# THE CENTRAL BANK AND THE TREASURY - The Mystery of Banking

We have seen that modern inflation consists in a chronic and continuing issue of new money by the Central Bank, which in turn fuels and provides the reserves for a fractional reserve banking system to pyramid a multiple of check book money on top of those reserves. But where in all this are government deficits? Are deficits inflationary, and if so, to what extent? What is the relationship between the government as Central Bank and the government in its fiscal or budgetary capacity?

First, the process of bank money creation we have been exploring has no necessary connection to the fiscal operations of the central government. If the Fed buys $1 million of assets, this will create$5 million of new money (if the reserve ratio is 20 percent) or $10 million of new money (if the ratio is 10 percent). The Fed’s purchases have a multiple leverage effect on the money supply; further more, in the United States, Fed operations are off budget items and so do not even enter the fiscal data of government expenditures. If it is pointed out that almost all the Fed’s purchases of assets are U.S. government bonds, then it should be rebutted that these are old bonds, the embodiment of past federal deficits, and do not require any current deficits for the process to continue. The Treasury could enjoy a balanced budget (total annual revenues equal to total annual spending) or even a surplus (revenues greater than spending), and still the Fed could merrily create new reserves and hence a multiple of new bank money. Monetary inflation does not require a budget deficit. On the other hand, it is perfectly possible, theoretically, for the federal government to have a deficit (total spending greaterthan total revenues) which does not lead to any increase in the money supply and is therefore not inflationary. This bromide was repeated continually by the Reagan economists in late 1981 in their vain effort to make the country forget about the enormous deficits looming ahead. Thus, suppose that Treasury expenditures are$500 billion and revenues are $400 billion; the deficit is therefore$100 billion. If the deficit is financed strictly by selling new bonds to the public (individuals, corporations, insurance companies, etc.), then there is no increase in the money supply and hence no inflation. People’s savings are simply shifted from the bank accounts of bond buyers to the bank accounts of the Treasury, which will quickly spend them and there by return those deposits to the private sector. There is movement with in the same money supply, but no increase in that supply itself.

But this does not mean that a large deficit financed by voluntary savings has no deleterious economic effects. Inflation is not the only economic problem. Indeed, the deficit will siphon off or“crowd out” vast sums of capital from productive private investment to unproductive and parasitic government spending. This will cripple productivity and economic growth, and raise interest rates considerably. Further more, the parasitic tax burden will increase in the future, due to the forced repayment of the $100 billion deficit plus high interest charges. There is another form of financing deficits which is now obsolete in the modern Western world but which was formerly the standard method of finance. That was for the central government to simply print money (Treasury cash) and spend it. This, of course, was highly inflationary, as—in our assumed$100 billion deficit—the money supply would increase by $100 billion. This was the way the U.S. government, for example, financed much of the Revolutionary and Civil War deficits. The third method is, like the first one, compatible with modern banking procedures, but combines the worst features of the other two modes. This occurs when the Treasury sells new bonds to the commercial banks. In this method of monetizing the debt (creating new money to pay for new debt), the Treasury sells, say,$100 billion of new bonds to the banks, who create $100 billion of new demand deposits to pay for the new bonds. As in the second method above, the money supply has increased by$100 billion the extent of the deficit—to finance the short fall. But, as in the first method, the tax payers will now be forced over the years to pay an additional $100 billion to the banks plus a hefty amount of interest. Thus, this third, modern method of financing the deficit combines the worst features of the other two: it is inflationary,and it imposes future heavy burdens on the tax payers. Note the web of special privilege that is being accorded to the nation’s banks. First, they are allowed to create money out of thin air which they then graciously lend to the federal government by buying its bonds. But then, second, the tax payers are forced in ensuing years to pay the banks back with interest for buying government bonds with their newly created money. Figure below notes what happens when the nation’s banks buy$100 billion of newly-created government bonds.

The Treasury takes the new demand deposits and spends them on private producers, who in turn will have the new deposits, and in this way they circulate in the economy.

But if banks are always fully loaned up, how did they get enough reserves to enable them to create the $100 billion in new deposits? That is where the Federal Reserve comes in; the Fed must create new bank reserves to enable the banks to purchase new government debt. If the reserve requirement is 20 percent, and the Fed wishes to create enough new reserves to enable the banks to buy$100 billion of new government bonds, then it buys $25 billion of old bonds on the open market to fuel the desired inflationary transaction. First, the Fed buys$25 billion of old bonds on the open market; this creates increased demand deposits in the banks of $25 billion, matched by$25 billion in new reserves. Then, the Treasury issues $100 billion of new bonds, which the banks now buy because of their new reserves. Their total increase of new demand deposits is$125 billion, precisely the money multiple pyramiding on top of $25 billion of new reserves. The changes in the balance sheets of the commercial banks and of the Fed are depicted in Figure below. FED AIDING BANKS TO FINANCE DEFICITS Thus, under the assumed conditions of a 20 percent reserve requirement, the Fed would need to buy$25 billion of old bonds to finance a Treasury deficit of $100 billion. The total increase in the money supply of the entire operation would be$125 billion. If the Fed were to finance new Treasury bond issues directly, as it was only allowed by law to do for a while during World War II, this step would be wildly inflationary. For the Treasury would now have an increased $100 billion not just of newly-created bank money, but of “high-powered” bank money—demand deposits at the Fed. Then, as the Treasury spent the money, its claims on the Fed would filter down to the private economy, and total bank reserves would increase by$100 billion. The banking system would then pyramid loans and deposits on top of that by5:1 until the money supply increased by no less than $500 billion. Hence we have the highly inflationary nature of direct Fed purchases of new bonds from the Treasury. Figure below depicts the two steps of this process. In the first step, Step 1, the Fed buys$100 billion of new government bonds, and the Treasury gets increased demand deposits at the Fed.

FED PURCHASE OF NEW GOVERNMENT SECURITIES

Then, as the Treasury spends the new money, its checks on the Fed will filter down toward various private sellers. The latter will deposit these checks and acquire demand deposits at their banks; and the banks will rush down and deposit the checks with the Fed, there by earning an increase in their reserve accounts. Figure below shows what happens in Step 2 at the end of this process.

Thus, the upshot of the Fed’s direct purchase of the Treasury deficit is for total bank reserves to rise by the same amount, and for the Treasury account to get transferred into the reserves of the banks. On top of these reserves, the banking system will pyramid deposits 5:1 to a total increased money supply of \$500 billion.

EFFECT OF FED PURCHASE ON BANKS

Thus, we see that the chronic and accelerating inflation of ourtime has been caused by a fundamental change in the monetary system. From a money, centuries ago, based solidly on gold as the currency, and where banks were required to redeem their notes and deposits immediately in specie, we now have a world of fiat paper moneys cut off from gold and issued by government-privileged Central Banks. The Central Banks enjoy a monopoly on the printing of paper money, and through this money they control and encourage an inflationary fractional reserve banking system which pyramids deposits on top of a total of reserves determined by the Central Banks. Government fiat paper has replaced commodity money, and central banking has taken the place of free banking. Hence our chronic, permanent inflation problem, a problem which, if unchecked, is bound to accelerate eventually into the fearful destruction of the currency known as runaway inflation.