The Government Budget Identity can be written as G = T + delta D + delta B, where G is government spending, T is tax revenues, delta D is the amount of new borrowing done by the government, and delta B is the amount of new “money” created.
Congress, with an independent Fed, would have the option of taxing or borrowing to finance it spending activities. When there is a central bank to rely on, it can also increase spending by simply spending newly “printed” dollars (most base money enters the system as deposit account balances on the Fed’s balance sheet liabilities, but the printing image works too). Central bank existence is often defended to insure the stability of prices, and to insure that the payments system is well functioning and efficient (i.e. when Mr. Jones uses his debit card to buy bread from Mr. Smith, the “reserves” from Mr. Jones’ account are safely, cheaply and quickly transferred to Mr. Smith’s account in the same bank, or some other bank). I would have you remember that non-bank financial institutions do not play any role in the payments system in the US – that is virtually what defines a bank. The reason that non-bank financial institutions exist is because financial intermediation is not the sole province of banks (and of course to regulatory rules that promoted the emergence of non-bank financial intermediation, remember Reg Q anyone?).
Anyhow, I just wanted to remind you that:
- The Fed’s discount window was intended to be accessible to banking institutions when they faced liquidity problems in the face of adverse clearings (i.e. to keep the payments system afloat) and NOT supposed to be used by non-bank financial institutions if the value of their loan portfolios was lower than the value of the claims on such institutions. Furthermore, such lending was intended to be at penalty rates, and temporary. Ask yourself if the Fed is doing that right now.
- The purchasing power of the dollar has fallen by roughly 95% since the Fed took over the reigns of the banking sector – as compared to ZERO percent decline from 1792 to 1913.
- Think of what happens when the Fed conducts open market operations. When it purchases Treasury Bills that are held by the public (the most common operation, but there is no reason the Fed couldn’t purchase shares in Pepperoni manufactuers or some other asset), D will fall. How does the Fed buy these things? It either prints the dollars, or it simply credits the deposit account of the bank who sold them the Treasuries with numbers that previously did not exist – in either case, the value B rises. What happens when Congress decides to spend more than it takes in from tax revenues? It issues bonds in the primary market. When it does this, D increases and government spending increases. NET of both these transactions, we see that government spending rises and the monetary base rises.
In other words, Congressional spending is paid for by printing up dollars. By the process happening in two steps rather than the Fed directly participating in the initial auction of Treasuries does not change the effect, it just makes it harder for the general public to see what is going on. New government spending is financed by new money, this process is what we call “Seigniorage.” At about $40 billion per year, this represented roughly 2% of federal government expenditures prior to the crowning of the messiah.
The Congress does not need the Fed in order to extract these revenues from the financial system. It did so more directly during the National Banking era and state legislatures did the same thing during the State Banking era by requiring chartered banks to hold goverment securities as collateral for their private note issue. But requiring commercial banks to directly buy US Treasuries would be too obvious a revenue grab for our corporatist state, so we get it through the back door. And in the Federal Reserve Act, this extraction is justified on the basis of seigniorage being the “price” the Fed pays to Congress for the privilege of issuing Federal Reserve Notes.
I thought that this exposition would be enough to disabuse people of the notion that the Fed and Congress were anything but dependent. Alas it was not – it took trillions of dollars of bailouts and special lending programs to make people wonder what is going on. Why must people see the wolf in the sheep’s den before understanding things like this?
Great explanation, Wintercow. When I have time, I’m going to copy it and ship it to my hard drive.
Today I read an article about inflation worldwide, and the writer was talking about the consumer price index in various countries. If I could, I’d refer him to the 24-hour gold graph on your page, but I’m afraid he’d infer that inflation was finally coming under control.
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