The statements, views and opinions expressed in this column are solely those of the author and do not necessarily represent those of this site. This site does not give financial, investment or medical advice.
Submitted by Steve Brown…
Today’s ‘money’ is a guarantee to honor government debt where the currency in our pockets represents trust that the United States government will honor its debt. That debt is purchased by the Federal Reserve and others (1) from the US Treasury or commercial banks so that the Federal Reserve may issue the notes that constitute the cash in your wallet. Just look at the face of any cash note in your wallet, where “Federal Reserve Note” appears at the top.
Besides Treasury support from regulation (taxation) the Federal Reserve purchases debt instruments from the Treasury (and others!) to allow the Treasury to honor its debt by the issuance of Federal Reserve notes. The Federal Reserve may also purchase debt instruments from commercial banks or others with the currency that the Federal Reserve issues for such purpose.
In other words, the Federal Reserve ‘monetizes debt’ by purchasing US public debt instruments (Treasury bonds/ bills and Mortgage Backed Securities – MBS, etc) from the Treasury, and purchases debt instruments from commercial banks or others to first enable the Treasury to service its debt, to pay interest on the outstanding National debt, and to issue cash notes known as Federal Reserve Dollars (USD).
The Federal Reserve may also sell such securities via ‘the Desk’ in its Open Market Operations so that cash may be taken out of the market if inflation runs too high. This is called ‘sterilization of capital’.
The Federal Reserve banks are privately owned corporations with commercial bank shareholders (paid dividends), and they enforce monetary policy in collusion with the US Treasury, and the Primary Dealer Banks of the Federal Reserve.
Other nations purchase US Treasury debt in significant amounts including Japan; China; Saudi Arabia; Belgium; Caribbean banking centers, and oil exporters. However, a large share of US public debt issued by the US Treasury is held via the Federal Reserve and its primary dealers, with most public debt interest paid to whoever holds those debt instruments, whether the Fed itself, or the private Primary Dealer Banks of the Federal Reserve or any other person or entity.
Thus, the Federal Reserve maintains and operates its own highly profitable market structure for buying/selling US debt on behalf of the US Treasury, via its own banks (or Desk) and these primary dealer banks:
Amherst Pierpont, Bank of Nova Scotia (Scotia), BMO Capital Markets Corp, BNP Paribas Securities, Barclays, B of A, Cantor Fitzgerald, Citigroup, Credit Suisse, Daiwa, Deutsche Bank, Goldman Sachs, HSBC, Jefferies LLC, J.P. Morgan, Mizuho, Morgan Stanley, NatWest, Nomura Securities, RBC Capital, Societe Generale, TD Securities, UBS, Wells Fargo
Besides the US Treasury and Fed itself, the above dealer banks are next to profit from the Fed’s permanent Open Market Operations, whether via Quantitative Easing (money issuance by the Fed on government debt purchased by the Fed), Operation Twist, the Fed’s Repurchase and Reverse Repurchase agreements (Repo’s), or by operations of the Exchange Stabilization Fund. For practical purposes these Primary Dealer banks have “first market use” of the US dollar funds “created” by the Federal Reserve via its purchase of debt instruments from the US Treasury or commercial banks or other sovereign entities.
To summarize, Mortgage Backed Securities (MBS) Treasury bonds, and T-Bills are the usual debt instruments purchased from the Treasury by the Federal Reserve (FOMC “Desk”) or purchased from Primary Dealer Banks/commercial banks and other entities to allow the Federal Reserve to issue Federal Reserve dollars. The Federal Reserve “Desk” is authorized to purchase any security or commodity in existence to support US Treasury operations under the auspices of the Exchange Stabilization Fund. (2)
The US Treasury and Federal Reserve, have first use of the new USD (Federal Reserve Notes) created by the Federal Reserve’s purchase of debt instruments, to manage monetary policy and service the government’s public debt however first commercial market use of the USD funds issued is via the Primary Dealer Banks.
After the Dealer Banks, then commercial and retail banks, and on down the line to the public. Finally, the Federal Reserve notes (cash notes in your wallet) are used by private individuals to pay for goods and services, thus trading the implicit value of the government debt represented by those notes to a third party, in exchange for those goods and services.
