To: SSU Students
From: Jude Wanniski
Re: Mechanisms of Money Creation
In our lesson last week on the basics of money we covered the general concept and functions of money. This week we will discuss the mechanics of money creation by the U.S. central bank, the Federal Reserve. Many of the world's major central banks now follow the same operating procedures, but there are many variations. A version of the following originally appeared as the appendix of a paper I wrote for Polyconomics' clients on March 9, 1995, "A Golden Polaris," which is available in its entirety in the SSU archive. I've updated it to include discussion of the deflation process and how to alter the Fed's operating mechanism to pull out of the current recession.
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The money you have in your wallet or purse is non-interest-bearing debt of the national government. In the United States, it comes into circulation through the operations of the Federal Reserve Bank, which has the power to "create money." It does so through the simple process of buying interest-bearing debt that had previously been issued by the Treasury Department. That is, Treasury issues a bond in the amount of $1000 in order to finance its spending needs if tax revenues are not sufficient. The $1000 bond pays an interest to its holder at maturity. The Fed can "buy" the $1000 bond with a check for $1000 written in a checkbook that has simply been given it by Congress. In actual fact, the "checkbook" is imaginary. The Fed simply has the power to buy these government bonds from private banks that hold them as reserves in their vaults, paying them with funds created out of thin air. Call it "ink money," as the Fed gives the bank the right to note in its ledgers that it has received $1000 from the Fed. When the Fed creates this "ink money," it has "monetized the debt," i.e., converted interest-bearing debt to cash. The process works because the citizenry needs cash as a medium of exchange, and is thus willing to hold government debt for this purpose without being compensated by the payment of interest.
At the conclusion of the purchase, the Federal Reserve has in its portfolio an asset of $1000 that is paying interest and a liability of $1000 that is not. The interest amount covers the expenses of managing the central bank, and funds in surplus are given to the Treasury as part of its general revenues. The Fed also has the authority to reverse this process. It can decide to withdraw cash from circulation, doing so by taking the $1000 bond from its portfolio of assets and selling it on "the open market," to banks that are members of the Federal Reserve System. The decision on whether or not to buy bonds to create cash or sell bonds to extinguish cash is made by the Fed's Board of Governors and the presidents of the regional Federal Reserve banks. They come together every several weeks as "The Open Market Committee" to decide on whether to buy, sell or hold steady. Their decision is communicated to the "open market desk" in New York City, which implements the policy decision through its own operating procedures.
Conceptually, the process of creating money adds "reserves" to the banking system. The banks are required by law to hold a percentage of their deposits in ready cash or the equivalent of cash -- its own checking account at the Mint. These reserves are a cushion to meet potential demands of the depositors. Thus, a Fed decision to "ease" may put more cash into the banking system than the banks are required to keep by law. This will push the banks into finding borrowers who will take the surplus cash in exchange for an asset that will earn a profit for the bank. A Fed decision to "tighten" may take out reserves that the banks are holding in accordance with legal requirements. This means the banks have to sell assets to private buyers in order to get their cash reserves up to par. The most critical part of the process is at the periodic meetings of the Federal Open Market Committee (FOMC). How does it decide whether to buy bonds to create money or sell bonds to extinguish it? Either it has a fixed rule that determines when to buy and when to sell. (We then say the dollar is in a "fixed system.") Or, it has no specific rule to guide the committee, which is permitted to consider a variety of signals from the market. (We then say the dollar is "floating.") Its value is determined by the "free market," as that market tries to guess what is going on in the minds of the open-market committee, which meets in secret.
When the central bank is on a "fixed system," the FOMC's power is enormously reduced. That is, it must act when the fixed standard it has chosen is being violated and it must not act when the standard is in equilibrium. A gold standard is one type of fixed rule. It requires that if the Treasury issues debt guaranteed in gold at the price which obtained at the moment of issue, the FOMC will be required to buy bonds when the dollar price of gold is tending to fall and to sell bonds when the dollar price of gold is tending to rise. In other words, if the target price of gold is $350, the Fed will be forced to advise the desk in New York City to buy bonds when gold has drifted to $349 and to sell bonds when it has drifted to $351.
