Neil H. Buchanan

How is Money Created? Debunking Some Myths About Recent Policies to Stabilize the Financial System and the Economy

By NEIL H. BUCHANAN


Thursday, June 18, 2009

The recent economic crisis in the United States has been so severe that we are now experiencing something that has happened only a few times in history: zero interest rates. In a phenomenon technically known as a "liquidity trap," the monetary authorities have pushed the interest rate that they control essentially as low as it can go, yet the economy still needs more stimulus.

The usual kick that we would experience from low interest rates is not being felt, because people are simply unwilling to spend in these difficult economic times. That was part of the argument for the stimulus package that was enacted in April, in which Congress and the President agreed on a two-year program to directly increase spending in an effort at least to slow the downward slide of economic activity.

Whether the stimulus bill is or is not effective (and, although I think it was too small, it is likely to play at least an important role in turning around the economy), some people have turned their criticism toward the Federal Reserve – commonly called the Fed, this country's central bank – saying that the Fed's creation of money to fight the crisis is threatening the country with long-term inflation, even hyperinflation.

These claims are not only overstated, but they often are based on a profound misunderstanding of how the financial system works. The danger is currently that the government is doing too little to fight the recession, not that the Fed is putting in motion an inflationary spiral. Understanding why this is so requires some basic knowledge about how money is created.

Money Out of Thin Air? The Myth that the Fed is Currently Doing Something Unusual and Dangerous

Modern financial systems are all based on money that is, in a very profound sense, created out of nothing other than group psychology. No one has any practical use for printed pieces of paper carrying portraits of dead presidents, yet everyone works to receive those pieces of paper. Why? Because everyone knows that everyone else will accept those pieces of paper in exchange for the things that we wish to own.

The process of creating money is, however, more complicated than just printing pieces of paper that people will treat as money. Most of the financial system, after all, carries out transactions in money that exists only in electronic form. Direct deposits of paychecks into bank accounts allows people to pay their bills online, which in turn allows merchants to pay their employees with yet more direct deposits (and some checks and cash).

Indeed, when we read about a company buying another company "with cash," that does not mean that millions or billions of dollars worth of greenbacks change hands. Typically, such a transaction is carried out in government IOU's known as Treasury Bills that, in fact, also never exist in printed form. Both sides to a transaction treat those securities as "cash" because they know that they can use them to buy things or trade them in for cash at some point.

The essential point to remember is that all of this is done with money that has been created out of nothing more than the common belief that the electronic transactions involved are meaningful.

The role of the Fed is to set up rules by which it can limit the amount of money (including both cash and non-cash forms of money) that is in existence. The Fed's methods of doing so are too technical to be of interest here, but the key point is that the Fed can create or destroy money by engaging in policy actions that are well-known and completely uncontroversial. The Fed – indeed, every central bank in the world – is constantly adjusting the amount of money that exists, generally as part of a strategy to set interest rates at a level that is projected to maximize growth with a low, stable rate of inflation.

All of the money that exists today was, therefore, created by the Fed out of nothing at all. Even so, we are now hearing and reading urgent cries that the Fed is creating money "out of thin air," as if this is something horrible and dangerous. Just within the last six months, for example, the New York Times has carried nine articles which raise this specter.

Even setting aside the two Times articles that were op-eds, regular Times news articles such as one from May 22 of this year have said quite bluntly: "The Federal Reserve is printing money from thin air." This is anything but objective language, and it is misleading at best. It is true that creating too much money can be dangerous, but the issue is not that money is being created from nothing, but rather that too much money can end up chasing too few goods. That is clearly not the problem that we currently face.

What About Gold? Why the Fed's Actions Would Be No Different if We Returned to the Gold Standard

Some readers might respond to the description above by saying that the problem is a different one: The Fed must be prevented from creating "fake money." What is "real money," then? Gold, of course!

