I know that the Fed creates money from nothing through open market operations, the discount rate, and fractional reserve banking, but my question concerns the actual procedure for creating the money in each of those instances.
Open Market Operations
As I understand it the Fed buys US securities from Dealer A and deposits (creates) say $10 million worth of electronic dollars into Dealer A's bank account. That seems pretty simple to understand, but where did the money come from initially for Dealer A to buy the US securities which he then resold to the Fed? That may be a stupid question but the money supply had to start somewhere.
The Discount Rate
This is the rate that the Fed charges to financial institutions for short-term loans of reserves. How does this create money? The reserves supposedly are on reserve so they already exist. Is it only after the reserves are lent out by the financial institutions to others that begins the money creation through fractional reserve banking? If so, on to my next question.
Fractional Reserve Banking
I understand how fractional reserve banking works but how is the actual money created? I know that for every $100 of deposits a bank can lend $900 on a 10% reserve ratio system, but that $900 must be able to be converted into actual paper or electronic dollars, so does the lending institution have a right to require the Fed to print that $900 if the borrower or someone else wishes to redeem it? If so, how does that process work? Can somebody point me to something that can explain the actual procedure that requires the Fed to print/create electronically that $900?
Many thanks.
To be honest, I think the salient feature about "How the fed creates money?" lies in keeping the truth simple. Recognize the Fed for what it actually does: changes the digits in its bank accounts and then spends it. Then, look at where the Fed spends the created money.
The money is conterfeited and fabricated out of nothing. It is truly analogous to YOU or ME hacking into our banks and moving around the decimal point of our own accounts. Everything else (open market operations, discount rate, reserve banking, etc. ) are just distractions to make the truth more complicated for the public to realize. If banking was completely private, those operations would probably still exist in one form or an other. Therefore, I think it is more complicated than necessary to look at them for understanding how the fed creates money.
I hate it when I try to tell people that the Fed just inflates the money supply and they say "No! The Fed uses OMOs! What? Are you ignorant?!?! or something??"
I wrote a post on Monetizing the Debt. There always is some money in circulation. Some of that money is used to purchase government securities. Approximately 10% of those securities are sold to the Federal Reserve. Fractional Reserve banking then creates the remaining 90%.
Banks don't always follow the exact limit of the legal reserve requirement. There is some wiggle room in the way the regulation is stated. I believe the reserve requirement is a 2 week average and not a daily requirement.
The Federal Reserve is barred from purchasing directly from the Federal government. In practice, that's a legal technicality.
The Discount Rate is currently 0.5% more than the Fed Funds Rate. Large banks may borrow at the Fed Funds Rate. Smaller banks borrow at the discount rate. Other types of borrrowing may occur at the discount rate. When a bank borrows from the Federal Reserve at the discount rate, it is borrowing brand new money. The Federal Reserve literally prints new money and loans it out.
When the Federal Reserve "monetizes the debt", it usually purchases Treasury Notes for an electronic credit. Sometimes, the Federal Reserve purchases Treasury Notes for actual physical Federal Reserve Notes. This guarantees that the volume of paper money in circulation is adequate.
In theory, everyone could go to the bank and simultaneously withdraw all their cash. In that case, the Federal Reserve would merely print enough Federal Reserve Notes to redeem all balances. Most banks have a limit on how much cash can be withdrawn per day. If you tried to withdraw $10k cash from your bank, you'd probably be suspected of drug dealing.
You might also be interested in my articles on the Compound Interest Paradox. I give a page of examples.
I have my own blog at FSK's Guide to Reality. Let me know if you like it.
fsk:You might also be interested in my articles on the Compound Interest Paradox. I give a page of examples.
Here I thought I might get immortalized on your blog but all you put is;
Argument from authority is another closely related, but different fallacy. On mises.org, some people write "Mises never wrote about the Compound Interest Paradox. Therefore, the Compound Interest Paradox does not exist." If you're merely citing other people and not thinking for yourself, then you aren't actually doing anything.
I'm definitely sure that's not the argument against your theory, at least not presented by me.
