Money creation and debt

post by AnthonyC · 2020-08-12T20:30:42.321Z · LW · GW · 15 comments

This is a question post.

I'm confused about fiat money creation and debt in the US. My mental model is that the Fed lends money into existence (either to banks or to the treasury), which creates a loan (that eventually has to be paid back with interest, though I think they can choose not to collect on loans to the treasury?) (I'm also not sure where the money the Fed uses to pay interest on bank reserves comes from, but since it used to not do that I'll ignore it and pretend I'm asking about the time before that existed). The fractional reserve banking system then creates a convergent geometric series of additional money creation through repeated lending and saving, and that's basically M2. (I'm ignoring the fact that the reserve requirement is currently zero, I don't think it affects my question anyway).


It seems like that means that for every dollar that exists, there is an equivalent dollar owed in debt to someone. And conversely, when debt gets paid down, the monetary base decreases. This suggests that it is not possible, economy-wide, for private sector net savings to increase unless the government debt increases, and that whenever government debt goes down, private savings must decrease. I feel like I'm missing something central, because otherwise this would be public policy 101 level stuff that the Left especially would be very vocal about, but I can't figure out what.

Answers

answer by johnswentworth · 2020-08-13T03:34:37.022Z · LW(p) · GW(p)

My mental model is that the Fed lends money into existence (either to banks or to the treasury), which creates a loan (that eventually has to be paid back with interest, though I think they can choose not to collect on loans to the treasury?) (I'm also not sure where the money the Fed uses to pay interest on bank reserves comes from, but since it used to not do that I'll ignore it and pretend I'm asking about the time before that existed).

This is true of the Fed's operations in the repo market, but those are a fairly recent development and it's not true in general.

In general, the Fed doesn't lend money into existence, they create money from scratch and then sell that money in exchange for some other asset (typically Treasuries). A bank sells the Fed $1 worth of Treasuries, and the Fed just adds $1 to that bank's account.

However, because the Fed buys a Treasury note/bond in this process, the (rest of the) government then owes the Fed money - i.e. the Treasury note/bond payments. So when the Fed issues a dollar, they also acquire one dollar's worth of somebody else's debt. Note that that's one dollar's worth of debt at current market prices; the Fed will actually be owed more than one dollar. Also, as current market prices shift and the Fed buys and sells assets the amount of money owed to the Fed will generally not be equal to the amount of dollars outstanding.

This suggests that it is not possible, economy-wide, for private sector net savings to increase unless the government debt increases, and that whenever government debt goes down, private savings must decrease.

Private investment is the main thing missing here. Private savings go into a mix of government debt and private capital investments (i.e. grid infrastructure, data infrastructure, railroads, oil wells, real estate, machinery, etc) - i.e. corporate bond/equity-financed capital expenditure. Thus the concern that too much government debt could (at least in theory) crowd out private investments in industry.

comment by sairjy · 2020-08-13T08:14:55.422Z · LW(p) · GW(p)

I think he meant savings as cash saving/bank deposits. Since all cash savings/bank deposits are the debt of someone else, for the entire private sector to increase its cash holding/bank deposits the government has to increase its debt.

Replies from: simon
comment by simon · 2020-08-13T17:31:28.626Z · LW(p) · GW(p)

Either definition could be used, as long as you keep track of what definition you're using and the consequences that follow.

There's a point of view called "Modern Monetary Theory" (MMT) which defines savings to exclude investments, resulting in Savings = 0 instead of the conventional Savings = Investment, but adherents of MMT tend to misapply this, arguing that government debt is needed for, e.g. people to be able to save for retirement, which is false when you take into account investment.

Replies from: AnthonyC
comment by AnthonyC · 2020-08-15T22:08:35.114Z · LW(p) · GW(p)

Yes, thanks, and that I think is the difference I was vaguely aiming toward. I was neglecting investment and real assets, and don't quite know how they fit in (since you can't spend them without selling them), so I did phrase my question in terms of cash and bank deposits.

