Morphemics

Okay, you've got a problem here: the government does not "create" extra "credits" and "store them" outside the economy. The government is actually an integral part of the economy. The equation for GDP, the ultimate measure of economic productivity, as it measures the value of all goods and services sold during a given year, is formulated thus, in descending order of magnitude: consumer spending, plus corporate spending, plus government spending. The consumer sector is about ten times as large as the corporate sector, which is itself several times larger than the government sector.

But here's the thing: the government is an employer. Government employees pay taxes too. Not only that, but the government buys and sells stuff. Tanks, planes, roads, snowplows, lawnmowers, buildings, all of these are purchased by the government from the private sector. The government directly sells things like licenses, contracts, and other semi-tangibles, and one could say that things like court fees and school taxes are the "sale" of things like justice and education. The government is no different from any other economic actor except where its own tax structure and bureaucracy create red tape and irregularities.

Your question can be answered "No" for reasons similar to those that make the following sensible:
Q: What's the difference between a Federal judge and you and me?
A: A Federal judge can say "It is so ordered" and have it be so ordered, and you and I can't.
Don't think of the government as some extra-economic entity with its own netherspace rules, because it doesn't work that way. It's an economic entitity, just like you, me, or any corporation, with one difference: it can kick your ass if it decides it wants to. That's it.

The government needs a tangible source of income. There have been isolated cases where this did not have to be individual taxes (for a few decades the government of Hong Kong made its money off horse racing...), but it can't just declare that it's spending x amount of dollars unless x amount of dollars somehow make their way into its coffers. Similarly, you can't for very long charge interest in fictional money. It works for a while, but eventually people start calling in their debts. And then bad things happen. Because you can declare that a certain bit of paper is worth something, but all the government backing in the world won't turn it into bread unless there's bread to be had.

The situation you suggest is one similar to the one that occurred in 18th century France. The crown was spending money far beyond its tax revenue, and was essentially borrowing two years in advance. Eventually, all the liquid capital in the country was tied up in worthless government bonds, and there were bread riots and other nastinesses in Paris. Good King Louis lost his head over the issue.

No, Kevin, taxes are required for governments to operate. Now, it's entirely possible for a government to exist without things like income tax, but that's a different discussion altogether...

Additionally, you forgot a significant raw material: labor. Agriculture, mining, and labor are the backbone of any economy, not just the first two. Production and sale of physical commodities is a fast-decreasing sector of the economy. Service is huge.

Ryan- Thanks for the response. The thing is, though, nothing you have stated convinces me that what I have suggested must be wrong (I can't say that it's right, but that's a different matter). Before that, however, I didn't forget labor. I just assumed that it was a part of the equation across the board. Labor will get you no where without any raw materials. If the farmers decided to spend all of their time in the fields doing calisthenics, the economy would crash while people in the higher economic layers searched for new ways to get some food. The reason that "production and sale of physical commodities is a fast-decreasing sector of the economy" is not that we suddenly require less stuff, but that a decreasing sector of the economy is required to meet the demand. The increased efficiency of this layer of the economy makes the service industry possible. The service industry, in turn, further unlocks the value inherent in the economy.

First, you have this whole section on the government being a significant economic participant. I agree; in fact, my thesis would not work unless this were the case. As to storing credits outside of the economy, I never meant to imply that the government is an extra- economic entity. It was just a manner of speech to try to explain something in the simplest terms possible. On a smaller scale, it's similar to what I'm doing right now by not spending the $16 in my right pocket. The money is, for all practical purposes, being stored outside of the economy. It will be a different matter when the government or I decide to spend our respective riches. About government employess paying taxes, this begs the question. If the government pays an employee x amount of dollars and then takes away y amount, why couldn't it have just paid the employee x-y amount of dollars in the first place?

