Dismiss Notice
Join Physics Forums Today!
The friendliest, high quality science and math community on the planet! Everyone who loves science is here!

The Money Thread: Where does it come from?

  1. Jan 10, 2009 #1


    User Avatar
    Homework Helper

    Amidst the current financial crisis, and possibly heading towards a recession (if not already in one), it begs the question as to how did we get into this mess. Then, when one starts looking into the system, something seems a bit confusing.... if a recession means that the majority of ppl does not have the ability to spend or has very weak spending powers, in other words not enough cash around, then one may ask where does all the money goes? After all, not too long ago, the economy was booming, and given that the Federal Reserve does not over/under-print money, money are just circulating, and shouldn't "disappear" as such ... unless there is something we don't know about the system. And don't understand, I am, starting with this (let's ignore the Fractional Reserve System and interest rates for the moment):

    since Money is no longer back by gold or silver and it is totally fiat, based on what do the US Fed decide how much money to "create" out of nothing? Also, how much control does the govt. have?


    I know I am over-simplifying the situation, but I want to start by fully understand where money comes from first, before tackling the issues of growth, debt and interest rates.
  2. jcsd
  3. Jan 10, 2009 #2


    User Avatar

    Staff: Mentor

    You almost have it: money doesn't disappear when you go into a recession, you go into a recession because people stop spending it. There is a cascading effect then of companies not making enough money (because people aren't buying), then they lay people off because they don't have the money to spend to pay their employees, then people don't have as much money because there aren't as many jobs.

    The health of the economy isn't about how much money is in it, it is about how fast that money circulates.
    The Fed's abitlity to create money from scratch is a little bit of a misnomer. They can make physical dollar bills, but the value of those bills is set by supply and demand, so adding, say, 1% more dollar bills into circulation won't result in there being 1% more value, as the value of those dollar bills will be 1% less than it was before more was added.
  4. Jan 10, 2009 #3
    i don't think actual cash disappears, but much of what people think they own and base their net worth on is assets in the form of land or stock shares. stock and land prices can easily go up in perceived value (what people are willing to pay cash for) without any increase in the amount of cash in circulation. this is a speculative increase, it doesn't increase the amount of money in circulation. when that speculative price decreases, no money has left.

    there is a booklet that the federal reserve printed many decades ago describing how they increase the money supply called Modern Money Mechanics. several free sources are available via google.
  5. Jan 11, 2009 #4
    A few reasons we got into this mess:

    1) Recessions are not unavoidable, if the economy booms, it eventually needs a recession, but usually, since the supply-side revolution, recessions have been very short and light.

    2) The Federal Reserve keeping interest rates so low, which in hindsight seems to have fueled the housing bubble.

    3) A real-estate bubble bursting is a HARD blow to an economy. It isn't like a stock market bubble burst.

    4) A greedy and corrupt banking system that made loans that could never be repaid back, but then sold those loans to Wall Street, passing on the cost to investors.

    5) Greedy Wall Street firms that packaged these loans into securities and sold them to investors.

    6) Credit-rating agencies and so forth that didn't do their work right and rated these securities as good

    7) Greedy people who took loans they couldn't afford to buy homes they couldn't afford

    8) Fannie Mae and Freddie Mac

    There are others as well, but those are some of the big ones from my understanding. As for money disappearing, money doesn't disappear, but wealth does. Money and wealth are separate, at least in our modern economy. In old times, money was from trade. Humans would trade goods and services and just usually there'd be one particular good that everyone wanted, that could be traded for anything. This universally-traded good, that could be traded for anything, would become money, for example jewels. Societies advanced it some by creating things like coins, made from silver, gold, etc...but these coins had intrinsic value. A gold coin had actual worth. In modern times, money is mostly worthless in itself, it only has value because the government says it does. Wealth is created by humans. Money is just what we use to trade wealth. Otherwise, the Federal Reserve could just print off each American $500 million dollars and we'd all be incredibly wealthy :)

    Of course the real result from that would be extraordinary inflation, as you'd have more and more dollars for the same amount of goods and services.

    Now just as wealth is created, it also can be destroyed, and that is what has happened. Stock values have declined, thus a lot of paper wealth disappeared, real-estate values drop, thus wealth disappears, etc...however this wealth will return. Wealth is really destroyed when businesses die off and so forth.

    As for how the Fed make their decisions, it is all incredibly complicated from my understanding, as the U.S. economy is the most complex and advanced in the world. I believe the Fed "creates" money in that you can temporarily print off a lot more paper money to do things like bail out the financial system if necessary, but then the Fed has mechanisms in place to begin withdrawing that money back out of the economy to prevent inflation from occuring (which it will if the money is allowed to circulate into the economy long-term).

    Like if you needed $2 million, and you had a money machine in your basement, and printed yourself off $2 million, then paid off your bills, bought yourself some luxuries, then began withdrawing $2 million back out of the economy before inflation took effect.

    Something like that.

