Further Evidence that Economics is a Dismal Science

2017 February 28
by Daniel Lakeland

Look, there's a crapload of shitty information on the web about what the Federal Reserve Bank does, including a crapload FROM the Fed. Do they "print money" or not for example?

The problem seems to be that people are generally stuck on a very literal view of what it means to "print". So, this punning between two concepts, kind of like "statistical significance" and "practical significance" causes a HUGE amount of confusion.

Wikipedia explains this well: (as of this moment)

"Since central bank money currently exists mainly in the form of electronic records (electronic money) rather than in the form of paper or coins (physical money), open market operations can be conducted by simply increasing or decreasing (crediting or debiting) the amount of electronic money that a bank has in its reserve account at the central bank. This does not require the creation of new physical currency, unless a direct payment bank demands to exchange a part of its electronic money against banknotes or coins."

So, the Federal Reserve in its open market operations buys bonds from say Bank Of America. How does it do this? It simply increments a counter in the electronic records that describes how much reserve BofA has at the Fed. This then alters the regulatory status of BofA because it now has more reserves to meet regulatory reserve requirements. Therefore, it can lend more money without getting in legal trouble. Where did the money that went into the BofA reserve account come from? Nowhere. The FED takes in a promise to be paid money in the future (a bond) and gives out money it creates now (a reserve balance increment). The FED creates money. Traditionally, creating money is called "printing" but if you use "printing" as a technical term of the paper industry... you can claim "the FED doesn't print".

If you add up all the balances in BofA, plus the balance it has with the Fed, the total has increased. There is more money available to the world. Unlike Energy, money is not conserved, money is created out of thin-air (computing) by just increasing the balance on the accounting sheets at the Fed. Only the Fed is allowed to do this, everyone else has to *exchange* money (that is, to buy a sandwich you use a debit card to take money out of your checking account and put it into the checking account of the sandwich maker... the total quantity of money is unaffected because your balance decreased by the same amount that the sandwich maker's increased). If you use a credit card, the situation is the same, except with a greater time-delay and potentially if you're not paying off the credit card at the end of the month, with interest payments through time to the credit card issuer and soforth.

Is the Fed "printing money" in the sense of actually telling the Treasury to roll special paper through printing presses and putting special ink on the paper, and then shipping physical bills to banks? No. But, a balance in the Reserve Account at the Fed is as good as a promise to print physical bills whenever the bank wants them. That is, more or less, what the FDIC is, a big fat promise to run the presses when a bank can't hand out all the currency it's supposed to be able to.

In extreme situations, money might be destroyed. With the FDIC for example if you have more than some amount of money in your checking account, and there is a run on your bank, and the bank goes bankrupt, the FDIC will if necessary physically print you an amount of money equal to whatever your deposit amount was at the bankrupt bank... but only up to some limit, like $100k. So people who had $1M in their checking account might lose money in a puff of smoke... But this is an irrelevancy in most cases. It's also true that you can have $5000 in bills in your desk drawer when your house burns down... Again, not relevant to the overall picture in the world... which is that the Fed is able to create money when "money" is defined as all the balances in all the checking accounts and similar accounts, plus all the currency in vaults, plus all the reserve balances at the Fed. (The M1 money supply).

Practically speaking, whenever someone says that "the FED doesn't print money" (which as you see linked above, is something that even the FED says!) they are weasel-word lying. The FED doesn't print money in the same way that Artists don't make pen-and-ink drawings..... they just make the *ideas* that lead to the pen and ink drawings, it's an ink company that makes the ink, and a paper company that makes the paper... A stupid and meaningless distinction.

14 Responses leave one →
  1. March 1, 2017

    Something that I have never understood is why, when a central bank creates money, it never just gives it away, it lends it out at interest. Does it receive interest payments in perpetuity? Does it at some point receive back the original loan? Either case requires the banks to pay back more money than they received. Where does the extra come from? New loans from the central bank? How does this not turn into in a system of exponentially growing but fictitious debts from all banks to the central bank that no-one intends ever be paid back. In effect, giving the money to the banks but pretending it's a loan.

