The Nature of Money

Questions from a friend that are commonly asked:

As you know our economy has been...shall we say...not stellar in these past few years. Now here is my question for you...does/has the Federal Reserve been simply printing more and more money that is basically worthless in order to pay off our huge debt?  What is the debt now...$20 Trillion?  Is our money basically worthless?
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My Response:

The financial crisis and policy response since 2008 has created an incredibly uneven recovery.  As we all know since the latter part of the credit crisis centered on housing finance, household leverage/debt reached all-time highs. 

Household Debt/GDP

It is important to understand that our monetary system is a based on private credit creation where the majority of the money we use exist as bank deposits.  Bank deposits are created and move throughout the system as income after a loan is created.  For example, when a prospective home buyer acquires a home as an asset, they take on a mortgage liability.  A bank deposit used to purchase the home is created.  The buyer transfers the bank deposit to the seller which is designated as income.  From there the seller will transfer a portion of the bank deposit amount to any stakeholder involved.  

This immediate speaks to one misconception.  The Federal Reserve does not create this broader money supply (aka "print" money).  The private banking system, in conjunction with willing counterparties (a household for example), do.  The Fed supports this mechanism by clearing transactions between banks so that anyone who banks in the US monetary system can transfer their deposit from one bank to another without any disruption*.  Banks, unlike you and I, have reserve deposits held at the Fed.  Even here my wording does not quite capture what is happening, because these deposits bank's hold at the fed are electronic in nature.  In reality, all bank deposits are electronic bits of information that are legally regulated within the US monetary system by the Fed, Fed member banks, and the US treasury.  Your bank account gives you the legal right to use the payment system to acquire goods, services, or other financial securities.  Your bank deposits also allow you to pay taxes and all debts denominated in US$ units.   

*Imagine a scenario where the prospective home buyer acquires a deposit from Bank A where the seller has an account at Bank B. The Fed would help facilitate this transaction between Bank A and Bank B.  The electronic reserve balance of bank A is reduced while Bank B's is increased.  This all a matter of accounting and regulatory compliance.  Fed reserves are the payment mechanism between banks.  This is only a very narrow type of "money" which only exists to complete payments between banks.  They cannot be used for any other purpose.  These Fed reserves also can't "leave" the Fed since they exist on a spreadsheet.   

Now as far as "printing money" is concerned, another function of the Federal Reserve/Treasury is to accommodate the public's desire to convert already existing bank deposits into physical bills and coins.  This can only come after a deposit comes into existence.  So, the banking system and its costumers still need to work in tandem in order to create the predominantly electronic money supply by way of new borrowing/lending.  A personal "check" is another form of physical money-like financial instrument, that can be used to transact in the real economy.  Here, the check acts as instructions to the banks who will facilitate the transaction between buyer and seller.  The buyer's bank deposit balance will adjust down after a purchase, while the seller's account will adjust up.  Physical bills and coins are transferred similarly, but are a non-personal (standardized) "check" type financial instruments that can be passed from any buyer/seller to another with the legal guarantee that it can be deposited back into the banking system or used for subsequent transactions in a way a personal check can't (seeing as a personal check can only be used by that person).  I like to think about physical notes as standardized checks which are paper type money that are accepted universally.  Again, their existence comes after deposits are created.  When a person exchanges an electronic deposit balance for paper bills the money supply does not increase, it only changes in composition.    

As you can see from the chart, the downward trend in household liabilities which facilitate the creation of some of the new money in the banking system has shifted down since the financial crisis.  During and following the financial crisis, households began to "delever" which is the act of saving by reducing existing debts.  This has two first order effects.  First, since household credit creates new bank deposits which flow throughout the economy/monetary system, when this process slows or stops, the aggregate level of incomes and revenues begin to decline.  Second, as existing deposits/ income are used to paydown bubble era debts, this activity shrinks the supply of deposits.  Essentially, the deposits which are used to service debt cannot be used to spend in the real economy.  This results in below trend real economic activity relative to the pre-2007 trend.

As economic activity and trade (the accounting market value for all recognized goods and services produced within the country--better known as nominal GDP) decelerates or declines , there is less of an incentive to produce due to the fall in demand for output.  This makes certain employment redundant and lay-offs occur.  Businesses have little reason to invest and are instead incentivized to cut costs by lowering the interest rate they pay on financial liabilities as well as trim their workforce and wages.  Hopefully my writing is clear enough for you to start seeing the positive feedback loop that is occurring.  Declining wages, hours worked, and employment all make it more difficult to service bubble era debts.  Psychologically when a person takes on a liability that needs to be serviced into the future, I doubt they expect to lose their job or have their wages cut.  As a result, the household is apt to restrain spending and delever more quickly, which intensifies the decline in demand for goods and services.  So on and so fourth...

