Money collected from taxes is basically recorded in a ledger / account by the Treasury. Some people look at this as the end of the lifespan of that money or the destruction of that money.
Money begins its life by being spent by the federal government. They essentially create money with the press of a keystroke (granted they are spending funds which are approved by Congress and allocated for projects), the money credits a Treasury account, then they transfer it / spend it which puts the money into circulation.
The federal government does not actually NEED the money you pay in taxes to fund their spending. Money does not come from people. It is created solely by the treasury. The federal government WANTS the money from taxes to approximately match the amount they put into circulation through spending in order to prevent runaway inflation. If they spend more than they collect they are adding to the supply of money which seems to be normal for a society with a growing population and successful marketplaces, but if they spend too much you get inflation.
The federal government believes that balancing is important. They want the amount of goods and services that America exports globally to match the amount America imports. Each year there is a deficit which means that America receives more goods and services than it exports. In order to balance this, the Treasury issues bonds equaling the amount of the year’s trade deficit. We don’t have to do this but we choose to because we believe it will create financial stability.
When the US issues bonds it collects money and gives a promise to make interest payments and to repay those bonds when they are due. Those bonds are debt. This is essentially how the government borrows money.
Money begins its life by being spent by the federal government.
No, in the modern system, money is created by commercial banks when they give a loan.
At the moment a loan for $1 million is created, a bank takes $0 and then turns it into two accounts: a loan with a balance of negative $1 million owed, and a deposit account with a balance of $1 million that can be withdrawn. From the bank’s perspective, and the borrower’s perspective, they went from having $0 to suddenly each having $1 million in assets and $1 million in liabilities, for a net value of zero. Obviously there are going to be fees and stuff paid out, and interest charged over the life of the loan, but you can think of that as fees for services rendered.
The money in that deposit account, created out of thin air, can then be spent elsewhere and enter the economy.
The limits on the ability of banks to do that indefinitely is default risk (the bank is left holding the bag if the borrower doesn’t repay) and liquidity (the bank needs to be able to use the loan balances as an asset on its balance sheets to go and borrow cash for its own operations so that its accountholders always have the ability to withdraw money on demand) and government regulation (the Federal Reserve and the FDIC have various regulations requiring their balance sheets to be able to survive stress tests and other adverse economic events).
So even though the government, through Federal Reserve policy, controls how private market participants might choose to create money, the actual act of money creation happens in the banks, not in the government (except when the government is acting as a bank by lending money through its loan programs).
When a bank issues a loan it creates a credit in the borrower’s account. When the borrower withdraws/transfers the money from their account the money comes from the bank’s reserves. The bank’s reserves consists of deposits and other liquid assets. The money in the bank’s reserves started its life by being created by the federal government. You may argue that the bank is loaning money that it does not hold in reserves, but for lack of a better description, this is a huge liability for the bank that can create insolvency issues (bank run). For this reason, I do not agree that banks create money when they issue loans, since the bank’s reserves are not created by the bank.
The money in the bank’s reserves started its life by being created by the federal government.
No, you’re misunderstanding how the money supply works. The creation of physical printed money might happen by the government, but those physical dollars represent such a small portion of the overall money supply.
First of all, through fractional reserve banking, one physical dollar can get multiplied many times over to represent many dollars in circulation. Especially because most transactions happen on paper, through a ledger that transfers funds from one account to another.
Everything you’re saying still relates to the practical limits of money creation by commercial banks, in terms of creditworthiness (banks don’t want to lend money they can’t get back) and liquidity/regulation (banks don’t want to be left vulnerable without sufficient reserves to satisfy account holders demanding their deposits).
Realistically, the bank takes one of their own assets, such as the balance on the loan, and uses that as collateral to borrow liquid cash as needed for its own reserves (which are only a fraction of the total deposits in its accounts). And every dollar in a circle in a closed loop that doesn’t touch the Fed is a dollar that doesn’t actually trace back to a governmental entity. The Fed is a lender of last resort, but they’re a last resort because they generally charge higher interest than bank to bank loans.
