Crash Course Chapter 8: The Fed - Money Creation

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Now we’re going to discover where money is created. The process works like this.

Suppose Congress needs more money than it has. I know, that’s a stretch! Perhaps it has done something really historically foolish, like cutting taxes while conducting two wars at the same time. Now, Congress doesn’t actually have any money, so the request for additional spending gets passed over to the Treasury Department.

You may be surprised, or dismayed, or perhaps neither, to learn that the Treasury Department lives hand-to-mouth and rarely has more than a couple of weeks’ of cash on hand, if that.

So the Treasury Department, in order to raise cash, will print up a stack of Treasury bonds, which are the means by which the US government borrows money. A bond has a ‘face value,’ which is the amount it will be sold for, and it has a stated rate of interest that it will pay the holder. So if you bought a bond with $100 face value and that paid a rate of interest of 5%, then you’d pay $100 for this bond and get $105 back in a year.

Treasury bonds are sold in regularly scheduled auctions, and it is safe to say that the majority of these bonds are bought by big banks, such as those of China and Japan recently. At auction the banks purchase these bonds, and then money gets sent into the Treasury coffers, where it can be disbursed for the usual array of government programs.

I promised you that I’d show you how money first comes into being, and so far that hasn’t happened, has it? The bonds are being bought with money that already exists. Money is created by this next mechanism, where the Federal Reserve buys a Treasury bond from a bank.

When the Fed does this: They simply transfer money in the amount of the bond to the other bank and take possession of the bond. A bond is swapped for money.

Now, where did this money come from? Glad you asked. It comes out of thin air, as the Fed creates money when it ‘buys’ this debt. New Fed money is always exchanged for debt, so we can now put the title on this page.

Don’t believe me? Here’s a quote from a Federal Reserve publication entitled “Putting it Simply:” "When you or I write a check, there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check, there is no bank deposit on which that check is drawn. When the Federal Reserve writes a check, it is creating money."

Wow. That is an extraordinary power. Whereas you or I need to work to obtain money, and place it at risk to have it grow, the Federal Reserve simply prints up as much as it wishes, whenever it wants, and then loans it to us all via the US Government, with interest.

Given the fact that over 3,800 paper currencies (and a few metallic ones) have been rendered worthless due to mismanagement, wouldn’t it make sense to keep a very close eye on whether or not the Federal Reserve is acting responsibly with our own monetary unit?

So now we know that there are two kinds of money out there.

The first is bank credit, which is money that is loaned into existence, as we saw here. Bank credit is a type of money that comes with an equal and offsetting amount of debt associated with it. Debt upon which interest must be paid.

The second type is money printed out of thin air, and that is what we see here at this stage.

The process by which money is created is so simple that the mind is repelled, so don’t worry if you need to review this chapter several more times. I’ve had some people attend my seminar four or more times and they say that this concept is just now starting to really sink in.

However, if you understood all that, and ‘get it,’ congratulations! Give yourself a hand, because it’s not easy.

These monetary learnings allow us to formulate two more extremely important Key Concepts.

The first is that all dollars are backed by debt. At the local bank level, all new money is loaned into existence. At the Federal Reserve level, money is simply manufactured out of thin air and then exchanged for interest-paying government debt. In both cases, the money is backed by debt. Debt that pays interest. From this Key Concept, we can formulate a truly profound statement, which is that at a minimum, each year enough new money must be loaned into existence to cover the interest payments on all of the past outstanding debt.

If we flip this slightly, we can say that each year all the outstanding debt must compound by at least the rate of the interest on that debt. Each and every year it must grow by some percentage. Because our debt-based money system is growing by some percentage continually, it is an exponential system by its very design. A corollary of this is that the amount of debt in the system will always exceed the amount of money.

I am not going to cast judgment on this and say that it is good or it is bad. It simply is what it is. By understanding its design, though, you will be better equipped to understand that the potential range of future outcomes for our economy are not limitless, but rather bounded by the rules of the system.