I don't deny that the government needs a tangible source of income. Similarly, I am not implying in the suggestion that government legislate its budget into existence that it create fictional money. I can see how this could be the case. In barter or coin-based economies, the money doesn't exist unless you're actually holding it. Government declarations aren't going to change a thing. If the government wants to increase the money supply, it's going to have to find some real gold or silver to mint. Another example would be when a government over whatever kind of economic system does not have the power to control the money supply. Take state and local government. Both of these need real revenue to operate. There are only two ways to get this: 1)Federal grants or loans and 2)Taxes. But the Federal government is not the same. It does have control of the money supply and this makes all the difference. The point I am making is not that the Federal government should be able to operate without revenue. I'm just suggesting that it's possible to obtain this revenue through the simple medium of adjusting the interest rate. In controlling the money supply, the goverment is not creating the value of the economy. It can't increase or decrease the supply too far out of proportion with the actual value of things and escape serious consequences. It looks like this is what happened in France. Tax revenue is only as valid as the economy on which it is based. The crown, through its irresponsible spending, increased the money supply beyond the breaking point of the French economy. I'm not suggesting that the Federal government do that.

Government is, as you point out, an integral part of the economy. It performs services that increase the value of the economy. In order to do this, though, it needs a legitimate way to insinuate itself into the economy. Taxes will do this. In one sense, the activities of the government are not unlike those of any other economic layer. They take something of value (the farmer's food and wood), apply labor to increase the value (make a plow out of the wood while using energy from the food), and reintroduce the good or service back into the economy, thereby increasing the economy's overall value (the farmer get's a plow and increases the productivity of food and trees). But it seems to me, since the government already has the power to control the money supply, that it has another means of entering the economy. First, increase the money supply beyond what it would be if only consumer and corporate spending were taken into account. Second, do something worthwhile to make the value of the economy increase in proportion to the money supply. Third (if necessary), adjust interest rates to account for any real differences in economic value. As to your statement about charging interest in fictional money, it does not address my point. The interest is designed to eliminate any fictional money. Think of it like this: government spending minus value added to the economy equals fictional money. Seen from another perspective, I'm not saying that government can eliminate revenue and spend what it does not have. Rather, I'm recognizing the essential nature of interest rates as a form of taxation.

I'm really not sure why you think raising interest rates will create revenue for the government. They aren't an essential form of taxation at all. I'm assumming what you're talking about here is the Federal Reserve prime rate. The Federal Reserve is the bankers' bank, from which major financial institutions can borrow on a short-term basis at the best rates possible. This Reserve was not designed and has never been conceived as a way for the government to make money. Even at the staggeringly high interest rates of the 1970s the government wasn't making much money off interest.

First of all, your idea is simply practically impossible. The Federal government spends about two trillion dollars every year. Do you have any idea the liquid capital it would have to control to generate that much revenue on an annual basis? In excess of twenty trillion dollars, and probably more like forty. That is several times larger than the entire economy itself. There is no way for that much liquid capital to be needed with an economy of our size. And an economy big enough to use forty trillion dollars of capital would probably require a government proportionally larger than ours, so there's no odds in that.

Not only is your theory completely implausible on that front, but it would require interest rates in excess of 10%. This would entirely crush our economy due to two immediate problems: 1) preventing all but the richest entities from borrowing; 2) crowding out.

See, banks base their lending rate on the Federal Reserve rate. The theory is that they're looking for the best combination of risk and reward. The government is viewed as having zero risk, since in over 200 years they've never missed a payment. Not bad. So in order for banks to be interested in lending to the private sector, they tack on a premium, which increases as your credit rating decreases. So if the Federal Reserve rate is 10%, the private sector would probably have to pay 13-14% in order for banks to be interested. Can you imagine paying that much on a home loan? Can you imagine a corporation taking out a few million dollars to build a new factory? Absolutely not. Even a simple auto loan would wind up costing you thousands and thousands in interest. Our current economic system depends on the ability for both individuals and corporations to finance their capital endeavors. The massively high interest rates you're talking about would prevent that.

