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Do Taxes and Bonds Finance Government Spending? Author(s): Stephanie Bell Source: Journal of Economic Issues, Vol. 34, No. 3 (Sep., 2000), pp. 603-620 Published by: Association for Evolutionary Economics Stable URL: http://www.jstor.org/stable/4227588 Accessed: 16/07/2010 13:01 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aee. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected].

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JOURNALOF ECONOMICISSUES Vol. XXIV No. 3 September2000

Do Taxes and BondsFinanceGovernmentSpending? StephanieBell

Debates over the impacts of various ways of financinggovernmentdeficits and about the relative impact of monetaryand fiscal policy have, unfortunately,been carriedout without recognitionof the institutionalprocess by which modem government spending, borrowing, and taxation are accomplished.1In the United States, close cooperationbetween the Treasury, the Federal Reserve System, and depository institutionsmakes the traditionaldistinctionsbetween monetaryand fiscal policy hard to use in describing actual processes and renders irrelevant many of the theories about the most appropriatemix of borrowingand taxation. Indeed, the entire treatmentof taxationand of governmentborrowingassumes a monetarysystem quite unlike that of the modern U.S. system. My purpose in this paper is to describe, in some detail, the way in which the Treasuryand the Federal Reserve coordinate policies that are neither purely fiscal nor purely monetaryand to argue that theories of monetary/fiscalpolicy should incorporatemore discussion of the issues of reserve management.

The "Reserve Effects"of Taxingand Spending Before examining the reserve effects of various Treasuryoperations, it is, perhaps, prudentto begin by looking closely at aggregatememberbank reserves.2 BeThe author is a Ph.D. candidate at The New School for Social Research and a Lecturer at the Universityof Missouri-Kansas City. Thispaper was wntten while the authorwas CambridgeUniversity Visiting Scholar at The Jerome Levy Economics Instituteat Bard College and has been presented at the Post Keynesian SummerConferencein Knoxville, Tennessee, July 1998; the Post Keynesian Graduate Workshopin Leeds, UnitedKingdom, 1998; and at the Conferenceon the Economics of Public Spending in Sudbury, Ontario, 1999. Financial supportfrom the Centerfor Full Employmentand Price Stabilityis grateftly acknowledged. Helpful commentsfrom Victoria Chick, John F. Henry, Peter Ho, Anne Mayhew, Edward Nell, Alain Parguez, James Tobin, Randy Wray, and twaoanonymousreferees greatly improvedthe argumentsmade in this paper.

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ginning with the Federal Reserve's balance sheet, equivalentterms can be added to each side, and the entries can be manipulatedalgebraicallyin order to isolate member bank reserves.3 The result, often referredto as the "reserveequation,"depicts total member bank reserves as the difference between alternativesources and uses of reserve funds. The reserve equationcan be writtenas seen in Figure 1. From Figure 1, it is clear that an increase in any of the bracketedterms on the left will increase reserves, while an increase in any of the bracketedterms on the right will reduce them. "ReserveEffects" of Taxingand Spending In this section, the reserve effects of two importantTreasuryoperations-government spending and taxing-will be analyzed. To emphasize the impact of these operations on bank reserves, the case in which all governmentpayments and receipts are immediatelycredited/debitedto accounts held at Reserve banks will be considered.4 When the governmentspends, it writes a check on its accountat the Federal Reserve. If, for example, a Social Security check is deposited into an account at a commercial bank, member bank reserves rise (by the amountof the check) as the Federal Reserve debits the Treasury'saccount, decreasingthe right-handbracketin Figure 1, and credits the account of a commercial bank. Thus, a system-wide increase in member bank reserves results whenever a check drawn on a TreasuryacFigure 1. The Reserve Equation

Sources Federal Reserve Credit: U.S. Gov't Securities Loans to MemberBanks Total Member Bank = Reserves

Float + Gold + SDR Certificates + TreasuryCurrency

Uses Currencyin Circulation + U.S. TreasuryBalance at Fed + Foreign Balances at Fed + TreasuryCash + OtherFed Deposits and accounts (net)

