Writing history of
There’s an ongoing discussion with Stanley Mulaik on Facebook, about money creation by the US central bank (the Fed) and the US budget deficit. If I understand him correctly, the US government can spend more dollars than they receive in taxes, because they can issue securities which somehow the central bank can redeem for free, with money created from thin air. So the national debt does not increase as a result of this.
I don’t think that’s possible.
There are many Facebook posts. As an example, below I quote from this post dated 20 June 2017, more specifically from this comment, which Stan made on his own post, and this one.
I’ll look at the balance sheets of respective parties involved in the transactions, how they change in each step, and what that means in terms of money creation and the US national debt.
Not specifically realistic, just to have a starting point for what follows.
Fed’s balance sheet:
| Description | Debit (assets) | Credit (liabilities) |
|---|---|---|
| Various assets including gold | 10 000 | |
| Commercial bank’s reserves | 1 000 | |
| Treasury’s account | 1 000 | |
| Capital | 8 000 |
Commercial bank’s balance sheet:
| Description | Debit (assets) | Credit (liabilities) |
|---|---|---|
| Reserves account with central bank | 1 000 | |
| Outstanding loans | 1 000 | |
| Various clients’ checking accounts | 1 000 | |
| Capital | 1 000 |
Quote from Facebook:
“So, we will begin considering dollars lent by U.S. banks
to the Treasury for deficit spending:
(1) Dollars received by the Treasury from the banks are spent on deficit spending into
circulation in the economy. However, Treasury cannot spend what Congress has not
authorized. Congress has the absolute power to borrow money. So, when the Treasury
encounters a deficit, the Treasury has to borrow from U.S. banks to cover the deficit.
It does this by issuing U.S. securities and bonds and sells them at public auction to
the banks at discount from the face value of the security. The security is just an IOU,
a promissory note, to pay the holder of the security the face value of the security at
some future date known as the maturity date for the security.”
Resulting situation (02) after the bank bought the securities, total face value 1 million dollars, at the discounted price of $990 000 (to account for the interest), paid for with its central bank reserves, settled via the central bank. Below all amounts are expressed in thousands of dollars:
Fed’s balance sheet:
| Description | Debit (assets) | Credit (liabilities) |
|---|---|---|
| Various assets including gold | 10 000 | |
| Commercial bank’s reserves | 10 | |
| Treasury’s account | 1 990 | |
| Capital | 8 000 |
Commercial bank’s balance sheet:
| Description | Debit (assets) | Credit (liabilities) |
|---|---|---|
| Reserves account with central bank | 10 | |
| Securities | 990 | |
| Outstanding loans | 1 000 | |
| Various clients’ checking accounts | 1 000 | |
| Capital | 1 000 |
Obviously it makes no sense for the government to borrow money if they don’t use it for anything. They borrow because they need to spend it. As Stanley Mulaik wrote: “Dollars received by the Treasury from the banks are spent on deficit spending into circulation in the economy.”
Here I assume the Federal Government makes a payment from the Treasury account to some contractor for maintaining infrastructure, like repairing an old bridge. For simplicity, the contractor company happens to have its bank account at the one commercial bank under consideration in this scenario. The resulting situation (03) is:
Fed’s balance sheet:
| Description | Debit (assets) | Credit (liabilities) |
|---|---|---|
| Various assets including gold | 10 000 | |
| Commercial bank’s reserves | 1 000 | |
| Treasury’s account | 1 000 | |
| Capital | 8 000 |
Commercial bank’s balance sheet:
| Description | Debit (assets) | Credit (liabilities) |
|---|---|---|
| Reserves account with central bank | 1 000 | |
| Securities | 990 | |
| Outstanding loans | 1 000 | |
| Various clients’ checking accounts | 1 000 | |
| Contractor | 990 | |
| Capital | 1 000 |
If we compare this situation 03 with the initial situation 01, we see that at the central bank, everything is back to what it was. At the commercial bank however, we see the added securities (an asset of the bank) and an extra liability: the bank now owes the contractor money it didn’t owe it before.
It’s almost as if the bank lent money to the contractor. The difference is the loan (the security) is to a different party: the Treasury, not the contractor. We could even say the bank did lend money to the contractor but with the Treasury as an intermediary.
The result in terms of money creation is the same: the amount of broad money has increased from 1000 (in Various clients’ checking accounts) to 1000+990 = 1990. Money creation took place as a result of government spending, not as a result of the bank lending money to the Treasury.
