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  • How Does the Federal Reserve Create Money?

    Posted on by Azrael Comment

    A few weeks ago, I solicited FEE daily readers for their questions about economics. Pretty quickly I got a question I was pretty certain I’d get eventually. It comes from a man named Warren from Chicago who asks:

    “what are the levers used by the Federal Reserve Bank to increase or decrease the money supply?

    I know it has something to do with interest rates and bank reserves, but how does it actually take place and who receives all the extra money in circulation to cause the inflation?”

    There are several channels that the Federal Reserve can use to create money, but I’m going to focus on the two most relevant ones: open market operations and interest on reserves.

    The first way the Federal Reserve can increase the money supply is by creating more dollars. It’s not as simple as them printing dollar bills then throwing them out of a helicopter, though.

    Instead, when the Federal Reserve wants to create money and put it into the system, it does so through banks. Banks hold several types of assets including treasury bonds. Treasury bonds are IOUs that the government issues in exchange for a loan. You buy a bond with cash today and the government promises to pay you back with interest in the future.

    Banks like to hold treasury bonds because they’re viewed as low risk—it’s unlikely the US government will default on debt (any time soon at least). Treasury bonds also have the advantage that they’re relatively easy to sell to someone else to get cash. Economists call this ease of converting an asset into money liquidity.

    The Federal Reserve offers to buy these bonds from banks. When the Federal Reserve buys bonds, they have an advantage you and I don’t. They are allowed to print new money to buy the bonds. It’s more likely that the money will be digitally created than literally printed, but the form of the money doesn’t make a difference.

    The Federal Reserve acquires government bonds and banks acquire newly created money. The process doesn’t stop there, however. Banks don’t generally like to sit on large piles of money because money doesn’t earn interest (unlike the bonds they just sold to the central bank). So what do banks do with their money?

    One thing they can do is make more loans to businesses. The increased supply of funds available to lend out means that there will be more loans available for the same number of businesses. Everything else held constant, this means the price of borrowing (the interest rate) will fall.

    Banks can also turn around and buy more treasury bonds if they want to replace some of the bonds sold. This higher bond demand means the government will be able to take on more debt to finance its spending.

    Economists call this process of the Federal Reserve using newly created money to buy bonds from private banks an open market purchase.

    So how much has the Federal Reserve utilized this tool as of late? Look at this graph:

    Figure 1: Treasury Securities Balances Held Outright

    Since January 2020, The Federal Reserve has increased its treasury securities from $2.3 trillion to around $5.6 trillion today, an increase of around $3.3 trillion.

    A more recent move by the Federal Reserve has been to purchase other types of assets as well. Before 2008, the Federal Reserve owned $0 in Mortgage-Backed Securities (MBSs). Today is a different story.

    I won’t go into detail about MBSs (you can read more about them here) except to say they’re another type of financial asset banks hold which are a good bit riskier than treasury bonds. Here is a graph showing how Federal Reserve MBS holdings exploded in 2008 (in an attempt to alleviate the housing crisis) and again in 2020 (in an attempt to curb the negative effects of COVID policies).

    Figure 2: Mortgage Backed Securities Held Outright

    As you can see, the Federal Reserve acquired around $1.3 trillion worth of mortgage backed securities from January 2020 to today.

    As economist Jim Gwartney pointed out for AIER,

    “[the] $4.2 trillion increase in federal spending over the two [COVID] years was financed entirely by borrowing from the Fed. Fed holdings of financial assets, mostly Treasury bonds and mortgage-backed securities of federal housing authorities, increased from $4.2 trillion in February 2020 to $8.8 trillion in December 2021.”

    So now we understand how the Federal Reserve creates new money, and who it goes to. Banks are the first recipient, and borrowers or those who sell financial assets banks demand (including the government itself) are the second recipients. And as Warren alluded in his question, this policy indirectly influences the interest rate.

    There’s one other important tool for how the Federal Reserve can influence the creation of money. It’s a relatively new policy lever called interest on reserve balances (IORB).

    To understand how the Federal Reserve impacts the money supply through IORB, you need to have a basic understanding of our banking system.

