Today, ‘money’ is a guarantee to honor government debt, where the currency in our pockets represents tax claims as well as debt purchased by the Federal Reserve and others (1) from the US Treasury, so that the Federal Reserve may issue the notes that constitute the cash in your wallet. Just look at the face of any cash note in your wallet, where “Federal Reserve Note” appears at the top.
Besides Treasury support from regulation (taxation) the Federal Reserve purchases debt instruments from the Treasury to allow the Treasury to honor its debt by the issuance of Federal Reserve notes. In other words, the Federal Reserve purchases US public debt instruments (Treasury bonds/ bills and Mortgage Backed Securities – MBS, etc) from the Treasury in part to enable the Treasury to service its debt, and to pay interest on the outstanding national debt.
The Federal Reserve banks are privately owned corporations with commercial bank shareholders (paid dividends), and they enforce monetary policy in collusion with the US Treasury, and the Primary Dealer Banks of the Federal Reserve.
Other nations purchase US Treasury debt in significant amounts, including Japan; China; Saudi Arabia; Belgium; Caribbean banking centers, and oil exporters. However, a large share of US public debt issued by the US Treasury is held via the Federal Reserve and its primary dealers, with most public debt interest paid to whoever holds those debt instruments, whether the Fed itself, or the private Primary Dealer Banks of the Federal Reserve, or any other person or entity.
Thus, the Federal Reserve maintains and operates its own highly profitable market structure for buying/selling US debt on behalf of the US Treasury, via its own banks (or Desk) and these primary dealer banks:
Amherst Pierpont, Bank of Nova Scotia (Scotia), BMO Capital Markets Corp, BNP Paribas Securities, Barclays, B of A, Cantor Fitzgerald, Citigroup, Credit Suisse, Daiwa, Deutsche Bank, Goldman Sachs, HSBC, Jefferies LLC, J.P. Morgan, Mizuho, Morgan Stanley, NatWest, Nomura Securities, RBC Capital, Societe Generale, TD Securities, UBS, Wells Fargo
Besides the US Treasury and Fed itself, the above dealer banks are next to profit from the Fed’s permanent Open Market Operations, whether via Quantitative Easing (money issuance by the Fed on government debt purchased by the Fed), Operation Twist, the Fed’s Repurchase and Reverse Repurchase agreements (Repo’s), or by operations of the Exchange Stabilization Fund. For practical purposes these banks have “first market use” of the US dollar funds “created” by the Federal Reserve via its purchase of debt instruments from the US Treasury.
Mortgage Backed Securities (MBS) Treasury bonds and T-Bills are the usual debt instruments purchased from the Treasury by the Federal Reserve (FOMC “Desk”) or its Primary Dealer Banks and others. The Federal Reserve “Desk” is authorized to purchase any security or commodity in existence to support US Treasury operations, sometimes under the auspices of the Exchange Stabilization Fund. (2)
The US Treasury and Federal Reserve, have first use of the new USD (Federal Reserve Notes) created by the Federal Reserve’s purchase of US Treasury debt instruments, to manage monetary policy and service the government’s public debt, but first commercial market use of the funds created is via the Primary Dealer Banks.
After the Dealer Banks, then commercial and retail banks, and on down the line to the public. Finally, the Federal Reserve notes (cash notes in your wallet) are used by private individuals to pay for goods and services, thus trading the implicit value of the government debt represented by those notes to a third party, in exchange for those goods and services. Simply put, the “intrinsic value” of cash is the value associated with holding Federal Reserve notes representing US government debt including taxes owed, where intrinsic value is only based on the “value” of, or trust in, US debt and its tax revenues.
Here is the “use list” of US Dollars (USD) created by the Federal Reserve from US Treasury debt instruments, in order:
- US Treasury
- Federal Reserve banks
- Federal Reserve “Desk”
- Primary Dealer Banks
- Commercial investment banks (including certain hedge funds)
- Non-dealer retail banks/credit unions
- Other financial entities
Some have stated that the Federal Reserve creates money out of “thin air” but that’s not strictly correct, because some debt instrument is required to create the new funds. In the case of a mortgage, the “money” created is only created by your signature on a note held by the mortgage company or bank. In the case of a bond (or Mortgage Backed Security) the “money is created” when some person or entity signs up for the purchase of that bond, T-bill, or MBS.
After the Treasury funds its programs with the capital created by the Federal Reserve in exchange for Treasury debt, the Treasury must pay interest on that debt to the Federal Reserve’s private banks and to the dealer banks engaged in Fed operations, and all other entities who hold US government debt instruments.
So, the Fed’s private banks and Primary Dealer Banks profit in part from the public debt, in the form of interest payments. Most profit realized by the Federal Reserve via “Desk” trades is returned to the US Treasury, but not all. At least 6% of the profit made by any single privately held Federal Reserve bank is paid in dividend to the shareholders in those banks, and only commercial banks may own those shares, and they may not be traded. Above a certain profit level, as much as 10% or more of the bank’s profit may be paid in dividend, with the percentage above 6% being equal to the high yield of the 10-year Treasury note as last auctioned.
