In “A Simple Solution to the Banking Crisis That No Country Will Implement” (Patreon link; Substack link—both open access), I argued that The Fed could end the current crisis simply by buying all outstanding Treasury Bonds at face value. After that, in future The Fed should either let Treasury run an overdraft on its account at The Fed, or The Fed should purchase Treasury Bonds directly from Treasury.

Neither of these practices are unprecedented: as I noted in that post, The Bank of England let the UK Treasury operate an overdraft during Covid, while The Fed routinely purchased bonds directly from Treasury before The Banking Act of 1935, and occasionally even after that—notably, during WWII.

Kenneth D. Garbade, a Vice-President of the New York Fed, explained the origin of the practice of requiring The Fed to only purchase bonds in the secondary market in “Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks” (Garbade 2014). It’s hard to read his history and not conclude that the current system—which requires Treasury to sell bonds to private banks and “primary dealers”, rather than to The Fed—was based on the rickety pillars of the self-interest of bond traders, and delusional ideas about money held by the mainstream economists who staff The Fed, and misinform our politicians.

The Abstract to Garbade’s paper highlights how Keystone Cops-like—to mix my analogies—the whole kerfuffle over direct Fed purchases of Treasury Bonds was:

1) Why did Congress prohibit direct purchases in 1935 after they had been utilized without incident for eighteen years, 2) why did Congress provide a limited exemption in 1942 instead of simply removing the prohibition, and 3) why did Congress allow the exemption to expire in 1981? (Garbade 2014, Abstract. Emphasis added)

As Garbade noted, direct Fed purchases of Treasury Bonds had not led to the sky falling—nor any other calamity—in the years before the 1935 Act. So why prohibit them then? The best reasons he could find in the literature were that this was done “to prevent excessive government expenditures”. The Federal Reserve Chair from 1934 till 1948, Marriner Eccles, put it this way in 1942:

“The restriction forbidding Federal Reserve banks to buy Government obligations except on the open market was imposed … on the theory that forcing the Government to borrow on the open market would afford a check on excessive public expenditures”. (Garbade 2014, p. 5, quoting Eccles)

Eccles followed up in 1947 with the explicit statement that this theory was erroneous:

Those who inserted this proviso were motivated by the mistaken theory that it would help to prevent deficit financing. According to the theory, Government borrowing should be subject to the “test of the market.”

[T]here was a feeling that [the absence of a prohibition] left the door wide open to the Government to borrow directly from the Federal Reserve bank all that was necessary to finance the Government deficit, and that took off any restraint toward getting a balanced budget. (Garbade 2014, p. 6, quoting Eccles)

Though Garbade queries both reasons on logical and empirical grounds, they are nonetheless the only ones he proffers—and humanity is hardly deficient in actions undertaken for illogical or empirically fallacious reasons. So arguably, and on the word of one of the most famous Chairmen of all time—for good reasons, for a change—the requirements that the Treasury should not run an overdraft, and also should not sell bonds directly to The Fed, reflect self-interest and ignorance of the monetary system, rather than logic and experience.

Technical stuff

The rest of this post is for nerds: if you’re interested in what how a monetary system would operate without government bonds, or with government bonds being purchased directly by The Fed, read on.

One clear advantage of both approaches is that it clears away the veil of unnecessary complexity created by believers in Neoclassical economics, to reveal the simplicity at the heart of fiat money creation: the government, as the fundamental creator of a nation’s money, creates money by incurring negative financial equity for itself, and generating identical positive financial equity for the non-government sectors of the economy.

No Government Bonds

Governments create “fiat money” by spending more than they get back in taxation: if the government didn’t run regular deficits, but instead ran a balanced budget, there would be no “fiat money” in existence. In fact, deficits have been the norm for the last century, as Figure 1 shows.

Figure 1: The average government deficit is more than 3 percent of GDP

If this were done by the Treasury having an overdraft at The Fed, and The Fed also paid interest on Reserve balances (more on that later), then the monetary system would look like Figure 2.

The first table in Figure 2 shows that, when the government runs a deficit, it spends more on the Private Sector than it gets back in taxes. This increases private deposit accounts, and therefore increases the net financial worth of the private sector. So, rather than borrowing money from the private sector when it runs a deficit—which is what economic textbooks claim, the government creates money for the private non-bank sector.

The second table in Figure 2 shows this from the point of view of the banks. As well as creating Deposits—which are a Liability of the banking sector—it also creates Reserves, which are an Asset of the Banking Sector. I also show the Banks receiving interest on their Reserves, since a legitimate role of bonds is to pay interest to banks to cover the social role they fulfil of maintaining the country’s payments system. If they didn’t have bonds, then there would be a legitimate case to pay them interest on Reserves. This interest income creates positive financial equity for the banking sector.

The final two tables show how these operations—the Deficit, and paying interest on Reserves—affects the two primary wings of the government, the Fed and the Treasury.