Like - does our current monetary system allow for any possible way for both people and the government to not, on average, be in debt for more money than they have in cash and bank savings?

Replies from: ChristianKl
comment by ChristianKl · 2020-08-16T10:48:44.311Z · LW(p) · GW(p)

Who do you mean with people? If I have 1000$ bank saving that means that I loaned the bank 1000$ and the bank owns me those 1000$. Do you see banks and not being people? Do you see businesses as being people?

answer by sairjy · 2020-08-13T08:29:50.627Z · LW(p) · GW(p)

As far as I understood money myself, your intuition is correct. All fiat currency are credit money, so that when you are holding a $, either in cash or bank deposit, you are holding someone else liability. The system is balanced, so that total liabilities are equal to total assets at any time. The net value of the entire monetary system in the economy is zero.

That's right, but that's the private sector as a whole. Some part of the private sectors will increase their debt, while others their savings. Clearly that would generate business cycles/boom and bust, and that's the big discussion of macroeconomics in what is the role of governments in damping/preventing them.

Since the Treasury owns the Fed, the profits made by the Fed are channeled back to the Treasury. The ECB is a bit more complex, but it works in a similar way. When a central bank buys government debt, that debt is the facto neutralized.

comment by G Gordon Worley III (gworley) · 2020-08-13T17:50:08.727Z · LW(p) · GW(p)

A small caveat is perhaps that fiat currency doesn't have to be debt based, but in practice seems to always be, thus it's maybe even a bit unfair to call it "fiat" money because it actually does have something backing it indirectly. I think there might be some evolutionary forces at work here: fiat money that isn't grounded in something tends to suffer hyperinflation because printing money is just too tempting and so we really only have debt-based fiat currency left after the winnowing process.

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comment by FactorialCode · 2020-08-12T22:00:44.591Z · LW(p) · GW(p)

https://en.wikipedia.org/wiki/Sectoral_balances

It is my understanding that this is broadly correct. It is also my understanding that this is not common knowledge.

Replies from: johnswentworth, AnthonyC
comment by johnswentworth · 2020-08-13T03:18:10.497Z · LW(p) · GW(p)

Careful with that. It's an accounting identity, and those have a reputation in economics for being easily misleading. Terms in accounting identities are usually aggregates of other terms with lots of interactions which are nonobvious from the identity.

Replies from: FactorialCode
comment by FactorialCode · 2020-08-13T06:14:02.028Z · LW(p) · GW(p)

Yeah, I'll second the caution to draw any conclusions from this. Especially because this is macroeconomics.

comment by AnthonyC · 2020-08-13T02:01:38.011Z · LW(p) · GW(p)

Thanks, that is exactly the article I needed! I knew my question was at least MMT-adjacent, I never made the accounting identity connection though.

comment by CellBioGuy · 2020-08-15T01:36:40.928Z · LW(p) · GW(p)

Correct. Keep in mind that private banks ALSO create money whenever they lend money out too. Then the asset and the liability are both contained within the private sector.


In the absence of sufficient federal deficits that make their way spent into general circulation, the private sector is obliged to become perpetually more indebted to the banking subsector. Welcome to the last forty years.

Replies from: ChristianKl
comment by ChristianKl · 2020-08-16T10:21:32.864Z · LW(p) · GW(p)

I think that's the M2 the question explicitely acknowledges. The Fed creates the M1 then the banks create M2 on top of that. 

comment by romeostevensit · 2020-08-12T22:39:50.065Z · LW(p) · GW(p)

Good job on noticing confusion!

(I agree with Factorial above)

Replies from: AnthonyC
comment by AnthonyC · 2020-08-13T02:02:51.811Z · LW(p) · GW(p)

I'm a research analyst, I spend a large portion of my day noticing my own confusion and helping other people resolve theirs ;-)