Crash Course Chapter 8: Money Creation: The Fed
For the best viewing experience, watch the above video in hi-definition (HD) and in expanded screen mode
Now we’re going to travel to the headwaters to discover where money is actually created.
The process works like this.
Suppose congress needs more money than it has. I know, that’s a stretch! Perhaps it’s 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 essentially 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 always 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 of face value and paying a rate of interest of 5%, then you’d pay $100 for this bond and in a year you'd get $105 back.
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 and by sovereign nations such as China and Japan.
The money that is used to purchase these bonds gets sent to the Treasury Department's coffers where is 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.
So where does money come from?
Money is created by this next mechanism where the Federal Reserve buys a Treasury bond from a bank.
If you've been wondering what the so-called "Quantitative Easing" - or QE - programs are, this next bit describes them.
When the Fed buys a bond from a bank or other financial institution, they simply transfer money sufficient to cover the cost of the bond to the other bank and then they take possession of the bond.
It's that simple. A bond is swapped for money. The Fed has the money, the bank has the bond.
Now, where did the Fed get the money to buy the bond?
I'm glad you asked. It literally comes out of thin air as the Fed simply creates money when ‘buys’ this debt.
Such newly created Fed money is always exchanged for a debt instrument, be that a Treasury bond, a mortgage backed security (or MBS), or even corporate debt on rare occasions, 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 in the markets 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?
What if they are overdoing it and printing too much? Because this is such an extraordinary power to have, we should really pay close attention to what they are up to.
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 tell me that they've reviewed this section four or more times before it really began to 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 2 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 mostly 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 over time, 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 in the system.
So...if there's always more debt in the system than money, and the interest to pay off the debt must be loaned into existence...well...that too deserves at least a few minutes of your careful attention.
It is not my role here to cast judgment on this system and say if it is good or if it's 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.
And that system is one that is designed to increase by some percentage, in this case the rate of interest on all the outstanding debt, over time.
That is, our money system is designed to expand exponentially. That is a feature of our money system. Whether we happen to believe this is a good thing or a bad thing does not change the fact that this is simply how our money system is designed.
All of which leads us to the fourth Key Concept, which is that Perpetual Expansion is a requirement of modern banking. Not a legal requirement, but a systemic requirement-- like your body, as a system, requires oxygen.
In fact we can make a rule; to avoid cascading disruption, 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 ruin, 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, or water, 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 assess whether that's even possible and, if we think that it's not, then we're free to imagine what might come next.
More philosophically, we might wonder about the long-term viability of a system that must expand exponentially forever but which ultimately lays claim to the resources of a finite planet.
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 That only has so much to offer?
Someday sooner or later, our monetary and economic models will collide with physical realities.
One more belief I happen to hold is that I will witness this collision in my adult lifetime and in fact it has already started, and 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 just over 40 years old.
In order to better appreciate just how remarkable this truly is, please join me for Chapter 9: A Very Brief History of US Money.
Thank you for listening.