How Is Money Created?

Print money. It sounds simple enough, but it just wouldn’t be government unless it made a very simple concept a very complex process. Does the government print money? Technically, no; the Fed does (though it’s purposefully difficult to distinguish the Fed from government). This article will go over the process of money creation, followed by what Federal Reserve Notes (aka “Dollars”) actually represent.

Inflation is strictly defined as an increase in the supply of money. The effect of inflation is expressed in the economy with price inflation, where prices are higher than they otherwise would have been in the absence of inflation. Although government doesn’t do the process of printing money, government is where it all begins. The expansion of credit is also known as “easy money”, “soft money”, or “expansionary policy”.

Here is the how the process of money creation occurs:

  1. The U.S. Treasury issues government bonds
  2. These bonds are purchased by banks or “independent dealers”; the government receives its money and the banks receive the bonds
  3. The banks then sell these bonds to the Federal Reserve; the banks receive newly printed money and the Fed receives the bonds and holds them as assets.

This is portrayed by the following flow chart:

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The government issues debt to fund its liabilities in the form of government bonds. Banks/independent dealers purchase and hold these bonds. The process of issuing bonds does not increase the money supply. No new money is created yet; there is only a change of ownership of money.

If the Fed wishes to expand the money supply, the Federal Open Market Committee (FOMC) approves the purchase of government bonds from independent dealers (the “open market”). The New York Fed then purchases these bonds from the open market. The dealers sell the bonds to the Fed and the Fed gives the dealers “new” money to be introduced into the economy. The Fed holds the government bonds as assets on their balance sheet.

It’s important to note that in this process, new money isn’t physically “created”. Only 3% of new money is physically printed as Dollars. The other 97% are electronic credits placed into the reserve accounts of the banks electronically held at the Federal Reserve (Federal Reserve Deposits). Gives a whole new meaning to “out of thin air”, doesn’t it?

What has happened? If we tracked everything correctly, a Federal Reserve Note (“Dollar”) is really just monetized government debt. It is a printed note by the Fed securitized by an IOU (from the government). The only thing backing the Dollar is the legal tender law, backed by the “full-faith” of the U.S. Government. Money is therefore debt, and it is created, so to speak, out of thin air. Each Dollar represents its respective fraction of U.S. debt. For every dollar created, an exact amount of government debt had to be created by the Treasury and purchased by the Fed.

Here’s an exchange between Marriner Eccles, Chairman of the Fed in 1941, and Wright Patman of the House committee on Banking and Currency. He testified before this House Committee in 1941 on how the Fed got the money to purchase government bonds:

Eccles: We created it.

Patman: Out of what?

Eccles: Out of the right to issue credit money.

Patman: And there is nothing behind it, is there, except our government’s credit?

Eccles: That is what our money system is. If there were no debts in our money system, there wouldn’t be any money.

Every Dollar you hold is debt owed to someone by the government. If the government paid off all its debts, no Dollars would exist. It’s somewhat scary that the American Dollar is a fiat money backed by the debt of one of the most spend-heavy governments in the world and that most of these notes only exist electronically. And this is just the tip of the pyramid of modern money mechanics. The problems created by central banking are exacerbated by a fractional reserve banking system, to be discussed in a separate article.


Money isn’t wealth

Something can not be produced out of nothing by a mere touch of the wand – J.B. Say

Money created is not wealth. Money is desired because of the things it can buy. We don’t build our houses out of money (unless you live in the Wiemar Republic or Zimbabwe), nor do we eat or drink money. Money does not represent wealth because it cannot be directly used to satisfy our wants. Printing (or rather electronically crediting) money doesn’t create anything that actually helps to satisfy our wants; only production of useful goods can do so.

The Federal Reserve holds a real danger in its hands, even more dangerous when armed with Keynesian economic theories. If they believe Keynes, they should try some of his other methods of creating wealth. From his General Theory:

Pyramid-building, earthquakes, even wars may serve to increase wealth (129)

‘To dig holes in the ground,’ paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services (220)

Sounds like a rational human being to me.

Printing to prosperity may work in the land of Cockaigne, but not on Earth. Following the current theories of Keynes only leads to one thing: price inflation. Mises rightfully points out that “radical inflationism, although not admitted explicitly, is an essential feature of the economic ideology of our age”. Inflating the money supply is a promise of price inflation; the question isn’t if but when. It’s no coincidence that since the Federal Reserve began, the dollar has lost over 95% of its value. But hey, at least we have $18 trillion of public debt to show for our efforts.