How Money is Created through Debt in our Fiat Economy -- Starting from Scratch

So now that we are starting to understand how this all works, let's revisit the OP.

Alright, so we have a hypothetical country with a Government, the Fed, a bank, and the private sector.

First thing is the Government wants something for the country. Let's say, they want to build roads. So what do they do? They go to the private sector and say we will pay you, say, $10,000 if you start building roads.

But now what? There is no money in the economy in which the Govt can pay to build roads. So the Govt then has to borrow money. But wait a second, no one has any money to lend to the Govt because it hasn't been created yet.

So the Govt goes to Bank A (Let's assume they are a Primary Dealer)... and says, hey lend us $1,000 and we will give you this piece of paper, saying we will pay you back with interest.

But the Bank says, but I don't have $10,000. I have $0. I can't lend you the $10,000.

How can the Govt get the $10k to build a road?

Enter the Fed. The Fed says, I have a super power. I can create reserves!

Great! says the Govt. Whip up $10k and give it to me.

Fed says no can do. I am prohibited by law to directly give you money.

OK, the Govt says, I'll give you a $10k note and borrow the money.

Fed says no can do. I am prohibited by law from directly buying your notes.

So now what?

The Private sectors says, give me the money! The Fed says I can't just give you some money. What do you have to sell?

Well, the Private Sector could dig up some gold, and sell it to the Fed which would create reserves, but that would take a while. So the Private Sector says, how about a loan? The Fed says, that might be possible, but generally I only lend to banks.

Then the bank comes in and says, I am a member of the Federal reserve system. Give me the loan.

The Fed says, I can do that!

And the Fed uses its super power and creates $10k reserves out of thin air and loans it to the bank.

Now we have money!

Banks A|L
Reserves $10k | Loan payable to Fed $10k​

And bank says to private sector, I can lend you money! And lends private sector $9k, which is deposited in Bank B. That leaves Bank A and B like this:

Bank A
Reserves $1k | Deposits $10k (owed to Fed)
Loan receivable 9k

Bank B A|L
Excess reserves 8100 | Deposits 9000
Required reserves 900​

So now we have for the whole banking system:

All banks A|L
Loan receivable $9 | Deposits $19k
Excess reserves $8100
Required reserve $1900​

Note that we still have total reserves of $10k. That never changes. However, deposits have been created.

Private sector A|L
$9 deposits | $9 note payable​

And Bank B lends $8100 which is deposited in Bank C, which lends $7,290, etc.

And after the money has been multiplied, you have:

All banks A|L
Loans Receivables $90k | Deposits $100k (including $10k owed to the Fed)
Required reserves: $10k

Private sector A|L
Deposits $90k | Loans Payable $90k​

As a result of the Fed creating $10 in reserves, we now have the same $10k in reserves, but deposits have been multiplied to $90k (excluding the $10 Fed loan) by fractional lending.

Now let's go back the Govt.

The Govt says, I cannot borrow directly from the Fed, but I can borrow from the Private Sector and I can tax those bastards! Ha ha.

Let's suppose the Govt is run by Republicans and they refuse to raise taxes, so the Govt has to borrow.

Private Sector loans the Govt $10k in exchange for a bond. The Private Sector write a check on their banks, which transfers $10k in reserves to the Govt, and lowers the Private Sector's Deposits by $10k.

So now we have:

All banks A|L
Loans Receivables $90k | Deposits $90k (including $10k owed to the Fed)
Required reserves: $0k

Private sector A|L
Deposits $80k | Loans Payable $90k

Govt
Reserves in Treas. Deposit acct $10k ​

OK, but oops, the banks don't have their required reserve!

No problem, because the Govt now takes that $10k it has in its Deposit Account, and expends it back to the Private Sector to build the road.

And that action restores the accounts to the way they were, and we have:

All banks A|L
Loans Receivables $90k | Deposits $100k (including $10k owed to the Fed)
Required reserves: $10k

Private sector A|L
Deposits $90k | Loans Payable $90k

Govt
Reserves in Treas. Deposit acct $0k ​

The only difference is that the Private Sector has a loan payable from the Govt, and the Govt has $10k in debt, which is what happens when you let Republicans run the Govt!

 

Your hypothetical is not how the real world works at all. The Fed does not decide who gets money. The Government decides how much it wants to spend and who gets this money.

If you look at the Federal Reserve balance sheet, every single reserve is backed by securities... aka debt, which was bought with previous existing money.

