ZEN and the Art of the Federal Reserve System

By J.D. ALT

I know nothing about motorcycles, and not much more about the U.S. Federal Reserve system—yet I feel compelled to dismantle, pick apart, and understand the latter for the simple reason that it seems to be a machine I’ve been riding on (and vaguely writing essays about) for some time now. So, it stands to reason I shouldn’t be ignorant of it. Not that I would get much help in this effort from American economists. Indeed, they seem intent on keeping the mechanism under wraps—as if it were a proprietary secret which they can only refer to in code. Or, perhaps, they are just the kind of bikers who leave it to their mechanic to know how the carburetor works. There are a few exceptions—one being Eric Tymoigne who saw fit to post a kind of on-line parts manual for anyone who wants to take the time, and make the mental effort, to figure the machine out. So, I have the parts spread out now on my workshop floor. Here’s my own interpretive consideration, thus far, of what I’m looking at:

Three Dollars

There are not just “U.S. dollars,” but three kinds of dollars—or, perhaps a better description: there are three “states of existence” a dollar jumps back and forth between. The most fundamental state of a U.S. dollar is as a “reserve” in the Federal Reserve banking system. “Reserves,” as they’re commonly referred to, are what you might think of as “real money”—the “actual thing” of which the other two states are what I’m perceiving to be “pre-reserve” and “post-reserve” variations.

Once upon a time, half a century or so ago, “reserves” were associated with gold specie that U.S. dollars were defined as being equivalent to. “Reserves” are no longer associated with gold—or any precious metal, or any other “thing”—but are simply “reserves” that are issued by the U.S. Federal Reserve as needed. (Since the Federal Reserve is uniquely authorized by the sovereign government to create “reserves,” they could rightly be called “fiat reserves” in that their authorization is created by a decree of the sovereign.)  Each bank in the Federal Reserve system maintains an account at the Federal Reserve which contains that bank’s “reserves.” Keep in mind that, in this form, these “reserves” are just numbers on a balance sheet.

The “post-reserve” state

The second “state” a U.S. dollar can jump to is a “bank-dollar” in a savings or checking account. It is crucial to see that a “bank-dollar” in a checking or savings account is not, itself, a “reserve” but, instead, is a claim on the “reserves” held by that bank. You can exercise that claim by withdrawing U.S. dollars from an ATM machine (printed U.S. dollars are “reserves” in a paper form). Most of the checking and savings account bank-dollars, however, are never converted to cash, but are, instead, exchanged back and forth within the Federal Reserve banking system in the form of check-writing and electronic payments and transfers. In other words, while they are a claim on the banking system’s “reserves,” the claim does not need to be exercised for the bank-dollar to be spent by the owner of the bank account.

When Bank A in the Federal Reserve system issues a loan, it makes a deposit in a Bank A checking or savings account. In other words, it increases the bank-dollar claims on the “reserves” that it holds. When a check is written, and then deposited in another account at the same Bank A, nothing much transpires: bank-dollar numbers are subtracted from one account and added to another. When a check is written and deposited in an account at another bank—Bank B—something else happens: Bank B, at the end of the business day, exercises a claim on the “reserves” of Bank A for the dollar amount of the check. To reconcile the transaction, Bank A must then transfer “reserves” from its account at the Federal Reserve, into the reserve-account of Bank B. This “clearing process” happens millions of times at the end of each business day at the Federal Reserve. For the system to work—for the “machine” to run—it is an absolute requirement that every check, and every electronic transfer, “clear.”

The banks in the Federal Reserve system decide how many claims they want to have against their “reserves” by controlling the number of loans they issue. If private commerce is in an expansive mood, and there is a lot of demand for loans to finance business ventures and consumer purchases, a bank may well decide to take advantage of the profit-potential and make a lot of loans, thereby increasing the claims on its “reserves.” Where this is the case, at the clearing process at the end of a business day, the bank may well find that claims against its “reserves” exceed their capacity to make good on the claims. (The bank is required by law to maintain a certain amount of “reserves”—so their capacity to fulfill claims is reached long before they’re drained to zero.) When this occurs, the bank must borrow “reserves” from another bank, or from the Federal Reserve itself.

But the “reserve” accounts of the Federal Reserve banks are always growing, as well. This is because when the U.S. government authorizes its Treasury to spend dollars for any purpose—say, to make a Social Security payment—the Treasury’s spending results in two deposits: the first deposit is in the bank-dollar account of the person receiving the SS check; the second, equal, deposit is in that bank’s “reserve” account. Federal spending, then, increases the claims on bank “reserves”—but also increases the “reserves” themselves by an equal amount.

The “pre-reserve” state

The third “state” a U.S. dollar can exist in is as a “future reserve” embodied in a U.S. treasury bond. Treasury bonds with short maturities are called treasury “notes” or “bills”—but they’re all the same thing: a container of “reserves” which can be opened at some specific date in the future. Treasury bonds are not issued by the Federal Reserve, but by the U.S. Treasury, which is uniquely authorized by the sovereign government to issue them. Why would the Treasury issue a treasury bond? Why are they necessary?

A primary reason is because very often the Treasury is directed by Congress to spend more dollars than are tallied to exist in the Treasury’s spending account (which consists, basically, of the “tax-dollars” which have been credited to it). To keep its checks from “bouncing,” the Treasury adds to its spending account by issuing treasury bonds. This happens through a coordinated effort with the Federal Reserve system, as follows:

The Federal Reserve arranges for a bank in its system to trade some of its “reserves” in exchange for the treasury bond. After the exchange is made, the Treasury now has the dollars it needs to spend, and the bank has the “future reserves” (the treasury bond) in its reserve-account at the Federal Reserve. Next, the Federal Reserve—which is the only entity authorized to create “reserves” out of thin air—creates and trades new reserves to the bank in exchange for the treasury bond. What is the end result of these operations?

1. The Treasury spends more dollars than it collects in taxes.
2. The Federal Reserve bank system has the same number of “reserves” it started with.
3. The Federal Reserve has a treasury bond on its balance sheet.

Is that “printing money”? Has the federal government “borrowed” money from somebody? Has the United States gone into “debt”? I’ll let you decide. I’m still parsing all these parts on my workshop floor before I put the machine back together to go riding again. I’m open, of course, to assistance and suggestions. There’s a pile of parts, I’m noticing now, that I haven’t even considered yet.