People tend to withdraw money from bank accounts on Friday, and deposit cash on Monday. Before the crisis, the Fed hit its interest rate target by keeping tight control over the supply of bank reserves. Back then, our central bank would engage in open market purchases late in the work week and sales Monday morning to keep rates stable. Today, the Federal Funds rate isn't what's important. Now the Fed simply pays interest on reserve balances held by banks and leaves excess reserves in the banking system.
Before the crisis, withdrawals of cash from bank accounts would reduce the national debt held by public because the Fed would buy Treasury securities to keep the Fed Funds rate from rising. To be sure, these actions were usually small, around 50 million dollars a pop. But this arcane fact of monetary operations can help impart an important lesson about the national debt.
Today, total US bank deposits total about 13 trillion, while total reserves held by the banks at the Fed stands at about 2.5 trillion. Bank deposits are nothing more than claims on reserve balances or Federal Reserve Notes. If we ever saw a mass withdrawal of cash from the banks to the tune of trillions of dollars, the Fed could and would supply the necessary liquidity to meet these withdrawals by purchasing Treasurys. If the public asked by 13 trillion in cash, the banks would run through their 2.5 trillion in reserves and the Fed would need to buy about 10.5 trillion worth of Treasurys. For its part, the public would hold 13 trillion dollars less in bank deposits, 13 trillion less of Treasury securities, and 13 trillion dollars more in physical cash.
Banks could continue to make loans in the same way they always do, by issuing new deposits. Again, the public could demand cash, which would force more open market purchases, and reduce the outstanding debt stock. This plan is not absurd because it would cause a banking crisis. (It wouldn't because the Fed would react accordingly) It is not absurd because it would cut off credit to the economy. It is not absurd because it would cause hyper-inflation (It wouldn't because it would not increase the public's spending power. Bank deposits would simply become physical cash) But it does demonstrate that the current discussion of the national debt is absurd.
The key point is that the Federal Government issues debt in many different forms. While securities issued by the US Treasury are what we typically call the national debt, reserve balances at the Fed or Federal Reserve Notes in your wallet are also a form of government debt. The Fed puts both currency in circulation and reserves in the liability column of its balance sheet. Again, bank deposits are a claim on reserves or Federal Reserve Notes. Bank debt is therefore a claim on government debt. In fact, to buy Treasury securities, one must hold reserve balances or a claim on reserve balances. You can only buy government debt if you already hold another form of government debt!
Here's where this "plan" falls apart. By themselves, bond sales by either the Fed or Treasury do not change the volume of government debt held by the public. They only change its composition. Reserve balances are replaced by Federal securities. Under my "plan," securities would ultimately be replaced by currency, with the banks acting as intermediaries. In an economic sense, the total liabilities of the Federal government would not change.
Interest groups and politicians care a great deal about outstanding Treasury securities, but nothing about reserve balances or currency (other forms of government debt) or bank deposits (claims on government debt). No politician would every say his constituents hold too much cash, or too much in reserve balances, or that Mr. X has too much money in his bank account. But there is definitely a consensus that there is too much government "debt." Politicians and otherwise serious policy makers falsely equate government debt with private debt. When Apple or Ford sells bonds, it exchanges its IOU for the government's IOU (reserve balances). When the Federal government issues debt, it exchanges its own IOU for another form of its own IOU. A key axis of monetary policy is the composition of government liabilities held by the public. Government securities are therefore an instrument of monetary policy, not fiscal policy.
Sadly, we allow the power of language to confuse our thinking. Because our private debts are a burden to us, we equate anything we call debt with something we find personally unpleasant. In reality, nearly all of the private sector's financial savings is either government debt or claims on government debt. It really doesn't make a difference if it is in the form of securities, reserve balances, bank deposits, or cash. Therefore, reducing government debt literally means reducing private sector savings. Something tells me that would not be a good campaign slogan. Sometimes, it takes an absurd idea to make us realize how absurd our own thinking is.
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