Originally published August 10, 2011 on the New Economic Perspectives blog.
Thanks for comments. I am cutting off the responses early, and will keep this short, because I am in Euroland and preparing to fly back.
Let me quickly respond to the six people who commented, and then provide a short answer to the homework question.
Neil: One imposed constraint is that banks can refuse instructions to make transfers, including transfers ordered by government that has abandoned its fiat money.
Answer: OK for individuals the bank might refuse in two cases: apparent fraud or insufficient funds. We certainly applaud any bank that refuses to shift funds out of our account if it suspects fraud! We are not quite so happy when it refuses to clear a check in the case of an overdraft, because we get charged fees. But, OK, so far. In the case of government, I’m not quite so willing to go along with your suggestion, for two reasons. First, I do not really like the term fiat money and do not know what it is supposed to mean. I use the term sovereign currency. As I will discuss in coming weeks, there are different sovereign currency regimes—from fixed to floating rates. A sovereign’s currency is, on my definition, sovereign. There are constraints on sovereign spending, including those self imposed. It could instruct its bank (the central bank) NOT to make payments when its deposits are insufficient. It might even instruct the CB to impose fees for insufficient funds! Beyond that I am not quite sure what point you are making. Even if the sovereign government did not have a “fiat currency” (whatever that means) it could decapitate any central bankers that bounced checks. This might become more clear soon.
Had ‘Nuff: Money of account can be replaced by medium of exchange; domestic currency should include demand deposits; government IOUs are not debt; currency tax.
Answer: Think of it this way: Money of account is the measure (foot, yard, inch), medium of exchange is the thing being measured (shoe, arm, earlobe). Domestic currency is the government’s IOU; demand deposits are bank IOUs—so in my view we should not mix them. They are issued by quite different entities. An IOU is a debt, so government IOUs are debts. Not sure what point you are trying to make.
Now, why would I disagree with JKH, who claims reserves should not be included in a definition of currency? Reserves, Federal Reserve Notes (our green paper money), Treasury notes (yes, Treasury has issued paper money, too), and Treasury coins are all IOUs issued by government (either Fed or Treasury), and all commit Uncle Sam. Fed losses come out of the Treasury. If Fed goes insolvent (which it might!), Treasury will cover the losses and recapitalize it.
Functionally there is one difference in that Reserves can only be held by banks; the rest can be held by you and me. But reserves are perfectly substitutable for all the others. So why do some resist recognizing this? They want to maintain the fiction that the Fed is not part of government. Sorry, Charley, it is. Plain and simple, it is a legal creature of Congress. Finally, I have no idea what a currency tax is.
James: Treasury’s account at the Fed is not counted as money supply but rather is a Fed IOU; but Treasury spending reduces its deposit at the Fed thus taxes do “pay for” Treasury spending.
Answer: Well, I do not see how. When you pay your taxes, you draw down your bank demand deposit. A private bank credits the Treasury’s account at the bank. BUT THE TREASURY CANNOT WRITE A CHECK ON THAT. There is no way the Treasury can “spend” your tax payment. It can only write checks on its account at the Fed, and you do not have an account at the Fed. You cannot deliver to the Treasury what it needs to spend. You might say I am being picky. I say I am being precise.
Hepion: Banks keep their money at the Fed; where does the Fed store it; and who manufactures it?
Answer: The Fed hides it in caves in Kansas City. Send a self-addressed and stamped envelope with $5000 in unmarked bills to me, and I will send you a secret treasure map with an X marking the spot.
Seriously: banks don’t keep money at the Fed, indeed, banks do not have any money. Willie Sutton (google him) was wrong. Don’t bother robbing banks, because that is NOT where the money is. Banks have an electronic account at the Fed—numbers on a harddrive. I suppose the harddrive is made in China. No other manufacturing is involved. In addition, banks have a very small amount of “vault cash” in their vaults. Believe me, not worth robbing. If you really want to rob banks, do what my colleague Bill Black says: the best way to rob a bank is to own one. Then you simply credit your own bank account with bonuses. Where will you get the millions of dollars to credit your account once you own a bank? Keystrokes.
Marley: How does Fed buy back Treasuries?
Answer: You are well on your way to getting this right. Fed credits private bank (selling the Treasuries) with Fed’s own IOU, bank reserves. Fed holds the bonds as assets, offset by reserves as liabilities. So in the end, although Fed cannot buy the bonds directly from the Treasury, it buys them from banks.
Adam: (Long post…I won’t repeat it)
Answer: By Jove, he’s got it! Excellent. Grade = A.
Homework Assignment: where does the electronic “scoreboard” money come from or go to? Think of the football game, or bowling. Where do the points “come from” when you score a touchdown or knock down a pin? Where do they go at the end of the game when we clear the score board?
Well, they are just “key strokes”—electronic pulses that light up the LED when points are scored, and we stop sending the pulses to turn off the LEDs. That’s all there is to it. Keystrokes.
Follow up homework? Can Government run out of keystrokes?