Why Debt and Money Created ‘Out of Thin Air’ Are Necessary, Not Evil

BY Paul Solman  October 25, 2013 at 4:37 PM EDT

By Paul Solman

Paul Solman sets the record straight on how he explains economics to himself and to his readers, tackling three different questions about the Federal Reserve, pictured above. Photo courtesy of Andrew Harrer/Bloomberg via Getty Images.

I am about to address three entirely reasonable questions concerning the Federal Reserve and its monetary policy. But first, let me make a general observation addressed to those of you who write in with genuine questions, like those below, and also to those of you who think you already know the answers and call people like me either “ill informed” or “part of a conspiracy” (see question three) when I try to explain that, for example, paper money is not the work of the devil, whose latest incarnation, many think, happens to be Ben Bernanke.

Look, I’ve been a journalist for 43 years. It was after the first six that I set out to do a story about municipal bonds. I was a pretty sophisticated guy, relatively speaking, and had even been on the board of directors of the weekly newspaper for which I served several years as editor-in-chief. But as I slogged my way through the bond story, I gradually realized how little I knew about the world of economics and its most basic workings.

I applied for a fellowship to go back to school (I couldn’t afford it on my own), lucked out with a year’s funding to attend business school, and underwent my professional conversion experience. As the year progressed, my suspicion was confirmed: there was a vast mechanism ticking away right in front of my eyes, chronicled regularly by the likes of The Wall St. Journal or Fortune or Business Week magazines, but except for the readers of those publications and perhaps a few others, few Americans really knew how it operated. “What an opportunity to be useful,” I thought. Or, as I later put it — using finance terminology — an intellectual arbitrage.

It was then (1977) that I turned myself into a business and economics reporter, learning the field as I worked it. I read the business and economics press, audited economics classes and interrogated those in the know, both on the right and the left. And that’s what I’ve done ever since. The journalist’s MO has been crucial — whenever I’ve encountered a strong opinion or pointed analysis I’ve asked, “What’s the best argument a skeptic would make as a counter?” Yes, that’s the sure road to ambiguity. But it’s also, I found, the key to understanding.

The point of this introduction is that when I began, I too was ignorant about money — about banking, bonds, the stock market, the Fed and hundreds of other key aspects of material life in the largest, most successful economy the world has ever seen. So I really appreciate people like Gary Barrett, Yan Doodan and Janice Bienn, whom I’m about to address, and the many others of you over the years, who know that they don’t know everything, and therefore send in questions of the very sort I’ve been asking for almost four decades now.

As for those who think they do know all the answers but haven’t spent years hearing the other side, beware. And with that, here’s this week’s q-and-a, with my answers put in the kind of simple, jargon-averse terms I try to use to explain things to myself.

Gary Barrett — Conifer, Colo.: Why does federal monetary policy target a 2 percent inflation rate? Why encourage inflation?

Paul Solman: Let me rephrase your question with a dose of skepticism, Gary. “Why encourage inflation of 2 percent a year when that means the U.S. dollar will lose half its value by 2050? How can inflation be a good thing?”

A simple answer lies in the nature of economic activity itself. What is an economy? People providing goods and services to others — period. The more goods and services, the bigger the economy. The faster the rate of providing more goods and services, the faster the economy grows.

If economic growth is what a society is after, then it wants to use the devices at its disposal to facilitate that growth. And one key way to get people to provide more goods and services is to make it easier for them to trade for something of value.

What’s a device to make trading a whole lot easier than it would otherwise be? Money. So when people in a society aren’t providing as much in the way of goods and services as they might be — if lots of them are sitting idle because they’re “unemployed,” say — then the creation of more money holds out the hope of goosing production.

Let’s say I’m unemployed. The government of my society creates some more money and gives it to me in return for providing a service like filling costly potholes, which are getting more costly to fix with every passing day. My fellow citizens get a service they can’t buy on their own, and I can now spend the money I get on their goods or services. That should, in turn, encourage them to provide more.