For all intents and purposes this is just a red herring to draw attention away from the real issues that make this theory questionable at best.
Not to hijack the thread...maybe we need one to specifically address this alleged paradox.
"Anonymous Coward" has not presented any arguments against the Compound Interest Paradox that I consider to be coherent or non-trolling.
If you want to create a separate thread on the subject, or a post on your own blog, go ahead.
The impression I have of "Anonymous Coward" is that he has a degree/PhD in economics or is a professor of economics. That makes it very hard to accept the Compound Interest Paradox, because that's like accepting "Everything I learned in my economics courses was a bunch of lies."
Do I have an emotional investment in the Compound Interest Paradox, or does Anonymous Coward have an emotional investment in the brainwashing he received as an economist?
Try asking a politician or politcs professor "Is taxation theft?" They'll have the exact same reaction as Anonymous Coward discussing the Compound Interest Paradox.
fsk:"Anonymous Coward" has not presented any arguments against the Compound Interest Paradox that I consider to be coherent or non-trolling.
I believe I certainly did (related post here) and Anonymous Coward's follow up post (to my message) in that thread would seem an entirely relevant and coherent post related to your proposed theory... There's nothing nasty about it, or illogical - it's just a regular, relevant post.
I gotta say though dude, you somehow manage to bring this paradox up in pretty much every thread on the forum, as though it's the answer to life, the universe and everything (which it can't be, because we all know that's 42). However, it appears to me that there is a very real chance that your theory is a little off base. As such it would seem a little premature to go presenting it as though it was a theorem. I'm not trying to be nasty - I think your theory is interesting in it's own right and merits discussion... but not in every thread that appears in these forums. I think a better approach would be to pick one thread and stick with it - either a new thread or the BIS thread above would seem like a good place for this (since quite a lot of discussion has already gone into it in that thread).
Let's us summarize...
But what of the banker? Initially, no one has any money and only he can create it. How will the banker purchase the sustenance he needs from the farmer without the money to do so? How will he purchase clothing or acquire medical services? Why not just use the same pen which magically created money to lend to the farmer, only this time use it to purchase the necessities of life? Doing so would add new money to Planet Doom's economy without creating additional debt for the rest of the inhabitants to repay. This is the primary flaw in Jaikaran's story. The banker is not an ethereal entity. No, he is a living, breathing person who needs to purchase the products and services which make life possible and enjoyable.
And how do you deal with this 'primary flaw'?
Let's ignore the effect of the bank's operating expenses and profits for now; this example is complicated enough as-is.
This seems to suggest that you are aware of this fatal flaw and simply assume it away because it is the only way your example would work.
Then later on;
The bank's operating expenses are probably much less than $1.92 million, so there's a huge unearned profit for the banks. You can correct this example to adjust for the bank's operating expenses. You can adjust the extremity of the boom/bust cycles. The principle is the same.Maybe the bank's management will pay themselves a salary of $1.8 million, leaving $0.12 million as dividend payments for shareholders. For this reason, an investment in a bank isn't necessary a great investment, even though banks are guaranteed a profit built into the rules of the monetary system.
With there only being ten people in the model it would presumably be some or all of these people who are either employed by the bank or shareholders. Up until the time of the first interest payment they earned no profit therefore were paid no salary or dividends therefore had no way to eat or do all the other things that bankers like to do like play with bunnies.
Nor do you account for all the real wealth that existed before the bank magically came into existence, ignoring the fact that money isn't derived as a declaration of a banker but develops over time from the most tradeable commodity on the existing market.
Now we have your answer to all this;
The argument "The banker has to pay his expenses" only applies to a gold standard in a free market. Fiat debt-based money is different.
No explanation of either why it is different or how they pay their expenses without turning on the money tap to produce the excess money that comprises the 'paradox'.
Also in direct contradiction to your example where you attempt to integrate the fact that the bankers actually have expenses that effect the model.
fsk:The impression I have of "Anonymous Coward" is that he has a degree/PhD in economics or is a professor of economics. That makes it very hard to accept the Compound Interest Paradox, because that's like accepting "Everything I learned in my economics courses was a bunch of lies."
