What Money Really Is
And how knowing this helps you see through hysterias.
The US monetary system is weird. It is surprisingly robust and liquid, while also being hyper-powerful and sometimes hurtful. Some aspects drastically reduce poverty, while other aspects actively drain wealth from citizens.
This article will not give a full overview of that system, but rather will focus on a few Fulcrum Facts, keeping things as simplified as possible without sacrificing accuracy. These Fulcrum Facts will provide an easy path to navigate what is actually happening with the money system in a way that is independent of any political or economic ideology. Instead of being panicked or apathetic about big financial news, this will help you to plan wisely, analyze objectively, and enjoy all the incorrect hair-on-fire pronouncements more completely.
As money can be a quite controversial subject, this article starts with a disclaimer: what is written here is mostly descriptive and not prescriptive; meaning it describes what is, without pontificating on what should be. It is valuable to understand how the current US dollar and similar systems work, even if one disagrees with some aspects of fiat currency. These monetary systems are very important societal technologies, but many people don’t really understand how they work.
Fulcrum Fact #1: The amount of money that exists is actually defined as the amount of debt owed to banks plus the debt they owe you (your deposits).
There are a few other sources of money, but this accounts for about 90% of it1. Here’s how this works:
When I put $1,000 in the bank, they are allowed to loan out 90% of that money2, or $900. There is a very important federal rule called the Marginal Reserve Requirement, which says they have to keep 10% of their deposits in reserve and cannot do anything with them. But the rest they can loan out.
So now there is this extra $900 out there, in say a new business loan. It is very likely that this new business will most of the time keep their money in a bank. It doesn’t matter if it’s a different bank or not. But when that $900 goes into any bank, that bank can do the same. They have to hold back $90, or 10%, but can loan out the other $810.
Then that $810 gets put in a bank, which loans out $729,
which gets put in a bank, which loans out $656,
which gets put in a bank, which loans out $590.49,
which gets put in a bank, which loans out $531.44…and so on.
Each bank is like a meat grinder where you put 1 pound of meat in and get 1.9 pounds out. Then that extra 0.9 pounds of hamburger gets put into another magic meat grinder that does the same, and so on.
Note that at each step, the bank still owes each depositor the full amount they put in, but they also get to put out 90% of that in new loans. In the end, that initial $1,000 in my account turns into about $9,000 extra outside my account after going through a lot of “meat grinders."
Where did that $9,000 come from? It came from permission.
The banks have permission from the Federal government to make new loans based on the amount of funds the bank holds. And while each bank can only “create” a 90% copy of their holdings in loans, it compounds each time that money is put in a bank. Which it almost always is, at least temporarily.
In a way, those new loans are not made with new money; they are the definition of new money. That is how most money is actually created.
Where did that new money come from? It came from permission.
The banks don’t get to pocket that money. They do, however, make interest off loaning it out. Most banks survive off this interest as a business.
(Side note: Keep in mind that once I make that initial $1,000 deposit, the bank owes me that $1,000, in the sense that if I go and ask for it back, they have to give it to me. They are just betting that at any one time, fewer than 10% of people will go withdraw all their money, which is almost always true. And even if everyone does that, the Federal government guarantees to back that up and make the bank {depositor} whole, up to certain limits3.)
Fulcrum Fact #2: The Fed doesn’t need to “print money.” They just change little things that encourage or discourage bank loans.
Imagine that the outcome of a football game is *primarily* influenced by its cheerleaders. In terms of the money supply, the Fed are basically Money Cheerleaders.
Most of what the Fed does is encouraging or discouraging lending. Because the money supply is (mostly) defined as the amount of money owed to banks and their customers, this has the effect of changing how much money exists.
The Fed changes the minimum recommended rate that banks lend money to each other (the Overnight Lending Rate). If this is lower, it is “cheaper” for banks to get cash, and thus encourages them to lend more out, even at low interest rates. If that rate is 2%, then they can borrow it at 2% and lend it out at 3.75% and make money with very little risk. If the Overnight Rate is lowered to 1%, banks will offer to lend even more money at even lower rates, and more people will want to borrow. This increase in bank loans increases the amount of money that exists. The opposite is also true for when the rate is raised.
The Fed can also buy or sell government bonds directly to and from the banks. This injects debt directly into the system, creating money in a more straightforward way.
There are other options as well, but the main takeaway here is that the Fed will often spur more economic activity by making lending cheaper, and slow the economy down by making lending more expensive.
Generally, more money = more economic activity, and vice versa.
Fulcrum Fact #3: Rich foreign people have kept your grocery prices low for 15 years and running.
In order to deal with the Great Recession in 2008-2009, the Fed undertook a lot of policy moves to vastly increase the amount of money lent by banks in order to increase the money supply.
And once the economy crawled back out of that hole, the Fed didn’t pull that lending stimulus back very much. So the amount of money (loans owed to banks) just continued to grow, even after tripling in just a dozen years or so.
Most people presumed that increasing the amount of money that exists would make money more plentiful, and so each dollar would be in less demand. The more of something there is, the less value each unit of it has. The US dollar was expected to lose some of its value.
When a currency loses its value, that is called inflation, because prices go up. It takes more dollars of lesser value to buy a loaf of bread.