Figure 2: A fiat money system with no government bonds

The deficit doesn’t alter the net equity of the Fed, because as a Deficit reduces The Fed’s liability to the Treasury—the Treasury’s “General Account” in the USA—it increases its liability to the private banks at the same time, in the form of their Reserve accounts at the Fed.

Interest payments on Reserves does affect the equity of the Fed however: the interest payments are made by the Fed going into negative financial equity. This would be catastrophic for a private bank—negative equity for a private bank means bankruptcy, which is what happened to the Silicon Valley Bank. But The Fed isn’t a private bank, and Central Banks can operate with negative equity (Bholat and Darbyshire 2016, p. 15).

For the Treasury, a deficit reduces its financial equity, and sustained deficits would ultimately drive the Treasury’s General Account into the red as well. But this negative financial equity for the Treasury is the mirror image of the positive financial equity that the Deficit creates for the non-bank private sector.

Summarising this system in terms of financial equity, the Deficit creates positive financial equity for the non-bank private sector, while interest on Reserves creates positive financial equity for the private banking sector.

Some people might object to the government being in negative financial equity—hello, my Austrian friends!—but that’s ignorant on at least three fronts.

Firstly, financial assets are claims on someone else: your financial assets are other people’s financial liabilities. By construction therefore, the sum of all financial assets and liabilities is zero. Therefore, if the government were in positive equity, the non-government sectors would be in identical negative equity. Does that sound so attractive now?

Secondly, financial assets aren’t the only form of assets. There are also nonfinancial assets—things which are assets to their owners, but a liability to no-one. For the private sector, it’s things like houses; for the government, it’s things like roads, schools, hospitals, etc. The paranoia about the government’s negative financial equity has meant decades of deficits that are too small, and—for America in particular—not enough nonfinancial assets have been constructed because of the irrational obsession with a balanced budget.

Thirdly—and again, hello Austrians!—even if the Austrian wet dream of a purely private monetary system were enabled by a government that always ran a balanced budget, this would mean that the private non-bank sectors must be in negative financial equity. This is a corollary of the definition of bankruptcy for a bank: it is bankrupt if its Liabilities exceed its Assets, and to function properly, it has to maintain positive equity. Therefore, the private banking sector must be in positive equity, which would mean—in a pure credit economy—that the non-bank private sector would necessarily be in negative financial equity.

I think this structural dialectic is why, when governments get seduced by the siren song of running a surplus, the private sector almost always indulges in an bacchanalian private-debt financed orgy of speculation on the value of nonfinancial assets—primarily houses and stocks—which almost always ends in a financial crisis.

Direct Fed bond purchases

Figure 3 shows the situation when The Treasury issues bonds to cover both the Deficit and Interest on Reserves. The outcome doesn’t change for the non-government sectors: the Deficit creates money (and net financial assets) for the non-bank private sector, while the Interest on Reserves creates money (and net financial assets) for the banking sector.

Figure 3: The financial flows when The Fed buys Bonds directly from the Treasury

Likewise, the aggregate situation for the government sector—the Treasury plus The Fed—doesn’t alter either: it goes into negative financial equity to enable the non-government sectors to go into positive financial equity.

The differences, therefore, are more nuances than fundamental changes. With the Treasury issuing bonds to cover both the Deficit and Interest on Reserves, and The Fed buying them, the Treasury’s account at The Fed remains constant and positive. Interest payments no longer push The Fed into negative equity. Instead, all of the negative equity of the government sector is now concentrated in the Treasury.

Conclusion

There is no substantive difference between these two alternatives to the current situation, but the sale of bonds by the Treasury to the Fed in the second case has the cosmetic benefit that, as under current laws, the Treasury’s account at The Fed remains positive. This eliminates the obvious negative optic of the government appearing to be running an overdraft with the Central Bank, and spending from that overdraft indefinitely. Instead, the Treasury spends from a deposit account that is always positive, and wears its negative equity on its own books rather than on The Fed’s.

The advantage of both situations, and especially the second, is that the fiction that the government borrows from the private sector when it runs a deficit disappears. Far from borrowing money from the private sector, the government, through both its Deficit and paying interest on Reserves, creates money for the private sector.

The case of direct Fed bond purchases is also just a hair’s breadth different to the current situation: there is nothing, absolutely nothing, preventing The Fed from reproducing the essence of this model today by simply buying, on the secondary market, all the bonds the Treasury currently sells to banks on the primary market.

This enables us to kill that old and stubborn furphy of the government debt being, to quote that father of Neoclassical economic fantasists Gregory Mankiw, “an unjustifiable burden on future generations” (Mankiw 2016, p. 557). It is in fact a gift to current generations, which lets them achieve positive financial equity, while the deficit itself—if it were large enough—would enable the creation of substantial nonfinancial assets for the country.

References

Bholat, David, and Robin Darbyshire. 2016. “Accounting in central banks.” In, edited by Bank of England. London.

Garbade, Kenneth D. 2014. ‘Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks’, Federal Reserve Bank of New York Staff Reports, No. 684.

Mankiw, N. Gregory. 2016. Macroeconomics, 9th edition (Macmillan: New York).