I don't know whether to laugh or cry but it is definitely a step up from;
fsk:I don't see any refutation there. I see the incoherent babbling of someone who doesn't understand how the US monetary system works.
Next you're going to start accusing me of being an agent in the employ of the Supreme Leader of Humanity I would imagine.
So why don't you try to address these issues instead of attacking my 'motivation' because I was brainwashed at Humboldt State while studying Art History...and anyone from California can tell you that's just 'secret code' for smoking a whole lot of pot on the government's dime.
So much for not hijacking the thread...
Back to the original poster's question, I think you'll find the following about one of the best (relatively) short descriptions of how money is both created and destroyed: http://mises.org/story/2926
You'll need to spend a bit of time reading through that and understanding what's going on, but understanding how money gets destroyed helps understand the real nature of it's creation much better... so it certainly pays to read the whole story (from birth to death).
As far as the mechaniscs of the OMOs is concerned, I haven't come across any good material on this yet (I'm hoping perhaps de Soto goes into it in Money, Bank Credit and Economic Cycles). The stuff on wikipedia is sorely lacking on details and merely mentions that the primary agents are instructed to "purchase assets" from the market - without any clarification as to the nature of those assets.
In broad terms though, all that's going on is that the central bank changes the amount of money in circulation by attempting to alter:a) Reserve requirementsb) The quantity of available reserves
They do not have absolute control over the later though (gold can be deposited as reserves and foreign currencies can also be used as reserves - something which has been pushing up inflation in NZ and Austrialia in recent years with the Japanese Uridashi bonds causing an influx of foreign reserves into the coffers of the banks in these economies).
Furthermore, the reserves are merely used by the banks to create loans. Essentially all money except physical cash and gold reserves (as Reisman explains) in our current system is based on debt. If people aren't willing to borrow then the central bank is powerless to create money (as the Bank of Japan has been finding out in the last 15 to 18 years). As such, you will often hear the analogy that when the Fed tries to create money or do pretty much anything to control the market, they are "pushing on a piece of string" - trying to alter one end of the string by pushing the other... quite ineffectually.
jimmy:In broad terms though, all that's going on is that the central bank changes the amount of money in circulation by attempting to alter:a) Reserve requirementsb) The quantity of available reserves
Thanks Jimmy. I understand that money is created through the fractional reserve process, which is what I believe your quote above refers to. What about when the Fed buys US T-bills and other securities from dealers/brokers. Does the Fed just create $10 million and credit it to the dealer's account in exchange for the security or does it use reserves deposited by the member banks into the fed system to pay for the securities?
reidbump: Thanks Jimmy. I understand that money is created through the fractional reserve process, which is what I believe your quote above refers to. What about when the Fed buys US T-bills and other securities from dealers/brokers. Does the Fed just create $10 million and credit it to the dealer's account in exchange for the security or does it use reserves deposited by the member banks into the fed system to pay for the securities?
When the Federal Reserve buys a T-bill or other asset, it's buying it with newly-printed money. The Federal Reserve literally creates a $10 million credit in whoever sold it the bond, and a debit of $10 million in its own account.
However, these purchases are usually outright bond purchases or repurcahse agreements. In the case of a repurchase agreement, the bond is sold back a few days later for a slightly larger amount, such as $10.1 million. The difference of $100,000 is never created. The Federal Reserve does get $100,000 to use for its own profits and expenses, but the missing $100,000 is never created. This is the whole point of the Compound Interest Paradox.
(For those of you keeping score, I've concluded that jimmy and Anonymous Coward are trolling and have nothing useful to contribute. I'm ignoring them.)
As I say, I haven't found a really good explanation of the detailed mechanics... to an extent, these are kind of irrelevant since the two basic facts above are what really counts... but here's the understanding that I've managed to piece together of the subject so far:
When the fed buys assets from the market (i.e. from it's primary dealers) it does so by taking possession of their securities (e.g. etheir T-Bills) on the one hand and by increasing their balance in the fed funds accounts on the other... basically increasing the reserves that they have on account at the Fed - it is this increase in their reserves which is how the newly created money gets magiked into existence (these reserves are completely abstract and fictive - they are reserves of precicely nothing at all).