Simply put, the “intrinsic value” of cash is only the value associated with holding Federal Reserve notes representing Fed / Treasury-held debt including taxes owed, where intrinsic value is only based on trust; the trust being that the US Treasury will remain solvent and honor its debt.
Now, here is the “use list” of US Dollars (USD) created by the Federal Reserve from US Treasury debt instruments, in order:
- US Treasury
- Federal Reserve banks
- Federal Reserve “Desk”
- Primary Dealer Banks
- Commercial investment banks (including certain hedge funds)
- Non-dealer retail banks/credit unions
- Other financial entities
Some have stated that the Federal Reserve creates money out of “thin air” but that’s not strictly correct, because some debt instrument is required to issue the new US dollars. For example, in the case of a mortgage, the “money” is only created when a home buyer signs his or her signature on a note held by the mortgage company or bank. In the case of a bond (or Mortgage Backed Security) the “money is created” when some person or entity signs up for the purchase of that bond, T-bill, or MBS.
After the Treasury funds its programs with the capital created by the Federal Reserve in exchange for Treasury debt, the Treasury must pay interest on that debt to the Federal Reserve’s private banks and to the dealer banks engaged in Fed operations, and all other entities who hold US government debt instruments.
So, the Fed’s private banks and Primary Dealer Banks profit in part from the public debt, in the form of interest payments. Most profit realized by the Federal Reserve via “Desk” trades is returned to the US Treasury, but not all. At least 6% of the profit made by any single privately held Federal Reserve bank is paid in dividend to the shareholders in those banks, and only commercial banks may own those shares, and they may not be traded. Above a certain reserve level, as much as 10% or more of the Federal Reserve bank’s reserves may be paid in dividends to the private shareholder, with the percentage above 6% being equal to the high yield of the 10-year Treasury note as last auctioned.
The banks may then leverage incoming capital as needed to guarantee more capital (whether via repurchase agreements, MBS or other bond trades, T-Bills, share trades, notes, currency swaps, proceeds from retail bank mortgages, etc, etc) using a method devised by gold dealers centuries ago, called Fractional Reserve Banking.
Fractional Reserve Banking
Fractional Reserve banking is based on the idea that no more than 10% of creditors will demand cash at any given time, an idea which harks back to antiquity and the Guild system of gold dealers. In the Fractional Reserve system, banks may keep 10% of depositors cash on hand for reserves, and loan out nine times that amount based upon the creation of new debt instruments for example new mortgages.
As the depositor’s funds are fractionalized and then multiplied and spread between banks, the system debases US dollars in the form of “leverage”. For example, signing a note for a $180K home mortgage allows the receiving bank to exchange that debt obligation for other debt obligations worth up to $1.6 million in debt – this is why banks love mortgages.
During the 2002 to 2007 US economic boom, some institutions leveraged capital by 40-to-1 and in Europe many big bank counterparts leveraged a 24-to-1 capital leverage ratio. High fractional reserve ratios work well when all participants in the system do not demand solvency (which is different from liquidity) or sound money. When part of a sound money system, a reasonable fractional reserve ratio might allow banking investments as part of a practical plan for growth, which works well when the market is free from corruption and the leverage rate is relatively low.
Public Debt Interest
In summary, the Treasury pays interest on the national debt held by the Federal Reserve and held by the Fed’s dealer banks (and on their reserves) and to all others who hold US debt instruments, via Federal Reserve notes. When the primary dealer banks are paid interest by the Treasury on the money created by the Federal Reserve on the basis of the Treasury’s debt instruments, then the dealers use that cash to reinforce their balance sheets, purchase Wall Street shares, purchase more Treasury’s or commodities, property, ETF’s or precious metals, and so on, etc etc.
So long as the Fed and its Primary Dealers can leverage the Treasury debt instrument system in collusion with the Treasury, and foreign buyers and others also purchase US debt instruments, the system stays afloat. The monetary system by definition must then rely on the support of an ever-increasing debt burden and the issuance of new debt instruments, with an eventual potential for massive cyclical instability. (3)
From 1840 to 1934 the gold standard and US National Banks system (in the US) enforced some form of monetary discipline, resulting in occasional serious Financial Panics as well. With growing population density and demand for economic growth – as well as governmental need to finance defense, war, and public services – the Independent Treasury system could not be maintained by the early twentieth century, and the private Fed banks were introduced to act as a Central Bank.
