Bogleheads

[tc101]

I realized in a conversation with a friend yesterday that neither of us understands how the government creates money. Later in the day I went to the YMCA to workout and started asking people there and nobody knew the answer.

So how does the government create money? As the economy and population expand more dollars have to be created. How is it done?
_________________
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The most important thing you should know about me is that I am not an expert.

[scuttlebuttrp]

The Fed says "Holy Guacamole! We need more cash!" and then the BEP prints it.
It's a fiat currency not backed by anything of value except our trust or gullibleness.
I think they determine they need more by looking at things like M1 and other strange numbers only economists comprehend.

[sewall]

There's currency (paper, coins) and there's money (a lot of which is not in currency). Obviously machines make currency.

The Fed makes money in a variety of ways which can seem very complicated if you look too closely. Abstracting from the messy details, the Fed makes money by increasing the reserve of funds banks have at the Fed in exchange for assets (used to be largely Treasuries but nowadays...).

What does this mean? A bank has a balance on the books at the Fed. That's a number. That imposes a limit on what the bank can "spend" (lend out). The Fed increases the number. That increases what the banks can spend. That's new money.

By the way, the Fed's website has lots of details, in jargon-free terms, on their operations. If you have time, take a look. You'll find other explanations and various levels of detail online (e.g., Wikipedia).
_________________
The Incidental Economist (blog) :::: Austin Frakt (flesh)

[jeffyscott]

I've always wondered about this...I knew the Fed could buy and sell, but where does the money come from for buying. I guess the Fed's answer is "money, we don't need no stinking money ".

One thing I read recently said something like: unlike us when the Fed buys securities in the open market, they do not have to write a check.

At: http://blogs.wsj.com/economics....-a-primer/ they put it this way:

[sewall]

[Otto]

There are two parts to it. There is monetary base and there is money supply. You can increase/decrease supply without affecting the base amount. That is the whole of "bank/Fed reserves". If you look at monetary base, which I haven't for awhile, it usually has always grown very slowly... usually just fast enough to keep up with productive capacity.

Edit: I should have looked.

[snowman9000]

Theoretically, if they run out of Treasuries to buy, they would buy corporate debts or stocks. Greenspan was worried about that possibility when surpluses were forecast in the 90s.

[dmcmahon]

To some extent, the treasury literally prints up bills. But then, it also destroys old worn-out bills, and of course some bills are lost in circulation.

The primary way is electronic - the fed can expand its balance sheet, putting on billions of dollars that are just as good (or bad, if you're a gold bug) as the printed kind.

The treasury can issue bonds/bills and borrow money from us citizens or from foreigners. This doesn't "create" money in the sense that you are asking about, it (in a way) soaks it up from existing holders.

The fed has proposed to buy treasuries to force interest rates down, using the electronically-created "money". Because money had to be created to do this, it's called "monetizing the debt" (the fed's been calling it "quantitative easing").

The way I think about the "money creation" (either printed bills or electronic) is that the government is issuing IOUs. Although gold bugs would say the "fiat currency" is backed by nothing, IMO this isn't really true. It's no different in principle from a paper "marker" you might accept from a friend after a poker game. Even if your friend doesn't have the money, you know that he has a good job and can eventually earn the money to pay you off. In the same way, these government IOUs are "backed" by the "earning power" of all of us citizens (who will ultimately pay off the IOUs through taxes).

P.S. the other part of the money creation story is fractional reserve banking. After the initial creation of money as described above, the fed puts it into the hands of banks (or us) and then additional money is created by the effect of lending it out while keeping only a fraction of the money on hand to cover withdrawals. The multiplier effect is 1/X where X is the reserve requirement. For example if banks are required to keep 10% on hand to cover withdrawals, the money supply can expand up to 10x the initial cash through lending (and the redepositing of the lent money).

Hope that's helpful.

[dumbmoney]

[tc101]

Thanks for the info and the links. I find this difficult to understand. I think if I applied myself and concentrated I could understand it, but right now I find that difficult. I wonder if I have some kind of mental block, or if it is just a difficult subject.
_________________
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The most important thing you should know about me is that I am not an expert.

[EmergDoc]

I toured the Bureau of Engraving and Printing last month in Fort Worth. I had previously seen the one in Washington D.C. That's where the cash comes from. They claim to only "replace" the cash that the fed banks take in, but they do have an allowance (about 5%) for the money that is presumably lost or destroyed. Most U.S. "Cash" is not in the U.S., BTW.

