The Federal Reserve Note is a ‘guarantee’ to honor US government debt where the currency in our pockets represents only that trust. The Treasury’s debt is purchased by the Federal Reserve and others (1) so that the Federal Reserve may issue the notes that constitute the cash in our pocket. Just look at the face of any cash note in your wallet where Federal Reserve Note appears at the top. The Federal Reserve deals in Treasury debt instruments to allow the Treasury to honor its public and private debt by issuance of Federal Reserve notes. The Federal Reserve may also purchase debt instruments from commercial banks or others with the currency that the Federal Reserve issues.
The Federal Reserve ‘monetizes debt’ by purchasing US public debt instruments (Treasury bonds/ notes/ bills and Mortgage Backed Securities – MBS, etc) from the Treasury, and purchases debt instruments from commercial banks or others to first enable the Treasury to service its debt, to pay interest on the outstanding National debt, and to issue cash notes known as Federal Reserve Notes (USD). The Federal Reserve may also sell such securities via ‘the Desk’ in its Open Market Operations so that cash may be taken out of the market if inflation exceeds the Fed’s target or threatens to; that is called, sterilization of capital.
Federal Reserve banks are all privately owned corporations with commercial bank shareholders (paid dividends) and they enforce monetary policy in collusion with the US Treasury and the Primary Dealer Banks of the Federal Reserve.
Other nations purchase US Treasury debt in significant amounts including Japan; China; Saudi Arabia; Belgium; Caribbean banking centers, oil exporters, etc. However, a large share of US public debt issued by the US Treasury is held via the Federal Reserve and its primary dealers with most public debt interest paid to whoever holds those debt instruments whether the Fed itself, the private Primary Dealer Banks of the Federal Reserve or any other entity. By that means the Federal Reserve maintains and operates its own highly profitable market structure for buying/selling US debt on behalf of the US Treasury, via its own banks (or Desk) and these primary dealer banks:
Amherst Pierpont, Bank of Nova Scotia (Scotia), BMO Capital Markets Corp, BNP Paribas Securities, Barclays, B of A, Cantor Fitzgerald, Citigroup, Credit Suisse, Daiwa, Deutsche Bank, Goldman Sachs, HSBC, Jefferies LLC, J.P. Morgan, Mizuho, Morgan Stanley, NatWest, Nomura Securities, RBC Capital, Societe Generale, TD Securities, UBS, Wells Fargo
Besides the US Treasury and Fed itself, the above dealer banks are next to profit from the Fed’s permanent Open Market Operations, whether via Quantitative Easing (money issuance by the Fed on government debt purchased by the Fed), Operation Twist, the Fed’s Repurchase and Reverse Repurchase agreements (Repo’s), or by operations of the Exchange Stabilization Fund. For practical purposes these Primary Dealer banks have “first market use” of the dollar funds “created” by the Federal Reserve via its purchase of debt instruments from the US Treasury or commercial banks or other sovereign entities.
To summarize, Mortgage Backed Securities (MBS) Treasury bonds, and T-Bills are the usual debt instruments purchased from the Treasury by the Federal Reserve (FOMC “Desk”) or purchased from Primary Dealer Banks/commercial banks and other entities to allow the Federal Reserve to issue Federal Reserve Notes. The Federal Reserve “Desk” is authorized to purchase any security or commodity in existence to support US Treasury operations under the auspices of the Exchange Stabilization Fund. (2)
The US Treasury and Federal Reserve have first use of the new USD (Federal Reserve Notes) created by the Federal Reserve’s purchase of debt instruments to manage monetary policy and service the government’s public debt; however first commercial market use of the USD funds issued is via the Primary Dealer Banks.
After the Dealer Banks then commercial and retail banks have use of the dollars, and on down the line to the public. Finally, the Federal Reserve notes (cash notes in your wallet) are used by private individuals to pay for goods and services, thus trading the implicit value of the government debt represented by those notes to a third party, in exchange for those goods and services.
