But Where Does New Money Go?

Diane Benjamin asks, “Where does all the new money go: 1) when it is created, and 2) when it goes away?”  Diane’s is a great question because she thinks, like most of us do, that money has to exist tangibly and then be moved from one owner to another.  So, for example, when the Fed increases the money supply, it must take money from some vault, put it into circulation, and then take it out of circulation and put it back in the vault when it wishes to decrease the money supply.  Diane asks further whether they keep track of the recipients.

It is not quite that simple, however.  There are several mechanisms through which the money supply is increased.  Let’s cover one of the most common.  When a bank takes my $1000 and creates a checking account, that money must be available to me in case I write a check.  The bank cannot lend out that money, but it can keep some percentage on hand as a “reserve” and then lend out the rest.  But wait, didn’t I just say that my $1000 had to be available at all times?  Yes, I did.  The bank (your bank does this all the time) is allowed to keep, say, 10% of my money on hand, and lend out $900.  If Smith comes in the bank to take out a $900 loan, the money he/she takes home is new money.  Let me say this again, because it does not make sense to most of us.

A bank loan literally creates new money.

Further, this $900 that Smith took out can then be deposited in a checking account at that same bank or even another one.  Now that bank can create more money by making a loan of $810 and keeping $90 “in reserve.”  As the chain extends, the money supply is increased each time until the fractions become too small to work with.  Those of you with a mathematical frame of mind will realize that in the end, the total money supply will go from $1000 to $10,000–it increases nine times over.  Other mechanisms the Fed uses to create money are more complex, but work on the same principle.

Our entire supply of money is based on debt.

Whenever there is a crisis (legitimate or not), the government prints more money through this or other mechanisms.  This gives the appearance that things are getting better.  We each see a little bigger paycheck and economic indicators sound better on the news.  It works almost as well as putting a Band-Aid on cancer.  As the money supply increases relative to the products and services available in the economy, prices also rise.

Inflation is the result of an increase in the money supply.

Government wants inflation because it allows them to finance their wars and social programs without most taxpayers knowing it.  If they were to do so through taxation, voters would tar and feather them.  So what’s the problem?  A little inflation is good, right?  No, it is theft.  The dollar you earn today will buy only a fraction of the goods it can buy today in just a few years.  It makes chumps out of those of us who still think saving money for the future is a sound practice.

We are now seeing the mirror-image of this process.  When someone defaults on a bank loan, that money goes back to the same magical place it came from.  It disappears from the system and the money supply goes down.  When the money supply goes down, there is less for everyone to spend and fewer loans are taken out.  Not only that, but many others whose business is tied to Smith’s cannot pay their loans.  Seeing this deflationary pressure, the government will at all costs increase the money supply to get things going, or at least foster the illusion that things are getting better.  When the economic system is highly leveraged like this, crises are common, leading to frequent bailouts, subsidies, and bone-headed public works projects.  Inevitably, people in such fiat money systems lose faith in their currency.

The eventual value of all fiat money is zero.

For us, this means that we are due for some kind of major economic disruption.  It cannot be avoided even if government were to say, expand and contract the money supply at just the right time.  When the tipping point is reached, no power on Earth can stop a meltdown.  Fiat money is based solely on peoples’ belief that they can purchase goods and services with it.  When that faith is squandered away, economies revert to real money like gold and silver or in extreme cases, barter.

Money is always what people say it is.

Thanks for a great question, Diane.

_________________

Terry is convinced that he is caught in a Monty Python universe.  Politicians cannot really be that stupid.  Can they?

About Terry Noel

I am an Associate Professor of Management and Quantitative Methods at Illinois State University. My specialty is entrepreneurship.
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1 Response to But Where Does New Money Go?

  1. Of course politicians can be this stupid – Remember Guam tipping over? Thanks for the explanation, makes more sense (can’t believe I said that) now!

    Like

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