But cash is a very small percentage of money. Money is created all the time. When you put $1000 in the bank, the bank loans out the money to another guy. That guy has $1000, and you still have $1000. Voila, money was just created. It isn't just created by the government.
_________________
1) Invest you must 2) Time is your friend 3) Impulse is your enemy
4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course

[andyt]

It depends on what the OP is really asking.
The FED can increase / decrease the money supply through open market operations (buying/selling treasuries [notes/bills/bonds]).
When they want to increase the money supply, they buy back treasuries from banks, which acts like a deposit, and triggers the deposit multiplier.
The multiplier in theory says that the bank will keep the amount of cash required for reserves (10%) and loan out the rest.
Say it was a $1000.00 treasury that was purchased, the bank gets 1000, keeps 100 for reserves, loans out 900. That 900 ends up being deposited somewhere, they keep 90, loan out 810, etc etc.
Time has shown the multiplier to be far less than the theoretical maximum.
I cannot remember exactly but I want to say its something like 2.5.
So that $1000 treasury purchase increases the money supply buy $2500.

The money supply is not that same as money.
I was assuming the question was not about the process of making physical money.

[Oicuryy]

The Federal Reserve is a collection of twelve banks. They create money by increasing the balance in someone's account at one of those banks. That's it. It's just a bookkeeping entry.

But the Fed doesn't just give money away. It's a loan. They get an IOU in return. Normally they buy Treasury securities. Lately, though, they've been loaning money to all sorts of folks.

The Fed can uncreate money by collecting on the IOU or by selling it on the open market.

Ron
_________________
Money is fungible

[Otto]

[LH]

I have heard that when a person uses a credit card to puchase something, some money is created as well.....

I do not fully understand it trying to follow it:



Say X amount of dollars in world economy.

Assume consumer with zero money.

consumer buys something with 1000 dollars from credit card.

Store gets 1000 dollars from credit card company, but the credit card company had to pay them the 1000 dollars.

Consumer gets 1000 dollar debited, the credit card company gets 1000 dollar credited.



Soooo, where is the new money?

1)the store by selling the item, actually makes a profit. If the consumer with zero money, did not have credit available, no sale would be made, and no profit would be made. Either by the store, or its supplier, as one assumes when the item is bought from the store, the store orders another from its supplier, giving the supplier a profit.... etc. on down the line to the raw materials and workers who make the item. So this credit, appears to increase velocity of money?????? I do not know how this increases the money supply per se, except that profit is being made, and wages paid out and such..... But I do not know if that just comes down to robbing future consumption and future wages, for present consumption, present profit, and present wages. It seems likely, it has a net positive effect, because that worker who gets paid for making the extra widget, will then go out and buy something else.... So it seems to magnify, and have a positive effect, at least early on.

2)The credit card company, has an asset equal to the 1000K is lent out... So it may be able to borrow some money based on that asset, even though it got rid of the "real" 1000 dollars it sent to the store. Therefore it borrows more money based on the credit it has from the consumer with zero money at presnt, then lends more money out to other credit card users, therefore increasing money supply????

That is kinda my gestalt, which may be entirely wrong at any point, or just entirely wrong from the original assumption. Interesting topic.

[danwalk]

FED 101: The Federal Reserve Today is a wonderful educational site. Although geared towards the high school classroom, it is a great resource for easy to understand material about the Fed.

Have fun,
Dan
_________________

"Time is your friend; impulse is your enemy."—Jack Bogle

[CrankyCube]

End the FED.


sorry, had to.

[Otto]

[EDM]

[bobcat2]

Hi tc101,

There are many ways the Fed can create money, but the following is the main way the Fed creates money.

At the trading desk of the NY Fed they have been ordered by the Fed Chairman to create billions of dollars of more money today. The Fed trading desk buys $1 billion in outstanding US Treasury bills from say some wealthy individuals. These individuals will have their 'payments from the Fed' deposited in their bank accounts. These payments from the Fed are nothing more than electronic notations, but the banks accept them as money, and since the banks lend out on a fractional basis (of say 10 to 1), and the banks now have a billion more in deposits, they can now loan out about $10 billion more than they could yesterday.

Under normal conditions this would increase the money supply by several billion in the next few days, depending on just how much of the new deposits are fractionally loaned. This normal way of increasing the money supply doesn't work very well now, because the banks are afraid new loans won't be paid back.

