How the Fed Creates Money Out of Thin Air

The Federal Reserve has a monopoly on the money supply in the United States.  No individual or business can legally do what the Fed does.  Although the Fed supposedly has a dual mandate of keeping stable prices and maintaining low unemployment, it does neither.  In fact, the Fed causes higher unemployment and less stable prices.  The real purpose of the Fed is to protect the big banks and allow Congress to deficit-spend.

Although more Americans are understanding that the Fed creates money out of thin air, most do not understand how it is done.  Basically, the Fed buys assets and it does so by creating digits.  These new digits represent money.  So when the Fed buys assets, it is creating money out of thin air, essentially with an accounting entry on the computer.

Now, many of us like to say that the Fed prints money.  This is technically not correct, but it does get to the point.  The Fed creates digits.  If more people try to redeem these digits from the banks, then actual money will be printed.

Before 2008, the Fed only bought U.S. government treasuries/ bonds.  In late 2008 and early 2009, the Fed bought huge amounts of so-called toxic assets.  These were mortgage-backed securities that were owned by the big banks.  These mortgages (pooled together) were in trouble because of the crash in the housing market and the recession.  More and more people were defaulting on their mortgages and these assets were declining in value.  The Fed bought many of them from the failing banks in order to save the banks.  The Fed bought them at their original value, instead of their lower market value.

Usually, if the Fed wants to lower its balance sheet (take money out of the system), it can simply sell some of its assets.  These assets are typically U.S. treasuries.  But in the case of these mortgage-backed securities, they may only sell on the open market for half of what the Fed paid for them.  Therefore, the Fed will have trouble pulling back the money supply with these.  And the Fed will not dare sell them back to the banks at the original values or else it would sink the big banks.

The Fed can create money out of thin air by buying anything.  The Fed could start buying cars and televisions.  But since the Fed typically buys government debt, it allows the federal government to run up its debt to very high levels as we currently see.  This has an effect on interest rates because of what the Fed is buying.  If the Fed bought cars and televisions, it would distort those markets, but it would not impact interest rates anything like buying government debt does.

With QE2 in full force, the Fed continues to create new money at a staggering pace.  Usually this new money would be lent out by the banks and the fractional reserve banking process would take over.  But this new money has gone into excess reserves, which has kept price inflation in check (for now).

It will just be a matter of time before the Fed has to make a major decision.  It will either have to continue to create new money and fund the Congress or it will have to stop and maybe even reverse.  If the Fed continues, it will eventually risk hyperinflation and a complete destruction of the currency.  If the Fed stops (which I think it ultimately will once we have high price inflation), then we will experience a major depression and the federal government will be forced to cut spending dramatically.

We have many reasons to be optimistic in the long-term.  We also have many reasons to be pessimistic in the short-term.  Hold onto your hat for a wild ride ahead.