I continue to quote Mr. Mulaik:
“a.
When the bank's security matures, ordinarily, the government would have to give to the bank the full face value of the security, which will contain interest as the difference between the discounted price at which the bank bought the security and the face value. That's what most Americans think will happen. It doesn't happen that way.
b.
When the bank's US security matures, the Treasury issues a new US security at the same face value but a new future maturity date and swaps that with the bank for the mature security. Treasury also pays interest on the mature security. The new security is discounted according to the public auction's current discount prices. The Treasury will then extinguish the mature security it gets. But the debt is now contained in the new security, but is to be paid off at a new,
future date.”
OK. Although this probably happens in a single transaction, for clarity, I split it in two. First the treasury redeems the mature securities at face value, then it sells the new ones to the bank at a discount (the same discount as before, although in reality this will vary). After the redemption step (situation 04):
Fed’s balance sheet:
| Description | Debit (assets) | Credit (liabilities) |
|---|---|---|
| Various assets including gold | 10 000 | |
| Commercial bank’s reserves | 2 000 | |
| Treasury’s account | 0 | |
| Capital | 8 000 |
Commercial bank’s balance sheet (now including profit and loss):
| Description | Debit (assets) | Credit (liabilities) |
|---|---|---|
| Reserves account with central bank | 2 000 | |
| Outstanding loans | 1 000 | |
| Various clients’ checking accounts | 1 000 | |
| Contractor | 990 | |
| Capital | 1 000 | |
| Proceeds from interest | 10 |
What we see is that the securities have vanished from the bank’s balance sheet, because they are mature, their durations have expired, so they are annihilated, they no longer have any value. In exchange, the original issuer of the securities, the Treasury, has paid the full face value, 1 million dollar, which is more than the discounted price of 990 000 that the bank originally paid for them.
The difference is the interest that bank has earned. It puts that in a proceeds account, so eventually it will appear in the annual profit and loss statement.
The Treasury’s account with the Fed went from 1000 to 0 thousand dollars, a difference of 1000, which is the face value of the old securities.
Next partial step: the situation (04b) after the Treasury has sold the new securities to the commercial bank:
Fed’s balance sheet:
| Description | Debit (assets) | Credit (liabilities) |
|---|---|---|
| Various assets including gold | 10 000 | |
| Commercial bank’s reserves | 1 010 | |
| Treasury’s account | 990 | |
| Capital | 8 000 |
Commercial bank’s balance sheet:
| Description | Debit (assets) | Credit (liabilities) |
|---|---|---|
| Reserves account with central bank | 1 010 | |
| Securities | 990 | |
| Outstanding loans | 1 000 | |
| Various clients’ checking accounts | 1 000 | |
| Contractor | 990 | |
| Capital | 1 000 | |
| Proceeds from interest | 10 |
The Treasury is almost back to what it had before the securities roll-over (situation 02), except that 1000 is now 990 thousand dollars, due to the interest payment it had to make to the bank.
Bank reserves went from 1000 to 1010 thousand as a result. So in terms of bank reserves, money creation has taken place. However, the Treasury’s lower balance with the central bank means the Treasury has paid the interest out of its own pocket, it could not use the reserve creation (which is real and has actually taken place) to pay the interest from that.
Stanley Mulaik on Facebook continued:
“c. The swapping of a new security issued by Treasury for an equal valued mature US security is known as a 'roll-over'. Rolling over and over and over can happen forever as each successive security matures. This means the debt is for all practical purposes no longer a real debt because it will never be paid back, although interest will be paid at each roll over.”
I don’t agree with this. A debt is a debt even if it isn’t redeemed for a long time. The possibility of roll-overs, in other words of refinancing expired debt, depends of the willingness of creditors to agree with that. Such willingness in turn depends on the creditworthiness of the debtor, here the US Federal Government and Treasury.
Here in Wikipedia I see that the US national debt is now well over 70% of the GDP (Gross Domestic Product), and developing towards 80%. That is not as problematic and worrying as Greece’s almost 160%, but it is still a huge amount of money.
Even at current low interest rates, the interest paid for that is immense. In the 2016 US Federal budget, interest amounted to 6% of Federal outlays, or 1.2% of GDP. Not very much as a percentage, but remember that interest rates are now extremely low, held artificially low by central banks. So in future they may go up, so that interest may one day be like 20% of total federal spends.