Second, there is a real economic factor known as "crowding out". This happens when the government is borrowing money at so favorable rates that all available capital starts winding up in Federal bonds, leaving no liquidity for other things. When the Federal Reserve raises interest rates, the Treasury Department has to raise the T-bill rate to stay competative, otherwise people will not buy government bonds. And the government always needs bonds. Bonds are supposed to be for the government what credit cards are for us: a relatively inexpensive way of stabilizing cash flow. But if the government is selling bonds at 11%, that's a damned good rate of return. Why should I buy stock, and risk losing my shirt, when I can buy bonds, make a killing, and face little to no risk? In this case, you might get turned down for your mortgage, not because you aren't a good risk, but because the bank doesn't have enough liquid capital to finance your home. A more likely situation would be corporations not being able to build new factories, but the idea is the same. When interest rates go way up, capital flows into the government, cramping the ability of the private sector to operate.

Low interest rates (1-6%) are vital to the operation of a free-market, minimially regulated economy such as ours. Interest rates are not designed to be and do not function as a form of taxation. If the government tried to generate its revenue on that basis, economic activity would grind to a screeching halt.

You make a good argument against raising interest rates and using the interest itself as a form of revenue, but I was saying something of the opposite. I'm sorry if I wasn't clear. The revenue would be tied to an increased money supply. At any given time, the economy has a particular value. The money supply represents this value. This supply needs to be as flexible as the actual value of the economy. If it weren't, then the supply would arrest the growth of the economy, or the growth would result in deflation. Negative growth would result in inflation. Fortunately, our money supply is not fixed. It can be manipulated by means of the prime rate. Lower rates increase it; higher rates decrease it. When the rate was increased the last time, the trick was to increase it enough to curb inflation, but not enough to kill economic growth. Say that the money supply equals the value of the economy. If it were to stay this way, the economy would stagnate. Consequently, the supply is increased. There are two possible results: 1) the value of the economy increases to match the greater supply of money, or 2) the extra money devalues all of the money and results in inflation.

When this extra money first enters the economy, it has no real value. It achieves this value when the economy grows into it. If not, it distributes its lack of value throughout the rest of the currency. Usually, there will be a combination of these results, not just a stark either/or. The amount of extra money needed is overestimated. It allows for growth, but the rest goes towards inflation. The inflation is curbed by decreasing the money supply through an increase in the prime rate. Decreased interest rates are not the only way to increase the supply of money. This can also be done by lowering taxes. Lower taxes, more available money, room for economic growth, larger tax base. I'm sure you're familiar with the theory. If the government needs x amount of dollars, it can either tax a greater percetage on a smaller economy, or a lesser percetage on a larger economy. The point here is that the infusion into an economy of money that lacks real value, whether by lowering the prime rate so that the banks are encouraged to borrow or by lowering taxes, does not necessarily hurt that economy. It is, in fact, necessary to economic growth. The money obtains its value only after it is a part of the economy. As paradoxical as it may sound, worthless money is essential to economic growth. My question is this- what difference does it make to the economy if the government introduces this money by means of the Federal Reserve or just by buying something? Either way, the government is creating money by fiat. Either it declares the money into existence, distributes it through the Federal Reserve, and then gets back what it needs to spend by means of taxes. Or, it creates the money, distributes most of it through the Federal Reserve, and just keeps what it needs to spend. Think of it as withholding on a grand scale.

I'm not suggesting unlimited or irresponsible government spending. No matter how it makes its way into the economy, the government is well advised to create no more money than can be absorbed by the short term potential value of the economy. If the government were to simply legislate its budget into existence, this wouldn't necessarily be fictional money bound to destroy the economy. Pretend that the government is capable of frugal spending (this may well be the point that destroys my theory). Unlike my spending, which merely redistributes the money supply, government spending would increase it. The economy does not care how this increase comes about. It will react by growing into the new money supply and, thereby, making the extra money valuable. If the government were to spend too much, the result would be just the same as any other overincrease in the money supply. The response would be two-fold: 1) Cut spending, and 2) raise the prime rate. But if the government is not spending beyond its actual value to the economy, I don't see why interest rates would have to be that high.

Incidentally, I don't know about you, but I'm enjoying this, so thanks for the input. My reason for posting in the first place was not so much to advocate tax reform, but to provide a means whereby I could think through and better understand the economy (I like to know why something is the case, not merely that it is). It's quite possible that what I suggest can be shot down in the details. However, I'm more interested in whether or not the overall principle is sound. So far, I can't think of anything to prove that it isn't.