Now, part of the government's balance sheet reacts to what is happening in the private sector.  As you well know, the government accumulates bank deposits via taxation on nearly all economic activity.  It is as if government is a toll collector.  So, when economic activity declines, the taxes that the government collects declines.  Secondly, in the US we have a system of automatic stabilizers that go into effect to combat a decline in private sector incomes during a recession.  This comes in the form of social insurance programs such as unemployment insurance.  This by definition increases the government's spending.  As a result, during drops in economic activity, the government deficit will widen.  The opposite is true, during times of expansion.  The deficit will decline or turn into a budget surplus.  This is the cyclical portion of the government's budget.  Therefore main reason the deficit expanded a few years ago and is declining rapidly now is because of the rate of economic activity.   

The above describes automatic (pre-decided) fiscal policy.  When the private sector can no longer create bank deposits (money) to the same degree that they could before, the government deficit acts to do so to the degree in which it is allowed by pre-existing legislation.  The congress via the treasury instructs the banking system to credit private bank accounts.  They can do this by sending out unemployment checks for example.  The recipient of the unemployment check presents it to their bank who then clears the check and adjusts the depositor's account balance up.  To offset this transaction on the bank's balance sheet, the Fed increases the banks reserves (deposits) at the Fed.  At that point the bank's assets and liabilities match.  This is another matter of accounting.  

-At some point, the treasury issues treasury securities which are either acquired by the bank or by non-bank (household, pension fund, hedge fund etc) to offset deficit.  

-If a non-bank acquires the treasury security, they trade a bank deposit balance to do so.  Instead of having the bank create a deposit for the unemployed depositor, the bank will transfer the deposit from the buyer of the treasury to the unemployed depositor.  If this is the case, the Fed does not increase reserves in the banking system.

-If a bank acquires the treasury security, then dollar denominated reserves which the Fed created to settle the initial transaction will be replaced on the bank's balance sheet by the t-security.  Assets and liabilities change in composition, but not amount.  

The above describes how the US government, "goes into debt."  

The Federal Reserve conducts monetary policy by influencing the interest rate which banks pay and receive when transacting in the federal (reserve) funds market.  This rate is a cost for banks in need of reserves.  The Fed targets a lower interest rate in this interbank market so that banks are incentivized to reduce the interest rates that their customers, borrowers, pay on new and existing loans.  The goal is to ease the burden of debt on households, while pushing new borrowers to create new bank money by taking out new loans.  

The Federal Reserve targets a lower Federal Funds Rate, by acquiring treasury securities from banks and replacing them with reserves deposited at the Fed.  So when the Fed does this it leads people to believe that the Fed is "paying off" the US treasury debt, but this is a misconception as the Fed is part of the consolidated government.  In this light, the Fed is merely swapping one government security for another.  

The US government, consistent of the Fed, Treasury, Congress, controls the quasi privatized money supply by a system of laws and regulations they place on financial institutions.  The US nation is a sovereign currency zone which works under the $ fiat/electronic monetary standard.  The US government can never be forced into default.  Traders, foreign entities, investors, pension funds, banks, all transact in treasury securities under the assumption that these securities are credit risk free.  Treasury securities are the most secure security a non-bank financial entity can hold within the US monetary system.  During the financial crisis when all privately created securities, stocks, MBS, corporate bonds were falling in price, the treasury securities increased in value.  They serve as a key cog in the financial machine as they can withstand financial disruptions.  This makes them a very good hedge to manage portfolio risk during distressed times as well as great as collateral to facilitate new lending. 

Conceivably for treasury securities to stop trading, we as a society would probably have much bigger things to worry about.  That doesn't mean t-securities can't decline in price before they mature, that is part of risk.  However, as long as they are held to maturity, the US treasury can always convert the security into a more money-like instrument by using the banking system as described.     

In reality, words like US government default, US government debt (treasury securities), and deficit (the annual increase in treasury securities held by the private sector), have radically changed meaning since the gold standard era.  "Money" is not something physical.  Money is a qualitative property which financial securities, like a bank deposit/account, possess.  Money is exchange value, or the degree in which a financial security can be exchanged for a good or service.  Money is a quantitative property that is embodied in financial securities.  In this way "money" is a like energy where different physical things such as a gallon of gasoline, waves, a battery all embody energy, but specifically are not energy in themselves. 

