How the Fed Creates Money From Nothing

Let’s set the scene with

The Private Business Method

Acme Widget Corp. wants to increase its manufacturing capacity but doesn’t want to use its available cash reserves (money) or sell more shares of the company (i.e., dilute its ownership). The only other option? Borrow.

When a business wants to borrow money it can go to a bank or to the public. When they borrow from the public they issue bonds. Let’s say, in our example, Acme issues ten-thousand $10,000 ten-year bonds—they borrow one hundred million dollars from investors. If the interest rate is 5%, Acme will have to pay $500 annually on each bond, and then will have to pay off each $10,000 bond at its ten-year maturity. Acme, hopefully, has calculated correctly that the hundred million dollars they have borrowed plus the interest they paid for those funds is less than the profit generated from the investment.

Where did the one hundred million dollars come from for those bonds? It came from the savings of investors. Each investor sometime in the past created more value, produced more, than he consumed and saved the difference. Let’s say one of those investors owned a grocery store. Over some period of time he sold a million dollars’ worth of goods, paid $600,000 in operating expenses, spent $100,000 on his own living expenses, and saved $300,000, which he then had available to invest in Acme’s bonds. The important point is the store owner created something of value for which he was paid, and which he did not spend but saved.

Remember we said in a previous article, money, real money, is only a representation of production. It is an accounting method for value produced.

That’s our background information.

The Government Method

Let’s say the government wants to pay Boeing Airplane Company to build a tanker airplane. The government doesn’t create anything to sell; it only has two sources of income to pay Boeing for this airplane. It can take money from citizens in the form of taxes, imposts, duties, and various fines, or it can borrow the money. Ignoring for now the process of taking from citizens, which as everyone knows doesn’t pay for anywhere near what the government purchases from Boeing and other suppliers or give as transfer payments to citizens and non-citizens alike, the only other option is to borrow the money. This the government does through issuing treasury bills, notes, and bonds.

The government can offer these to the public and does, but it’s not always willing to pay the interest rate required to sell all the bonds needed. So, to whom does the government sell bonds?

You guessed it – the Federal Reserve Bank. Notwithstanding its name, the Federal Reserve Bank is not a government institution. It is, in fact, a private corporation with private citizen owners who profit from its operations. It is, however unique among all other incorporated businesses in that it can create money. Let’s repeat that: it is UNIQUE in that it is the only entity in the world that can CREATE UNITED STATES MONEY.

Let that sink in.

When the U.S. government needs money it doesn’t have, it creates a bond, a promise to pay someone at some future time. The government can sell those bonds to the public, which it does, but unlike a business, the government is ASSURED of a buyer for all the bonds it cares to sell. Who is the buyer? The Federal Reserve Bank. Where does the Federal Reserve Bank get the money to purchase government bonds? With a keystroke on a computer keyboard. The “money” comes from nowhere. There is no production, no value behind it. Its only value is in the fact that an agreement between the government and the Fed says that money now exists. The treasury may print paper currency to represent some of the money just created, but they probably won’t. Most “money” in circulation today exists merely in electronic format, as ones and zeros in computers that track the supply of cash and deposits in the nation’s banks.

Let’s imagine for a moment that the increase in “money” exactly coincides with the increase in national production. (Money defined as coins and notes in circulation and other money equivalents that are easily convertible into cash, short-term time deposits in banks and 24-hour money market funds, short-term repurchase agreements and larger liquid assets, plus longer-term time deposits and money market funds with more than 24-hour maturity. That’s M0, M1, M2, M3, and M4. Next time someone tells you the money supply is under control, ask them exactly which definition of money they’re talking about. Most likely you’ll get a blank stare.)  If that were the case, the Fed would be doing a good job and the inflation rate of prices of goods and services would be zero.

Sadly, this has not been the case. Since the creation of the Federal Reserve Bank the dollar has lost over 97% of its value. You’ll hear that the Federal Reserve Bank is not influenced by political concerns. You’ll also hear that the tooth fairy will bring you a quarter if you’ll leave a tooth under your pillow and Santa Clause keeps a list of who’s naughty and nice. Adults know better.

I’ve gone past my normal blog length, so I won’t go into a proof that the Fed is anything but apolitical. The Federal Reserve Bank is in cahoots with the government and big business interests, especially (surprise!) big banking interests.

In the next installment of this series we’ll discuss how the Fed manipulates interest rates and why this matters.

Wishing you well,

DeMar

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