Obviously, in any given nation, there has to be something defined as money, which people accept as legal tender in settling debts and obligations. In a republic, it is the duly elected and representative government which has the power to define what is money for that country. Having the power to define what money is, however, does not necessarily include the power to create it at will. In a country such as the United States was until the Civil War, for example, the nation's money was coined gold and silver, together with private notes issued by trusted banks. As we saw in the earlier post, allowing a bank to issue paper notes allows it to create "money" out of thin air. The reserve requirements were imposed to keep such a temptation from going unchecked.
When a bank in a democratic republic is allowed to create money without limit, then to keep the people's control over their government, there has to be some kind of check on that bank's power. If exercised independently of the peoples' will, then there is no longer a resonance with that will, and the money system is in the hands of others, no matter how wise or well-intentioned they may be. At the same time, the people themselves do not have the power to create money without limit, either, since it would lead to the destruction of the republic by other than democratic means.
This is the great problem of democratic governments, as first stated by Aristotle: left to their own devices, the electorate will end up voting themselves all the collective wealth. The tendency of pure democracy is to devolve into socialism, and then communism, and finally despotism. If money is created without limit, runaway inflation is the consequence. Goods are hoarded, and become scarce, because no one knows each morning what money will still purchase by the time evening comes.
The United States has tried to solve this ancient problem since 1913 by giving free reign to the Fed to create money, and by imposing on it two overall goals or purposes to guide its operations: (1) to prevent inflation; and (2) to secure full employment. The problem is that these two goals are at odds with each other. While there is money available for investment and expansion, new supplies of labor can gradually be absorbed and accommodated. But if everyone were fully employed and earning money at every available job, there would be too much money chasing too few goods, and inflation would result. In fact, the state of "full employment" has never been reached: there will always be some lag between jobs available and people looking for work, with just the skills required to fill those jobs.
In the meantime, however, the Fed has been given the power to create money without limit. It is only in the last four years or so that it has exercised this power to a degree never before seen. It used to be the practice of the Fed, when it wanted to expand the money supply, to purchase existing (already-issued) Treasury securities from selected bond dealers. It would write them checks on its bottomless account in payment, which the dealers could deposit only in their own bank accounts (since the Fed accepts accounts only with member banks). Those banks would happily send the checks back to the Fed, which credited their reserves. And with the increased reserves, the banks could now create more money which they could lend out at interest. Everyone was happy.
Lately, however, the Fed has been writing its checks to purchase from the banks assets that no one else will buy -- securities for mortgages in default, for example. These are the so-called "toxic assets" which were worthless on their balance sheets, and which deflated their reserves. The idea seems to be that if anyone can wait long enough for those assets to turn around, it will be the Fed. Meanwhile, they are out of the banks' hands, and they can use the Fed's payments to them to help meet their reserve requirements once again.
Notice that I have not talked about the U.S. Treasury's purchase of toxic assets through the TARP program -- only the "off-balance-sheet" activities of the Fed. (Being an independent institution not owned by the federal government, the Fed's books are separate from those of the government.) But the Treasury has been right in there, too, bailing out banks, and feeding money into "stimulus" programs. The difference is that when the Treasury does it, it does it with borrowed money. And the end result, because net borrowing stays the same, is zero stimulus to the economy, but more interest now owed by the government.
And thus we come to the craziest feature of the current system. The government cannot print money; only the Fed can do that. Both the Fed and its member banks, therefore, can do what the government cannot do -- and they get to earn interest on the money they create. The government, on the other hand, borrows that money from them, and repays it to the banks with interest. Normally, it does so with revenues from taxes, customs duties and the like. But in deficit years, when the government's expenses outrun its income, the government will borrow new money to repay old debt. The result, if not stopped, is an ever-increasing cycle of debt, driven by the power of compound interest.
This is probably far enough for now. I realize that some of this can be hard to follow, and certainly some of it is even harder to believe. Why do the banks get to create all the money at zero cost, and then make money off the rest of us? What is so privileged about banks? And how can the cycle of compound interest ever stop? (The more money that is created and lent, the more additional money has to be found or earned to pay the accumulating interest.) We will begin looking into those issues starting with the next post in this series.