The banks may then leverage incoming capital as needed to guarantee more capital (whether via repurchase agreements, MBS or other bond trades, T-Bills, share trades, currency swaps, proceeds from retail bank mortgages, etc, etc) using a method devised by gold dealers centuries ago, called Fractional Reserve Banking.
Fractional Reserve Banking
Fractional Reserve banking is based on the idea that no more than 10% of creditors will demand cash at any given time, an idea which harks back to antiquity and the Guild system of gold dealers. In the Fractional Reserve system, banks may keep 10% of depositors cash on hand, and loan out nine times that amount based upon the creation of new debt instruments, for example new mortgages.
As the depositor’s funds are fractionalized and then multiplied and spread between banks, the system debases US dollars in the form of “leverage”. For example, signing a note for a $180K home mortgage allows the receiving bank to exchange that debt obligation for other debt obligations worth a total of $1.6 million in total debt – this is why banks love mortgages.
During the 2002 to 2007 US economic boom, some institutions leveraged capital by 40-to-1 and in Europe many big bank counterparts leveraged a 24-to-1 capital leverage ratio. High fractional reserve ratios work well when all participants in the system do not demand solvency (which is different from liquidity) or sound money. When part of a sound money system, a reasonable fractional reserve ratio might allow banking investments as part of a practical plan for growth, which works well when the market is free from corruption and the leverage rate is relatively low.
Public Debt Interest
In summary, the Treasury pays interest on the national debt held by the Federal Reserve and held by the Fed’s dealer banks (and on their reserves) and to all others who hold US debt instruments, via Federal Reserve notes. When the primary dealer banks are paid interest by the Treasury on the money created by the Federal Reserve on the basis of the Treasury’s debt instruments, then the dealers use that cash to reinforce their balance sheets, purchase Wall Street shares, purchase more Treasury’s or commodities, property, ETF’s or precious metals, and so on, etc etc.
So long as the Fed and its Primary Dealers can leverage the Treasury debt instrument system in collusion with the Treasury, and foreign buyers also purchase US debt instruments, the system stays afloat. The monetary system by definition must then rely on the support of an ever-increasing debt burden and the issuing of new debt instruments, with an eventual potential for massive cyclical instability. (3)
From 1840 to 1934 the gold standard and US National Banks system (in the US) enforced some form of monetary discipline, resulting in occasional serious Financial Panics as well. With growing population density and demand for economic growth – as well as governmental need to finance defense, war, and public services – the Independent Treasury system could not be maintained by the early twentieth century, and the private Fed banks were introduced to act as a Central Bank. NB: The Bank of New York Mellon or BNY effectively operates as the Federal Reserve Bank of New York.
Is the Federal Reserve System Fair?
Obviously, there is some unfairness and inequity in this system. Since the Federal Reserve banks are privately owned corporations, they must maintain markets in a way that is advantageous to them, and will prevent their banks from failing since it is possible for a Federal Reserve Bank to fail. This gives Federal Reserve banks an unfair advantage in the system, along with the private profit in public debt that they skim, and the interest they are paid on the public debt which goes to private profit, not to the public.
The Federal Reserve banks work in tandem with their Primary Dealer Banks, which provides an opportunity for rigged markets. And in some instances, for example reverse repurchase agreements, the Federal Reserve guarantees the Primary Dealer banks a profit. While a guaranteed profit works well for the Fed and its dealers, the dealer profit is entirely private, and none of that profit goes to the Treasury, except for taxes levied on the primary dealer profit. It may also be argued that for a Quasi-governmental entity like the Federal Reserve to guarantee a profit to a private bank (from public funding) is not only unethical, but also immoral. Also, the fact that the public does not own the interest related to the creation of its money, and is last to benefit from that creation, is likewise flawed.
Since the introduction of the Federal Reserve system in 1913, we must confront global monetary challenges as the fiat (by decree) monetary system – global floating currencies – may potentially catastrophically destabilize over time, as the system collapsed in the United States during the 2008-2009 financial crash. One potential remedy (for the United States) is based on a scholarly rework of the Chicago Plan of 1935 (4) but such great austerity would likely lead to political instability in the United States, and perhaps global instability too.
Another idea is to return the profit on public debt interest made by the Primary Dealers to the Treasury by effectively nationalizing the private Federal Reserve banks via transfer of ownership of Federal reserve bank shares to the Treasury. The US Treasury will then take back ownership of all public debt by once again issuing United States Notes via the Treasury (instead of by the Fed) while still supporting private banks as the Fed does now.
Put simply, the US Treasury will extinguish the debt of the Federal Reserve by issuing United States notes to gradually purchase the existing Fed debt while recalling Federal Reserve notes, and once again own the interest on the public debt. The US Treasury will then assume ownership of the shares of the current Federal Reserve banks, converting them to US-owned shares, just as the Bank of England operates now. All employees of the Federal Reserve Banks would then become federal employees of the US Treasury, instead of corporate employees. The Treasury will thus end the out-sourced money-issuance that the Federal Reserve has been engaged in since 1913, by issuing US Notes via a US-owned central bank and using US notes to extinguish the Fed’s balance sheet and put the Fed out of business.