Is the Federal Reserve System Fair?
Obviously, there is some unfairness and inequity in this system. Since the Federal Reserve banks are privately owned corporations, they must maintain markets in a way that is advantageous to them and will prevent their banks from failing since it is possible for a Federal Reserve Bank to fail. This gives Federal Reserve banks an unfair advantage in the system along with the private profit in public debt that they skim, and the interest they are paid on the public debt which goes to private profit not to the public.
The Federal Reserve banks work in tandem with their Primary Dealer Banks, which provides an opportunity for rigged markets. And in some instances, for example reverse repurchase agreements, the Federal Reserve guarantees the Primary Dealer banks a profit. While a guaranteed profit works well for the Fed and for its dealers, the dealer profit is entirely private, and none of that profit goes to the Treasury, except for taxes levied on the primary dealer profit.
It may also be argued that for a Quasi-governmental entity like the Federal Reserve to guarantee a profit to a private bank (from public funding) is not only unethical, but also immoral. Also, the fact that the public does not own the interest related to the issuance of its money, and is last to benefit from that issuance, is unethical at best, or illegal according to the US Constitution at worst.
Since the introduction of the Federal Reserve system in 1913, we must confront global monetary challenges as the fiat (by decree) monetary system – global floating currencies – may potentially catastrophically destabilize over time as the system collapsed in the United States during the 2008-2009 financial crash.
One potential remedy (for the United States) is based on a scholarly rework of the Chicago Plan of 1935 (4) but such great austerity would likely lead to political instability in the United States and perhaps global instability too.
Another idea is to return the profit on public debt interest made by the Primary Dealers to the Treasury by effectively nationalizing the private Federal Reserve banks via transfer of ownership of Federal reserve bank shares to the Treasury. The US Treasury will then take back ownership of all public debt by once again issuing United States Notes via the Treasury (instead of by the Fed) while still supporting private banks as the Fed does now.
Put simply, the US Treasury will extinguish the debt of the Federal Reserve by issuing United States notes to gradually purchase the existing Fed debt while recalling Federal Reserve notes, and once again own the interest on the public debt.
The US Treasury will then assume ownership of the shares of the current Federal Reserve banks, converting them to US-owned shares, just as the Bank of England operates now. All employees of the Federal Reserve Banks would then become federal employees of the US Treasury, instead of corporate employees. The Treasury will thus end the out-sourced money-issuance that the Federal Reserve has been engaged in since 1913, by issuing US Notes via a US-owned central bank and using US notes to extinguish the Fed’s balance sheet and put the Fed out of business.
In other words, the US Treasury will once again print the United States Note to replace the Federal Reserve note, meaning that United States Notes will be used to purchase back the debt held by the Federal Reserve, and extinguish that debt in exchange for public debt being issued and held by the Treasury itself.  The profits on that public debt are then owned by the US Treasury instead of by the private Federal Reserve Banks as occurs now.
The foregoing can be compared to nationalisation of the Bank of England. But the Treasury will not own the private Primary Dealer banks it will only own the interest paid on the public debt, and own the shares of the formerly private Federal Reserve banks; that change will occur on behalf of the people of the United States, instead of on behalf of the private Federal Reserve Banks and its private Dealer Banks as occurred in 1913.
However, one can imagine that such reform would be opposed by the Fed itself and by the Dealer Banks, and even by the US Treasury, which more accurately colludes with the Federal Reserve instead of having the Fed work on its behalf as the Treasury claims.
The idea to turn the system on its head by “ending the Fed” in its current form – even though the lender of ‘last resort’ will still be a US Central Bank owned by the Treasury – would certainly be strenuously opposed, to say the least, by those who lead the current system.
When the US ended the Central Bank in 1834, the nation experienced the Hard Times era by the Panic of 1837, arguably induced by Nicholas Biddle and his banking cronies, who sabotaged the US monetary system. So, if the Treasury were to nationalize the shares of the Federal Reserve banks today — as unlikely as that may be — the consequences imposed on the US populace (and by extension the world) would likely be quite dire.
