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How the Fed Creates Money

Ben Bernanke in his now infamous 60 Minutes interview said:

One myth that's out there is that what we're doing is printing money. We're not printing money. The amount of currency in circulation is not changing.

This statement is disingenuous at best. It is a play on semantics similar to Bill Clinton's statement: It depends on what the meaning of the word 'is' is.

It is technically true that the Fed is not actually printing money. When Bernanke wants to create money he doesn't crank up the printers to start churning out crisp new dollar bills. He simply sits down at a computer, types in a few numbers, and presto new money is created.

Of course the Fed needs something to show for the new money that it creates and this is where the U.S. Treasury and the big banks come in. The whole process actually goes something like the following.

  1. The Treasury sells a bond to a bank. This transfers money from the bank's account at the Fed to the Treasury's account. The transfer is just an electronic transaction handled by the Fed. No physical money changes hands. At this point no new money has been created.

  2. The Fed now buys the bond from the bank. The price it pays is usually higher than what the bank paid at auction plus the banks charge a commision for the sale. How does the Fed pay for the bond? It just creates the money by crediting the account of the bank. It is at this point that the world has more money to deal with than before. The money doesn't exist in physical form, it's all electronic.

  3. Now both the Treasury and the bank have extra money in their accounts due to the one bond that has ended up in the hands of the Fed. The government now spends the money on salaries, goods and services in the general economy. The people receiving the money, deposit it in their individual bank accounts so that banks eventually end up with all of the new money. The end result is that bank reserves (accounts that banks have at the Fed) are increased by the amount that the Fed payed for the bond plus commissions.

So yes, the Fed is not printing money, but, call it what you like (imagineering money?), they are creating money. Since most transactions in the economy are handled electronically the point about printing money is meaningless anyway. The chairman was just trying to obfuscate things when he said he was not printing money. He thought he could get away with it because sadly few people understand how the federal reserve and the financial system in this country operate.

The remaining question is what happens to all this extra cash the banks now have? It's hard to say for sure. Consumer credit is not increasing so the money is not going there. The only thing going up is the price of financial assets. The banks are obviously using some of the money for trading and lending to hedge funds. The stock market keeps going up no matter how bad things look. The price of commodities show no sign of slowing their upward climb. The world has a severe case of financial asset inflation. It is only a matter of time before the inflation shows up at the consumer level. There are signs that it already has. A new bubble is being created that will eventually burst like the last one. God help us when it does.

Somehow all of this makes sense to Ben Bernanke. I guess you need a degree in economics to grasp the logic.

© 2010-2012 Stefan Hollos and Richard Hollos

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