Look at the dollar bill.
It says, quite prominently, "The United States of America" and, less prominently, "This note is legal tender for all debts public and private."
Take that dollar bill into a store and you can buy a dollar's worth of merchandise. Put enough of them together and you can pay your rent or buy a car.
In other words, the dollar bill is money -- and the modern economy could not function without it. You are willing to accept dollar bills in payment for your services because you can use them to buy other things. Coins and checks are money for the same reason.
Money is the thing individuals always seem to have too little of today, although economists tell us the economy has too much of it. Because the economy has too much money, economists say, inflation occurs. Inflation is the condition in which the general price level rises.
The Federal government -- through the Federal Reserve system, the nation's central bank -- tries to ensure that the money supply grows to just the right degree. The Federal Reserve wants to keep money -- currency, coins and checking accounts -- growing fast enough so that there is enough around to permit persons and corporations to buy what they want, but not fast enough to make the overall price level rise.
But prices have been rising sharply in recent years. More than once the rate of inflation has been 10 percent or more. Many economists blame the Federal Reserve for that inflation, arguing that the central bank has created too many dollars too fast.
To see how the Federal Reserve creates money with the institutional cooperation of the banking system, first take another look at the dollar bill.
The dollar bill also says it is a "Federal Reserve note." That means the piece of paper is an IOU, representing a debt, from the Federal Reserve, the U.S. government bank. But take that dollar bill to the nearest Federal Reserve bank -- there are 12 of them plus a few branches scattered around the country -- and the Fed (as economists and bureaucrats call it) will give you another dollar bill. Take it to your local bank and the teller either will give you a newer dollar bill in exchange, or open an account in your name that credits you with having a dollar on deposit.
The dollar is an asset to you -- because you can buy things with it -- but a liability to the Federal Reserve. Your account at the bank is an asset to you but a liability to the banker, who may loan the dollars you deposited to someone else but must pay you back when you ask for your dollars.
It is because money is someone's liability that the Federal Reserve can create more of it.
And it can do so, according to Robert Weintraub, an economists for the congressional Joint Economic Committee, because "unlike you and me, the Federal Reserve can create its own liabilities."
Citizens or corporations can develop financial liabilities -- that is, debt, only if someone else cooperates. To borrow money to buy a car, a consumer has to convince a bank to make a loan. A company has to find a bank willing to make it a loan or, perhaps, another company or individual to buy its bonds. A bank has to have a customer willing to make a deposit before it can incur a liability.
The Federal Reserve does not have to convince anybody to do anything when it decides to create its own liabilities; i.e., it own loans to itself.
Since much money is nothing more than the debt of the government, when the Federal Reserve creates its own liabilities, it creates money. Although it can do so merely by printing more currency -- Federal Reserve notes that come in denominations of $1, $5, $10 and so on -- the normal procedure usually is more complicated. It involves the debt issued by the U.S. government and the fact that many private banks keep accounts at the Federal Reserve just like individuals and companies keep accounts at private banks.
The Federal Reserve starts the money-creation process when it buys from someone in the public a security issued by the government, usually the Treasury Department. The Federal Reserve's decision to buy that security may have nothing to do with a desire to increase the money supply. But an increase in the money supply is the almost inevitable result.
Here's how it happens:
The Federal Reserve rings up a dealer in government securities that may be a bank, a broker or whatever. The Fed buys the government security, which represents money the government has borrowed from the population at large. For simplicity's sake, suppose that the Treasury borrowed $100 from a citizen and promised to pay that money back in 20 years and to pay a 10 percent per year interest rate. The citizen who owns that Treasury security, (in this case a Treasury bond), has coughed up $100 from his or her own bank account. No money was created. The individual used money to buy an asset. The individual has an asset (that can be converted back to money). The government has the money.
The Federal Reserve, for whatever reason, decides it wants to buy that government security. To induce the owner to sell, it offers whatever price is required.
If the citizen sells the bond directly to the Federal Reserve, the central bank will send a check. But the Federal Reserve has no bank account of its own to draw on. It just creates $100. If a bank sold the bond, the Federal Reserve simply will add $100 to that bank's account at the Fed.
The citizen takes that $100 check and deposits it in a bank. Suddenly the bank has $100 in new deposits (a liability as far as it is concerned, since it owes the $100 to the depositor). And -- with the flick of a pen or, more likely today, the punch of a computer button -- there is $100 more on deposit in the nation's bank than there was a moment before.
The bank cannot make money on that deposit by letting it sit around, so it lends a portion of it, say $80, to a customer. The customer takes that loan and deposits it in a bank (or pays off someone else who does the same thing). Now there is $180 in new deposits in the banking system. The process continues when the bank with the $80 in new deposit lends it out. By the end of the game, in the textbook example, about $500 in new deposits -- money -- is created when the Federal Reserve buys a $100 bond from the public.
No banking system is that efficient. The money is not created immediately, but over a period of days or even weeks. Under normal circumstances, too, some of those new deposits might be taken in currency, which would slow the process of ever-expanding checking deposits.
The central bank uses a reserve procedure to destroy money. If it sells some of the $115.8 billion of government securities in its portfolio, it soaks up deposits that banks might otherwise lend.
In the real world, the process is not as neat as in the textbook world. It is not always easy to figure out how much money must be created to support the expected growth of the economy in a noninflationary way.
Individuals and companies may spend their money faster than they are expected to looking at historical data. A dollar that used to sit in a checking account for a week may sit there only a day because individuals or companies now immediately use their unneeded money to buy an asset. The Fed may think, looking at historical data, that it will take $1 in money to support each $5 of economic production. If it takes only 90 cents today, the Fed unwittingly will create too much money.
Furthermore, in recent years there has been a huge growth in so-called money market mutual funds that permit investors to write checks on their fund holdings. The $85 billion on deposit in the money market funds are not considered money in the federal definitions, but because depositors can write the equivalent of a check on those funds, then some portion of money market accounts add to the effective, if not the official, money supply.
Nevertheless, although it may be harder for the Fed to follow a proper monetary policy than it is to describe it, the essence is that despite all the ballyhoo about cutting the budget to stem inflation, government debt creates inflation only if the cental banks decides to buy that debt. In the parlance of economics, the Federal Reserve monetizes debt. When it monetizes too much debt, it creates too much money. When it creates too much money, it creates inflation.
Economists will disagree about how important the rate of growth of the money supply is to the general well-being of the economy. But all but the most irascible will agree that inflation today (like the sharp decrease in prices during the Great Depression) is disruptive to the economy and that inflation is due in large part to excessive growth of the money supply. CAPTION: Picture 1, Larry Graves stacks and straightens by hand sheets of $1 bills to feed into the cutter.; Picture 2, Signed and counted bills in bundles of $100 pass along a conveyor system at the Bureau of Engraving and Printing. Photos by Harry Naltchayan -- The Washington Post