Money Creation – How does it work?



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Money creation: described by many as the biggest scam in the history of mankind; for others, it’s a blessing and a driving force of the economy. For John Maynard Keynes it was a process that “engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” We hope that after seeing this video you will be this one man in a million.

Let’s look at the case of US dollar creation, as it is a global reserve currency. Many people don’t realize that any dollar spent by the government sooner or later, one way or another, will be taken from the taxpayers’ pockets. The government can finance new spending in several ways. Raising taxes is one way to do it, though this method is unpopular. Another option is to cut spending in some sectors, but this can provoke dissatisfaction or even social unrest for the groups cut off from the money faucet.

However, there is another option. The government may increase the budget deficit and thus finance current expenditures at the cost of increasing debt. The US Treasury can issue securities like government bonds. Simply put, a bond is a promise to repay a certain amount of money with interest after a certain date. It constitutes a debt obligation. The government bonds are sold to financial institutions at auction. By itself, issuing bonds doesn’t necessarily lead to money creation. Bonds can be bought by a private individual with previously saved money. However, some bonds are bought by means of open market operations by the Federal Reserve, which is the US central bank. The process goes as follows: The Fed buys bonds from a commercial bank by issuing a check in its own name. There are no savings in the Fed’s account. The Fed reports bonds on the asset side of the accounting equation, and on the liabilities side, the Fed reports new money equal to the value of the check.

When the check is received by a bank which is selling the bonds, the check simply becomes a new money in circulation. Complicated? Well, let’s try to simplify our story here. Let’s just skip the intermediary, the financial institutions. The government issues bonds and then sells them to the central bank who buys them with newly created money or, in other words, the check for the government debt. What we now call money, or more precisely monetary base, is created by the fact that the two institutions exchanged paper or digital records. Each asset purchased by the Fed increases the monetary base. Government bonds are interest-bearing, so it is necessary to pay interest on each bond issued. This is called debt service. In order to pay for an existing bond the government usually just issues some new bonds. This doesn’t seem to be reasonable at all, does it? Imagine if you borrowed some money, and spent it all at once.

Now suppose that you took another loan to pay off the previous debt, even though you were still paying interest. This is called “rolling over” debt. Although the face value of the loan is never repaid, the periodic interest is. This procedure is listed among other budgetary items as the cost of servicing debt. These costs are incurred regardless of whether the money is created or not. When the citizens buy bonds from the government for their savings, the interest on the debt is still paid. At the same time, the Fed gives earnings from interest to the government. Thus it is cheaper for the state to borrow through monetization of the debt, rather than to simply sell bonds.

It is important to understand that in this way the debt becomes a burden for everybody and for years to come, regardless of whether the debt was incurred by involving money creation or not. Money creation exacerbates the problem further by reducing the purchasing power of money holders, and by allowing for a greater debt than would be possible otherwise. However, the monetary base is only one narrow measure of money; let’s see what happens next. The government still spends money on things like the military, pensions, social programs, and many other things. So the money is eventually received by the public one way or another. This money is then deposited by the public in commercial banks. As you already know from the previous video about fractional reserve banking, in a process of lending to the public the commercial banks can, in turn, create even more money based on the newly deposited funds. About 95% of the US currency is created precisely in this way, rather than being issued directly by the government.

If you watched our video about inflation, you probably already know the effects of money creation. Each new dollar reduces the purchasing power of every dollar in existence. This is why inflation is sometimes referred to as a hidden tax. Not many people understand this phenomenon. Most of us just feel that each year we can buy less and less for the same amount of money. But it is easier for some to put blame on the greed of entrepreneurs who raise the prices. To sum up: each newly created dollar causes the purchasing power of all other dollars to decrease. As a result of this process, the dollar’s inflation is also exported abroad due to its global position as both reserve currency and a unit of account. You may have noticed that throughout the entire process the newly created money is based on debt. When the Fed increases the monetary base, the public debt also increases. And granting a loan by any of the commercial banks necessitates an act of fiduciary media creation.

The money thus created ceases to exist once the debt is repaid. Without further borrowing, the repayment of the debt would have resulted in a strong monetary deflation. Economics Professor Robert Murphy once said: “if people in the private sector ever paid off all of their debts, and the federal government paid off all of its bondholders, then the supply of US dollars would be virtually extinguished.” In spite of this fact, the money is not the same as debt.

The bonds and loans are. Perceiving money as debt is a rather popular misconception. Inflationary policy not only reduces the purchasing power of money, but it also leads to clusters of malinvestments, as we have already seen in our video entitled “Austrian Business Cycle Theory”. For this reason, many Austrian economists oppose this kind of monetary policy, and they even consider the very existence of central banks as detrimental to both society and economy.

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