Now back to our tiny example of balance sheets, to see what happens at each step. Again, I continue to quote from Mr. Mulaik’s text:
“c d. The deficit-spending dollars spent into circulation are debt-free / ”
No, they are not. As we see above, the 990 thousand dollars now owned by the contractor (as a liability of the bank) corresponds to the bank owning the IOU issued by the Treasury. The Treasury spent the money it borrowed. The Treasury has an increased debt and has had to pay interest.
The interrupted quote again, now in full:
“c d.
The deficit-spending dollars spent into circulation are debt-free and potentially could cause inflation if the amount spent into circulation makes the quantity of money in circulation exceed what is necessary to clear the market of goods and services and pay for innovation at full production and employment at stable prices.
e. Commercial banks love the debt-free interest they receive at each roll-over of a US security and are eager partners with the Treasury in the roll-over arrangement.
(5) The national debt is ‘owed’ to two kinds of creditors:
a. US commercial banks for bank loans to cover deficit spending. These loans are rolled over perpetually making dollars borrowed essentially debt-free.
b. private and foreign investors who buy US securities and whose dollars are sequestered in time-deposit securities accounts at the Fed, are not spent on government programs and activities.
i. investors securities are redeemed by Fed at maturity by withdrawing the dollars from the investors’ securities accounts and returning them to the investors along with interest that the
Fed creates out of nothing.”
Item 5b. particularly interests me, because I anticipate that that might be the key to the whole issue. First, it seems to assume the investor buys securities the Fed already owns. Confer what Stanley Mulaik wrote in his second June 2017 comment:
“(7)
The Federal Reserve bank (the Fed) can buy US securities from banks in Quantitative Easing directly from the banks or at public auction by depositing the face value of the security in reserve dollars created out of thin air in the banks’ reserves accounts at the Fed.
a. This cancels the debt of the government to the banks in the securities.
b. The debt of the government is now shifted to the Fed.
i. The Fed can retain the mature securities until inflation arises and then take the securities to the Treasury and swap them for new securities. Treasury will extinguish these mature securities returned to its possession.
ii. The Fed can now sell the new securities to private and foreign investors to drain dollars out of circulation to counter or prevent inflation. This dissolves the government’s debt on the securities to the Fed and places it on the securities of the the investors now holding the securities. Hereafter the Fed only serves as an agent for the government in managing the investors’ sequestered dollars at the Fed and paying interest to investors”.
When an investor buys such securities previously owned by the Fed, the investor pays by having its bank account charged, at the credit side of the bank’s balance sheet (BS). In exchange, the bank has its reserves lowered (debit side in bank’s BS, credit side of Fed’s BS). This balances out the loss of the security by the Fed (debit side of Fed’s BS).
If instead the dollars that the investor has to pay, are stored in a time-deposit at the Fed (is “sequestered” the right word, by the way?; not according to my dictionaries), those should logically reside at the debit side of the Fed’s BS. Instead of having a liability (bank reserves) decreased as payment, an asset is increased on the Fed’s BS. If so, that time-deposit must be at the credit side of the investor’s BS, being a liability, balancing the asset (securities) at the debit side. In fact, the investor would then, instead of having paid, have borrowed the payment money from the Fed.
I wonder if that is even allowed: it would mean the Fed is placing a time-deposit, is investing money, in a non-bank. Wouldn’t the investor need a banking licence for that? I do think so.
It just doesn’t make sense. Yesterday (29 Sep) I started googling to learn more. I used as search terms sequestered in time-deposit securities accounts at the Fed, and quickly found a text on LinkedIn by Eddie Delzio (a name completely new to me). Under it, there is a comment by Stanley Mulaik, so I was again in familiar territory. The description is quite clear, and Mr. Mulaik liked it, which is reason for me to quote it almost in full:
“Most of us keep some our dollars in accounts at banks, and at those banks we have checking accounts and savings accounts…
We transfer our dollars back and forth between our checking accounts and our savings accounts…
We transfer dollars from checking into savings, because savings accounts earn interest over time, and we also transfer dollars that we instead need to be liquid from savings back into checking...
Most people today aren’t familiar with the actual workings of our US monetary system on this same operational level. A big source of many myths and collective angst comes from all those mysterious machinations of Treasury bonds behind the scenes over at the Federal Reserve Bank. Let’s pull the curtain at the Fed back a little bit.
