Untangling Reserves

 

🏛️ Untangling Reserves: What They Are, What They Aren’t, and Why It Matters

By Dwain • Monetary Systems & Institutional Analysis

📌 What Are Central Bank Reserves?

Central bank reserves are often misunderstood—even by professionals. They are not cash in a vault, nor are they "printed money" in any conventional sense. Reserves are:

• Liabilities of the Federal Reserve, held exclusively by institutions with Master Accounts.

• Digital-only entries on the Fed’s balance sheet—no physical form.

• The backbone of interbank settlement and monetary policy implementation (e.g., through interest rate management and payment system operations).

They are strictly internal plumbing of the financial system—not money that circulates or is spent by the public.

🏦 How Banks Acquire Reserves

Banks obtain reserves through specific reserve-creating transactions. The most common mechanism:

• Selling SOMA-eligible assets—such as Treasury securities or agency MBS—to the Fed (usually via a Primary Dealer).

• Upon purchase, the Fed credits the seller's Master Account with reserves.

• These reserves become:

  • An asset for the bank

  • A liability for the Fed

No reserves exist outside this framework.

💰 What Banks Can Do With Reserves

While reserves are essential, their uses are highly specific:

• Settle interbank obligations via Fedwire

• Satisfy Liquidity Coverage Ratio (LCR) requirements under Basel III

• Earn interest through the Fed’s Interest on Reserve Balances (IORB)

• Pledge as collateral to access temporary funding via the SRF or discount window

• Hold excess reserves, though these remain within the Fed’s closed system and are not lendable to the public

🚫 What Reserves Are Not

This is critical:

• ❌ Not cash in the public sense

• ❌ Not bank capital—they are assets, not sources of loss-absorbing equity

• ❌ Not deposits—banks can’t offer reserves to customers

• ❌ Not “public money”—they do not circulate beyond the Fed’s balance sheet

• ❌ Not the instrument of fiscal policy—Treasury disbursements do not use reserves

🔒 What the Fed Cannot Do With Reserves

Operational integrity matters. The Fed:

• Cannot arbitrarily confiscate or reassign reserve balances

• Cannot "inject" reserves into specific banks without a qualifying transaction (e.g. a repo or asset purchase)

• Cannot create reserves through fiat disbursement—it must expand its assets first

🧾 Collateral and Temporary Facilities

When banks access liquidity via the SRF or discount window:

• They pledge their own high-quality assets (Treasuries, MBS, loans)

• Assets are pre-positioned with custodians (e.g. DTC, BNY Mellon)

• The Fed applies haircuts to determine eligible collateral value

• No SOMA asset is involved, and no "new" reserves are created system-wide—just shifted temporarily

💡 The Capital Stock Subscription

Membership in the Federal Reserve System requires banks to subscribe to Reserve Bank stock:

• 6% of capital and surplus

  • 3% is paid-in

  • 3% is callable (unpaid unless needed)

The paid-in capital earns dividends, but:

• It is not usable as reserves

• It does not count toward regulatory capital for Basel purposes

• Payments are made using existing reserves—not in exchange for them

🧠 Common Confusion: "Reserves = Cash"

This misperception stems from the fuzzy use of the word “cash” to mean:

• Vault currency (Federal Reserve Notes)

• Commercial bank deposit balances

• Central bank reserves

But only physical currency circulates publicly. Reserves:

• Do not settle retail transactions

• Do not increase bank lending capacity

• Do not fulfill Treasury obligations

They are purely institutional instruments—intended for Fed-supervised settlement between banks.

🪙 Backing of Reserves and FRNs

According to Part 7 of the Fed’s H.4.1:

> Every Federal Reserve Note (FRN) in circulation is backed by collateral held in the SOMA—at par value.

This includes:

• U.S. Treasuries

• Agency debt

• Agency MBS

This same asset base supports reserves indirectly. While reserves and FRNs are distinct liabilities, both are claims on the Fed, collateralized by the SOMA.

🔍 Final Word

To grasp the Federal Reserve system is to understand how tightly reserves are walled off from public-facing finance. They exist only inside the Fed's institutional architecture, performing a specialized function that has nothing to do with commercial credit, fiscal spending, or consumer liquidity.

Treating reserves as “money” outside that context is not just imprecise—it’s incorrect.

