U.S. Federal Reserve Conjures - and Redefines - Money

ATLANTA, Georgia - The private central bank of the United States, the Federal Reserve, has begun purchasing $600 billion of long-term U.S. Treasury Bonds, essentially subsidising the federal deficit for the year.

Many economists say the significance of this new role for the Federal Reserve cannot be overstated, especially because the agency is literally creating money at the stroke of a keyboard.

The practice is called Quantitative Easing 2 or QE2 - "quantitative" because the Federal Reserve is changing the quantity of money in the economy, and "easing" because it is easing the pressures of the market.

The vast majority of all money in the U.S. economy is created already, when private banks issue loans to individuals.

IPS has previously reported on how, through a little-known practice called fractional reserve lending, private banks create new money when they issue loans, although how much new money they are allowed to create is regulated.

This means, when private banks create money, it is not being taken from somewhere and then loaned to someone else; it is instead being conjured into existence.

This also means that private banks control how much money is in the total money supply of the U.S. economy at any given time.

Enter the Federal Reserve

It should not be terribly surprising the Federal Reserve is creating money; this power rests with the U.S. government, although the U.S. has not created money since President Abraham Lincoln printed all the money needed to win the U.S. Civil War against the South.

Economist Ellen Brown explained the mechanics of QE2 to IPS. The U.S. Treasury typically sells bonds, or interest-bearing promises to pay, at an auction, to primary dealers like Goldman Sachs. The dealers sell the bonds to others, including foreign governments like China, although China has recently stopped purchasing new U.S. bonds.

In QE2, the Federal Reserve is buying the bonds from Goldman Sachs with money it literally created. However, instead of profiting off of the interest from the bonds, the Federal Reserve refunds all of its proceeds into the U.S. Treasury. Therefore, the Federal Reserve is financing the U.S. deficit almost interest-free.

Brown argues this is a good thing and even suggests that over time the Federal Reserve could purchase all of the U.S. debt.

"What it [QE2] is doing, why we have to have it, is, we can't afford to pay any more interest on the federal debt. Half of our personal income taxes go to pay interest on the federal debt," Brown said.

"The government is perfectly capable of printing its own money. Ideally, the government itself would issue the money, but what we have is the central bank issuing money to the government interest-free," she said.

"What people don't realise is all money is borrowed into existence. The loans have collapsed. When the loans collapse the money isn't out there and that's why we have a Depression. The credit system has collapsed, the pitcher doesn't have anything in it," she said.

"People are complaining about inflation but what we have is deflation. When old loans get paid off and new loans aren't issued, money is destroyed. Fifteen trillion has disappeared from real wealth. So we need to fill that bucket back up before we can get to inflation," Brown said.

The first quantitative easing by the Federal Reserve, QE1, took place last year. The Federal Reserve bought 1.2 trillion dollars in toxic mortgage-backed securities from private banks.

"If QE1 had any positive impact, it allowed banks to unload some of their toxic waste... it strengthened their balance sheet a little bit, but to really help the banks you'd have to buy trillions in bad assets," said Randall Wray, a professor of economics at the University of Missouri-Kansas City.

Wray argues there is no need for the government to issue bonds, because the bonds are circuitous. In fact, Wray argues, when one understands how the government issues money, the whole idea of a deficit is a myth.

"The way the government spends is through keystrokes. It credits bank accounts," Wray said. "A sovereign government, the U.S., is the issuer of the currency. It's impossible for the U.S. to borrow dollars. You can't borrow IOU's from yourself."

"Really it is religion. Economists figured it out in the 1960s - the way the government spends is by crediting bank accounts. But if the public understood this, they would demand more services. We need the myth [of deficits and the need to balance budgets through borrowing]. They're just really scared to death people will find out," Wray said.

"There is no financial limit on the government. There's real limits, there's inflation limits, there should be budgets," Wray said.

Japan, over the last 20 years, had its own quantitative easing programme.

"In Japan they did a lot of this, over the last 20 years, they did monetise the debt," said Mark Weisbrot, co-director of the Center for Economic and Policy Research. "They didn't get any inflation out of that at all, five percent total inflation over 20 years. That indicates they could have done and should have done - monetised a lot more."

"We have two competing systems. The European Union is doing the austerity thing- they have a fixed amount of money and they're gonna make do. That system won't work- it won't work with Greece, Ireland, Spain, Portugal. They're gonna have to let more money into the system," Brown said.

"The Japanese have been doing QE for some time, they're still the third largest economy in the world. For a small island, they're not doing that bad. They have a big debt, but it doesn't hurt anything in terms of productivity. Half of that debt is owned by their central bank."