To: SSU Students
From: Jude Wanniski
Re: Mechanisms of Money Creation
In our lesson last week on the basics of money we covered the general concept and functions of money. This week we will discuss the mechanics of money creation by the U.S. central bank, the Federal Reserve. Many of the world's major central banks now follow the same operating procedures, but there are many variations. The following originally appeared as the appendix of a paper I wrote for Polyconomics' clients on March 9, 1995, "A Golden Polaris," which is available in its entirety in the SSU archive. At its conclusion, I've added a section on the monetary mechanism prior to 1934 that will help you see the process in a different dimension.
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Currency is non-interest-bearing debt of the national government. In the United States, it comes into circulation through the operations of the Federal Reserve Bank, which has the power to "create money." It does so through the simple process of buying interest-bearing debt that had previously been issued by the Treasury Department. That is, Treasury issues a bond in the amount of $1000 in order to finance its budget deficit. (Note that "money" cannot exist if there is no national debt.) The $1000 bond pays an interest to its holder at maturity. The Fed can "buy" the $1000 bond with a check for $1000 written in a checkbook that has simply been given it by Congress. When the Fed creates this "ink money," it has "monetized the debt," i.e. converted interest-bearing-debt to cash. The process works because the citizenry needs cash as a medium of exchange, and is thus willing to hold government debt for this purpose without being compensated by the payment of interest.
At the conclusion of the purchase, the Federal Reserve has in its portfolio an asset of $1000 that is paying interest and a liability of $1000 that is not. The interest amount covers the expenses of managing the central bank, and funds in surplus are given to the Treasury as part of its general revenues. The Fed also has the authority, of course, to reverse this process. It can decide to withdraw cash from circulation, doing so by taking the $1000 bond from its portfolio of assets and selling it on "the open market." The decision on whether or not to buy bonds to create cash or sell bonds to extinguish cash is made by the Fed's Board of Governors and the presidents of the regional Federal Reserve banks. They come together every several weeks as "The Open Market Committee" to decide on whether to buy, sell or hold steady. Their decision is communicated to the "open market desk" in New York City, which implements the policy decision through its own operating procedures.
Conceptually, the process of creating money adds reserves to the banking system. The banks are required by law to hold a percentage of their deposits in ready cash or the equivalent of cash -- its own checking account at the Mint. These reserves are a cushion to meet potential demands of the depositors. Thus, a Fed decision to "ease" may put more cash into the banking system than the banks are required to keep by law. This will push the banks into finding borrowers who will take the surplus cash in exchange for an asset that will earn a profit for the bank. A Fed decision to "tighten" may take out reserves that the banks are holding in accordance with legal requirements. This means the banks have to sell assets to private buyers in order to get their cash reserves up to par. The most critical part of the process is at the periodic meetings of the Federal Open Market Committee (FOMC). How does it decide whether to buy bonds to create money or sell bonds to extinguish it? Either it has a fixed rule that determines when to buy and when to sell. (We then say the dollar is in a "fixed system.") Or, it has no specific rule to guide the committee, which is permitted to consider a variety of signals from the market. (We then say the dollar is "floating.") Its value is determined by the "free market," as that market tries to guess what is going on in the minds of the open-market committee, which meets in secret.
When the central bank is on a "fixed system," the FOMC's power is enormously reduced. That is, it must act when the fixed standard it has chosen is being violated and it must not act when the standard is in equilibrium. A gold standard is one type of fixed rule. It requires that if the Treasury issues debt guaranteed in gold at the price which obtained at the moment of issue, the FOMC will be required to buy bonds when the dollar price of gold is tending to fall and to sell bonds when the dollar price of gold is tending to rise. In other words, if the target price of gold is $350, the Fed will be forced to advise the desk in New York City to buy bonds when gold has drifted to $349 and to sell bonds when it has drifted to $351.
If the credit markets know that the Fed by law is forced into this rigid operating procedure, keeping the dollar at all times as good as gold, they do not have to guess at what is going on in the minds of the FOMC members in their secret meetings. If gold remains the most reliable proxy for the value of all other commodities, the creditors of the national government will be assured that the gold or gold equivalents they lend by buying government bonds will be returned to them with interest at maturity.
The risk of a small number of men and women making incorrect decisions at the FOMC is replaced by the risk of the broad market for government credit making the wrong decisions. It is for this reason that gold standard interest rates are inevitably much lower than interest rates on floating debt.
Inasmuch as private citizens who are drawing contracts in the government unit of account benefit from this reduction of risk, they are able to take greater risks in their investments in each other. The efficiency of capital is increased. It is also possible to fix an automatic course on the central bank's deliberations without gold or with gold averaged in with several other commodities. The Fed's desk could be required to buy bonds when the sum of the dollar price of gold, silver, cocoa, wheat, platinum and copper -- divided by six -- is, say, $200. The markets would be informed of this certainty by an act of Congress or an executive order of the President or, at present, by a simple vote of the FOMC. It may be that such a system would be superior over time to a system without any rules to guide the market, but it seems obvious that as a unit of account, such an index would require so many calculations that contracts drawn against it would carry interest rates considerably higher than a gold contract.
