How does FIAT money come into existence?  And how much “money” is out there?

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Be warned. This is not fun reading. And the insights are likely depressing particularly if you are young or poor or both. But understanding the mechanics of FIAT money creation will place you among a tiny minority of people who actually know how easily the thing everybody is after is fabricated.

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For a start, let’s define money in a narrow sense and see it as currency (coins and banknotes) and bank deposits. This money comes into existence in broadly one of two ways.

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‘Standard’ money creation happens in commercial banks when they make loans. Let that sink in. Banks can create money. Yes. It does not require the government or the central bank to do anything.  The central bank sits on the sidelines and closely watches the miraculous money creation by banks. It retains a kind of veto in the process.

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Central banks like the FED require commercial banks to keep a fraction of deposits from customers in an account with themselves. These are called ‘Reserves’. (It is the reason why some refer to a ‘Fiat Money System’ as ‘Fractional Reserve Banking System’). These ‘Reserves’ are an asset for the banks. They are a type of money that you and I cannot have. It’s special money only available to and required by banks.

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Let’s look at the process with a focus on the US and the US FED. Other central banks operate similarly.

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Reserve money is the blood pumping through the financial system. It moves when funds flow from one bank to another, say because you, who are banking at Bank A, send money to your buddy who has her account at Bank B. Your deposit in Bank A is nothing but a loan to the bank and so a liability for Bank A. Now with an outflow of some of your money from your account in Bank A, Bank A’s liabilities shrink. Bank A also sees its ‘Reserve’ account with the FED, which is an asset account for the bank, shrink by the same amount. Conversely, Bank B sees the deposit account of your buddy go up along with its own ‘Reserve’ account with the FED. You may look at the central bank as the spider in the payments system observing how money flows through the FED wire.

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Let’s assume the FED sets a Reserve Requirement Ratio (RRR) of 10%, meaning 10% of a bank’s total deposits have to be in the bank’s Reserve account with the FED at any time. More is ok. Less is not. The FED can set this RRR since it is the supreme supervisor of banks and the entire banking system. It’s kind of like a “safety” deposit you need to put up when you rent an apartment.

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Let’s further assume your Bank A has an inflow of $100’000 into its Reserve account since it sold a US Treasury Bill for this amount to the FED. The FED has a trading desk so can and does trade securities with banks. Total reserves by Bank A have increased by $100’000. Since another asset, securities holdings, have shrunk by the same amount, the overall size of the balance sheet of Bank A has not changed.

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To illuminate the following tedious read, you may look at the table following this paragraph. It depicts the net effect of the transactions described next.

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Now, let’s assume Bank A receives a loan request from Alpha Company for $100’000. Bank A approves it. As a result, Alpha Company finds their deposit account at Bank A increased by $100’000.  Alpha Company uses the funds to make a purchase from Bravo Company, which banks at Bank B.  Bank B now sees an inflow into the deposit account of their Client, Bravo Company, along with its Reserve account up by $100’000.  Bank B must keep $10’000 of this amount in the Reserve account with the FED, while the remaining $90’000 may be lent out. It just so happens that Charlie Company puts in a well-argued application for a loan of $90’000 with Bank B.  Bank B approves it.  Charlie Company didn’t ask for the loan to leave the funds on deposit with Bank B.  Charlie Company uses the money to buy a truck from Delta Company that banks at Bank C.  So Bank C has an inflow of $90’000, of which it has to put $9’000 into Reserve. Guess what? Bank C now has a business customer, Echo Company, asking for a loan of $81’000. It gets its loan approved and finds $81’000 in its deposit account. This deposit also travels to Bank D. Then Bank D gets a loan request. You get the idea.  And so the chain continues.

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At the end of the journey, given a 10% RRR, an inflow of $100’000 in Reserves in a Bank allows for creation of a maximum of $1 million in new deposits and loans in the banking system. The lower the RRR, the more money (deposits) may be created. This process is called the Multiple Deposit Creation System. FIAT money multiplies itself. Marvelous.

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In short, new money, i.e. new deposits, are created when banks make new loans.