This point, however, misunderstands the psychological nature of money, and it also mischaracterizes the true difference it would make if we were to take the radical (and completely unwise) step of returning to some kind of gold standard. Most people do not have any practical need for bars of gold, any more than they have a practical need for pieces of paper covered with numbers and the faces of long-dead politicians. Thus, the sole reason to hold gold (other than to use it for certain industrial and decorative purposes) is that other people want it – just as is the case with paper money.

Moreover, even if we were to shift to a gold standard, the electronic nature of the current financial system would still require that we allow transactions to occur without the actual physical trading of gold, with "gold certificates" being created in print or electronic form, or both. Once we did that, however, we would then need a Fed-like agency to regulate the non-gold representations of money -- which would put us right back where we are now, with money not tied to gold or any other commodity.

If we wanted to limit the Fed's ability to manipulate the amount of such money that exists, we could simply link the amount of non-gold money to gold by some fixed multiple. However, doing so would have many undesirable consequences -- the most obvious being that our money supply would respond only to changes in the amount of gold in the world. The two countries with the largest known stocks of gold in the ground are Russia and South Africa, which means that those two countries could then increase or decrease the amount of our money by flooding the gold market or hoarding their stocks.

In other words, even for those who yearn for a system in which the government has no ability to manipulate the amount of money that exists, the reality is that there is no such system. Moreover, the systems that purport to limit the Fed's discretion either do not actually do so, or do so at too great a cost to the health of the economy (as well as national security).

The Real Issue: How Should the Fed Decide How Much Money to Create?

Perhaps the core concern of those who complain about the Fed's creating money "out of thin air" is really that the Fed is creating too much money too fast, not that it is creating money in an illegitimate way. The question, then, is how we would know when enough is enough.

Attempts to find an answer to that question have filled economics journals for as long as there have been economics journals, but the key issue is that there is a tradeoff: Merchants want their customers to have enough cash to buy their goods, but no one wants there to be so much money that inflation ensues.

One formulation of the issue is based on the assertion that there is a reliable, direct mathematical relationship between the amount of money that the Fed creates and the inflation rate that we experience in subsequent months and years. That assertion has, however, not held up at all well to empirical testing, with inflation not reliably tracking the amount of money being created. The reason for this is that people do not always spend all of the money that they could spend, meaning that money can be created but not result in inflation.

That is not to say that there is no limit to how much money the Fed could or should create. Everyone agrees that if the Fed were to order the Government Printing Office to print up $100 trillion in new currency and distribute it to the public tomorrow, there would be massive hyperinflation. Raising that specter as a reason to criticize the Fed today, however, is like saying that the possibility of drowning means that one should never drink water, or swim, or bathe. That it is possible to create too much money does not mean that we should create none.

If there is no reliable relationship between the amount of money that the Fed creates, within broad boundaries, and inflation, then what should the Fed do? Essentially, it should do exactly what it is doing right now.

As noted above, the Fed has pushed its policy-sensitive interest rate as low as possible, in an effort to stimulate economic activity. This was completely sensible, given the extreme nature of the current crisis. We knew that it was rare that rates could go to zero, but that has happened before. If those rates cuts had been enough, that would be fine.

Unfortunately, the economy needed more stimulus. That is where the Fed's further actions came in, supplementing and enabling the actions by Congress and the President to try to create more economic activity directly. When the federal government needed money to finance various bailouts and the stimulus spending, the money had to come from somewhere. The alternative to continued borrowing from abroad was to have the Fed buy the federal debt that is being created, directly injecting new money into the system in an effort to stimulate spending.

This strategy has its limits, of which the Fed is well aware. The current concern, however, has not been inflation but deflation, a decline in prices that can itself be a disastrous part of a decline into economic depression. The Fed wisely concluded, in short, that we should not worry about drowning when our most pressing problem is a severe drought.

When the situation turns around, policy can and will change: We can create less money than we have been creating lately. That does not mean that the Fed will stop creating money out of thin air, but only that it is responding appropriately to changed circumstances.


Neil H. Buchanan, J.D. Ph. D. (economics), is an Associate Professor at The George Washington University Law School, where he teaches tax law and policy.

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