All of which leads us to the fourth Key Concept, which is that perpetual expansion is a requirement of modern banking. In fact we can make a rule: Each year, new credit (loans) must be made that at least equal the amount of all the outstanding interest payments that year. Without a continuous expansion of the money supply, past debts would not be able to be serviced, and defaults would ripple through, and possibly destroy, the entire system. Defaults are the Achilles heel of a debt-based money system, which we saw in our local banking example in the previous chapter. Because of this, all the institutional and political forces in our society are geared towards avoiding this outcome.

So the banking system must continually expand – not necessarily because it is the right (or wrong) thing to do, but, rather, simply because that is how it was designed. It is a feature of the system, just like using gasoline is a feature of my car’s engine. I might wish and hope that my car would run on straw, but I’d be wasting my time, because that’s just not how it was designed.

By understanding the requirement for continual expansion, we will be in a better position to make informed decisions about what’s likely to transpire and take meaningful actions to enhance our prospects.

More philosophically, we might wonder about the long-term viability of a system that must expand exponentially but which exists on a spherical planet. The key question is, “Can our current money system somehow be modified to be stable, fair, and useful when it is not growing?”

So the question is this: What happens when a human-contrived money system that must expand, by its very design, runs headlong into the physical limits of a spherical planet?

One more belief of mine is that I will witness this collision in my adult lifetime, and in fact it may have already started. I am extremely interested to see how this is all going to turn out.

Now this is, admittedly, a truly gigantic proposition to consider, and some would say that this is not very interesting at all, but rather frightening. Well, if you want the future to look just like the past, then I suppose it is frightening. But if you are flexible in your view of the future, then you have an opportunity to make the most of whatever future actually arrives. These are fascinating, invigorating, and truly unprecedented times, and I, for one, am thrilled to be living right now, right here, with you.

In the next section we’ll be looking at some very important historical context about our money system, where you’ll learn that our money system could be viewed as a masterpiece of sophisticated evolution or as a historically brief experiment that is not yet 37 years old.

Comments

Burk's picture
Burk
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On the value of inflation

This is all very well written, but there is a polemical issue- the denigration of inflation. Why would one want to have money buried in a coffee can hold the same value over a century? What is the point? Really, there is no point.

As you say, inflation induces continual hard work and productive investment. It discourages unproductive (coffee can) savings. That is why a low rate of inflation (~2%) is the optimal policy stance of our current monetary system. It is slow enough that we do not get all those scary consequences (Zimbabwe!) that you trot out here, and fast enough so that it has the positive effects above. End of story. Whether my dollars now can buy my descendents an icecream cone or not in a hundred years.. that may be an issue for the Wall Street nobility, but it isn't an issue for me or any other working person. The system should reward work, not lethargy.

blk924s's picture
blk924s
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Don't incomes have to rise

Don't incomes have to rise proportionally in order for us to reap the benefits of those "positive effects"? I remember seeing a chart in a link from a daily digit on this site that showed incomes stagnating in the u.s. For a long time. If you're in a bust part of the cycle and or your country's mean income is falling aren't you getting screwed by even "healthy" inflation?

Nick Hill's picture
Nick Hill
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Posts: 5
More debt than money

i have been through the crash course a few times over the last few years. I find it hard to get around key fact 3 the idea that there must be more debt than money.

As I understand the logic, because interest is charged on the principal, the principal plus interest is greater than the principal on it's own. Therefore, there is always more debt than principal. Therefore total debts cannot be paid off without  default equivalent to the total interest charged in the system.

I can see a different perspective which I stand by to be corrected on.

If you consider the interest charged as a utility bill - a bill for services which is rendered to the borrower whilst money is on loan, then surely the effect of the interest is the same as any other type of bill, for example, water or electricity on the economy or money supply as a whole.

The interest charged pays for building the bank, or rent on the premises, electricity, lighting, wages for the employees, water, repairs, building the counters, paying for the wood, metal, glass etc, computers, computer engineers, marketing etc etc. and some insurance against bad loans. As this interest payment pays for these essentials, then doesn't that very same interest money go straight back into the economy, then get earned back by those who do the work... those same people who borrow? If this is the case, then surely interest charges make no effect on the actual amount of money in the economy as it recycled whilst the loan is paid back. This would then suggest that all debts could be unwound without default. Am I right, or am I missing something?

