How Money (i.e. Legal Tender) Gets Created in Our Nation (the U.S.)*

not as complicated as all that

[* Broadly, what follows applies to any nation with a central bank (which is all nations) and a ‘sovereign’ currency, i.e. one over which the authorities in that nation have control (which is technically all nations outside the E.U. — though less economically powerful nations routinely have demonstrated to them how little control over their monetary affairs they really have).]

Photo by NeONBRAND on Unsplash

Legal tender is defined as that which may be used to pay taxes to the central government and may be required by banks to repay loans. So neither of those entities may require gold, or cattle, or land, or some cryptocurrency, or one’s first-born, etc. for either purpose (unless, of course, some such has been put up as collateral for a loan and repayment in legal tender has stopped).

Since what counts as legal tender is decreed by the central government, it is often referred to as ‘fiat money’. Some people seem to equate “fiat” with ‘ersatz’, but that is incorrect: fiat money is in fact money. “Fiat” merely refers to the notion of a governmental decree. In reality it’s a protection for people.

Herein, “money” always refers to legal tender. I am limiting myself to trying to explain as clearly as possible a somewhat confusing process: how what counts as money/legal tender gets created in the nation in which I live.

To start, we must note that there are two kinds of money: actual and virtual. Actual money is currency. Though currency might be digital, rather than physical cash and coins, it is always actual money. “Virtual money” does not refer here to a cryptocurrency. It is money that exists in the form of credit. Since whatever is virtual is always at least relatively more interesting than its actual counterpart is, let’s go there first.

There are two forms that virtual money takes: lines of credit and blocks of credit. Let’s do lines of credit first.

A line of credit is a certain amount of credit that is available for use without further ado. No further permission is needed to use that credit to make a purchase. (Interest is only paid on whatever part of that line of credit has been used to make a purchase and not been fully repaid.)

Credit cards are lines of credit. Whenever a new card is issued or the limit of an existing card increased, virtual money is created (to be totally accurate, potential virtual money, but we’ll get to that shortly).

‘Regular’ banks also extend lines of credit — usually to businesses — but they also create blocks of credit. Banks do that when they make loans. They credit an account with a lump sum of ‘money’. That money is not currency. It is not actual money. It is virtual money. (Interest is paid on the full amount of a block of credit, so it is generally all used to make a purchase immediately.)

Whether from lines of credit or blocks of credit, when that (virtual) money is used for purchases the credit-qua-money has become income for the seller. The seller then uses it as money — and ‘round and ‘round it goes from there. It (or some part of it) might be used somewhere to make a payment on a line or a block of credit or to pay taxes. It is money, legal tender, but it is still virtual money, not actual money.

Once money that was borrowed from a bank has become income by using it to make a purchase, it is then indistinguishable from any other money. It has become legal tender. So credit ‘officially’ enters the economy as (virtual) legal tender once it has been used to make a purchase, once it has become income for some seller of a good or service.

It must be noted that when banks create blocks of credit —make loans — they are creating money, but they are not necessarily expanding the total supply of money. Money is constantly being returned to banks in the form of payments on loans. Much of that money is re-lent to other borrowers: recirculated. So when banks make loans the money supply is only increased if the total amount of money loaned by all banks has increased — if lending is outpacing repayments.

There is only one way for actual money, currency, to be created: the central bank has the central government (via its treasury) create it. The central government cannot on its own create money. Neither can the central bank. Both must participate for currency to be created.

There are two ways that can happen. One is when the central bank uses new currency to purchase newly issued debt of the central government and the other is called ‘quantitative easing’ (QE). Let’s start with the former.

One of the functions of the central bank of every nation is to be the ‘lender of last resort’ for the central government of the nation. That means it is responsible for making sure that all debt issued by the central government gets purchased. As part of that process the central bank can have the treasury of the central government create new money — actual money: currency — for the central bank to use for that purpose.

That money is handed over to the central bank, then comes right back to the central government when the debt is purchased. It is then used by the central government to make purchases, pay employees, pay off old debt, etc. It is legal tender when it is created.

QE was invented as a response to the financial crisis of 2008 and succeeding years. In QE the central bank has the treasury of the central government print money for it to use to purchase other debt, from financial institutions. That new currency is also legal tender when it is created.

[Obviously, the purpose of QE is to pump money directly into the financial system as quickly as possible. Other forms of QE were invented to deal with the financial affects of the Covid crisis; all involve debt one way or another. (There is talk of extending QE to the purchase stocks, but so far that is only talk.)]

So that’s it. That is how all money gets created in the U.S.

The limit on how much virtual money can be created is determined by the amount of money banks have on hand for lending and the size of the ‘reserve requirement’. That is the amount they are required to have on hand relative to the credit they extend; turned around, it limits how much credit they can extend based on the amount of money they have on hand. (The central bank raises or lowers the reserve requirement to help manage the economy, thereby making less or more money available for lending, and to manage the solvency of the banking system based on the perceived level of threat to it at any time).

There is no set limit on how much actual money can be created. The only limit is the possible negative consequences of creating too much of it, such as high inflation or even hyper-inflation. What that limit might be at any time is pretty much anybody’s guess.

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unaffiliated, non-ideological, unpaid, academically trained philosopher and political economist