The Nature of Money
We all (well, many of us) know that if the Federal Reserve wants to prod the economy into prosperity, it lowers the interest rate. If it wants to cut off inflation, it increases it. Who is this Federal Reserve, and what interest rate does it raise or lower? And why is the Fed's chairman so powerful?
If you want to borrow money for a mortgage, does the Fed's chairman set the rate of interest? Of course not. Your bank does. So, what does the chairman do?
In medieval times, world currencies were mainly in gold and silver. The pound sterling was a pound of silver. About the fifteenth century, European traders tired of carrying gold and silver in their pouches (it was heavy and likely to be stolen), so they deposited it with reliable goldsmiths, who issued them paper receipts. If a goldsmith was well known and trusted, his receipts would pass from hand to hand in trade, because the recipients knew they could always redeem them for gold.
Soon the goldsmiths discovered that as the holders of their certificates passed them to each other, these certificates stayed in circulation and only infrequently came back for redemption. Guess what? They decided to lend to traders (at interest) by issuing more certificates than they had gold to back them up. Sometimes they merely opened deposit accounts on their books instead of issuing certificates, and the depositors would pass the "right to gold" on to others by writing checks. Of course, to ward off bankruptcy, the goldsmiths had to have enough gold to cover the amount of claims likely to be presented. Say, if 10% was needed, they would have to keep £10 of gold for every £100 of certificates issued. This 10% was called their reserves. At that point the goldsmiths began to be called banks.
Did you know that every time you or a business borrows from a bank, new money is created, and every time a loan is repaid, the money vanishes? Well, that's true, and this is how the money supply increases or decreases.
Now, there is a relationship between the amount of money in circulation and the size of the economy (usually measured by the gross domestic product, or GDP). M1 (the amount of money) is some fraction of GDP because money circulates over and over, from hand to hand. This relationship usually changes only slowly. At the end of 2002, M1 in the United States was $1.2 trillion, compared to GDP of $10.4 trillion during 2002. Thus GDP per year was approximately 8 times the amount of M1 (data from International Monetary Fund).
About 1910, bankers began to feel the amount of gold was insufficient to support the ever-increasing world GDP. To solve this problem, the various countries created central banks that could make "bookkeeping gold." In 1913, the United States created the Federal Reserve System. According to its location, each commercial bank that followed certain guidelines would join the System. These member banks deposited their gold in one of twelve Federal Reserve banks. Thus their gold reserves were transformed into deposit reserves ("bookkeeping gold") with the Fed. A Board of Governors was set up in Washington to oversee the system. As of this writing (2003), the chairman of this board is Alan Greenspan.
Each bank's reserve deposit with the regional Fed is now in lieu of gold. But there is an important distinction. The Fed can now create "bookkeeping gold" (also known as reserves) by lending them to a bank at a certain interest rate. It is this interest rate that the Fed Board strongly influenced by its chairman increases (to control inflation), or decreases (to spur the economy). Presumably the lower rate enables member banks to borrow more reserves from the Fed, or from each other, and therefore to lower their own lending rates (on your mortgage) so they can lend more to you and to businesses.
There is one catch. Economists (me, too) widely believe the economy swings up and down according to business investment. To economists, "investment" does not mean stocks and bonds; it means the process of constructing machinery and buildings for corporations that will hire people. Once constructed, the machinery and buildings are "capital." Additional consumer spending (because you could borrow on mortgage) spurs investment (building that house), and investment spurs prosperity. The catch, however, is that businesses will not borrow (increase the money supply) to invest just because the interest rate is low. They must foresee a profit that is, conditions must be favorable (consumer demand high, lots of exuberance, new products, and the like), as has been the case in the United States for the past twenty years, up until last year). Exuberance pulls the economy along, as on a string. Without it, lowering the interest rate is like pushing the string. It won't spur investment unless exuberance is pulling it. Then a lower rate of interest helps because investment funded by credit is quick and easy, compared to issuing stock.
If the central bank creates too much bank reserves, and hence too much money (such as to finance a war, or mansions for the elite or even housing for the poor), inflation follows. This has been the problem of many less developed countries (not to speak of the United States), Argentina for instance.
Inflation is avoided only if banks lend for productive purposes; that is, for loans that will produce goods and services, which will be traded for the new money. If banks (or the central bank) lend to governments as they do in government deficits the result is inflationary, unless it is offset by more production by private companies.
I may be wrong, but I think it was Kenneth Boulding who once said:
This letter is intended to give you an introductory course in macroeconomics (the economics of the whole system, as opposed to microeconomics, which covers individual prices). Please remember it, or have this letter ready for reference when the next one comes. In TQE 74 I plan to tell you how I would propose a money supply for full employment and prosperity. To understand that, you must first understand the macroeconomics explained in this letter.