Now, here is the “use list” of US Dollars (USD) issued by the Federal Reserve from US Treasury debt instruments, in order:
- US Treasury
- Federal Reserve banks
- Federal Reserve “Desk”
- Primary Dealer Banks
- Commercial investment banks (including certain hedge funds)
- Non-dealer retail banks/credit unions
- Other financial entities
The first use of Fed-created currency is especially important. The Fed-Treasury wishes to finance their liabilities first and avoid inflationary dollars littering the pockets of the public later on. By sterilization of capital the Federal Reserve prevents inflationary dollars from reaching those who spend it indiscriminately, instead of on Wall Street shares, or Treasury or Dealer Bank debt instruments, which are required to maintain the system.
The foregoing system including all of its components – including the dollar derivative bitcoin – is only based upon trust; that trust being that the US government will somehow remain solvent and honor its debt, and that the dollar will remain a trusted unit of account. That’s called fiat money and is typical of all global currencies.
Some have stated that the Federal Reserve creates money out of “thin air” but that’s not strictly correct because some debt instrument is required to issue the new Federal Reserve Notes (US dollars). For example, in the case of a mortgage the “money” is only created when a home buyer signs his or her signature on a note held by the mortgage company or bank. In the case of a bond (or Mortgage Backed Security) the “money is created” when some person or entity signs up for the purchase of that bond, T-bill, or MBS.
After the Treasury funds its programs with the capital created by the Federal Reserve in exchange for Treasury debt, the Treasury must pay interest on that debt to the Federal Reserve’s private banks and to the dealer banks engaged in Fed operations, and all other entities who hold US government debt instruments.
So, the Fed’s private banks and Primary Dealer Banks profit in part from the public debt in the form of interest payments. Most profit realized by the Federal Reserve via “Desk” trades is returned to the US Treasury but not all. At least 6% of the profit (reserves) made by any single privately held Federal Reserve bank is paid in dividend to the shareholders in those banks, and only commercial banks may own those shares and they may not be traded.
Above a certain reserve level, as much as 10% or more of the Federal Reserve bank’s reserves may be paid in dividends to the private shareholder with the percentage above 6% being equal to the high yield of the 10-year Treasury note as last auctioned. The banks may then leverage incoming capital as needed to guarantee more capital (whether via repurchase agreements, MBS or other bond trades, T-Bills, share trades, notes, currency swaps, proceeds from retail bank mortgages, etc, etc) using a method devised by gold dealers centuries ago, called Fractional Reserve Banking.
Fractional Reserve Banking
Fractional Reserve banking is based on the idea that no more than 10% of creditors will demand cash at any given time, an idea which harks back to antiquity and the Guild system of gold dealers. In the Fractional Reserve system, banks may keep 10% of depositors cash on hand for reserves, and loan out nine times that amount based upon the creation of new debt instruments for example new mortgages.
As the depositor’s funds are fractionalized and then multiplied and spread between banks, the system debases US dollars in the form of “leverage”. For example, signing a note for a $180K home mortgage allows the receiving bank to exchange that debt obligation for other debt obligations worth up to $1.6 million in debt – this is why banks love mortgages.
During the 2002 to 2007 US economic boom, some institutions leveraged capital by 40-to-1 and in Europe many big bank counterparts leveraged a 24-to-1 capital leverage ratio. High fractional reserve ratios work well when all participants in the system do not demand solvency (which is different from liquidity) or sound money. When part of a sound money system a reasonable fractional reserve ratio might allow banking investments as part of a practical plan for growth, which works well when the market is free from corruption and the leverage rate is relatively low.
Public Debt Interest
In summary, the Treasury pays interest on the national debt held by the Federal Reserve and held by the Fed’s dealer banks (and on their reserves) and to all others who hold US debt instruments via Federal Reserve notes. When the primary dealer banks are paid interest by the Treasury on the money created by the Federal Reserve on the basis of the Treasury’s debt instruments, then the dealers use that cash to reinforce their balance sheets, purchase Wall Street shares, purchase more Treasury’s or commodities, property, ETF’s, Bitcoin, or precious metals, etc.
