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.