Saturday, September 06, 2008

Where does money come from?

As my final post in the short series on the dollar (read part 1 and 2), I wanted to quote what I believe to be an excellent (though complicated) explanation on where money comes from. This also exposes some of the problems with the Federal Reserve System--a system that Ron Paul, Bob Barr, and Chuck Baldwin want to eliminate. This came by way of a Campaign for Liberty Meetup mailing list with some formatting modifications.

How is money actually created by the Federal Reserve?

Debt is traded to the Fed in exchange for the money. In order to get
money from the Fed, banks or government have to provide a promise to
pay the money back.

The borrower promises to pay the money back and the lender creates the
money based on that promise. The money is backed by the promise. That
is what is meant by the full faith and credit of the U.S. government.
The U.S. Treasury Bonds are the promissory note to repay the money.
They are only one type of instrument accepted by the Fed. During the
current mortgage crisis, the Fed is trying something new. Instead of
covering illiquid member banks with straight currency to satisfy their
short term obligations, the Fed is swapping one kind of promise for
another. The banks need cash, but hold mortgage notes. What would
normally happen would be the bank would borrow cash from another bank
to cover its obligations and use the notes as collateral, or sell the
notes for cash. Banks are no longer willing to lend to other banks who
want to use the mortgages as collateral or buy the notes outright. So,
the Fed is trading the government debt to the banks for the mortgages,
so its members can get cash quick by either selling the government
bonds or using them as collateral.

This is something I have drilled my kids on.
Q: How is money created?
A: Money is created when someone promises to pay it back to the
lender. All money is debt. Every dollar in your wallet is someone
else's promise to pay the bank back.

Q: How is money destroyed?
A: Money is destroyed when the promise is kept, or it is broken. Repaying
a debt or filing bankruptcy ends the obligation that was created when
the money was. No obligation means no debt. No debt means no money in
a fractional reserve banking system.

During the Roaring 20's many people borrowed to buy stocks. The stocks
purchased were the collateral for the debt. As long as the banks kept
lending, more money was being created and demand for stocks continued.
When the banks stopped lending, stock prices started to drop because
the creation of money through lending stopped. People were in debt and
had to sell the stocks to pay off their debt. Nobody could borrow to
buy the stocks, but the banks were calling in their loans because the
value of the collateral was dropping, so there were more sellers and no

Today something similar has happened with mortgages. A lot of this
debt is going to have to be written off. If the Fed injects capital
(unbacked money) cover the bad debt after it runs out of government
notes to trade, inflation will result. If it doesn't, the supply of
money will shrink. That is deflation. Prices drop. It seldom happens.
It happened during the Great Depression. The usual tactic is to paper
over the broken promises of the borrower by creating money not backed
by a promise to repay. This steals the value from the money. That's
inflation. Prices rise. It is always easier politically to steal a
little from the many than a lot from a few.

In summary:
1) Banks ask the Fed for money.
2) The Fed waves a magic wand saying "Now you have money, as long as you pay it back with interest."
3) The banks then loan out that money at even higher interest (like mortgages, etc.) so they can pay back the Fed.
4) The system works great until it backfires. Mortgage recipients don't pay, then the bank can't pay, then the fed doesn't get the money back.

The result: The Fed creates money (with nothing valuable to back it up) that then devalues money that already exists. Normally this money is then destroyed when it is paid back, bringing things back into balance. However, it often doesn't get paid back.

Another result: The lower the Fed sets interest rates, the more money that banks will borrow. The more money banks borrow, the more they try to loan out. So people take loans they should have never taken and then can't pay back. Low Fed interest rates directly lead to the "housing bubble" that has now burst, destroying the economy.

How does Congress propose to handle the problem? Give the Fed more authority over mortgage regulation. But weren't they the ones that caused the problem in the first place?

How does the fed react to the housing problem? Lowering interest rates.

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