An Explanation of the Federal Reserve Money system and what it means for the potential accomplishments of American Democracy

By J.D. ALT

“Reserves”—that esoteric term in money-talk that postures to explain everything but explains nothing at all—have been much in the news of late. The Wall Street Journal even tried, recently, to explain what they are! They didn’t do such a great job. That’s unfortunate because, properly explained and understood, Reserves hold a big key to the political befuddlement—especially acute in the present election cycle—about what we can “afford” to accomplish as a collective society. This includes “paying for” real solutions to the five, money-intensive, life-defining dilemmas America now confronts: (1) climate change (2) healthcare (3) student debt (4) early child-hood care and development (5) affordable housing. It is therefore well worth the effort, I think, to attempt an explanation of “Reserves” that might actually be grasped by the collective consciousness of our political dialog.

To accomplish that, I need a good metaphor to get started. Since I’m an architect, what comes to mind is exploring the structure of a building to discover what is holding up what—and discovering in the process, perhaps, some rooms with surprising views. It’s a strange edifice (I warn you) that often seems unnecessarily complicated. But, observed with patience, it has its own peculiar beauty and logic— and, in the end, it’s this strange beauty and logic that reveals what we can, in fact, do about the five dilemmas just listed. So, hold onto your brain-handles. We’ll go slow and easy, so no one gets lost.

Sovereign fiat money

Without going into the history of the term, let’s simply begin by saying that in America today “Reserves” are the sovereign fiat money issued by the U.S. government. They are also the only official, “real” U.S. dollars that the federal government will accept as payment for taxes, fees, or fines owed to the government—which is why, by definition, they are America’s fiat money.

Having started with that statement, it may seem odd to you that the U.S. government, itself, issues the very thing that it wants to get paid with. You might ask, “If that’s the case, why doesn’t it just issue the money to itself, and leave me out of it?” As it turns out, that might not be a totally ridiculous question, though the answer might not be the tax-freedom you’re hoping for. Reserves—modern fiat money—are strange things indeed, but they do, in the end, have a structure that can make sense out of the world.

One of the strangest things about Reserves—even fascinating—is that you can’t get your hands on them. They exist only as digital entries inside America’s central bank—created and cancelled by keyboard strokes on an electronic balance sheet maintained by the U.S. Federal Reserve (the “FED”).

Reserves, then—even though they are the “real” U.S. fiat dollars—are not the “money” American citizens and business borrow and spend every day. That money comes in two other forms: Federal Reserve Notes (the cash dollars we have tucked in our wallets) and bank-dollars which is the money we have on balance in our demand bank-accounts (checking and money-market accounts). What is the relationship between these other forms of money, that we actually use every day, and Reserves?

The relationship is very simple: Federal Reserve Notes (cash dollars) and bank-dollars are claims on the Reserve dollars posted on the electronic balance sheet at the FED. So, while you can’t get your hands on Reserves, you can make a claim on them when you actually need them. This is not something you need to worry about accomplishing—it happens, automatically, as needed, when you spend your cash or write a check.

This happens because of the way the central bank is structured. Every private bank in the Federal Reserve System has its own Reserve account at the FED. In its Reserve account, each bank keeps track of the “real” sovereign U.S. fiat dollars it is in control of. (Remember, these are just digital entries on the electronic balance sheet—very much like the scoreboard at a basketball game.) The FED can debit Reserves from one bank’s Reserve account and credit them to another’s, “keeping score,” if you will. The FED can also simply “issue” new Reserves and add them to one account or another—again, with keystrokes—in exchange for another asset (collateral). Importantly, the U.S. Treasury also has a Reserve account at the FED—which is the spending account for the U.S. federal government: Not only does the federal government expect to be paid with Reserves, it only makes payments, itself, with Reserves.

At this point, you’re no doubt asking one big question: WHY? Why is it set up like this? Before we look into an answer to that question, however, let’s make sure we understand how the structure of the building we’re exploring actually works.

Exercising your claim on Reserves

Here’s an example of how you can exercise your claim on Reserves: Let’s say you owe Uncle Sam $1000 in taxes. Uncle Sam demands that you pay him with Reserve dollars. How do you do that? You write a check from your account at Bank-A to Uncle Sam for $1000. At the end of the business day, Uncle Sam presents the check it has received to the FED for “clearing.” In the “clearing” process, the FED debits $1000 from the Reserve account of your Bank-A, and credits $1000 Reserves into the Treasury’s Reserve account. Your check is “cleared” (cancelled), $1000 bank dollars are debited from your checking account at bank-A—and your taxes are marked “PAID”.

