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Sic Semper Tyrannis

Friday, October 10, 2008

Re: Where is all this money coming from?, or, The Federal Banking System 101

Some material to expand on my comment to Lance and help with the concept of the Fed's "magic money":
Part of the answer lies in understanding bubbles and monetary inflation, but especially the Federal Reserve System. The Federal Reserve is charged with controlling inflation through interest rate manipulation, however, many fail to realize that creating money, and therefore inflation, is really its only tool. When the Federal Reserve inflates the dollar as drastically as it has in the past few decades, the first users of the newly created money go in search of investments for their dollars. They must invest this money quickly and aggressively before it loses value. This causes certain sectors to expand beyond what would naturally occur in the free market. Eventually the sector overheats and the bubble bursts. Overinvestment in dotcoms eventually led to a collapse of the NASDAQ. Next we had the housing bubble, and now we are seeing the price of oil being bid up in the creation of another new bubble. Investors are now looking to commodities like oil, for stability and growth as they pull capital out of real estate. This increased demand for investment vehicles related to oil contributes to driving up the price of the actual product.

Doesn't matter where the fake dollars go, the Fed will be there with more free money. Next:

On Friday [Aug. 10, 2007], the Federal Reserve — and other central banks around the world — pumped money into the global credit markets to head off a developing panic. The move was supposed to calm down the markets and ease fears that the mortgage mess will get worse before it gets better. All of which has some readers wondering just what happens when the Fed pumps money into these systems. Whose money is it — and where does it go when the pumping starts?

What does it mean when the Fed (and other countries) inject money into the banking system? Does this mean the government is printing money to get itself out of jam? Doesn't such an action create inflationary consequences? If so, wouldn't lowering interest rates be an at least equally effective mechanism? It seems to me that of those two mechanisms, even though both have inflation consequences, the lowering of interest rates would help the end consumer quicker.

— Richard, address withheld

The Federal Reserve, like all central banks, has several tools at its disposal to pump more money into the banking system (or drain it out), which helps to grease the economy and the financial markets — or slow them down. Contrary to popular notion, printing physical reserve notes (currency) isn’t the most important mechanism. (Thanks, anyway, to those readers who kindly remind us that the Fed's secret manipulation of illegitimate, 'fiat' currency is root cause of the world's economic and financial ills.) Most of the ‘money’ that flows through the global financial markets is actually electronic data moving from one account to another.

And last, a nice little nuts-and-boltz article for the layperson:
One of the more mysterious areas of the economy is the role of the Fed. Formally known as the Federal Reserve, the Fed is the gatekeeper of the U.S. economy. It is the central bank of the United States -- it is the bank of banks and the bank of the U.S. government. The Fed regulates financial institutions, manages the nation's money and influences the economy. By raising and lowering interest rates, creating money and using a few other tricks, the Fed can either stimulate or slow down the economy. This manipulation helps maintain low inflation, high employment rates, and manufacturing output.

Of course, there are those who are in denial:
The Federal Reserve DOES NOT create money out of thin air.
Every dollar printed is backed by collateral- that collateral being a US treasury bond which is sold off by the federal reserve to a buyer like your grandma, China, a pension fund, etc. That means every dollar is borrowed and has to be paid back with interest. How do we pay it back? With your tax dollars. 100% of your federal income taxes goes to pay these bond holders back. NONE of your taxes goes to fund the govt. or the military [emphasis mine, since for some it may be unclear that neither your grandma, China, nor a pension fund are actual collateral].

It may be easier for the government to manage money now that it's not based on anything at all, but that's also become its greatest weakness. It's just paper, and we can pump out a lot of paper.