Bob K
_________________
The real difficulty in changing any enterprise lies not in developing new ideas, but in escaping from the old ones. - JM Keynes
Good questions outrank easy answers. - PA Samuelson

[phejjeff]

[sewall]

[astroturf]

Perhaps more than you ever wanted to know about the subject:

http://www.econbrowser.com/arc....ation.html

[Ron]

And sometimes, you can just print your own:

http://www.mcall.com/news/loca....4853.story

- Ron

[tacitus7]

An excellent explanation of how the monetary supply is increased can be found in Dr. Rothbard's, What has Government done with our Money. It is a short and clear read. Here is the link to the on line book, and to the section relevant to the question of this conversation:

http://mises.org/money/3s9.asp

all the best,
Joe E.

[scuttlebuttrp]

[chaz]

It all started with Native Americans and their wampum.
_________________
Chaz
"It is better to travel well than to arrive." - Buddha
http://www.bogleheads.org/wiki/index.php/Main_Page

[k5]

I saw this months ago, and it was an intriguing explanations of (one person's) understanding on how money is created via debt.

video.google.c0m/videoplay?docid=-9050474362583451279 (sorry, haven't posted enough to be able to create links. Please replace the "0" with an "o")

The suggestions near the end are somewhat odd. Do you feel this is a pretty accurate portrayal of the money system? Or is it sensationalist conspiracy theory nonsense?

-J

[LH]

http://video.google.com/videop....2583451279

[drjdpowell]

[k5]

Thanks LH

[gchan]

[drjdpowell]

[snowman9000]

GE doesn't operate on fractional reserves, though. Well, maybe they do now!

[dumbmoney]

[theac]

I found this to be a fun and simple explanation to how money is created:

http://www.youtube.com/watch?v....re=related

It's part 2 of a good 5 part series. You can see the rest by starting with this one.

This is good:

http://www.youtube.com/watch?v....8&NR=1

[drjdpowell]

Here's a great (IMHO) description of both the creation of money and of the current actions of the Fed:
http://www.econbrowser.com/arc....rve_1.html
--James

[tacitus7]

One economist I respect, Dr. Murray Rothbard, wrote of quasi-money. Things like stocks and bonds can act like money, or lower the demand for money. But they do not increase the money supply per se. I could find the links if anybody is interested.

In regard o the issue raised by Drjdpowell, it seems to me when one purchases corporate bonds or any private debt it does not increase the money supply. If I give up the use of my money and receive a bond in return, then there has been no new money purchasing power created.

Same with demand deposits. If I put money in the bank, that means I am not spending it although others can. So there is no net increase in purchasing power, or increase in the money supply, and thus no inflation. Maybe I am missing something here though.

all the best,
Joe E.

[Otto]

[Dan Moroboshi]

Reading all of this makes me dizzier than reading that infamous "How is babby formed?" thread on Yahoo Answers.

Aw heck...

They need to do way to instain poeple> who kill the economy. because these citziens cant frigth back?

it was on the news this mroing a politicain in DC who had kill the Big Three. they are taking the Big Three back to detroit too lady to rest my pary are with the wrokers who lost thier jobs ; i am truley sorry for your lots

(Link to explanation, if you have no idea what I'm babbling about. Yes, it's inane.)

[drjdpowell]

"Money" is hard to even define, and being a part of macroeconomics, the theory of money supply and inflation isn't actually well-understood by anyone.
-- James

[dmcmahon]

That video is very misleading. A bank that has $1k on deposit at the fed can't just create $10k for a loan to someone. It can only loan out $900, leaving $100 at the fed. The $900 is then spent and ultimately deposited back into a bank. It might even be the same bank. Now the bank has $1k cash again, $900 loaned out, and $1900 deposited. It can now loan out another $810, which might go round again, and again, and again, until ultimately $11k is on deposit and $10k is loaned out, supported by just $1k in reserves. So the numbers are kinda right, but the mechanism they described is wrong, banks can't simply create money in someone's account. Anyone who doesn't want to loan out their money can simply hold it in cash and earn no interest. You want interest, you agree to have your money loaned out in this fractional reserve scheme.

The real question of the original poster isn't about the creation of this type of money (as debt), the real question is about the original $1k. This is also debt but of a different kind. In effect it's just an IOU from the government, meaning all of us. The government can create an arbitrary number of IOUs, just like someone short of cash at a poker game can write IOUs. The IOUs are accepted because it's the law, but also because people know that ultimately the issuer of the IOUs is "good for it" by virtue of future earnings (in the case of the government, its power to tax, meaning it can claim a portion of future goods and services). Of course people don't pay their taxes in goods and services, they pay them by giving the government back it's own IOUs and calling it even-steven.

[tacitus7]

[scuttlebuttrp]

Or perhaps instead of all of us arguing about what the OP meant with his question, the OP could come back and join this discussion?

