The Federal Reserve and Money Creation Magic

“There are some things money can’t buy. For everything else, there’s MasterCard” is a famous advertising slogan associated with credit and debit card company, MasterCard. Have you ever wondered how this money is created for you to purchase goods and services? Are all the money in the world just printed from the mint or is there a more sophisticated way of how the money we use is created?

To understand how money is created, we need to look at the US monetary system. The US monetary system is controlled by the Federal Reserve Bank (the Fed), which was established in 1913 via the Federal Reserve Act. The Fed, despite its name, is not part of the government. The Fed is a central bank that consists of several secretive, private banks  (yes, u read it right, private banks). The Fed has several goals. Firstly, it loans money, with interest, to the federal government. Secondly, it adjusts interest rates according to the economic situation. Thirdly, it prints fiat currency to be used as legal tender. Fiat currency is money that gets its value from government regulations. In a US dollar bill, you can find the following phrase and it’s this phrase in all its bills that gives value to the US dollar:

(Image courtesy of http://epiac1216.wordpress.com)

Let’s say the US Congress needs money to fund certain projects. The US Treasury prints treasury bonds and these bonds are sold to the Fed in exchange for money. This money from the Fed is then used to fund the government projects. The money lent by the Fed is accounted for only digitally and is not physically printed (only around 5% of the money in the world exists as paper currency and the rest of the 95% of the money is all in digital form).

The Fed, like all other banks, uses fractional reserve banking system. It’s a system where 10% of the money deposited by someone is kept and the 90% of it is loaned out. By using this system, a mind-boggling 9 times the money deposited can be created out of thin air for others to borrow. To illustrate the fractional reserve banking system, let’s say a new bank started off with a $1000 deposit. This $100 deposit can then go on to create $9000 in the banking system (not the same bank as money flows). If you don’t believe what I have just said, take a look at the Excel spreadsheet that I created to make myself believe.

This fractional reserve banking system is made to work because not every single person in the world will withdraw his/her money at the same time. If this really happens, it will cause catastrophic failure to the whole banking system. This is called a “bank run” and it’s a dirty word among bankers.

Let’s sidetrack a bit. Why did the fractional reserve system come about in the first place? Why can’t we use the full-reserve banking system which is the opposite of fractional reserve system? The full reserve system (Gold Standard where each dollar is fixed to a mass of gold) was being utilized till 1971 when President Richard Nixon decoupled the dollar bill from the gold backing.  Banks make money by charging a higher interest on loans given out than on the interest given to money deposited in the bank. The difference in interest earned is the revenue of the bank. By having a full reserve banking system, the banks revenues are minimized as they cannot loan out more money than they have. By switching to the fractional reserve banking system, the profits of banks can be maximized as not everyone will withdraw their money at the same time.

By creating 9 times more money when using the fractional reserve banking system, you would have noticed something astonishing. When people borrow, money is created. So, essentially money circulating in the world is all debt. We are living in a debt-based monetary system. Yes, it is true. Money = Debt. Since all the money for the past 30 years (since 1971 when Gold Standard ceased) is debt, when all the debt is paid up, money will cease to exist. Ironically, debt is needed for the economy to flourish.

When a person cannot afford to pay his/her debts (together with the interest owed), default looms. This gives immense pressure to the person on the brink of default as the amount owed will always be more than the amount borrowed. Let’s now shift our attention to a country. When a country cannot pay debt, it just simply prints more money. This creates more debt at an exponential rate. An apt analogy will be digging a deeper hole to bury oneself. This is what is happening in Europe and US. These debt problems were created after adopting the fractional reserve system. The world leaders are working hard to control this debt bubble from bursting. If it bursts, it will create a complete failure to the whole banking system!

Can this problem be solved if we go back to the Gold Standard? I think it can be since every dollar will be equivalent to a certain mass of gold and since gold is a limited resource, it cannot be “printed” as and when the government needs.

For a detailed understanding and to get a better picture of what I have just mentioned, you need to invest 47 minutes of your time to watch the following video. It will be absolutely worth the time (I promise!).

The next video is basically the same as the previous video but it’s a shorter version:

A brief U.S. history of money:

The problems the money creation method is creating and what does it mean in the future (must watch videos!):

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2 thoughts on “The Federal Reserve and Money Creation Magic

  1. I believe there are several misunderstandings in the article.

    1. FED can’t buy US debt directly from The Treasury Department. FED buys from secondary market and through repo or reverse-repo mechanism to manage its holding of the US debt. After 2008, FED created many other ways to buy US treasuries, which includes QE2, but I can’t remember the details any more.

    2. FED is the bank of banks. FED is only a direct lender to other banks. that’s why Goldman Sachs and Morgan Stanley must convert to bank holding company to borrow money from the FED and why AIG can’t do the same and need to be bailed out by the Treasury Department. Paper money is printed by mint under The Treasuries Department and sold to FED at a nominal cost. FED then lends the money to commercial banks, thus the money will start to circulate within the economy. So it is not exactly “right” that FED prints the money.

    3. I could be wrong, but I remember fractional reserve banking dates back far before Nixon. and itself has nothing wrong. A full reserve banking system is a total waste of resource. As no one is going to use the money all the time, there is no point to prevent commercial banks from lending the excess money to other people who need a loan. Essentially, commercial banks help circulating money, which is beneficial to the economy, I believe.

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