If you want monetary clarity, start by separating the pipes from the stories.

Did I Ever Tell You About The Time The Fed Went Insolvent?

 

The week the Fed loaned away the collateral backing your currency,      and no one noticed.

In the chaos of the 2008 financial crisis, amid the alphabet soup of emergency programs and bailout debates, the Federal Reserve did something that violated decades of precedent, undermined the legal foundation of the Federal Reserve Note, and signaled the quiet death of the old monetary order.

It loaned away the collateral backing your currency.

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Prelude to a Quiet Collapse

Throughout the summer of 2008, the Fed was desperate to keep liquidity flowing to the banking system without triggering alarm bells about "money printing." So it tried to sterilize its emergency lending operations — that is, to lend to banks without expanding its balance sheet.

To do this, the Fed created facilities like the Term Securities Lending Facility (TSLF), the Primary Dealer Credit Facility (PDCF), and the Term Auction Facility (TAF). These programs funneled liquidity into the financial system while the Fed simultaneously sold off or lent out Treasury securities from its SOMA (System Open Market Account) portfolio to offset the effect on bank reserves.

By early September 2008, this balancing act broke down.

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When Reserves Surpassed Assets

According to the H.4.1 balance sheet from September 3, 2008, the Fed's outright holdings of Treasury securities had dropped to $479.7 billion. At the same time, reserve balances held by depository institutions were surging, driven by escalating emergency lending and growing panic in financial markets.

In other words, reserves issued by the Fed exceeded the traditional high-quality assets backing them. The central bank had injected hundreds of billions in liquidity into the system, but no longer held enough Treasuries to credibly back those reserve liabilities.

This would be troubling enough. But it gets worse.

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The Collateral Behind Currency

Traditionally, currency in circulation — physical Federal Reserve Notes — is backed by assets held by the Fed, primarily U.S. Treasury securities. This backing is not a gold standard, but it has long served as a legal and accounting convention that lends credibility to the dollar.

But in September 2008, the Fed began dipping into those assets too.

Quoting directly from a 2009 Fed staff paper:

"By mid-September 2008, the capacity to sterilize additional credit extensions had essentially been exhausted, and the securities traditionally allocated as backing for currency had been drawn down."

In plain English: the Fed loaned out the collateral backing your cash.

This was a profound break from the pre-2008 monetary regime. It meant that for at least a brief period, Federal Reserve Notes were circulating without a full allotment of legally required collateral. The fiction of convertibility, already tenuous since 1933, became irrelevant.

Side note: Technically, the assets held as collateral are not what "backs" the Federal Reserve Note as money. Rather, the law requires Reserve Banks to post collateral (usually Treasury securities) to access new notes from the Treasury. The FRN itself is the money—a final means of payment by statute (31 USC §5103). The collateral governs the issuance of notes to banks, not their value in circulation.

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Enter Quantitative Easing

By October 2008, the game changed. Congress authorized the Fed to pay interest on reserves, and the Fed abandoned sterilization altogether.

It started expanding its balance sheet without constraint, buying agency debt, MBS, and eventually Treasuries in size. This was the birth of quantitative easing (QE) and the beginning of a new era where reserves would permanently float atop a sea of Fed assets, and the link between currency and specific collateral was never fully restored.

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Why This Matters

While the financial media obsessed over Lehman, TARP, and AIG, the Federal Reserve quietly defaulted on its own internal rules.

It demonstrated that, when pushed, the central bank would not hesitate to abandon long-standing collateral structures, legal frameworks, and operational norms. The traditional relationship between assets and liabilities on the Fed’s balance sheet was severed — and has never been reattached.

The world now runs on fiat, not just legally, but operationally.

And almost no one noticed.

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Sources & Documentation

• Federal Reserve H.4.1 Release: September 3, 2008

• New York Fed SOMA Holdings Archive Data, 2008

• "Federal Reserve Tools for Managing Credit and Liquidity Risk," Board of Governors (2009)

• Congressional approval for interest on reserves: Emergency Economic Stabilization Act of 2008

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If you've ever wondered whether central banking rests on law, collateral, and accounting discipline — or just narrative control and political expediency — consider this your answer.