This has not been the easiest TQE for me to write, nor for you to understand (unless you are an economist, in which case it will be a snap). But if you truly want to learn how the economy functions, you just have to study it. The information in this TQE is essential.
I'll see you next time.
Your friendly economist,
Note: The verse by Kenneth Boulding comes from his 1958 textbook, Principles of Economic Policy. Loren Cobb, TQE Editor, 2005.
Revised 12-Jan-06 to reflect the fact that Alan Greenspan has retired as Chairman of the Federal Reserve Board.
If I loan you my tractor and you agree to pay a rent fee, I am legally and morally entitled to that rent as a return on my asset. If I instead loan you a piece of paper (a demand) that entitles you to use my assets, I again would be entitled to a rent or interest fee. If, however, I created a similar piece of paper that gave you a demand to use assets in which I owned only 10% and the rest belonged to the general public, my claim for a rent fee would be dubious, if not fraudulent. But that is essentially what our banks do. They create legal tender (it's not really money the US Constitution carefully defines money as gold and/or silver) that is a demand for goods and services of others, and they charge interest for it.
Jim Joyner, Murfreesboro, (TN) Worship Group.
If the banks did not charge interest for their services, who would pay the salaries of the tellers and other officials? Who would pay the rent for the bank building? And the property taxes? Jack
My observation: Alan Greenspan lowered interest rates repeatedly with NO effect. The economy went south anyway. I suspect that his manipulation to defeat inflation had the same 'effect', i.e. none. Greenspan lucked into good correlation in time with his increases, but not with his cuts. His actual efficacy level = 0.
Charlie Thomas, Cascabel Worship Group, Tucson (AZ).
Charlie, I would appreciate it if you would send me a copy of the data on which you based your research. Thank you. Jack
Jack, a very clear description of how monetary policy works, which is only when business wants to invest. Otherwise we need fiscal policy, to put money into the hands of people who will spend it. When you sign paychecks for mill or office workers who are having FICA of $35 and income tax of $50 withheld out of a $550 paycheck you see what a fraud the Bush tax cuts are if you want to increase consumption cut these two taxes on the first $20,000 of income,
Dick Wolf, Coral Gables (FL).
Dear Jack, this was the first TQE letter that I read. It was very informative. Thank you.
Chris Wright, Philadelphia (PA), Emergency Material Assistance Program (AFSC).
Paul Burkholder has forwarded me your recent The Quaker Economist, Letter No. 73, sparking a very interesting, and to me confusing, discussion about money and the control of it. Since I work with Paul at Economists Allied for Arms Reduction, and since my only actual economic training thus far was an introductory class at a large state university which mostly served to confuse me, I think it would be beneficial for me to begin to receive your letter.
I was right there with you up until 1913, when things were no longer so straightforward. I guess my sophistication is at a medieval level, monetary policy-wise. After several emails back and forth, Paul explained that the Fed controls the supply of money by selling or buying bonds, and therefore the cost of money, also known as the interest rate. That I can understand.
I look forward to future learning, and as always, the opportunity to connect economy, money and spiritual practice.
Thea Harvey, Kerhonkson, NY, Development Manager, Economists Allied for Arms Reduction
In my search for economic and political knowledge and understanding in the past few years, I have continually found myself sifting through information that was either too difficult or detailed to understand or too laden with bias to be useful. My biggest frustration has been a feeling that I am basically alone in my concern for the world's poor. So you can imagine my utter delight when, in the last few months as I started to read TQE back issues, I began to find out more about you. I had almost given up hope of discovering someone like yourself.
I greatly respect your opinions. You have a wealth of experience, a rational and realistic mind, and a compassionate heart.
I hope somebody can help me with this question. Suppose that the FED buys government debt of (say) $1 million with 4% interest. I understand that this would increase the money supply, but in the end the government has to pay this money back with interest of 4%, thus decreasing the money quantity. In the end, all debt must be paid back, so how can the money supply grow indefinitely every year, on and on? How is it possible that the Federal Reserve banks actually puts money into the economy, and that the money supply keeps on growing, when at the same time all this money has to be paid back eventually? Does this mean the money does not have to be paid back? In what way do they put the money into the system so that it does not have to be paid back?
Thank you for your wonderful site.
Nico Samara, The Netherlands [letter dated 14 May 2005].
Reply: This is a reasonable question, which has doubtless puzzled many. While it is true that each such debt must be paid back or settled eventually, at any one moment in time there is a total amount of debt outstanding. Individual debts are created, accrue interest, and then are repaid each on its own schedule but it is the total amount of this kind of debt that constitutes the supply of money. The various technical definitions of money supply (M1, M2, M3, etc.) differ only in the kinds of debt that they count. For more on how this works, you may find the Wikipedia article on money supply to be helpful. Loren Cobb, TQE Editor.
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