So long as the Fed and its Primary Dealers can leverage the Treasury debt instrument system in collusion with the Treasury, and foreign buyers and others also purchase US debt instruments, the system stays afloat. The monetary system by definition must then rely on the support of an ever-increasing debt burden and the issuance of new debt instruments, with an eventual potential for massive cyclical instability. (3)
From 1840 to 1934 the gold standard and US National Banks system (in the US) enforced some form of monetary discipline, resulting in occasional serious Financial Panics as well. With growing population density and demand for economic growth – as well as governmental need to finance defense, war, and public services – the Independent Treasury system could not be maintained by the early twentieth century, and the private Fed banks were introduced to act as a Central Bank.
Is the Federal Reserve System Fair?
Obviously, there is unfairness and inequity in this system. Since Federal Reserve banks are privately owned corporations, they must maintain markets in a way that is advantageous to them and will prevent their banks from failing, since it is possible for a Federal Reserve Bank to fail. This gives Federal Reserve banks an unfair advantage in the system along with the private profit in public debt that they skim, and the interest they are paid on the public debt which goes to private profit not to the public.
The Federal Reserve banks work in tandem with their Primary Dealer Banks, which provides an opportunity for rigged markets. And in some instances, for example reverse repurchase agreements, the Federal Reserve guarantees the Primary Dealer banks a profit. While a guaranteed profit works well for the Fed and for its dealers, the dealer profit is entirely private and none of that profit goes to the Treasury except for taxes levied on the primary dealer profit.
It may also be argued that for a Quasi-governmental entity like the Federal Reserve to guarantee a profit to a private bank (from public funding) is not only unethical, but also immoral. Also, the fact that the public does not own the interest related to the issuance of its money and is last to benefit from that issuance, is unethical at best or illegal at worst, according to the US Constitution.
Since the introduction of the Federal Reserve system in 1913, we must confront global monetary challenges as the fiat (by decree) monetary system – global floating currencies – may potentially catastrophically destabilize over time as the system collapsed in the United States during the 2008-2009 financial crash.
One potential remedy (for the United States) is based on a scholarly rework of the Chicago Plan of 1935 (4) but such great austerity would likely lead to political instability in the United States and perhaps global instability too.
Another idea is to return the profit on public debt interest made by the Primary Dealers to the Treasury by effectively nationalizing the private Federal Reserve banks via transfer of ownership of Federal reserve bank shares to the Treasury. The US Treasury will then take back ownership of all public debt by once again issuing United States Notes via the Treasury (instead of by the Fed) while still supporting private banks as the Fed does now.
Put simply, the US Treasury will extinguish the debt of the Federal Reserve by issuing United States notes to gradually repurchase the existing Fed debt while recalling Federal Reserve notes and once again own the interest on the public debt.
The US Treasury will then assume ownership of the shares of the current Federal Reserve banks converting them to US-owned shares, just as the Bank of England operates now. All employees of the Federal Reserve Banks would then become federal employees of the US Treasury instead of corporate employees. The Treasury will thus end the out-sourced money-issuance that the Federal Reserve has been engaged in since 1913 by issuing US Notes via a US-owned central bank, and using US notes to extinguish the Fed’s balance sheet and put the Fed out of business.
In other words, the US Treasury will once again print the United States Note to replace the Federal Reserve Note meaning that the United States Notes will be used to purchase back the debt held by the Federal Reserve and extinguish that debt in exchange for public debt being issued and held by the Treasury itself.  The profits on that public debt are then owned by the US Treasury instead of by the private Federal Reserve Banks as occurs now.
The foregoing can be compared to nationalisation of the Bank of England. But the Treasury will not own the private Primary Dealer banks it will only own the interest paid on the public debt, and own the shares of the formerly private Federal Reserve banks; that change will occur on behalf of the people of the United States instead of on behalf of the private Federal Reserve Banks and its private Dealer Banks as occurred in 1913.
However, one can imagine such reform to be strenuously opposed by the Fed itself and by the Dealer Banks and even by the US Treasury, which more accurately colludes with the Federal Reserve rather than having the Fed work on its behalf as the Treasury claims. (ESF is an exception where the ESF mandates to the Fed. -ed.)