In times gone by, this process was perhaps a ledger entry done with pen/paper. These days it's a bit that flips inside a computer somewhere. Nothing has happened in the real world at all, except that the primary dealer that sold those securities to the Fed now has increased reserves in their account with the Fed, which they can then use as the basis for loans (so these reserves will get multiplied out via those processes of fractional reserve banking that you're already familiar with)... and the government has a the extra cash (that came essentially from the Fed) which was used to buy it's T-bills... so the government are the most obvious beneficiaries of the newly created money.
As Anonymous Coward points out in the thred I linked to above, the interest on those T-bills hasn't generally been paid by the federal government in recent years - the Federal Reserve has been giving this straight back to them in the form of a rebate... which equates to the monetization of interest (if not the monetization of debt outright). This is one step away from the monetization of debt and is already an admission that the Federal Government is incapable of maintaining it's debt - it is incapable of servicing the interest on it's loans... not a good first sign. Next stop is monetization of debt outright - soon to be followed by hyperinflation - but only if we don't see massive monetary implosion (as described by George Reisman in the other article I linked to) first. So on the one hand, you have the serious risk of hyperinflation, and on the other you have the very real risk of serious and spiralling monetary contraction and deflation... neither of which would be very good for the economy... both outcomes would, essentially, be the result of excessive debt however - and that could never have come about if the people loaning the money were actually loaning their own money. The only reason we risk financial catastrophe at present is because the people loaning money are not, in fact, loaning their own wealth at all - they are loaning wealth that has been confiscated from them using the process described above. When the Fed creates new money, it steals a little bit of the value of all the other money that was existence before it's new money came into being... similarly, when banks multiply their reserves by the process of FRB they are also creating new money and thus stealing a slice of all the value held in money that existed before they created new credit backed by only a portion of the total sum they loan out. None of these people are making their own money or loaning out their own money - they're like gamblers in a casino playing with the money they just stole from someone's back pocket a moment earlier.
fsk:However, these purchases are usually outright bond purchases or repurcahse agreements. In the case of a repurchase agreement, the bond is sold back a few days later for a slightly larger amount, such as $10.1 million. The difference of $100,000 is never created. The Federal Reserve does get $100,000 to use for its own profits and expenses, but the missing $100,000 is never created. This is the whole point of the Compound Interest Paradox.
For crying out loud fsk, would you knock it off. Anyone who disagrees with you (and who's argument you are incapable of understanding) is automatically a troll? You have entire sectors of your blog dedicated to all the logical fallacies and you fall back on good old number one: ad hominem!
Two people, $10 in the economy. Person A lends person B $8 at $4 interest, so he wants $12 back. Oh no, the sky is falling - that amount of money doesn't even exist!!! Well sure, but person B gives person A a haricut (for $2) and uses the $2 to pay person A back $2 of the interest. Person B repeats serveral times this process and eventually has no only enough money to pay the interest, but enough to SAVE some as well.
So, once again, your silly paradox does not exist if the bankers spend any of the interest that they make in the real economy. As already pointed out numerous times the interest paid to the Fed does, in fact, find it's way back into the economy in the following forms:
Aside from which, the Fed has been rebating almost all the interest in recent years.
So would you stop calling everyone trolls and pretending that the world couldn't possibly be other than how you conceive it, because of your Jesus goggles?