Where would the new money I get come from? The government would borrow it. How would it pay the money back? Ultimately, by collecting higher taxes in the future and/or borrowing even more. And who will it borrow from? Well, among other lenders, the Federal Reserve Bank, whose workings we’ll explain in the q-and-a that immediately follows this one. Suffice it to say, in this answer, that when the government (via the U.S. Treasury) borrows from the government (via the Federal Reserve), the Fed creates the money, aka “monetizing the debt.”

Of course, there’s many a slip ‘twixt cup and lip. In other words, there are lots of possible screw-ups in the process. The most obvious of which is that by creating so much new money, the money itself becomes worth less and less, thereby becomes less and less of an encouragement to trade.

But the general idea of pursuing a modest inflation rate like 2 percent is that people won’t much notice the diminution in value. And meanwhile, economic growth, with all its new and cheaper goods and services, will make everyone better off.

Yan Doodan — Fairfax, Va.: So, after the taper, what’s the Federal Reserve going to do with all those bonds? They should be worth four trillion dollars or so by then. If the Fed sold them, wouldn’t they be competing with the Treasury? Could they give them to the main part of the government? What would the bonds be if that happened? Mad money?

Paul Solman: If you’ve been reading from question one, here now we get to the agency of the government that actually creates our money, and thereby tries to control inflation: the Federal Reserve. It creates U.S. dollars not by printing them, but by generating them electronically as deposits in our banks, deposits known as “Federal reserves.”

The Fed doesn’t just give the reserves to the banks, however. It uses them to buy some of what the banks have in abundance: bonds.

And what are bonds? Legal debt contracts, as in “my word is my bond, but just in case you don’t take my word as Gospel, here’s a written promise that I’ll pay you back.”

Banks are in the business of taking money from depositors and lending it out. Often they lend to individuals and small businesses. Other times, they lend to large institutions or governments. Those loans are usually made in return for bonds — IOUs. So banks have lots of them.

The world’s biggest issuer of bonds is the U.S. government, which has run up a cumulative $16 trillion national debt. As a result, the U.S. has $16 trillion worth of bonds outstanding. U.S. banks hold a significant portion of them.

When the Fed wants to spur the economy, as I explained in my answer to the first question, above, it buys bonds from the Treasury, thus injecting its “Federal reserves” into the banking system, which can then lend out most of the new money as loans and spur economic activity. That’s what the Fed has been doing ever since the Crash of ’08.

Look at the Fed’s situation six years ago, in October of 2007. It held about $800 billion worth of U.S. Treasury IOUs, meaning it was financing less than a trillion dollars worth of U.S. debt. As of this week, that number had swelled to $2.2 trillion, with the Fed having bought another $1.5 trillion worth of mortgage-backed securities (housing loans) as well. So yes, Yan, the Fed is now the proud owner of nearly $4 trillion dollars worth of loans.

All told, the Fed has newly taken on about $3 trillion worth of loans since the Crash of ’08, which it paid for with newly created electronic “Federal reserves.” That’s the policy known as “quantitative easing,” so-called because the Fed increased the quantity of money in the banking system in order to ease ( as opposed to “tighten”) economic activity. And to be clear: this is what the Fed has always done when it tried to stimulate the economy. The Fed was blasted by conservative economists Milton Friedman and Anna Schwartz for not having done so in the early 1930s and thus having contributed mightily to the Great Depression by failing to ease.

The talk now is that the Fed will slow and eventually stop its bond buying and money creation — gradually. It will, in short, taper off its easing, as it typically has done in the past.

Yan asks a question beyond tapering, however: If the Fed were to start selling its bonds instead of continuing to buy them, wouldn’t that flood the bond market with U.S. Treasuries, making it more difficult for the Treasury to borrow money by selling new bonds of its own and indeed forcing the Treasury to offer a higher interest rate to get anyone to lend to it?

Well, yes, which is why the Fed will only start selling bonds when it wants to tighten the economy — should it show signs of overheating and bubble-like activity. Those signs would presumably show up first in lots of buying and price and wage rises and thus, a sudden spurt in the inflation rate. To “taper,” in short, does not mean “to suddenly reverse course.”

