I ran into this in a video about money and monetary history. I noted that nothing they said conflicted with what I knew about The Fed and the creation of money – yet it was not something presented in my Econ Degree studies. Something of a WT? moment as it is a pretty simple thing.
I’m going to present it as a “story” and then in a simple graph or table format. I’m still not convinced I’ve not just “missed something” somewhere.
The basic thesis is that since the US Government (or most national governments, really) must issue Bonds to their central bank in order to get a money credit, then they must eventually repay the bond plus the interest, it is inevitable that National Debt to said Central Bank must grow. In the case of the USA, it s the Federal Reserve Bank that issues currency (the Treasury Bureau Of Engraving and Printing prints it, but it is handed over to The Fed as it is a liability of The Fed who must redeem it once issued). So even if you wanted to tax currency from We The People to pay off the debt it would require having that currency brought into existence via The Federal Reserve.
A non-technical overview of the process (and a bit thin, IMHO) is here:
Suppose the U.S. Treasury prints up $10 billion in new bills, and the Federal Reserve credits an additional $90 billion in readily liquefiable accounts. At first, it might seem like the economy just received a monetary influx of $100 billion, but that is actually only a very small percentage of the actual money creation.
Essentially, The Fed holds US Bonds (along with lots of other stuff from open market operations) including loads of printed currency. The US Government can print the currency for The Fed, but does not own it. The Fed owns the currency as it is their liability. The Fed can have more currency printed up, or issue credit balances to folks, but only against their assets, including Government Debt. To get more currency, you need more assets at The Fed, which means more debt from others held by The Fed.
The link confuses the issue with that reference to some other ill defined “readily liquefiable accounts”. The basic mechanism is that the US Treasury issues bonds for, say $10 Billion. The Fed takes them, and issues a credit to the US Treasury. Now the Treasury can spend that credit electronically, or physically print up $10 Billion of new Federal Reserve Notes and spend them (cancelling that credit from The Fed).
Alternatively, The Fed, now having an Asset worth $10 Billion (the US Bonds) can just have the $10 Billion of physical currency printed and delivered by the US Treasury to The Fed, who can then issue these “liabilities” (to them) against their asset of US Bonds (A liability to the US Government). The Fed must keep enough assets around to cover that issuance of (their) liabilities (cash). When they hand over that currency, they get some assets in exchange (like gold or mortgages), so it is net about a wash.
The Fed can now distributed those new notes to other banks, as needed. The Fed gets $10 Billion of cash, for taking in a $10 Billion pile of bonds. The Treasury just does the printing and gets to spend any credit for the bond. (i.e. it could spend that cash directly, but more likely it just has it’s “credit” balance handed out via the banking system as Social Security payments or a new build aircraft carrier or ‘whatever’). So that $10 Billion of bonds paid $10 Billion of bills (either as cash in hand or bank credits).
Now the problem comes in 20 years later…
After 20 years, that bond has racked up a lot of interest. Just for grins, let’s say it was a 5% coupon (straight interest). That would be 20 x 5% or 100% of face value. Over that 20 year period, $10 Billion of interest was paid by taxing away currency or bank credits, and handing that money over to The Federal Reserve. Yet now ANOTHER $10 Billion is needed to buy back the principle of the bond. From where does it come?
You have already taxed back the original $10 Billion spent / created in the first transaction.
Well, you could just tax everyone a whole lot more, but that will cause a large contraction of the money supply. Since ALL the money created went though this process anyway, there just isn’t enough in existence to tax back to pay off all the bonds. You issued X Bonds, paid X Interest + X Bonds or 2X the money created. Ooops.
The only real option that avoids contracting the money supply is to issue new bonds to create more new money to pay off the old bonds, plus the interest paid.
JFK tried to side step this by having the U.S. Treasury directly print Treasury Notes (with a red seal on them). In this way the U.S. Treasury would just skip that whole bonded debt cycle and pay off the existing bonds with new cash. He ended up dead not too long thereafter, the program was scrapped immediately, and other than a few money geek conspiracy theorists, nobody talks about it much.
