Your Civics Lesson

I'm teaching intermediate macro-economics this semester. One thing that keeps coming up in this class is the generally low level of knowledge regarding the role and relationship of various actors in the government. This is not some screed about how "kids are so dumb these days", I know plenty of adults who are similarly uninformed about how things work. So here is a quick primer for you:
- The Fed. The Federal Reserve Bank is just that, a bank. It is a very special bank, yes, but it is just a bank. Just like regular banks, it takes deposits. The deposits at the Fed are a) the "savings accounts" of regular banks (their reserves),  b) the "checking account" of the U.S. Treasury, and c) all the currency in circulation.  If you look at your cash, you'll notice that it is a "Federal Reserve Note". It's a claim on the assets of the Fed. Now, you'll never actually go in and redeem this, but it remains a liability of the Fed.  The Fed uses its deposits (all liabilities) to buy assets. These assets include gold, Treasury bonds, and in the current situation, several other more exotic financial products (mortgage-backed securities, etc..).

What can the Fed do? The Fed can buy and sell financial assets (and gold). If it buys Treasury bonds from private firms, it pays for these by giving that firm an additional deposit (more reserves). In this way, the Fed can create money out of thin air, because the additional deposits are nothing more than an entry on a computer.  If reserves go up, then the firms holding these reserves have the capacity to make more loans to private individuals, and because of a greater supply of loanable money, the interest rate goes down. So the Fed can increase the supply of money and lower the rate of interest. If the Fed sells bonds, the process works in reverse.

What can the Fed NOT do? The Fed cannot issue Treasury bonds. In other words, the Fed may NOT increase the indebtedness of the United States on its own authority. It cannot drive the U.S. into bankruptcy and it cannot determine the amount of government spending that occurs.

- The U.S. Treasury. The Treasury manages the money of the U.S. government. The Treasury has a "checking account" with the Fed that it uses to process payments and income.

What can the Treasury do? If Congress and the President ask it to, the Treasury can issue new Treasury bonds. Private individuals (and sometimes the Fed) will buy the Treasury bonds, and will deposit money in the Treasury's checking account to pay for the bonds. The Treasury can then spend the money on tanks, highways, Social Security checks, shovel-ready projects, and $400 Pentagon toilet bowls. Government debt goes up because the government decides to spend more than it earns in taxes, and it issues Treasury bonds to make up the difference. The people responsible for government debt are your elected officials, no one else.

What can the Treasury NOT do? The Treasury may NOT increase the supply of money. In other words, when the Stimulus bill passed, this did not create $787 billion in new money. It created $787 billion in new *spending*. The supply of *money* in the economy is the same.

(One confusion is that the U.S. Mint, who actually does physically print cash, is run by the U.S. Treasury. But the supply of U.S. dollars and coins in circulation is controlled by the Federal Reserve.)

(Another confusion is that the dollar bills are signed by the U.S. Treasury secretary. This is because the Treasury secretary is guaranteeing that the Treasury will accept the bills as payment for taxes - that's the "legal tender for all debts public and private" part. One of the reasons that dollar bills have value in transactions is because we always know that the government will accept them for taxes.)

- So who do I blame? And for what? If you are concerned about government debt, then you have an issue with Congress and the President(s) who signed off on higher spending and lower taxes. You want to lower government debt, raise taxes and/or lower spending. But shut up about the Fed "driving us into bankruptcy" or "forcing us into a debt spiral".  Blaming the Fed for government debt is like blaming your credit card company for making it "too easy" for you to get into debt. It's not their fault you are impatient and an idiot.

If you are concerned about inflation, then you have an issue with the Fed, who has recently massively expanded the money supply. This *could* generate high inflation in the future if they do not reduce the money supply appropriately as the economy grows again. If you are worried about inflation, though, the last thing you want is Congress to get more control over the Fed. The only people with the stones to actually keep inflation under control are the guys running the Fed right now. Congress would basically print money at will to buy their districts new on-ramps, and then we'd really have inflation (ask Zimbabwe).

Last thing - for one moment consider your own financial situation and why your biggest worry is inflation. For me, I have a big mortgage, meaning I have a really big nominal debt to pay each month. If there is general inflation, then both prices and wages go up. My wage goes up, but my mortgage payment stays the same, I'm better off. EVEN if all the other prices in the economy go up too. So for someone like me, with a big debt, I kind of LIKE inflation. Too much, and the economy will fall apart, so I don't want 1,000% inflation, but a little inflation ain't so bad if you are heavily in debt.