It’s very difficult to find an explicit description of the entire process. I think I understand the story, but I want to run this by you guys to see if you spot any errors:
The Process of Monetization of the Debt
(1) The US government runs a deficit and borrows money by issuing bonds that must be repaid plus interest at a later date.
(2) The Federal Reserve sets the target federal funds rate. To achieve this rate, money is printed and added to the economy by exchanging it for real assets. Typically these assets are US government bonds allegedly due to their high liquidity in large volumes.
(3) When US bonds held by the Fed mature, the revenue paid by the Treasury is used by the Fed to cover its operation expenses. In this way, the Fed does not require allocation of funds in the yearly budget (thus maintaining its “independence”).
(4) Any profits made on bonds by the Fed (above operating expenses) is sent back into the Treasury.
Observations
(a) The Treasury reduces its debt obligations in two separate ways: (i) it repays all debts, held by the Fed, the public or foreign governments, in debased currency due to the inflation caused by the Fed (step 2); (ii) part of the debt owed to the Fed was immediately returned (step 4).
(b) The part that the Fed used to cover its own operations was paid by the Treasury (step 3). Thus, effectively, this transfer is not the repayment of debt, but budgeting for the Fed’s expenses.
(c) The part that was returned (step 4) was never paid out by the Treasury at all. This part of the debt was effectively paid by the government with printed money when the Fed previously purchased the bond (step 2).
(d) Inflationary effects are mostly reversible up until the bond matures. Before that, the Fed can always resell the bond and destroy the bank notes that it receives in payment.
Conclusion: A simple model
So, in conclusion, the entire complicated process can be simplified through the following mental model:
The government sells bonds. Some of these it pays by printing up its own money (Fed purchase). The rest it pays at a discount with debased currency due to its own printing (public, foreign owned). Annual expenses of the Central Bank come from taxes (part of revenue Fed keeps from the Treasury for operating expenses).
Common Misconceptions
One last point – confusion over this process leads to two popular erroneous conclusions. It is not commonly understood that profits made by the Fed go into the Treasury. Two other assumptions are often made:
(1) Profit made by the Fed goes to its shareholders.
This leads to the argument that a group of elite bankers that own the Fed use the shroud of secrecy that gives the Fed its independence to fleece the public by profiting off the printing press.
This is false. In reality, the government prints money as a means to transfer our savings and salaries into government programs, without resorting to blatant taxation.
(2) Revenue from maturing bonds is destroyed by the Fed.
In this scenario, the Fed would destroy more money (principle + interest) than it created when it purchased the bond (principle only). To pay off the interest owed to the Fed would eventually consume more money than is in existence. Therefore, the Treasury would need to issue bonds and sell them to the Fed at an exponential rate so that more money would always be printed than is consumed.
This is false. This misconception probably stems from the fact that the Fed can sell assets to reduce the money supply (by destroying the money it receives). If the Fed really destroyed its revenue, then it would need funds allocated from the budget. Also, this would defeat the purpose of having a government run printing press to fund deficits.
Does anybody see any errors? Comments?