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count at a Federal Reserve bank is depositedwith a commercialbank. Government spending, then, increasesaggregatebank reserves (ceterisparibus). When, insteadof drawing on its accountat the Fed, the Treasuryreceives funds into this account, the reverse is true. For example, if a taxpayerpays his/her taxes by sending a check to the InternalRevenue Service (IRS), his/her bank and the bankingsystem as a whole, lose an equivalentamountof reserves, as the IRS deposits the check into the Treasury'saccountat the FederalReserve. Total memberbank reserves decline as the right-handbracketin Figure 1 increases. Thus, the payment of taxes by check results in a system-wide decrease in member bank reserves (ceteris paribus).5 If Treasuryspendingout of its accountsat FederalReserve banks were perfectly coordinatedwith tax receipts depositeddirectly into the Treasury's accounts at Reserve banks, their opposing effects on reserves would offset one another. That is, if the governmentran a balancedbudgetwith daily tax receiptsand governmentspending timed to offset one another, there would be no net effect on bank reserves. However, as Figure 2 shows, the Treasury'sdaily receipts and disbursementsfrom accounts at Reserve banks can be highly incommensurate.Indeed, during this short sample period, Figure 2 shows that they can differ by almost $6 billion. This is substantial, given that total member bank reserves average only about $50 billion [Meulendyke 1998, 145]. Thus, a one-day decline in total reserves-to $44 billion-amounts to a 12 percentdecrease in memberbank reserves. Such a sharp decline is likely to result in an immediatebiddingup of the federal funds rate. Thus, despite an attenuationof the reserve effect due to the simultaneousinjection and withdrawalof reserves, governmentspendingand taxationwill never perfectly offset one another. Moreover, even if a more even pattern could be established, some discrepancieswould persist because, as Irving Auerbach [1963, 349] recognized, "thereis no way to determinein advance, with complete accuracy, the total amountof the receipts or the speed at which the revenue collectors will be

Figure2. Daily Flowsinto/fromFederalReserveAccounts,March 1998 (Net of Transfersto/fromT&LAccountsand Debt Management) @1 c 0

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Source:DailyTreasuryStatement, http://fedbbs.access.gop.gov/dailys.htm

eis

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able to process the returns."Thus, while concurrentgovernmentspendingand taxation have some offsetting impact on reserves, the reserve effect from the Treasury's daily cash operations would still be substantial,especially "if they were channeled immediately through the Treasurer's balance at the Reserve Banks" [Auerbach 1963, 333]. The Importanceof the "ReserveEffect" The inability to perfectly coordinateTreasuryreceipts and expenditureshas serious implications for the level of bank reserves and, subsequently,the money market. Because banks are requiredby law to hold reserves against some fraction of their deposits, but earn no interest on reserves held in excess of this amount, they will normallyprefer not to hold substantialexcess reserves. Governmentspending, then, will leave them with more reserves than they will prefer/needto hold, while the clearing of tax payments will leave them with fewer reserves than are desired/required(ceterisparibus). The fed funds marketis the "marketof first resort" for banks wishing to rid themselves of excess reserves or to acquirereserves needed to meet deficiencies [Poole 1987, 10]. When there is a build-upof reserves within the system, many banks will attemptto lend reserves in the federal funds market. The problem, of course, is that lending reserves in the funds marketcannot help a bankingsystem, which began with an "equilibrium"level of reserves, to rid itself of excess reserves. Moreover, when the system is flush with excess reserves, banks will find that there are no bidders for these funds, and the federal funds rate may fall to a zero percentbid. Likewise, the clearing of tax paymentswill leave a banking system that began with an "equilibrium"level of reserves short of required(and/or desired) reserves. Banks will look to the funds marketto acquire needed reserves, but since all banks cannot return to an "equilibrium"reserve position by borrowing federal funds, a system-wide shortage will persist. That is, like a system-wide surplus, a systemwide deficiency cannot be alleviated through the funds market;attempts to do so will simply drive the funds rate higher and higher.6 Importantly,the funds rate is not the only interestrate affected by changes in the level of bank reserves. As the "focusof monetarypolicy, " the funds rate is the "anchor for all other interest rates" [Poole 1987, 11]. Thus, when banks are content with their reserve positions, Treasuryoperations(such as governmentspendingand taxation) disrupt these positions by adding or drainingreserves, and banks react to these changes by first turningto the funds market.There, the funds rate is bid up or down, and other short-terminterest rates are affected. Although some individual banks will be successful in eliminatingtheir own reserve deficiencies/excesses, the banking system as a whole will not be able to alleviate a shortage/deficiencyon its own. Only throughgovernmentadding/drainingof reserves can a system-wide im-

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balance be eliminated. Because attemptsto resolve system-wide reserve "disequilibrium"throughthe funds marketcan affect a numberof other interest rates, a variety of procedures has been developed to mitigate the adverse impact of Treasury operationson banks' reserve positions. Strategiesfor Reducing the Reserve Effect In the preceding discussion, the effects of governmentspending and taxing on bank reserves were examinedby assumingthat all disbursementsand receipts were immediately credited/debitedto the Treasury's accounts at Federal Reserve banks. This treatmentallowed us to highlightthe impactof each of these operationson the level of bank reserves, but it did not paint a realistic picture of the way things currently work. If things did indeed work this way, there would be an unrelentingdisruption of banks' reserve positions and, subsequently,chronic turmoil in the funds market. Because these consequencesare highly undesirablefrom a policy perspective, some importantstrategieshave been developed to mitigatethese persistent, yet unpredictable,reserve effects. The Use of Tax and Loan Accounts The disruptivenatureof the Treasury'soperationswas recognized under the Independent Treasury System7 and ultimately led to the use of General and Special Depositories,8 which are private banks in which governmentfunds could be kept. This was the first importantstrategy developed to mitigate the reserve effect. As John Ranlett recognized, the reserve effect caused by the "pointinflow-continuous outflow natureof Treasuryactivities"could be temperedby placing certain government receipts into tax and loan accounts at private depositories [1977, 226]. Thus, the reserve drain that would otherwise accompanypayments made to the government could be temporarilyprevented.9The benefits of using these depositorieswere quickly recognized, and their functions were broadenedwhen it became clear that they could be used to furthermitigate the reserve effect. As the size of the government's fiscal operationsgrew, Special Depositoriesquickly became the most important group of bank depositories [Auerbach 1963]. As Figure 3 shows, just over two-thirds of all Federal tax receipts are currentlydeposited directly into tax and loan accounts. Today, the tax and loan accounts are by far the most importantdevices used to guard the money market against the sizable daily differences (shown in Figure 2) between the flows of governmentreceipts and disbursements.