    Now prior to the Third Reich in Germany, the Weimar Republic started printing more and more paper money without any clue as to what they were doing. Prices began skyrocketing from inflation, which the government blamed on "greedy businesses," and thus printed off more money to "help" the citizens pay for these exorbitant prices. They had no idea it was this very printing that was causing prices to skyrocket, and prices kept going up and up, it was a vicious cycle.

    The Federal Reserve understands about this though.
  6. Jan 11, 2009 #5
    I disagree. It is true the velocity of transaction can expand the money supply but In my view the money supply was excessive expanded because of excessive leverage (see fractional banking) and it faced a server contraction because this leverage could not be sustainability for several reasons, which include: capital requirements (see BIS), bankruptcies/credit write offs , and margin requirements.


    Last edited: Jan 11, 2009
  7. Jan 11, 2009 #6
    Recessions are caused because credit expands much faster then demand. Call it a boom if you want. I call it a market failure.
    I agree but I wonder if their aren't also advantages of cheep borrowing costs. That said I don't think that cheep borrowing should arise only if the market permits it and not though manipulation via the federal reserve.

    Systems aren't greedy. People are. If people thought housing prices would continue to clime then the recovery rate would be high and defaults wouldn't mater.
    I understand that securtizatoin creates a lot of potential for fraud but it it also helps to reduce the default risk of an asset. This would effectively reduce the risk premium of a borrower with lower credit rating and make it so that more people can borrow cheaply. I understand that cheaper borrowing costs could be inflationary but I think obtaining cheaper borrowing costs though innovative finance is preferable then though federal reserve manipulation.

    This is a big problem. Unfortunately certain new types of derivatives such as synthetic CDOs and credit default swaps lack adequate standards for rating the credit risks.

    In a climate of rising rent and housing prices what do you suggest people do?
    Last edited: Jan 11, 2009
  8. Jan 11, 2009 #7


    User Avatar
    Homework Helper

    oh thanks, but slow down....
    let's take a step back from the financial crisis (although it motivated my questions, it is a distraction to the discussion at this point), and concentrate on the basics of fiat money creation first :smile:

    ok, you've mentioned that the FDR "creates" money to do things (eg. buying govt. securities etc.), now the bit I haven't understood is that while commerical banks have to obey the fractional reserve requirement, does the FDR has any "limit" at all? Or just to the discretion of the reserve governors? Since we have foregone the gold standard long ago, so my question is based on what does the FDR operates?

    Let assume the hypothetical situation, where we reboot the system, and create a new Fed. This new Fed will need to issue money to the society for the first time....

    Does the new Fed need to hold anything (say commodities, land etc.) as reserve to back these newly printed money?
    If so, WHO provides them? Would those who provides these assets are effectively loaning them to the new Fed (i.e. the Fed will have to repay with interest later)?

  9. Jan 11, 2009 #8
    I'm not sure what your point is. When their is massive deleveraging the net result is a massive contraction in the money supply which means that each dollar bill is worth more not less. Give the high level of debt this means that people become overwelmend by credit and conscequently their is a sever contraction in demand.

    Yes in these circumstance the fed tries to counteract this market failure by printing more money. The fed injects money into the marekt by either buying treasuries (open market action) which controls the fund rate. Changing the discount rate (fedural reserve overnight lending rate). And quantitative easing (see also).

    Ironically the amount of money the fed can print are based on the amount of assets it has which are primarily US treasuries (government debt). A monetary system backed by debt instead of gold is called a fait money system.
    Last edited: Jan 11, 2009
  10. Jan 11, 2009 #9
    The federal reserves primary ascent is US treasuries (AKA government debt). It also has other assets example corporate paper (AKA bonds) and gold. The fed does usually maintain a capital ratio around the same as a bank. Sine the majority of the federal reserves ascents are US treasuries which are considered to have zero default risk the fed could in theory safely sustain a higher leverage ratio then banks. However, I am not sure if the quality of a banks assets significantly effects the leverage ratio a bank is allowed to sustain.

    P.S. Here is the federal reserve balance sheet:
  11. Jan 11, 2009 #10
    Technical the base money supply "federal reserve notes" are represented in the federal reserve balance sheet as a liability, and they must have sufficient assets to balance these liabilities. As I stated above, their primary asset is government debt (US treasuries). Thus the amount of money they can issue is restricted by the amount of government debt they have on the balance sheets. This debt is given to them freely by the government in exchange for federal reserve notes.

    The fed keeps most of this money and debt in the federal reserve bank to avoid over inflating the money supply. The federal reserve notes represent an ownership of the federal reserve. In the event that the US government decides to dissolve the federal reserve, the proportion of the federal reserve notes you hold would represent the proportion of the federal reserve which you own.

