Money And Debt

Have you ever thought about how money gets created?

I suspect most people think the government creates money. It does not. Money is created by the Federal Reserve System, a cartel of privately-owned banks. Despite its name, it is no more a Federal agency than Federal Express.

When the Treasury Department needs money to pay the government’s bills, and if collected taxes aren’t enough, it borrows money from the Federal Reserve. In return, the Federal Reserve receives Treasury bonds of equal value. Treasury bonds are simply “IOUs”, a promise from the Treasury to repay the money to the Federal Reserve System – with interest. (All this happens with computer accounts, not pieces of paper.)

Where does the Federal Reserve System get the money to loan to the Treasury Department? It essentially writes a check on itself, creating money out of thin air. Every dollar in circulation was created as debt. If government and citizens repaid all public and private debt, there would be no money in circulation. If the federal government repaid all its debt, there would be quite a lot less money in circulation. A country’s monetary system doesn’t have to work this way, but that’s the system we have.

To avoid cycles of economic boom and bust, inflation and deflation, the Fed manages the amount of money in circulation. When the economy is growing too fast and inflation is creeping upward, the Fed shrinks the money supply (or slows its rate of growth). When the country is in a recession, the Fed boosts the money supply. Increasing the money supply helps the economy grow by reducing the cost of loans and making money easier to borrow. Boosting the money supply therefore promotes job growth. Shrinking the money supply makes loans more expensive and harder to obtain, thus causing the economy to grow more slowly (or shrink as businesses fail). Shrinking the money supply therefore promotes higher unemployment.

What happened in 2007 was a housing crash and then a banking crash. The image below shows the Fed’s R.100 chart from its 2nd quarter 2011 Flow of Funds (Z.1) report. Click the image for a larger picture. Line 1 shows the change in net worth of American families and nonprofits in billions of dollars. Prior to 2007, net worth had been growing at a rate of 5 or 6 trillion dollars per year. But in 2007, net worth grew a pitiful $22 billion. And in 2008, $12.8 trillion dollars of net worth suddenly vanished.

Remember, shrinking the money supply hurts the economy and promotes higher unemployment. That’s why the government rushed to pass a 2-year stimulus package. The idea was to get money back into the economy to replace some of the money that had vanished. (The stimulus bill was passed with no G.O.P. votes.) The problem was that the stimulus was so small relative to the amount of wealth that had disappeared that it was unlikely to help much. The stimulus did help, but it was no match for the amount of hurt that the housing/banking crash had inflicted.

Today, conservatives in Congress are trying hard to cut government spending. While this is good for the budget, it has a down side. A lot of paychecks in our economy are funded by government borrowing and spending. Cutting government spending will shrink the money supply which, in turn, will harm the still-struggling economy and curtail job growth. It all comes down to what you think is more important: the debt or jobs. Ironically, the spending cuts that hurt jobs are often made by cutting safety-net programs that were there to help people who are out of work and out of money.