Money Creation in the U.S. Federal Reserve System

Money creation is a highly controversial and complex process.  To simplify it to a single flow diagram is perhaps an injustice to the nuances of the process.  However, to make the muddy waters slightly less murky, here is a summary of the basic principles of money creation in modern, Western banking.

A simplified chart of the U.S. Federal Reserve System.  The U.S. Federal Reserve, banking model of money supply was based largely, but not wholly, on its forbearer, the Bank of England.  The process in the U.S and U.K. is thus somewhat similar.
 

The process

The U.S. President, hopefully with the support of U.S. Congress, sets governmental monetary policy.  This budgetary spending plan requires money, more money than taxes alone.  The President then authorise the U.S. Treasury to sell Treasury bonds to raise cash for these government programs.  These bonds have a stated rate of interest to be paid to the buyer after a designated period of time.  Since governments are not meant to ever default on this contract, as they can always raise more taxes to cover any unexpected liabilities, these bonds are deemed “safe as houses” by the money markets.  Thus, Commercial banks, both local and foreign (largely China and Japan currently), will readily buy these Treasury bonds.

When too many bonds are in circulation, or they have matured naturally, the government has to pay its promised interest debt.  At this point, it must create new, “printed” dollars.  This “printing press” of new money is virtually done these days and rarely requires physical printing of notes.  The “printing” is carried out by The Federal Reserve Bank, which is comprised of 12 regional banks and one central supervisory board.  Importantly, it is a separate entity from the government itself; even though the U.S. President has the power to nominate the Federal Reserve’s chairman (currently Ben Bernanke).   Not being under direct governmental jurisdiction, the Federal Reserve is actually owned and controlled by private, Commercial banks.

The money creation process doesn’t end there.  Treasury bond issues and Federal Reserve buy-backs is just the first stage.  The real, big, money creation process occurs by the Commercial banks themselves.  They “loan money existence”.  As they are sanctioned to only ever hold a fraction (often 10%) of the amount they hold on deposit, they can turn a small amount of money “in the bank” to a large amount of loans.  This “Fractional Reserve Multiplier” (detail here) is deemed controversial by some, but like it or not, it is the foundation of our banking system.  For instance, it turns the $1.2 Trillion dollars of debt created by President Obama for QE2 (Quantitative Easing 2) into $10 Trillion dollars of DEBT (via this Fractional Reserve Multiplier system).   This debt is provided to people both with business ideas and ambitions or potential home owners, to realise their dreams, in the face of a lack of ready cash.  The productivity of business and the requirement to pay these loans back at interest, allows the “loaned into existence” debt to acquire real value.  In principle, as people work they provide new goods and services that match the created money’s value and thus make the new money’s value real.

The Central Banking model controversy

There is much debate with regards to the relative merits of a having a unique, non-governmental entity, a Central Bank, involved in the money creation process.

“Give me control of a nation’s money and I care not who makes it’s laws.”– Mayer Amschel Bauer Rothschild (founder of the Rothschild family international banking dynasty

Should Central Bankers, who are also private bankers,  have a say in the money creation process, and be allowed their profit margin from it?  Or, should a government bypass this step and create new money wholly on its own?  One could argue that Central Bankers are far from impartial in their views.  They are investors themselves and thus have their own, associated, vested interests.   Shouldn’t there be a Chinese Wall between their personal, money making ambitions and the money creation process?  However, one could also argue, what is the alternative?  Would you trust your politicians with, not only the budget allocation of your tax money, but also the creation of the money supply as well.  If so, where would the governments money spending spree ever cease.  They would be unleashed to spend limitlessly.  Thus, we have the Central Bank to act as a, perhaps, independent authority to make sure the politicians spend within their means.

Conclusion

Money is created in 2 major ways: by the Federal Reserve’s printing press  and the Fractional Reserve Multiplier model.  The former is used to pay for government bond issues, the latter involves Commercial banks leveraging deposits by about x9 into new loans.  Both these methods assume the principle that all new money is backed by debt.  Thus, this implicitly requires us to create enough new money every year to service our current debt’s interest.  Consequently, in modern, Western banking inflation is a must.  We must constantly inflate (i.e. increase the supply of money) our economy to pay for the current debt that has been hitherto driving it.  Contrary to popular belief, inflation is healthy; well, in small amounts anyway.  That’s why the Central Banks’ prime concern is to maintain a steady, say a 3%, inflation rate to keep this whole positive feedback, system in balance.   For a healthy world economy, money creation must closely match people’s productivity.

As all new money is formed by creating debt and debt is frequently deemed an onus, or even a shackle, are we slaves to the banking system?  Are we, the people, forever in debt and chasing a carrot on a stick?  In one regards, that perception can be deemed reasonable.  On the other, this system does allow money to be created quickly and easily and by given to those who are the most productive.  New money is a shackle, but, don’t forget, also a liberator.  We can gain access to capital readily.  True, we have to pay it back at interest to make the loan process appealing to the creditor, but this easy credit is the foundation of business innovation and investment.

Money creation, through debt creation-  it’s not perfect, but nothing ever is.  It’s probably the best mechanism we’ve got (until proven otherwise), so all we can do is make the most of it?

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One Response to Money Creation in the U.S. Federal Reserve System

  1. Jimbo says:

    I have to add this “quote”, which sums up the home truths of government spending. Taxation and socialistic redistribution of wealth is essential, but it’s all about swings and round-a-bouts. Buddhist Balance is required and perhaps this sums up, most succinctly, a caution for our current, Western, political persuasion – moving too Left:


    Buy yourself a present: you care what it is and how? much it costs.
    Buy for someone else: cost matters, quality doesn’t.
    Buy for yourself with someone else’s money: quality matters, cost doesn’t.
    Buy for some else with someone else’s money: neither cost, nor quality matters…

    Welcome to the government.

    Search for “Friedman’s Four Ways” for Full Version
    From an astute and sadly, missed economist, Milton Friedman (2004)

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