    P.S. Not all countries have reserve requirements, some counties only have capital requirements. In these countries open market action plays less of a role in determining the interest rate.
  12. Jan 11, 2009 #11
    A small point, but technically the US treasury prints the dollar bills and not the federal reserve. However, it is the federal reserve that gives them permission to print the money based upon the number of treasuries they hold and the demand for physical currency.
  13. Jan 11, 2009 #12


    User Avatar

    Staff: Mentor

    Maybe it's just semantics... I agree that leverage is a problem if abused but leverage doesn't add value to the economy, it allows people to hold off on paying for goods and services temporarily. The goods and services that are then created add value to the economy.

    The whole reason a collapse is possible is becaused leveraged credit is not backed by real money - if it were, there'd be no possibility of collapse (and it wouldn't be called leverage).
  14. Jan 11, 2009 #13
    I didn't say it adds value to the economy I said it ampliefies the swings in the money supply. There was plenty of value in the economy before the crisis but not enough money once companies were forced to start deleveraging and writing off the value of their assets.
    Temporarily can be a long time. Debt (corporate personal and government) has risen considerably since 1980. This inflated the money supply but it did so in an unsustainable manner.


    Do you mean that people don't put enough money down before taking loans? If so then yes, people do consider this a contributing factor but it's not the whole story.
  15. Jan 12, 2009 #14


    User Avatar
    Homework Helper

    ok, let's see if I've got this right...

    The FDR "creates" money by simply saying to the govt, "ok, you can print such and such amount of money, BUT you owe me such and such which you need to repay as some point in the future...."

    now, that's interesting, and I have some further questions:

    1) how often does the govt. pay back that debt?
    2) does our govt. need to pay interest to the FDR when it is paying off that debt?
    3) so, how would the govt. repay its debt... mainly taxes? or privatisations of govt. utilities etc?

    So in a sense, it seems that the entire population is in debt to the FDR as soon as the first dollar worth of money is printed (or enter the economy). And when we fully repay our debt, there will be no money in circulation??

    Also, if 2) is true, ie. govt. do pay interest for those debts, where would THAT extra bit of interest money come from??? Would the govt. need to ask the FDR to print MORE money, and further put govt. into debt?? There seems to be some inconsistencies here or have I got it wrong?

    by the way, where would that extra bit of interest money flow to anyway? In commerical banks as extra reserve when they received it from the govt?

  16. Jan 12, 2009 #15
    After giving the government money the FED will re-sell some of these bonds. Given the bonds are sold at a discount to their face value and I believe also pay interest (A coupon) money will be injected into the economy once the bonds reach maturity.
  17. Jan 13, 2009 #16
    The Fed controls interest rates (on US Securities) buy choosing to purchase or sell US Securities. Low interest rates have corresponded to rising oil prices in which it became easier to borrow from the Fed, and a housing boom created a large outflow of American dollars. As oil prices began to push down, interest rate have been expected to rise making it more difficult to lend and corresponding to a housing decline.
  18. Jan 13, 2009 #17


    User Avatar
    Science Advisor
    Homework Helper

    Basically never - the Bank of England is a loan the goverment took out in the 1600s and is still paying back.

    Yes it pays interest on treasury bonds that someone buys as an investment.

    You can have a surplus because of a booming economy (more tax), privatisiations or selling things like RF spectrum (the 3G auctions) or mineral rights. You can then decide to spend that money on paying off some debt, buying stuff (weapons) or giving a tax break - depending on your politics.

    That's why some government debt is a good thing. It gives the people something safe to invest in.
  19. Jan 13, 2009 #18
    You’re right. The fed does control the interest rate partly buy buying and selling securities. However, when there is inflation, interest rates tend to be higher because in order for people to want to save money they are going to want to be compensated for inflation. Similarly if there is deflation, interest rates tend to be lower because people know if they save their money they will get more for it in the future. You are right though in that because the FED kept the interest rate artificially low the FED contributed to the housing bubble since people new if they bought a house now it would be cheaper for them then if they bought it in the future. At least that is what buyers thought would be the case.
  20. Jan 13, 2009 #19


    User Avatar
    Science Advisor
    Homework Helper

    Low interest rates meant that people could afford larger mortgage payments. So lenders were willing to lend upto what people could afford to pay each month - rather than the traditional conservative 3x salary. Which is fine until rates go up.
    People were willing to do this because you could always sell your house next year when it had gone up by 10%.

    Very high interest rates actually make people want to buy - because high rates mean high inflation. People that bought houses in the 70s knew that with 20% inflation the real cost of their mortgage payments was going down - at the end of my parents mortgage they were paying about as much as a takeaway pizza each month.

    The danger with low rates is people who take loans they can only just afford but with paymants that will stay roughly the same amount for 25years.
  21. Jan 13, 2009 #20
    If interest rates are bellow inflation then real interest rates are low and that is inflationary. People always try to maximize the return and when the fed keeps rates artificially low it drives inflation.
Know someone interested in this topic? Share this thread via Reddit, Google+, Twitter, or Facebook

Have something to add?

Similar Discussions: The Money Thread: Where does it come from?