Where dollars come from

Dollar generator at the FedIt was hearing one rant too many about “money out of thin air” that finally drove me to learn about how our money system actually works. Where do those dollars come from, anyway? I think I do understand now, even if I can’t quite believe it. It’s spooky, no question.

While most of us are handicapped by the lack of an economics degree, many would still like to know what the fuss is about. I’ll offer a rough report of my own findings about one crucial phase of the system: how the Federal Reserve creates money out of thin air — or thin pixels, as the case may be.

This of course is the notorious fiat money, i.e., “let-there-be” money that is simply declared into existence. Turns out, this is not such a bad idea.

Here’s what happens. The US Treasury gets much of its money from our taxes, but it also borrows money from the public by “selling” bonds and notes collectively known as “treasuries.”  A good part of the US budget goes toward paying interest on these, in fact. Usually, though, the revenue from taxes isn’t enough to cover the debt.

Enter the Federal Reserve. From time to time, the Fed will decide to buy some treasuries from John Q. Public. These are traded on the open market, just like other bonds and stocks. But unlike other mortals who have to fork over ready cash, when the Fed buys a bond from someone, all they do is this: they enter the purchase price in the “credits” column of the seller’s bank account.

That’s it. They get to do that. At that magic moment, it’s brand new legal tender, ready to spend. It’s known as “monetizing the debt.” It’s a classic two-fer: it gets the US Treasury out of hock, while at the same time putting money into circulation for everybody’s use.

Just in case this is too simple, not all dollars originate this way; only about ten percent of them do, in fact. Private banks create the rest. When you deposit $1000 in a bank, they turn right around and lend it out again, minus the legally-required reserve amount, which is currently at 10%. Then the new borrower deposits their $900, and the bank lends that out, minus the reserve, and so on until the last dime, of which they lend out nine cents.

At every step, the bank is creating new money. They get to do that. And keep the profits, as well. It’s called “fractional reserve banking.” It’s also nice work if you can get it.

Before going on with how this scheme could possibly be a good idea, it’s probably worthwhile to add a disclaimer about money. Fans of “real” money assume that gold and silver have some kind of inherent value, whereas fiat money is backed by nothing but thin air. I suggest that this is cultural bias, pure and simple.

Precious metals may be more tangible, but their value as money lies essentially in a social agreement. It just so happens that the agreement about metals is much older than the one about fiat currency notes. Money — in any form — functions as a token of value, a means of accounting our many acts of exchanging items of actual value, whether goods or labor.

So, a money system is essentially an information system.

It’s fair to ask Why bother with these novel fiat-money tokens, when the shiny metal ones have such a well-established track record? The problem comes when there aren’t enough of the metal ones to represent the overall amount of value that’s happening throughout the whole economy.

Money as an information system should be accurate, we would hope, and when an economy grows too large for the current number of metal tokens to represent it accurately, we can’t always just open up new silver mines and mint more of them to relieve the shortage. Nature puts a lid on it.

This actually occurred in the US when metal-backed money was the order of the day: the first Great Depression ran from 1873 to the mid 1890’s, a period characterized by stagnant growth due in large part to the limited money supply imposed by gold and silver.

With fiat-money tokens, however, we can issue however many (or few) it takes for accurately representing the amount of value currently in the economy. That’s the potential, anyhow. Since it is money, there’s always the temptation to issue too much of it, which leads to inflation: more and more dollars chasing the same amount of value.  That’s the opposite problem from the deflationary 1873 depression.

It all comes down to keeping the money supply accurate, then, and with fiat money, we’re asked to trust the government to do so. For many, that’s not necessarily an acceptable leap of faith, and indeed is probably one of the key indicators of where they fall along the political spectrum. Still, we do drive across government-built bridges in complete faith that we will arrive alive.

However firm or queasy our faith in the monetary system might be, we as individual citizens really don’t have a lot of choice in the matter. But at least if we know how it works, we can spot the real abuses, and perhaps be a little less tempted to move the nest egg into Krugerrands whenever we hear more table-pounding about “money from thin air.”

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