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Journal of Post Keynesian

Economics
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Fiscal effects on reserves

and the independence of
the Fed
Stephanie Bell & L. Randall Wray
Published online: 23 Dec 2014.

To cite this article: Stephanie Bell & L. Randall Wray (2002) Fiscal effects
on reserves and the independence of the Fed, Journal of Post Keynesian
Economics, 25:2, 263-271

To link to this article: http://dx.doi.org/10.1080/01603477.2002.11051356

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 STEPHANIE BELL AND L. RANDALL WRAY

Fiscal effects on reserves and the

independence of the Fed

Abstract: Modern governments with a floating currency face no inherent finan-

cial constraints. Unfortunately, most modern macro-theorists continue to write
as if these nations were financially constrained by (1) the magnitude of current
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tax “revenue” and (2) the private sector’s willingness to “finance” (i.e., buy
bonds) spending in excess of (1). Such a position badly misrepresents the ac-
tual workings of government finance. In this paper, we provide an abbreviated
description of the manner in which the U.S. government carries out its fiscal
operations in practice, including an analysis of coordination of the activities of
the Fed and Treasury.

Key words: fiscal policy, functional finance, monetary policy, reserve manage-
ment.

Van Lear (2002–3) begins with a brief review of the orthodox position,
summarizes what he takes to be the Bell–Wray (BW) view, and then
offers a critique and attempted correction of the BW position (Bell, 2000;
Wray, 1998). There is no need for additional commentary on the ortho-
dox view that taxes and sovereign debt finance government spending,
and that deficit spending by government threatens to crowd out private
spending. However, a quick summary of Van Lear’s exposition of, and
critique of, BW is in order. According to Van Lear, BW argue that be-
cause Treasury operations affect bank reserves, the Fed must cooperate
with the Treasury and thereby loses its independence. Consequently, the
BW claim that fiscal policy creates or destroys money is true only if the
Fed is compliant. In reality, according to Van Lear, independent central
banking divorces government from money—only if the Fed or private
banks choose to buy its debt will government have new money to spend.
Otherwise, government spending will be constrained by the magnitude

The authors are Assistant Professor and Professor, respectively, at the University of
Missouri–Kansas City.
Journal of Post Keynesian Economics / Winter 2002–3, Vol. 25, No. 2 263
© 2003 M.E. Sharpe, Inc.
0160–3477 / 2003 $9.50 + 0.00.
 264 JOURNAL OF POST KEYNESIAN ECONOMICS

of its tax revenue. Hence, the central bank can nullify any attempt by the
Treasury to use fiscal policy to stimulate the economy simply by refus-
ing to buy sovereign debt. The Treasury cannot circumvent central bank
intransigence because in most nations it is prohibited by law from “print-
ing money” to finance spending. Van Lear advocates institutional re-
form that would make money the province of the state. If this were done,
then (and only then) would the chartalist or state money approach accu-
rately describe the operation of the monetary system. More important,
if the state did adopt a Chartal money system, then the Treasury would
be able to keep the interest rate low through its spending and borrowing
authority—by creating more reserves to push the Fed funds rate down.
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Some background on the debate