So of the entire money supply, the vast majority of it is dollars created by banks, not dollars created by the government.
You’re right that that article does talk about banks creating money and it’s true that banks can create money when they lend more than they have in reserves and assets. But my larger point was that IMO bank loans are credit but the bank loans are repaid with actual money. Maybe it’s semantics.
Also, you mentioned fractional reserve banking but that no longer exists. It ended around 2020 when the government changed regulations and no longer requires banks to hold any ratio of reserves to debt.
it’s true that banks can create money when they lend more than they have in reserves and assets
To be clear, the article is saying (and I’m saying) that the bank creates money every time it makes a loan, in the amount of the loan. Regardless of whatever its reserve and asset situation is. An asset and a liability are created in that moment that cancel out, and then each side can take their asset and do something with it: the borrower uses that cash to spend, and the lender uses that loan balance as an asset it can borrow against or otherwise count on income from.
IMO bank loans are credit but the bank loans are repaid with actual money.
It’s repaid with actual money, but it’s all actual money. When the loan is created the balance in the deposit account can be withdrawn or transferred from there and it’s real money that can buy real goods and real services. The money is created, and then it’s real money in the economy. Then the loan is repaid with real money, and then destroyed in the act of repayment and reducing the balance owed on the loan.
Also, you mentioned fractional reserve banking but that no longer exists. It ended around 2020 when the government changed regulations and no longer requires banks to hold any ratio of reserves to debt.
No, that had the opposite effect of what you think. The minimum reserve requirement was abolished, so banks could then do fractional reserve banking in any fraction they pleased, including even smaller ratios than what was previously allowed. The change in regulation didn’t eliminate fractional reserve banking; it eliminated limits on fractional reserve banking, and every bank continued to hold a reserve that is much, much smaller than 100% of the amount of their deposit liabilities. So the fractions still exist. And can continue to exist in any number, with other practical limits on their ability to loan (creditworthiness and solvency).
I didn’t consider that you could still classify banking as fractional reserve banking even though there are no fractional reserve banking requirements. In my mind the concept was one of regulatory oversight.
Do you think that when a bank loans money to another bank they are creating money out of thin air? If they can do that then why do they need to borrow money?
I think you’re doing a good job interpreting and explaining modern monetary theory, I just don’t agree with all of it, although I agree with the concept.
Do you believe that the US government must collect taxes before it can spend money? Or do you agree that government spending is self financed and money creation (in spending by the US government) is only limited by concerns of inflation?
Do you believe that Banks hold digital money in their reserves? I do. Who do you think created that money?
In my mind the concept was one of regulatory oversight.
No, the core concept is one of whether a bank has full reserves, sufficient to cover all of the deposit liability. If the bank keeps only a fraction of the total liability in reserves, then that’s a fractional reserve.
Do you think that when a bank loans money to another bank they are creating money out of thin air?
Yes, that creates money.
If they can do that then why do they need to borrow money?
They need to borrow money for liquidity, to cover the payments they owe to others. An IOU isn’t money, so having a bunch of IOUs in the asset column may require a bank to pledge those IOUs to borrow some money from someone else, maybe even another bank. Then, with money in hand, they can make payments to fund their own operations (pay employees, rent, vendors, taxes, etc.) and pay depositors on demand.
And as a financial institution borrows too much and pays that interest, or is overextended without enough assets to remain solvent/liquid to be able to make payments as they’re due, they may find themselves with insufficient creditworthiness to be able to borrow freely (as other banks are wary of lending to someone who might not pay back). And they might fail. So that general concern always provides a limit on how much they can borrow from other private entities.
They can borrow from the central bank as a lender of last resort, but that carries a cost (and can still only borrow as much as their assets can support). If they’re paying more interest to their creditors than they’re collecting from their borrowers, they’re gonna fail.
Do you believe that the US government must collect taxes before it can spend money? Or do you agree that government spending is self financed and money creation (in spending by the US government) is only limited by concerns of inflation?