In our system, the debt has to be created first before the Fed can convert anything in to reserves. This means a deposit has to be created before the Fed can create any money. Debt comes before reserves since debt is needed to create reserves.

So you are going to have to come up with a different hypothetical that is backed by more factual information on how it works in the real world.

 

The Fed has absolutely no control over who gets money in this country. That is the key point. The Govt, which represents the country as a whole, says hey we need to build roads... it's going to cost this much.

The rest is just how they fund this spending between the Fed and the banks. My OP is 100% accurate in it's hypothetical sense of how you would start a country that works exactly like ours.

The banks in the hypothetical can start off with a reserve deficiency and wait for the Federal reserve to purchase the treasuries to create reserves. But it still comes down to the Government issuing debt.

 

The reserves are transferred from the payor's bank to the payee's bank. We've previously been thru this (which is why we needed to understand a simple transaction before we could look at the big picture.

MMM step 6:

... because borrowers write checks on their accounts at the lending banks. As these checks are deposited in the payees' banks and cleared, the deposits created by Stage 1 loans and an equal amount of reserves may be transferred to other banks.

STAGE 1 BANKS

Assets
Reserves with F. R. Banks . -9000 (matched under FR bank liabilities)

Liabilities
Borrower deposits . . . -9,000 (shown as additions to other bank deposits)

http://www.rayservers.com/images/ModernMoneyMechanics.pdf

The payment of the check requires a transfer of reserves to the payee bank.

If the lending/payor bank does not have the reserves, it cannot pay the check.

If it didn't need reserves, runs on banks would never be a problem because depositors could simply write a check to another banks.

But it wouldn't do them any good because the bank has to transfer reserves.

You are confusing required reserves, which the Fed says they need, with reserves in general. The banks only need to maintain required reserves. Other reserves they have, "excess reserves" can be used to fund checks (or make new loans.

Thus, the MMM states:

If the lending banks expect to lose these deposits - and an equal amount of reserves - as the borrowers' checks are paid, they will not lend more than their excess reserves.

The fact that the "interbank" system has reserves doesn't help you one iota if *your* bank goes belly up and doesn't have reserves to pay your checks.

 

Let's clarify.

Which assumptions do you think are wrong, and why, and how does that affect what I have explained?

The point is that after the notes are resold to the non-bank public, it is the non-bank public that is funding the Govt. Which is why deposits don't change with Govt spending.

It doesn't, otherwise the Govt Treasury account would go negative, but that point is immaterial because ultimately they wash out for no change.

The Primary Dealers purchase the debt but resell it. That's what brokers do. who ended up holding that $800 billion? That is what matters.

9. Depository Institutions

US debt holdings: $269.8 billion

As of June 2010 (the most recent numbers currently available), the Federal Reserve Board of Governors lists depository institutions as holding approximately $269.8 billion in US debt.

This group includes commercial banks, savings banks and credit unions and has nearly tripled from Q4 2008, when holdings stood at $105 billion.


http://www.cnbc.com/id/29880401/The_Biggest_Holders_of_US_Government_Debt?slide=8

See, of the $14 trillion debt outstanding depository institutions (ie all US banks) hold only a small fraction of it. $269 billion only represents 1.9% of all US debt outstanding.

If those banks were buying and holding 99% of it, those the banks would be holding 99% of US debt. They don't, not even close.

Until investors don't want to buy any more US debt.

Not at all, see the illustration on the OP I wrote.

 

No it does not!! The MMM does not say this, you are making this up to try to validate your point. Banks do not need reserves on hand to complete check clearing. Banks can have negative amounts of reserves. The check clearing house simple debits the amount of reserves from one bank and credits the reserves in another. If this debit leaves the bank in the negative, the check still clears. Checks will never be bounced because a bank does not have reserves. Deposits and reserves are completely separate entities. Banks acquire reserves by mandate.

Reserves do not matter in one person writing a check to another persons bank. The only times reserves become a problem is when people hold on to more currency. The transfer of reserves from one bank to another has no affect on the banking system.

It's simple accounting Iriemon... we have been through this 100 times. Banks don't lend excess reserves or use excess reserves for anything other than leverage. Excess reserves simply become required reserves when banks create more deposits. We have gone over this 100 times.

Completely independent of one deposit decreasing and one deposit increasing. We have gone over this many times.

We are not in the 1920s any more.

Reserves can not be created unless Govt goes in to debt.

We are going in to circles again. Time to take a step back and focus on an area. The fact you do not see how the debt that is created in this process is the basis for money is what is so challenging here.

