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.