“The process by which money is created is so simple the mind is repelled.” – JK Galbraith
There’s a reason why myth # 1 in my “biggest myths in economics” is “the government prints money”. It is, by far, the most pernicious and misleading of the economic myths that exists. I was reminded of this today as I was reading a piece in Reason by John Stossel who is discussing the merits of replacing Hamilton on the $10 bill. He writes:
“But none of us would have to fight about whom to put on currency if it weren’t all created and printed by a central government.”
Ah, but John – we already have an entirely private money creation system. It just so happens to be controlled by these things called banks which compete within a private market based system to create loans! So, maybe we all need to be reminded where “money” really comes from. While it’s true that the government can “print” money it’s much more important to understand where money actually originates and how that printing fits into the broader context because it doesn’t work the way most people seem to think it does. I hope this simple explanation helps clarify:
1) Banks create most of the money in our system. Loans create deposits and deposits are, by far, the most dominant form of money in the economy. Importantly, banks do not “multiply” reserves as is commonly believed. Banks make loans first and find reserves later. The money multiplier is a myth. So, if you want to say someone “prints money” you would be most accurate saying that private banks print money.
2) The government is a user of bank money. When the government taxes Paul they take Paul’s bank money and redistribute it to Peter when they spend.
3) If the government runs a budget deficit (taxes less than it spends) then Paul buys a bond from the government and the government gives Paul’s bank deposit (which he used to buy the bond with) to Peter. Paul gets a bond which the government created in much the same way that a private corporation creates a bond when they issue corporate debt. If you want to say these entities “print” financial assets then fine. Corporations print stocks and bonds every day and you don’t hear the world exploding with hyperinflation rants because of it. Likewise, the government “prints” bonds when it borrows.
4) When the Fed performs quantitative easing they perform open market operations (just like they have for decades) which involve a clean asset swap where the bank essentially exchanges reserves for t-bonds. The private sector loses a financial asset (the t-bond) and gains another (the reserves or deposits). The result is no change in private sector net financial assets. QE is a lot like changing your savings account into a checking account and then claiming you have more “money”. No, the composition of your savings changed, but you don’t have more savings.
5) Coins and cash notes like the ones you have in your wallet are created by the US Treasury and are issued to the Federal Reserve upon demand by member banks. This cash is “printed” by the Treasury, but serves primarily as a way for banks to service their customers. In other words, if you have a bank account you can exchange your bank deposit for cash from the ATM or the bank teller. Cash is preceded by the dominant form of money, bank money which means that before cash gets into the system it is demanded by a bank customer who draws down their bank account. Importantly, cash doesn’t get printed off the presses and fired into the economy as some would have us believe. It enters the system through the banking system.
The accounting treatment of cash and coins sometimes leads to confusion as coins are not always listed as a government liability (the Fed’s Z.1 does properly account for coins as a Treasury Liability). Cash and coins are best thought of as contingent liabilities where the government is liable to replace the cash and coins and accept them in payment. Cash is treated as a direct liability of the Federal Reserve in the USA and is created directly by the US Mint. Functionally, cash and coins serve no economic difference and can be thought of interchangeably within the context of properly accounting for the US government’s balance sheet items.¹
Operationally, all cash and coins are created by arms of the US Treasury, the US Mint and Bureau of Engraving. When a private bank needs cash they order it from the Fed who must purchase it from the US Mint or Bureau of Engraving. The Fed pays only the cost of printing notes, but since coins are a direct liability of the US Treasury the Fed pays the face value of the coin.
6) Bank reserves exist for the purpose of helping banks settle interbank payments. The best way to understand this is to think of bank customers having their own banking system (the deposit system we all use every day) and banks as having their own banking system. This system is within the interbank system and is operated by the Central Bank to help banks settle payments between one another. In other words, banks have their own deposit system in which they settle payments among one another. This system exists so that Bank A can settle a payment cleanly with Bank B and transfer its liabilities accordingly. The reserve system is best thought of as a system that helps facilitate the transfer of deposits in the primary banking system by intermediating transfers in the secondary payment system (the reserve system).
In the proper context it becomes clear that “money” originates within the private banking system and can be transformed or swapped into differing types of “money” such as cash. Unfortunately, because many people don’t understand banking and the difference between inside money and outside money, they make this common mistake of assuming that the government controls the money supply directly.
¹ – Some economists insist on claiming that cash, coin and reserves are not liabilities. This is incorrect according to US government laws and basic accounting facts. First, the Fed specifically treats cash and reserves as their liabilities. This can be seen on their balance sheet as liabilities. Second, US government laws treats these items as liabilities.
Now, some people might say “what is the government liable for”? Well, it depends on the specific item, but there are many things they’re liable for including:
- Paying interest on reserves and bonds.
- Maintaining the real value of their liabilities.
- Redeeming their liabilities when demanded.
* Still confused? See the following pieces:
2. Understanding The Modern Monetary System
3. Understanding Inside & Outside Money
7. Understanding Quantitative Easing
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.