The one “out” from this that I can see might be that The Fed can also take in, for example. a large commercial mortgage bundle on a chunk of a city. That becomes an asset, so they could issue a load of currency (liabilities) against it. Then that currency could be taxed away and used by the Government to pay off their bond and retire it. But all this does is move the National Debt into Private Debt. You still end up with the ever growing debt pile.
Near as I can tell, this process continues until The Fed holds all debt. We saw a preview of that in the Financial Crisis where The Fed basically sucked up any debt needing coverage (about 4 $Trillion worth, IIRC). The only way to reduce the net debt is to hand to The Fed more currency or credit balances than it created in the issuance of the debt.
I’m going to use _____\ as an arrow since WordPress steals anything between angle brackets to try turning it into HTML…
So the schematic form here is:
The Fed /_____ $10 Billion Bonds from The Government The Fed _____\ $10 Billion Credit (then that print money cycle if desired) The Fed /_____ $10 Billion of interest payments over 20 years. The Fed /_____ $10 Billion redemption of Bonds in 20 years.
The net net of all that is The Fed gets $20 Billion from the US Government who spent $10 Billion revenue from Bonds.
Even if the US Government taxed $10 Billion from We The People to pay the interest on the bonds, that’s still $10 Billon of debt due in 20 years. To pay it requires more money, that doesn’t exist unless the money creating cycle is cranked again:
The Fed /_____ US Bonds The Fed _____\ Credit US Govt. or U.S.Treasury printed Federal Reserve Bank Notes - bank liability.
But that only gets you another round of debt to pay off the old round, plus interest.
I’m not seeing any way to extinguish the debt that doesn’t require the creation of Yet More Money via Yet More Debt; other than the issuance of US Treasury notes – a US Treasury liability.
The Commercial Banks & Multiplier
This often confuses folks. No SINGLE bank can just create money at the stroke of a pen (with the exception of The Fed via changing the reserve requirement). The banks COLLECTIVELY do create money from nothing via the “Fractional Reserve” Banking requirement.
So that $10 Billion at The Fed (newly printed cash to be issued against some asset in the vault) can be shipped out to some regional bank based on their pledging some ‘assets’, like your mortgage or the gold in their vault. (Different asset classes have different relative worth as collateral and I’ll not go into that here; other than to note that during the Banking Crisis there was a lot of hand wringing and they they just decided to value a lot of crap mortgages and “repos” as good as gold…)
Then The Fed transfers to them that $10 Billion. Now here is where the “magic” happens:
The bank can NOT just say “make that 10 a 100”. They must loan the money out. BUT, they have to keep a bit of it in ‘reserves’. So if the “reserve ratio” were, say, 10%, they could loan out $9 Billion. Say they loan it to Boeing for building a new airplane and factory. That would be $9 Billion to Boeing who deposits it in their bank, who can also then lend it out again. BUT, they have to keep part of it as “reserves” for when the first Boeing Check to buy a bit of land, or some aluminum, or pay a payroll rolls around. But their bank can only now loan out 90% of $9 Billion, or $8.1 Billion. This process continues as each party who gets some of the money deposits it in their bank.
The money multiplier is a heuristic used to demonstrate the maximum amount of broad money that could be created by commercial banks for a given fixed amount of base money and reserve ratio. This theoretical maximum is never reached, because some eligible reserves are held as cash outside of banks. Rather than holding the quantity of base money fixed, central banks have recently pursued an interest rate target to control bank issuance of credit indirectly so the ceiling implied by the money multiplier does not impose a limit on money creation in practice.
The money multiplier, m, is the inverse of the reserve requirement, R:
m = 1/R
For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a fraction:
R = 1/5
So then the money multiplier, m, will be calculated as:
m = 1 / (1 / 5) = 5
So a 10% reserve requirement would be a multiplier of 10. That means a $10 Billion “credit” from The Fed (or that much currency handed out to regional banks) would eventually become $100 Billion if all of it were re-deposited as many times as possible.
Now you might think The U.S. Government could just tax away $10 Billion of that and use it to pay off the Bond. Except that the same monetary expansion has a matching monetary contraction when funds are withdrawn from the banks and extinguished by handing it back to The Fed. So suck out the $10 Billion, and that $100 Billion “goes poof” as the expansion unwinds.
