Money Machine Go…
Whether it feels like it or not, we are still very much in the midst of a global crisis. So, for the majority of the population, it was a pleasant surprise to receive a hefty check in the mail from good ol’ Uncle Sam.
But where did that money come from? Out of thin air? Did the Federal Reserve (or Fed, for short) really just let loose? Well, sort of…
@femalelandlords on Twitter
So, is our friend on the left there correct? Is the Fed just printing money to artificially inflate the economy? To understand that, we first have to understand where money comes from.
So, where Does Money Come From?
Hold onto your seats folks. The answer may surprise you.
In the U.S., the majority of money is actually generated through private banks—pretty much out of thin air. How does this work? Well, by lending you (and other individuals and corporations) money.
Contrary to what many believe, banks can essentially lend an unlimited amount of money; they are not restricted by the amount that has been deposited with them.
If they see a good loan application, they will type the number into your bank account and *click* that money into existence.
(For those accounting folks out there, this transaction creates a loan, which is an asset to the bank and a liability to the customer, and a deposit, which is an asset to the customer and a liability to the bank. It is balance sheet-neutral.)
Okay, okay. But that money has to come from somewhere, right? Sort of. When you obtain a loan, money is generated out of thin air and deposited into your checking or savings account. In other words, the newly created money never actually left the bank. So, nothing needs to happen.
But what if you then begin to purchase items for your business? For instance, Mr. Flash sells you 3,000 copies of Finance in a Flash — 2020 Edition. The newly generated money has now left your bank and moved to Mr. Flash’s bank. It is this negative cash outflow that must be accounted for.
At the end of each business day, banks reconcile their cash inflows and outflows with what is called a Central Clearing House (CCH). If a bank has net negative cash flows, they owe the CCH the difference. If they have positive cash flows, the CCH will owe the bank instead.
To cover a negative cash flow day, banks will borrow a special type of money called “bank reserves” from other banks that had a positive cash flow day. In the example above, Mr. Flash’s bank could lend your bank all the money it received from the sale.
(The interest rates that banks use to lend to one another overnight is called the Federal Funds Rate. This will become important later.)
Since the money never actually left the private banking industry, it’s all very circular. A net-neutral asset/liability pair was generated on each party’s balance sheet, and any positive/negative cash flows were reconciled at the end of the business day.
But the amount of money available in the economy has changed. If before your loan (say you borrow 1 million dollars), the economy was comprised of 10 million dollars, after the loan it would be comprised of 11 million dollars.
Poof. New money.
The Federal Reserve
Okay, sure… I guess that makes sense. But what about my stimulus check? Where did that come from? To answer this, we next have to understand the role of the largest central bank in the world—the Federal Reserve.
While the U.S. Government enacts fiscal policy by deciding where to spend the money it raises through taxes and borrowing, the Fed enacts what is called monetary policy.
Monetary policy is the method by which the Fed changes the amount of money in circulation (usually through buying and selling short-term government debt, like Treasury bills). It does this in order to meet inflation targets and help the U.S. economy achieve sustainable growth.
There are two main approaches to monetary policy.
The Conventional Approach
The “conventional” approach to monetary policy is just that—the buying and selling of short-term government debt. These transactions are often referred to as "Open Market Operations." Over the past decade or more, the Fed has enacted monetary policy in order to target an inflation rate of roughly 2%. Great! How does it do that?
Well, inflation is largely brought on when too much money is injected into the economy through private bank lending. More money is available to buy things, but production hasn’t necessarily caught up. So, demand outstrips supply and prices go up.
In moderation, inflation is a good thing. It means that, since your money will be worth less in the future, you are more incentivized to spend it—thus stimulating and growing the economy further.
But if the economy is too hot and banks are lending too much money, high inflation rates may become problem. To combat this, the Fed can start selling short-term debt to banks, which reduces the amount of reserves they have on hand.
Fewer reserves means less money to lend in the overnight bank lending market. This drives the Federal Funds rate up, making it more expensive for banks to lend each other money. With less money moving around, lending decreases, and the economy slows down.
Similarly, if the economy begins to stagnate—with the population not spending money or requesting loans—the Fed can start buying short-term debt. This has the opposite effect. The Federal Funds rate decreases and borrowing becomes cheaper.
Banks more freely lend money, people more freely spend money, and the economy has been stimulated.
That’s pretty much where we were before the pandemic. Since the financial crisis in 2008, the Fed has intentionally kept interest rates low in order to stimulate the economy.
But what happens if interest rates are already low, and people still aren’t borrowing and spending money (maybe because we’re all afraid to leave our houses)? That’s where unconventional monetary policy comes in.
Phew! That was a lot. Let’s take a break.
Okay, back at it.
The Unconventional Approach
If the interest rate is already close to 0%, the Fed loses a lot of its influence over the economy. It can buy or sell as many short-term government securities as it wants, interest rates cannot go below 0% (otherwise, you’d be paid to borrow!).
So, in very rare circumstances, the Fed will enact what is called unconventional monetary policy. Sometimes referred to as “Quantitative Easing,” this is when—among other things—the Fed widens its scope of which assets to buy and sell.
With conventional monetary policy, it’s almost always short-term Gov't securities (Treasury bills). But when things get really serious—like they did in 2008, and like they are today—the Fed agrees to also purchase longer-term government securities (Treasury bonds), mortgage-backed securities, and corporate bonds.
The idea is to provide liquidity to the economy and lower long-term interest rates in order to further stimulate borrowing and spending. Unconventional monetary policy also signals to many corporations—and the U.S. Government itself—that if they need money, they can have it. All they need to do is create and sell bonds (debt) to the Fed.
Your Stimulus Check
Perhaps not coincidence, a few days before the U.S. Government announced the $2 Trillion CARES Act—the source of your stimulus check—the Fed announced that it would buy an unlimited amount of Treasury bonds and mortgage-backed securities.
The U.S. Government was then able to freely create and sell around $1 or $2 Trillion worth of Treasury bonds to the Fed. The Fed then typed and clicked that money into existence.
If by some miracle you’re still reading, you might think: “the U.S. Government still has to pay interest on those bonds, right? It’s not just free money.” Well, it sort of is.
As it turns out, the majority of the Fed’s profits (including interest payments on Gov’t bonds), by law, must go to the Treasury. So, out of one government pocket and into another. Rarely have the U.S. Government and Federal Reserve ever worked so closely in lock-step with one another.
Real picture of the Federal Reserve & U.S. Gov't
There you have it. The U.S. Government “borrowed” money from the Fed, which typed and clicked that money into existence. Yes, the Government technically still owes that money, but since any interest is effectively paid back to itself, those bonds may as well no longer exist.
Okay, back to the beginning. Is our friend on the left correct? Absolutely not. The Fed can absolutely do this. Whether or not it should is a discussion for a later date.
Future Covid Economy Posts
I hope you enjoyed this iteration of Covid Economy! If you’ve made it to the end, you’re a real trooper. But I hope you learned a lot as well! I know I did as I was researching and writing this article.
Look forward to the next article in this series where I discuss what this means for inflation and the stock market!
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