Money From Thin Air

Economist John Kenneth Galbraith said: “The process by which money is created is so simple that the mind is repelled.”

If you ask most people where money comes from, they’ll say they get it from their employer. The employer, in turn, gets it from customers who get it from their employers who get it from their customers, and so on, ad infinitum. It’s an infinite regression with no clue where all that money comes from in the first place.

All money comes from an issuer. Users of that money need to get it from someone else, such as an employer, a bank (loans), taxes (local governments), etc. The issuer, though, does not need to get its own money because it issues it – that is, it creates it.

How does it do that? Prepare to have your mind repelled: Money is created from thin air using nothing more than computer keystrokes.

You probably don’t believe me, just as I didn’t believe it when I first heard it. Keep reading.

To understand how our monetary system works, let’s first talk about the board game “Monopoly.” Before the game can start, the currency issuer (Bank) must distribute $1,500 to each player. Without that, the game can not proceed because nobody would have any money with which to transact. That means that, right off the bat, the Bank is running a deficit of $1,500 per player. The Bank will remain in deficit to varying amounts throughout the game. If that deficit ever shrinks to 0, that would mean all the money is off the board, meaning all players have none.

Now, let’s look at one particular Monopoly rule: “The Bank never ‘goes broke.’ If the Bank runs out of money, the Banker may issue as much more as needed by writing on any ordinary paper.” Well, isn’t that nice! The preprinted paper currency that comes in the game box is just for convenience. The Bank can create as much money as it wants by writing arbitrary numbers on ordinary scraps of paper!

Even better, you really need only one sheet of paper. Instead of handing out bills to the players, just write their names across the top of the paper and 1,500 under each name. Then add and subtract numbers as the game progresses to keep a running tally of their respective wealth. And, if you can’t find a pencil, you could do exactly the same thing with a spreadsheet or accounting program, such as Quicken, on a computer.

So what does Monopoly teach us?

  • The currency issuer must always be in deficit or there is no money on the board.
  • The currency issuer can never go broke.
  • The currency issuer can create as much money as it wants by writing numbers on paper or typing numbers on a computer.

So that’s a game, but what does it teach us about our monetary system?

Let’s ask a couple people you might know.

Ben Bernanke was chairman of the Federal Reserve from 2006 to 2014. Here’s what he said on “60 Minutes” when asked about the money created by the Fed in response to the 2008 financial crisis. Click on the video to play it.

Ben Bernanke on “60 Minutes”

So there you have it, direct from the guy at the top: Money is created from thin air using nothing more than computer keystrokes.

You might not believe it can be that simple, but it is. (Feel free to replay the clip as many times as necessary.) Think about it. Is there anything magical about applying ink to paper to produce paper currency? Just as it is in the case of the Monopoly game, marking up numbers on a computer is much easier and much more efficient than running a printing press.

Your next question might be: Is there a limit to how much money the government can create that way?

Let’s ask another expert. Alan Greenspan was chairman of the Federal Reserve from 1987 to 2006. Here’s what he had to say when Congressman Paul Ryan tried to promote privatization of Social Security to make it more “secure”:

Alan Greenspan & Paul Ryan

So there you have Greenspan admitting that the currency issuer – the federal government – can create as much money as it wants. No mention of taxpayers, China, borrowing, etc. – just pure creation. (He goes on to say that the more important question is whether the real goods and services are available for that money to purchase. That should be the real concern. Creating money is easy, but you can’t eat it. We need food and other real things to live.)

Even though the government can create as much money as it wants, that doesn’t mean it should. Giving every citizen a million dollars would create a host of problems. Everyone would want to buy things but nobody would feel the need to work to produce them. The government – specifically, the Congress – should spend money on socially beneficial programs and ensure that the funds go to the right recipients to achieve the intended public purpose. (Congress has a spotty record in that regard. Sometimes it does well, other times not so much.) The point is that the government is not limited by the availability of its own currency but by the availability of the real resources – labor, raw materials, machinery, know-how, etc.