The idea to turn the system on its head by “ending the Fed” in its current form – even though the lender of ‘last resort’ will still be a US Central Bank owned by the Treasury – would certainly be opposed, to say the least, by those who lead the current system.
When the US ended the Central Bank in 1834 the nation experienced the Hard Times era by the Panic of 1837, arguably induced by Nicholas Biddle and his banking cronies who sabotaged the US monetary system. So, if the Treasury were to nationalize the shares of the Federal Reserve banks today — as unlikely as that may be — the consequences imposed on the US populace (and by extension the world) would likely be quite dire.
Another idea for monetary reform is Warren Mosler’s “Modern Monetary Theory” or MMT. MMT suggests the current Keynesian principle of US economic operation may be maintained, but modified to encourage more fiscal responsibility and more efficient use of resources allowing government spending to increase on what MMT considers to be a noble cause, for example full employment.
Mosler’s seeming advocacy for increased government spending tempered by efficient use of resources seems like a great idea. However, in practice the probability is high that many more inflationary ‘Moslerian’ dollars will enter the monetary base. As we have seen, bankers always favour quick profit over noble causes and the unlikely idea of issuing many more dollars to assist the poor and unemployed will certainly result in very high inflation and economic destabilization.
Since the 1950’s the practice of blowing up inflationary dollars in pointless US international interventionism, US military provocations, and wars has worked well for the US federal government to extinguish inflationary dollars. MMT seems to imply that the current warfare state should be replaced by the welfare state instead… an MMT-proposed development that will certainly be strenuously resisted by the establishment.
MMT does not address the endangered status of the US dollar as global reserve currency and tends to look at US monetary issues in isolation discounting that the bulk of all US dollars created are exported.
Inflation and Debasement of the Currency
Reviewing our data about monetary inflation we see that the chart is relatively flat until the creation of the Federal Reserve, which essentially placed the Money Trust (private banking families) back in charge of the monetary system as it was from 1793 until 1834. On the creation of the Federal Reserve as Central Bank, the chart documents the loss of 70% of the dollar’s purchasing power from 1971 to today and this spike proves the glaring weakness of the current system.
At a minimum, Fractional Reserve ratios should be reasonably maintained noting that the derivative bubble and collateral of intrinsic value (gold) is left out of this argument for reasons of brevity and clarity. Likewise, some slight attempt must be made to balance the US budget. With reform money will again have some value and begin to work again as an incentive to production, employment, and commerce for the people.
Now, only public trust overall in the US Dollar and the ability of the Federal Reserve to maintain the system (in collusion with the US Treasury and others) keeps the USD currency system afloat and prominent as global reserve currency. If the US operated equitably and fairly perhaps trust in the ‘by decree’ monetary system can work forever, and the US Dollar may remain global reserve currency forever as MMT for example maintains.
However, the US financial system did collapse in 2008-2009 and the glaring inequity and growing disproportion – and even corruption – at the heart of the system certainly must endanger the US Dollar’s status as providing 61% of the globe’s reserve currency in the form of Federal Reserve Notes.
(1) The US Treasury’s financial instruments – usually Bonds, T Bills, TIPS or MBS – may be purchased by other sovereign entities, privately, or by the Federal Reserve via its Primary Dealers, or directly by the Exchange Stabilization Fund.
(2) The “Desk” and Exchange Stabilization Fund operate without independent oversight and do not provide any detailed public disclosure.
(3) By 1844 Van Buren’s Independent Treasury operated privately owned Banks (which became the National Banks system in 1863) however the debt created and the interest on that debt were returned to the Independent Treasury (and thus the people of the United States) and not to private interests. The private National Banks do make profits from their banking activities but the public debt profit goes to the Treasury and not to a private central bank, as a percentage of those profits do now.
(5) John F Kennedy as president re-introduced the United States note and actively embraced this idea, however issuance of the US Note ended in 1964 subsequent to his murder.