The Federal Reserve Bank operates independently, yet is part of, or within the federal government, the issuer of dollars. The Fed is set up almost exactly the same as any private bank, with one notable exception–The Fed has a monopoly power over dollars. The Fed, our central bank, where all the banks do their banking, has a similar account setup as any other bank, but instead of a checking account, the Fed calls it the Reserve account; and instead of a savings account, the Fed calls it the Securities account.
All banks with deposit liabilities are required to keep a certain percentage, called a reserve requirement, in the Reserve account at the Fed, because it needs to be liquid, like a checking account at any other bank. In addition, any bank, plus anybody else that wants to, may deposit their dollars in the Securities account at the Fed, because it earns interest, like a savings account at any other bank. Making a deposit in the Securities account at the Fed is also known as buying a US Treasury bond.
All marketable US Treasury securities (Treasury bonds, notes, bills, and also TIPS), are nothing but interest earning time deposits in the Securities, or savings account at the Federal Reserve Bank. When anyone buys a Treasury bond, they are opening a term deposit in the savings account at the Fed, just like opening a deposit in the savings account at any bank, or like getting a CD at any bank, except a Federal Reserve Bank CD is called a Treasury bond.”
(CD = certificate of deposit, I had looked that up before.)
OK! Indeed checking account and savings accounts of bank clients are at the credit side of a commercial bank’s BS: a liability of the bank.
Likewise the reserve accounts that commercial banks have in the Fed, are on the credit side of the Fed’s BS. And so is this time-deposit securities account, that I’ve been looking for. So this time-deposit does not contain the money the investor paid for securities he purchased (which would place the deposit at the debit side the Fed’s BS); instead that time-deposit IS the security!!!
What used to be IOU’s on paper, is now an electronically administered account.
If this is so, and those accounts really belong on the balance sheet of the Federal Bank System, then it’s the Fed that is borrowing money by issuing securities, not the Treasury. For the money to arrive at the Treasury, the Fed would have to on-lend it to the Treasury. Likewise, when the Fed redeems the securities, it must charge the Treasury for that.
Yesterday (29 Sep) I consulted the Fed’s 2015 Annual Report. The full 456 page report is also available as a single PDF.
The financial statement that starts on page 311 (319 in the PDF) is of the Board of Governors of the Federal Reserve System. It is about operational costs, and is kept separate from the consolidated financial statement for the regional Federal Banks. That latter starts on page 338 (346 in the PDF): instead of a Consolidated Balance Sheet, they call it the Combined Statements of Condition. That’s fine with me.
On it, I do see huge holdings of Treasury securities, but not something like the time-deposit securities accounts of investors, that Mr. Delzio and Mr. Mulaik were writing about. In the US Treasury Resource Center however, I found info like this DAILY TREASURY STATEMENT, which mentions various types of Treasury Securities, for example the US savings bonds, for which investors need a TreasuryDirect account.
So instead of the time-deposit securities accounts residing on the Fed’s balance sheet, I think it is much more likely there are on the Treasury’s. That makes it much more logical: it is the Treasury who borrows and the Treasury who spends.
However it may also be that the Fed assists the Treasury in actually handling and administering these accounts, just like the Fed organises Treasury Securities Auctions on behalf of the Treasury. This is described on page 97 of the Fed’s 2015 report, as follows:
“As fiscal agents and depositories for the federal government, the Reserve Banks auction Treasury securities, process electronic and check payments for Treasury, collect funds owed to the federal government, maintain Treasury’s bank account, and develop, operate, and maintain a number of automated systems to support Treasury’s mission.”
Be that as it may, I don't think it makes an essential difference. What matters is, is too much government debt a problem? And can the US borrow for free? My answers are: yes and no respectively. Eddie Delzio sees this differently. I quote more text from LinkedIn:
“So what exactly happens when anyone buys an existing or newly issued US Treasury bond? The dollars used to buy Treasury bonds usually originate from checking accounts at private banks, and because these dollars are excess dollars, were most likely transferred to the checking, or Reserve account at the Fed. On the settlement date of the Treasury bond purchase, those dollars are transferred from the Reserve, or checking account at the Fed, over to the savings, or Securities account at the Fed, and registered in the buyer’s name. That’s it, that’s buying a Treasury bond. Buying a long term Treasury bond, a medium term Treasury note, or a short term Treasury bill is nothing but a simple transfer of dollars from the Fed’s checking account to the Fed’s savings account, just like you do at your own private bank, and for the very same reason–to transfer your liquid, demand deposit of dollars, over into an interest earning, time deposit of dollars.
