A great educational article from the desk of Keith Weiner. Find it in full HERE.
“To help clarify our point, let’s go through the mechanics of this. Step one, a commercial bank borrows $1 million. Step two, the bank buys a bond. That is, it gives up $1 million in cash, and gets a $1 million bond in exchange. Step three, the Fed borrows $1 million. Step four, it buys the bond. That is, it gives up $1 million in cash to the commercial bank, and gets the $1 million bond in exchange.
“The act of borrowing and the act of buying are combined in one step with the Fed. It’s simple but it’s so hard to see, because people think of the dollar as money. However, the dollar is actually the Fed’s liability. When a bank sells a bond to the Fed, it prefers the Fed’s liability to the bond. If the bond is a Treasury bond, then why would the bank prefer the Fed’s credit to the Treasury’s credit?
“There is not so much difference between the two. Both are government credit. The Treasury pays interest (barely) and has a maturity that is a date in the future. By law, the Fed’s credit is a current asset, that is, zero maturity. And it may be used to pay all debts.
“To sell a bond is to exchange one credit paper for another.”