Treasury Auctions, Fed Runoff, and the Great Reserve Myth

 

By Dwain Dibley and Grok, June 16, 2025

One of the most persistent misconceptions in monetary economics is the idea that Treasury auctions and Federal Reserve asset runoffs affect bank reserve balances.

They don’t.

This confusion stems from a deeper misunderstanding of what reserves actually are, how they are created, and why they exist at all. Most commentary today treats reserves as some kind of free-floating liquidity pool — “money” that the Fed can inject or withdraw at will. But that’s not how the system works.

Let’s reset the framework and walk through what actually happens.

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🏛 What Reserves Really Are

Reserve balances are not money, not government spending tools, and not public assets. They are:

• Bank-owned assets held at the Federal Reserve.

• Liabilities of the Fed, backed 1:1 at face value by assets held in the Fed’s System Open Market Account (SOMA).

• Used only for final settlement of obligations between banks.

The only way reserves come into existence is when a bank gives something up — either by:

1. Selling assets to the Fed (e.g. Treasury securities during QE), or

2. Borrowing from the Fed (e.g. discount window lending).

In exchange, the Fed creates a new liability (reserve balances) backed by the incoming asset. Reserves cannot leave the interbank system, and the Fed cannot use them for any purpose. They are accounting claims that facilitate interbank payment, not transferable funds.

📌 Reserves are not money. They are asset-backed settlement claims, issued by the Fed in return for something of value.

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🏦 Treasury Auctions — No Reserves Involved

When the Treasury issues new securities at auction, here’s what happens operationally:

1. Investors (banks, dealers, MMFs, pensions, etc.) place bids.

2. If an investor wins, their custodian bank facilitates settlement.

3. On settlement day, the investor’s deposit account is debited, and the Treasury General Account (TGA) is credited at the Fed.

At no point are reserve balances involved in this process.

In fact:

• Not all Treasury auction participants have reserve accounts.

• The Fed does not accept payments from nonbanks directly.

• Treasury auctions settle via the commercial banking system — using bank deposits, not reserve balances.

When a bank is involved (as custodian), the Fed adjusts the master account of that bank, which may or may not include a change in the reserve subaccount. In most cases, it does not. The transaction is simply a shift from one Fed liability (the bank’s master account) to another (the TGA).

🔍 Treasury auction settlement involves deposit credit and liability transfers — not the reserve system.

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📉 Fed Balance Sheet Runoff (QT) — Not a Reserve Event

When a Treasury security held by the Fed matures:

• The security rolls off the asset side of the Fed’s balance sheet.

• There is no “payment” made to the Fed.

• The matched liability (typically reserves held by banks) remains unaffected unless a separate transaction removes it.

There is no redemption, no reserve adjustment, and no transaction between the Fed and Treasury. The asset simply expires.

🔥 Fed runoff is a passive asset reduction, not a financial flow. It does not “drain” reserves from the banking system.

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💱 FX Swaps — Yes, Reserves Are Created, But Only With 1:1 Asset Offset

This is one case where reserve balances are created outside QE or lending, but still fully asset-backed.

When the Fed conducts a foreign exchange swap with another central bank:

1. The Fed creates reserve balances and credits them to a designated U.S. bank.

2. In return, the Fed books an asset: a foreign exchange receivable, fully collateralized and short-dated.

3. The reserve liability is backed at face value by the FX swap asset.

This is not “liquidity injection” in the free-money sense — it is a balanced exchange of claims, with the Fed holding a receivable and the counterparty holding temporary reserves.

When the swap unwinds, the reserves are removed, and the FX receivable is extinguished.

💡 FX swaps create reserves only because they also create a new Fed asset. The 1:1 asset backing is never broken.

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📊 So When Do Reserve Balances Actually Change?

Let’s break down the only legitimate sources of reserve balance changes, and debunk the common myths:

✅ Events That Truly Change Reserve Balances

Event	Effect on Reserves	Explanation
Fed Open Market Operations (QE/QT)	✅ Yes	Buying adds reserves, selling removes them. Always 1:1 against SOMA assets.
Discount Window Lending	✅ Yes	Bank borrows and posts collateral; reserves created and backed by the loan asset.
FX Swaps	✅ Yes	Reserves created and backed by short-term FX receivables from foreign central banks.
Currency Withdrawals	✅ Yes	Physical cash withdrawals reduce reserve balances via a liability swap (reserves to currency).

