Basics of Money Creation Jude Wanniski February 18, 2006

Now that we have covered the basics of the exchange economy and money, we move to the process of money creation in today's lesson. How is money created? Often the best answer politicians can muster is that the Federal Reserve does it or that it is printed at the U.S. Mint. But there is a lot more to it, as Jude Wanniski explained in this lesson delivered July 16, 2005. Once you understand the operating mechanism of the Fed, you can see how easy it would be to switch to a gold standard.

Polyconomics Staff

Memo To: SSU Students
From: Jude Wanniski
Re: The Operating Mechanism

Ask the President or practically any member of Congress how money is created and the best they will be able to do is say the Federal Reserve does it or that it is printed at the U.S. Mint. There is a lot more to it, which is why I devoted a special section to it in my March 9, 1995 essay, "A Gold Polaris", which I specifically wrote to introduce members of Congress to the mysteries of money and the absolute need for a gold-based international monetary system. Here is the section as written, with some added comments appended.

MONETARY MECHANISM

Currency 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 budget deficit. (Note that "money" cannot exist if there is no national debt.) 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. 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, of course, 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." 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.

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. 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 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. Of all the members, Greenspan watches the gold price most attentively, and as chairman he gets to throw his weight in that direction. In addition, his attempt to get the gold price down by raising interest rates instead of draining liquidity has not worked. This hardly constitutes a Polaris, especially when the markets also have to reckon on the value of the dollar a year from now, if Greenspan is replaced by a Clinton appointee who will be driven purely by political goals.

* * * * *

Ten years later: No sooner had I applauded Greenspan a decade ago for keeping his eye on the price of gold as a guide to creating or extinguishing money than he seemed to put it completely out of his mind. The result was one of the most serious monetary deflations in the nation's history, which was first felt around the world in countries that had been managing their currencies by keeping them fixed to the dollar. Gold had hovered around $350 oz from 1985 to 1993, then crept up to $385 after the Clinton tax increase of 1993 decreased the demand for money and left the system with a surplus. With no mechanism to drain the surplus, the gold price rose. In 1997, a supply-side package of tax cuts sharply increased the demand for money, but the Greenspan Fed ignored the gold signal as its price dropped from a $385 plateau to as low as $255 oz in the early summer of 2001. The commodity deflation crushed those commodity-producing nations tied to the dollar and also hammered those parts of the U.S. that are heavily dependent upon commodity production. The 9-11 tragedy caused a sharp decline in the demand for dollars and ended the deflation as gold climbed back toward $350 oz.

We are still more or less on a "Greenspan Standard," but with the Fed's target being an unknown balance of inflation and employment -- which Greenspan believes the Fed will know when it sees it following a long series of increases in the overnight "federal funds rate," the rate at which banks lend to each other to meet their reserve requirements. As with a gold standard, the operating mechanism of the central bank requires the New York trading desk to estimate from day to day whether to buy bonds or sell bonds in order to keep the funds rate at the level chosen by the Fed's Open Market Committee.

Once you understand the mechanism, you can see how easy it would be to switch to a gold standard. The FOMC need only cease trying to control prices and employment at the same time and aim at keeping the dollar/gold price constant. It would take an executive order by the President and/or a congressional statute to make the switch. The unemployment target would be achieved by the right combination of fiscal and regulatory policies.