Yeah, this is fun.

Here's the thing though: what you are suggesting has been attempted before, but you're missing something. Interest rates are not the only way, nor are they the easiest way for the government to create money. The easiest, most common, and frequently most disasterous way of creating money is for the Federal Reserve to buy Treasury bonds. Money created ex nihilo is lent to the government. This means that the government is borrowing from itself. If this sounds like a bad idea it's because it is.

The Indonesian economy completely imploded for precisely this reason in the 1990s. What happened was the Indonesian treasury decided it needed money. And hey, what do you know, the Chairman of their central bank said, sure, we'll buy bonds from you, how much cash do you need? So the government borrowed from itself, and inflation promptly assumed a position somewhere outside high orbit.

The Federal Reserve can influence the money supply by fiddling with interest rates, it is true. But the reason that the Fed is so careful when it does this is that they are not dictating value. The market dictates value. They're trying to apply just enough pressure to maintain favorable economic conditions without going all Indonesian and shit. The government does indeed produce money out of thin air. It also makes money disappear when it needs to. But it does so in tightly controlled amounts, because to do otherwise has always, *always*, proven disasterous.

Everyone who has tried to dictate value to the economy has wound up collapsing central banks as soon as some dictator's nephew looses control of his monetary sphincter and hey, what do you know, people in Brazil are using a barter system again because their currency is so worthless. Economies are remarkably delicate things. All the Fed can do is provide a tiny bit of lubrication to the squeaky wheel that is the national economy. Think of it as an engine running at 6000 RPM. You can't make very large adjustments to such a beast while it's running, and the economy never stops running. At best, you can lube it a bit and hope to all that's holy that you don't screw something up beyond your ability to unscrew it.

Interesting, I didn't know about Indonesia. I think, though, that there are some differences that make it not quite relevant. The orbital inflation rate suggests that they created far more currency than the Indonesian economy could handle. I also suspect that their economy was not that robust in the first place (I'm confident that it wasn't anywhere close to ours). I have qualified my suggestion throughout with a strong economy and fiscal responsibility. There is another difference that relates to the Fed buying Treasury bonds. I'm assuming that in both this case and that in Indonesia the government owes interest on the money it lent itself. This could turn into a pretty nasty little spiral. The whole process looks schizophrenic to me. The government calls part of itself a bank and then decides to become indebted to itself. It's as though this were an elaborate process to convince everyone that it hadn't actually created the money. Why not be bolder about the whole process? Create the money, spend the money, and owe no one. When the money supply is increased through Treasury bonds, there can be economic growth. That is, until the bonds become due. But why should the government feel any obligation to pay itself back? I'm kind of curious as to whether or not this reluctance to admit that money is being created is a holdover from gold standard economies.

You mentioned other ways to increase the money supply; are there ways to decrease it other than raising interest rates? Is there a direct link between tangible currency and electronic currency? There is one method, but it only applies to virtually worthless currency. When I lived in Brazil, the standard currency was the cruzeiro. It was the rei before that. When we arrived there, the exchange rate was 8 cruzieros to the dollar. It stayed at 10 for a long a time. By the time we left it was up to 35. This may look bad, but, for Brazil, it wasn't. At the time the country was under military rule. They kept a fairly tight control on things economic. [I remember Brazilian bank lobbies. There was was a round bulletproof booth, with darkened glass, containing a soldier. Protuding from a slit in the booth was a machine gun pointed directly at us. Robberies were unheard of.] Well, Brazil goes through this cycle. Once the military gets the government running as smoothly as possible for a third-world nation, it turns it over to the civilians. A civilian government has yet to be able to handle the Brazilian economy. I kept up with the exchange rate and it wasn't long at all before 35 turned into 8000. I saw it get up to 35,000 before it suddenly dropped to 35 again. But now, their currency was called the cruzado. They simply print new money and lop off three zeros. Since then, the cruzado has gotten out of control and they're back to the rei. If Brazil doesn't get its economic act together, the military will probably step in again.