No, the government can (and does) borrow money to finance its operations, as well. For the U.S., the sheer amount of government spending is such a high percentage of economic activity that it would be highly inflationary to combine the fiscal power of spending money with the monetary power of controlling the money supply (through creation of base currency, influencing private transactions and interest rates to control bank-created money, and buying/selling securities on the open market).
I think if we lived in a different system without an independent central bank, we’d see a lot of different things going on, including a temptation to elected officials to just create money without regard to inflationary effects. But in the current system, most of the money is created by banks.
Do you believe that Banks hold digital money in their reserves? I do.
Yes, that’s what we’ve been talking about the whole time. When a commercial bank creates a loan, that’s just a ledger that creates an asset in one column and a liability in another column. It could be paper, or it could be digitally stored. If the funds are transferred electronically to another bank, that’s often an electronic record with no physical movement of anything. So yes, those are effectively digital dollars that can be withdrawn as paper money on demand at any given time.
With that said, while this comment does correctly describe what the USA federal government does with tax revenues, it is mixing up the separate roles of the government (via the US Treasury) and the Federal Reserve.
The Federal Reserve is the central bank in the USA, and is equivalent to the Bank of England (despite the name, the BoE serves the entire UK). The Federal Reserve is often shortened to “the Fed” by finance people, which only adds to the confusion between the Fed and the federal government. The central bank is responsible for keeping the currency healthy, such as preventing runaway inflation and preventing banking destabilization.
Whereas the US Treasury is the equivalent to the UK’s HM Treasury, and is the government’s agent that can go to the Federal Reserve to get cash. The Treasury does this by giving the Federal Reserve some bonds, and in turn receives cash that can be spent for employee salaries, capital expenditures, or whatever else Congress has authorized. We have not created any new money yet; this is an equal exchange of bonds for dollars, no different than what you or I can do by going to treasurydirect.gov and buying USA bonds: we give them money, they give us a bond. Such government bonds are an obligation that the government must pay in the future.
The Federal Reserve is the entity that can creates dollars out of thin air, bevause they control the interest rate of the dollar. But outside of major financial crisis, they only permit the dollar to inflate around 2% per year. That’s 2% new money being created from nothing, and that money can be swapped with the Treasury, thus the Federal Reserve ends up holding a large quantity of federal government bonds.
Drawing the distinction between the Federal Reserve and the government is important, because their goals can sometimes be at odds: in the late 1970s, the Iranian oil crisis caused horrific inflation, approaching 20%. Such unsustainable inflation threatened to spiral out of control, but also disincentivized investment and business opportunities: why start a new risky venture when a savings account would pay 15% interest? Knowing that this would be the fate of the economy if left unchecked, the Federal Reserve began to sell off huge quantities of its government bonds, thus pulling cash out of the economy. This curbed inflatable, but also created a recession in 1982, because any new venture needs cash but the Feds sucked it all up. Meanwhile, the Reagan administration would not have been pleased about this, because no government likes a recession. In the end, the recession subsided, as did inflation and unemployment levels, thus the economy escaped a doom spiral with only minor bruising.
To be abundantly clear, the Federal Reserve did indeed cause a recession. But the worse alternative was a recession that also came with a collapsed US dollar, unemployment that would run so deep that whole industries lose the workers needed to restart post-recession, and the wholesale emptying of the Federal Reserve and Treasury’s coffers. In that alternate scenario, we would have fired all our guns and have lost anyway.
The Federal Reserve is the entity that can creates dollars out of thin air, bevause they control the interest rate of the dollar.
They control the base currency by physically printing dollars and lending money directly to banks. Then, more significantly, they influence the money supply by influencing how much commercial banks are lending, through interest rate operations, and sometimes through market operations that provide liquidity for certain types of securities (especially government bonds).
Taken together, it’s the power to create or destroy money in response to macroeconomic trends.
The Federal Reserve system is independant of the US federal government.
Kinda. The board of governors is chosen by the president to 14-year terms, theoretically making them independent of any specific President’s specific priorities. But there’s a Supreme Court case heading when the President can fire the governors, which might effectively end or limit Fed independence.
