Money & Debt:  A few notes on the Federal Reserve 

In my previous blog post, we talked a bit about money, debt and the banking system.  We observed that most money isn’t in the form of coins or bills but, rather, is a creation of the banking system and exists only as entries in a computer ledger.  We did not explain how the whole process is directed by our nation’s central bank, the Federal Reserve.

In principle,  the Fed is supposed to regulate the availability of money and credit, making sure that there is not so much of it that we have price inflation nor so little that we fall into a recession.  How successful it has been in achieving those goals is a topic for another day, but it is worth noting that the dollar is worth less than 5% of the value it possessed in 1913, the year the Federal Reserve came into being.

No, today’s topic is merely to briefly explain how the Fed creates money.  This is mostly done through the purchase of US Treasury Notes (bonds) in what are referred to as Open Market operations.  When the Fed purchases say $10 billion in Treasuries, it credits the bank selling the bonds with $10 billion.  Normally, the bank is required to keep 10% of that amount on hand as a reserve but can now lend out an additional  $9 billion.  And , if you remember back to last week’s post, you will recall that, through the repeated  process of loaning and depositing, that could actually result in an increase in the money supply of up to $100 billion.  Poof!  Magic!

Of course the Fed can also destroy money by selling US Treasury Notes or raising the reserve requirements.  And, in the short term, that does occur.  But, over time, the expansion of money & debt is pretty much guaranteed to continue.  But, you say, we need more money in circulation as our economy grows and develops.  That may be true.  But I would urge you to keep one thing in mind about this process and that is who most benefits from it.  

As the amount of money grows, the value tends to decline,  but that doesn’t happen immediately.  If you owned a business and, suddenly, your sales doubled, you would take that as a cue that you have a product people want and would be prompted to produce more.  But what if you came to realize that the increase in your sales was simply the result of twice as much money being available?  Your costs would quickly rise and you would have to increase your prices to account for that fact.  In time, things would, more or less, come back into balance.

But what about that first group of customers?  They made out pretty well before things came back into balance.  It is almost like they simply printed up some counterfeit bills and got full value for it.   And there’s the “gotcha!”  If we think back, those large banks and the government spent that new money at the same value as the money previously in circulation.  They did well for themselves.  But, as time went by and prices adjusted themselves, the vast majority of us had cash reserves worth less in purchasing power than before.  So who benefits?  And who gets screwed?  Well, I will let you decide.

Will probably do a couple shorter blog entries over the next week or so before I begin to discuss what I consider the most difficult problem of politics and economics:  property.  Until next time, thanks for reading and have a great week!

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