    Another aspect that I've never seen mentioned is that the use of debt as money does not in principle require any financial institutions. Suppose I lend you $10,000 and you write a promise to pay it back (perhaps plus interest) in a year's time. If that written promise is payable to its bearer, then I can use it as money with whoever is willing to trust your signature on it, at the same time as you are using my $10,000. Presto, $20,000 where there was $10,000 before, without any bank being involved. When the debt falls due, the extra $10,000 goes away (whether you can pay it back then or not).

    • Daniel Lakeland
      March 1, 2017

      Hi Richard, I too have been somewhat confused about how the Fed works, in fact I think this is intentional, here is the Fed itself describing its open market operations: https://www.federalreserve.gov/monetarypolicy/bst_openmarketops.htm

      It is quite frankly full of either weasel words or technical jargon.

      Here's what I gather actually happens. The Fed doesn't create money and lend it out at interest. The Fed creates money NOW in exchange for money the government owes the recipient LATER. Specifically, it buys government bonds. These government bonds are promises to pay money to the holder later. Since the Fed pays for this bond by crediting an electronic account, it's possible in the technical jargon that this is *called* "credit" to distinguish it from "currency" which is physical bills and coins. In some sense, the Fed is promising to get some currency printed later if you want it but it doesn't do the printing. In some sense, this is an anacronism. In the distant past men were men and money was coins and bills 🙂 These days I certainly think of "real money" as the stuff in my bank account, because the amount of coins and bills I have at any given time often isn't even enough to purchase a sandwich. In this sense the insistence on "currency" being "real money" and "credit balances in an account" being "something else = credit" because it represents a claim on some currency, is potentially confusing to the everyday person.

      The fact that that Fed creates this "money" and places this balance into the member bank's reserve account then changes the regulatory status of the member bank, it is now legally allowed to lend that money until the amount of money it has lent meets the regulatory requirement for reserve. So if the Fed buys $2 Billion in bonds from a bank, typically the bank can then lend out $2B in more loans.

      It's the *member bank* (ie. B of A or Wells Fargo or Chase or whoever) that is lending for interest. And the member bank then takes this interest and invests it as it sees fit, or pays dividends to the bank stock holders or whatever.

      Now, what happens to that bond that the Fed buys? Well, the Government either collects taxes to pay the interest on the bond, or it issues new bonds and then uses the money to pay interest on the bond, or some combination. But, for the bonds held By The Fed... the money gets paid back to the government. So interest on the debt is in part paid to the Fed whose profits belong to the government, and so they cancel out.

      In a sense then, there are 3 ways to pay off the government debt.
      1) Tax people and use the money to pay the debt
      2) Issue more bonds and use the money you get now to pay the interest you owe now
      3) Buy the bonds back from the public by "printing money" via the mechanism described above.

      You might ask, "why not just make the bond disappear in a puff of smoke since the government owns it anyway?" and I think the answer is that this would wind up being much less flexible. If you need to "retract" the money supply one way you can do it is to have the Fed sell bonds back to the member banks and then decrease their balances in the reserve accounts... and having this mechanism in place is also important. Furthermore the accounting is perhaps more consistent if the bonds don't just disappear in a puff of smoke. As long as the government is paying the Fed the interest, the bond effectively doesn't exist except for its potential to be put back into circulation.

      • Richard Kennaway permalink
        March 5, 2017

        It still looks like an inevitably exponential growth of fictitious debt. The Fed lends money that it has dug out of its private bottomless pit to the Government. The Government bond whose purchase is that loan is a promise to repay it at interest, i.e. to repay more money to the Fed than it received. But the Fed is the source of all money, so...

