Money is ubiquitous and fungible. It also plays an important, if not dominant, role in practically everybody's life. A minuscule number of individuals (economic nerds), however, truly understand how money is created in our financial system. The process by which the money supply of a country is increased or decreased is important in understanding how an economy functions. Before proceeding with the details, I should mention I am specifically addressing money creation in the United States. Most other countries with a central bank operate in a similar fashion, but this blog will only pertain to the United States.
The majority of the money supply that the public uses for conducting transactions is created by the commercial banking system. This is done by commercial banks exercising their lending function. Bank loans expand the quantity of bank deposits. Our system of banking is called fractional reserve banking because banks only keep a fraction of deposits as reserves, and they loan out the rest. A bank creates new money merely by issuing a loan. The amount it creates is limited by the reserve ratio or "fraction" it is required to maintain to cover its cash-flow needs and comply with standards mandated by its regulators. With a general industry reserve ratio of 10%, then each $100 it lends includes $90 that never existed before. A commercial bank, therefore, can create a sizable amount of money merely by making loans. Conversely, money is destroyed when bank loans are paid off by borrowers or charged off by the lender.
In the world of dollar creation and destruction, the "Wizard behind the curtain" is America's central bank, the Federal Reserve Bank. There are multiple levers the Federal Reserve can pull to influence the nation's money supply. One way a commercial bank can expand reserves and make even more loans is to borrow funds from the Fed. This process is called going to the "discount window." When a bank goes to the discount window, the bank is expected to pledge collateral. The collateral can be government bonds, but it commonly consists of commercial loans. The Fed then grants credit to the bank in an amount equal to the debt instruments. This allows the bank to convert its old loans into new reserves. Every dollar of those new reserves then can be used as the basis for lending nine more dollars in new money.
The Federal Reserve Bank is the banks' bank. That is, banks hold deposits at the Fed much like you or I might hold deposits in a checking account at our local bank. From its inception in 1913 until October 2008, the Federal Reserve never paid a penny of interest to its various depositors (commercial banks). That all changed a month after the collapse of Lehman Brothers during the throes of the Great Financial Crisis. On October 6, 2008, the Federal Reserve began paying interest on depository institutions reserve balances (both required and excess). The program is known as the Interest on Reserve Balances (IORB). This tool allows the Fed to implement monetary policy by influencing short-term interest rates. The higher the interest rate the Federal Reserve offers to pay its member banks on their reserve balances, the less likely it is for the banks to lend money to private borrowers. Banks are generally unwilling to lend to private parties at a rate lower than what they can earn risk-free on reserves at the Fed. If the Federal Reserve wants banks to lend more of their deposits, thereby creating more money, all they need to do is lower the IORB. And that's exactly what they did during COVID. In January 2020, the interest rate on reserves was 1.55%. By mid-March 2020, the Federal Reserve had dropped the rate to 0.1%.
The Fed can also manipulate the amount of reserve deposits in the financial system by purchasing or selling bonds (primarily Treasury securities) in the market. This is referred to as open market operations. When the Federal Reserve buys bonds from banks they digitally create new money out of thin air and exchange this new money for the bonds that are then included on the Fed's balance sheet. An increase in bank reserves theoretically increases bank lending and in turn increases liquidity and the money supply. This open market purchase strategy is known as Quantitative Easing (QE) when it is pursued on an aggressive basis for an extended period. QE during the financial crisis (2008-2009) added about $3 trillion to the Fed's balance sheet. The COVID crisis triggered the addition of another $5 trillion to the Fed's balance sheet. From January 2020 to January 2022, the M2 money supply increased from $15.4 trillion to $21.6 trillion. That's a 40% increase in the money supply - unprecedented in recent U.S. history.
There are risks associated with an insufficient money supply, but it happens so rarely in history it is not worthy of discussion. The historical problem, however, which we happen to be currently experiencing, is excessive money supply with more most assuredly coming down the pike. Excessive money supply growth, when outpacing economic output, triggers inflation, erodes purchasing power, and causes currency devaluation. To quote Milton Friedman: "Inflation is always and everywhere a monetary phenomenon." When too much money chases too few goods, prices invariably rise. High money growth often precedes inflation by roughly a year. This was seen in the 1970s when inflation hit double digits and hung around for a few years at dangerous levels. It was also evidenced in 2021-2022 when inflation went from 2% to 9%. This was triggered by the massive (40%) increase in the money supply in response to the COVID pandemic. Consumers painfully discover their cash buys fewer goods and services. Excess money and liquidity can also flow into stocks, real estate, and other assets, creating asset price bubbles. Sound familiar?
Although it will never be acknowledged by the leaders of either of our major political parties, it is my opinion that the government will continue to run the economy hot and intentionally target an inflation rate of 3% - 5%. Inflation works as a "soft default" on current debt since the real value of the debt is repriced. The total real liability of the current federal debt decreases by 19% with an inflation rate of 5%. Inflation acts as a mechanism that reduces the consequential debt-to-GDP ratio. It also effectively transfers wealth from holders of government debt (creditors) to the U.S. government (debtor). Inflation is an insidious, hidden tax that decreases the purchasing power of the populace. Using inflation to reduce debt is a blunt, dangerous tool that ultimately can serve as a catalyst for a fiscal crisis and significant social upheaval.