Excess net taxation can really crush the money supply and the economy as that money exits the fractional reserve banking system, especially if it is used to extinguish debt to end the debt cycle.
I don’t know if I’ve explained this well enough and I’m not sure I’ve got it all complete and correct. I hope I’ve missed something somewhere. If I’ve not, then the imposition of The Fed between the U.S. Government and We The People as an interest collecting holder of National Debt must of necessity cause the total debt to always increase and never be extinguished.
So what did I miss? What’s the way out?
Former Federal Reserve Chair Janet Yellen said she doubts that President Donald Trump has a good grasp of monetary policy and what the central bank does.
Regarding arrows or pointers. I’ve used the brackets and equal sign.
My attempt here:
It worked on a different WordPress site. Oh well.
The Original system to solve Government indebtedness was the Missippipi scheme in France in the 1717-1720’s.
Based on the belief that credit could be expanded without limit, especially if ‘backed’ by the Government. French government bonds were selling then around 84% discount (i.e. 16% of face value) and the French Government couldn’t borrow any more except at exorbitant interest (the ‘Credit Farmers’ disaster followed in that the Government ‘sold’ future revenue in return for a set sum. The Credit Farmers made a profit by extorting more from the lower classes. The other problem was the ‘sale’ of nobility in that for a lump sum you (and your heirs) became noble and largely tax free. As the government NEVER reduced expenditure the burden fell on a decreasing percentage of the population. Eventually they reduced their financial obligations by the reduction of the nobility (à la guillotine)). There was a ‘bubble’ where bonds rose (about) 60 times their original value before the inflation and collapse.
The French Government protected most of those guilty and thrust the cost onto the general population, so it was decades before the economy recovered.
This was sort of copied by a number of financial sharks in the South Sea Company in England who offered Company shares (at a premium) to holders of Government stocks. When the scam collapsed all the Directors and Company Officers (except one conveniently in exile for 23 years) were prosecuted before the Houses of Parliament (despite a number of members having received bribes) and ‘fined’ various amounts of their nett wealth – from less than 10% for the ‘innocent dupes’ to 95+% for the guilty. The country recovered fairly quickly.
John Carswell – The South Sea Bubble is useful reading.
My understanding is that when any nation just prints money without increasing that nation’s worth, invites inflation (as a reduction in purchasing power). Yes there are lots of fancy financial tricks that can be done to delay inflation but it will arrive sooner or later.
Here’s a few graphic pointers to cut an paste. On my Linux box they are available by holding down Alt (graphics) and press ‘Y’, ‘U’, ‘I’ and Alt+Shift ‘U’.
← (Alt + ‘Y’)
→ (Alt + ‘I’)
↓ (Alt + ‘U’)
↑ (Alt + Shift + ‘U’)
Nice trick, but on my keyboard I get nothing with those chords. I could do the Unicode, but it is a pain to type. Basically, your keyboard maps maps those chords to some Unicode that my keyboard map does not. (There are dozens of keyboards and mappings…)
Per inflation: It happens any time the money supply increases faster than the economy grows. The basic identity is that QP=MV the Quantity of goods/services x Price equals the Money Supply x Velocity of Money.
So increase of M can be sucked up either as more P (inflation) or more Q (economic growth).
It can also be absorbed by a lower V, but during times of increased money printing and especially after a touch of inflation starts, V usually rises a lot rather than falling… so while theoretically possible, usually more money printing does not go into lower Velocity… but gets faster V and ever faster P growth. (Q can only increase at the max physical growth rate, long term, so limited by technology growth to about 2% to 3% over long periods of time)
Since the “stuff sold” is a physical known, and the prices are a real price at which they sold, that side of the equation is pretty much “by definition” reality based. Then if you had a $2 Billion annual economy but only $20 Million of “money”, then for that physical trade to have happened, again by definition, that money had to change hands 2 x 10^9 / 2 x 10^7 or 100 times in the year, on average.