Here’s another example: You write a $1000 rent check from your bank-A to your landlord who uses bank-B. What happens? At the end of the business day, the landlord’s bank-B sends your check, deposited by the landlord, to the FED for “clearing.” During the clearing process, your claim on your bank-A’s Reserves is exercised: $1000 Reserve dollars are debited from your bank-A’s Reserve account and are credited to the Reserve account of the landlord’s bank-B. Your check is cancelled and, lastly, $1000 bank-B bank dollars are credited to the landlord’s account, while $1,000 bank-A bank dollars are debited from your account.

In each case, from your perspective, it appears that you are simply using the bank dollars in your checking account to pay someone—the government or your landlord—$1000 dollars. Hidden from you is the other operation in which your bank dollars exercise their claim on Reserves at the FED, causing the actual payment to be made with Reserves— “real” U.S. fiat dollars.

Who creates bank-dollars?

There’s one more thing we need to understand before we get to the question about why things are structured this way: If the U.S. government’s central bank—the FED—issues Reserves, who issues the bank-dollars that are the claims on the Reserves? As the name implies, they are created by private banks—but by what process? The FED has a lawful mandate to simply issue Reserves by “fiat”—out of thin air. But what is a private bank’s mandate to create bank-dollar claims on the “real” money created by the FED?

The key is to see that a private bank can only issue claims on the Reserves that reside in its own Reserve account at the FED. Because this is key, it is useful to have a quick understanding of how each bank acquires, in the first place, those Reserves it can create claims on: The FED issues the Reserves (with keystrokes) and credits them to a bank’s Reserve account in exchange for some collateral provided by the bank. Coming up with this collateral is a necessary component of becoming licensed as a federal reserve bank. The FED stipulates what the collateral must be. Once the Reserve account is established, the bank can begin to issue the bank-dollars which are claims on those Reserves in its account.

A bank “issues” its bank-dollars by making loans to individuals and businesses. When bank-A loans you, say, $10,000 to make home-improvements, it credits your bank-A checking account (using keystrokes, of course) with $10,000 bank-dollars. These are now your claims on the Reserves bank-A holds at the FED. You then write checks to various contractors and vendors, and those checks are presented for “clearing” at the FED where your claims on Bank-A’s Reserves are exercised.

This little example seems to suggest that a bank must be careful not to create more bank-dollar claims than it actually has in its Reserve account to meet those claims. As is famously known, however, banks create many more bank-dollars than they have in Reserves. How can this be? Doesn’t that mean the “clearing” process at the FED will break down—that eventually you’ll write a check on your bank-A account, only to find that it can’t clear because bank-A’s Reserves have already been tapped out by other claims? There’s a couple of reasons why, in modern times, this cannot happen (if everyone keeps their fingers crossed).

The first reason is that banks have come to understand that, on any given business day, only a tiny fraction of the bank-dollars they’ve issued will make claims on their Reserves at the FED. The remainder—the vast majority—will remain passively silent in their various checking accounts, or in checks written but not yet deposited. Also, if a given bank (Bank of America, for example) is used by a large segment of a local, regional, or perhaps national population, the recipients of many checks written will deposit them back in the same bank—in which case they do not go through the FED’s clearing process at all, but simply result in a tally on the bank’s own bank-dollar balance sheet. A final “also” is this: if banks in the federal reserve system stay, more or less, at the same “scale” of operations, during the FED’s clearing process any one bank should be credited, from other banks, about the same number of Reserves as it’s debited.

The second reason banks “safely” create many more bank-dollars than they have in Reserves is because the FED has put in place, and operates, a number of fail-safe “mechanisms” which ensure that, every business day, the clearing process will always be successfully completed. Your check on bank-A will always clear (assuming you have sufficient bank-dollars in your account to cover it.) For our purposes here, we don’t need to know or understand the details of the fail-safe systems the FED operates—except one: As a last resort, the FED can, and will, simply issue new Reserves, as necessary, and credit them (in exchange for collateral) to the Reserve account of whatever bank comes up short in the clearing process. It has to do this—otherwise the whole structure collapses.

Okay, now we can ask WHY?

Why is our modern fiat money system set up this way? Why not just have a single “money” that we all use—the government, the banks, all of us—and be happy with that?