Here, then, in a nutshell, is how money is created. We’re discussing the U.S. dollar, but other nations’ currencies work in essentially the same way.

Let’s suppose Congress passes a law, signed by the President, to pay Joe $1400 for COVID relief. The appropriate government agency will direct the government’s bank, the Federal Reserve, to pay Joe that amount. The Fed identifies Joe’s bank – let’s say it’s Citibank – and adds $1400 to Citibank’s reserve account at the Fed by simply using a computer keyboard to change (mark up) that account’s balance. In turn, Citibank uses its own computer keyboard to mark up Joe’s account by $1400. Joe now has $1400 more than he did before. Where did it come from? From thin air, using keystrokes. (Paying Joe with a check would accomplish the same result but with more steps.)

Now consider what happens when Joe owes $1000 in income taxes the following year. The process works in reverse. We’ll assume he pays via electronic funds transfer. (A check accomplishes the same thing with more steps.) Citibank simply marks down his account by $1000 while the Fed marks down Citibank’s reserve account by the same amount. Where did the money go? Into thin air. That happens with all such payments to the federal government. Our federal tax dollars are simply destroyed because the government doesn’t need them; it will simply create new dollars when it spends.

Wait, what? Why does the federal government levy taxes? The answer: to create demand for the currency. If the government did not levy taxes, then there wouldn’t be any sellers of goods and services interested in that currency, and the government wouldn’t be able to provision itself by spending its currency. If the government tried to spend dollars without first imposing tax requirements, the dollars would be of no interest to anyone and therefore worthless. By threatening imprisonment for failure to pay taxes, the government can hire people and buy things it needs. Other purposes for federal taxes are to help regulate the economy and to encourage or discourage certain activities.

Article 1, Section 8 of the U.S. Constitution gives the federal government the sole legal authority to create the goverment’s currency, but the government can and does delegate that power, under certain conditions, to its agents, the banks. In fact, most of the money in circulation is created by banks, but their money creation process affects things differently from that of the government. Banks create credit by issuing loans. They do not lend out their reserves nor depositors’ funds. When a bank lends, it essentially buys a promissory note from the borrower by crediting the borrower’s account.

Suppose Alice borrows $1000 from Ally Bank. She signs a promissory note and gives it to the bank. The bank uses its keyboard to mark up her account by $1000 as payment for her note that the bank now owns. Where did that money come from? Thin air. Alice now has $1000 additional cash but also an outstanding debt of the same amount. The bank now holds a promissory note (asset) along with an additional $1000 liability (her account). Eventually, Alice pays off the loan and the bank destroys the promissory note. Where did that money go? Thin air. (Alice would need to get additional money from somewhere to pay the interest due.)

In our first example, Joe increased his net worth when he received $1400 from the government. In the second example, Alice’s net worth didn’t change from receiving the loan, but she had to find additional money to pay back the loan and the interest. Government-created money from government spending increases monetary wealth in the economy; bank money from bank loans does not, but the interest and fees transfer wealth from the borrowers to the banks. It should be no surprise that banks would prefer to restrict government spending so that more people need to borrow to live – unless, perhaps, the government spending is to bail out banks as happened after the 2008 crisis.

You might be wondering: If the government’s spending can create as much money as it wants, why does it borrow? Why is the national debt a (really big) thing?

To understand the national debt, we need to revisit the gold standard, which officially ended in 1971 but was effectively ended in this country nearly a century ago. Under the gold standard, the federal government promised to exchange (convert) gold for dollars at a set rate. The idea was to establish the value of the currency in terms of a stated quantity of gold. However, this meant that the government could never allow more money in circulation than there was gold to back it. If it needed to spend more than that, it would issues bonds in exchange for dollars. That removed the dollars from circulation, allowing the additional spending. Unfortunately, the scheme introduced several problems (which are beyond the scope of this article). For instance, governments on such fixed standards would typically suspend convertability during times of war so that they could spend whatever it took to fight the war.