The individual federal reserve banks also operate in their regions with a lot of leeway to meet local needs, and those are public/private partnerships where nationally chartered banks also have a voice in their operations.
Money collected from taxes is basically recorded in a ledger / account by the Treasury. Some people look at this as the end of the lifespan of that money or the destruction of that money.
Money begins its life by being spent by the federal government. They essentially create money with the press of a keystroke (granted they are spending funds which are approved by Congress and allocated for projects), the money credits a Treasury account, then they transfer it / spend it which puts the money into circulation.
The federal government does not actually NEED the money you pay in taxes to fund their spending. Money does not come from people. It is created solely by the treasury. The federal government WANTS the money from taxes to approximately match the amount they put into circulation through spending in order to prevent runaway inflation. If they spend more than they collect they are adding to the supply of money which seems to be normal for a society with a growing population and successful marketplaces, but if they spend too much you get inflation.
The federal government believes that balancing is important. They want the amount of goods and services that America exports globally to match the amount America imports. Each year there is a deficit which means that America receives more goods and services than it exports. In order to balance this, the Treasury issues bonds equaling the amount of the year’s trade deficit. We don’t have to do this but we choose to because we believe it will create financial stability.
When the US issues bonds it collects money and gives a promise to make interest payments and to repay those bonds when they are due. Those bonds are debt. This is essentially how the government borrows money.
This is a fantastic article from the Bank of England which is like the US Treasury https://share.google/GmWpluu76vSJpuw5C
Edit: read the discussion below for more context and clarification. Banks create more money then the federal government does, I wasn’t aware.
No, in the modern system, money is created by commercial banks when they give a loan.
At the moment a loan for $1 million is created, a bank takes $0 and then turns it into two accounts: a loan with a balance of negative $1 million owed, and a deposit account with a balance of $1 million that can be withdrawn. From the bank’s perspective, and the borrower’s perspective, they went from having $0 to suddenly each having $1 million in assets and $1 million in liabilities, for a net value of zero. Obviously there are going to be fees and stuff paid out, and interest charged over the life of the loan, but you can think of that as fees for services rendered.
The money in that deposit account, created out of thin air, can then be spent elsewhere and enter the economy.
The limits on the ability of banks to do that indefinitely is default risk (the bank is left holding the bag if the borrower doesn’t repay) and liquidity (the bank needs to be able to use the loan balances as an asset on its balance sheets to go and borrow cash for its own operations so that its accountholders always have the ability to withdraw money on demand) and government regulation (the Federal Reserve and the FDIC have various regulations requiring their balance sheets to be able to survive stress tests and other adverse economic events).
So even though the government, through Federal Reserve policy, controls how private market participants might choose to create money, the actual act of money creation happens in the banks, not in the government (except when the government is acting as a bank by lending money through its loan programs).
When a bank issues a loan it creates a credit in the borrower’s account. When the borrower withdraws/transfers the money from their account the money comes from the bank’s reserves. The bank’s reserves consists of deposits and other liquid assets. The money in the bank’s reserves started its life by being created by the federal government. You may argue that the bank is loaning money that it does not hold in reserves, but for lack of a better description, this is a huge liability for the bank that can create insolvency issues (bank run). For this reason, I do not agree that banks create money when they issue loans, since the bank’s reserves are not created by the bank.
Your own link from the Bank of England starts off with the thesis that agrees with me:
And you might as well link to the canonical URL of the PDF or the Bank of England website landing page for that article instead of Google Drive acting as a middleman.
No, you’re misunderstanding how the money supply works. The creation of physical printed money might happen by the government, but those physical dollars represent such a small portion of the overall money supply.
First of all, through fractional reserve banking, one physical dollar can get multiplied many times over to represent many dollars in circulation. Especially because most transactions happen on paper, through a ledger that transfers funds from one account to another.
Everything you’re saying still relates to the practical limits of money creation by commercial banks, in terms of creditworthiness (banks don’t want to lend money they can’t get back) and liquidity/regulation (banks don’t want to be left vulnerable without sufficient reserves to satisfy account holders demanding their deposits).