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Figure 3. Disposition of Federal Tax Deposits (November 1997-March 1998)

Other 2%

FederalReserve Account(Direct) 13% RemittanceOption Depositaries 18%

Taxand LoanNote Accounts 67%

Source:DailyTreasuryStatement,http://fedbbs.access.gop.gov/dailys.htm

Managing the Treasury'sBalance at the Fed Since almost all governmentspendinginvolves writing checks on accountsat the Fed, virtually all funds in tax and loan accounts must eventually be transferredto Reserve banks.10 Because only net changes in the Treasury'saccountat the Fed impact the aggregate level of reserves (ceteris paribus), maintaining"the Treasurer's balance with the Reserve Banks at a reasonablyconstantlevel" is the second strategy used to minimize the reserve effect of the Treasury's operations [Auerbach 1963, 364]. Specifically, the Treasury "aimsto maintaina closing balance of $5 billion in its Federal Reserve checking accounts each day" [Manypennyet al. 1992, 728]. The trend line fitted to the data in Figure 4 shows how successful the Treasury is in its endeavor to maintainthis target closing balance. With the exception of mid-January,one of the major (quarterly)tax dates, and mid-Novemberand midMarch, when a variety of taxes are withheld from businesses, the closing balance fluctuatesonly moderatelyaroundthe $5 billion targetlevel. Recall that the government receives funds into its accounts at the 12 Reserve banks as well as thousandsof commercialbanks each day, but that nearly all government spending is done by writing checks on accounts at Reserve banks. Maintaining a closing balance of $5 billion at Reserve banks, then, usually requires transferringthe appropriateamountfrom tax and loan accountsto the Treasury'saccount at the Fed. For example, if the Treasury expected to receive $5 billion directly into accounts at Reserve banks (today) and expected $6 billion in previously issued checks to be presented for payment (today), $1 billion would need to be

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Figure 4. Daily Closing Balance in Treasury's Account at the Federal Reserve (November 1997-March 1998)

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transferredto the Treasury's account at the Fed (today) so that there would be no net change in the level of reserves. The Treasury transfersfunds to cover anticipatedshortfallsby making a "call" tax and loan accounts. In most cases, advancenotice is given before transferring on funds from these accounts.11A "reverse-call"or "directinvestment"is also possible. This would be necessary if the Treasuqr'sclosing balanceat Reserve banks was expected to substantiallyexceed $5 billion. To avoid the reserve drain that would result from an excessive closing balance, the Treasurymay place some or all of the excessive funds into tax and loan accounts at Special Depositories (a.k.a. note-option banks). Whether"calling"fundsfom tax and loan accountsto make up for an expected shortfall or transferringfunds to tax and loan accounts throughdirect investment (or canceling previous calls) to prevent an excessive closing balance, the amounts transferredare intended to maintain the Treasury's balance at Reserve banks as steady as possible. In pursuitof this goal, the Treasuryrelies on the cooperationof the Federal Reserve. Coordinationwith the Federal Reserve The Federal Reserve is extremely interestedin helping the Treasuryachieve its targetclosing balance, because the Treasury'sbalanceat the Fed "is the reserve factor that shows the most variationfrom one reserve maintenanceperiod to another" [Meulendyke 1998, 156]. Indeed, the Fed's ability to successfully conductmonetary policy (specifically, to hit its target funds rate) depends, to a large extent, on the