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❌ Events That Do Not Change Reserves

Event	❌ Effect on Reserves?	Why Not?
Treasury Spending	❌ No	The TGA is debited, and a bank’s master account is credited. Reserve balances are not necessarily touched.
Tax Payments	❌ No	Bank debits customer deposits and sends payment to the TGA. This is a deposit transfer, not a reserve movement.
Treasury Auctions	❌ No	Settlement uses deposit credit from custodian banks. Reserves are not transferred.
Fed Runoff (QT)	❌ No	Maturing assets roll off the balance sheet passively. No payment occurs, and reserves remain unchanged.
Reverse Repo Operations (RRP)	❌ No	Shifts the form of Fed liabilities (reserves to RRPs), but does not reduce total reserves held by depository institutions.

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🧠 Why This Matters

The myth that reserves are constantly moving in and out of existence based on fiscal operations has led to poor analysis and policy confusion. The truth is far simpler:

🧾 Reserves exist only because banks voluntarily gave the Fed something of value.
They do not enter or exit the system through Treasury activity, taxation, or asset maturities.

Recognizing this structure clarifies everything from the Fed’s limited powers to the mechanics of sovereign debt issuance.

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📌 Conclusion

Reserve balances are not money. They are not government funds. They are not fiscal tools.

They are claims on Federal Reserve assets, issued only when a bank gives up something real, and used only for interbank payment.

Every dollar of reserves is matched by a dollar of SOMA assets — at face value — and this 1:1 parity is what keeps the system coherent.

So next time you hear that Treasury auctions are “draining reserves” or that Fed runoff is “pulling liquidity” out of the system, remember:

Reserves don’t move unless a Fed asset does — and even then, only when a bank chooses to make that trade.

Understanding Fed Held Reserves

 Why the Fed Must Treat Its Securities at Face Value: The Hidden Logic of a Par-Based System

The Federal Reserve System operates at the core of the U.S. monetary architecture, yet it's frequently misunderstood—even by professionals—when it comes to how it values the assets it holds. In particular, there's growing confusion around the use of amortized cost in the Fed's accounting, and how that relates to its actual operations involving Treasury securities, reserves, and reverse repos.

This post unpacks why the Fed must treat its securities at face value operationally, even though it uses amortized cost for internal accounting—and why any deviation would introduce fatal mismatches into the reserve system.

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1. Reserves Are Backed by Fed Assets at Face Value

Reserves are not just digital entries—they are claims on the Fed's balance sheet, backed by real assets. These claims are designed to be fungible and transferable across the banking system on a 1:1 basis, with no pricing variability.

To support this, the Federal Reserve holds collateral—mostly U.S. Treasuries—at face value. This ensures that each $1 in reserves is backed by $1 in Fed-held assets, preserving legal parity and systemic integrity.

Crucially, there is a 1:1 relationship between reserves and Federal Reserve Notes (legal tender). The same assets that back reserves at face value also serve as collateral for the issuance of currency. This creates a unified monetary base, with a consistent valuation anchor: face value of Fed-held assets.

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2. Amortized Cost Creates Irreconcilable Pricing Mismatches

If the Fed were to treat its holdings at amortized cost in operational terms (not just in reporting), it would introduce unavoidable inconsistencies:

• Buying a bond at $95 (discount) would back only $95 in reserves

• Buying a bond at $105 (premium) would back $105 in reserves

Yet interbank transactions always assume reserves are worth $1 per $1, not subject to market drift. Any attempt to back reserves with fluctuating asset valuations destroys the par foundation of the system.

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3. Interbank Payments Require a Closed, Par-Based System

The Fed facilitates interbank settlement through reserves, and these reserves are:

• Uniform in value

• Cleared at par

• Backed by assets valued at face

There is no room for market-based variability in the reserve system. If Bank A's $1 in reserves isn't worth the same as Bank B's, the system loses coherence. That’s why market value and amortized cost are accounting fictions in this domain.

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4. The Role of Reverse Repos Reinforces the Face-Value Logic

The Fed's reverse repo (RRP) facility allows it to drain reserves by lending securities temporarily. These transactions are:

• Structured around face-value exchanges

• Compensated with interest to maintain parity

If amortized cost mattered here, it would introduce pricing arbitrage, misalignments in reserve value, and disruptions in monetary control. Instead, the Fed ensures all reserve movements retain a 1:1 asset backing at face value.

