Money makes the world go ‘round. It serves as the essential means of exchange, facilitating the exchange of goods and services by reducing friction. Money allowed billions of humans to increase their standards of living and wealth.
Despite its importance, very few could answer even the most basic questions about money: Where does it come from? How much money actually is there?
If I asked you how much money you own, you could likely determine the answer with a few clicks by checking your account balances. Store owners are aware of the dollars in their cash registers and in the bank. Any bank knows exactly how many dollars (or any other currency) are on its balance sheet. The government knows. The number of total dollars in circulation, then, should be a known quantity.
Here is an experiment you can do right now: google the question, “How many dollars exist in the world?” You will be puzzled by the result: a wide range of different figures. For example, Wikipedia will tell you there are $2.1 trillion in circulation, while the Federal Reserve Bank lists $20.8 trillion as the monetary base just of the US. The Financial Accounts of the US mention $95 trillion in outstanding public and private debt—to which we can add more than $80 trillion in hidden debt identified by the Bank for International Settlements, bringing the total figure for American debt to over $175 trillion. Surprisingly, the exact total number of dollars in existence remains unknown.
The lack of a definitive figure stems from varying definitions of what qualifies as money. Consider the unused portion of your credit card limit—does it fall under the category of money? Similarly, when two non-US banks engage in a cross-currency swap agreement involving US dollars, booked as potential liabilities off of the balance sheets, should that be considered money? These examples highlight the complexities and uncertainties surrounding the precise determination of the total amount of money in circulation.
What is money?
Money exists in diverse forms and exhibits varying characteristics. For instance, for a car dealer, the primary concern would not be the specific form of payment a customer uses to purchase a car. Whether the customer pays with a suitcase full of cash (money laundering concerns aside), obtains financing from a bank, or secures a loan or lease from the manufacturer’s in-house financing arm, the main objective, from the dealer’s point of view, would be completing the sale.
In the first scenario, the customer uses money created by the central bank, which is commonly referred to as public money.
In the second case, the customer relies on money created by the private banking sector, known as private money.
The third example involves the in-house financing arm bundling customer loans and selling them to investors in the form of collateralized car loan obligations. This practice exemplifies money creation by the shadow banking sector. (The term “shadow banking” refers to financial activities that fulfill similar functions to traditional banking but take place outside the scope of traditional banking institutions.)
These examples demonstrate the varied sources and mechanisms that create money, encompassing public money issued by central banks, private money generated by commercial banks, and even forms of money creation within the shadow banking sector.
In all three examples, debt plays a significant role as a method of payment. In our fiat monetary system, the creation of money is tied to the creation of an equivalent amount of debt. In other words, when new money is brought into existence, an accompanying debt is simultaneously created.
This means that one person’s savings represent another person’s debt. As a result, the total amount of money in circulation must match the overall amount of outstanding debt. This explains why, when searching for the number of dollars in existence online, it is common to encounter search results mentioning “debt.”
The functioning of our monetary system can indeed be unintuitive. It can be challenging to grasp the notion that money we hold in our bank accounts represents someone else’s debt and that when we transfer money, we are essentially passing on IOUs.
This lack of awareness or disbelief about the nature of money is not uncommon. Many people may view money as a tangible and independent entity without recognizing its interconnectedness with debt.
Where do the dollars come from?
I spoke about institutions that create money. “Isn’t it the government that creates money?” you might ask. The reality is not so simple.
A country’s central bank creates money in physical (notes, coins) and digital form (deposits credited to its clients, which are other banks). Both forms constitute a liability for the central bank. By examining its liabilities, the total amount of money created can be determined. In the case of the Federal Reserve, the US central bank, this amount currently stands at approximately $8.25 trillion.
Of the over $175 trillion of debt in the economy, the vast majority has not been created by the central bank but rather by the private sector. The US central bank accounts for less than 5% of total money outstanding. However, despite its small contribution, the central bank is often held responsible for the entire amount outstanding, despite this amount being 20 times greater than its own creation.
Central banks face criticism for their perceived role in “printing” vast sums of money seemingly out of thin air. However, as previously mentioned, their direct impact on the total amount of money in circulation is relatively small compared to the contributions of the private sector.
Instead of solely focusing on central banks, it can be valuable to recognize and appreciate the functioning of our monetary system. This system, despite not being backed by any physical commodity like gold, has been operational for several decades. The longevity and resilience highlight the system’s ability to facilitate economic transactions, support economic growth and maintain relative stability.
Why do we need private banks?
Money, as a medium of exchange, is a public good. However, private sector banks are permitted to create money, under strict regulations, through the issuance of loans. Why should the private sector be allowed to participate in money creation?
The reason lies in the nature of lending and the risk of individual loans. It is not feasible for average citizens to lend significant amounts of money directly to strangers for purchases like cars or homes. It would be impossible for individuals to assess creditworthiness and risk. Banks, with the help of equity buffers and deposit insurance, take care of that risk. This enables your neighbor to finance his house without you having to worry about his creditworthiness causing sleepless nights.
