Lately I've been trying to understand macroeconomics in general, and specifically our banking system. Partly this is because Simon has proposed an interesting alternative and in order to understand its relative merits I want to know how we do things now. I reproduce the information here because it may be useful to others. Note that my perspective is that of a libertarian interested in private banking alternatives. I'll give a summary of the current system in this entry, with some references, and talk about alternatives later. For reference, here is Federal Reserve Purposes and Functions", on the Fed, by the Fed

First, we must understand a little about government securities. The United States Government raises money by issuing and selling bonds, just like a corporation. So the interest on US Government Securities (hereafter called "govsecs") is owed by the US government, which effectively means by the taxpayers, as they pay the interest with tax revenue. The "national debt" which you hear so much about is mostly in the form of these debt instruments. So if you own a government bond, you are one of the people to whom the national debt is owed (breakdown of public vs. intragovernmental debt, lots more information on the debt). Govsecs are a little useful for the economy in that they are considered the safest interest-bearing instrument, as our government is thought less likely to default than any private issuer of bonds. Its kinda nice to have reliable debt instruments, but I don't think there is much reason for the government to issue these instruments (except arguably in wartime), and I don't think they are a necessary part of the economy. Its mostly that the government has a fat future income (taxes), and it wants to spend that money before it gets it.

The largest single holder of govsecs is the Federal Reserve System, a private group of "banks for banks". They were created by an act of Congress to stabilize the banking system, and are generally thought to act in the public's interest. The main income of the Fed comes from the interest on govsecs. In a strange example of circularity, the Fed gives most (~95%) of their yearly profits to the US Treasury (reference). For example, in 2000 the Fed made $33B, spent $2.9B, and gave $25.3B to the government. The USG paid $362B in interest on the national debt in 2000, so the Fed apparently held around 8-9% of it. So some of the interest on govsecs is paid to the Fed and then given back. Also, Government Trust Funds are required to invest on govsecs, so much of the interest on the debt is paid to other government agencies. I think this is the "intragovernmental holdings" linked to above, which would mean that around 40% of the interest on the debt is actually being paid to parts of the government. More circularity.

While the National Debt is a Bad Thing, there are a few things to note here. One is that is that a vast financial system is built on debt instruments, some of which are used circularly. This will become important when we consider Simon's system. A second is that it ain't quite as bad as it looks because of the good circularity (the government paying interest to itself). But then there is bad circularity - the Treasury Department's FAQ on govsecs states that the primary motivation for selling govsecs is to pay off other govsecs that people are turning in. That's right, the government is paying off the Visa bill with their Mastercard. Sounds like a recipe for disaster - no wonder the debt has been spiralling up. To stop the feedback loop, we would have to stop spending tax income and start using it to pay back the debt. Ok, back to the Fed.

The Fed also makes money by providing services to member banks, such as check clearing and electronics funds transfers. It acts as a central clearinghouse for interbank activites. It makes some money by loaning cash to member banks at the so-called "discount rate" for loans within the system (reference), and from foreign currency investments. All nationally chartered banks have to join the Federal Reserve system, using 3% of their capital to buy stock in the system. State banks have the option of doing this if they want. This stock does not allow any direct control, although it does pay a dividend of 6% a year.

The Fed controls the money supply through three main mechanisms. One of the two simple ones is changing the reserve ratio (the percentage of deposits which banks must hold as cash). When it's a higher proportion, banks can't loan out as much money, so the money supply goes down, and when its lower the opposite happens. The other is that it can change the discount rate, which is the interest rate for interbank loans. Banks will of course borrow more or less money if the interest rate is lower or higher, respectively.

The more complicated way in which the Fed changes the money supply is by buying or selling govsecs on the open market. Now, the fact that they buy or sell govsecs is not what changes the money supply. What changes the money supply is pure accounting magic that would make Enron proud. When they buy govsecs, they literally create money to do so. They pay by adding to the account balance of the seller without subtracting from anyone elses balance. When they sell govsecs, they take the money used to pay, and make it disappear from the system, subtracting it from the sellers balance without adding it to anyones. Theoretically, as the central clearinghouse (backed by a government monopoly and the ability to print paper money) they could perform this magic trick whenever they wanted, adding or subtracting to accounts at will. They choose to limit their shenanigans to the particular activity of buying & selling govsecs, because there is a "broad, highly active market that can accomodate the transactions without distortions or disruptions to the market itself." Govsecs are very liquid, and so the fed can buy and sell them constantly to achieve fine-grained control over the money supply. There is nothing to stop them from buying more than they sell, and thus adding more to the money supply than they take away. In fact, they do so, and it is considered part of their role to (slowly) create money.

Perhaps this is the explanation for the circularity mentioned above, where the Fed makes its money from govsec interest, and then gives it back. In order to create money, the Fed has to buy more govsecs than it sells, and thus it accumulates govsecs in order to expand the money supply. These govsecs were essentially bought with funny-money, so the Fed gives the interest back to the government, which authorized them to do the whole funny-money business thing to begin with (by enforcing a monopoly for the Fed on money and banking services). Note that the Fed does not only engage in such dubious transactions. They also do things like "matched buy-sell transactions", in which they buy a number of securities now with a contract that the seller will buy them back (usually in less than a week). This ensures a temporary effect on the money supply.

Since the Fed can print money, by definition under a fiat system they cannot have a liquidity crisis. If all banks with a Fed account ask to take all their money out in cash, (a run on the Fed), the Fed can accommodate that as long as there is enough paper and ink. This adds stability to the banking system. Unlike what I had previously thought, the government does not appear to add to the money supply by directly printing cash. The Fed can issue currency, but it must be secured by collateral, mostly govsecs, of course. This currency is "a first lien on the assets of the issuing Reserve Bank". So the way the government devalues the currency (AKA "expands the money supply") is a bit more complicated, if I understand things correctly. But it centers on the fact that the Fed's books don't have to balance, and it creates money electronically when it buys govsecs.

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