Other ideas for monetary reform, such as Warren Mosler’s “Modern Monetary Theory” or MMT, says that the current system should continue to operate with the same Keynesian authority that it employs today but encouraged by more fiscal responsibility and more efficient use of resources, allowing government spending to increase on what MMT considers to be a noble causes, for example full employment.
Mosler’s seeming advocacy for increased government spending tempered by efficient use of resources may seem like a great idea, however in practice the probability is high that many more inflationary dollars will enter the monetary base. As we have seen, bankers always favour quick profit over noble causes, and the unlikely idea of putting many more dollars in the pockets of the poor and unemployed would certainly result in very high inflation.
Since the 1950’s the practice of blowing up inflationary dollars in pointless US international interventionism, US military provocations, and wars has worked well for the US federal government to extinguish inflationary dollars. MMT seems to imply that the welfare state should replace the warfare state.
MMT does not address the endangered status of the US dollar as global reserve currency and tends to look at US monetary issues in isolation, discounting that the bulk of all US dollars created are exported.
Inflation and Debasement of the Currency
Reviewing our data about monetary inflation we see that the chart is relatively flat until the creation of the Federal Reserve, which essentially placed the Money Trust (private banking families) back in charge of the monetary system as it was from 1793 until 1834. On the creation of the Federal Reserve as Central Bank, the chart documents the loss of 70% of the dollar’s purchasing power from 1971 to today, and this spike proves the glaring weakness of the current system.
At a minimum, Fractional Reserve ratios should be reasonably maintained noting that the derivative bubble and collateral of intrinsic value (gold) is left out of this argument for reasons of brevity and clarity. Likewise some slight attempt must be made to balance the US budget. With reform, money will again have some value and begin to work again as an incentive to production, employment, and commerce for the people.
Now, only public trust overall in the US Dollar and the ability of the Federal Reserve to maintain the system (in collusion with the US Treasury and others) keeps the USD currency system afloat, and prominent as global reserve currency. If the US operated equitably and fairly perhaps trust in the ‘by decree’ monetary system can work forever, and the US Dollar may remain global reserve currency forever as MMT for example maintains.
However, the US financial system did collapse in 2008-2009 and the glaring inequity and growing disproportion – and even corruption – at the heart of the system certainly must endanger the US Dollar’s status as providing 62% of the globe’s currency in the form of Federal Reserve notes.
(1) The US Treasury’s financial instruments – usually Bonds, T Bills, TIPS or MBS – may be purchased by other sovereign entities, privately, or by the Federal Reserve itself.(2) The “Desk” and Exchange Stabilization Fund operate without independent oversight or and do not provide any detailed public disclosure.
(3) By 1844 Van Buren’s Independent Treasury operated privately owned Banks (which became the National Banks system in 1863) however the debt created and the interest on that debt were returned to the Independent Treasury (and thus the people of the United States) and not to private interests. The private National Banks do make profits from their banking activities but the public debt profit goes to the Treasury and not to a private central bank as a percentage of those profits do now.
(5) John F Kennedy as president of the United States re-introduced the United States note and actively embraced this idea, however issuance of the US Note ended in 1964 subsequent to his death.
Steve Brown is the author of “Iraq: the Road to War” (Sourcewatch) editor of “Bush Administration War Crimes in Iraq” (Sourcewatch) “Trump’s Limited Hangout” and “Federal Reserve: Out-sourcing the Monetary System to the Money Trust Oligarchs Since 1913”; Steve is an antiwar activist, a published scholar on the US monetary system, and has appeared as guest contributor to The Duran, Fort Russ News, Herland Report, The Ron Paul Institute, and Strategika51.
The statements, views and opinions expressed in this column are solely those of the author and do not necessarily represent those of this site. This site does not give financial, investment or medical advice.
