It's very difficult to find an explicit description of the entire process. I think I understand the story, but I want to run this by you guys to see if you spot any errors:
The Process of Monetization of the Debt
(1) The US government runs a deficit and borrows money by issuing bonds that must be repaid plus interest at a later date.
(2) The Federal Reserve sets the target federal funds rate. To achieve this rate, money is printed and added to the economy by exchanging it for real assets. Typically these assets are US government bonds allegedly due to their high liquidity in large volumes.
(3) When US bonds held by the Fed mature, the revenue paid by the Treasury is used by the Fed to cover its operation expenses. In this way, the Fed does not require allocation of funds in the yearly budget (thus maintaining its "independence").
(4) Any profits made on bonds by the Fed (above operating expenses) is sent back into the Treasury.
Observations
(a) The Treasury reduces its debt obligations in two separate ways: (i) it repays all debts, held by the Fed, the public or foreign governments, in debased currency due to the inflation caused by the Fed (step 2); (ii) part of the debt owed to the Fed was immediately returned (step 4).
(b) The part that the Fed used to cover its own operations was paid by the Treasury (step 3). Thus, effectively, this transfer is not the repayment of debt, but budgeting for the Fed's expenses.
(c) The part that was returned (step 4) was never paid out by the Treasury at all. This part of the debt was effectively paid by the government with printed money when the Fed previously purchased the bond (step 2).
(d) Inflationary effects are mostly reversible up until the bond matures. Before that, the Fed can always resell the bond and destroy the bank notes that it receives in payment.
Conclusion: A simple model
So, in conclusion, the entire complicated process can be simplified through the following mental model:
The government sells bonds. Some of these it pays by printing up its own money (Fed purchase). The rest it pays at a discount with debased currency due to its own printing (public, foreign owned). Annual expenses of the Central Bank come from taxes (part of revenue Fed keeps from the Treasury for operating expenses).
Common Misconceptions
One last point -- confusion over this process leads to two popular erroneous conclusions. It is not commonly understood that profits made by the Fed go into the Treasury. Two other assumptions are often made:
(1) Profit made by the Fed goes to its shareholders.
This leads to the argument that a group of elite bankers that own the Fed use the shroud of secrecy that gives the Fed its independence to fleece the public by profiting off the printing press.
This is false. In reality, the government prints money as a means to transfer our savings and salaries into government programs, without resorting to blatant taxation.
(2) Revenue from maturing bonds is destroyed by the Fed.
In this scenario, the Fed would destroy more money (principle + interest) than it created when it purchased the bond (principle only). To pay off the interest owed to the Fed would eventually consume more money than is in existence. Therefore, the Treasury would need to issue bonds and sell them to the Fed at an exponential rate so that more money would always be printed than is consumed.
This is false. This misconception probably stems from the fact that the Fed can sell assets to reduce the money supply (by destroying the money it receives). If the Fed really destroyed its revenue, then it would need funds allocated from the budget. Also, this would defeat the purpose of having a government run printing press to fund deficits.
Does anybody see any errors? Comments?
Your simplified explanation was accurate at one time, but now more than half of the Fed's assets are mortgage-backed securities, loans to primary dealers, and similar assets.
Also, although the banks do not directly benefit from the monetization of Treasury securities, they do benefit from fractional reserve banking and the support from the Fed that makes this possible.
Thanks for the reply.
Yes, I've seen some data showing this. But it seems to me that this is a separate function of the Fed. In other words, the Fed apparently serves at least four functions:
(1) It regulates the banking system, making fractional reserve banking possible by ensuring that banks inflate the money supply together.
(2) Although out of direct control of the Treasury, it can under its own discretion benefit the Treasury by printing money to cover some of its outstanding debt. But this only occurs when the Fed buys US bonds.
(3) It offers loans and bailouts to struggling companies deemed critical for the US economy. In this capacity, it prints money to offer low interest loans or buy assets which would otherwise be worthless on the market (so-called toxic assets; mortgage-backed securities).
(4) It controls interest rates by expanding or contracting the money supply. To do so it prints money to buy any kind of asset it wants.
Sounds about right, except for the part about "contracting the money supply." I've never heard of that.
The fallacies of intellectual communism, a compilation - On the nature of power
I think the Fed under Volker contracted the money supply in the early 1908's, but it doesn't happen very often.
DougM: I think the Fed under Volker contracted the money supply in the early 1908's, but it doesn't happen very often.
I think you mean 1980s :
Technically the Fed can contract the money supply. Reserve Ratios are the easiest way to do this. In a normal economy if our government raised reserve ratios to 30%, this would severly tightnen the money supply and reduce the amount of money created through the money multiplier. When the Fed sells assets it generally slows down the growth of money, its very hard/dangerous to reduce the amount of money in the economy.
RockyRaccoon:This is false. In reality, the government prints money as a means to transfer our savings and salaries into government programs, without resorting to blatant taxation.
Common misconception this is. Seigniorage is a trivial source revenue today as I learned.
scineram: RockyRaccoon:This is false. In reality, the government prints money as a means to transfer our savings and salaries into government programs, without resorting to blatant taxation. Common misconception this is. Seigniorage is a trivial source revenue today as I learned.
We could only know this if the natural rate of interest prevailed on the bond market. The difference between the manipulated interest rate the government pays and the real rate it ought to be paying is its seigniorage profit.
RockyRaccoon:(b) The part that the Fed used to cover its own operations was paid by the Treasury (step 3). Thus, effectively, this transfer is not the repayment of debt, but budgeting for the Fed's expenses.
I just realized something else. Part of the Fed's "expenses" is, by law, paying out a fixed 6% annual dividend on shares of the Fed held by member commercial banks. But, as I described originally, the Fed's expenses are effectively budgeted for in the Treasury's expenses (disguised as honoring its debt obligations held by the Fed).
In other words: part of the expenses of the Fed, effectively paid for by the US Treasury under the guise of paying off its debts, is a 6% annual yield to private banking institutions. That basically means that annual payments to member commercial banks are basically built into the annual budget of the Treasury.
Obviously, we're all against central banking. But even so, it does not seem necessary to require commercial banks to hold shares to make the system work? Does anybody know the "official" reason why that is necessary? I suspect it's done to support the illusion that the Fed covers its own expenses.