We learned our money and banking from John G. Ranlett. As he taught
us, government spending always increases bank reserves, whereas pay-
ment of taxes always reduces bank reserves, all else equal (Ranlett, 1977,
ch. 9). By contrast, balance sheet activity that involves only the Fed and
the Treasury has no impact on banking system reserves. Hence, from
the point of view of the nongovernment sector, purely intergovernmen-
tal balance sheet operations (involving the Fed and the Treasury, or, for
another example, the Treasury and social security) can be ignored. This
is why we consolidate the Treasury and Fed for the purposes of analyz-
ing governmental effects on the monetary base (or, as we prefer, high-
powered money—HPM). In a moment, we will return to the possibility
that the central bank and Treasury might choose not to coordinate ac-
tivities that impact the nongovernment sector.
So far, this is not a Chartalist theory, or, indeed, theory of any sort. It is
simply a statement of balance sheet logic—the Treasury and the central
bank are the only sources of HPM, which is supplied through Treasury
or central bank purchases of goods, services, or assets held by (or pro-
duced by, or issued by) the nongovernment sector. Similarly, the HPM
held by the nongovernment sector can only be destroyed when it returns
to the Treasury or central bank—through tax payment; retirement of
loans provided by the Treasury or central bank; or sales of goods, ser-
vices, or assets by the Treasury or central bank. In stating this, we are
not advocating a change of policy, or even discussing policy at all. We
are merely explicating the balance sheet logic. Frankly, we are surprised
that good Post Keynesian economists find the balance sheet entries and
the subsequent impact on various monetary aggregates (for example,
M0 versus M1) difficult to follow (Mehrling, 2000; Van Lear, 2002–3).
 FISCAL EFFECTS ON RESERVES AND THE INDEPENDENCE OF THE FED 265

Part of the confusion appears to derive from the fact that the Treasury
coordinates the timing of the flow of receipts into its accounts at Federal
Reserve banks with the spending it undertakes by writing checks on these
accounts. Currently, most tax “revenue” (from payroll tax withholdings,
corporate taxes, and individual income taxes) is initially deposited into
one of the 9,890 depository institutions that maintain Treasury Tax and
Loan (TT&L) accounts. But since all government spending involves
writing checks on the Treasury’s account at the Federal Reserve, the
Treasury schedules “calls” on these accounts (that is, requests that all or
some portion of its TT&L balance gets transferred to an account at the
Federal Reserve bank) in order to offset the reserve injection caused by
its spending. Unfortunately, this coordination of flows appears to have
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led many observers to conclude that the balances being transferred from
TT&L accounts are actually “financing” (that is, being used to pay for)
the government’s spending. Thus, as Van Lear argues, “private sector
payments to the state transfer [existing] purchasing power, denominated
in U.S. money, to the state” (Van Lear, 2002–3, p. 254). “Only when the
Federal Reserve and [private] banks choose to buy government bonds,”
he continues, “will the state have new money to spend” (ibid.).

Fiscal effects on reserves and the “independence of the Fed”

There are at least two problems with Van Lear’s position. First, as ar-
gued in Bell (2000), the proceeds from taxation and bond sales cannot
possibly be “used” to finance government expenditures because they
are destroyed, as a matter of balance sheet logic, when they are depos-
ited into the Treasury’s account at the Fed. Given that Van Lear recog-
nizes that “money is either in the form of bank deposits or central bank
notes and reserves” (Van Lear, 2002–3, p. 254), it is unclear why he
resists this. When the Treasury receives tax payments (either directly or
as transfers from TT&Ls), the banking system loses an equivalent quan-
tity of reserves (that is, HPM). Thus, as the Federal Reserve debits the
reserve accounts of private banks, HPM is destroyed. Van Lear is appar-
ently focusing on the simultaneous credit to the Treasury’s account at
the Fed and calling this “money.” But the Treasury’s balance at the Fed
is not part of any standard monetary aggregate (that is, M0, M1, and so
on). Indeed, we know of no agency, textbook, or other authority, that
considers the Treasury’s balance at the Fed “money.” Thus, Van Lear is
incorrect when he argues that “private sector payments to the Treasury . . .
do not destroy money” (ibid.). Whereas this might appear to be nothing
more than semantics, it emphasizes that the Treasury’s deposit claim on
 266 JOURNAL OF POST KEYNESIAN ECONOMICS