A couple of errors in the article, where the skim on “profits made” should read skim on “reserves”. Another thing, the USD is *not* a claim on taxes. The USD is not a claim on *anything* – except trust that the US government will honor its debt. MMT people will argue about that until they are blue in the face. But put simply, the cash dollar debt notes in your wallet equate to some US government debt instrument somewhere, but it’s impossible to know where, and to who or whom that instrument is owed — unless you purchased it yourself…… Read more »
More drivel by Steve Brown, who hasn’t the foggiest. How the hell can you sit here and claim that the USD is not a claim on Federal and State taxes? How else do you extinguish tax obligations? With Yen? With cotton? Reserves are central bank liabilities. How can the FED skim on liabilities? For anyone interested in how fiat money works, read Beardsly Ruml’s article from 1946, Taxes for Revenue are Obsolete, published in the Journal of American Affairs. TAXES FOR REVENUE ARE OBSOLETE by Beardsley Ruml Chairman of the Federal Reserve Bank of New York Mr. Ruml read this… Read more »
A Federal Reserve note is only a claim on US government *debt* as there is some corresponding debt instrument OR tax revenue behind it… but even that is irrelevant. The only thing that truly maintains the US dollar is TRUST in the system. For example when that trust was shaken by Moody’s downgrade of federal debt (which Obama forcibly reversed) that’s why the DXY hit 70 in 2011. US government spending is $4.75 trillion and its revenue is $3.65 trillion and less than 1/2 of that revenue is from the US taxpayer. A dollar is a claim on taxes only… Read more »
https://www.philstockworld.com/2019/10/24/fed-injects-134bn-in-liquidity-term-repo-obersubscribed-amid-monthend-liquidity-panic/ This is not an expansion of the tax base. in 2013 2014 POMO allowed the Fed to “create” 85 Billion USD per month, that was not an expansion of tax credits.
Alan Greenspan to Congress:
“There is nothing to prevent the government from creating as much money as it wants.”
Committee on the Budget, House of Representatives, March 2, 2005 Paul Ryan: “Having personal retirement accounts is another way of making a future retiree’s benefits more secure for their retirement. And also, do you believe personal retirement accounts as a component to a system of solvency does help improve solvency, because when you have a personal retirement account policy, if it is a company with a benefit offset, with that feature in place do you believe that personal retirement accounts can help us achieve solvency for the system and make those future retiree benefits more secure?” Alan Greenspan: “I wouldn’t… Read more »
What this M4 post says is how things should work, not how they do work. The Brown article is on how the us operates its money which seems to me accurate, not how it should work. From what I read, you are saying the tax base should be expanded with new tax when the tax base is shrinking. There are many good ideas from you but the article seems more about what is going on, not how to change it.
Unlike the hack jobs of Steve Brown, here’s an honest take of MMT by a pro-Bitcoin libertarian Nima Mahdjour. beinglibertarian(dot)com/mmt/ For quite a while now I’ve been pretty unsatisfied with mainstream as well as Austrian economics-based takes on the global economic situation, in particular phenomena such as record low to negative interest rates in countries with record debts (such as Japan), massive excess reserves, and QE 1 through infinity without much consumer price inflation, etc. No economic school I had learned about offered fully coherent answers regarding those. So I thought it may be worthwhile to throw another heterodox economic… Read more »
MMT is souped-up Keynesian theory which says the government can issue $ forever (actually the Fed does that on behalf of the Treasury) and can forever grow the currency base, and says that the gov can never default…. that is all true. BUT the story does not end there. The $ can only maintain ‘intrinsic value’ via the global trust placed in US government debt, so long as the US $ remains predominant as global reserve currency. Likewise, M4A does not address the means by which this system actually and *only* operates.. M4A interprets that as MMT sees fit, according… Read more »
They are saying efficient use of resources which is good capitalism can allow the government to greatly expand the monetary base. But who is going to enforce good capitalism? Efficient use of resources has occurred only briefly in the Fed’s existence, and that was not due to the government or Fed. For example the CCA might have been a good thing because the government had so many unemployed people to employ. Now the government spends on the military, beltway bandits, useless contractors and waste etc and that cannot be changed.
Okay article but Brown misses that the Fed has kept QE going. The Fed said it was selling its assets purchased in the decline but quit, and has continued on with its temporary operations. Peter Schiff is always going on about QE 4 but QE4 is still with us in the form of repos. The temporary operations with the fed banks was not stressed enough.
This article describes how the Fed operates fairly well and I have only one minor quibble with it. The Fed purchases securities from commercial banks too, not just the US treasury to issue currency. Many of those bank securities purchased by the Fed are toxic. That seems to be lost in the discussion. Also this article does not describe how the Fed balances its purchases of different types of securities (to create dollars) between treasury products and bad bank assets to manage the federal funds rate. But presumably that is too macro for such a discussion.