The Govt can spend whatever it wants. It is the Fed and the banks job to make sure the Govt has the funds in it's account. It is THEIR JOB to make sure the Govt can spend whatever it wants.

But a change in assets which is the pivotal piece to this entire discussion

No, it funds 1% to the Govt. It purchases 99% of the treasuries from the funds created through Govt spending. Huge difference.

Sure it does, it matters more than anything

You end up with another asset

The deposit comes before the treasury is purchased. That is all that matters in this discussion as shown by the OP.

And the fact you are not even acknowledging the fact that the Fed purchased $800 billion of Govt debt off of the Primary Dealers just 1 year ago, shows me that you are just trying to drill in to this chicken and egg theory to save face. The fact is Govt spending increases the nonbank publics accounts before the nonbank public ever decreases their accounts to purchase treasuries on the secondary market.

 

I agree banks can hold US Govt treasuries. But that is not how they make money. US Treasuries pay, what 1%? A loan pays multiple times that.

This is proved by the fact that Dealer Banks buy 99% of Treasuries, but only hold 1.9% of them. Obviously the vast bulk are being resold.

To the contrary, I have agreed and acknowledged an asset (loan receivable) as well as the offsetting liability (loan payable) is created when a loan is made.

But that is not "money".

The asset created -- a loan receivable, is not an asset.

The Govt doesn't increase the amount of money in the system. I agree the Fed uses Govt debt to inject reserves into the system. That accounts for $1.5 trillion.

What purpose did the other $12.5 Govt debt trillion serve in money creation? None.

Not at all. It's based on the Fed creating reserves.

 

Iriemon, this is completely false assumption. Last year the Fed's purchased $800 billion of debt from the Primary Dealers. So this right there invalidates your claim that 99% of treasuries are purchased by the nonbank public considering that $800 billion is almost 10% of debt held by the public.

And it's a rolling system. The key point is that the nonbank public gets an increase in their deposits before they ever decrease their deposits to purchase the debt. It is a complete and utter false assumption to assume that Govt spending is a wash.

No, they do not

No it doesn't

I never said the Primary Dealers hold on to the debt, I said they credit our deposit accounts before our accounts are used to purchase the debt. And $269 billion + $800 billion last year is over $1.069 trillion. Which is over 10% of debt held by the public. Your point about it doesn't matter who funds the Govt is where this conversation can't go any further. If you think that it does not mean anything that the nonbank public is funded first before they "fund" the Govt, then this conversation is dead.

Then the Primary Dealers will hold to the debt.

 

WHO CARES!!! They are being bought with money that was created from the Government spending money. That is the entire point. And the amount the Primary Dealers hold varies greatly based on the economy. Over $800 billion was bought off them last year and right now investors all over the world with money are purchasing debt off the secondary market. This still doesn't change the fact that the nonbank public doesn't fund the Govt deficit spending.

It is not money but money is owed to redeem it. That is the whole point. It is a circular system that keeps going day in day out, but the cornerstone to how they affect the amount of money created is based on how much debt the Govt creates.

Intragovernmental debt is not real. It is an asset and a liability to the Govt and is not included in net debt. That money does not exist. The rest of the debt is broken up and primarily held by the Fed, foreign central banks, and pensions.

$1.5 trillion is 15% of the debt held by the public. That is A LOT of money for banks to create new loans and for the amount of deposits that go with that.

Not at all. Fed's create reserves to make Govt spending usable in the real economy.

 

We are now in a period of circular logic. You believe the Fed has to create reserves in order for the Government to spend... I believe the Government has to spend in order for the Fed to create reserves.

Regardless of what comes first, the accounting is still the same and the nonbank public pays it's taxes and purchases Govt debt with the money the Govt spends.

 

Where Do Bank Reserves Come From?
From the standpoint of money creation, however, the essential point is that the reserves of banks are, for the most part, liabilities of the Federal Reserve Banks, and net changes in them are largely determined by actions of the Federal Reserve System. ... One of the major responsibilities of the Federal Reserve System is to provide the total amount of reserves consistent with the monetary needs of the economy at reasonably stable prices.

Except for reserves borrowed temporarily from the Federal Reserve's discount window, as is shown later, the supply of reserves in the banking system is controlled by the Federal Reserve.

MMM p. 4

 

Yes, we've already gotten through the point that the Federal Reserve creates reserves

 

And if you do reverse logic using accounting, you would see that if you paid off the national debt there would be $0 in existence.

