The Government’s Bank

How does the government pay for stuff?

That’s a question we should all be asking ourselves. I’m speaking here both from a philosophical and functional perspective. You and I have to earn our money by working. Usually we deposit this money in a bank account that we use as our funding vehicle to buy stuff. When we buy stuff, we debit money from our bank accounts electronically or in currency form. If we don’t have enough money on hand, we can borrow it. So if our lenders cut us off, we better have enough earnings power to pay for our stuff without borrowing or we are bankrupt. That’s how it works for you and me.

So how does it work for government? Well, the Wikipedia entry for the Federal Reserve has a pretty good summary of how the Fed operates as the government’s bank:

In its role as the central bank of the United States, the Fed serves as a banker’s bank and as the government’s bank. As the banker’s bank, it helps to assure the safety and efficiency of the payments system. As the government’s bank, or fiscal agent, the Fed processes a variety of financial transactions involving trillions of dollars. Just as an individual might keep an account at a bank, the U.S. Treasury keeps a checking account with the Federal Reserve, through which incoming federal tax deposits and outgoing government payments are handled. As part of this service relationship, the Fed sells and redeems U.S. government securities such as savings bonds and Treasury bills, notes and bonds. It also issues the nation’s coin and paper currency. The U.S. Treasury, through its Bureau of the Mint and Bureau of Engraving and Printing, actually produces the nation’s cash supply and, in effect, sells the paper currency to the Federal Reserve Banks at manufacturing cost, and the coins at face value. The Federal Reserve Banks then distribute it to other financial institutions in various ways. During the Fiscal Year 2008, the Bureau of Engraving and Printing delivered 7.7 billion notes at an average cost of 6.4 cents per note.

The banking relationship piece is pretty much the same as it is for me and you. The government has a bank through which it pays for stuff. But that bank also acts like the government’s investment bank too, offering bond deals of government debt as an investment bank does for corporate debt. So far, so good.

Here’s the thing though: The Fed also is there on the money creation side, as the Wikipedia quote attests. The government creates currency. It literally makes the money we use. That is an important difference between government and us. Moreover, that money is not tied to any physical commodity like gold. That’s why you will often hear MMT’ers quip that sovereign debt or taxes don’t fund the government’s spending in a fiat currency system. What they are saying is that the government creates currency – and, therefore, as it’s creator they can buy stuff with money they create without funding it first.

Taxes give the fiat currency value by forcing people to use that specific currency in order to discharge their tax obligation. From an accounting perspective, they merely expunge a liability on the government’s balance sheet ledger.  They don’t fund spending per se. There is a vestigial tie to taxes as a ‘funding’ source in that the U.S. government is required to issue debt in the form of Treasury bonds, bills or notes to cover deficits But this is a relic of the gold standard mandated by Congress which has not prevented the government from deficit spending. Legal tender laws make the currency widely distributed and entrench it as the money of choice within an economy. In a fiat currency system, sovereign government debt doesn’t serve an important currency function like funding deficits.

As I wrote last year:

From the government’s perspective, there is no functional difference between any of its obligations like bank notes, electronic credits, or treasury bills and bonds. As the Ten pound note says, “I promise to pay the bearer on demand the sum of [fill in the blank sum][fill in the blank fiat currency].”

So, the U.S. government could legitimately stop issuing bonds altogether if it wanted to.  When people complain about the admittedly enormous government debt, they don’t think of the mechanics of the issue. As I see it, in a fiat money environment, the first function of the Treasury bonds is to serve as a vehicle to add or subtract reserves in the system to help the Federal Reserve hit a target Fed Funds rate. The second is to give holders of government obligations a return on their investment. After all, bank notes or bank reserves don’t pay much if anything.

If the U.S. stopped issuing treasuries, would it go broke?

I hope that makes it clear how few constraints there really are on government as compared to you or me.

I like to think of it this way. Imagine I am the creator of currency in our country, let’s call the currency "The Harrison," paper notes with little pictures of Benjamin and William Henry Harrison on them that I print up in my basement print shop. Now Harrisons have no intrinsic value. They are valuable only insofar as they are widely circulated in exchange for goods and services. And they retain that value only insofar as their supply remains limited. If I reel off a bunch of Benjamins to buy Treasury bonds, it will not necessarily erode the value of the Harrison if those Benjamins sit in bank vaults without being lent out.

Imagine one day I decide to buy a few tanks for a military expedition abroad. I go to my basement and reel off a gazillion Harrisons equal in value to the tanks.* I then march down the street to the Government Bank and deposit the money in my account. Then I march down to the tank dealer and give him a check written on my Government Bank account of equivalent value to the Harrisons and the tanks. He gives me the tanks. I didn’t earn the money I used through collecting taxes, now did I? Technically, I didn’t actually have to issue any debt to do this. Nothing was ‘funding’ my purchase except the money I just created.