This "automaticity" eliminates the possibility that the FOMC will make a mistake by forcing too much money (which pays no interest) on a public that doesn't need or want it for transaction purposes. If there are more dollars in the economy than the public wants, each one of them will be worth a little bit less in its purchasing power. That is "inflation." Once it takes an extra dollar to buy an ounce of gold, at $351 rather than $350, the inflation is eventually transmitted throughout the entire galaxy of prices. On the other hand, if the public needs and wants more money (even though it pays no interest), and the Fed refuses to supply it, dollars will become scarce relative to gold, and the price will decline to $349. This begins a "deflation," which then transmits the deflation through the galaxy of prices.
If the credit markets know that the Fed by law is forced into this rigid operating procedure, keeping the dollar at all times as good as gold, they do not have to guess at what is going on in the minds of the FOMC members in their secret meetings. If gold remains the most reliable proxy for the value of all other commodities, the creditors of the national government will be assured that the gold or gold equivalents they lend by buying government bonds will be returned to them with interest at maturity. The risk of a small number of men and women making incorrect decisions at the FOMC is replaced by the risk of the broad market for government credit making the wrong decisions. It is for this reason that gold standard interest rates are inevitably much lower than interest rates on floating debt, at least in "real" terms.
We do have to bring in this concept of "real" interest rates as opposed to "nominal" interest rates when the system is in a deflationary environment. When the dollar is becoming more and more scarce relative to "real" things, like gold, the nominal interest rate can become very low, even close to zero, as it is in Japan today. This is because the bond is becoming more valuable in terms of its purchasing power at the same time it is also paying interest. The holder of such a bond is so happy that it is becoming more valuable that he is willing to hold it without payment of interest. Again, this has been the condition faced by the Japanese economy over the last several years, as the Bank of Japan has been making deflationary mistakes. In supplying fewer reserves to the private banks than have been asked for, the BoJ has made yen bonds more valuable to the point where investors are willing to buy them just for the capital gain, without interest payments. When you read in the financial press that the "real interest rate" is 8% although the nominal rate is 5%, you are having someone's guess at the deflation return added to the nominal return. Guessing is all that can be done as only nominal rates can be observed in the auction markets.
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When the government's Treasury Department borrows resources from the market by the sale of bonds, the interest it must pay bondholders is determined in the auction market as buyers assess the risk of holding the bonds. If the government wants to buy a thousand apples which cost $1 each, it sells a bond for $1000 that will mature in ten years. If the government has a history of keeping the value of the dollar as good as gold, the interest on the bonds will be relatively low, perhaps 3%. Because a certain amount of gold will generally buy a certain amount of apples at roughly the same ratio today, next month and ten years from now, the 3% represents a "real" interest rate. The government must necessarily pay some rate of interest even if it is keeping the dollar as good as gold -- because private transactors are also in the market offering bonds and stocks. A government bond will generally command a slightly lower interest rate than the best corporate bonds, there is less risk of government default. If the government does not have a history of keeping the dollar as good as gold, allowing the dollar to fluctuate with steady losses in purchasing power, the bond buyer will have to add the risk that $1000 in ten years will buy fewer than 1000 apples. The real rate of interest will remain 3%, but the nominal rate may go to 5%, 10% or higher. The risk of a dollar devaluation through inflation becomes a cost of doing business, which means less business will be done. The marginal producer of goods would be closed out of the market at 10%, but not at 3%.
Inasmuch as private citizens who are drawing contracts in the government unit of account benefit from this reduction of risk, they are able to take greater risks in their investments in each other. The efficiency of capital is increased. It is also possible to fix an automatic course on the central bank's deliberations without gold or with gold averaged in with several other commodities. The Fed's desk could be required to buy bonds when the sum of the dollar price of gold, silver, cocoa, wheat, platinum and copper -- divided by six -- is, say, $200. The markets would be informed of this certainty by an act of Congress or an executive order of the President or, at present, by a simple vote of the FOMC. It may be that such a system would be superior over time to a system without any rules to guide the market, but it seems obvious that as a unit of account, such an index would require so many calculations that contracts drawn against it would carry interest rates considerably higher than a gold contract.