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Treasury's ability to hit its target closing balance. Daily contact between the Treasury and the Fed provide the Treasurywith "numerousoccasions . . . to assist the Reserve authoritiesto achieve a desired objective"[Auerbach1963, 328]. Unfortunately,the Treasuryis unable, even with the cooperationof the Federal Reserve, to completely offset the effects of its daily spending using tax and loan calls and direct investment. Indeed, as Table 1 shows, the Treasury's average monthlyclosing balance can differ substantiallyfrom its $5 billion target. This, again, is the result of the inherentuncertaintyregardingthe size/timing of receipts and expenditures.While it is easy to see how this uncertaintywould prevent daily inflows and outflows from offsetting one another,Table 1 shows that even on an average monthly basis, the Treasury's balance can close as much as 31 percent above its target level. Thus, as Figure 5 confirms, one expects a non-zerochange in the Treasury's daily closing balance. Despite this, changes in the daily closing balance do tend to fluctuate fairly closely aroundzero, deviating most drasticallywith Table 1. (Give this a short, descriptive title) AverageClosing Balance($ Millions)

Month November 1997 December 1997 January1998 February1998 March 1998 Five-MonthAverage

5,015 5,371 6,563 5,118 5,763 5,618

Source:DailyTreasuryStatement,http://fedbbs.access.gop.gov/dailys.htm

Figure 5. Change in Daily Closing Balance (November 1997-March 1998) 10,000 8,000 6,000

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Do Taxes and Bonds Finance GovernmentSpending?

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quarterlytax payments (January,April, June, and September)and with the collection of withheldbusiness taxes. In sum, three importantpoints have been made regardingthe Treasury's operations. First, the Treasuryrecognizedthe disruptivenatureof its cash operationsand responded by maintainingaccounts at private depositories. Second, the Treasury uses these accounts to diminishthe reserve effect of its operationsby using tax and loan calls and direct investmentsto minimize the net changes in Reserve account balances (to coordinate the flow of its receipts with its expenditures).Finally, the Treasury and the Fed cooperate to bring about a fairly high degree of harmonyin managingthe Treasury'sbalancesat Reserve banks.

Bondsto Coordinate the Treasury'sOperations SeUling So far we have addressedonly the Treasury'sattemptsto balance its taxing and spending flows in order to minimize the reserve effect of its operations.Implicit in our discussion, therefore,was the notion thatthe governmentattemptsto balance its budget. What if it doesn't? That is, what if the governmentruns a budget deficit? How does the sale of bonds affect the Treasury's cash flow operations and, subsequently, the reserve effect? There are three scenariosthat must be analyzed in order to determine the reserve effect of selling bonds, the key being by whom and how are they purchased. First, it must be recognized that tax and loan accountsactually receive not only proceeds from tax payments, but also funds from the sale of government debt. When commercial banks with tax and loan accounts (or customers of these banks) purchasegovernmentbonds, there may be no immediateloss of reserves to the purchasing bank or the banking system. If, when the Treasuryauctions new debt, it specifies that at least some portionof the bonds are eligible for purchaseby credit to tax and loan accounts, Special Depositoriesmay acquirethe bonds by crediting deposits (in the name of the U.S. Treasury). These depositories, therefore, will not lose reserves as they purchase newly issued bonds.F4Similarly, the purchase of newly issued governmentdebt by a customerof a Special Depository, as long as the Treasury specifies that some (or all) of the offering is eligible for purchaseby tax and loan credit, will leave reserves unaffected.For example, when a customer of a Special Depository purchases government securities, the Treasury redeposits the check into the bankon which the check was drawn. The bankthen credits the Treasury's tax and loan account, offsetting the debit to the buyer's account. Thus, like the purchase of governmentdebt by a Special Depository, the sale of governmentdebt to a customer of one of these institutionscan be effected without any loss of reserves. The second method concerns the private purchaseof newly issued government debt that does not involve creditinga tax and loan account. When the securities are

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ineligible for purchaseby tax and loan accountcredit and/or are not purchasedby a so-called "note-option"bank (or one of its customers), the purchaseof government bonds will immediatelydrain reserves from both the bank and the banking system. This is because the proceeds from the sale of the securitieswill not stay "in the system," but will be deposited directly into one of the Treasury'saccountsat a Federal Reserve bank. When bonds are sold in this way, memberbank reserves decline as the Federal Reserve credits the Treasury's account, increasing the right-hand bracketin Figure 1. Thus, a bank wishing to purchaseU.S. governmentsecurities, when tax and loan credit is not an option, will do so by drawing on its account at the Federal Reserve. A system-wide loss of reserves will, therefore, accompany every private purchase of newly issued government debt not eligible for payment throughtax and loan credit. Finally, the sale of Treasury securities to the Federal Reserve must be considered. If the Fed purchasesnewly issued bonds directly from the Treasury,it will not cause a change in memberbank reserves. This, as Figure 1 makes clear, is because both the right-hand bracket (U.S. Treasury Balance at Fed ) and the left-hand bracket (U.S. GovernmentSecurities ) increase by the same amount, leaving total reserves unaffected. Furthermore,since the government'sbalance sheet can be considered on a consolidatedbasis, given by the sum of the Treasury'sand Federal Reserve's balance sheets with offsetting assets and liabilities simply canceling one anotherout [Tobin 1998], the sale of bonds by the Treasuryto the Fed is simply an internal accounting operation, which provides the government with a self-constructedspendablebalance. Although self-imposedinstitutionalconstraintsmay prevent the Treasuryfrom creatingall of its deposits in this way, there is no financial constraintto prevent it from doing so. 15 Now, the Treasuryclearly has choices regardingthe mannerin which newly issued bonds will be sold. For example, if the governmentplans to engage in deficit spending, the Treasury can sell bonds, allow them to be purchasedby tax and loan credit, and thereby eliminate any immediateimpact on reserves.16 When the Treasury sells bonds in this way, the bonds act as a sort of ex ante coordinationtool. Since the Treasurycan control the size and timing of funds transferredfrom tax and loan accounts, this type of bond sale helps the Treasuryto drain (more or less) the same numberof reserves from the system that are being addedto the system as a result of its deficit spending.17 If, however, there is a problemwith the coordination(for example, if the Treasury and Fed underestimatethe amount of checks that are drawn on the Treasury's accountat the Fed), bonds could be sold in orderto drainexcess reserves.18In other words, insufficient tax and loan calls (which result in a system-wide increase in reserves and threatento send the overnight lending rate to a zero percent bid) could prompt the sale of bonds as an ex post coordinationtool. In order to immediately

