By J. D. Alt, author of The Architect Who Couldn’t Sing, available at or iBooks. Originally published at . Please read Part One here
FIRST: Prime the fuel-pumps
As it stands, our diagram-machine has no fuel (“money”) in it, so it can’t operate. We could go through an exercise to imagine how it could prime itself in order to begin operations. But this would lead to other topics and considerations which would only distract us from our present goal—which is to simply understand HOW the diagram-machine operates—and how, and when, in the course of its operations, it creates money. To move things along, we’ll simply (and arbitrarily) populate the machine with some money to get it started.
We’ll assign to each of the eight “accounts” of our diagram-machine a value of ten dollars:
- $10 worth of Reserves (Rs) in Bank#1 Reserve account
- $10 worth of future Reserves (fR) in Bank#2 Reserve account
- $10 worth of Reserves (Rs) in Treasury Reserve account
- $10 worth of Promissory Notes (Pn) in the FED account
- $10 worth of bank-dollars (Bd) in private bank account#1
- $10 worth of bank-dollars (Bd) in private bank account#2
- $10 worth of Promissory Notes (Pn) for bank#1
- $10 worth of Promissory Notes (Pn) for bank#2
You’ll notice there seem to be a lot of different “identities” the ten dollars can take: “Reserves,” “bank-dollars,” “promissory notes” etc. So, we need to take a quick moment to understand the different flavors of the fuel our machine will be running on.
Here’s the menu:
- $10 worth of Reserves represents $10 worth of what the U.S. government will accept as a payment for taxes or other debts owed to the federal government. This, in fact, is what you might consider “real” money. (Sorry for the odd name; someone else decided to call them “Reserves.”) The other flavors are all derivatives of Reserve dollars. While the other flavors play crucial roles in the operation of the machine, they must always be converted to Reserves in order to make the one payment every citizen and business is required, by law, to make on a recurring basis—payment of federal taxes.
- $10 worth of future Reserves are just that: Reserves that the government promises to create at some specific point in the future. These are commonly referred to as “treasury bonds.” While they are virtually identical to corporate or municipal bonds, they are distinctly different in one crucial characteristic (explained in a sidebar on page __). This crucial distinction makes it more appropriate—and less confusing—to simply think of treasury bonds as “future Reserves.”
- $10 worth of bank-dollars are claims on $10 worth of Reserves held in the Bank#1 or Bank#2 Reserve accounts at the Central Bank. (Think of bank-dollars as being “claim-checks” for “real” dollars that are held at the Central Bank. Since the claim is guaranteed, operationally there is little distinction between the claim-check and the “real” dollar it makes claim to. They are, in effect, interchangeable.)
- $10 worth of Promissory Notes are legal promises that $10 bank-dollars (or Reserves, if it’s a note to the FED)— an interest premium—will be exchanged for the Promissory Notes at a specific time in the future. When that promise is fulfilled, the Promissory Note is cancelled.
All the “dollars” in the machine, then, are either Reserves, or claims on Reserves, or promises to pay Reserves (or claims on Reserves) at some point in the future. If you’re wondering where “cash” dollars—those things we all think of as “money”—fit in, please read the side-bar on page__. (Short answer: Federal Reserve Notes, i.e. “cash” dollars, are simply another form of claim on Reserves at the Central Bank. In that sense, they are no different than bank-dollars, and they are not something that plays a unique role in the operation of our machine.)
Those are the “fuel-flavors” our Diagram-machine is going to run on. Now we’re finally ready for our first machine operation.
OPERATION #1—A simple transaction in Private Commerce
STEP 1: Private bank #1 makes a loan.
- The person with bank account#1 gives Bank#1 a promissory note promising to pay the bank $20 (with 5% interest) at some point in the future. In exchange, Bank#1 credits to bank account#1 $20 bank-dollars, increasing that account to $30 bank-dollars. Bank#1 records $21 worth of new Promissory Notes ($20 + 5% interest=$21).
- The bank-dollars are, in effect, the bank’s promissory notes back to the borrower. They promise two things: First, Bank#1 will accept its own bank-dollars as repayment for the loan; second, the bank-dollar will be recognized as a legal claim on the Reserves Bank#1 holds in its Reserve account at the Central Bank.
- PLEASE NOTE: Our machine has just “created” $20 in fuel! The owner of bank account#1 is now ready to purchase goods and services worth up to $30.
STEP 2: A transaction occurs in the Private Combustion Chamber.
The person with bank account#1 purchases a new pair of shoes for $25. They write a check on their account#1 and exchange it with the shoe store for the shoes.
- Bank account #2 happens to be the shoe store’s account. The shoe store deposits the check it received for the shoes in bank account#2.