    Let’s say Warren deposits $1,000 in his bank, FEEbank. What happens to the money then? In the United States, it’s unlikely that the money will sit in a vault. Instead, FEEbank will likely try to make a return on that money by lending some of it out to someone else.

    So let’s say Jim comes and asks for a loan of $800 from FEEbank. FEEbank lends out $800 of Warren’s $1000. So how much money does Warren have? Well, when the bank lends out your money, your balance doesn’t go down. Warren can still go withdraw his money so long as the bank can give him deposits they’ve kept from other customers.

    If everyone came to get their money at once, the bank would run out of money, but so long as that doesn’t happen, FEEbank doesn’t have a problem.

    So now Warren has $1,000 and Jim has $800. There is now $1,800 in the economy compared to $1,000 before. FEEbank created more money!

    The process doesn’t even have to end there. Jim can deposit the $800 in another bank, which can lend out a portion to someone else.

    This system of banking is called fractional reserve banking because banks only keep a fraction of your deposits as reserves, and they loan out the rest.

    So private banks in this system can create money by lending deposits, but what does this have to do with the Federal Reserve?

    In 2008, the Federal Reserve adopted a policy of paying banks interest for the money they kept in reserves. So, instead of FEEbank loaning out Warren’s money, the Federal Reserve could offer to pay FEEbank to keep the money in the vault.

    The higher the interest the Federal Reserve offers to pay FEEBank, the less likely it is to lend out the money. Why make a risky loan at a 3.5% interest rate if the Federal Reserve will pay you 3.5% for keeping it in the vault? The Federal Reserve is essentially paying banks to not make loans.

    Notice, too, this also allows the Federal Reserve to more directly control the interest rate. If the Federal Reserve wants loans to have a 4% interest rate, all the agency has to do is promise to pay 3.9% IORB to not make the loan. In that case, a private borrower would have to offer at least 4% to beat the Federal Reserve.

    So if the Federal Reserve wants banks to lend more of their deposits thereby creating more money, all they need to do is lower the IORB. And that’s exactly what they did during COVID.

    In January 2020, the interest rate on reserves was 1.55%. By mid-March 2020, the Federal Reserve had dropped the rate to 0.1%.

    This policy made it relatively more lucrative for banks to increase lending and, everything else held constant, when the benefits of an action goes up, people will do more of that action.

    The result of these policies has been a large increase in the supply of money. Economists measure what counts as money a few different ways, but one of the most commonly used and accepted measures is called M2.

    From January 2020 to January 2022, the M2 money supply increased from $15.4 trillion to $21.6 trillion.

    That’s a 40% increase in the money supply— unprecedented in recent US history.

    Figure 3: M2 Money Supply

    As I’ve explained since May of last year, this increase in money supply inevitably led to higher prices across the board (aka inflation). FEE’s Dan Sanchez has explained this in depth as well.

    Unfortunately, the Federal Reserve seems to have printed itself into a corner.

    Utilizing open market purchases and lowering IORB may have propped up the economy by stimulating lending and investment in 2020, but the chickens are coming to roost. At this point, if the Federal Reserve wants to use its levers to bring inflation down, it’s going to do so by hurting investment opportunities.

    As of this month, the IORB has been raised to 3.15%. This means less funds will be available to borrowers. Whether we’re in a technical recession or not right now, it seems unlikely to me the Federal Reserve will be able to bring inflation down without allowing an economic correction to take place.

    There’s no such thing as a free lunch. Printing dollars does not mean there are more sandwiches to go around. And although the Federal Reserve can affect the economy with their levers, they cannot print prosperity.


    Peter Jacobsen

    Peter Jacobsen teaches economics and holds the position of Gwartney Professor of Economics. He received his graduate education at George Mason University.

    This article was originally published on FEE.org. Read the original article.


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  • Coronavirus Crisis Exposes a Devastating Consequence of Fed Policy: Americans Have No Savings

    Posted on by Azrael Comment

    During a March 17 address to the nation in response to the COVID-19 outbreak, President Donald Trump asked that Americans work from home, postpone unnecessary travel, and limit social gatherings to no more than 10 people.