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There is another way ‘narrow’ money may be created, a most straight-forward one. The FED itself can create or ‘print’ more money. It cannot only put more currency (coins and bills) in circulation but also create Reserves out of thin air. The FED created new money when it bought Treasury Bills from Bank A in the above example. It usually does create new money exclusively for the benefit of the government. (Remember central banks have basically been set up to help run the government’s finances). It can do this indirectly as described above or directly.

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The FED can put money directly into the account of the Treasury. (In most countries the Treasury is called the Ministry of Finance). The government is practically the only entity, other than banks supervised by the FED, that has an account at the FED (called the Treasury General Account (TGA)). The FED can put money into the TGA in exchange for a written promise of the government to repay this money. Bingo. When the FED puts money into the TGA, the FED’s balance sheet increases: it has now more government I.O.Us  (typically bonds) on the asset side, and more money in the TGA (which is a liability for the FED).

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The FED can also buy government debt from banks at its discretion and so create ‘Excess Reserves’. The end result is the same – the government has fresh funds to pay public employees, build roads or finance military gear. Conveniently, there is no need to raise taxes.

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When the FED increases its balance sheet by acquiring more government debt and paying for it by creating more Reserves, we generally talk about ‘Quantitative Easing’ or ‘monetization of debt’ or simply ‘money printing’.

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Nobody is worse off. So it seems.

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So how much money has been created and is “out there”? 

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Currency in circulation and deposits are easy to measure and track. Central banks make the data of various ‘monetary aggregates’ generally readily available.  The FED publishes data on the monetary base – weekly! Investors in stocks and bonds pay close attention to them for good reason as we will see in a blog post. For the US FED, you find the data here[1].

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The first, M0 (M zero), keeps track of the sum of currency in circulation and the Reserves banks hold at the FED. Both are liabilities on the FED’s balance sheet. M0 is also referred to as ‘base money’.

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Another monetary aggregate, labelled M1, tracks the sum of currency outstanding (coins and bills), Demand Deposits and Other Liquid Deposits. M2 incorporates all of M1 plus Small-Denomination Time Deposits and Retail Money Market Funds.

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Not long ago, the FED reshuffled some ingredients from M2 to M1. As a result, M1 and M2 are now very similar in size. In the old days the FED published data for M3 and M4 which included large interbank loans among others. In short, there is a lot of arbitrariness to draw the line of what constitutes money and in which “basket” a particular type of money belongs.

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With the advent of electronic payments (and so electronic money) and easy trading in securities, money of old has morphed into something new. Instead of looking at money as currency (or cash if you will) and deposits, counting liquidly traded bonds and stocks in private possession is appropriate. After all, it is very easy to convert any type of traded security, which are now nearly traded round the clock, into cash to make a payment. As a matter of fact, securities such as stocks and bonds can also be used to make payments. Bottom-line, a narrow view of money is – like the Blackberry – outdated!

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Tracking a broader aggregate of “money” tells us something we suspected all along. There is sooo much money out there these days. In relation to a measure like size of the economy (GDP), money has mushroomed beyond anyone’s wildest imagination.

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A team at McKinsey, generally smart folks, went through the tedious effort to estimate how much “financial assets” (meaning stocks, bonds, deposits etc) are out there in the world. This is an even wider measure of money as it also incorporates illiquid financial assets.

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Source: Woetzel, J. et al (2021, November). The rise and rise of the global balance sheet. McKinsey Global Institute.

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The size of this very wide monetary aggregate was roughly 4.4 times (2.5 + 1.9) the size of GDP in 1970, and about the same in 1980. Then growth of “wide” money took off. It is now 12 times (6.0 +6.0) GDP, or nearly 3 times more than in 1980. McKinsey calculates that there is around USD 1000 trillion of financial assets floating around the world. In comparison, the world economy produced around USD 90 trillion of goods and services in 2020. If, miraculously, life was discovered on another planet, and the folks there were eager to trade with us humans on earth and could be tricked into accepting our FIAT money, all of us humans on earth could stop working as we would have enough “money” to pay for consumption at the present levels for the next 12 years. Not bad, ey? No wonder everyone is so keen to explore the moon and mars.

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How could this money growth happen? How could work (GDP) and money (financial assets) develop so independently?

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To understand that we have to first look at the “rental price” of money, interest, and then revisit demography.

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Reference

 

[1] https://www.federalreserve.gov/releases/h6/current/default.htm