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drain the excess reserves, banks could not be allowed to purchase the bonds by creditinga tax and loan account, but this is somethingthe Treasurycan specify. The Nuances of ReserveAccounting The purpose of this section is twofold. First, the commonly held belief that the purpose of collecting taxes and selling bonds is to provide the governmentwith the financialresources that fund its expenditureswill be examined. The questionwill be addressed intuitively,drawingon the reserve effects analyzed in the first three sections of the paper. Second, for those who remainunconvincedby the intuitiveanalysis, the question as to whether the proceeds from taxes and bond sales are even capable of financing government spending will be considered. The argument requires an application of basic accounting principles to an analysis of reserve accounting in order to determine whether it is possible to use the revenues from taxationand the sale of bonds to finance the government'sspending. There is surely no doubt that the proceeds from taxationand bond sales are deposited into accountsheld by the U.S. Treasury(eitherwith commercialbanks or at the Federal Reserve) and that the governmentspendsby writing checks on Treasury accounts at Reserve banks. Moreover, since funds are transferredfrom tax and loan accounts to the Treasury'saccountat the Fed in order to cover anticipatedshortfalls in these accounts, it certainly looks as though the purpose of taxing and selling bonds is to fund expenditures.This coordinationundoubtedlysupportsthe belief that taxes and bond sales are necessary sources of governmentrevenue. But the coordination of taxationand bond sales with (deficit) spendingis actuallya somewhat different operation. An intuitive analysis of Treasuryoperationssuggests a practical motivation for the coordinationof taxationand bond sales with governmentspending. Specifically, because of the reserve effects of taxing, spending, and selling bonds, the government chooses to coordinate these operations in order to mitigate the impact on banks' reserve positions and, hence, on short-terminterest rates. This interdependence, then, is not defacto evidence of a financingrole for taxes and bonds. Similarly, the governmentneed not borrow from the private sector by issuing bonds in order to enable it to spend in excess of currenttaxation.This, again, is because the governmentcan always create its own spendablebalance internally(on its consolidatedbalance sheet) by offsetting a Treasuryliability against a Federal Reserve asset (e.g., but not necessarily, a Treasurybond). In the absence of private bond sales, deficit spending would result in a net increase in aggregate bank reserves. Bonds, then, are used to coordinatedeficit spending, draining what would otherwise become excess reserves. Govermnent debt provides the private sector with an interest-earningalternativeto non-interest-bearinggovernmentcurrency, allowing the governmentto spend in excess of taxationwithout driving the overnight