Thank you for the reply. I thought you might find it interesting that the Fed at least now admits that it creates money out of thin air through OMOs. Watch this nifty online presentation of how the Fed creates money through OMOs on its own website.
http://www.federalreserveeducation.org/fed101/policy/money.htm
"I know that for every $100 of deposits a bank can lend $900 on a 10% reserve ratio system," per
this phrasing seems confusing to me.
it would seem that it would be more correct to say that for every $100 of reserves in a bank the bank has lent out $900 of deposits.... based on a 10% reserve system
or perhaps for every $100 of deposits in a bank , the bank has lent $900 based on a 10 percent reserve ratio.....
i dont understand the omo and federal target mechanism well enough to know if they are inflationary in a negative sense or not.
but if a non market participant, the federal reserve, creates money in a way that permits a few poor money mangers keep getting (loans form thin air??) money to prop up a banking system...it would seem to me that it is a failed procedure.
as i understand this process...it seems that continually creating spending money from "promises to pay money" is like shooting oneself in the foot raising prices more than they would have otherwise raised.
does the process really help anyone except those who get closest to the federal reserve and its agents?
sthomper: does the process really help anyone except those who get closest to the federal reserve and its agents?
The financial industry is one big scam. The financial system is solely set up for the benefit of financial industry insiders.
When the Federal Reserve, Federal government, and financial industry print new money, they steal from everyone else via inflation. If you have the perk of being able to print new money for free, you can always profitably lobby to block reform.
Why is this obsession with thin air? Is the more efficient production of something with less resources a good thing?
fsk:When the Federal Reserve, Federal government, and financial industry print new money, they steal from everyone else via inflation.
Creation is not stealing.
scineram: Creation is not stealing.
scineram:Creation is not stealing.
Ah, cool - so everyone should be allowed a printing press then?
scineram: Why is this obsession with thin air? Is the more efficient production of something with less resources a good thing? fsk:When the Federal Reserve, Federal government, and financial industry print new money, they steal from everyone else via inflation. Creation is not stealing.
How can you not understand this yet have 100s of posts on mises.org?
No, creation is not stealing. But, when you print pieces of paper that must, under threat of violence, be accepted in lieu of debts, then you are effectively stealing the assets they buy. Think about it this way: imagine the government printed £100bn and gave it to banks. Say there was purchasing power of £10,000bn in the UK economy before. Now there is £10,100bn of money, but still £10,000bn worth of goods. The banks, however, have gone from whatever they had before, to £100bn more. They will now be able to buy more goods, due to the legal tender status of the notes. The prices of goods will have gone up, and they will cost more for everyone, but only the banks have got more.
The difference between libertarianism and socialism is that libertarians will tolerate the existence of a socialist community, but socialists can't tolerate a libertarian community.
Thedesolateone: How can you not understand this (printing new fiat money equals stealing) yet have 100s of posts on mises.org?
How can you not understand this (printing new fiat money equals stealing) yet have 100s of posts on mises.org?
Maybe he's a professional disinformation agent. I've concluded that most online discussion forums are filled with people who have a professional interest in spreading disinformation. For this reason, I usually mostly focus on my own site, rather than wasting time arguing with idiots.
reidbump: Fractional Reserve Banking I understand how fractional reserve banking works but how is the actual money created? I know that for every $100 of deposits a bank can lend $900 on a 10% reserve ratio system, but that $900 must be able to be converted into actual paper or electronic dollars, so does the lending institution have a right to require the Fed to print that $900 if the borrower or someone else wishes to redeem it? If so, how does that process work? Can somebody point me to something that can explain the actual procedure that requires the Fed to print/create electronically that $900?
It seems to me that if a bank had a $100 deposit and was restricted by a 10% reserve requirement then that bank can only make a $90 loan while keeping $10 on reserve.
There seem to be two positions I see Austrians taking regarding a reserve requirement (lets say 10%):
1. With a $100 deposit the bank can make a maximum $900 loan.
OR
2. With a $100 deposit a bank can make a maximum $90 loan.
Number 2 seems to be to be the logical and correct answer, but I see enough people asserting number 1 (such as that a bank can loan 10 dollars for every 1 dollar on deposit) to make me question myself.
James Greene: It seems to me that if a bank had a $100 deposit and was restricted by a 10% reserve requirement then that bank can only make a $90 loan while keeping $10 on reserve. There seem to be two positions I see Austrians taking regarding a reserve requirement (lets say 10%): 1. With a $100 deposit the bank can make a maximum $900 loan. OR 2. With a $100 deposit a bank can make a maximum $90 loan. Number 2 seems to be to be the logical and correct answer, but I see enough people asserting number 1 (such as that a bank can loan 10 dollars for every 1 dollar on deposit) to make me question myself.