It really is a very easily proved thing and one of the few things in Econ that is straight forward and simple. It does get complicated when you get to things like M3, M3, etc. and have a variable quantity of “money” as credit card limits get monetized (used) or not… but that doesn’t change the overall long term.
The Fed remits its profits to the U.S. Treasury so there needn’t be an ever-increasing positive feedback loop of debt.
Consider also that for a few years after WWII the U.S federal government decreased its absolute indebtedness and for a longer period decreased its debt-to-GDP ratio so they needn’t be monotonically increasing.
The driver of Federal Debt is budget deficit spending (spending more than taxes received). Even an an annual basis this is a common short term phenomenon, since tax payments peak quarterly. Making 2 of each 3 months possible deficits.
Balancing the budget takes the pressure off (but does not remove it) the FED to borrow, except to maintain the current balance, EM’s perpetual increase. A slight over collection of taxes, a budget surplus, DOES REMOVE BORROWING, except for those 2 months scenarios. That would equate to a change of borrowing length to just cover those short 2 month cycles, ?90 to 180 days?.
Federal Spending to a balanced budget level with a slight surplus covering inflation/interest. If we stop over Federal Debt increase stops and payoffs occur with the maturation of each bond/note /etc. cycle. As they mature the budget can be increased by the interest previously paid on those bonds/notes/etc.
We don’t need to payoff $21T+, but do need to stop annual overspending.
Another factor is inflation- from inflationdata.com via google search
“As we saw the Average annual inflation rate is 3.22%. That doesn’t sound too bad until we realize that at that rate prices will double every 20 years. That means that every two bars on average prices have doubled or about 5 doublings since they began keeping records. April 1, 2014”
perhaps like from the modern economic theory That’s the way you do it inflation makes it free (the bonds are replaced with diluted currency and the bondholder has simply parked their money for 20 years to break even
Speaking of paying taxes, I highly recommend that you do your tax preparation early. After doing mine I have concluded too many filers are going to be surprised by the changes. I think many will get reduced refunds due primarily to the 2018 changed withdrawal tables provided by the IRS. They in effect gave more cash in paychecks throughout the tax year, and most after the initial pleasant surprise forgot to estimate the effect on their tax status. This has added a great deal of confusion and even anger when calculating taxes.
BTW, for a large, perhaps huge, group of tax payers the new tax law does make it possible to file using the EZ form, (Taxes on a card).
I have always liked martin Armstrong on this subject, e.g. https://www.armstrongeconomics.com/armstrongeconomics101/economics/the-solution-4/
Part of that which has been missed is that the FED is a GSE. It “looks’ private, but it isn’t. It is and is not subject to the Treasury. It is directly subject to Congress! Until a few years ago, if I am remembering correctly, the only “assets” it held was special Treasury bonds (notes with special rules), and the Federal government’s specie (gold and silver). It set interest “directly”, never mind that people who buy and sell can and do have different ideas of “value”. See the Austrian School for that.
It could and did set acceptable commercial bank rules. It still sets reserve ratios. Through these, commercial banks were “nationalized” in fact, even if the politicians said otherwise. When the Treasury mints coins, it “buys” the metal from the FED, if the metal is specie; though I may be wrong about that. I spent years reading the FEDs reports that were available at some public libraries (Birmingham’s, for instance, was one where the reports were made available to those interested in them; and there was, and maybe still is, a branch of the Federal Reserve Bank of Atlanta on 5th Ave. N., Birmingham, AL.).
@C.K. says: 5 March 2019 at 3:30 pm
“As we saw the Average annual inflation rate is 3.22%.
Not sure where you found that 3.22% the annual average inflation rate has not been that high for years.
3.24% in 2006, and 3.85% in 2008, & 3.16% in 2011 – been in the 1.x% – 2.x% range for 7 years now. In short physical productivity is keeping up with increased demand as more people get on the job rolls. January 2019 was 1.55%, Dec of 2018 was at 1.91%
I thought it was their excess profits that were remitted? Anything over some value like 6%. That slows the rate but does not eliminate it.