- The owner of bank account#1 walks home with a new pair of shoes. This is the consumption which is the ultimate purpose of our Diagram-machine! But the machine, itself, isn’t quite finished with this transaction:
STEP 3: Check-clearing and Reserve allocations at the Central Bank
- This is the first “pay-attention-to” moment in the operation of the Diagram-machine: The $25 check deposited in bank account#2 is a claim on the Reserves held in the Reserve account of Bank #1. This causes the following operations to occur at the Central Bank:
- At the end of the business day, the $25 check for the shoes is presented, by Bank#2, at the Central Bank to be “cleared.” Specifically (and operationally) this means that the claim the check represents on the Reserves held in Bank#1’s Reserve account shall be exercised. This happens, in fact, automatically:
- Bank#1 Reserve account is debited $25, Bank#2 Reserve account is credited $25, and bank account #2 is credited $25 bank-dollars. The check has now “cleared,” and the transaction appears to be complete—but not quite!
To see why our diagram-machine isn’t quite finished with OPERATION #1, we must take note that our fuel flow-meter is telling us Bank#1 Reserve account is minus $15Rs! It didn’t have $25 Reserves to transfer to Bank#2 Reserve account!
This is our second “pay-attention-to” moment: A bank’s Reserve account at the Central Bank cannot be negative! Banks are required, by law, to maintain adequate Reserves in their Central Bank account to handle the “clearing” demands that might come due at the end of each business day. Something else, then, must happen in our Diagram-machine to correct this “impossible” situation—or else our machine will seize up. Fortunately, the machine is designed to manage and accommodate this very situation. Watch, now, what it does:
STEP #4: The FED loans Reserves to Bank#1
- Bank#1 needs to borrow Reserves in order to “clear” the $25 check. Who does it borrow Reserves from? Normally, it would borrow Reserves from another bank with excess Reserves. (Reserves, it should be noted, do not pay interest—or only very low interest. They just sit there, like lumps on a log, in the various Reserve accounts. Banks with excess Reserves in their account at the Central Bank, therefore, like to lend them out to earn interest and add to their profits.) Borrowing from another bank’s excess Reserves, however, is not always possible—as is the case with the present circumstances of our Diagram-machine.
- The lender of last-resort is the FED. Ultimately, the FED’s primary job is to ensure that all the checks in the banking system “clear” at the end of each business day. In our present case, the FED credits Bank#1 Reserve account with $25 Reserves, and accepts, in exchange from Bank#1, a Promissory Note promising to pay the FED $25 Reserves + 2% interest at some point in the future.
- Now, here is the third “pay-attention-to” moment: Where does the FED get the Reserves it loans to Bank#1? We should note that the FED has no Reserves in its account—it has only Promissory Notes. So where do the Reserves it loans to Bank#1 come from? ANSWER: the FED simply “issues” them—because that is what it was specifically established and authorized to do. The FED “issues” the new Reserves out of thin-air in exchange for Bank#1’s Promissory Note.
PLEASE NOTE: our machine has just created more new fuel! This time $25 new Reserve dollars.
Our first operation of the Diagram-machine is now (finally) complete. But let’s not forget what was really accomplished by all this accounting: Someone in America (in this case the owner of bank account#1) has a obtained a new pair of shoes! That’s what the operation was all about.
Summarizing OPERATION #1
Let’s stop here, before continuing, and consider what we’ve just observed. First, our diagram-machine has facilitated a transaction in the Private Combustion Chamber resulting in the consumption of a new pair of shoes. What we’ve observed, however, is that the “real” financial transaction doesn’t take place at the shoe store. It takes place, instead, at the Central Bank when Reserves (the “real” U.S. dollars) are claimed and then debited and credited between Reserve accounts. This exchange takes place entirely within the Central Bank, and “mirrors” the exchange that took place—with bank-dollars—at the shoe store.
Also note that Reserves, themselves, never leave the Central Bank! They are debited and credited between different accounts at the Central Bank, but they never leave its confines. The Central Bank, in effect, is a “score-keeper” of the exchanges that are going on in the outside world and Reserves are the “points” that keep the score! If the players in the outside game decide to run up the score (as the owner of bank account#1 did when it signed the $20 Promissory Note) the Central Bank operations automatically create the necessary “points” to keep the game going.
Second, we’ve observed that when we began our operation, there was not enough fuel (money) in either of the bank accounts (or both together) to buy the shoes. As we just noted above, the machine, itself, produced the necessary dollars to make the transaction happen.
The Reserves the FED loaned to Bank#1 were new Reserves it created out of thin air. When the FED needs to produce Reserves, it does not withdraw them from an “account,” it simply issues them. This is precisely what it was designed and empowered to do.
What we have observed in OPERATION #1, then, is that the American consumer decided a new pair of shoes was needed—and our diagram-machine produced the dollars that enabled the shoe-consumption transaction to take place. Specifically, the FED produced the new Reserves that enabled the “clearing” process to complete itself. We might stop here and ask ourselves: Is this what people mean when they talk about “printing money”?
The FED, in the operation of our diagram-machine, has created $25 Reserves which previously did not exist. Is that good or bad? Is that creating a problem, or solving a problem? Is there even a problem? Is the diagram-machine simply operating as it was intended—or has some travesty just occurred? These questions will become even more important in our next diagram-machine operation involving the Public Combustion Chamber.