But we did not see that. In the graph below, the blue line is basically the amount of US money that exists, and the red line is the inflation index. It was generally expected that these should follow each other, as they did before 2009. From 2009 through 2020, inflation stayed very low and modest by most standard measures, usually about 0.8-2.3% annually. This is much lower than the historical average. How could this be when so much money had been “printed” as shown by the blue line?
A big part of the answer is that a lot of rich people in other countries deemed America to be a particularly safe place to store their money, at least compared to elsewhere. Some bond rates in Europe had gone negative4, markets were down as growth faltered in some developing countries, and general lack of growth was found in most places. But America just plugged right along.
So people bought a ton of U.S. Treasury Notes, especially 10-year Treasury Notes. These I.O.U.s promise that if you give the US government $1,000 now, then in 10 years, the US government will give you that money back with interest. Now, that level of interest is based on how much demand there is. The more demand there is, the less interest has to be promised in order to successfully sell all those I.O.U.s.
While most buyers are American, a huge number of foreign people also flooded into the market looking for these safe I.O.U.s. There was a LOT of foreign wealth that people wanted to park in safe American Treasury Notes. As of the writing of this article, foreign holdings of US Treasury notes is well above $7 Trillion. (Interestingly, China holds less than 15% of this, and less than 5% of all US debt.) So the government was able to lower and lower and lower the interest rate, and still always sell all their 10-year notes. The interest rate for them fell down to below 1.5%5, and it remains near there at the time of the writing of this article.
But remember I said that the Fed will buy bonds from or sell bonds to the bank in order to encourage or discourage lending? Well, a lot of those bonds are in the form of the 10-year T-notes. Therefore, these notes have always been sort of the base interest rate of the economy. When their yield is 5%, then mortgage rates are typically 1-2% higher than that. And thus the 10-year T-note rate becomes the highest price the banks pay for money.
And the price banks pay for money determines quite directly the interest rates that are competitive across the lending industry.
And thus the interest rates of T-notes basically sets the cost of money for EVERYONE6.
The T-note yield is usually very close to the rate of inflation. So all that international demand for US debt pushed that T-note interest rate way down and kept it down for a decade. And this helped keep American inflation low.
This solves the mystery. This is why there has not been massive inflation even though the money supply has drastically increased.
So here is a very useful trick: You don’t have to worry about structural inflation until you see the 10-year Treasury Note rate go above 3% and stay there for a month or so. The 10-year rate is your inflation warning light.
Fulcrum Fact #4: In this system, structural deflation is SUPER bad.
Deflation means each dollar is growing in value over time. If you have $1,000 in the bank, a year of deflation will make that money gain in buying power so that it’s like you have $1,050.
If banks can make money by doing nothing, just holding dollars in their accounts instead of lending them, then they will. They will drastically reduce lending. Which you now know means that it will drastically reduce the amount of money. So it becomes more “rare,” and people will hold onto it rather than spend or lend it. With less money moving around because it’s gaining in value, more people and banks will hoard it. Which makes it even more rare, and the deflation increases (the money gains in value over time even faster).
Less money means less economic activity. Stock markets can crash. Small businesses can’t get loans to start or continue. Large businesses and home buyers have to pay higher and higher interest rates to get the banks to lend them money. It’s disastrous, and a lot of people lose their jobs. It is usually hard to get out of this deflation hole. So the Fed and most economists are always on the lookout for deflation7.
But they will likely see it in 2022, even though it won’t be “real” in some sense. This is another big insight you will gain from reading this article: you will not be tricked by the coming Deflation Mirage.
Right now, there is an uptick in inflation because of Covid. Supply chains are failing somewhat due to factories and ports closing or limiting their workforce due to Covid. This causes widespread product scarcity, which causes prices to rise. Note that the U.S. Treasury Note yield is still very low, even as inflation measures show high inflation. This is because the inflation is not structural. It is just a side effect of Covid messing with supply lines.
When supply lines re-normalize in Spring/Summer 2022 stuff will become cheaper. And that will look like deflation. But it’s not deflation caused by anything the banks are doing. If the banks or Fed caused deflation, or if people were hoarding cash, that would be real, structural deflation.
But a LOT of people will freak out because they will think deflation has come to America.
But you will not be fooled. You will look at the mortgage and business lending rates, and you will see that they are staying very low, just above the very low 10-year T-note rates. And so you will see through the Deflation Mirage of 2022.
You will be ready to buy the panic dip, or buy property for cheap, or refinance your home at a very favorable rate while everyone else is belt tightening or running around with their hair on fire because the TV said it is time to do so.
And because of your calmness, society will be in your debt.
This ~10% is known as M0, and is the amount of money that exists as actual physical money (bills and coins) plus Central Bank reserves.
This is called Fractional Reserve banking. Lawrence H. White’s testimony before the House Subcommittee on Domestic Monetary Policy and Technology is a great summary of the history, advantages and disadvantages of fractional reserve banking.
The FDIC insures deposits up to at least $250,000.
You give a government 1,000 euros, and 10 years later they promised to give you back 985 euros. Yes, you read that right.
The real rate is much lower than that as this isn’t indexed for inflation. But it is tricky to determine the real rate as it is tricky to forecast inflation, fortunately the Treasury sells 10-year inflation indexed note. The interest rate of this note is currently negative. Yes, you read that correctly. People are paying the US government for the privilege of lending it money. (Graph)
The Federal Funds rate and Treasury bond rates are the two rates that drive short term and long-term borrowing rates respectively. (St. Louis Fed)