So far, what I suggest still looks sound in theory. Like I said, this is what I'm really after as a means of understanding the economy. I take your point on the delicacy of the economy. My idea might fail, then, for practical reasons. I've been assuming that the amount of money introduced into the economy by means of a small government spending in a fiscally responsibile manner would only be a percentage of what is currently introduced by other means. Perhaps, but it may not matter. If I understand the Federal Reserve correctly, the money does not enter the economy as a lump sum, but is introduced gradually as it makes its way through various layers of lending institutions. In this case, even if government spending were kept to the smallest necessary amount, money introduced into the economy by this means would cause too great a shock. I don't know. To extend your engine analogy, maybe the Federal Reserve is like an economic carburetor.

There are ways of decreasing the money supply, something which Brazil, in your example, did not do. Brazil revalued its *currency*, but did not affect its *money supply*. Counter-intuitive as that may seem, the two are only loosely related. All they really did was akin to a stock split: there's still just as much stuff as there was before, only it's in smaller/larger bits, as the case may be. The Fed can decrease the money just as easily as they can increase it by messing with interest rates.

Okay, let me explain how the Federal Reserve adjusting interest rates affects the money supply. See, the Federal Reserve is actually a bank. It's the bankers' bank. When a large financial institution needs a short-term loan, it applies to the Federal Reserve, which lends them, and I cannot emphasize this strongly enough, *previously non-existant money*. Now, the bank is constantly in the process of lending this money to other institutions who spend it with others... and so on. So if the Fed lends $1000 to a bank, that bank will lend about $800 of that to other people, keeping the remaining $200 in reserve to maintain liquidity (reserve amounts are rigidly regulated by the Fed, and are another way of influencing the money supply, albiet a fantastically dangerous one: no one, and I mean *no one* sees this as a viable way of regulating the money supply). So the $800 is lent to someone else, who spends it.

Let me explain in more detail. The bank has borrowed $1000 from the Fed, so it has an asset worth $1000. It also has a liability worth slightly more than that, because it owes the Fed $1000 plus interest, though not much, as these loans are very short-term, generally no longer than days. The bank then keeps $200 in reserve, and lends out another $800. So the bank's ledger book shows a liability of $1000+interest, $200 in reserve, and a loan for $800+interest. Yet they are charging more interest on the $800 than they are paying to the government, so by borrowing $1000 even, they generate an asset worth more than that, even allowing for the interest on the initial loan.

Let's look at the situation after everything is paid off: both the Fed for its $1000 and the bank for its $800. The bank is all of a sudden sitting on money, the interest/profit on the $800 loan, that it did not previously have. There is more money than their used to be. In short, we've just pulled money entirely out of our asses. The amount of money depends on two things: current interest rates, and current reserve requirements. The lower the reserve requirements, the more the bank can lend. The lower the interest rate, the more money is created, as borrowing is easier and happens on a larger scale.

That's only the first step. From there, the person who borrowed the $800 spends it, and that money winds up back in a bank somewhere, where the bank lends *that* out, again generating money seemingly out of nothing. Then, the person who borrowed the $800 spends that money on something.

But the thing is that none of this money makes its way into government coffers without taxes. That's the part of your deal I just can't understand. Yes, the Fed can and does affect the money supply. But simply creating more money does not actually give the government anything to spend. The easiest way of doing this is, as you said, schizophrenic, for it involves buying government bonds with previously non-existent money, the government borrowing from itself. Say the Fed does decide to increase the money supply tomorrow. So what? The government still doesn't have any of this new money unless you erase the barriers between the Federal Reserve and the US Treasury, which is, as I said, exactly what causes meltdowns like Indonesia. The government cannot simply spend money it has printed. That's currency, but not money. It has to enter the money supply somehow, either through adjusting interest rates or open market transactions (like the Fed buying T-Bills).

I commend several Wikipedia articles (money, money-supply, inflation, and monetary policy) for your perusal. They're not particularly detailed, but it's a place to start.