They're one in the same (except the $900 crowd neglect to describe certain steps)... you simply have to follow it through a little further. After the bank has loaned $90 the borrower spends this and the person/company they give it to puts it in their bank... which then proceeds to loan our a further $81... and so on an so forth. Ultimately the total sum of loans that can be made on the back of $100, with a 10% reserve requirement, will come out to be close to $900 (it will "tend" towards this as banks loan themselves up to their reserve requirements).
A pretty good description can be found on Wikipedia.
jimmy: James Greene: It seems to me that if a bank had a $100 deposit and was restricted by a 10% reserve requirement then that bank can only make a $90 loan while keeping $10 on reserve. There seem to be two positions I see Austrians taking regarding a reserve requirement (lets say 10%): 1. With a $100 deposit the bank can make a maximum $900 loan. OR 2. With a $100 deposit a bank can make a maximum $90 loan. Number 2 seems to be to be the logical and correct answer, but I see enough people asserting number 1 (such as that a bank can loan 10 dollars for every 1 dollar on deposit) to make me question myself. They're one in the same (except the $900 crowd neglect to describe certain steps)... you simply have to follow it through a little further. After the bank has loaned $90 the borrower spends this and the person/company they give it to puts it in their bank... which then proceeds to loan our a further $81... and so on an so forth. Ultimately the total sum of loans that can be made on the back of $100, with a 10% reserve requirement, will come out to be close to $900 (it will "tend" towards this as banks loan themselves up to their reserve requirements). A pretty good description can be found on Wikipedia.
Ahhah! Nice, thank you. That makes sense. It IS very misleading hearing people constantly say that a bank can loan 10 dollars for every 1 dollar that they have, because that is clearly not what happens. It happens in the indirect way that you describe. A couple of synapses just clicked together in my brain. Ahhh that feels good.
now you too can say 'Money Multiplier' and bemuse your friends and family! congrats!
Where there is no property there is no justice; a proposition as certain as any demonstration in Euclid
Fools! not to see that what they madly desire would be a calamity to them as no hands but their own could bring
J. Russell Wagner:Since each unit of fiat has its purchasing power lowered through the injection of more fiat currency, a loss of wealth results.
That does not necessarily mean loss of wealth. It might be that just its distribution changed. The problem with these argument is that any production becomes stealing then.
jimmy:Ah, cool - so everyone should be allowed a printing press then?
If you outlaw printing presses only outlaws will have them!
Thedesolateone:pieces of paper that must, under threat of violence, be accepted in lieu of debts
I am not saying this is not a problem. It should be abolished.
Thedesolateone:imagine the government printed £100bn and gave it to banks. Say there was purchasing power of £10,000bn in the UK economy before. Now there is £10,100bn of money, but still £10,000bn worth of goods. The banks, however, have gone from whatever they had before, to £100bn more. They will now be able to buy more goods, due to the legal tender status of the notes.
This is not due to legal tender. If supply increases prices fall ceteris paribus.
Thedesolateone:The prices of goods will have gone up, and they will cost more for everyone, but only the banks have got more.
Again, this is an indictment of any production. There are innumerable problems with fiat money. Out of thin air is not one of them. (They cost paper and ink. lol)
Scineram, I can't be bothered to selectively quote you so just know this is aimed at you:
(1) Printing money would have little effect without legal tender laws, so long as no contract was broken. Government money would trade at a gigantic discount due to its unbacked nature. On the other hand, banks who backed their money with something other than administrative fiat would find their currency in use. But you haven't tackled the issue - it's still theft!
(2) I have no idea what you mean by your last point. Of course money needs paper and ink to produce! The point is that the money is treated as if it were worth a lot more than just the paper and ink, for no reason. Its strength rests only on fiat and confidence (which itself rests on fiat). What I said was not an indictment of production because production is pareto-efficient. Printing money is not; it costs most people and benefits a small group of entrenched elites.