[SkylightMT]

[ed1837]

[dmcmahon]

[evofxdwg]

[ed1837]

[SkylightMT]

Denninger (who most of the time is an, well, a**, but occasionally says something profound) wrote this about fractional reserve banking:

"Ok, on to the meat of this thing - fractional reserve banking in general. We've established that it's not fraud to lend money, take a deposit of the money you lend after its spent, and lend part of that again. But wouldn't we have a "safer" economy if there was no fractional reserve banking?

Maybe. But would you want that system?

Let's go back to TimmyLand, the land with no banks, and set one up.

We're going to need a building; let's assume we can lease 3,000 square feet (a small bank) for $20/ft all-in (its not Class-A space, but it's reasonably decent.) That's $60,000 a year in leases.

We need three tellers, one branch manager and one loan officer. Figure $40,000 (all-in cost, including taxes, health insurance, etc) for the tellers, $60,000 for the branch manager and loan officer (heh, we're cheapskates!); that's $250,000 a year in labor.

We need computer gear to keep track of our books, and we need a long-term lease on a vault, since we're not open 24x7, utilities, and other sundries. Call that another $40,000 a year all-in.

We've got a gross operating cost of $350,000 a year.

Now let's assume we capitalize this bank with $5 million dollars of our hard-earned money (heh, I've got some cash, I'm gonna open a bank!)

What's a reasonable "return on investment" for those funds?

I would argue that 10% is reasonable. After all, if I invest in this business I could lose everything. I can get 5% tax-free in Munis, which on $5 million is somewhere around 8% or so taxable. Add a small premium for working 14 hour days (as opposed to the munis that leave me sipping Mai Tais by the pool all day) and 10% is actually quite low.

But this means I need to make $500,000 pretax, and I start with a deficit of $350,000 in operating expenses; ergo, I need to be able to gross $850,000 annually for this business venture to make sense.

Now let's assume I cannot fractionally reserve. That is, I can't loan out deposited funds (I must reserve them all), only those funds that I have as paid-in capital.

So I can loan out, at best, my $5 million dollars. Once.

I thus must make on that $5 million dollars $850,000 in interest charges to make this enterprise worthwhile.

That means that on average I must charge 17% interest, and this assumes that I never make a bad loan! If there's a bad loan here and there in the mix then the average interest rate must of course be high enough to cover that too. In all probability I need to charge an average rate of around 20%, net-on-net.

This means your mortgage rate is about 15%, car loans are 20% interest, credit cards are 30% (and not only when you don't pay either), and on and on and on.

That sucks, to be blunt. With those sorts of interest rates nobody's going to be borrowing anything, because they simply can't afford to.

But what if I can fractionally reserve?

Then it gets much better.

Let's take the $5 million and run it "to extinction" on a 10% fractional reserve system. In this case I can have around $50 million in loans outstanding at the maximum, but note that I still only need to make the same $850,000, because my capital at-risk is $5 million, not $50 million.

Now my average "net interest margin" must only be 1.7% to make a reasonable amount of money after charge-offs and similar events.

Heh, that's not so bad!

Now I can pay interest on deposits such as savings accounts and CDs, I can offer 6% home mortgages and 7 or 8% car loans. I can offer 10% credit cards. If I pay 2% in interest for the deposits that people place with me, my net interest margin on that mortgage is 4% - well into the safe zone - and this means that I can have a few loans go bad without going bust. I can thus take a bit more risk and do loans with 20% down instead of 30%, and perhaps not force you to prove six or 12 months of segregated cash reserves - just in case you lose your job.

In fact, if you think about this you'll quickly realize that banking in a fractional reserve system is a nicely profitable business - without doing anything dangerous at all.

Without using unreasonable leverage, without gaming the system, without any sort of nonsense I can make a very nice chunk of money.

But you know there is never a free lunch, right?

There is a cost to fractional reserve banking, and it comes from the law of exponents.

See, nobody will loan you money at less than the expected growth rate in the economy. They'd be nuts to; the law of basic business balance says that you can't get something for nothing. Remember, the banker has to pay his operating costs, and that money must come from you, the borrower.

So let's assume that the average economic growth is 3% annually. Let's further assume that the average loan is made at 6% annually.

Well, now we've got a problem; over 30 years $100 in "base economic output" turns into $243.

But over that same 30 years $100 in "interest expense" turns into $574!

It doesn't start out all that different. After five years its $116 for growth and $134 for interest. That's a difference of 16%. But over 30 years its nearly a double.