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lending rate down. Thus, taxes can be viewed as a means of creatingand maintaining a demand for the government'smoney, while bonds, which are used to prevent deficit spending from flooding the system with excess reserves, are a tool that allows positive overnight lending rates to be maintained.Their coordination,it is argued here, is undertakenfor pragmaticratherthan "financial"reasons. There is a danger that this argumentmay be viewed as pure semantics. This is not so. That is, while it is certainlyappropriateto consider taxationand bond sales as part of the process of governmentfinance, the implicit treatmentof money, in its physical form, being transferredfrom the private to the public sector results in a misleading treatmentof taxes and bond sales as necessary sources of government revenue. In a world where money has been effectively divorced from commodities, and where public and private sectors can vary the amountof money to be spent, this naive way of thinkingcan be highly deceptive. That such a treatmentcould have gone uncontestedfor so long is, perhaps, surprising. Indeed, some readersmay resist acceptingthe claims made in this paper on the grounds that they would, were they correct, have been made long ago. But there have been a number of earlier critics who, although they did not undertakea detailed analysis of the institutionalworkings of governmentfinance, reached similar conclusions. Abba Lerner, for example, argued that "taxingis never to be undertaken merely because the governmentneeds to make money payments"[1943, 40]. He furtherrecognized that the governmentshould sell bonds "only if it is desirable that the public should have less money and more governmentbonds, for these are the effects of governmentborrowing,"adding that "thismight be desirableif otherwise the rate of interest would be reduced too low" [1943, 40]. Thus, the main points made in this paper were made long ago, but they did not succeed in overthrowingexisting theories regardingthe natureof governmentfinance. Perhaps this was because Lerner, who attemptedto persuadehis opponentson logical grounds alone, providedno evidence to supporthis claims. A more compelling case can be made, it is arguedhere, throughan applicationof simple accounting. The argument is a technical one and requires an understandingthat Federal Reserve notes (and reserves) are booked as liabilities on the Fed's balance sheet and that these liabilities are extinguished/dischargedwhen they are offered in paymentto the state. It must also be recognized that when currency or reserves returnto the state, the liabilities of the state are reduced,and high-poweredmoney is destroyed. The destructionof these promises is no differentfrom the private destructionof a promise once it has been fulfilled. In otherwords, when a bankmakes a loan to an individual, it results in a promise to the bank. Once the promise is kept (i.e., the loan is repaid), the loan debt is eliminatedfrom the borrower'sbalance sheet. Likewise, the state, once it fulfills its promise to accept its own money (high-powered money) at state pay-offices, eliminatesan equivalentnumberof these liabilities from its balance sheet.

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Thus, while bank money (MI) is destroyed when demanddeposits are used to pay taxes, the government'smoney, high-poweredmoney, is destroyedas the funds are placed into the Treasury's account at the Fed. Viewed this way, it can be convincingly arguedthat the moneycollected from taxationand bond sales cannotpossibly finance the government'sspending. This is because in order to get its hands on the proceeds from taxationand bond sales, the governmentmust destroy what it has collected. Clearly, governmentspending cannot be financed by money that is destroyed when received in paymentto the state. How, if not by using the money received in payment of taxes and bond sales, does the governmentfinance its spending?Notice that the governmentwrites checks on an account that does not comprise part of the money supply or high-powered money, but that when it does, the fundsbecome partof the money supply (Ml if deposited into checking accounts, M2 if into savings accounts, etc.) and part of the monetarybase. It is therefore apparentthat while the paymentof taxes destroys an equivalentamountof money (MI immediatelyand high-poweredmoney as the proceeds go into the Treasury'saccountat the Fed), spendingfrom this accountcreates an equivalent amount of new money-both bank money and high-poweredmoney. In short, the governmentfinances all of its spending throughthe direct creation of new (high-powered)money. Summaryand Conclusions If the government(Fed and Treasury)had no regard for the "reserveeffect" of its operations, it would have little use for tax and loan accounts. It could simply create its own spendable deposit (on its consolidated balance sheet) and then spend without regard for the size/timing of its tax receipts. But this behavior would frequently leave a bankingsystem which was previously satisfied with its reserve position, with substantiallymore excess reserves than it wished to maintain. A system flush with excess reserves would find few biddersfor these funds, and the overnight lending rate would fall towardzero. Taxes, as they driftedin, would draina portion of the excess reserves. Still, the funds rate could remainat a zero percent bid for a prolongedperiod of time. In order to move to any positive funds rate, either the Federal Reserve or the Treasurywould be forced to sell bonds to drainexcess reserves. Banks, not wishing to hold an excessive amount of non-interest-bearinggovernmentmoney, would be all too happy to exchange non-interest-earningreserves for interest-bearingTreasury bonds. The bonds would have to be sold until enough excess reserves had been drainedto yield a positive (target) funds rate. Although this process of adding and later drainingreserves could work, it would involve substantialvariationin the level of reserves and, subsequently,significant turmoil in the market for federal funds. Knowing that these are the undesirableeffects of disregardingthe reserve effects of

