Despite claims to the contrary, proper currency management is simple. A currency's value is determined by the balance of supply and demand. The currency is supplied by the issuer of currency, which today are central banks. The currency is demanded by anyone worldwide who wishes to hold the currency.

Whenever supply is growing relative to demand, the currency loses value. Whenever supply is shrinking relative to demand, the currency gains value. When supply maintains an equal relationship with demand, stable currency value results.

Everybody knows that if a central bank increases supply (i.e., "prints money") willy-nilly and far in excess of demand, the currency's value will fall. However, this is not the only means by which inflation can take place. If demand shrinks and supply does not shrink accordingly, the result is that supply grows relative to demand and the value of the currency falls. It is possible for the currency's value to fall even when supply is shrinking -- if demand is shrinking even faster.

A fall in supply relative to demand will push the currency's value higher. This can happen through a contraction of supply, but it is also common to find that the demand for a currency can increase sharply. This will raise the currency's value even if supply is stable or growing.

All fluctuations in a currency's value, which can be noted in the foreign exchange market and currency's exchange rate with gold, are the result of the mismatch of supply and demand.

Money is supplied by institutions with the power to create money. In the past, private commercial banks created money. At other times, money has been created by government treasury departments or ministries of finance. Today, money is created by central banks, although central banks were not created for that purpose.

Today, money is rarely printed in the first instance, but rather comes out of a very special checking account at the central bank that nobody puts any money into. The central bank will buy something on the open market, usually either domestic government bonds or foreign currencies, and will pay for the purchase with its magic checking account, creating an increase in the seller's bank account. In a normal transaction, A has a bond and B has $1,000, and afterward, B has a bond and A has $1,000. The amount of money in circulation does not change. However, if A sells the central bank a bond, A's account is credited with $1,000, but no account is debited. New money enters circulation. This money ends up as bank reserves, which can be redeemed for paper banknotes on demand. If the government does not have sufficient paper currency in its vaults, it prints new currency to meet this request. Thus, increasing the money supply by buying bonds with the magic checkbook is equivalent to printing money.

Supply can be reduced through the opposite process. If the central bank sells a bond to A, A's account is debited, but no account is credited. The money simply disappears. One can imagine the issuer of currency "running the printing press backward." Central banks today have enough bonds or other assets to buy back the entire supply of money available. The U.S. Federal Reserve, for example, can buy up every single dollar in the world. Thus, it can supply any amount of money, from zero to infinity.

Even if a central bank, or government, did not have enough assets to purchase currency, it could issue new bonds or eliminate currency taken in from tax revenues.

The central bank is in a nice position here. It can buy things with money it simply creates out of nothing. The profit inherent in producing money is known as seignorage, a word signifying that it has long been considered the right of kings. However, it does not have to be done by governments. Many of the early commercial banks, in eighteenth-century Scotland, for example, specialized first in printing paper money (replacing metallic coinage) and only later diversified into making loans. As private institutions, they profited from money creation in the same way that governments profit today.

Today, the interest income from the roughly $800 billion of government bonds held by the privately owned Federal Reserve is remitted to the U.S. Treasury, after deducting the operating expenses of the central bank. (At least, that is the official story.)

The money that is created by the Fed's magic checking account is known as base money and consists primarily of Federal Reserve Notes (i.e., paper currency, dollar bills) and bank reserves, which are deposits of commercial banks with the central bank and are recorded electronically at the central bank. Only the Fed can create base money, and the Fed can create no other type of money except for base money. Paper bills make up the majority of base money. At this time, the U.S. Federal Reserve counts about $812 billion of base money, with $750 billion in bills and coins, and $62 billion in bank reserves. During the 1990s, U.S. base money grew at an average rate of 7.14 percent per year.

The term base money is used because upon the base of base money sits a much larger pyramid of credit. A bank deposit is not money, but is actually a kind of debt instrument, a bond that must be repaid at the request of the lender, called the depositor. As a bond, it pays interest. While the amount of base money available is determined to the dollar by the central bank (at least insofar as bills are not destroyed or lost by their holders or created by counterfeiters), the amount of existing credit can change according to a nearly infinite number of factors.

Thus it is incorrect to say that "banks create money." Only the Federal Reserve creates base money. Banks can only create credit, which does not alter the supply of base money, but which may have an effect on the demand for base money. Actually, anyone can create credit, simply by making a loan. Credit is not money.

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© 2007 Nathan Lewis

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Posted in Monetary Commentary, Guest Commentary, Nathan Lewis