    Ten days later, Trump signed a stimulus package of more than $2 trillion to provide relief to an economy on the precipice of collapse.

    The aid package includes handouts and loans to individuals, small businesses, and other distressed industries.

    Despite Trump “having created the greatest Economy in the history of our Country,” when the markets tanked, massive and immediate government intervention was the only thing left to forestall a total collapse.

    So why can’t the greatest economy in the world handle a temporary shock without needing trillions of dollars injected to stay afloat?

    The Federal Reserve and its vicious and ongoing war on savers are to blame.

    Using the Federal Reserve Note—commonly (but incorrectly) referred to as the dollar—introduces a dilemma. Because of inflationary monetary policy, Americans have long been forced to select among three undesirable options:

    A) Save. Hold Federal Reserve Notes and be guaranteed to lose at least 2 percent in purchasing power every single year.

    B) Consume. Spend Federal Reserve Notes on immediate goods and services to get the most out of current purchasing power.

    C) Speculate. Try to beat the Fed’s deliberate inflation, seeking a higher return by investing in complicated and unstable asset markets.

    With businesses and Americans defaulting on their rent and other obligations only days into the collapse, the problem is clear: Few have any savings. And why should they when saving their money at negative real rates of return has been a sucker’s game?

    Lack of sound money, or money that doesn’t maintain its purchasing power over time, has discouraged savings while encouraging debt-financed consumption.

    American businesses and individuals are so overleveraged that once their income goes away, even briefly, they are too often left with nothing.

    Fiat money is especially pernicious in the way it harms its users. To some, two percent losses can go easily unnoticed, year to year. Over 100 years, the loss has been well over 97 percent.

    And who can save for emergencies when you’re being forced to work and spend more—simply to maintain the same quality of life?

    Over 100 years, the Federal Reserve has destroyed more than 97 percent of our currency’s purchasing power.

    With the Fed slashing short-term rates to zero, the US Federal Reserve Note has been further destroyed as a method of preserving savings. (And negative nominal interest rates could be coming next.)

    Inflationary economic policy, absent the guardrails of sound money, has created a situation with an obvious and deadly conclusion: that many Americans lack savings to protect themselves against downturns.

    This situation isn’t necessarily the fault of the people, but rather the fault of a system in which discouraging and punishing savers is a crucial tenet of the entire framework.

    The Federal Reserve, the US Treasury, and the White House are trying to reassure the public that everything is “under control,” that “the US economy’s fundamentals are still strong,” and that the economy will skyrocket once COVID-19 is taken care of. What if they’re wrong?

    Maybe the greatest monetary experiment in history is coming to an end. Maybe sound money can still save the day, but we must not waste any more time in restoring it.


    Jp Cortez

    Jp Cortez is Policy Director for the Sound Money Defense League, a non-partisan, national public policy organization working to restore sound money at the state and federal level and which maintains America’s Sound Money Index.

    This article was originally published on FEE.org. Read the original article.


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  • Yes, a Currency Devaluation Is Very Much Like a Tax

    Posted on by Azrael Comment


    Britax is a global corporation with a manufacturing hub in Fort Mill, South Carolina where it employs 300. It is there that the company creates car seats for children. Unknown is how long it will continue to.

    While it’s surely risky to draw immediate correlation, James Politi of the Financial Times recently reported that Britax is thinking about relocating. The impetus for relocation is the tariffs the Trump administration has levied on foreign goods.

    It seems the car seat business is a low margin affair, and beginning in 2018, Britax suddenly faced a 10 percent tariff on the textiles it imports to cover its seats. The tax moved up to 25 percent after a breakdown of trade talks this past May, and then this month a new, 15 percent tariff on metallic inputs such as harnesses and buckles was imposed. The taxes levied on imported inputs Britax relies on to complete its car seats has put it at a disadvantage vis-à-vis car-seat makers located outside the U.S. According to Politi, foreign producers of the seats enjoy a tariff exemption care of the “U.S. trade representative for some, but not all, safety products.”

