Who creates Money

Does the origin of the money in your wallet make a difference? Often. If the money is counterfeit you may have your money confiscated before you can spend it. If your money was manufactured by certain countries you may find it impossible to get the face value in other countries. For instance, the 5 trillion note issued by Zimbabwe will never be equivalent to any other currency. Why is that? The value of a currency is not the value stated on the bill, but is the value when used to make a purchase. If the note from Zimbabwe can be exchanged for a new Xbox, then is equivalent to $319 US dollars since that is the amount of currency necessary to purchase the product in the United States. The comparative value of a currency defines a currency into a known item. Think about "one." Your first question is "one" what? In the case of currency the "one" is the number of another currency.

There is one unique difference about paper money. Other products get a value when they go to market. Walmart will put a product on their shelves at a price they hope the product will sell for, but if it doesn't sell, they will reduce the price until a value is found that customers accept. Money has a value printed on the front of each bill, but banks will not reduce the notational value on the face to get their depositors to take the bills out of the bank. In fact the government dictates the currency must be accepted at the face value. Consequently, if the currency value is greater than the public will accept the product value must go up. This situation occurs everyday throughout the world to various currencies. What do banks do? If they are exchanging one currency for another they adjust the exchange rate. If a customer is withdrawing funds to make a now higher priced purchase, they will complain to the bank, but are powerless to restore the value of their currency. The result is what we call inflation. These movements in the value of currency are very destructive to a stable economy. Stability is extremely important. Why? Pricing is based on convention and forces that upset or change economic conventions often result in economic stress and uncertainty.

How do the institutions in the United States attempt to maintain stability? The Federal Reserve does not give money away to individuals, they use the private banking system to distribute it. The Fed distributes money through banks or federal agencies to maintain control. Ignore distribution through federal agencies for the moment. Most money is distributed through banks so let’s look at that process. Physically the money does not exist until it is utilized. The Fed sets certain rules to ensure more money is not created by the banks than products. The Fed creates potential, but money only comes into existence when a bank takes it figuratively out of the Fed. And, this is the most important point, banks only take it out when they have a borrower able to repay the funds. The amount of dollars requested by the borrower sets the value of money created. Let's look at that from a slightly different angle. The federal government does not create money, the Fed does not create money, the banks do not create money; borrowers create money by agreeing to expand the quantity of circulating currency by starting a profit earning business or investment, and repaying their loan. Note the importance of profit. It is one of the most important economic concepts. Note the insignificance of government printing presses and regulatory restraints or incentives. The final judgment is in the hands of a country's entrepreneurs. The cleverness of entrepreneurs determines the growth rate of a society not a government agency.

Now you can see why rising interest rates is an effective deterrent to economic expansion. Higher interest rates place a roadblock in the way of the money creators, the borrowers.  But let me return to the point of this brief article. Money creation by the government is meaningless unless the money is utilized by borrowers. Most governments outside the top twenty focus on the wrong strategies to grow their economies. They buy things: roads, bridges, schools, military equipment, etc. to increase the appearance of government. Nothing is wrong with these acquisitions, but building wealth in the private sector is the only way to put in motion a mechanism to pay for such purchases. Public services and facilities are great, but if a private sector does not exist to pay taxes then the facilities will not be maintained. Governments should put the focus on creating entrepreneurs. This is the strategy China is utilizing to grow their economy.

Who decides to increase the Money Supply?

Who decides to increase the Money Supply? Throughout most of the world we are taught it is the central banks who perform this function. In the United States expanding the Money Supply is acknowledged to be one of the core functions of the Federal Reserve Bank. They are given this responsibility since it is a fundamental technique of monetary policy. The central banks were created to execute monetary policy and keep the economy robust. This monetarist is an outgrowth of a 17th century theory about money. This theory is known as the Quantity Theory of Money (QTM).

The current formation of the theory is captured in a short equation developed by Irving Fisher: M = (P + Q) / V , where M equals the Money Supply; P equals an average price; Q equals the quantity of goods and services offered for sale; and V equals the velocity of money or the number of hands money passes through in the period of study. In another blog the end of last year I showed V or velocity of money is an invalid concept. It really does not matter for the validity of the QTM idea. Let's assume you find the average price of all the goods and services for sale in a period and if all are to sell the amount of M or money must equal the total value of the for sale items.

The more interesting question is how do the central banks know what the total retail price of all these goods and services equals. The answer is they do not have much of a clue. The solution does not come from the top down. It percolates up from all the individual banks in a country and slowly rises through the bank system as wholesalers borrow to fund the acquisition and manufacturing of products. This results in more of a guessing game and less a matching game. There are huge gaps in the system that totally miss the banking industry. One such circumstance is the lending of short term credit between manufacturers and merchants and between suppliers and manufacturers. Numerous non-monetary transactions occur to incentivize sales and maintain trading relationships. This gets even more complicated when subsidiary companies exist or when multi-national companies engage in asset sales or transfers. The point is central banks are too far removed from the action to clearly see what action they need to undertake, and hopelessly out of the loop to be an effective mechanism for fine tuning the Money Supply.

Who does decide to increase the Money Supply? It is not the central banks. It is the community loan officer who chooses to make a bank loan. Her decision certainly facilitated by the central banking system, but her decision is what prompts the creation of "new" capital. "New" capital is money created out of air and put to use to buy products or services. Until money is spent in a financial transaction it is only an electronic notation in a ledger with no affect on the economy. In N Theory I explain it is incorrect to think that central banks play a significant role in expansion of the Money Supply. The recent Global Financial Crisis in 2008 and the huge cash creation strategies employed by central banks throughout the world show the ineffectiveness of their ability to create "new" money. The only person who can effectively do that is your local loan officer.

Here is a medical analogy to make this concept more easily understood. The National Medical Agency might train a 1,000 new doctors, but the health of the country will not improve until the doctor sees a patient and prescribes a treatment. Even though in the Global Financial Crisis the central banks polished up the balance sheets of the banks, it was not until the banks made "new" loans, that the economy got any better.