Yet another rule, proposed by the monetarists and actually followed in the first years of the Reagan administration, was a quantity rule. The Fed was forced to sell bonds when the quantity of all money in circulation exceeded an amount scientifically determined by the monetarists and to buy bonds when the quantity was beneath that target. The theory took no account of day-to-day needs of the market for liquidity, on the grounds that over a long period of time the excesses and deficiencies would wash out. It was in this period that the price of gold underwent its most violent fluctuations on a day-to-day basis even as the Federal Reserve was hitting the monetarist quantity targets with some precision.
At present, the dollar is technically floating on what might be called a "Greenspan Standard." The FOMC members each have their own preferences on how fast the economy is growing nationally, how fast in their region, what statistics constitute rapid growth, how commodity prices are acting, how the dollar is performing against other national currencies, what the White House wants done politically, and what their advisors are advising. The market never quite knows what the future value of the dollar will be.
Even though the price of gold, now $280, has been declining since November 1996, when it traded above $380, interest rates remain higher than they would be if the gold price was fixed as the official Fed target. The price decline can best be explained as the result of a long series of errors made by the Fed in not supplying the reserves (liquidity) being asked by the market. Over this period, tax rates were reduced in a way that increased rewards to risk-taking. The economy needed more dollars for transaction purposes, but because the Fed paid no attention to the gold price in the auction market, it ignored that need. The economy had to make do with existing money, and as each dollar had to do more "work," the gold price declined and so did other commodity prices. As the economy has weakened over the last 18 months, the Fed nine times this year has lowered the "federal funds rate" in an attempt to increase economic activity. This "funds rate," now 2½ %, is the rate the banks must pay when borrowing from each other at the end of the business day, to reach the amount of dollar reserves they are required to hold by law. It is an "administered rate," in that the Fed cannot fix it precisely. Each day, though, the Fed makes a decision on how much liquidity to add to the banks in order to keep funds as close as possible to the 2½ %, or whatever the rate may be.
This "operating mechanism," by its very nature, cannot stabilize the dollar's value against gold or some other currency. This is because a change in the rate will in itself change the demand for liquidity by the economy which is served by the banks. For the Fed to now stop the economic decline that has led to the current recession, it cannot simply lower the funds rate again and again until it gets to almost zero. Japan has tried this and it has not worked. The operating mechanism itself must be changed to take into account the deflationary errors made by the Fed over the last five years. This means ignoring the fed funds rate and targeting gold directly, at some dollar price which would short-circuit the deflation process now underway. I've suggested $325 as a minimum and $350 as a maximum. To get there from the current $280 would mean the government in some way would have to tell the market that this is what it thinks will be necessary to make up for the Fed's mistakes and get the economy rolling again. The Fed might have to actually add liquidity to make that happen, but it is also possible the market's expectations of a small inflation instead of continued deflation would cause it to use existing dollar reserves more efficiently. The "velocity" of money would have to rise, each dollar doing more work over a given time period. Businesses and households that are now sitting on money because of deflation fears would begin buying goods at a faster clip to beat the price increases. As the dollar would buy less gold at $325 than at $280, people who owe their creditors dollars that are now scarce and cannot manage to do so will then be able to service their debts, avoiding bankruptcies. If the Fed then stuck to this operating mechanism, telling the markets it would add or subtract reserves in order to keep gold at $325 or $350, we would be on a gold standard instead of a "Greenspan standard."
This lesson can hardly cover all the ground we would need to cover to understand all that goes into the interaction of the markets and the Fed's operating mechanisms. I'm expecting there will be many questions about the process that you will ask of me. I'll try to answer them next week, in a Q&A session.