It would be nice to say the answer is because well-intentioned and forward-thinking people thought a Reserve/ bank-dollar system would best serve our needs. The real answer, however, is that under the circumstances of history, it was the best solution that could be cobbled together that all the stakeholders would agree upon (and using the term “agree” is being generous).

In the century leading up to the Federal Reserve Act of 1913, America struggled mightily with its money system. These struggles became a crisis after the Civil War. Basically, there were three problems:

The “value” of money was suspect.

There was no national currency—only bank-dollars issued by different banks around the country. While these dollars generally promised to be exchangeable for gold, the amount of gold held by each bank to back up its promise was often suspect. Merchants had to be concerned which bank-dollars they were being paid with. This was a significant impediment to national commerce.

The “clearing” process between banks often broke down.

Transactions written on an account in bank-A and submitted for deposit in bank-B were often not accepted by bank-B if it was suspicious that bank-A might not be able to back up the promises of its bank-dollars. In the 1800’s there were a series of banking crises in which this “clearing” process between banks broke down, resulting in severe economic distress.

There simply wasn’t “enough” money!

As things unfolded after the U.S. Civil War, this turned out to be the biggest problem of all. The civil war had been paid for with Abraham Lincoln’s fiat money— “greenbacks” that were printed and circulated to buy everything from mules to musket balls. A great many debts were racked up during the war—mostly to big banks on the East Coast. When the war ended, these East Coast banks refused to accept the greenback dollars as payment for the debts. They demanded to be paid, instead, in gold.

The only problem was there was not enough gold in the country to redeem the greenbacks and underwrite the need for an expanding money supply the new post-war commerce was demanding. The result was that southern and western farmers were unable to sell their crops for “dollars.” Instead, because of the lack of money in the system, they were forced to begin selling their crops for store credits. This began the era of the corrupt “crop-lien” system with its “furnishing merchants” who, over time, put the farmers so deeply in debt they were forced to become sharecroppers on what had once been their own farms. This, in turn, precipitated what nearly became a successful grass-roots political revolution over the issue of “money and, ultimately, led to the Federal Reserve Act of 1913. (Please read “The Populist Moment” by Lawrence Goodwyn.)

The Federal Reserve System—solving the three money problems

Creating the U.S. Federal Reserve banking system was a long and hard-fought political battle. In the end, the Reserve/bank-dollar system was created because it was the only structure everyone could agree upon that solved the three money problems just described:

Private banks could still issue their own bank-dollars—a prerogative they fought tooth and nail to maintain—but now, since the different bank-dollars were all claims on the same Reserve dollars, they could be treated equally in the marketplace. As intended, today it is impossible to distinguish between one bank’s bank-dollars and another’s. The risk and uncertainty were removed from the “clearing” process for transactions between different banks. That process was now conducted, at the end of each business day, by the FED itself—with the guarantee that every legitimate check or bank transfer cleared. Interstate commerce was free to blossom, and the epidemic of bank crises essentially came to a halt. Large as these first two benefits were, the third benefit was, by far, the most significant: The most important fact about the Federal Reserve system is that it was structured and put in place to enable the money supply that served American Enterprise to expand—as necessary—to meet the needs of what it was decided American Enterprise wanted to undertake and accomplish. After the post-Civil War money crisis, all stakeholders understood a simple fact of logic: If the labor, materials, energy, technology, and ingenuity exist to undertake and accomplish something—and it is desirable that it should be accomplished—it makes no sense to say that it can’t be done because there isn’t enough “money” in the system to pay for the doing of it. “Money,” in other words, is not a limiting resource. To say that, as a collective society, we don’t have enough “money” to do something is makes as much sense as saying we don’t have enough “numbers” to count something.

The Federal Reserve System, then, was cobbled together to solve these three problems. No one claimed it was the perfect solution. There were many compromises made to reach consensus in in the U.S. Congress. The banking interests didn’t want politics and the government to run the show. The government didn’t want the bankers to have exclusive control over something that the common good, ultimately, depended on. The FED, then, became a partnership—partially under the banker’s control, partly under the control of the federal government.

That’s the introductory tour of the edifice we’re exploring—a look at the big pillars holding up the roof. In PART 2, we’ll explore some of the rooms and activities that accommodate the needs of the “big partnership” that lives under that roof. It’s a partnership not of people, but of interests. The bankers represent the interests of private enterprise, the federal government represents the interests of public enterprise. Together, they comprise what I think of as The American Enterprise.

END PART 1