Realistically, the bank takes one of their own assets, such as the balance on the loan, and uses that as collateral to borrow liquid cash as needed for its own reserves (which are only a fraction of the total deposits in its accounts). And every dollar in a circle in a closed loop that doesn’t touch the Fed is a dollar that doesn’t actually trace back to a governmental entity. The Fed is a lender of last resort, but they’re a last resort because they generally charge higher interest than bank to bank loans.
So of the entire money supply, the vast majority of it is dollars created by banks, not dollars created by the government.
You’re right that that article does talk about banks creating money and it’s true that banks can create money when they lend more than they have in reserves and assets. But my larger point was that IMO bank loans are credit but the bank loans are repaid with actual money. Maybe it’s semantics.
Also, you mentioned fractional reserve banking but that no longer exists. It ended around 2020 when the government changed regulations and no longer requires banks to hold any ratio of reserves to debt.
To be clear, the article is saying (and I’m saying) that the bank creates money every time it makes a loan, in the amount of the loan. Regardless of whatever its reserve and asset situation is. An asset and a liability are created in that moment that cancel out, and then each side can take their asset and do something with it: the borrower uses that cash to spend, and the lender uses that loan balance as an asset it can borrow against or otherwise count on income from.
It’s repaid with actual money, but it’s all actual money. When the loan is created the balance in the deposit account can be withdrawn or transferred from there and it’s real money that can buy real goods and real services. The money is created, and then it’s real money in the economy. Then the loan is repaid with real money, and then destroyed in the act of repayment and reducing the balance owed on the loan.
No, that had the opposite effect of what you think. The minimum reserve requirement was abolished, so banks could then do fractional reserve banking in any fraction they pleased, including even smaller ratios than what was previously allowed. The change in regulation didn’t eliminate fractional reserve banking; it eliminated limits on fractional reserve banking, and every bank continued to hold a reserve that is much, much smaller than 100% of the amount of their deposit liabilities. So the fractions still exist. And can continue to exist in any number, with other practical limits on their ability to loan (creditworthiness and solvency).
I didn’t consider that you could still classify banking as fractional reserve banking even though there are no fractional reserve banking requirements. In my mind the concept was one of regulatory oversight.
Do you think that when a bank loans money to another bank they are creating money out of thin air? If they can do that then why do they need to borrow money?
I think you’re doing a good job interpreting and explaining modern monetary theory, I just don’t agree with all of it, although I agree with the concept.
Do you believe that the US government must collect taxes before it can spend money? Or do you agree that government spending is self financed and money creation (in spending by the US government) is only limited by concerns of inflation?
Do you believe that Banks hold digital money in their reserves? I do. Who do you think created that money?
No, the core concept is one of whether a bank has full reserves, sufficient to cover all of the deposit liability. If the bank keeps only a fraction of the total liability in reserves, then that’s a fractional reserve.
Yes, that creates money.
They need to borrow money for liquidity, to cover the payments they owe to others. An IOU isn’t money, so having a bunch of IOUs in the asset column may require a bank to pledge those IOUs to borrow some money from someone else, maybe even another bank. Then, with money in hand, they can make payments to fund their own operations (pay employees, rent, vendors, taxes, etc.) and pay depositors on demand.
And as a financial institution borrows too much and pays that interest, or is overextended without enough assets to remain solvent/liquid to be able to make payments as they’re due, they may find themselves with insufficient creditworthiness to be able to borrow freely (as other banks are wary of lending to someone who might not pay back). And they might fail. So that general concern always provides a limit on how much they can borrow from other private entities.
They can borrow from the central bank as a lender of last resort, but that carries a cost (and can still only borrow as much as their assets can support). If they’re paying more interest to their creditors than they’re collecting from their borrowers, they’re gonna fail.
No, the government can (and does) borrow money to finance its operations, as well. For the U.S., the sheer amount of government spending is such a high percentage of economic activity that it would be highly inflationary to combine the fiscal power of spending money with the monetary power of controlling the money supply (through creation of base currency, influencing private transactions and interest rates to control bank-created money, and buying/selling securities on the open market).
