Money Creation Jude Wanniski September 24, 2004

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 I suggest you read in its entirety.

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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 what we call “liquidity.” 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.

When you read about the Fed “printing money,” this is what reporters are talking about. The Fed doesn’t actually print money. That’s the job of the U.S. Mint. It does not create dollar bills of various denominations until it gets an order from the Federal Reserve. It is the central banks that directs the “money” to its member banks, which are willing to give up interest-bearing bonds in order to get that cash for the liquidity that its customers can turn into cash for transaction purposes. Remember here that most dollar transactions don’t even need “cash” in order to close. Most people pay their bills with checks or credit cards. Corporations pay their bills electronically, moving around debit and credits. This is why it is important for SSU students to understand the difference between “liquidity” and “currency.” The term “liquid” means you have an asset that can easily be converted into a real good or service. WalMart will not take a bond for a basket of stuff, nor will dentists or lawyers. They want liquid money.

Going back to the Fed’s purchase of a government bond with “ink money.” At the conclusion of a 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 liquidity 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 money or sell bonds to extinguish money 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 liquidity 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 liquidity 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 mechanism, which I advocate by the way, nips incipient inflations and deflations in the bud.

In other words, 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. Imagine $20,000 buying a Chevrolet today and, because of deflation, buying a Cadillac tomorrow.

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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I will have a second part to this lesson next week. Questions are always welcome.