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HOW DO CENTRAL BANKS DO IT – CONT’D

The creation of money out of thin air

This is a fairly common expression that many people use, but we doubt that they fully understand its meaning. It is a metaphor. What we mean when se say create out of thin air, is that right now, there may not be any money in a Central Bank’s account and a few computer key strokes later there is.

Literally, Central Banks create money out of nothing just because they define what money is.

Literally, what Central Banks do is to:

Create money by bringing it into existence by an arbitrary decree, sanction, order or pronouncement.

In other words, they create money just because they said that they created money. This is something so simple that it is actually difficult to explain. The way Central Banks operate is to define that they have a certain amount of money and therefore they have it.

It is the purest definition of fiat money you can ever come across.

But what is then this kind of fiat money? It is simply an IOU redeemable against the reserves held in the Central Bank. And if you take one of these IOUs to the Central Bank and demand redemption? They will gladly pay you in… money… which are IOUs!!!

In other words, fiat money are IOU’s which are redeemable in the very same IOUs. Because of this fact, in the end whether or not a Central Bank actually has any assets is irrelevant, since they can print all the IOUs they will ever need, to redeem all the IOU’s that have printed before!

Furthermore, this process means that no matter how many loans or debts a Central Bank incurs, they can simply print money and pay them all! Central Banks cannot, by definition, get into bankruptcy.

Plain old printing

You can’t beat an old classic. Printing money is the old fashion way, tested and true. Central Banks do print (and mint) currency. However, the amount of such currency is negligible in relation to the amount the manufacture digitally. Still, worth a look.

Central Banks run presses and minting machines. Once this new currency is available, it is mostly used to replace old and worn out bills and coins as well as to cover cash demands from the public from private banks. When there is demand for cash, private banks go to the Central Bank to exchange their digital cash (which they hold in digital accounts at Central Banks) for paper and coin cash.

In very rare occasions Central Banks may actually spend paper and cash money themselves, but this does not happen very often. Usually, there is an underlying political or public relations excuse to do so, such as printing or minting collectibles or to celebrate the anniversary of some national hero or patriot. In general terms, Central Banks tend not to create money by actually printing money.

They prefer not to use this method for three reasons. The first is that minting and printing is expensive. Why go to all the trouble if they can just as easily push a few buttons in a computer and get the same result. The second is that printing physical money out of thin air in the vast amounts that they need, would be a clear giveaway that something is very wrong indeed. They need to maintain the illusion. The third reason is that printing and minting money means that they cannot control the money multiplication process with ease (more of this topic in the next sections).

Plain old printing and direct spending

There is always an exception. When hyperinflation has hit a country, in a few occasions Central Banks were forced to print and loan or gift that paper money directly to the government to be spent.

In this mode of operation, governments have accounts at the Central Bank, for example, from the Treasury. When the Central Bank creates let’s say one million RUB, it deposits this money directly into the Treasury’s account at the Central Bank. The Treasury then proceeds to spend this money.

Alternatively, the Treasury may issue bonds and the Central Bank purchases those bonds directly from the Treasury (using freshly printed money) and deposits the proceeds in the Treasury’s account at the Central Bank.

This phenomenon does not happen very often, but it is known to occur. When this happens, it is usually accompanied by printing paper money with massive amounts of zeros. The classic modern example is Zimbabwe that went from bills of 1 Zimbabwe dollar to bills of 100.000.000.000.000 Zimbabwe dollars! You can see their pictures in our lesson Alpha And Omega.

Digital printing and direct spending

As we explained above, Central Banks have the power to create money at will. They prefer to do this electronically almost always. However, the direct utilization of this power is not exercised too often. What do we mean by direct? It means that the created money is used directly by the government exactly in the same manner as in the methods described immediately above. The only difference is that this time the money is fully digital (i.e. virtual).

This type of printing is typically done in Latin American countries to finance large deficit spending.

Digital printing

When people talk about printing money, they are referring to new money created out of nothing. However, the technical way in which it is created is usually collaboration between Central Banks and Private Banks.

A typical transaction is a two-step affair as in the following example.

Step #1:

  1. The Treasury of the government sells a bond (IOU) to the public for 10 million Pesos.
  2. The Central Bank writes a check from its own account in the Central Bank for 10 million Pesos (the Central Bank just created this money out of thin air).
  3. The Central Bank uses this check to buy the bond from a bond owner.
  4. The bond owner deposits the check in their Private Bank.
  5. The Private Bank deposits the check in their account at the Central Bank.

Note: at this point, the Central Bank created “only” 10 million new Pesos.

Step #2:

  1. The Private Bank considers these 10 million new Pesos as “excess” reserves and loans them out.
  2. The borrower, takes those 10 million new Pesos and buys goods and services. The money ends up in Bank B who must keep 10% as a reserve and lends 9 million Pesos to another customer.
  3. This customer spends those 9 million Pesos and the money ends up in Bank C who must keep 10% as reserve and lends 8.1 million Pesos.
  4. This cycle continues until the last Bank receives insufficient money to make further loans

Note: at this point the Central Bank created 10 million new Pesos but the chain of banks starting with the Private Bank created another 90. Final result? The total amount of Pesos in the economy increased by 100 million.

Note: please see the Glossary if you are unfamiliar with certain words.

 Continue to Central Banks - engines of the evil empire - Part 4

 

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