Creating Money Out of Thin Air!!!

Ye'gast!

 

During the 1980s when I ran the Baltimore Branch of the Richmond Fed, I also taught a Money and Banking course in the graduate evening program of The Johns Hopkins University.  As in all such courses, I showed the students how banks create money when they make new loans and how the Fed influences that process with the tools of monetary policy, especially open market operations. I went into the multiple expansion process, showed how the impact of fiscal policy depends largely on how deficits are financed-with newly created money or existing money-and so forth. It was standard stuff using standard textbooks.

In the context of a classroom and textbooks, students readily accepted the fact that central banks can create money out of thin air and they accepted that the exercise of that process can be helpful in promoting economic stability or can be disastrous if abused.

I find that outside the classroom, however, when TV viewers first learn about money creation-these days usually misleadingly called printing money-in the context of Fed support of illiquid markets or in its role as lender of last resort, the reaction to central bank money creation is quite different. It is often regarded as sinister. Alchemy! People don't worry so much that the process will be abused with negative consequences; they regard the process itself as abuse. They don't worry about the possibility of inflation; they worry about the certainty of inflation. I've even heard some define inflation as money creation.

For such people who are open to clarification or context-and I realize that's probably not a majority-I have two points to make that should be reassuring.

1. Money creation doesn't cause inflation until it is spent. Too much spending relative to the economy's capacity to produce real goods and services will cause inflation. If the velocity of money slows, resulting in slower spending, as it has in recent months, more money is needed just to sustain spending levels, much less drive them to excess. Lately, extraordinary money creation has been necessary to avoid deflation, or falling prices on average. As velocity expands in the future, along with confidence, less money creation will be needed. Our central bankers know this very well. They are watching carefully. They are on the case. Hyperinflation is not a likely outcome of recent policies.

2. As for the alchemy or voodoo involved in creating money out of thin air, be comforted in the fact that new wealth is not being created in the process. New assets in the hands of the public are not being created. Just new money in exchange for assets that are not defined as money.

When the Fed buys government securities in the open market-traditional open market operations-some sellers of these securities give up assets in the form of government securities for bank deposits that are included in the definition of money. It's an exchange of assets held by the public, from assets not included in the definition of money to assets that are.

If a counterfeiter prints new $100 notes, new (illegitimate) money is created; and so is new (paper) wealth since the counterfeiter can spend the new notes for other things. Not so with open market operations. For money, people have to exchange something of value that they earned, ultimately by production. I hope this makes some of you feel better. Central bankers aren't alchemists.

Comments (5)

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  1. hoho says:

    Gee, is this the best you can get, Bob?
    why didn’t you mention a word of March 18?
    what can i say? Americans, Republicans.

  2. John Booke says:

    Your point about that newly created money “does not cause inflation until it is spent” is well taken. For me the scary part is that “banks” (and I guess other finanical companies) can “create money out of thin air.” The government is supporting banks that made side bets using unregulated insurance instruments and that is causing a huge spike in the monetary base. At some point won’t the smart financial guys figure out a way (a good bet would be speculation in hybrid FX instruements) to spend that spike in money and cause velocity of money to rocket?

  3. EBD says:

    Mr. Mc. Teer,

    Granted, “prices” don’t rise until money is spent, but isn’t that what Obama, Geitner, and Bernanke wish most?

    Current experiments rest on the assumption that the Fed can reduce the money supply before inflation (rising prices) occurs. This isn’t likely to occur due to political will as well as the Fed’s new found ownership of some less liquid assets (with negative convexity as well).

    The government as largest debtor depends upon this inflation for survival as they are the first beneficiary.

    You say rest assured no new wealth is created with money creation. Of course not, that is what is treacherous. Money is created out of thin air without the wealth building characteristics of a free market economy such as innovation, entrepreneurism, risk, and labor. That is was debases the nations wealth.

    In the words of Voltaire,”It is dangerous to be right when the government is wrong.”

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