Yan also asks: “Could [the Fed] give [the Treasury bonds] to the main part of the government? What would the bonds be if that happened? Mad money?”

I’m no finance lawyer, but the answer is almost surely “no.” I can’t imagine that the Fed has authority to simply give away its assets. And why would the Treasury need the bonds? It has nothing to fear from the Fed. If the Fed holds Treasury bonds, it’s not likely to dump them, is it? Not unless the economy needs dramatic tightening, that is, in which case the Treasury should be happy to see the Fed start unloading.

But let me ask a question you didn’t pose, Yan: what happened to the nearly $3 trillion dollars the Fed has created between 2008 and today?

Well, look again at the Fed balance sheet. In the second section, entitled “1. Factors Affecting Reserve Balances of Depository Institutions (continued),” the seventh row is labeled “Reserve balances with Federal Reserve Banks.” Up until the Crash of ’08, that number was in the low billions. Today, as you can see if you look, it’s $2.3 trillion.

In other words, most of the money the Fed has created — “out of thin air,” as Fedophobes like to declaim — is right back at the Fed in the form of deposits by banks.

“But why would that be?” you might well ask.

And the answer is this: at the time of the Crash, the Fed instituted a policy of paying the banks to redeposit money at the Fed. That payment is known as “Interest on Excess Reserves” (IOER). It appears to have been a way of discouraging banks from making risky loans, a way of keeping the newly created Fed money from circulating throughout the economy and thus creating inflation. In fact, some observers would say its main purpose was simply to shore up the wobbly banking system with Fed money. I wouldn’t disagree.

Janice Bienn — Dallas, Texas: What are your thoughts on the video “Money as Debt” by Paul Grignon? I sent someone your article, and he fired back with this video, stating that you were either ill informed, or part of the “conspiracy.” I don’t believe either conclusion is true. But I would appreciate some clarification. Thanks in advance for your time.

Paul Solman: I don’t mean to sound defensive, Janice, but if even I am ill informed, after all these decades of time and effort, we might as well go fishing and leave the economy to — well, whom, exactly? Paul Grignon? His great insight, as near as I can tell, is that money is debt — true — and debt is bad. Really? Debt is bad? Money is bad?

Look, debt can be abused. Who would doubt it? The ability to create money can be abused. Again, who would argue otherwise? But for goodness sake, everything of value can be abused, from land to love to food to friendship!

The easiest form of communication, I discovered early in my career, is to denounce, to deride, to find flaws. That’s because pretty much nothing in this all-too-human world of ours works quite as intended.

People and larger groups of people (institutions) and even larger groups (governments) take on financial commitments they can’t meet. What else is new? This has been happening throughout the entire course of financial transactions. Here’s the translation of a message on a clay tablet, in cuneiform, from A. Leo Oppenheim’s book, “Letters from Mesopotamia”:

From Silla-Labbum and Elani

Tell Puzur-Assur, Amua, and Assur-samsi:

Thirty years ago you left the city of Assur [one of the capitals of ancient Assyria, 250 or so miles north of Baghdad]. You have never made a deposit since, and we have not recovered one shekel of silver from you, but we have never made you feel bad about this. Our tablets have been going to you with caravan after caravan, but no report from you has ever come here. We have addressed claims to your father but we have not been claiming one shekel of your private silver. Please, do come back right away; should you be too busy with your business, deposit the silver for us. (Remember) we have never made you feel bad about this matter but we are now forced to appear, in your eyes, acting as gentlemen should not. Please, do come back right away or deposit the silver for us.

If not, we will send you a notice from the local ruler and the police, and thus put you to shame in the assembly of the merchants. You will also cease to be one of us.

I suppose it’s possible to attribute the fall of Assyrian hegemony to widespread debt abuse. But personally, I’d be more inclined to believe that cross-desert commerce was good for the Mesopotamian economy — the world’s very first economy, some say — and that such commerce was facilitated by debt and money, as all commerce has been ever since. If that makes me part of a conspiracy, so be it.

This entry is cross-posted on the Rundown — NewsHour’s blog of news and insight.