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Friday, April 29, 2011

What is the Difference Between the Federal Reserve and the U.S. Treasury?

Chairman Bernanke heads up the Federal Reserve and Treasury Secretary Geithner heads up the Treasury Department. Bernanke walks around spouting about his "dual mandate" and the Treasury Secretary says over and over that "...a strong dollar is in the interest in the U.S."  But what is the difference between the Fed and Treasury?

Each semester I tell my class that I wish we could hold a class at the local mall asking people as they walk in if they know the difference. In fact, I tell my class that I believe that the public not knowing the difference is part of the huge debt crisis problem facing the country. Sadly, I have to say that I believe we would be lucky if one person in ten could give a coherent explanation of the difference. One important take-away from my class is understanding this difference.

I begin my explanation by drawing a big circle on the board to represent the macro economy.  Inside the circle I put the main players:  Households (maximize utility), Businesses (maximize profits), Government (federal, state, & local), U.S. Treasury.

The U.S. Treasury is the bank of the federal government. Our federal government borrows more than it brings in in taxes, and it does this by issuing Treasury issues bills, notes, and bonds. Much of what goes on in the circle is off setting. Notice that it's simple - there is no international sector.

Outside the circle is the Federal Reserve. It, among other functions, manages the nation's money supply. To put more money in the circle, it buys Treasury securities from the entities in the circle. In this way, it creates money out of thin air. In fact, it could buy anything - used cars or pigs, for example. In fact, in recent times in response to the financial crisis, it has expanded the financial instruments it buys.
 
Once the Treasuries are bought and paid for with a check drawn on the Federal Reserve, the banking system can lend out a portion of the increased deposits because it is a fractional reserve system. If there is a demand for loans, and/or banks are willing to lend, a multiple expansion of money takes place with (again) money being created out of thin air.

If we go back and think of the Treasury borrowing by issuing bills, notes and bonds and realize that these can be bought by the Federal Reserve, we arrive at the concept of "monetizing the debt." This is the modern-day version of printing money. This debases the currency over time, lessens the value of saving, and leads to the problems that are slowly coming to a head today.

4 comments:

  1. I thought the similarity was that neither group seemed to actually understand what they are doing or what their mandate is.

    At least Bernanke, by his own admission, is not printing money when he monetizes the debt.

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  2. Nice explanation Robert! Foreign governments buy a large amount of treasuries as a leverage. Something to keep in mind.

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  3. I am still not clear on differences. Seems govt can print money at will, with nothing backing it. I would love to take a class on how the supply and demand theory effects the value of the dollar. One thing that baffles me is why government will cut back on things like military or other vital elements to our sovereignty due to lack of funds, when it can print money.

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  4. Actually the notion that "the government can print money at will" is worth exploring. The way it works is that the government, i.e. the Treasury, borrows by issuing Treasury issues to cover the deficit. This conceptually is like any corporation that raises money by issuing bonds.
    To increase money in the economy the Fed then buys those Treasury issues in the open market. If you think this through you see that the Treasury is actually getting savings from economy participants. In other words individuals etc. have foregone present consumption and saved and used those savings to lend to the U.S. Treasury. So the Fed in buying those isn't just creating money out of thin air. I say this because, in contrast, bitcoin, which is getting considerable notoriety is in fact creating money out of thin air. By solving a computer puzzle you "mine" bitcoins etc. As it turns out,whatever people will accept in payment for goods and services qualifies as money. Bitcoin is accepted in various places, the U;S. dollar is accepted everywhere.
    This led me far astray. I was hoping in the post to help people understand the difference between the U.S. Treasury functioning as the government's bank and the Fed as the independent entity managing the nation's money supply and acting as the "lender of last resort" during times of economic panic.
    I hope I at least cleared up your last question. The U.S. Treasury cannot just say "ok we need a bigger military let's just print up $100 billion and start recruiting more soldiers". Zimbabwe tried that - you may want to check them out.

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