        Something similar goes on in the UK, where the Bank of England have tried to explain the process here: http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf

        According to that, UK banks -- ordinary retail banks -- create money when they make loans, i.e. they do not actually have to have the money that they lend. They are limited only by their own prudence. But the same phenomenon surely applies: they require more money back than they lent. Where does it come from? Even bad debts do not release the created money from the debt, as it comes off the bank's balance sheet. If the bank itself goes bust, its debts come off the balance of whoever they were owed to, and so on. For a large bank, the government may take it on, which just means that the government's debts increase. There does not seem to be any mechanism for these debts to ever be repaid short of a whole currency collapsing and wiping the slate clean. Or the government writing it off by writing a different number into the electronic records. Which goes back to the question of why the money wasn't created that way in the first place.

        Back when there was a type of money that could be physically dug out of the ground, maybe that provided an answer to the question of how all debts could ever be repaid. But when most money is debt-created, the only possibility I can see of the system working is if the rate of growth of this debt-money tracks the rate of growth of the economy. Presumably this is the argument for the idea I've seen in a few places of making the money supply proportional to nominal GDP. It leaves undetermined what the ratio should be and how it can be attained.

        • Daniel Lakeland
          March 6, 2017


          With the Fed at least, it can "print the money" in the reserve balances of the retail banks. So, if you have a bond and you want some money, you can sell it to a bank, who sells it to the Fed, and the Fed magically mines the money out of its bottomless pit and deposits it in the banks' Fed account. This alters the future in that in the future the Govt doesn't have to tax as much to pay its debts because some of the interest is getting paid to the Fed which for this purpose really is the same as the government. And it alters the present because now there's more money to buy stuff today.

          In fact, in the 2008 fiasco, a lot of money disappeared in a puff of smoke when people went bankrupt and their house was repossessed and sold at lower than what the loan balance was. The banks had to write down the loans, and so their balance sheets collapsed.

          The solution was to convert future money (Bonds) into present money (balances in the bank's reserve). Quantitative Easing was born. The problem is, that QE has continued for quite a while and all the money was funneled through the finance industry. As you can see in graphs I linked below, it wasn't used to loan to individuals buying houses except for the first year or so, it has been pumped into the creation of WhatsApp and the inflation of Facebook and Google and Elon Musk's Battery Plant in the desert and Vulture Capital funding a billion Uber rides to the tune of $2B lost last year, and whatever other stuff that may or may not (maybe mostly may not) be of real interest for the purpose of consumer's standard of living.

          Later on I'm going to argue that by establishing a Universal Basic Income as a thing that we do, future money supply problems will be mitigated if when money disappears from the economy because debts are erased in bankruptcy etc the UBI payments are financed by simply paying each and every citizen their monthly UBI using money mined out of the Fed's infinite pit (that is, just create it and give it out to everyone in equal share).

          The result will be that everyday people will buy things that everyday people want, and businesses will focus their energy on producing things that everyday people want, and so we won't have a lot of puffery in financial leaning towers.

  2. Daniel Lakeland
    March 1, 2017

    As to the possibility of individuals writing out promises to pay money later... Of course this is what corporations do when they issue bonds. And, in the distant past (several hundred years back?) I think there were banks which did this as well. The real advance in all of this government central bank stuff is to potentially regulate how its done to reduce the risk of outright fraud from individuals, rogue banks, or Bernie Madoff. If the government issues bonds, and the government issues currency and the government creates the money, then there is more liquidity in that you aren't stuck with an enormous number of sources of money and hence an enormous number of risk-adjusted exchange rates etc. After all, some people might think that a promise from me to pay $10,000 on Jan 1 2018 is worth say $9,950 today and others might think it's worth $2.50 based on wildly variable assessments of how likely it is for me to be able to pay then. The government being big, run by a strict set of laws, having the power to tax, and etc etc at least reduces the risk-assessment spread on its debts.

    Yet, we still do have a corporate bond market, so in that sense the mechanism you describe is in fact partially in play.