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its operations, the Treasury chooses to coordinateits operations, transferringfunds from tax and loan accounts (drainingreserves) as it spends from its account at the Fed. Taxes are not capable of financinggovernmentspendingwhen they are paid using high-powered money (i.e., by cash or check in a fiat money system). In order for the government to get its hands on the proceeds from taxation, it must place these funds into the Treasury's account at the Fed. As it does, the banking system loses an equivalent amount of desired and/or requiredreserves (either immediately or as the Treasury transfers the proceeds from tax and loan accounts into its accounts at Reserve banks), and an equivalentamount of high-poweredmoney is destroyed. Similarly, reserves are drained, and high-powered money is destroyed when the Treasuryissues bonds (immediatelyif tax and loan credit is not allowed or with a lag as the proceeds are transferredfrom tax and loan accounts). In contrast, government spending from the Treasury's account at the Fed injects reserves and creates an equivalent amount of new money (MI, M2, etc., and high-powered money). It is impossible to perfectly balance (in timing and amount)the government'sreceipts with its expenditures.The best the Treasuryand the Fed can do is to compare estimates of anticipatedchanges in the Treasury'saccountat the Fed and to transfer approximatelythe correct amountto/from tax and loan accounts. Errorsdue to excessive or insufficient tax and loan calls are the norm. Althoughsame-daycalls and direct investments are designed to permit the authoritiesto react to these errors, they are not always an option. When the Treasuryis unable to correct these errors on its own, the Federal Reserve may have to offset changes in the Treasury's closing balance. This will be necessary whenever the errors are large enough to move the funds rate away from its target rate. In fact, as argued previously, the uncertaintyfaced by monetary authoritiesis often primarilydue to uncertaintyregardingthe Treasury'sbalance at the Fed. Its role as an offsetting agency is essentially forced upon it by its commitment to a target funds rate. Indeed, William Poole [1975] goes further, stating that the Fed will usually abandon any other objective target in order to maintain the funds rate within its tolerance range. The adding/drainingof reserves, then, is largely non-discretionary,as monetarypolicy is concernedprimarilywith maintaining the overnight lending rate. Fiscal policy, in contrast,has more to do with determining the supply of high-poweredmoney than is usually acknowledged.Moreover, while both taxation and bond sales drain reserves from the banking system, neither provides the government with money with which to finance its spending. Indeed, both taxation and bond sales lead (ultimately) to the destructionof high-powered money. In addition to a reconsiderationof taxation and bond sales as financing operations, perhaps it is time to reassess the definitions of monetaryand fiscal policy.

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Fiscal policy has more, and monetarypolicy less, to do with the money supply than is usually recognized. An analysis of reserve accountingreveals that all government spending is financedby the direct creation of high-poweredmoney; bond sales and taxationare merely alternativemeans by which to drain reserves/destroyhigh-powered money. The debate over alternative "financing"methods, then, should really be a debate over the alternativemethodsfor drainingreserves (taxes vs. bond sales) in order to prevent the overnight lending rate from falling to zero. As Lerner argued, it is not so-called "sound"but "functional"finance that moderngovernments should practice, and this means using taxes and bonds "simplyas instruments,and not as magic charms that will cause mysterioushurt if they are manipulatedby the wrong people or withoutdue reverencefor tradition"[1943, 51]. Notes 1. Early debates [Modigliani 1961; Blinderand Solow 1973, 1976; Barro 1974; Buiter 1977; Lerner 1973; Tobin 1961] over the optimal method by which to finance deficit spending remain a controversial topic today [Trostel 1993; Ludvigson 1996; Smith and Villamil 1998]. Despite differing beliefs about the macroeconomicconsequences of, say, borrowing vs. "printingmoney," economists on both sides of these debatesclearly accept that the purpose of collecting taxes and selling bonds is to secure funds that are then respent by the government. In other words, it is generally agreed that the role of taxationand bond sales is to transfer financial resources from households and businesses (as if transferringactual dollar bills or coins) to the government, where they are respent (i.e., in some real sense "used"to finance government spending). This erroneous view follows from an implicit treatmentof money in its physical form and can be avoided by considering the balance sheet and reserve effects of taxationand bond sales. This, in short, is the purpose of this paper. 2. Although reserve requirementsare generally met by holding a combinationof vault cash and checking accountsat districtFederalReserve banks, accountsheld by depositoryinstitutions at Federal Home Loan Banks, the National Credit Union AdministrationCentral LiquidityFacility, or correspondentbanks may also count toward satisfyingthe reserve requirement. Depository institutionsdo not have to meet these reserve requirementson a daily basis. They have a two-week "reserveperiod"(endingon Wednesdays)within which they must maintainaverage daily total reserves equalto the requiredpercentage of average daily transactionsaccounts held during the two-week period ending the preceding Monday. Thus, despite being referredto as a contemporaneousreserve accounting(CRA) system, it is, in practice, lagged for two days. That is, banksalways have two days (Tuesday and Wednesday)within which to acquire (ex post) reserves needed to eliminate a known deficiency. While some banks may choose to hold excess reserves, profit-maximizing banks will economize on reserves. Unless a bank has a preference for idle funds, it will exchange excess reserves for "earningassets" such as loans or securities. 3. See Ranlett [1977, 191-1931for the derivation. 4. It is, of course, true that the Treasury keeps accounts at thousandsof commercial banks and other depository institutionsas well as Federal Reserve banks. This changes things considerablyand will be takenup in the next section. 5. It is worth noting that governmentspending must originally have preceded taxation. That is, the payment of taxes could not increase the Treasury's account at the Fed (Figure 1, right-handbracket), reducing bank reserves, until the reserves had been created. More-

