How the US government "borrows" USD
It involves banking reserves and Treasury auctions
When I started this post, my intention was to understand, and document, the step by step process of the US government creating new money, from a bill being passed that has a funding requirement, to money being added to an account at the Federal Reserve that the Treasury draws upon.
But, after reading up on the details, I came to realize the relationship between new money creation by the Fed, and the Treasury getting some to cover their bills, is indirect.
As a result, the format of this post changed from a step by step process definition, to a collection of facts, which when put together, tell the story.
But, there is still one unanswered question in my mind, which I bring up at the end.
General caveat to this entire post: It is my current understanding.
If/when I later learn things work differently, I’ll update this post.
Important facts
The Federal Reserve is a public/private hybrid
I think they’re the only institution in the United States for which this is true.
The Federal Reserve Board of Governors is an agency of the US government1.
The twelve Federal Reserve banks are private corporations. Each operates within a defined geography. They are supervised by the Board of Governors.
Federal Reserve member banks hold stock in their regional Federal Reserve bank.
They must subscribe to the capital stock of its District Federal Reserve Bank in an amount equal to 6 percent of the member bank's paid-up capital and surplus and must pay in half of that amount. The other half is subject to call by the Board of Governors2.
Federal Reserve banks are not operated for profit3.
Ownership of stock is a condition of membership in the Federal Reserve system.
The stock can not be sold or pledged as collateral for loans4.
When Federal Reserve banks generate a profit, most of it is remitted to the US Treasury as required by the Federal Reserve Act5.
So while Federal Reserve banks are private corporations, they’re operated as if they were part of the US government, even though they’re technically not.
Treasury auctions
Treasury funding obligations are created by bills passed by Congress and signed into law by the President. Some of these (Social Security and Medicare for example) create recurring, or perhaps a better word is perpetual, needs for funding. In US government speak, these are called mandatory expenses.
The Treasury announces and conducts auctions of Treasury securities. The last step in the process6 is settlement (the issuing of the securities in exchange for payment).
Treasury auctions are open to the public and if you as an individual investor wish to participate, you create an account on the Treasury Direct system7. On the system the language used is that you are buying savings bonds.
Treasury auction “settlement dates” are 3 to 4 business days later than the date of the auction. Settlement is the Treasury providing the security in exchange for the money.
While anyone CAN show up to bid, certain banks are designated as Primary Dealers8 and part of that designation is that they MUST show up and bid, at every auction. There are 24 primary dealers. The tweet below says 25 because at that time both UBS and Credit Suisse were on the list, but Credit Suisse no longer exists.
The Federal Reserve can not buy directly from the Treasury
The Federal Reserve is prohibited by six words in The Banking Act of 1935, from buying Treasury securities directly from the Treasury9.
Banking reserves
Banks buy Treasury securities with banking reserves, and primary dealers are banks.
Banking reserves can be seen as a special kind of money, which are used almost exclusively for interbank payment settlements. They are not deposits of bank account holders and they can never be loaned out. They are accounts banks are required by banking regulations to open with the Federal Reserve.
Banking reserves is an interesting topic in it’s own right, and later I will devote a post to them. But for now, what matters most is they CAN be used to buy Treasury securities.
The level of reserves in the banking system are set by Federal Reserve policy.
Creating banking reserves is creating money
A special kind of money, namely banking reserves, but money nonetheless.
The most common form of reserve creation (but by no means the only one) is through open market operations where the Fed buys (sometimes borrows) Treasury securities from commercial banks. This operation increases the money supply.
And creates the unanswered question I mentioned earlier. The unanswered question comes from the fact that when the Federal Reserve increases banking reserves, they’re buying Treasury securities from the banks.
So increasing banking reserves decreases the level of Treasury security held by banks. Some describe this as an asset swap.
And… banks use reserves to buy Treasury securities
Which puts money created by the Federal Reserve into an account the Treasury draws upon.
In closing
The Federal Reserve does not create money specifically for the primary dealers to enable them to buy Treasury securities.
Which means the creation of new money being used to fund the US government is indirect.
The Fed creates new money in the form of banking reserves.
Banks use those reserves to buy Treasury securities.
Primary dealers MUST show up at every auction and buy.
And the Treasury account at the Federal Reserve gets an inflow of money.
But… That unanswered question
Since banks need banking reserves to buy Treasury securities from the Treasury, and banks obtain banking reserves by selling Treasury securities to the Federal Reserve, how would such a system be initially setup?
If a new country came into existence and wished to setup an identical system, how do banks initially obtain reserves, since the way they obtain reserves is by selling Treasury securities, when none have yet been issued?
If you know the answer to this question, please let me know.
For your unanswered "bootstrap" question, there are various possibilities, which I think I discussed elsewhere, but I'll put them here too.
1. The bank could sell something tangible (e.g. gold) to the central bank to obtain reserves to lend to the government.
2. The bank could borrow from the central bank using something tangible as collateral, and lend the new reserves to the government.
3. If the nation used a different type of money beforehand, it's almost certain that the central bank would exchange it for reserves. (The Fed would issue FRNs in exchange for red-seal US notes, which are liabilities of the Treasury).
4. It's possible that to bootstrap the system, legislators could allow the central bank to buy a limited quantity of bonds directly from the government as a one-off.
There are probably others I haven't thought of here, but all of these solve the problem.
This is an excellent resource for anyone who wants an overview of the whole process in straightforward terms, and well-referenced. Very impressive.