  3. Daniel Lakeland
    March 1, 2017

    As for just giving out the money the government creates... This will be the topic of a later post. In my opinion, one of the huge advances for the economy that the Universal Basic Income (UBI) would create is the ability to inflate the money supply without distorting the economy towards the production of useless financial crap. Since the whole way that money gets into the economy now is sort of banks -> investment firms -> corporations and start-ups -> purchasing the worthless crap that start-ups create -> founders of start-ups -> buying a few measly "real" items and putting the rest back into further bullshit financial schemes

    we are creating an enormous problem.

    With the UBI, if you need to inflate the money supply due to instability and deflation problems, you can simply deposit electronic money into the checking accounts of 350,000,000 people. Then, they each go out and buy stuff that they need, and so the stuff it's spent on is much closer to "the stuff people need" than the stuff that new money is spent on when it filters through the finance industry. This prevents massive distortion to the price structure and the economic activity that is occurring (ie. you don't hire a bunch of people and pay them million dollar a year salaries to write apps that track your body odor through time or whatever)

    In the past, I don't think the technology existed to make this work. I mean, even in 1950 to put $200 into each person's checking account would have required several hundred million entries into physical ledgers at bank branches. It'd take the entire banking industry a couple of weeks just in finding ledgers and writing numbers and running those adding machines with the crank handles....

    Of course, these days my desktop computer could complete 350 million addition operations before my finger left the mouse button.

    As to why you'd want to inflate the money supply. If money disappears somehow (like for example several big companies go bankrupt and they don't pay their debts...) then whoever had money before now has a bigger fraction of the pie. And if the money supply continues to fall as suppliers to the big corporations in turn go bankrupt etc... then the "investment" Of just holding onto currency and waiting becomes a way to get rich.... and this in turn causes more bankruptcies, and eventually a collapse of the economy as all the money gets rolled back to just that amount that exists as currency. That's pretty obviously bad, so in cases where that seems like a problem, it can make sense to simply create money so that holding currency isn't an effective investment. But, feeding it into the banking system is really a shit idea except for the fact that it significantly reduced the overhead in the days before massive computing power.

    • Corey Yanofsky permalink
      March 3, 2017

      What's the relative proportion of bank lending to investment firms vs. mortgage loans? The main channel of influence of monetary policy is thought to be through mortgage rates...

      • Daniel Lakeland
        March 3, 2017

        I'm not sure where to get the "total outstanding loans by banks" but here's the "total outstanding mortgages" divided by the M2 money supply:

      • Daniel Lakeland
        March 3, 2017

        Which suggests that money is going somewhere else other than mortgages 2009 to now.

  4. Daniel Lakeland
    March 3, 2017

    Here's the M1/MZM which shows that maybe the enormous M1 growth isn't so bad. MZM is more or less M2 + Savings Accounts + Money Market Accounts

    • Daniel Lakeland
      March 3, 2017

      I think there's a major issue regarding how "stock and stock options" are essentially "Money" when it comes to paying wages in the tech sector. The problem is, no one is controlling the supply of this pseudo-money. And it's by no means stable. So people are able to attract productive workers to do lots of things with this promise of "a crapload of cash later" which eventually doesn't pan out. Sometimes it does pan out short term (like Yahoo looked good the first 10 or 12 years) and that's even worse... because then these individuals are rewarded big for doing stuff that is pretty marginal and everyday people are left holding the bag.

      There is no "MS money supply" (MZM + all pre IPO Stock Options + all Short term maturity stock options in public companies). Estimating that would be hard.

  5. Daniel Lakeland
    March 3, 2017

    Here's mortgage loans outstanding divided by commercial loans outstanding:

    • Daniel Lakeland
      March 3, 2017

      That again tells me that lending is not going to mortgages. Shortly after the crash there was a flood of mortgages to people who bought all the house repos... but after 2011 or so it's been steadily plummeting.

      • Daniel Lakeland
        March 3, 2017

        Relevant to the period 2011-now: http://www.pewinternet.org/fact-sheet/mobile/

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