With the end of the gold standard, there was no need to keep issuing bonds, but we still do and the bonds are used for a couple of nonessential reasons. First, the central bank (the Fed) uses bonds to establish a specific base interest rate as a means to regulate economic activity. (Whether that actually works as intended is debatable.) Second, some investors enjoy the stability and security of government bonds as part of their portfolios. In reality, the government could function perfectly fine without bonds, but they remain a thing.

But wait, you say! The government owes $30 trillion or something like that in the form of our national debt! What about that?

A currency issuer has no need to borrow its own currency. A dollar is nothing more than an IOU from the government. The government promises to cancel $1 worth of tax liability in exchange for the dollar. Suppose Joe wrote an IOU to Alice for $10. That IOU is worth money to Alice. Sometime in the future, she can present the IOU to Joe and get $10 in return. Can Joe write an IOU to himself? Sure, but what would be the point? As the IOU issuer, he would be borrowing from himself, which makes no sense. No matter how many IOUs he writes to himself, he wouldn’t be any richer.

What we call federal borrowing is nothing more than an exchange of one form of money for another. At the central bank, there are reserve accounts, similar to checking accounts at a regular bank, and securities accounts, similar to interest-bearing savings or CD accounts. To issue a bond, the Fed simply uses a computer keyboard to mark down the reserve account and to mark up the securities account by the same amount. To pay off that “debt”, it simply reverses the process, debiting the securities account and crediting the reserve account, and tacks on some interest, all done with keystrokes. This happens all day, every day.

Our national debt is the total of all those government securities, which represent the total dollars created by the government which have not yet been taxed out of existence. The nice thing is that you don’t need to worry about it. The government will not run out of keystrokes. If the keyboard breaks, they’ll get a different one. And keep in mind that some of that “debt” might be part of some of the mutual funds or other assets that you hope to pass on to your children and grandchildren. I really doubt they’ll view them as a burden!

Again, it is important to understand from all this that just because the government can create as much money as it wants doesn’t mean that it should do so without limit. There are many factors that must be considered in deciding how much and for what purposes money is spent. In broad terms, government spending should be used to ensure that aggregate demand meets but does not exceed what’s offered for sale, which in turn is limited by the productive capacity of the economy. This is most important with regard to establishing and maintaining full employment of people (human capital). If spending pushes demand above that capacity, then higher prices will likely result.

By now, I hope you understand that money creation is incredibly easy. “Finding the money” to do useful things is not the hard part. The hard parts are (a) achieving political agreement on what things should be done and (b) securing the resources – labor, raw materials, machinery, etc. – required to do them. For too long, our nation (and others) have been hung up on how to pay for things when, in fact, we’ve had the means to do that all along. We’ve been stuck on the wrong question! Imagine if we used the power of thin air to put all unemployed people to work fixing our infrastructure, combatting climate change, improving education, healthcare and eldercare, or addressing any number of other vital needs! We could have the kind of society that would benefit everyone!

So what have we learned?

  • Money creation is easy.
  • Your federal taxes don’t pay for anything. But you really should pay them anyway if you want to avoid jail.
  • Federal government spending is limited not by the availability of money but by the availability of real resources offered for sale. (State and local governments are not issuers; they follow the same rules as you and me.)
  • Government money is better than bank money unless you own a bank.

Here is a quote often attributed, perhaps erroneously, to Henry Ford, Sr.: “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” Perhaps he meant that people would be justifiably outraged that their own government had unnecessarily imposed austerity when we actually had the capacity to create a more robust and more equitable society.

I believe that if people understand how money is actually created, they will view the world and its possibilities much differently than they currently do. (Feel free to add your thoughts in the comments below.)

The next time someone mentions our deteriorating infrastructure, our lack of universal healthcare, our lack of climate action or any number of other vital things that aren’t being done, and someone else asks, “How will we pay for it?”, you’ll have an answer: Thin air.

And then you can ask the question that matters: “How will we resource it?”

(Thanks to J. and W. for their feedback and suggestions on this article.)

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