Dollar which is symbolized by the $ is the quantitative unit we use to describe how much of one particular financial asset exists or we hold.  The symbol $ (unit of account) is a unit of measurement that is legally constructed by the US government.  

"I have $10 (in electronic deposits legally tied to a bank)."

"I have $10 (in physical bills)." 

"I have $10 (worth of nickles)."

"I have $10 (worth of company XYZ shares if I were to exchange them for deposits right now)."

"I owe $100,000 (worth in deposits to a bank to eliminate my mortgage liability)."

"I own a home worth $250,000 (if I were to sell the home right now and convert it into a bank deposit).  A home is a bit different considering it is a depreciating consumer good.  If anything the land is what is changing in real value.  Even here we "own" a home, but can also "owe" a mortgage against it (most of the time). 

When asked the question how much "money" do you have, usually a person doesn't hesitate to include all the above when answering.  In reality, we only hold money if we are in possession of bank deposits, physical notes, and coins.  Even here the answer should be net of all liabilities.  If someone has 1,000,000 dollars in deposits, but owes that much to a bank, they don't "have money" in the same way someone without liabilities does.  

Is our money basically worthless?

To answer your question, allow me to re-frame.  Is your personal bank deposit balance worthless?  If you convert that bank deposit balance into a physical bills or coins, are the bills or coins worthless?  If you really think so, I will take them off your hands free of charge.  It really is no trouble.  Please do not send me pennies though.  Joking aside, the $ denominated financial securities each serve a role.  As you know, $ bank deposits easily allow us to transact with one another.  Ultimately, we trade and transact with each other in this manner because it is efficient and robust.  The goal (I hope) is for these transactions to promote higher living standards for all of us.  

The money aka bank deposits have value also partially because they are used to pay off debts.  As loans create deposits, this process inherently creates a demand for the deposits as the debtor will need them to make loan payments.    

 As for the question of whether bank lending or the government budget deficit, is inflationary we can look to the equation MV = PQ.

 M = quantify of money/credit

V = velocity, or rate of turnover (someone spends which passes on the dollar deposit, which then that person spends.  The same dollar deposit balance can result in more spending across time given behavior).  

P= the price level, prices in aggregate

Q = quantity of goods/services produced.

If M is increased via bank lending or government transfers (government sends out checks to people, spending), it isn't necessarily true that the brunt of the adjustment will come from prices.  Quantity of goods produced might rise in order to meet the new demand.  Velocity might decline where that additional deposit balance will not be spent on goods and services, but maybe used to swap for other financial securities.  The additional dollar balance might just sit idle.  

Furthermore, low rates of inflation might not be an appropriate goal.  If inflation is low because corporations are keeping prices down by putting downward pressure on labor costs (which is inversely someone else's wage, salaries, benefits), the price level may be stable, but quantity produced might not be as high as otherwise would be given that those earning a wage will have had their potential purchasing power reduced.  This reduces demand for goods and services.  If the bulk of the adjustment comes in the form of Q, than price may not fall but quantity will.  Right now aggregate economic activity is trending below potential.  Corporations/businesses are not producing to their fully capacity.  Some refer to where we are today as the "age of oversupply."  Also keep in mind that the service sectors size of the economy has risen to roughly 80% of the economy.  On top of this the internet age and software developments has given people the ability to produce desired digital goods at near zero costs.  The sale of music is a great example of this.  It went from an industry of tangible goods to digital goods.  As you are aware this process of going from tangible to digital is changing the path of developed economies.  

Right now the economists at the Fed and economists more generally are more concerned with the threat of disinflation/deflation and the effects of falling prices on employment, finance/credit, and production.  Slowing or falling prices and/or low levels of economic activity (quantity produced) as the cause or effect of sustained high employment, falling real wages, and rising inequality is the main concern today.  Unfortunately, alarmist in past years have been overly concerned with rising inflation, currency collapse, government debt implosions that never happened.  It shouldn't be a surprise then that Congress and the President have been more concerned with cutting the budget deficit instead of focusing on instituting policy that directly deal with the high unemployment, falling real wages, the lack of economic opportunity, and rising inequality.  By focusing on inflation/ the Fed "printing too much money"/the government spending and "borrowing" too much, certain members of society are essentially placing more emphasis on problems we currently don't have but "might" have in the distant future instead of the real problems actually confronting us today.