But who knows what laws Congress might have changed since I learned that bit…
The post W.W.II reduction is encouraging, but could just be an issue of length of time. We were THE economic engine then and basically being bank to the world, so an anomalous time in many ways. Could that continue for decades to zero? I don’t know…
Good point… wish I’d thought of it ;-)
@C.K. & Larry L:
Likely a long term vs recent issue. We had a round of high inflation that Reagan had to kill off with 17% to 19% Fed Rates… Depending on in or out of the average, that will matter.
I thought The Fed was one of those “Quasi-GSEs”.
So the Federal Reserve Banks cream off 6% or so, while the Board of The Fed doesn’t directly take a cut. It is subject to Congressional Oversight, with emphasis on their tendency to overlook things… but not really a governmental entity.
While The Board isn’t owned by anyone, the actual banks are…
I’m still not seeing that as government ownership and repatriation of all profits… so I think the thesis that there’s an issue here remains in play.
More fantasy economics. It’s a new game. What if the government’s only debt is the borrowing?
It’s not a real game. The real problem is the off the book debts, pensions and medicare. Not reported, but a real debt.
Also they are linked to inflation, so the print to pay argument doesn’t work.
OFFTOPIC, but since there a bunch of knowledgeable people here ….
Given that mortgage insurance would have been required for most the “junker” mortgage loans that failed, were the mortgage holders covered. Are they still covered … how long were/are they covered, how does the whole mortgage insurance thing work?
Who covered the insurance? Was AIG tied in somehow as (primary) ultimate holder of the insurance debt? Did the mortgage holders (banks, equity investment groups, etc) really come out OK, because the insurers were the ones that were bailed out?
I don’t see what’s “fantasy” about it. The Fed does exist. The Board Of Governors does set policy. The Government does do the printing at the Bureau Of Engraving And Printing. The Fed does control the Regional Federal Bank policies. The Regional Banks do have members on the board of governors (though a majority are Government appointed). There is a real debt of about $20 Trillion at present. What part is “fantasy”?
Yes, there is another and potentially bigger problem of “Unfunded Liabilities” and yes they can be seen as a kind of non-secured debt (no “security instrument” like a bond is involved). But one thing existing does not make another thing that is real cease to exist.
Or is your point really that “Yes, the $20 T is a problem but the really big one is the $200 T of unfunded unsecuritized liabilities”?
Per “print to pay”: That very much can work as a “long game”. You jigger the “inflation index” definition to under-correct. Reagan did that when he was POTUS and bought a few more decades. It has also been commonly done in many other countries around the world, sometime spectacularly. (When the USSR imploded, they essentially inflated away their “Pension Problem” via a similar means – I have exchanged comments with someone retired on a very good University Pension who had it basically turn to dust in Russia).
The assumption that inflation indexing is accurate and correct is unfounded… at least when set by the denizens of the Den Of Thieves in charge of Government.
That’s a really big pile of questions…
At the core of it is “What was the real risk? and To whom?”. I’m not sure that’s known.
My take on it is fairly rough and high level. It largely comes down to the removal of Glass-Steagall isolation between Investment “Banks”, Commercial Banks, and Insurance.
With G.S. Act they were all VERY separate. A “run on the banks” didn’t take down the insurance companies nor the “investment banks” (think stock brokers / Morgan Stanley). A stock market crash didn’t take down the banks. Insurance companies had lots of assets including lots of real estate isolated from both commercial lending and stocks.
After Clinton got G.S. Act killed off (and with the Republicans being bought off with removing other regulations so they would vote for it) in exchange for his mortgages for everyone fantasy; banks were mandated to make bad loans into bad areas to insolvent borrowers. Everyone with a pulse was getting mortgages and the housing market was on a rocket ride bubble.
Then came the time to deal with reality.
Stocks started dropping AND real estate started being a bad idea, both at the same time. That meant most of the collateral for the Banks and the Insurance companies was melting away.
Worse, many of the mortgages (that were clearly crap) had been packaged up in bundles and given an ‘A’ rating on the reasoning that a few might go bad, but the average of the bundle could not. Clearly a fallacy.
Once all that “unwind” started, it became clear that the crappy mortgages were not so good, even in bulk.