In other words, the US Treasury will once again print the United States Note to replace the Federal Reserve note, meaning that United States Notes will be used to purchase back the debt held by the Federal Reserve, and extinguish that debt in exchange for public debt being issued and held by the Treasury itself.  The profits on that public debt are then owned by the US Treasury, instead of by the private Federal Reserve Banks as occurs now.
The foregoing can be compared to nationalisation of the Bank of England. But the Treasury will not own the private Primary Dealer banks, it will only own the interest paid on the public debt, and own the shares of the formerly private Federal Reserve banks; that change will occur on behalf of the people of the United States, instead of on behalf of the private Federal Reserve Banks and its private Dealer Banks as occurred in 1913. However, one can imagine that such reform would be opposed by the Fed itself and by the Dealer Banks, and even by the US Treasury, which more accurately colludes with the Federal Reserve, instead of having the Fed work on its behalf as the Treasury claims.
The idea to turn the system on its head by “ending the Fed” in its current form – even though the lender of ‘last resort’ will still be a US Central Bank owned by the Treasury – would certainly be strenuously opposed, to say the least, by those who lead the current system. When the US ended the Central Bank in 1834, the nation experienced the Hard Times era by the Panic of 1837, arguably induced by Nicholas Biddle’s sabotage of the system. So, if the Treasury were to nationalize the shares of the Federal Reserve banks today, as unlikely as that may be, the consequences imposed on the populace – and by extension the world – would likely be quite dire.
Other ideas for monetary reform, such as Warren Mosler’s “Modern Monetary Theory” or MMT, says that the current system should continue to operate with the same Keynesian authority that it employs today, encouraged by more fiscal responsibility and more efficient use of resources, by increasing government spending on what MMT considers to be a noble cause such as full employment. However, Mosler’s seeming advocacy for increased government spending tempered by efficient use of resources may seem like a great idea, however in practice the probability is high that many more inflationary dollars will enter the monetary base.
Since the 1950’s the practice of blowing up inflationary dollars in pointless US international interventionism, US military provocations, and wars has worked well for the US federal government to extinguish inflationary dollars. MMT seems to imply that the welfare state (effectively) should be expanded instead of the warfare state; however as we have seen, bankers always favour quick profit over noble causes, and the idea of putting many more dollars in the pockets of the poor would certainly result in high inflation. MMT also does not address the endangered status of the US dollar as global reserve currency and tends to look at US monetary issues in isolation, discounting that the bulk of all US dollars created are exported.
Inflation and Debasement of the Currency
Reviewing our data about monetary inflation we see that the chart is relatively flat until the creation of the Federal Reserve, which essentially placed the Money Trust (private banking families) back in charge of the monetary system as it was from 1793 until 1834. On the creation of the Federal Reserve as Central Bank, the chart documents the loss of 70% of the dollar’s purchasing power from 1971 to today, and this spike proves the glaring weakness of the current system.
At a minimum, Fractional Reserve ratios should be reasonably maintained noting that the derivative bubble and collateral (gold) is left out of this argument for reasons of brevity and clarity; likewise some slight attempt must be made to balance the US budget. With reform, money will again have some value and begin to work again as an incentive to production, employment, and commerce for the people.
Only public trust overall in the US Dollar and the ability of the Federal Reserve to maintain the system (in collusion with the US Treasury) keeps the USD currency system afloat, and as global reserve currency. If the US operated equitably and fairly perhaps trust in the ‘by decree’ monetary system can work forever, and the US Dollar may remain global reserve currency forever, as MMT for example maintains. However, the US financial system did collapse in 2008-2009 and the glaring inequity and growing disproportion – and even corruption – at the heart of the system certainly must endanger the US Dollar’s status as providing 62% of the globe’s currency as Federal Reserve notes.
(1) The US Treasury’s financial instruments – usually Bonds, T Bills, TIPS or MBS – may be purchased by other sovereign entities, privately, or by the Federal Reserve itself.(2) The “Desk” and Exchange Stabilization Fund operate without independent oversight or and do not provide any detailed public disclosure.
(3) By 1844 Van Buren’s Independent Treasury operated privately owned Banks (which became the National Banks system in 1863) however the debt created and the interest on that debt were returned to the Independent Treasury (and thus the people of the United States) and not to private interests. The private National Banks do make profits from their banking activities but the public debt profit goes to the Treasury and not to a private central bank as a percentage of those profits do now.
(5) John F Kennedy as president of the United States re-introduced the United States note and actively embraced this idea, however issuance of the US Note ended in 1964 subsequent to his death.
Steve Brown is the author of “Iraq: the Road to War” (Sourcewatch) editor of “Bush Administration War Crimes in Iraq” (Sourcewatch) “Trump’s Limited Hangout” and “Federal Reserve: Out-sourcing the Monetary System to the Money Trust Oligarchs Since 1913”; Steve is an antiwar activist, a published scholar on the US monetary system, and has appeared as guest contributor to The Duran, Fort Russ News, Herland Report, The Ron Paul Institute, and Strategika51.