the Fed is nothing but an internal claim. Second, as we’ll argue below,
the notion that banks might refuse to buy government bonds implies
either that banks do not have any excess reserves, or that they prefer
nonearning reserves over earning bonds. But this would in no way con-
strain Treasury spending, as we’ll see below, because the Treasury or
Fed can always inject more nonearning reserves into the system, or can
develop procedures to allow banks to buy government bonds without
debiting their reserves.1
In addition, Post Keynesians like Lavoie (2002) and Van Lear (2002–3)
are misled by formal prohibitions on the Treasury. Yes, the Treasury is
prohibited from physically “printing money” and from selling bonds
directly to the Fed. So it spends by emitting a check, which once depos-
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ited leads to a reserve credit for the receiving bank. And, yes, the Trea-
sury normally moves a deposit from a note option bank to the Fed more
or less simultaneously with its payment by check. Clearly, however, it
does this to ensure its payment won’t suddenly increase bank reserves.
This allows the Fed to simultaneously reduce reserves at one of the note
option depositories while increasing reserves when the Treasury’s check
is deposited. From the perspective of the nongovernment sector, exactly
the same effects on reserves can be achieved by allowing the Treasury to
write a check on the Fed without first moving deposits from note option
depositories, and then simultaneously reducing Fed loans at the discount
window or engaging in an open market sale by the trading desk.
Hence, again, we prefer to consolidate the Fed and Treasury, and leave
the minutiae of coordination between them to the side. By this we do
not mean to propose a formal consolidation but rather attempt to lay
bare the essentials of the impact of fiscal operations on HPM. From the
perspective of the nongovernment sector, the only thing to note is that
government spending will increase HPM unless some offsetting reserve
drain is undertaken. This can take the form of tax payments, sales of bonds
by the Fed or Treasury to the nongovernment sector, a shift of Treasury

1 Further, when it comes to buying government debt, banks do not have the degree of

freedom attributed to them by Van Lear. Specifically, it must be emphasized that, in

order to qualify as a TT&L depository, the institution must agree to abide by certain
rules, established by the Treasury, regarding the maintenance of TT&L accounts. Most
important, TT&L depositories must agree to hold collateral, in the form of U.S.
government securities, “against all [TT&L] deposits over the maximum insurance
coverage provided by the Federal Deposit Insurance Corporation and the National
Credit Union Share Insurance Fund” (Federal Reserve Bank, 2002, p. 1). Given that the
Treasury has institutionalized a kind of guaranteed buyer program, it seems inappropri-
ate to speak as though banks can somehow choose not to buy government bonds.
 FISCAL EFFECTS ON RESERVES AND THE INDEPENDENCE OF THE FED 267

deposits from TT&L accounts at note option depositories to the Fed,

reduction of discount window loans, and so on. Exactly how the Fed and
Treasury coordinate to achieve this reserve drain should be as interest-
ing, but no more confusing, to economists studying fiscal effects as the
within-the-household financial transactions between husband and wife.
In a similar vein, we wish to make it clear that the logical impact of
bond sales by government (Fed or Treasury) is to drain reserves. Two
points can help to clarify our understanding of this. First, suppose the
Treasury spent without draining reserves through tax receipts, or by shift-
ing deposits from a note option bank to the Fed. Second, suppose that
the Fed did not drain reserves (that is, sell bonds) to offset the effects of
Treasury spending on reserves, either. Then, if the banking system, pre-
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vious to the increased Treasury spending, had held all the reserves it
required or desired, then it would hold excess reserves subsequent to the
Treasury spending. The impact of the spending, then, would be to place
downward pressure on the Fed funds rate. (So much for crowding out!)
To relieve this, the Treasury (or the Fed) could sell bonds. It would then
be clear that the purpose of the bond sale would be to relieve the pres-
sure on the Fed funds rate—and not to provide “finance” for the govern-
ment spending that has created the excess reserves.
But wait a minute, the critics object, the U.S. government doesn’t spend
first and sell bonds to drain reserves later; it is financially constrained
by the magnitude of its existing deposits. Thus, spending cannot exceed
tax revenue (that is, deficits cannot be run) unless the government first
borrows enough to generate a surplus of credits, which can be drawn
down later, as deficit spending occurs. Let’s break this down carefully.
These critics seem to misunderstand the nature of deficit finance. We
can articulate the problem this way: when the government runs a deficit
it can (1) auction new Treasury debt, specifying that note option banks
may purchase all or a portion of the debt by crediting a TT&L account,
(2) sell bonds to banks or the nonbank public in exchange for existing
deposits, or (3) sell bonds directly to the central bank in exchange for a
credit to its primary account. Lerner (1943) referred to (1) and (3) as
“printing” money and to (2) as “borrowing.” Under options (1) and (3),
the bond sales themselves have no impact on reserves. Reserves are
affected only as the Treasury transfers funds from its TT&L accounts to
its account at the Fed (draining reserves) or as it draws on its account at
the Fed (injecting reserves as checks clear).
The passage of the Treasury–Federal Reserve Accord on March 4, 1951,
relieved the Federal Reserve System of its obligation to support the mar-
ket for Treasury debt. Still, a variety of provisions enabled the Fed to
 268 JOURNAL OF POST KEYNESIAN ECONOMICS