 

The italicized portion of my post is directly quoted from MMM, show that reserves are transferred when a check is paid (unless the payee has the same bank as the payor)

More:


What Limits the Amount of Money Banks Can Create?
If deposit money can be created so easily, what is to prevent banks from making too much - more than sufficient to keep the nation's productive resources fully employed without price inflation? Like its predecessor, the modern bank must keep available, to make payment on demand, a considerable amount of currency and funds on deposit with the central bank. The bank must be prepared to convert deposit money into currency for those depositors who request currency. It must make remittance on checks written by depositors and presented for payment by other banks (settle adverse clearings). Finally, it must maintain legally required reserves, in the form of vault cash and/or balances at its Federal Reserve Bank, equal to a prescribed percentage of its deposits.


MMM page 3.

Why would a bank need to worry about keeping currency and funds on deposit with the central bank available to remitt checks if it is not required to pay checks?

For individual banks, reserve accounts also serve as working balances.(2) Banks may increase the balances in their reserve accounts by depositing checks and proceeds from electronic funds transfers as well as currency.

How could reserve accounts increase from the proceeds of depositing checks if checks were not a transfer of reserves?


When cash letters or image cash letters are deposited with Federal Reserve Banks, they credit the Federal Reserve account of the depositing institution or its correspondent. The Reserve Banks debit the Federal Reserve account of the paying institution or its correspondent when the checks drawn on the paying institution are presented to that institution for payment.

http://www.newyorkfed.org/aboutthefed/fedpoint/fed03.html

Suppose the Federal Reserve System sells $10,000 of Treasury bills to a U.S. government securities dealer and receives in payment an "electronic" check drawn on Bank A. As this payment is made, Bank A's reserve account at a Federal Reserve Bank is reduced by $10,000. As a result, the Federal Reserve System's holdings of securities and the reserve accounts of banks are both reduced $10,000.

Bank A's reserves are reduced when it the dealer writes a check on its account to the Fed (explaining how reserves are removed from the system).

MMM p. 12.

Since the most important component of money is transaction deposits, and since these deposits must be supported by reserves, the central bank's influence over money hinges on its control over the total amount of reserves and the conditions under which banks can obtain them.

http://en.wikisource.org/wiki/Modern_Money_Mechanics/Bank_Reserves—How_They_Change

Why must deposits be supported by reserves if reserves aren't required to fund checks?

They are in big trouble if their reserve are negative!

The are required to have reserves ("required reserves") equal to a percent (10%) of deposits.

As long as the banks have reserves to transfer.

However, banks are required to maintain reserves equal to only a fraction of their deposits. Reserves in excess of this amount may be used to increase earning assets - loans and investments.

MMM p. 4

When a loan check is paid, it decreases the excess reserves of the lending bank.

If the lending banks expect to lose these deposits [created by the loan] - and an equal amount of reserves - as the borrowers' checks are paid, they will not lend more than their excess reserves.

Why would they lose reserves as the checks are paid if reserves are not required to pay checks?

Why would banks not lend more than their excess reserves if they expect the loan to be paid out in checks?

If the lending banks expect to lose these deposits - and an equal amount of reserves - as the borrowers' checks are paid, they will not lend more than their excess reserves.

Why? Why would MMM say a bank loses reserves when check is paid if no reserves are transferred?

Why would they not lend out more than their excess reserves?

Expansion continues as the banks that have excess reserves increase their loans by that amount, crediting borrowers' deposit accounts in the process, thus creating still more money.


Contradicts your position.

Your own source completely contradicts you.

Today we have the FDIC to provide depositor insurance for banks that go insolvent and have insufficient reserves to cover checks and deposits.

Why would we need an FDIC if a bank didn't need reserves?

Any time the Fed purchases assets reserves are created. It recent purchase of commercial paper (subprime loans) is a case in point.

The fact you do not see how the debt that is created in this process is offset by the decrease in deposits of tax payers and nonbank purchasers of Govt debt is what is so challenging here.

If the Fed an Banks funded the Govt, they would be holding $14 trillion in debt. They barely hold 1/10 of that.

No, we are talking about the money supply.

And sells 99% to the non bank public, decreasing their deposits.

Huge difference.

When a Dealer buys a Treasury and holds it, what happens to overall deposits?

When a Dealer buys a Treasury and sells it to the nonbank public, what happens to overall deposits?

That's why it matters who ends up holding int.

but not more deposits or reserves -- money.