Conversely, what exactly happens when someone sells their Treasury bond, or their Treasury bond matures? Those dollars are transferred from their savings, or Securities account at the Fed, back to the checking, or Reserve account at the Fed, just like you do for the same reason–to transfer your interest earning, time deposit of dollars over into a liquid, demand deposit of dollars.
The same thing happens for QE or LSAP when the Federal Reserve Bank forces the sale of marketable Treasury bonds out from the secondary Treasury bond market to manipulate the price, or interest rates of dollars lower. The Fed is not printing money, they are just transferring the dollars of the holders, or sellers of those Treasury bonds from their Securities account at the Fed, over to the Reserve account at the Fed. Their dollars were transferred at the Fed, purposely done by the Fed, in an exercise of monopoly control of the Fed.
Again, the exact same thing would happen if China ever decided to sell their US Treasury bonds, dump them, even all at once. That would certainly cause turbulence on the airwaves and in the markets, but after all the selling on the rumors and all the buying on the news, at the end of the day, it would just be more transfers of dollars with extra noise. There is nothing to worry about if any country sells their Treasury bonds because China, or anybody else that owns Treasury bonds paid for them with dollars, our free floating currency that is no longer backed, or convertible, nor fixed to gold, and which our federal government, the issuer of dollars, creates. In this scenario the Fed would again merely transfer China’s dollars from their Securities account to the Reserve account. Click…Enter…Blink. Done. No burden on your children. No unsustainable debt. No out of control borrowing, and no danger to the financial stability of the country.”
I think this is wrong and misleading. I’ll check what happens under both assumptions: that the Treasury securities (also known as time-deposits in securities accounts) reside with the Fed, and that they reside with a Treasury where they belong.
In this chapter, I do not present full balance sheets, but rather I indicate increases by a plus sign and decreases by a minus sign. So in fact these tables are journal entries, which show the changes in general ledger accounts. Also, I disregard interest.
First assuming the Fed has the securities accounts:
| Debit (assets) | Credit (liabilities) |
|---|---|
| Investor: | |
| + Security | |
| − Checking account in bank | |
| Bank: | |
| − Bank reserves | Investor’s checking account − |
| Fed: | |
| Bank reserves − | |
| Security + | |
| + Loans to Treasury | Treasury’s checking account + |
| Treasury: | |
| + Treasury’s checking account | Loans from Fed + |
In words:
The investor obtains the security, and pays for it via its bank account.
At the bank, the investor’s account decreases, but because the
payment is not for the bank but for the Fed, the bank reserves must also
decrease. This is reflected at the Fed (other side of the BS), serving as
payment for establishing the security for the investor. However, because
the purpose of it all is really to provide the government with money, not the
Fed, the Fed increases the balance on the Treasury’s transaction
account, and in return must establish some sort of loan.
The Treasury has received extra money in its account, which it borrowed from the investor, via the Fed.
There has been money destruction, both in terms of broad money (the investor now has less money in his bank account), and in bank reserves (see minus signs indicating decreases).
When the security is redeemed (not rolled over), everything happens in reverse. Money creation takes place, seeing that bank reserves and the investor’s account go up. Yet, this money creation is not a magical wand to have money for free: the Treasury loses the money it had earlier obtained from the issue of securities (and in practice even more, because of the interest).
The government must pay its debts like everybody else. The only possibilities to cover for this are: taxes or new loans. Not money creation, although that really happens.
Now let’s see what happens assuming the Treasury itself has the securities accounts:
| Debit (assets) | Credit (liabilities) |
|---|---|
| Investor: | |
| + Security | |
| − Checking account in bank | |
| Bank: | |
| − Bank reserves | Investor’s checking account − |
| Fed: | |
| Bank reserves − | |
| Treasury’s checking account + | |
| Treasury: | |
| + Treasury’s checking account | Security + |
The two cases are really very similar. Instead of seeing the decrease of bank reserves as payment for the security, the Fed now increases the Treasury’s account in exchange. The Treasury has more assets (money in its account with the Fed), and it has an extra liability: the security.
Here too, redemption means loss of balance in the Treasury’ account. Simply pay the debt, no magical wand available.
Money for free through money creation out of nothing, or out of thin air is a myth. Governments must pay their due. Taxation and borrowing are the only possibilities.
Written 21–23, 27 and 30 September 2017, researched annual reports of Fed and Treasury: 29 September.
Copyright © 2017 R. Harmsen. All rights reserved.