conduct outright purchases of government debt until 1981, when “au-

thority for any kind of direct loans to the Treasury lapsed” (Meulendyke,
1998, p. 238). Thus, in the United States, the central bank currently lacks
the authority to conduct outright purchases, leaving option (3) a mere
theoretical possibility. As Boulding recognized, the “usual method of
financing a governmental deficit in these days” (1966, p. 232) is via
option (1). “When,” he says, “a government or any organization sells
newly-created securities to a bank, the bank purchases these securities
with newly-created bank deposits,” where “the effect is much the same
as if the government had created money directly” (ibid.). When the Trea-
sury sells bonds in accordance with option (1), it does so because it
anticipates a reserve injection (from government spending) in excess of
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the reserve drain (from tax collection). By selling bonds in accordance

with option (1), the Treasury can coordinate (ex ante) its cash flow op-
erations, transferring funds from TT&L accounts simultaneously with
its anticipated deficit spending, in order to prevent a net injection of
reserves. But since calls on TT&L accounts are scheduled in advance,
and actual tax receipts cannot be known with certainty, the reserve effect
cannot be completely neutralized. When, for example, too few funds are
transferred from TT&L accounts, the reserve injection from government
spending will outweigh the reserve drain and the overnight lending rate
will decline. When this occurs, bonds can be sold in accordance with
option (2), whereby they will serve as an ex post coordination tool.
All these machinations are not to obtain some kind of finance allow-
ing the Treasury to sell government bonds so that it might deficit spend,
but rather are required to manage the reserve effects that arise as a con-
sequence of the government’s fiscal operations. Exactly the same effect
could be obtained by allowing the Treasury to sell bonds to the Fed,
having the Treasury write checks on the created deposit at the Fed, in-
creasing bank reserves when these checks are deposited at private banks,
and then draining reserves through a Fed open market sale. Or, we could
legally consolidate the Fed and Treasury, have the government issue the
check and directly credit reserves to the receiving bank while simulta-
neously selling bonds and directly debiting reserves. In other words, if
we simplified actual internal accounting procedures, the results on the
nongovernment sector would be no different, but economists might be
able to follow the logic.
This leads to the second point—the supposed “independence” of the
Fed. There is one sense in which the Fed is independent: it can set the
Fed funds rate exogenously (Moore, 1988). Contrary to what Van Lear
claims, the Fed does not keep reserves “scarce” to hit its target, and it
 FISCAL EFFECTS ON RESERVES AND THE INDEPENDENCE OF THE FED 269

