The Fed As Inevitable Debt Factory

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:

https://www.investopedia.com/articles/investing/081415/understanding-how-federal-reserve-creates-money.asp

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.

In Pictures

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.

https://en.wikipedia.org/wiki/Fractional-reserve_banking

Money multiplier

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.
Formula

The money multiplier, m, is the inverse of the reserve requirement, R:

m = 1/R

Example

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.

In Conclusion

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?

Subscribe to feed

Advertisement