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5. Why Face Value Is Operational, Amortized Cost Is Optical

The key distinction is this:

• Face value governs operations (reserve creation, collateral, RRP)

• Amortized cost governs internal reporting (yield smoothing, P&L, disclosures)

So-called "unrealized losses" are meaningless to the system's function, because the Fed does not mark its assets to market for reserve-backing purposes. When a bond matures, it pays out at face. Period.

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Conclusion: Only Face Value Preserves Systemic Parity

The Fed's role is not to profit on bond trades. Its securities are not investments—they are tools. And to function as monetary instruments, they must retain their face value discipline throughout their lifecycle.

Face value keeps the reserve system coherent. Amortized cost is just an internal lens.

When commentators fret about "unrealized losses" or the Fed's "insolvency," they are mistaking accounting optics for operational mechanics. The real machinery of the Fed runs on par, and always has.

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 The Fed’s Passive Machinery: Unmasking the Fiction of Money Creation

The Federal Reserve’s balance sheet is often portrayed as the heart of the U.S. economy, a powerful tool for steering credit, controlling inflation, and shaping fiscal policy. But this narrative is a myth, rooted in a 19th-century fiction that bank deposit accounts are money. In reality, the Fed’s balance sheet is a passive machinery, a record-keeping device constrained by the banking system’s needs, disconnected from private credit creation, and unable to directly influence inflation or government spending. This post exposes the truth: banks create debt, not money; dollars (legal tender) are the real money; and the system hides that banks lack the dollars to back the deposits we treat as cash.

The Fed’s Balance Sheet: A Passive Ledger, Not a Control Panel

The Fed’s balance sheet, valued at $7.2 trillion (May 2025), holds assets like U.S. Treasuries ($4.6 trillion) and mortgage-backed securities ($2.2 trillion), backing liabilities such as bank reserves ($3.1 trillion) and Federal Reserve notes (~$2.3 trillion). Mainstream narratives suggest the Fed uses this to “create money” or “tighten liquidity.” But the reality is different:

• Assets are stuck: The Fed can’t sell its assets without disrupting interbank liquidity. Reserves, claims to these assets, are essential for banks to settle transactions (via Fedwire, ~$1 quadrillion annually). Selling assets drains reserves, risking crises like the 2019 repo spike when reserves fell to ~$1.4 trillion.
• Liabilities are untouchable: Reserves and notes (legal tender, per 12 USC 411) support the banking system’s operations. Reducing them threatens stability, as banks rely on reserves for settlements and notes for cash demand.
• Passive role: The Fed reacts to banks’ needs, not the other way around. Banks’ demand for reserves and notes dictates the balance sheet’s size, making it a record-keeping device for reserves, notes, and Treasury interactions (e.g., Treasury General Account, ~$0.7 trillion).

The Fed isn’t pulling levers; it’s maintaining the plumbing of a system driven by banks.

Banks Create Debt, Not Money

Textbooks claim banks “create money” when they lend, but this is a misnomer. When a bank issues a $100,000 loan, it creates a $100,000 deposit—a liability, a promise to pay dollars, not dollars themselves. These deposits (~$17 trillion of M2 ~$21 trillion) are counted as money because they’re accepted for payments, taxes, and debts. But they’re debt, a bank IOU, not money in the true sense.

• Dollars are money: Only Federal Reserve notes (~$2.3 trillion), legal tender per 31 USC 5103, are true money, issued by the Fed and collateralized by assets (per 12 USC 411). Deposits are bank-created debt, not dollars.
• Endogenous money: Banks lend based on demand and capital, not reserves ($3.1 trillion), creating deposits endogenously. Loan growth ($12 trillion, C&I loans up ~2% YoY) drives M2, not Fed actions, disconnecting the balance sheet from credit creation.

The 19th-century fiction that “deposits are money” (e.g., legal acceptance of checks, 1848’s Foley v. Hill) conflates bank debt with dollars, obscuring the system’s structure.