Yet another rule, proposed by the monetarists and actually followed in the first years of the Reagan administration, was a quantity rule. The Fed was forced to sell bonds when the quantity of all money in circulation exceeded an amount scientifically determined by the monetarists and to buy bonds when the quantity was beneath that target. The theory took no account of day-to-day needs of the market for liquidity, on the grounds that over a long period of time the excesses and deficiencies would wash out. It was in this period that the price of gold underwent its most violent fluctuations on a day-to-day basis as the Federal Reserve was hitting the monetarist quantity targets with some precision.
At present, the dollar is technically floating on what might be called a "Greenspan Standard." The FOMC members each have their own preferences on how fast the economy is growing nationally, how fast in their region, what statistics constitute rapid growth, how commodity prices are acting, how the dollar is performing against other national currencies, what the White House wants done politically, and what their advisors are advising. Of all the members, Greenspan watches the gold price most attentively, and as chairman he gets to throw his weight in that direction. In addition, his attempt to get the gold price down by raising interest rates instead of draining liquidity has not worked. This hardly constitutes a Polaris, especially when the markets also have to reckon on the value of the dollar a year from now, if Greenspan is replaced by a Clinton appointee who will be driven purely by political goals.
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As you can see from this last paragraph, things have changed since 1995, when Greenspan was still "watching the gold price" as a signal of incipient inflation. It was when the gold price began its decline in December 1996, signaling incipient deflation that Greenspan decided he no longer wished to be guided by gold. He then made excuses why it no longer performed the function he said it did throughout his adult life. In his most recent testimony before House and Senate Banking Committees, Greenspan no longer pretends that his job primarily is to supply the liquidity being demanded by the banking system and the exchange economy. He now insists the Fed must manage the national economy in a way that prevents wealth from being created, as I covered in my Tuesday memo this week to Paul Krugman of the NYTimes.
As I noted in the introduction to this lesson, I will take a few more minutes of your time to discuss the mechanisms involved in "money creation" earlier in our history. Under what economists now call a "pure gold standard," which ended when Congress created the Federal Reserve in 1914, the only real function the government played in "money creation" was its issuance of currency -- gold or silver "certificates" -- in exchange for species presented at the Mint. The government also issued government bonds to cover the national debt. And in the process of returning to the gold standard after the Civil War, it issued bonds for "greenbacks" that had been in circulation, paper not convertible into gold. As it took in the greenbacks, it extinguished them, which contracted the outstanding money stock, forcing gold and all other goods to come back into balance with the dollar at the pre-Civil War price of $20.67 an ounce. There was in this "free banking" era no "central bank." The private banks relied on the government's maintenance of the unit of account at the specified dollar rate and supplemented the government's gold and silver certificates with bank notes of their own.
The distress felt in the national economy as a result of the purposeful deflation began an agitation for government involvement in the national banking system. The tariff wars in Europe that led the way to conflict in WWI also contributed to financial turmoil in the United States that further pressed the case for government involvement -- the concept of an "elastic currency" that could smooth out the bumps attributed to changing economic conditions in a faster-growing world economy. With the creation of the Fed in 1913, banks that were short of liquidity could present their paper assets -- commercial paper -- at the Fed's "discount window" in exchange for dollar liquidity. If they had a short-term loan from a corporate customer who paid 4% over, say, 90 days, the bank could put it up as collateral in exchange for the Fed's money at, say, 3½%. The Fed would pocket the difference in support of its service as the "lender of last resort." In the period to 1934, the Fed only "created" new money in this fashion, as it still was not possible for the central bank to give private banks liquidity in exchange for government debt. In other words, it could not "monetize" government debt.
It was the intellectual debates that surrounded the causes of the Great Depression that led to a provision of the 1934 Glass-Steagall Act which permitted the Fed to monetize government debt. The Fed today can monetize government debt by buying Treasury bills and bonds from the banks with "ink money," created out of thin air. Or, it can discount commercial paper at its discount window, as it did in its early days. In the last 20 years or so, for all practical purposes the discount window is no longer used, and all "money" is created or destroyed by the Fed's open-market operations -- buying or selling government bonds to several designated member banks.
This has not been an easy lesson, because the mechanisms become more complex as they deal with the myriad realities and complexities of the marketplace. I also apologize for oversimplifying, taking a sentence or two here and there for concepts that can occupy students for an entire semester. My aim, though, is to have you understand one truly simple idea at the core of all monetary theory and practice, which is the importance of money as a unit of account. If the government, any government, can maintain the value of its paper money in terms of real things -- that are real because they embody the labor required to make them -- it will be doing a primary service to the national economy it serves. As the leader of the world economy, the United States would do a primary service to the international economy if it would find a better way to provide a dollar that maintained its value in real terms.