All of this is a bit scary.  I think fiat money is dangerous because the temptation to just print money is always there – and there are few constraints to this. I imagine that if people realized that governments have this much control and so few constraints, they would be worried. But that is the essence of how our fiat monetary system works.


*Note: when the government creates money, from an accounting perspective, it has increased assets by the currency it now owns but also increased liabilities of the currency it owes by the same amount. It is a wash.  When that money is then transferred to another party for real assets like tanks, the government has just acquired real assets it now owns and the transaction partner has got an equivalent value of currency it owns. So, this is an asset swap by government. The original government money liability is still on the government’s balance sheet of course. Ostensibly, the transaction partner will soon exchange the currency with someone else for real assets. Everyone is happy. It is only later – far down the line after many exchanges – when the ultimate holder of the currency would lose through inflation if the currency falls in value.

  1. Tom Hickey says

    1. The gold standard did not prevent the Great Depression, strongly suggesting that discipline cannot be imposed externally.

    2. Bill Mitchell explains how the present monetary system works:

    The consolidated government — treasury and central bank

    1. Edward Harrison says

      More than not preventing the depression, the gold standard exacerbated the depression. So there is no silver bullet for imposing discipline – if that is a reputable aim for government. I think the more important aim for government is to help real resources from being underutilized.Nevertheless, I do look askance at unchecked government power, so I think in terms of limiting power rather than discipline.

      1. Tom Hickey says

        Agreed. What I see happening is a merging of corporate and state power that is disturbing. This will not change materially without getting the money out of politics and closing the revolving door.

  2. Jon B says

    Wonderful, Edward. The next step is to explain how the plutocrats use the fear of inflation to maintain their grip on society.

    “Let’s have everyone in the country go into debt, and also let’s make sure that we get them to fear inflation, because what’s the point of having everyone under our thumb, if they can get out from under it in ten years? Where’s that idiot Santelli. Didn’t we buy his soul a while back. He did great with that Tea Party thing, now let’s have him go after inflation.”

    And before you bring up retirees, Edward, screw them The baby boomers milked us for everything we have. Our gift to them will be 5% inflation (God willing!).

    1. Jon says

      Oh, and let me add that the plutocrats, in the name of the worker, decry the stickiness of wages as an reason why inflation is bad. These of course are the same plutocrats that have invented the temp society. Brilliant right? The whole country is underemployed, but wage stickiness makes inflation bad. Suuuuuuuure.

  3. TheInterest says

    “…the first function of the Treasury bonds is to serve as a vehicle to add or subtract reserves in the system to help the Federal Reserve hit a target Fed Funds rate.”

    The MMT’ers say that loans create deposits and thus a bank never concerns itself with reserves since it can always go the Federal Reserve to get necessary reserves.

    What I’m curious about is that the MMT’ers say that if the government doesn’t deficit spend then Treasuries are NOT bought and sold via the Federal Reserve. And as you say in the above quote, reserves are not added to or subtracted from the Federal Reserve.

    If these reserves are not added to the Federal Reserve, my local bank won’t make the loan to me since it doesn’t know if the Federal Reserve will have reserves to provide for making the loan.

    Thus, according to MMT’ers, credit markets are tied to government deficit spending and if the government does not deficit spend, credit likewise will disappear in the private sector.

    Do you agree?

  4. ryanclarke says

    The Federal Reserve CAN NOT … nor Congress … nor the US Treasury … issue bank notes without the corresponding ‘debt instrument.’

    That is … when the US Treasury prints 10,000 one dollar bills ( the liability ) it also creates a debt note with a face value of $10,000 ( the asset ). That debt note may pay little in interest … but the owner of such a note is entitled to $10,000 when the note comes due.

    The problem with the US gov’t … and many others … is the US gov’t has sold its assets ( the $10,000 interest bearing debt notes ) to others entities outside the US gov’t. One of the ways a gov’t can psuedo default on debt ( and survive ) is to create a great deal of debt … and money at the same time … and hold onto the money … at the same time interest rates on the debt go sky high … which means the debt is currently worthless … and then use the money to ‘repurchase’ the worthless debt.

    Difficult to state … but for another head shaker …

    The Fed has ‘purchased $1.25 trillion in MBS securites’ … starting in the Fall of 2008 and ending in the spring of 2010. As most know … private banks aren’t lending the money … given to them by the Fed in exchange for the MBS securities … out to others … the banks are sitting on it for the above noted reason.

    But now the Fed can do something illegal … provided the Fed is not audited. The Fed can claim the MBS securities are completey ok … that folks are paying their mortgages on time … by creating money without the US Treasury issuing the corresponding debt instrument. The Fed then uses this ‘money created from nowhere’ and buys US Treasury bills from the banks … giving the banks even more money. Each dollar printed is tagged with an associated ‘debt instrument that accrues interest’ … but the Fed can change such a tag with a click of the keyboard …


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