Uncontrolled, increasing, and undisguised.
By James Lavish
Compiled by: TechFlow
Printing money may seem simple, but it’s actually confusing. Why would the Federal Reserve sell bonds to the public when it can just print more dollars and pay for whatever the government wants to spend? The answer is simple, but it requires a little critical thinking.
If you visited Twitter last week, you might have seen a video clip of Jared Bernstein, chairman of the Council of Economic Advisers (a group that advises the White House on economic policy), “explaining” bonds.
Even so, he seems to have a real hard time understanding the basic concepts of national debt and how it works. Honestly, these concepts are really hard to grasp, so let’s break them down in simple and clear terms so that we can understand.
Money Supply Basics
To understand “printing money” we must first understand the basics of money. Or more precisely, the basics of “money supply”, and we’re going to keep it super high level here and make it easy to understand.
Narrow money
Of the money supply measures, the strictest is what is known as narrow money, or M0 ('em-zero'). This includes only currency in circulation and cash held as reserves by banks. M0 is often referred to as the monetary base. Going up one level, we have what is known as M1. M1 includes all of M0 plus demand deposits, plus any outstanding travellers' cheques. Demand deposits are simply liquid deposits in bank accounts that customers can withdraw at any time, i.e. customer cheques and savings.
Banks don’t keep all the cash in their vaults; they use risk analysis to estimate how much money would be available at individual branches in the event of a bank run. All that’s left are the zeros and ones on the digital ledger they keep.
Anyway, M1 includes any cash that can be withdrawn (including those traveler's checks), and nothing more. For this reason, M1 is often referred to as narrow money. Here are the dollar amounts of M1:
I know what you’re thinking: What exactly happened in 2020 that caused the M1 money supply to spike? You guessed it: by printing money. We’ll get to that in a moment, but let’s first unpack the next level of money supply, broad money.
Broad money
Expanding our scope a bit, M2 includes all of M1 plus money market savings deposits, limited-time deposits under $100,000 (i.e., CDs and money market). In other words, M2 includes all funds held in cash-equivalent accounts, liquid and semi-liquid accounts.
Expanding to M2, this is today’s dollar amount. You can see in the chart of M2 how the expansion has been more gradual after 2020, and how it takes a while to “filter down” into personal accounts.
Why? Because of the Cantillon Effect. Named after the 18th century economist Richard Cantillon, the Cantillon Effect describes how those who receive new money first (i.e. banks, governments, or financial institutions) benefit, while everyone else experiences a delayed effect.
Now, let's explain the difficulty Jared Bernstein has in describing (and apparently not understanding) the U.S. Treasury bond.
Basic knowledge of national debt
At its most basic definition, a U.S. Treasury bond is a bond issued by the U.S. government. It's no different than a bond issued by Apple, Microsoft, or Tesla, except that it's the country (or company) lending money to whoever buys it.
What happens when you borrow money? You pay interest to the person who lends you the money, just like you pay a bank interest on a mortgage. You borrow money from a bank to buy a house, and you pay the bank interest on that loan. We all know that the government has been borrowing a lot lately, and that's because it's running a deficit (spending more than it's taking in in taxes) and is borrowing to make up the difference, which is increasing the U.S. public debt.
How much money has the United States borrowed, and how much does it owe to everyone who has lent it money?
Can you believe it? The total is 34.6 trillion US dollars!
So who is buying all these bonds? In other words, who is lending the United States so much money?
Basically you and I and others buy bonds directly in their IRAs, 401Ks, personal accounts, and indirectly through mutual funds and money markets, US banks, foreign central banks (i.e. Bank of Japan, Bank of China, other foreign countries), including the Fed itself buying bonds.
You may be wondering, how is it possible that they own all this U.S. Treasury debt? Let me explain step by step.
How is money printed?
This involves quantitative easing (QE) and quantitative tightening (QT).
During times of financial crises or recessions, such as the financial crisis, we saw the Fed use QE in a shotgun manner, recklessly buying Treasuries and MBS (mortgage-backed securities) QT is when the Fed sells them back into the market.
During the GFC QE period, the Fed purchased over $1.5 trillion of these assets over a few years (and then continued to increase them for several more years).
Fast forward to 2020, markets are reeling from the pandemic lockdowns, and the Fed has added a cash bazooka to its cannon. That means more than $5 trillion in just 2 years, look at the difference between 2009 and 2020.
But how did they do it?
As the central bank of the United States, the Federal Reserve has a unique ability to create money. When the Fed uses QE to buy securities such as Treasury bonds, it does so by creating bank reserves out of thin air, a digital process of money creation. Here’s how it works:
The Federal Reserve announces its intention to purchase securities and the amounts it will purchase.
Primary dealers (large intermediary banks) purchase these securities on the open market on behalf of the Federal Reserve.
Once the purchases are made, the Fed credits the newly created money to the reserve accounts of primary dealers and adds the Treasury securities to its own balance sheet.
This process increases the total reserves of these banks, injecting liquidity directly into the banking system.
Essentially, primary dealers act as brokers and settle trades, sending these newfound funds to sellers of Treasury bonds, and sending the Treasury bonds to the Fed, where more cash enters the system.
Imagine you are playing a game of Monopoly and all the money has been allocated and is already in the game, and then a new player shows up with Monopoly money from "his" house, and he just starts buying properties around. What has happened is that he has added new money to the game that wasn't there before, and he has expanded the money supply, so Park Place and Boardwalk have become more expensive. This is exactly how the Fed operates when it implements QE and buys bonds in the open market.
The Fed adds money to the market that wasn't there before, injecting liquidity into the market. Look at how the M2 money supply (blue line) rises as the Fed's balance sheet expands. This is a classic money printing press.
As for why we don't just skip the whole QE and Treasury lending system and just print money, if we did that we would completely turn into what is known as a "banana republic" where blatant and excessive money printing to finance government deficits would lead to hyperinflation. Imagine a world where the Treasury (actually Congress) spends whatever it wants and the Fed just prints as much money as it needs to spend.
Uncontrolled, increasing, and undisguised.
As the money supply expands dramatically, prices will rise exponentially (Park Place and Boardwalk will be sold for millions, billions, trillions), and people will lose confidence in the dollar as a store of value and at some point lose confidence in the dollar as a means of exchange. The streets will be filled with dollars because it will take a cartload of dollars to buy anything, and the prices change by the minute.
(If you think this is an exaggeration, go see what’s happening in Venezuela or Lebanon for yourself.)
This will lead to a loss of confidence, confusion and a rapid move toward hyperinflation, and the dollar will collapse. The Fed and the Treasury will do everything they can to confuse the issue and distract from the unlimited money printing press.
They will sell bonds.
Even if it’s selling to themselves.
If the country's chief economist is confused by the system, then everyone else must be confused too.
Well, the show will go on.