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over, the Federal Reserve and/or Treasury, as the only agents capable of supplyingthem, must have been the original source of these reserves. This will be taken up in the section titled TheNuances of ReserveAccounting. When there is a reserve deficiency for the bankingsystem as a whole, banks could attempt to resolve the deficiency by reducingdeposits. If a single bank begins this process (selling U.S. securities to a member of the non-bankpublic or allowing loans to be repaidwithout reissuing them), it will result in a multiplecontractionof deposits (assumingall banks follow suit). Though this would ultimatelyeliminatethe banking system's reserve deficiency (without requiringbanks to acquire additionalreserves), the process takes time and will disruptinterest rates until "equilibrium"is restored. Deficiencies thereforewill usually be eliminatedas the bankingsystem acquiresmore reserves, not as it reduces depositsthat reserves are requiredto "backup." The IndependentTreasury System was in effect long before the establishmentof the Federal Reserve System. It was established in 1840, abolished the following year, re-established in 1846, and discontinuedin 1921. General Depositories have become known as "remittance-option banks,"while Special Depositories are currentlyreferredto as 'note-optionbanks."Both are depositoryinstitutions bank," like its predecessor, the Genwith tax and loan accounts, but a "remittance-option eral Depository, must remit its tax and loan accountbalancesto a Reserve bankthe day after the funds are received. In 1978, note-option banks were given the opportunityto accumulatethe daily tax paymentsthey receive by transferringthem from the ordinarytax and loan accounts (where they are held interest-freefor one day) into an interest-bearing "noteaccount." Up to a pre-approvedlimit, these funds can remainin "noteaccounts"until the Treasury "calls"for them to be transferredto Reserve Banks [Manypennyand Bermudez 1992, 728]. In this case, a distinctionbetween the "supplyof money" and high-poweredmoney (bank reserves and currency outstanding)should be made. When tax receipts are placed into a tax and loan account, high-poweredmoney is not affected. The narrowmoney (MI), however, is. When funds are transferredfrom demand deposits, where they are part of M1, into tax and loan accounts (or the Treasury's accountat the Fed), which is not part of any standardmeasureof the money supply (MI, M2, etc.), the "moneysupply"declines. This is not because the government needs the proceeds from taxation in order to spend again, but because it chooses to coordinateits taxing and spending. This will be taken up in the final section. Special Depositories (or note-optionbanks) fall into three categories: A banks, B banks and C banks. A and B banks are typically smaller institutions,while depositoriesthat are classified as C banks are generally large banks. Tax and loan calls are calculatedas fractions of the book balance in each tax and loan account on the previous day. "Calls"made on A and B banks are usually made with longer lead times than calls made on C banks, and the latter are usually the only banks against which same-dayor next-day calls may be issued. The closing balance in the Treasury's account at the Fed could exceed the target level for two reasons. First, previously placed tax and loan calls may have been too large. In this case, the amount of spending from accounts at Reserve banks is less than the sum of the paymentsreceived directly into accountsat the Fed and the amounts "called"from tax and loan accounts. Second, it is possible that the paymentsmade to the governmentand deposited directly into accounts at Reserve banks exceed the amount presented for payment from these accounts. This could happen, for example, during months in which quarterly tax payments sent directly to accounts at the Fed are large enough to more than compensate for governmentspending. The Treasurywill not, in all instances, be successful in its attemptto directly invest its excess funds. Some note-optionbanks will not meet the collateral requirementsand will be

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ineligible recipients of additionaltax and loan funds. Additionally,tax and loan accounts, like the Treasury's account at the Fed, may swell during unusually heavy quarterlytax payments. Because banks must pay intereston tax and loan accounts, they limit the size of the tax and loan balances they are willing to accept. When direct investmentis not an option, the Treasury can attemptto cancel previously scheduledcalls in an attemptto draw down its balance in Reserve banks. The reader might wonder whetheradditionalreserves are requiredas a result of the larger tax and loan balance. The answer is no. Since the establishmentof interest-bearingnote accounts in November 1978, Special Depositories have been free of reserve requirements againsttax and loan deposits. The Federal Reserve was, for a time, prohibitedfrom purchasingbonds directly from the Treasury. This changed during World War II, when the Fed was authorizedto purchase up to $5 billion of securities directly from the Treasury. Since then, the limit has been raised several times. Boulding [1966] notes that deficit spendingmost commonly involves this practice. Note that the government can deficit spend without taxing or selling bonds first, but if government spending is greater than taxation, the bankingsystem will be left with excess reserves. The Treasury, therefore, prefers to use bonds to coordinateits deficit spending, selling them to Special Depositories (and allowing tax and loan credit) before spending from its accounts at Reserve banks. The bonds, then, allow the governmentto defend (ex ante) the fed funds rate. Note that bonds would have to be sold even if the governmentran an annually balanced budget. This is because it is impossibleto eliminatethe "reserveeffects" of the Treasury's daily operations. Thus, swings in the Treasury's daily closing balance, which threatento move the funds rate away from its target, would induce the sale of bonds despite an annually balancedbudget.

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