This is helpful. I don't get the distinction you're making between currency and money. How is currency not money? I can see how money is not always currency, but reversing this is like saying that vipers are not snakes (evidently, currency is not money when it really only represents money, such as in a gold standard, but this seems to be a disitinction without a real difference). While it is the case that the government doesn't print money and then spend it, it does not follow that it cannot. Yes, the currency does have to enter the money supply; however, this would have been accomplished in the initial act of spending. I have not suggested that simply creating more money will give the government more money to spend. It does appear that the money supply is kept sufficiently inflated so as to allow for taxes without removing any money necessary for trade. Still, money introduced through the Fed has to make its away through the economy and into taxes before the government can have it. I've been saying that spending money created ex nihilo will simply increase the money supply. And if this is all that happens, why not just deal with the increased supply the same way you would on the other side of the economy? I think I see what I missed.

My basic contention has been that the government can spend created money without consequence if the increased money supply can be dealt with through absorbtion into a strong economy and an efficient means of removal. The argument is valid. The conditions are unlikely. There's a part of the equation that I've known all along but just haven't factored in: when the Fed creates money and lends it out, the banks have to give it back. Consequently, the increase in the money supply cannot be made of this created money. It is, rather, comprised of the interest left over after this money has been put to work. Your account of this money generated from interest gives the impression that it, too, comes out of nowhere. I disagree. This is not so much the creation of money as it is the extraction of money. If a bank ends up loaning its money to me, the interest it makes comes as a direct result of my labor. The increase in the money supply is already tied to the value of the economy. It is, therefore, not the same thing as creating money at the point of government spending. This kind of money, in the quantities required for the government to function, would constitute too great a shock to the economy. Also, manipulating the prime rate would be insufficient to eliminate the extra money. This does not actually decrease the money supply; it only slows the rate of increase. There would have to be some means, similar to the Fed calling its loans due, of getting the excess money out of the economy. But, for all practical purposes, this would waddle and quack like a tax.

The distinction I'm aiming for here is very counter-intuitive, but it is absolutely foundational to macroeconomcs: currency is not logically identical to money. The two have very different definitions, and the two do not entirely overlap. Currency is a legal tender bit of stuff that represents money. Money is an abstracted medium of exchange. Work with me here, because this difference is essential.

The money supply is defined as being made up of several componants, labeled M0-M3, see here. The kicker is this: currency that has been printed by the Fed but not entered into circulation is *not*, I repeat *NOT* money. It may be one day, but it does not count as money.

Furthermore, the current money supply in its broadest definition (M3) is about $9 trillion. The Federal budget is $2 trillion. We would have to increase the money supply by about 25% every year for your suggestion to work, and that's some damnably high inflation if you ask me. And you can't adjust for that amount of new money every year. The current GDP and M3 includes government assets and expenditures, it doesn't need them to be tacked on afterwards.

Second, you seem to not have understood about how money is created by the Fed lending to other people. It is also exceptionally counter-intuitive, but what sounds like simple transfer of funds through profitable exchange is really the creation of money ex-nihilo. The fundamental fact is this: $1000 in initial assets created by the Fed loaning money to a bank can be loaned again and again without an actual increase in assets. Step 1: Fed loans to bank. Total assets: $1000. Step 2: Bank loans to other bank. Total assets: $1000 plus whatever portion was lent. Step 3: Second bank loans to consumer. Total assets: $1000 plus step 2 plus whatever was loaned to consumer. All of this with only $1000 in backing collateral. In just those three steps we could have $2300 in assets running around with only $1000 initial assets.

Read this, and be sure to read the whole thing, because the concept is very subtle and quite easy to miss. If you can't be bothered, you'll have to take it on faith that interest-bearing assets do not merely generate profit, they actually increase the amount of money in circulation. Or, if you don't want to take my word for it, read the article I linked to. It's all there.

On the issue of the creation of money and how that works, it's not just me you're disagreeing with, though I may not be explaining it as best as it can be done. Every macroeconomics professor everywhere will tell you exactly what I've told you. Kevin: you're just wrong. This isn't something for which there's room for negotiation. The problem here isn't that the principles of macroeconomics make sense, it's that I've failed to present them in a way which you understand. Which doesn't say much about either of us, because men who are much better economists and teachers than you or I will ever be consider the concept of money to be a maddeningly complex thought.

