So much of this is ripe for misunderstanding though, it's forgivable.
I glossed over a lot of points in the last post with an asterix promising I'd get back to the details. In this post, I'll gradually expand from the elegant principle to gradually include more details of our rube goldberg-esque implementation.
Here's that design principle again. The government, which is to say the public, as issuer, spends money into existence. It may also tax it out of existence if and when required to tame inflation or slow irrational growth. The government is not a business, it is not a separate entity; it represents us, the public, and the nation's shared interest.
It will be obvious during our study of the details that there are many places where things could be improved or simplified, either slightly or drastically, but remember that what we've got works, and will continue to work, and we've got ample time to carefully design improvements in parallel with continuing current operations.
In every fiat currency-issuing nation in the world right now that I'm aware of, the government has the sole right to issue the public currency but in practice has outsourced the operation to a central bank. Central banks are private entities in some respects, but in the end remember that they are under government oversight; they work for us. In the US, our central bank is called the Federal Reserve. The fed dates back to 1913, the days of the gold standard, and its creation was made possible in part by a public and government tired of panics and banking runs. A chain of regional "reserve" banks owned in turn by large private banks was set up and congress outsourced to the fed its power to issue currency (actually, money in the US had already been a mix of private bank notes and government-issued notes up to this point). Under this system and all others like it, the government finances itself by selling interest-bearing bonds to the central bank in exchange for its own currency. In practice the only way to get the money to pay off the bonds, with interest, is to sell more bonds to the central bank. This is the national debt, that's why it grows constantly, and what it actually represents is the difference between the amount of currency that's been put into circulation and the amount that's been taken back out.
Sound convoluted enough? As it turns out, even that is a simplification. Roger Erickson puts it this way:
...congress outsourced to the quasi-private FED the responsibility for monitoring and managing an equitable supply of currency nationwide...
Under this system and all others like it, public governance accounts for public finances by creating currency & injecting it into a double-entry accounting system as a one-sided entry, and inventing ways to drain the inevitable "bank reserves" created as a consequence of double-entry bookkeeping - the Holy Grail of banking methodology. Such bank-reserve drains typically take the arbitrary form of pretending to "sell" Treasury Security bonds to the Central Bank to mitigate the consequence of injecting single entries into a double-entry system. As an arbitrary method of paying the salaries of the private CB staff doing the actual bookkeeping, an extra surcharge is added to the Treasury Securities, making the bonds, in effect, interest-bearing. The size of that surcharge has sometimes been fixed by Congress, and sometimes allowed to float at auctions where the FED would re-sell the bonds to it's private bank members instead of simply holding them in house. These comical arrangements led to instances where the surcharge earned by the FED grossly outraced public decency of their salaries, triggering the bizarre "solution" where net "profit" earned by the FED yearly is "returned" to the US Treasury currency issuer - untouched & unused by the public! To streamline this comical scenario, couldn't the CB accountants - who were once required but are themselves now replaced by spreadsheets - simply be salaried employees in a department of the Treasury Agency, and couldn't the pretend "bonds" required to satisfy double-entry accounting methods simply bear zero-interest? Bingo!
Why wasn't that simple scenario pursued from the start? Habit, lack of imagination, and of course the interest of an active banking lobby accustomed to higher-than public service salaries. By current, bizarre practice standards, the only way to acquire the currency surcharge to pay off the invented public bonds, with interest, is to sell extra public bonds to the central bank. This entirely explains the so-called national debt, and why that dimensionless number grows constantly. It is a semantic oddity arising entirely from archaic design. In short, a system bug. Debt is actually a completely incorrect name for it. What that number actually represents is the accumulating difference between the amount of currency that's been put into circulation and the amount that's been taken back out. It's not 'owed' to anyone, it's just the accumulating record of currency supply growth required by a population growing in both size and per capita transaction rate.
Astute readers could come up with endless, more elegant, methods for handling public accounting for public currency supplies, but that's a topic for others to explore.
See why I started with the simpler version?
There is massive confusion over the role of foreign buyers of treasury bonds, particularly China, in all this. China owns a lot of bonds, so people get the false impression that our government has borrowed from them. What actually happened is that China sold us an enormous amount of goods, representing incalculable inputs of real resources and human labor. We paid them in dollars, which is a pretty sweet deal for us in many ways. We sent them virtual numbers, they sent us real things. After years of trade imbalance, China had a lot of dollars accumulated, which can only be used to buy things that are denominated in dollars. Actually, a lot of things are sold in dollars the world over, like oil, but they have more dollars than they need to buy all those things for now. They could buy anything they wanted from the US at market value, but what can they buy from us they can't produce domestically for lower cost? Not much, at least in the context of how many dollars we're talking about. So they choose to park their dollars in treasury bonds for now as a hedge against inflation. They bought our treasury bonds using dollars we already sent them for real goods they worked hard to produce. When those bonds mature, they can always choose to have their dollars back and we still won't have sent them anything of real value. When viewed this way, all the fears over "borrowing from China" are ridiculous. They don't have the authority to issue our currency, only we do. There's no debt, we already paid them for their goods and services, which is where they got the dollars they used to buy the bonds in the first place. What we should be more worried about is that they'll cash out for dollars and buy artificially undervalued real assets in the US while our economy is in the toilet. That sounds weird given that we're still going through the bursting of bubbles in things like real estate where prices were artifically overvalued, but if the deficit-slashing continues, deflation sets in, and a depression takes hold, it's a possibility.
