsheets.)
So can the government just “print more money” to pay off its debts? No. Only the Fed can make more money appear in the economy. The Fed—not the government—controls how much money is in the economy. Can we print too much money and cause hyperinflation, or a devaluing of the currency. Yes, in theory. But the Fed’s main job is to control inflation. So it works to prevent this. Also, the Fed does not issue new money to help the government with its problems; it only issues new money to help the Fed with it’s problems—that is, with managing the economy to get it growing and keep inflation in check. So the Fed doesn’t authorize the issuance of new cash so the government can pay off the federal debt. Which would be monetizing the debt (i.e., paying it off by printing money). Rather, the Fed’s only concern is whether or not there is enough cash sloshing around in the economy to keep it running efficiently.

The way the Fed controls the amount of money flowing in the economy at any moment (that is, controls liquidity) is by buying and selling Treasury securities in the private markets. If it wants to push out more money it announces it is buying Treasury securities, and when it buys the bonds from the sellers it gives the sellers cash from its reserves. This injects cash into the economy (more money is now circulating). If the Fed wants to restrict the money supply, it announces it is selling Treasury securities. When it gets the cash from the buyers it puts this cash in its reserve, thus taking the money out of circulation.
Keep in mind that this control of the flow of money in the economy is not the same thing as increasing the total amount of money in the economy, which can only happen when the Fed “prints” new money by “buying” new government bonds from the Treasury.
The Fed can also buy other forms of assets, like foreign currencies. But this is not optimal as a way of putting more money in circulation. If the Fed buys, say, Chinese currency with its new money that places the new money in circulation in China, not in the U.S. To expand the money supply in the U.S. the Fed has to buy U.S. assets.
Where it seems to get a little tricky is when the Fed wants to expand the amount of “money” in the economy (to stimulate it) but not necessarily the amount of cash money in the economy. The Fed can create more “money” in the economy by just generating more Treasury securities. They don’t have to follow through with the physical printing of additional currency—especially since 97% of the “money” in the economy is just in the form of computer entries anyway.
So let’s say the Fed wants to expand the U.S. money supply by $600 billion (as it recently announced its intention to do). The Fed tells the Treasury it wants to “buy” $600 billion in Treasury securities. The Treasury agrees. Then four things happen in succession:
1) The Fed now increases its balance sheet to show that it owns an additional $600 billion in assets (the Treasury securities);
2) The Fed credits the government’s account with $600 billion in new “cash” from this “purchase”;
3) The government will now be $600 billion deeper in debt.
4) The economy will expand by $600 billion.
This purchasing of new assets by the Fed is called “quantitative easing.” It is the way that the Fed expands the money supply.
Now, an old-fashioned traditionalist might worry whether anything of real value has been created by this process, but that’s how the modern financial system works and there is little point in fretting about it now.
One advantage of buying Treasury securities rather than private-sector debt instruments is that the money is certain to be spent! This is because—among other reasons—the government has no mechanism for saving money, since it is not allowed to invest in the private economy. The only way the government can “save” money is by buying back some of the outstanding government debt. In fact, this is what happens automatically whenever there is a surplus in the federal budget. (This was, by the way, Bill Clinton’s plan for “saving Social Security”—just buying back some of the overall debt, so as to position the government to be better able to fund Social Security in the future.)
So, who owns the additional $600 billion in debt the government has just generated? The Fed. And who owns the Fed? The member banks. So can the government just cancel this debt, because it “owes it to itself?” Nope.
Of the $13.5 trillion in outstanding U.S. government debt, the Fed owns about $2 trillion; the Social Security Trust Fund about $2.5 trillion; various other “governmental entities” own about $2 trillion; and the “public” owns the remaining $7.1 trillion (the Fed’s holdings are actually considered part of the “public” debt—but it is broken out separately here).
That’s how the money supply is controlled in this country. That’s our quasi-private, quasi-public financial system in all its glory. Ain’t it grand!
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Coda: Social Security and Treasury Debt
Well, maybe the government cannot repudiate the Fed debt or the public debt, but can it repudiate the $2.5 trillion it owes the Social Security Trust Funds, since it only owes this money “to itself?”
No. For two reasons.
First, it is not correct to say the government owes this debt only to itself. The Social Security Trust Funds are not the government or an entity of the government. The Trust Funds are, in this context, a sovereign financial entity, for whom the government—in the form of the Board of Trustees—is merely the fund manager. The owners of this financial entity are the taxpayers who paid the payroll taxes that give them a claim on future benefits from this fund. The government no more owns the Social Security Trust Funds than the manager of a mutual fund owns the monies invested in the fund. (It was being confused on just this point that sent Bernie Madoff to prison.)
Second, all Treasury securities have the same status: they are all promissory notes backed by “the full faith and credit of the U.S. government.” Defaulting on any of them would bring the whole house of cards tumbling down. It is generally conceded that a collapse of the government’s credit system would produce a generalized world-wide economic collapse. For even the most crazy Tea Party nutjob this would be too high a price to pay just to cheat the Social Security system out of a couple of trillion dollars.
These facts should not be confused with the kind of “political hazard” that does exist in the Social Security system. It is certainly possible for a future Congress to change the rules of the game anytime it wants. So it can reduce or cancel promised benefits anytime it likes. But it cannot make the Trust Funds go away. There is already $2.5 trillion in Treasury bonds held by the Trust Funds. It is too late to do anything about this. These bonds are assets just like any other Treasury IOU. The Congress could alter the program such that no more surpluses will be generated. That is, they can stop the Trust Funds from growing—but they cannot make the existing fund disappear.
(By law, the assets in the Social Security Trust Funds cannot be spent for any purpose other than Social Security. But Congress could, in theory, change this provision of law. (It will not happen because it would be political suicide, for no purpose.) But Congress could do this. But what Congress cannot do—on pain of a default in the U.S. Government credit system—is make this asset disappear. Somebody, somewhere, somehow, has to reap the value of this asset. There is $2.5 trillion in asset value sitting out there, and it will not vanish—it will eventually be redeemed and spent by someone—whatever else may happen to Social Security, in theory.)