At this point you just need to sit down with a few macroecon texts and learn about money. Once you do, you should see why what you are suggesting is completely and entirely unworkable. It is technically possible for the Fed to spend newly printed money without introducing it to the money supply through normal means, but it always spells immediate disaster. If you don't understand this by now, you'll need to get a textbook or something to fix that, because I'm running out of ways of talking about this. You just don't get it, and the fact that I can't explain to you how in a way that you'll accept doesn't change that fact.

Thank you, Ryan. I conceded in my last response that simply spending newly printed money would not work, so I'm not sure how I just don't get it. I think you've done a good job of explaining things. Your latest response clarifies things even further. I did say that my argument was valid and I still maintain this, even though it could never work in the real world. In my defense, consider this quote: If the only money in the economy were government-issued paper, money creation would be easy to understand. Money would be created when the government printed more to pay its bills. If money did not need to be redeemable in terms of precious metal, there would be no limits to the amount of money that the government could print. Alternatively, the government could destroy money by collecting it through taxes and burning it. This is a question of the way in which the monetary system actually did develop, not of the way it particularly needed to develop.

I've read the article you linked to (the whole thing) a few times. Most of it made sense. The first part does make me question the ethics of goldsmiths. "Want me to store your gold?" and gives them pieces of paper that represent their right to the gold. Notices that they're leaving the gold with him because the paper is so convenient. Turns to another group, "Want to borrow some gold? I can store that for you," and then gives them pieces of paper with IOUs that are just as useful for trade as the pieces of paper held by the gold's owners. This is about the conception I had of how money is created that led me to believe that a government print and spend model wouldn't work. Money is created, but the extra cash only lasts as long as the loan is still out. There's a built in limit to the money supply. However, if it were created simply by printing, the money supply keeps growing. Like you said- high inflation. There is no efficient means, such as calling in a loan, to get rid of it. Tax and burn would work, but this defeats the whole purpose of suggesting the idea in the first place.

There also appear to be limits to money creation in modern banks. In the example you gave, the Fed loans a bank $1000, that bank loans a portion of this to another bank, which, in turn, loans a portion to a consumer. Each loan is considered to be a new asset and the total keeps increasing. This doesn't quite capture it. The assets of the first bank are the $100 in reserve (assuming 10%), and $900 in loans. The assets of the second bank are $90 in reserve and $810 in loans, etc. But this does not represent an inrease in assets because the first bank owes the Fed, the second bank owes the first bank, and the consumer owes the second bank. Other than the increasing interest with each step, simply passing loans down the line does not increase assets. Something else needs to happen. Money on loan is going to have to do double duty. The banks accomplish this by loaning someone else's money.

Say that I go to the first bank and open a checking account with $500. The bank now holds a total of $1500 (it has suddenly occurred to me how unviable these numbers are for a bank). It needs to increase its reserves to $150 to keep the correct percentage. $900 is already out in loans so it needs to do something with the extra $450. My checking account is an asset to me, but it represents a liability to the bank: I could close it at any time. If the bank is really worried about this, it will keep my money in reserve. It would rather use it. If it has reason to believe that I am unlikely to draw out more than it has in reserve, it can use my money to increase its total loans to $1350. At this point, it has just created money. I am still using my $500, but someone else has borrowed $450 of it from the bank. Eventually, all of the loans come due and the bank receives $1350 plus interest. The bank pays the Fed and receives a new loan (something it has done several times by now). I'm still maintaining an average checking account balance of $500. The bank starts the whole thing over again.

Here's what I'm seeing so far: the Fed creates money ex nihilo and passes it down the banking system until a consumer takes it out on loan. The consumer spends some of the money, which makes its way into other people's checking accounts The banks loan some of this money, which, in turn, is spent and ends up in other checking accounts. Diminishing returns eventually stop the whole process. Throughout it, though, more and more money is being circulated than the Fed ever put in the system. And then all that money is destroyed as each of the loans comes due. There is no drastic fluctuation in the money supply because the process is constantly moving in both directions at once.