Nick Hill's picture
Nick Hill
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Posts: 5
More debt than money or more bank deposits than money

After writing the above, I realise that the proportion of interest the bank take for servicing the loan is probably benign as it is a regular utility bill. What is perhaps not benign is that the total amount on deposit keeps growing at the rate of deposit interest, which in turn requires money to ultimately repay the deposit that doesn't exist in the system at the time the money is first deposited.

Therefore, money needs to come into existance from thin air to cover depositors growing balances.  If the economy is static (i.e. isn't growing), increasing money supply (the sort that makes money from thin air) is typically inflationary, and therefore, the average inflation adjusted interest rate in a static economy must tend towards zero (interest - inflation = 0). In a shrinking economy, the inflation adjusted interest rate must tend towards negative (interest - inflation < 0) as a result of the two effects of increasing money in circulation (to cover deposit and bond interest) and same money chasing fewer products.

So it may be fair to say that positive interest rates (interest - inflation) only exist where the economy is growing sufficiently to make that possible, and at the same time, the government leaves sufficient on the table after paying for their programmes for savers to enjoy. It may also be fair to suggest that if the economy is static or shrinking, and the government is spending more than the tax revenues, holders of the sovereign nation's currency or bonds denominated in that currency, on the whole will inevitably be paying the bill.

Therefore, I believe the postulation in the crash course to be true for key fact 3 and by extension key fact 4.

Krishna Davinci's picture
Krishna Davinci
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$ Out of Thin Air

The owners of the Fed can print themselves as much $ as they want.  This is the major problem. Then on top of that they get paid interest on their counterfeit currency ... which we pay them through their collection agency called the IRS.

mmtdebtkiller's picture
mmtdebtkiller
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No national debt in Fed's securities


redwoods's picture
redwoods
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Posts: 20
please explain..

As something of a layman...how can the big banks selling the bond to the fed, accept money that doesnt exist!? 

The Federal reserve buys the bond from say the Bank of China and transfers money to them that doesnt exist?

ReallyCool's picture
ReallyCool
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Chapter 8 The Fed

Amazing article.  It would be very interesting to learn how other countries i.e. Japan, Germany, China, Russia, Brazil, India create money.  Do they do it through debt or simply by printing it out?smiley

auldhickory's picture
auldhickory
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Congress Must Continually Run Budget Deficits?

If money must be loaned into existence to pay the interest on the bonds held by the Federal Reserve, then, based upon the illustration, the US government must run continual budget deficits to create the money.

Is this correct? I'm feeling very queasy in the stomach!

Abi Drew's picture
Abi Drew
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Exactly!

You got it exactly right! Congratulations. Sorry, though, ain't got anything for that queezy feeling you're getting from learning the truth.

Abi Drew's picture
Abi Drew
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The entire world economy is based on debt.

They are debt based too. Mostly their versions of the Fed, rather than being housed entirely within and populated entirely by people living only in their own countries are such institutions as The World Bank and others.

Abi Drew's picture
Abi Drew
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Posts: 5
I agree with the main points thus far...

I agree with the main points thus far as far as they go in describing the present economic situations... I strongly disagree with some of your assertions. First that China and Japan are buying most of the bonds, this is simply untrue and any remotely cursory investigation would reveal that.

I also disagree that there is ANYTHING to be excited about in the present situation. It IS bloody scary as all. But not because of any tomfoolery such as you claimed about me wanting the future looking remotely like the past. But because I know what all this stuff MEANS. And it means that we're fast approaching complete systemic collapse of society in any form. Not simply 'as we know it', not to be remade into glorious anarchy, but chaos. A second Dark Age, and this time, it won't just be Europe.

You can be all giddy with excitement about how you're going to exploit what's coming for your own best advantage if you like, but all that makes you is a sociopath. Me, I'm far more interested in trying to save some small part of humanity, get them into a nice proper peaceful anarchy, and NOT destroy the world in the coming cataclysms.

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