Now here’s where it got lethal: “Mark To Market” was enforced.
In prior eras, a Bank holding the $200,000 mortgage of Mr. Smith could continue to count it as a $200,000 “asset” on their books, even if the current selling price of Mr. Smith’s home had dropped to $180,000 or $150,000. They could take the long view. “New rules” forced banks to “price” their assets “to market” every quarter or two (maybe up to a year in some cases, I’m not sure on the details). This meant that even though 90%+ of their portfolio WOULD retain value and be paid off (folks don’t move out of the home they own just because the sales price dropped…) the bank had to assess ALL of them as dropping 25% in “value”. As their “assets” dropped, the mortgage market dropped, the bank stocks dropped, the insurance company (or branch / division) had their assets drop, so their stocks dropped, so more bank collateral dropped along with the “Investment Bank” inventory dropping… it FORCED a tight negative feedback loop.
Now since G.S.Act was gone, in many cases it was the same company having all the divisions take a hit at once, even if only one of them had a “problem” from some questionable loans.
This continued until several Banks and Investment Banks (and conglomerates of them) were on the ropes.
The Coup De Grace was that IF you were “originally a Bank”, you could get a loan / hand out from The Fed as “lender of last resort”. IF you were originally an “Investment Bank” you could not. That largely determined who went under. Lehman Bros. as an investment house and AIG as an insurance company did not have access to the “Discount Window”. Chase and BofA, Citibank, etc. etc. all could hand over their marginal loans as collateral to The Fed and get money. Bear Stearns could not.
The Fed had an emergency meeting about it and basically everyone scrambled to convert to a Commercial Bank if at all possible; while The Fed tried to get the law changed so it could be the “lender of last resort” to all those “integrated financial institutions” that in function were identical to the “integrated financial institutions” of Banks, but with different founding documents as they had originally been “investment Banks” or Insurance companies. In the end, IIRC, BS missed it by one weekend. Folded on Friday with too much demand for money it could not supply … then the following week The Fed announced a change of policy / law. (Folks speculate about was this accidental or by design…)
In the end, nobody really knew if the insurance was any good (adding to the panic) or if the Insurance Companies would go POOF! too (see AIG). The Commercial Banks “won” as they got Federal Bailouts to buy their competition at discount rates and could fob off anything to The Fed as collateral (The Fed temporarily eased rules on collateral AND started “open market operations” to the tune of about $4 Trillion of asset purchases.
Over the years, many of the “crap loans” have in fact been returned to value and / or paid off on regular schedule. The balance sheet of The Fed is slowly running off those assets. Many “investment banks” converted to “commercial banks” (I think Goldman was one of those) after the weakest ones went out of business. I don’t know much about the final structure of the insurance companies other than that it was brutal for a while.
IMHO, we still need G.S. Act to be put back. It worked for a couple of generations just fine. I think “Mark To Market” was scrapped as stupid and contributing. Some of the “redlining” rules mandating bad loans were reduced or eliminated. And a ton of money was handed over from the Tax Payers to The Bankers. Not nearly enough of them lost their property, jobs, bonuses, or really anything.
So that’s my “from memory” thumbnail sketch. The reality is far more complex and involves a load of acronyms like SIVs (Special Investment Vehicles), RPOs (Repurchase Agreements) and a variety of insurance and options products. Some of them matter. In some cases (RPOs IIRC) it was basically insurance that required NO collateral to back it up, so essentially not going to work when needed in mass. That contributed to the OMG as not only were the Real Insurance companies questionable, but the SIVs and RPOs were seen as naked.
Hopefully that answers your questions. In about 2009/10 I did a more in depth posting on it and that could likely be found with a small search on some of those acronyms and bank names… Also the CRA Community Reinvestment Act that largely started this whole mess of bad loans, non-Bank banks and removal of G.S. Act. Yet Another debacle originating with the Clinton’s and Democrats… but in this case with the complicit “help” of the Republicans demanding banks be free of the G.S.Act in exchange for their vote for the CRA.
Does <this> work?
It’s done as “<” and “&rt;”