Why, why, why “the money’s not here …. Your money’s in Joe’s house! Right next to yours!” But, that isn’t how money works – George Bailey owes us an explanation if that is his real name. In lieu of George showing up and explaining it to us, we can take a high level look at how money is created. This examination is timely, as commentators and some policy makers seem to imagine the Federal Reserve can simply step in and curtail the amount of money in circulation effectively pressing the big red “Stop Inflation” button – but the truth is much more nuanced. The Federal Reserve doesn’t so much control the flow of money as it controls the interest rate one bank must pay another to borrow money; in sum, it controls the cost of money.
You were probably taught the same basic lesson Jimmy Stewart delivers to mid-bank-run Bedford Falls residents. The bank gives you interest on money you keep in your savings account because they aggregate all the savings accounts together and use those to issue mortgages so folks can buy homes, auto loans for cars, and the like. Your interest is a portion of the interest they receive on your lent out money, and the cycle continues.
Except that’s almost exactly backwards.
Deposit accounts don’t create lending opportunities, lending creates deposit accounts. The It’s a Wonderful Life version of banking would cast banks as being little more than entities that connect people with extra money to lend with people looking for money to borrow. The reality is banks do most of the money creation in the modern economy. If you’re wondering why, then, you’ve never seen a giant minting machine churning out bills in the lobby of your local Wells Fargo, then perhaps we should begin at the beginning.
What is “money?”
The above-referenced cash is but one type of three: currency, central bank reserves and bank deposits. They all represent, in physical or abstract form, an amount owed from one individual or entity to another. So the very first thing we need to do in order to get our arms around how money actually works is dispense with the notion that “adding money” to the economy necessitates printing cash – it can, but needn’t, and usually doesn’t. The creation of a bank deposit, for instance, can be every bit the creation of money as printing a greenback.
The important takeaway is an understanding that, for every dollar in a deposit account somewhere, there needn’t be a physical dollar bill in the real world. “Money” in the economy includes currency, central bank reserves and bank deposits.
How is money “created?”
Now that we have decoupled the idea of “money” from physical bills and coins, we can explore how money can be created.
The Federal Reserve is the central bank of the United States and it is tasked with controlling the monetary system. By way of explaining its role, a quick earth science lesson digression: do you know … Read the rest