need not drain reserves to raise the target. Nor does a “neoclassical”
central bank keep fewer reserves in the system than a “heterodox” cen-
tral bank would. Rather, the central bank announces a target and supplies
(horizontally) the quantity of reserves banks want/require. Given that
demand for reserves is highly interest inelastic, there is very little rela-
tion between the Fed funds rate target and the quantity of reserves re-
quired/desired. Hence, the central bank can increase or decrease the Fed
funds rate without draining/adding any reserves at all. This became much
more obvious in the past few years when the Fed began to publicly an-
nounce its target rate, rather than forcing banks to figure out what it is.
However, when Van Lear claims the central bank is independent, he is
not referring to the federal funds rate target, but to the Fed’s supposed
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ability to refuse to cooperate with the Treasury. What if fiscal policy

affected reserves, but the Fed refused to offset this through open market
or discount window operations? Then the implication would be that the
federal funds rate would move away from target. In other words, the
only independence the Fed has is to administer the overnight interbank
rate, which requires that it offset any impact on reserves that results
from fiscal operations. That is, independence of the Fed requires that it
cooperate with the Treasury to offset any effects of fiscal operations on
bank reserves.
We do not intend to address the issue of putting control of the Fed
funds rate under the Treasury, or, of making it subject to democratic
control—that is, of eliminating Fed independence. This might be a good
idea. Actually, we’d prefer to replace the Federal Open Market Commit-
tee (FOMC) with a robot programmed to hold the Fed funds rate target
at 1 percent—but that is all irrelevant to the topic at hand.

An alternative view of government finance

Let us turn to the final point we wish to make. We have only described
the system as it functions.2 This makes it clear that neither taxes nor
bonds really finance government spending, on any reasonable definition
of the term “finance.” This means government cannot face any normal
“financial” constraint. A policy prescription that might follow from this
would be that government should spend on a sufficient scale to accom-
plish what Keynes called its “agenda” (Keynes, 1963). If this results in

2
Throughout this paper, we discuss the characteristics of any “modern money” system,
that is, one that is based on a floating currency. Governments operating with a gold
standard or a currency board function differently. See Bell (2001) and Mosler (1997).
 270 JOURNAL OF POST KEYNESIAN ECONOMICS

generating too much nongovernment sector income, then government

should use taxes to reduce disposable income. If this still leaves the
nongovernment sector with too much HPM, government ought to sell
some bonds. Many readers will recognize these as the policy prescrip-
tions that follow from Lerner’s two principles of functional finance
(Lerner, 1943, 1947). Government can tell if there is “too much dispos-
able income” because the economy will be operating beyond full em-
ployment. If the nongovernment sector has “too much HPM,” then the
overnight rate will fall. Whereas these policy prescriptions might be
controversial, by understanding the balance sheets involved we can tackle
them without all the ideological fervor surrounding the principles of
“sound finance” that are based on misunderstanding of the simplest bal-
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ance sheet manipulations that used to be taught even in the orthodox

money and banking courses, like John Ranlett’s.
In today’s world, governments spend by crediting bank reserve ac-
counts at their central banks. There are no inherent financial constraints
on this process, though most nations have opted for self-imposed con-
straints. These include both “no overdraft” provisions for the Treasury
as well as “debt ceiling” legislation. Although with today’s floating ex-
change rates, these constraints serve no economic purpose (apart from
destabilizing markets from time-to-time, and apart from generating cre-
ative governmental procedures to subvert the constraints), they are none-
theless part of the political landscape. With government nominal spending
(and lending) inherently constrained only by legislative decision (not by
economic principles), government receipts are best thought of as fol-
lowing government spending or lending. Government expenditure (and
lending) leads to credits at member bank accounts, followed by govern-
mental receipts (taxes and bond sales) that debit member bank accounts.
If government spending plus loans inject more HPM than is drained
through tax payments and bond sales to the nongovernment sector, then
HPM accumulates as banking system reserves. If excessive, this results
in a zero bid condition in the interbank (Fed funds) market. This is ex-
actly what is taking place in Japan, because the Bank of Japan maintains
excess reserves in the banking system (generated by Treasury deficits)
while paying no interest on reserves.

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