The Govt cannot spend money it doesn't have.

But irrespective, its a wash, no change in the money supply.

When the Fed purchases Govt debt from the public though a dealer, the amount of reserves are increased. I've said that serveral times. That is how money is created.

Where does the Govt get reserves to spend?

 

I believe the Government has to spend in order for the Fed to create reserves.

The Govt spend $3.5 trillion last year. The Fed didn't create $3.5 trillion in new money.

 

That is not true. You are making the error that the amount of debt equates to the amount of money.

 

I'm not making an error at all... if you want to do the accounting to see for yourself you will understand what I am talking about. Paying off the debt to zero would require the elimination of all money from the economy.

 

Let's start from here, you tell me where you think I am wrong then we will go from there.

Let's do a hypothetical country.

The Federal Reserve
A | L
Treasuries $1000 | Reserves $1000

The Banking System
A | L
Ex Reserves $500 | Deposits $5000
Req Reserves $500
Loans $4000

The nonbank Public
A | L
Deposits $5000 | Loans $4000
Treasuries $5000 | Equity $6000

Ok so the hypothetical balance sheets has a country with $6000 in Government Debt and $1000 in reserves. Now the only way to pay off debt is for the Government to tax money out of the system. So let's say the Government taxes $5000 to pay off the $5000 the nonbank public has.

The Nonbank Public
A | L
Deposits $5000 | Loans $4000
Treasuries $0 | Equity $1000

Now, say the nonbank public pays off all it's loans... what does it look like?

The Nonbank Public
A | L
Deposits $1000 | Equity $1000

The banking system
Reserves $1000 | Deposits $1000

Now... this is where the money gets destroyed. When the Government pays back the Fed. This is what would happen if the Govt taxed $1000 out of the economy to pay the Fed $1000

The Nonbank Public
A | L
Deposits $0 | Equity $0

The banking System
Reserves $0 | Deposits $0

The Federal Reserve
Treasuries $0 | Reserves $0

The United States of America
$0


That is exactly what would happened if you paid off the debt. There would literally be no money left.

 

1) The Govt could pay off all debt except for debt held by the Fed with no effect on the money supply.

2) Not all assets held by the Fed are Govt debt. It also holds other assets like gold and commercial paper.

3) If in the unlikely scenario the Govt were also to pay off the US Govt debt held by the Fed, it would have to replace it with other assets, which could be gold, commercial debt, or even stocks.

 

But the country would lose half it's assets. But you agree with me that paying off all the National Debt would drain us of all our money?

We have $11 billion in gold and the commercial paper is a temporary loan to support that market.

False, if the Fed can create money out of thin air to purchase debt they can destroy money out of thin air to sell debt.

But... you agree with the premise that paying off the national debt to $0 would essentially destroy the money in this country?

 

I honestly think we agree on the same principles in terms of accounting. What we don't agree on is the interpretation of this.

My interpretation is the Fed plays a role in making Government spending usable to the private sector. But regardless, the Government has to spend first before anything else is viable!

 

So you agree, that if all debt is paid off, including debt to the Federal Reserve... that there would be absolutely zero dollars in existence other than the $11 billion of gold certificates?

 

People just need to think of it like this.

The Govt and Banks create deposits

The Fed creates Reserves/Currency

 

The Fed doesn't decide who gets the money. The Fed decides how much money to inject in the economy.

Folks who offer assets to the Fed (generally Govt securities) decide who gets it by offering the most competitive prices.

 

But the primary dealers sell it. When they do, it decreases deposits. It doesn't invalidate my position at all.

You're getting hung up on dealers. They are just brokers. They just pass the assets thru to the ultimate buyer. It doesn't make any difference if the ultimate buyer were to buy it directly from the Fed.

I disagree that they get the increase first. Where does the Govt get the money to spend if it doesn't have it?

But it doesn't matter because in the end, any increase in deposits from Govt spending is washed out by the decrease in deposits from taxes and loans.

Then where does the Govt get the money to spend if it doesn't have it?

When a deposit decreases when a person buys a Treasury, how does that not wash out the deposit increase when the Govt spends?

Of course they do. Banks only hold a small portion of the debt. Dealers less.

What do you mean dealers credit out deposit accounts?

Banks don't hold anything near $1 trillion in US Govt debt. I should you a source that all banks, not just dealer, held $269 billion in 2010. Where are you getting $1 trillion? Source please.

But they don't. All banks hold only a small portion of the debt.