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A Simple Guide to Creating Money

I often hear people say that the Fed, or the government, or just the ever-present "they," are "printing too much money." This conjures up an image of rows and rows of printing and stamping presses running wild in the basement of the U.S. Treasury, spewing out endless stacks of worthless paper notes and coins with a metal value less than their face value. Well, this may come as a shock, but that image is wrong.

Reality check
True, the Government does create hard currency. However, the money that is printed and minted represents just a tiny -- but important -- fraction of what we call money in our economy. Along with bank reserves, paper notes and coins compose what's known as the monetary base.

But the vast majority of what we call money is "credit money," and it's created in the banking system. It comprises checking or demand deposits, loans, and other forms of credit. Each time a bank makes a loan or extends credit, a deposit is created in the borrower's account, adding to the money supply. Through the miracle of "fractional reserve banking," this can add up very quickly, because the Fed requires banks to hold only 10 percent of their deposits as reserves. For every one dollar that a bank takes in as a deposit or creates by crediting someone's account, it can lend out ten more.

Not even the amount of reserves on hand can hold back a bank's ability to lend; after all, reserves can always be borrowed. There's an actively traded inter-bank market for reserves, with an interest rate matching the Fed funds rate (which I'll get to in a minute). The only limit on the amount of loans or new deposits that a bank can create is its capital, which equals its assets minus its liabilities. (The capital adequacy rule requires that the ratio of a bank's capital to its risk-weighted assets be at least 8%.)

Banks, therefore, have the ability to create huge amounts of money in our economy virtually out of thin air -- and they do. Most of what we call "money" comes from the banking system. Total bank credit in the U.S. is around $8 trillion, while the monetary base -- all those notes, coins, and reserves -- is $837 billion. In accordance with that 10-to-1 reserve ratio, bank credit is 10 times greater than the amount of money the Government prints, mints, or credits.

The Fed
No discussion of money would be complete without looking at the Fed's vital role. By buying and selling Treasury securities for its own account, it controls the level of reserves in the banking system -- and the cost of those reserves.

For example, when the Fed buys Treasury securities, it creates a deposit at the Federal Reserve Bank for the seller's own commercial bank. This tends to add to the overall level of reserves pushing down the cost of those reserves -- also known as the overnight lending rate or the Fed funds rate. When the Fed wants to raise the overnight lending rate, it sells Treasury securities from its own portfolio (usually to big banks and primary dealers). This debits the buyer's account, reducing reserves and leading to a higher Fed funds rate.

The banking system always needs an adequate level of reserves; otherwise, a payments crisis could develop. Depositors might want to withdraw funds, and if the bank does not have enough cash on hand, it could suffer a "run" on the bank. This has happened many times in U.S. history, most notably in 1933. To avoid this possibility, the Fed always acts to maintain the integrity of the banking system.

However, the Fed also wants to avoid injecting too much money; that could cause the economy to overheat, prompting inflation. Rather than trying to guess the proper level of reserves in an ever-fluctuating economy, the Fed only seeks to control the cost of those reserves via the Fed funds rate. By gently adding and subtracting just the right amounts of reserves, the Fed can maintain its target interest rate.

The deflation danger
As I mentioned earlier, the amount of money created in the economy is not determined by the Fed, but by the demand for cash and credit from businesses and the public. The Fed can certainly influence credit conditions, but it cannot force banks to lend, nor borrowers to borrow. If economic conditions provide for few business opportunities, the Fed can exert little influence over monetary growth.

Japan suffered just such a state toward the end of the 1990s, when the economy fell into a serious deflation. Because prices of goods, services, and assets were falling, there was little business opportunity, and therefore little demand for credit. Moreover, the Japanese banking system was getting crushed under the weight of hundreds of billions of dollars in bad loans. The Bank of Japan tried to combat this by pushing interest rates all the way to zero in an effort to stimulate lending, consumption, and money creation. It didn't work. In the end, only massive deficit spending by the Japanese government turned the economy around.

Here in the U.S., many people have been saying that the Fed has been "adding too much liquidity." But although real interest rates were pushed to negative levels from 2002 to 2004, monetary growth rates remain below their five-year average. In other words, despite the Fed's best efforts to print money, it couldn't.

So, next time you hear someone saying, "They're printing money like crazy," don't believe them. Better yet, ask them exactly who is doing the printing, how much is being printed, and how it's being done. Chances are, they'll have no clue. Then you can give them a lesson.

Now that you've learned how the government manages its money, get great advice about managing your own! Sign up for a free sneak peek at our new personal finance service,Motley Fool GreenLight.

Fool contributor Mike Norman is founder and publisher of theEconomic Contrarian Updateand aFox News business contributor. He also is a radio show host atBizRadio Network.

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