Remember above when I said that the treasury sells bonds to the fed (central bank) in exchange for dollars? That's how it worked until the Banking Act of 1935 prohibited the treasury from selling bonds to the fed directly, and required them to sell them to an "open market" which in practice means a bunch of big banks. The banks in turn sell the bonds to the fed. Why on earth bother? I wasn't there, so I can only assume a mix of greed on the part of some and well-intentioned cluelessness on the part of others. There are 20 "primary dealer" banks which are authorized to sell treasuries to the fed directly. They provide no particularly valuable service, and basically get exclusive right to be profit-skimming middlemen.
Another topic surrounded by confusion is fractional reserve banking. At different times in history under different monetary systems, bank reserves meant different things.
In the beginning, goldsmiths charged for a service where they'd lock up your gold in their safe and give you a paper receipt for it, becoming some of the first entities we'd recognize as banks. It became popular for people to do business using only the pieces of paper and people came to redeem the paper for metal infrequently, which gave the enterprising bankers the idea to start loaning out either the gold itself or eventually just the paper notes with interest. As long as they kept enough in the vault to satisfy the occasional customer who wanted to redeem his paper, they could go on using other depositors' collective wealth to become fantastically rich. When they miscalculated and then word got out that paper couldn't be redeemed, there would be a run on the bank, which probably rarely ended well back in those early days. Importantly, this questionable practice caused the amount of usable money in circulation to rise dramatically because they'd started with x amount of gold and effectively created new money equivalent to it in the minds of the people, out of nothing. It made these banks very willing to make loans since if a debtor couldn't pay the bank merely lost potential income, not an irreplaceable asset. This turned out to be so useful for funding real productive enterprise the likes of which stagnant, medieval Europe had never seen (like expeditions to bring back cloth and spices) that it was accepted and regulated. The origin of reserve requirements were royal decrees that banks must at all times hold at least some minimum fraction of the value of their outstanding paper as gold in the vault to lessen the risk of panics and runs. These very important discoveries about the circulation of currency and the availability of credit, made accidentally during an effort by shady goldsmiths to make easy money, foretold the next technological advance of non-convertible currency backed by a government, if you think about it.
In our current system, which is not based on gold but on the good faith of the US as a nation, "bank reserves" are issued only by the federal reserve, and simply record currency transactions that banks have reported. Bank reserves are created by bank loans, and drained by other bank deposits, are in effect only changed in net volume by those bank reserve notations affected by mismatches in public issuance of dollars and issuance of treasury bonds. Adding further to the special advantages of primary dealer banks, they are allowed access to what's called the "discount window", which is a basically unlimited line of credit where they may borrow dollars from the fed directly and at exclusively low interest rates. Smaller banks can't just grab virtually free money when they need it and so have to borrow from big ones and still worry about reserves. You can see how every step of the way these primary dealers get to sit back and rake in the arbitrage. Warren Mosler and others have argued that reserve requirements in the US could be dropped if all banks had equal access to that low-interest discount window, which is perfectly plausible since Canada eliminated their reserve requirements entirely. In our modern system where everything happens electronically, bank reserves are obsolete.
A final note on bonds: the interest rate the treasury sets on them serves as an indicator for banks to decide what interest rates they should set on loans, which doesn't seem like that important a function to me. I'll expand on this later.
There's not as much point in diving further into details, because there are tons of people who know much more about banking and finance than I do and they've written volumes on the subject. A from-scratch introduction preparing a reader for further materials and discussion was missing in my opinion, so that's all I'm going to attempt. If you want to keep going, check out the mandatory reading section at Warren's site:
http://moslereconomics.com/mandatory-readings/
Also, just search for MMT modern monetary theory and you'll find a wealth of blog posts, news articles and comments related to the subject. Here are some highly-referred links to get started with.
http://moslereconomics.com
http://rodgermmitchell.wordpress.com/
http://bilbo.economicoutlook.net/blog/
http://neweconomicperspectives.blogspot.com/
http://mikenormaneconomics.blogspot.com/
http://www.levyinstitute.org/publications/
http://pragcap.com/
http://www.columbia.edu/dlc/wp/econ/vickrey.html
http://johnsville.blogspot.com/2011/06/modern-monetary-theory-mmt-in-nutshell.html
http://tinyurl.com/y3dkda3
http://www.cfeps.org/ss2008/ss08r/fulwiller/Fullwiler%20Modern%20CB%20Operations.pdf
I can't stress enough that what we've got works and will keep working so long as we understand at least the fundamental concepts behind it and use that knowledge to avoid unwittingly doing anything outright stupid to ourselves. In the last and final installment, I'll move back to the familiar theme of saying what the eventual replacement would look like if I were asked to design it. Consider parts 1-3 as laying the foundation and stating my terms.
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