The Money System

This will be a long thread, its end being a complete picture of the US, and by extension global monetary system. I only have a partial picture of it so far, some of the things written here may be incorrect. This is my current best understanding only, and I am by no means well versed in economics. We will move progressively toward an accurate understanding, discarding what proves inaccurate.

In addition, the exploration will begin with the "hard money" system of physical dollars, excluding digital money where digital money is not merely an extension and representation of a tangible currency. Eventually I want to include digital money in this complete picture of the money system. Your comments and insights are appreciated.

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Money (dollars) begin when printed at the US Treasury, and from here move into the central banks (because it is the federal reserve central banks that issue the order for more dollars to be printed). These dollars are deposited into central banks and flow outward to other banks, and eventually enter the economy at large by flowing to businesses and individuals in the form of loans and payments. Payments occur when, for example, the US government makes payments on its debts or pays recipients of programs like social security. Payments also occur when a business pays its employees, as the business often acquires the money to pay its employees through short-term loans to meet payroll. These loans are then paid back based on schedules of revenue gain for the business. Loans occur when banks lend money to individuals or businesses, in exchange for promises to be paid back the loan + interest. The bank will transfer a quantity of money, either in physical dollars or electronic dollars, from itself to the individual who borrows the money.

There is an idea that banks create money when they give loans. I cannot see how this is the case. When a bank loans it must transact a quantity of dollars to the loan recipient, either directly (a personal car loan) or indirectly (a home mortgage). Rather banks seem to loan money that they either possess or borrow from other banks. In fact banks borrow money from each other all the time, and this is reflected by a changing rate of interest on loans between banks (the federal funds rate).

There is always a very large amount of dollars in circulation around the world. Every year a number of dollars are returned to the Treasury and destroyed, and another number of dollars are newly printed. Newly printed dollars add directly to inflation. For example, if there are 1 trillion dollars in global circulation and the Treasury prints, after a number of old dollars it destroys, a net increase of 10 billion new dollars then the inflation rate will be 10,000,000,000 / 1,000,000,000,000, or 1%. Of course some of those dollars may not immediately enter circulation, in which case inflation will be less than 1%.

Now, the idea has also been out there that dollars = debt. This is somewhat correct, since much of the dollars which the US Treasury prints or which flows into the US economy via central banks comes from outside the US in the form of loans from other governments. For example, China purchases US treasury bonds/bills (t-bonds), which are promises that the US government will pay back the purchase amount + interest. Issuing t-bonds allows the US government to create more money that does not directly cause inflation, but adds to the national debt. How this works specifically: China prints large amounts of its own currency (yuan) and uses these to exchange for US dollars in currency exchange transactions. China then uses these dollars to purchase t-bonds from the US government. This allows China to keep its own currency artificially low, while at the same time China assist the US government with financing itself at the cost of its rising debt. This also increases the market for t-bonds globally, raising their value, which is also good for China (because it owns these bonds) and for the US (because the large market means the US can always sell more bonds).

This is where the Federal Reserve comes in. The Federal Reserve is always buying up a portion of available t-bonds on the market. After 2008 the Fed began buying much larger quantities of t-bonds, in order to stabilize the US economy. This works in the following way: with a large number of t-bonds being taken off the open market and transferred to the Fed, the relative value of t-bonds in the market increases. This means the Fed can get away with setting interest rates very low on these bonds, because even though interest rates are very low (near zero) the bonds still keep increasing in value. Remember that China and others who own t-bonds will trade these amongst themselves in a global market for US bonds, as the price of these bonds will fluctuate over time.

So the Fed artificially lowers the available supply of bonds, increasing the relative value of bonds in the open market. Like said above, this also means that the Fed (which sets interest rates) can set the interest rate very low and the US government can still sell many of its bonds. Thus the US treasury gets a large influx of dollars from foreign sources like China, and the US government uses this money to finance itself.

Now, the US treasury could also just print more money without getting this influx of dollars from outside, and it does this, but as noted above this adds directly to the rate of inflation.

Also, we know that dollars are fiat currency and not backed by any tangible asset. This means that dollars are created or destroyed with no result other than the effects this has on the overall supply of dollars and the value of the dollar.

That's it for now, more to come later.

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One question that needs answering at this point: does the Fed actually transfer money in its central banks to the US treasury when it purchases t-bonds, or are these t-bonds just transferred to the Fed "for free", just to get them out of the general market?