Daddy where does money come from and how do you make it?
By Melvin J. Howard
The announcement this week of another round of quantitative easing by the U.S. Federal Reserve got me thinking about the time when my children were very young. One of them ask me dad how do you make money and where does it come from? I said good question that got me to thinking how many grown ups do not know the answer of how money is made and where it comes from either. For many years I had really had no answer they do not teach it in school and the people at the time in my circle did not have clue either. That’s when I set out on a quest for knowledge not just about making money but the philosophy behind it. How do societies start how do they rise and fall why some countries are rich and why some are poor? Science, Philosophy, Metaphysics, Anthropology, Sociology all the stuff I use to avoid like the plague in school I find myself drawn to it now. My mother use to always tell me that I think they switched babies at the hospital on me because I was always asking WHY? Let’s get back to our original question. How is money created, and what role does the Federal Reserve and its member banks play?
Let’s start with some common misconceptions about money, and why they are not true:
Misconception 1: You make money by going to work, or by selling something.
FALSE: Nobody can make money except commercial banks (also called depository institutions) and the Federal Reserve, which is owned by the commercial banking industry. When you get paid for work it is merely a transfer of money that already exists. It was, at some time in the past, created by the banking industry (or really lend) money. The main reason people get a job is to get a transfer of money from people who already have some.
When we talk about money here we mean money that can be used in all transactions and in the repayment of all debts. This is what we are calling bank money. However many non bank types of so called "money" raising instruments are increasingly being used by non bank corporations to avoid direct contact with the bank money creating process. This includes things like corporate bonds and shareholder equity, which expand on the bank money supply, but all are completely dependent on, and rely on the confidence that they can be liquidated for, "bank money". Hence the credit crunch in the sub prime commercial paper and bond markets. We might call this other stuff "near money". Since, in our society, it is really bank money people seem to need for the basics of life, and these other near monies are luxuries for people that have excess, we will just focus on bank money here.
Misconception 2: Money has something to do with gold at Fort Knox.
FALSE: The monetary system use to be backed by the gold standard until President Nixon abolished the Gold Standard in 1971 during the Vietnam War. He did this because there was not enough gold at Fort Knox, KY to back all the money that needed to be created to fund the massive wartime expenditures. The axing of the gold standard backing the US dollar led to the "floating" of most national currencies, which were no longer pegged to a gold conversion standard .This lead to phenomenal growth in speculation against international currencies, which later led to massive economic and social crises in various countries that were speculated against. Examples include the Mexican Peso crisis of 1994-95, the Asian financial crisis of the late 1990s, followed by the Russian ruble crisis. Since the death of the gold standard and the floating of most major currencies we have seen currency speculation increase to an astonishing 98% of all international transactions. This means that "real economic" transactions account for a mere 2% of international transactions. This data on currency speculation is derived from the Bank for International Settlements and summarized in the book "The Future of Money" by Bernard Lietaer.
Money supply and debt have exploded in the absence of gold convertibility. Money is no longer a store of value. It is only a measure, an electronic accounting system of credits and debits that has come to be accepted world over as the only way of conducting trade. Each day several trillion dollars travels the globe trying to attract more electronic credits for its owners. Today's money is not backed by gold. It is now backed by our trust in the monetary system. This is ultimately a trust in those that create and control money the commercial banking system, and its major shareholders. The statement on all Federal Reserve Notes "In God we Trust" is a solid reminder of that trust.
Misconception 3: Money is Created by the Government Printing it.
FALSE: Today almost NO money is created by the government. Most of the total money supply is created by banks making loans to the non-bank public. Almost all money (more than 95% at any time) is created by the creation of a corresponding amount of debt. Currency in circulation is just a very small proportion of the total money supply and it is created by the Federal Reserve System, not the government.
Having gotten some of these misconceptions out of the way lets talk briefly about the actual mechanics of money creation. Money creation happens in two main ways. First the creation of base money, which is mostly physical currency notes, created by the Federal Reserve. The second money creation process involves checking account or deposit money created by the commercial banks, and which makes up most of the money supply.
Base money, also called high powered money, is created when the Federal Reserve performs what are known as Open Market Operations. In this process the Federal Reserve injects money by buying Government Securities, which then become debt owed by the government (that is the American Taxpayer) to the Federal Reserve. And where does the Federal Reserve get this money to buy the government securities? Well, that’s another story. The Federal Reserve has no budget, quite simply because it doesn’t need one. In fact, almost all money we come by has its basis in high powered money that the Federal Reserve pumped into the system at some time in the past. Most of this base money is currency in the form of Federal Reserve Notes.
The Federal Reserve then creates a spurious "liability" on its balance sheet called Federal Reserve Notes outstanding, and in return gets an asset in the form of government securities, which the public must repay through the efforts of real work. Every time the Federal Reserve creates or extinguishes base money the financial press and other mainstream media reports it as an interest rate announcement. This is not technically correct but it does sound more palatable than saying that the Federal Reserve just printed some money up or just took some money out of circulation.
Once this base money is created, banks can create around 10 times this amount in checking accounts and other deposits. They do this by making loans to the non-bank public. A corresponding amount of checking account money is created for each new loan. So most money is created just by bankers writing some new numbers on a piece of paper, or these days, entering bits and bytes in computers, since money really now exist just on a bunch of computer records. This means that when you go to borrow money to buy a house or car, the money is really being created by the bank, and being credited to the checking account of the seller.
The bank has a distinct advantage in all this just by being a bank. For if you can’t pay the loan through your hard work, they automatically get the house, and all they did was write some numbers into the computer. From the banks perspective however, if you don’t pay off the loan, they would have to write down their asset (i.e. your loan) and this would affect the earnings they report. If lots of people did this the bank could go "belly up".
To reduce risk of banking system failure (which ultimately comes from sudden loss of confidence or trust in the system) institutions such as the IMF and World Bank have evolved into mechanisms for preventing banking system collapse. Unfortunately, however, what these mechanisms amount to is transferring the cost that could collapse the banking system outside of the banking system. And these costs end up being borne by those who have the least say in the financial system the regular taxpayer.