So now I have a question about your statement that "interest-bearing assets do not merely generate profit, they actually increase the amount of money in circulation." Are you suggesting that there is a net increase in the money supply for each loan cycle even if the amount of money created and destroyed by the Fed remains constant? If so, I've completely missed something. As it is, when I drew the distinction between the creation of money and an increased money supply, stating that the increase was no more than the amount of interest generated, I was thinking net increase. I had no intention of suggesting that interest-bearing assets do not increase the amount of money in circulation, at least as long as the loans are still out. And the point there was to say to myself, "You're wrong, Kevin." I've been asking what the difference would be if the government simply printed its own spending money. 1) There would be a yearly net increase of the money supply too large for the economy to handle. The government does create money on the other end, but it destroys it just as fast. The idea is for it to circulate. 2) Because money is created through loans, it is already tied to the economy. If the economy couldn't handle it, fewer people would take out loans and the money supply would not grow. Printing and spending would increase the money supply whether or not the economy was ready to handle it.

In short: yes I am. There are two primary things that affect the rate at which money is created/destroyed. The first you've already got: the reserve ratio. The more money banks have to keep in reserve, the less they have liquid, and thus the less they can loan. The second is interest rates.

Think of it this way: When a bank borrows from the Fed, all of a sudden we have a new asset worth, say, $1000. That $1000 is lent out and the loan is worth $1100 with interest. Then, the $1000 is paid back to the Fed, destroying our arguably fictional but surprisingly authoritative $1000 asset. The bank now has $100 it didn't used to have.

If the Fed weren't in the picture, this would not be the creation of money, it would be simple profit. The question is where the initial asset comes from. When it comes from within the economy, as in a bank or consumer doing business with another bank or consumer, there is no net increase or decrease in the money supply. When banks lend to each other or consumers, profit spreads around, but there isn't any new money. But when we talk about the Fed, we're talking about an influx of money that didn't used to be part of the economy, and we're charging interest on *that*. So yes, I am suggesting that there is a net increase in the money supply for each loan cycle *provided the Fed is in the cycle*.

This sounds essentially the same as what I meant: the net increase in the money supply is only as great as the left over interest. So I'm all set to agree until I read your statement that "profit spreads around, but there isn't any new money," which got me to thinking. This is exactly what 's happening with the interest, even when the Fed is there. The bank may very well have more money than it used to, but it does not follow that this money was created. It's profit; it was moved from another sector of the economy. If anything, interest is a mechanism whereby money is shifted and destroyed, not created . Consider: the Fed creates $1000 and loans it at 1.25%. If the bank that receives this money keeps it all in reserve, the final payback will represent the net destruction of $12.50. Interest charged on money the Fed creates does not increase the money supply. When a bank receives money from the Fed, it lends out the remaining liquid assets at a higher rate of interest than it was charged. And so on: either the interest rate keeps growing the further down the line it goes, or the base keeps broadening as new money is created through loans. The lines keep branching out until they each reach a point where someone has borrowed money, owes interest on that money, but does not pay this by loaning out the money again. This is the point where the money actually enters and exits the economy outside of the banking system. I need a car, so I take out a loan with interest. I buy the car and the money that has been created by the banks is injected into the economy at large. Now I need to pay the loan back. I go somewhere and offer to provide goods or services in exchange for some of the money that is in the greater economy. I pay back more than I put in. The bank from which I got the loan turns around and pays its creditors. Since it was charged less interest than it charged me (or because it had a broader base), it gets to keep some of the money it received from me that I obtained for my provision of goods and services. Each bank, all the way up the line, makes a profit with the money that I and those like me earned. All that profit is not created, just shifted. The final bit of interest, however, is paid back to the Fed. Unless there is a way to get it back into the economy ( I don't know- would something like a government bond do that?), interest serves to cause a net decrease in the money supply for each loan cycle. The interest rate does affect the rate at which money is created and destroyed, but this is because it either encourages or discourages lending. It's a matter of how soon the point of diminished returns is reached in the loan cycle. Higher interest makes this sooner, fewer loans are made, less money is created and destroyed. All other factors being equal, interest hikes lead to a decrease in the money supply and the opposite to an increase. But there is no cumulative net change either way.