    It’s all a reminder of the basic truth that tariffs are a tax, plain and simple. Not only do they harm the businesses they’re naively assumed to protect by shielding them from market realities, they’re paid for by other businesses reliant on imported inputs; meaning all businesses.T

    Figure that something as prosaic as the pencil is a consequence of global cooperation, so imagine by extension just how much a car seat is the end result of production taking place around the world. In this case, the Trump administration falsely “protects” textile and metal companies located in the U.S., and the bill for the protection is sent to companies like Britax. The tax paid by the latter has shrunk its already slim margins even more.

    Interesting about tariffs is that they bring about agreement among people with differing ideologies. President Trump’s NEC head Larry Kudlow strongly believes that tariffs are a tax, as does Democratic presidential hopeful, and frequent Trump critic, Pete Buttigieg. Tariffs raise the cost of doing business, which means they’re a tax on earnings. It’s all very simple.

    Which is why the quietude about President Trump’s dollar stance is so strange. As some know, Trump would like a weaker dollar. He incorrectly believes a debased greenback would make U.S. industry more competitive. Except that it wouldn’t, and one reason that a falling dollar wouldn’t enhance the health of U.S. corporations is because currency devaluation is 100 percent a tax.

    Tariffs raise the cost of importing simply because a 10, 15 or 25 percent tariff is a tax above and beyond the price of the imported good in question. When Trump imposes tariffs that are paid for by importers, the U.S. Treasury ultimately collects the proceeds of same.

    With devaluation, much the same is at work. In this case, devaluation of the dollar logically raises the cost of importing foreign goods. It also raises domestic prices, but that’s another piece of commentary for another day. For now, it should be said that money is an agreement about value. If the agreement is shrunk such that it means something different, or is exchangeable for less, it’s only logical that the cost of importing foreign inputs is going to rise unless foreign producers are willing to accept haircuts for what they send our way.

    And what about the U.S. Treasury. While it doesn’t collect the “proceeds” of dollar devaluation in the way that it does the false fruits of tariffs, the result is the same. A dollar is yet again an agreement about value. If the exchangeable value of the dollar is shrunk, so shrinks what Treasury owes.

    Devaluation is most certainly a tax, and it has a very similar impact on corporations as a tariff. Not only does it raise the cost of purchasing the inputs necessary to produce market goods, it at the same time shrinks company earnings. If the dollar is devalued, so must shrink the value of the dollars a corporation takes in.

    For those who think a dollar is a dollar is a dollar, think again. No one earns dollars, as much as they earn what dollars can be exchanged for. There’s a big difference. If the value of the dollar decreases, so must we decrease the value of a dollar earned by a business.

    The previous paragraph helps explain why periods of dollar devaluation (think the 1970s, think the 2000s) correlate with greatly subdued stock-market returns. If the market value of a company is a speculation by investors about all the dollars a company will earn in the future, it’s only logical that a devaluation of the currency unit that investors use to attach a value to corporations is going to negatively impact share prices.

    Taking the previous point further, companies logically grow via investment; be it in people, processes, and nearly always both. Investors, as readers of this column well know, are buying future dollar returns when they put money to work. Devaluation logically shrinks the exchangeable value of those returns. Again, it’s a tax.

    Which leads to the final question of this piece: why do honest members of left and right readily acknowledge the tax that is the tariff, all the while ignoring the tax that is devaluation? In each instance policymakers are shrinking the value of individual and corporate work, all the while shrinking what individuals and corporations can get in return for their work.

    Yet Trump’s tariffs bring forth all manner of reasonable (and sometimes unreasonable) hand wringing, while his calls for a shrunken dollar happen mostly without comment. This despite them being the same. Yes, a tariff is a tax. And so is devaluation. Why don’t policy types and candidates for public office speak up about the other devaluation?

    This article is republished with permission from Forbes. 


    John Tamny

    John Tamny is Director of the Center for Economic Freedom at FreedomWorks, a senior economic adviser to Toreador Research & Trading, and editor of RealClearMarkets.

    This article was originally published on FEE.org. Read the original article.


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