I think if we lived in a different system without an independent central bank, we’d see a lot of different things going on, including a temptation to elected officials to just create money without regard to inflationary effects. But in the current system, most of the money is created by banks.
Yes, that’s what we’ve been talking about the whole time. When a commercial bank creates a loan, that’s just a ledger that creates an asset in one column and a liability in another column. It could be paper, or it could be digitally stored. If the funds are transferred electronically to another bank, that’s often an electronic record with no physical movement of anything. So yes, those are effectively digital dollars that can be withdrawn as paper money on demand at any given time.
Really interesting. I just read the Bank of England’s companion article: Money in the modern economy, an introduction https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-in-the-modern-economy-an-introduction
So that’s what is going on. Good reply.
For the benefit of non-Google users, here is the unshortened URL for that Bank of England article: https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy
With that said, while this comment does correctly describe what the USA federal government does with tax revenues, it is mixing up the separate roles of the government (via the US Treasury) and the Federal Reserve.
The Federal Reserve is the central bank in the USA, and is equivalent to the Bank of England (despite the name, the BoE serves the entire UK). The Federal Reserve is often shortened to “the Fed” by finance people, which only adds to the confusion between the Fed and the federal government. The central bank is responsible for keeping the currency healthy, such as preventing runaway inflation and preventing banking destabilization.
Whereas the US Treasury is the equivalent to the UK’s HM Treasury, and is the government’s agent that can go to the Federal Reserve to get cash. The Treasury does this by giving the Federal Reserve some bonds, and in turn receives cash that can be spent for employee salaries, capital expenditures, or whatever else Congress has authorized. We have not created any new money yet; this is an equal exchange of bonds for dollars, no different than what you or I can do by going to treasurydirect.gov and buying USA bonds: we give them money, they give us a bond. Such government bonds are an obligation that the government must pay in the future.
The Federal Reserve is the entity that can creates dollars out of thin air, bevause they control the interest rate of the dollar. But outside of major financial crisis, they only permit the dollar to inflate around 2% per year. That’s 2% new money being created from nothing, and that money can be swapped with the Treasury, thus the Federal Reserve ends up holding a large quantity of federal government bonds.
Drawing the distinction between the Federal Reserve and the government is important, because their goals can sometimes be at odds: in the late 1970s, the Iranian oil crisis caused horrific inflation, approaching 20%. Such unsustainable inflation threatened to spiral out of control, but also disincentivized investment and business opportunities: why start a new risky venture when a savings account would pay 15% interest? Knowing that this would be the fate of the economy if left unchecked, the Federal Reserve began to sell off huge quantities of its government bonds, thus pulling cash out of the economy. This curbed inflatable, but also created a recession in 1982, because any new venture needs cash but the Feds sucked it all up. Meanwhile, the Reagan administration would not have been pleased about this, because no government likes a recession. In the end, the recession subsided, as did inflation and unemployment levels, thus the economy escaped a doom spiral with only minor bruising.
To be abundantly clear, the Federal Reserve did indeed cause a recession. But the worse alternative was a recession that also came with a collapsed US dollar, unemployment that would run so deep that whole industries lose the workers needed to restart post-recession, and the wholesale emptying of the Federal Reserve and Treasury’s coffers. In that alternate scenario, we would have fired all our guns and have lost anyway.
They control the base currency by physically printing dollars and lending money directly to banks. Then, more significantly, they influence the money supply by influencing how much commercial banks are lending, through interest rate operations, and sometimes through market operations that provide liquidity for certain types of securities (especially government bonds).
Taken together, it’s the power to create or destroy money in response to macroeconomic trends.
The Federal Reserve system is independant of the US federal government. Doesn’t the government of the UK own the Bank of England?
Kinda. The board of governors is chosen by the president to 14-year terms, theoretically making them independent of any specific President’s specific priorities. But there’s a Supreme Court case heading when the President can fire the governors, which might effectively end or limit Fed independence.
The individual federal reserve banks also operate in their regions with a lot of leeway to meet local needs, and those are public/private partnerships where nationally chartered banks also have a voice in their operations.