Federal Reserve should run an overdraft

Arnold's academic career didn't pan out, and his internet startup didn't make him a millionaire either. He writes bitter posts about no one reading his book, so I guess author/pundit isn't quite working out so far. I'm sure his high-school student appreciate him though. Either way, the car wreck that is this post represents everything that is wrong with macroeconomics. Be sure to check out the comments where the horror show continues.

Here is the basics for how the banking system works in reality, and therefore what "quantitative easing" actually means.

The Federal Reserve Bank is a bank, just like BofA or Wells Fargo. The Treasury has an account at the bank, just as you or I have a checking account at our local bank. Other banks, like BofA and Wells Fargo have accounts at the Fed as well, and they are called reserve accounts.

So, that's the first thing you need to know -- reserve accounts are not made up of money held in reserve in case a loan goes bad, they are money held at the Federal Reserve for payment settlement. The reserves of money held in case loans go bad are capital. Reserves are held as assets at the bank and liabilities at the Fed. Capital is held as an equity liability at the bank, and does not exist at the Fed at all.

Misunderstanding what reserves and capital are and how they are accounted for is a fundamental error in macroeconomics. It also explains why banks aren't making loans, nor is there any inflation, even though reserve accounts are so swollen. Reserves are for payment settlement, not loan enablement, so excess reserves have no impact on anything (except letting banks really really settle payments).

When the US Government buys something, say a TV from China, the Treasury writes a cheque to the Chinese manufacturer in US$. The Chinese manufacturer then deposits the cheque in some bank that is linked to the Federal Reserve -- because all dollar accounts ultimately must tie back to the Fed. So the Treasury's reserve account is debited, and the Chinese manufacturers reserve account is credited. The total number of outstanding dollars has not changed.

When the Chinese manufacturer then buys a Treasury bill, it writes a cheque to the Treasury and the Treasury's account is credited, while the Chinese manufacturers account is debited. Again, the total number of outstanding dollars has not changed.

It's interesting to note here that the US "borrowing" from China turns out to be nothing more than a number moving from one account at the Fed to another account at the Fed. When the private sector borrows money, the total quantity of gross outstanding financial assets increases, as balance sheets get larger (a receivable asset is credited, and deposit liability is credited as well). But, when the Govt borrows, the total quantity of gross and net financial assets does not change, all that changes is their term structure.

So, suppose the Treasury account hits zero, and it writes yet another check. Will the check bounce?

Back in the days of the gold standard, the Treasury account hitting zero would mean there was no gold left in the vault. If the Treasury promised someone more gold, it could not deliver. The check would, indeed bounce.

But we are no longer on a gold standard, and for the Treasury to clear its check, all it needs is for the Fed to process the payment, and let the Treasury account go into the negative (overdraft). The Fed would need to let the Treasury account have a "-" in the spreadsheet cell that tracks its number.

Currently, this is illegal. However, the one time it happened, there was an obscure clause that let the Treasury go into overdraft temporarily until some bill was authorized and it moved back into the black. If the Fed decides to toe the line, and Congress does not change the law, it means that the US Govt will have decided to bounce its own checks. Its next decision, one presumes, will be to dissolve itself entirely.

MMT elides this point by combining the Treasury and the Fed into a single entity. It is reasonable for it to do this, as they are both part of the Government. Nevertheless, in reality they are separate, and although this law will be waived or changed when the time comes, it still exists right now.

In QE2, the Fed buys Treasury bills at longer durations, which means it changes the composition of its balance sheet. You are correct in noticing that this will have no economic consequence of note.