In theory, it is conceivable for central banks to undertake the lending function. However, central banks primarily have a public mandate to ensure monetary stability and implement monetary policy. Determining the creditworthiness of individual borrowers on a local level would require a vast network of branch offices, which could divert resources and focus away from the central bank’s core responsibilities.
Private banks not only perform risk transformation, by shifting credit risk from individual depositors onto the bank, but also maturity transformation. This means that while banks provide longer-term loans to borrowers, depositors have the flexibility to access their savings daily. This maturity transformation allows banks to match longer-term loans they make with shorter-term deposits, ensuring the smooth functioning of the financial system.
Economic growth requires the expansion of debt
Most big-ticket items, like cars as mentioned in the earlier example, are financed rather than paid for in cash. As a result, availability and accessibility of credit play a vital role in facilitating car sales and driving economic activity.
A credit contraction, in which credit institutions tighten lending standards, leads to fewer loans and therefore economic contraction.
As the expansion of debt often outpaces economic output, debt service levels may eventually become overwhelming. This situation can result in borrowers being unable to meet their debt obligations, forcing banks to write off loans and thus triggering a recession. In cases where loan losses exceed safety buffers, banks may face the risk of closure. Fortunately, depositors can rely on deposit insurance schemes within certain limits, which is crucial to instill trust in private institutions despite the possibility of insolvency.
In addition to deposit insurance, trust in private institutions is also bolstered by the possibility of converting bank deposits, representing a claim against a private institution, into cash, which carries no risk of bankruptcy. However, this feature can trigger bank runs once the trust in a particular bank has been shattered.
The role of cash
Public money, in the form of cash, serves as a critical mechanism to maintain the uniform value of dollars, regardless of their issuer. Prior to the establishment of the Federal Reserve Bank System, a dollar note issued by a bank in Connecticut, for example, would be cashed at a discount to its face value when presented in New York City. Only the introduction of a central bank ensured full fungibility of dollars regardless of their origin or issuing entity.
Bank deposits can be thought of as stablecoins, with deposit insurance and convertibility into cash functioning as the mechanism guaranteeing the 1-for-1 peg.
As we transition towards a cashless society, the role of public money (cash) as the anchor of our monetary system is undergoing a transformation. Currently, cash serves as the only means through which individuals can access public money, as only banks are permitted to hold accounts with the Federal Reserve.
This is where Central Bank Digital Currency (CBDC) comes in. With the eventual retirement of physical forms of money, CBDC will emerge as the sole means for central banks to directly engage with individuals.
CBDC can be thought of as tokenized cash, representing a digital form of central bank-issued currency. It retains the characteristics of cash in terms of being a liability of the central bank, ensuring its stability and reliability.
Keeping seigniorage alive
Central banks benefit from cash in circulation as cash represents interest-free debt, providing them with a significant source of income from investing proceeds in interest-bearing securities, resulting in profits known as seigniorage.
The US Federal Reserve, for example, has around $2.3 trillion of currency in circulation. If these funds were invested at a hypothetical interest rate of 5%, the annual return would amount to $115 billion, a sum greater than the military budget of any country other than the US and China.
With the disappearance of physical cash, the traditional source of such profits would cease to exist. However, the introduction of Central Bank Digital Currency (CBDC) presents an opportunity to sustain and continue generating seigniorage profits. Furthermore, public money is vital to support increasing sums of private money outstanding. The introduction of CBDC should therefore be welcomed.
A debt-based monetary system is a feature, not a bug
The current monetary system frequently faces criticism for lacking tangible backing and enabling unlimited issuance. In contrast, assets like gold and Bitcoin are seen as different because they do not represent any counterparty’s obligation. However, while some proponents applaud this aspect, it can be viewed as a drawback rather than a desirable feature.
The absence of counterparty risk and limited issuance in assets like gold and Bitcoin can lead to a phenomenon known as hoarding. This hoarding behavior is reminiscent of medieval kings sitting on vast treasure chests filled with gold, rendering the gold inert and unavailable for circulation within the economy. Consequently, this results in a restricted monetary base in circulation, which hampers economic growth.
A fiat monetary system possesses the unique feature of allowing for the simultaneous creation of savings and debt, enabling economic growth even in the presence of accumulating savings. This characteristic is a significant advantage of such a system.
The potential drawback of a fiat monetary system lies in the temptation to create excessive debt or money, which can lead to devaluation. This factor renders fiat money less reliable as a store of value, while it represents an excellent medium of exchange.
The stability and functionality of a fiat monetary system relies on individuals’ willingness to hold their savings in fiat currency. While it is impossible for everyone to convert fiat into tangible assets, individuals still have the freedom to make such choices.
Despite its drawbacks, a fiat monetary system remains preferable to a system based solely on hard assets, which would create deflationary pressures and possible economic depression. The dynamic nature of a fiat system allows for central banks to make adjustments in money supply to accommodate economic needs.
[Anton Schauble edited this piece.]
The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.
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