The System Hides Banks’ Lack of Dollars

The banking system is designed to make deposits feel like dollars, but banks hold shockingly few actual dollars to back them:

• Vault cash reality: Banks operate on vault cash ($0.2 trillion), the physical notes in branches and ATMs, not the total currency in circulation ($2.3 trillion, much of it abroad). This covers just 1.2% of deposits ($17 trillion).
• Dollar scarcity: If depositors demanded cash, banks couldn’t deliver—notes ($2.3 trillion) and reserves ($3.1 trillion, convertible to notes) cover ~18% of deposits. A bank run would expose this gap, as seen in historical crises (e.g., 1930s, 2008).
• Systemic facade: Digital payments (~80% of transactions, 2024 Fed data), Visa-like networks, and Fedwire (transferring reserve claims, ~$1 quadrillion annually) make deposits seem like dollars. The Fed ensures banks can access notes or settle claims, hiding the shortfall.

The system’s plumbing—Fedwire as a mechanism transferring claims to assets (like Visa for deposits)—sustains the illusion that banks have the dollars they don’t.

Quantitative Tightening: A Monetary Mirage

Quantitative tightening (QT), the Fed’s attempt to shrink its balance sheet (~$1.2 trillion reduction since 2022), is often sold as a way to “pull liquidity” from the economy. But it’s a fiction:

• No impact on deposits: QT, via roll-offs ($60 billion/month, Treasuries and MBS maturing), primarily reduces the Treasury General Account ($0.7 trillion), not reserves (~$3.1 trillion) or deposits (M2 stable at ~$21 trillion). Deposits, bank debt, persist unless borrowers default or banks fail.
• Limited reserve effect: Roll-offs don’t directly drain reserves, unlike open market operation (OMO) sales. Even OMO’s reserve reductions don’t destroy deposits, as banks lend endogenously.
• No economic control: QT can’t steer credit (loan-driven) or inflation (e.g., 2021–22 spikes from supply/fiscal factors), as the balance sheet doesn’t touch deposits, the economy’s lifeblood.

QT’s failure to shrink M2 shows the Fed’s balance sheet is disconnected from the real economy, a passive ledger, not a policy tool.

No Constraint on Government Spending

Pundits claim the Fed’s balance sheet limits government spending, but this is false. When the government spends, it creates deposits (bank debt) by issuing Treasuries or drawing on the TGA. The Fed accommodates this:

• Treasury operations: The Fed buys Treasuries ($4.6 trillion held) or manages the TGA ($0.7 trillion), ensuring liquidity for fiscal policy.
• No dollar limit: Spending creates deposits, not reliant on physical dollars (~$2.3 trillion). The deposit-as-money fiction enables this, as banks absorb government debt as new deposits.

The balance sheet reacts to fiscal needs, not constrains them, debunking deficit hawk myths.

The 19th-Century Fiction at the Core

The modern monetary system rests on a 19th-century fiction: bank deposit accounts are money. Legal and economic shifts (e.g., 1848’s Foley v. Hill, check acceptance) equated bank debt (deposits) with dollars, creating a system where:

• Banks dominate: They create deposits (~$17 trillion) through lending, not Fed-controlled dollars.
• Fed as backstop: The balance sheet ($7.2 trillion) provides reserves ($3.1 trillion, claims to assets) and notes (~$2.3 trillion) to make deposits function as dollars, but it’s passive, per banks’ discretion.
• Illusion persists: The system hides banks’ dollar scarcity (vault cash ~$0.2 trillion vs. deposits ~$17 trillion), with Fedwire and Visa-like systems transferring claims, not dollars.

This fiction locks the Fed into a reactive role, supporting a debt-based economy it can’t control.

Conclusion: A Passive Machinery, Not a Mastermind

The Fed’s balance sheet isn’t a tool for steering the economy—it’s a passive machinery, a ledger tracking reserves ($3.1 trillion), notes ($2.3 trillion), and Treasury interactions to sustain the illusion that bank deposits (~$17 trillion) are dollars. Banks create debt, not money, and the system hides their lack of dollars (vault cash ~$0.2 trillion). QT is a fiction, unable to shrink deposits; credit and inflation are driven by banks and external factors, not the Fed; and government spending faces no balance sheet limit. Rooted in a 19th-century fiction, the monetary system thrives on a lie: deposits aren’t dollars, but we treat them as such. It’s time to see the Fed for what it is—a record-keeper, not a ruler.