What this means is that over time the net percentage of output required to cover debt increases, all things being equal.

This is the mathematical principle of exponents, otherwise known as "compounding" in the investing and banking world.

Not all loans are productive. Some are made to do things like buy a machine that makes car parts, and as such the output gain from the machine grossly exceeds the interest cost. That productive investment, financed with debt, doesn't get the person who takes it out in trouble, because his personal growth in productivity exceeds the interest cost.

But some loans are made to finance consumption; the person who borrows to buy a bigscreen TV or a vacation as just two examples. There is no particular productivity increase in such a purchase.

As the "spread" between production and net interest expense rises, the economy falters. A higher and higher percentage of the loans ultimately cannot be paid back, even productive loans, because the net interest expense over time exceeds the productive gain of the person who takes them out. The presence of this ever-widening spread, which is inherently part and parcel of fractional reserve banking, means that recessions are necessary and more importantly, some people who have taken out loans and some people who made loans must, during those recessions, go bankrupt.

That is the purpose of a recession - to clear out the excess indebtedness along with excess capacity, resetting downward the "spread" between net interest expense and gross output (GDP).

This is mathematically necessary for any monetary system to remain stable in which fractional reserve lending is used. Should government attempt to prevent (or shorten) recessions by manipulating liquidity (that is, "make it better Joe!" when times get tough), or worse, try to "spend its way out" of a recession, preventing the imprudent or simply unlucky from going broke all that happens is that the system becomes more and more "backloaded" with excessive debt carrying costs that have not been cleared.

Eventually these costs overwhelm the ability of government - or anyone else - to paper them over and you get the sort of collapse we are seeing now.

The math always wins, and the more you stretch the rubber band the worse the snapback hurts.

Does this mean that we should get rid of fractional reserve banking?

Not necessarily.

There is nothing particularly wrong with it; it comes with both costs and benefits. Certainly, the ability of a farmer to borrow at 5% to plant his field, instead of at 20% (which he could not afford, and thus he would not plant all of his acreage) is tremendously to the weal and wealth of society. Certainly, the manufacturer who buys a machine with debt that produces toasters contributes to the benefit of society. And we, of course, like being able to buy houses and cars at reasonable interest rates.

But we must recognize that just as fractional reserve banking contributes to booms, it brings the necessity of busts.

Proper regulation of leverage and prudential standards for lending prevent those booms from getting out of control, and thus limit the ugliness of the busts - but make them inevitable at an earlier date.

That is, the benefit of reserve banking (the availability of credit on reasonable terms for a wide variety of purposes) comes with the cost that those who use credit to finance consumption ("pulling forward demand") or engage in speculation are likely to go broke during the inevitable busts; they are those who are in effect gambling with their use of credit and when the cyclicality catches up with them, they (and those who loaned to them) will be the ones who go under.

Our failure over the last 20 years is not found in the principle of reserve banking. It is, rather, found in the complete and utter refusal to accept the cyclicality that is a necessary component of reserve banking systems - to accept the costs that come with the benefits.

Instead of accepting these facts we have gamed the system in an attempt to prevent the inevitable costs from coming to fruition with actions such as:

Gramm-Leach-Bliley, which repealed Glass-Steagall, allowing banking leverage to cross into investment services, where it should have remained tightly regulated.
Sweep account exemptions put into effect for banks that made reserve requirements nearly meaningless, allowing more leverage expansion than was lawful under a proper reserve implementation.
Removal of leverage limits from investment banks.
Refusal to regulate both sellers and buyers of leveraged derivatives, such as the CDS that AIG sold, then providing "back door bailouts" to the counterparties for the demonstrably-unsound paper they wrote.
Granting of "23A Exemptions", which circumvented limits on related-party capital tie-ups by banking entities.
The recent authority granted to The Fed to set reserve requirements on banks anywhere, including to zero.
The continued levering up of The Fed's and Government's balance sheets, essentially without limit, in an attempt to prevent the unwinding of the excesses of the previous 20 years (since mid 2007)
All of these actions and more are simply attempts to forestall what mathematics tells us is an inevitable process, and one that gets far worse the longer we delay it.

Our problems today are no different than they were in 1929 or 1873. We have once again refused to accept the mathematical inevitability that comes with the system of finance and banking we (and the rest of the world) have chosen for hundreds of years, and instead of enforcing prudent regulation up and down the line, including in our government itself, we have once again tried to game the outcome.

Unfortunately you can't game mathematics - no matter what you decree, 2 + 2 will always equal 4."

http://market-ticker.denninger....03/13.html