[Puffer Fish]

Most of you do not really understand how Central Bank notes work.
(For those of you reading this in the US, the Federal Reserve is the central bank there)

Basically in almost all developed countries now, the national currency is a central bank note.
So when you want to understand what that paper money really actually represents, you have to understand central bank notes.

I know some of you are going to want to just reply that paper money is intrinsically worthless, but if you leave such a response here, it will be obvious that you have not read and understand this opening post.

First, I want to apologize in advance that the information here will be presented in such a disorganized way. And second, it may take more than one post to convey the entire message here due to the word limit allowed in each post.

Basically, the federal reserve will only issue notes to member banks in exchange for some form of collateral.

Usually this collateral consists of mortgages and loans. So effectively, federal reserve notes are backed by bank mortgages on property that have not been completely paid off, and by the obligations of people who have borrowed money from the bank. But these poses a fundamental problem. How much is the property and obligations worth? Specifically, if the federal reserve decides to introduce more money, it will cause inflation, decreasing the value of these obligations (since the borrower typically must pay back a fixed dollar ammount). So the actual effect of introducing more money creates additional inflation, in addition to the obvious direct effect.

There have been assertions that the federal reserve can just print all the money it wants and buy up all the assets in the country.

Generally, the federal reserve is "holding" assets that have been used as bank collateral, and issuing notes back to the bank. Effectively then, federal reserve notes are IOU's on the assets. The banks can get back their assets by paying back the notes that were given to them in exchange. So the federal reserve is not buying up the assets only to sell them back for more money after they have caused inflation. Theoretically, the banks could give back all their notes to the bank and get back all the assets that the federal reserve is holding.

Treasury notes/bonds are actually issued by the US Treasury, not the Federal Reserve. The Treasury collects taxes, and is responsible for paying all the country's expenses. If the expenses are greater than taxes collected, the Treasury issues Treasury notes or bonds. This is basically borrowing money from wealthy people and private corporations, which must be paid back with interest. The Treasury will try to offer as small of an interest rate as it can get away with while still getting enough investors to loan it money.
There a legally-imposed (by Congress) debt ceiling. If this is not raised, the Treasury will eventually not be able to pay the countries expenses, because it would not be allowed to borrow any more money (issue more notes/bonds).
It should be noted that although the Treasury actually prints the notes, the notes are given to the Federal Reserve, and it is the Federal Reserve that basically tells the Treasury how much to print! The Federal Reserve orders new currency from the Bureau of Engraving and Printing (which is part of the Treasury. The Federal Reserve pays only for the printing costs the notes. The cost to print a single note was about 5.7 cents (in 2005), although the cost has probably risen to about 8-12 cents today. Essentially the Federal Reserve pays the Treasury 5.7 cents, and gets 100 dollars back! But remember, although the US Treasury is the one printing it, it is only doing so on behalf of the Federal Reserve, since the notes are technically Federal Reserve Notes, not money issued directly by the US government. The Federal Reserve has never been rigorously audited, and many of its activities are not completely transparent. To many people, the system sounds like a complete scam.

U.S. Constitution, Article I, Section 8, says that only the U.S. Congress has the ability "to coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures". However, Congress has apparently appointed the Federal Reserve with the responsibility to control the money supply, and make decissions about how much money to print, in accordance with the law (The Federal Reserve Act ch. 6, 38 Stat. 251). The Federal Reserve, however, is not actually a government institution, as it is privately owned by the member banks.

There does not exist any federal law which requires that private businesses must accept cash as a form of payment. Private businesses are free to develop their own policies on whether or not to accept cash unless there is a state law which says otherwise. However, taxes must be paid based on the market value of any form of exchange, and these taxes must be paid in legal tender. The Treasury does issue gold coins (American Eagle) which can be used as legal tender. This was only done relatively recently, in 1985, as the government had previously confiscated by law all the gold coins it had previously put into circulation.

So theoretically, it is possible to avoid inflation eating away at your savings by buying gold coins. However, the price (and actual value) of gold can greatly fluctuate, and the price of gold is very high at this time. Because of speculators, much of the present value of gold may likely be a bubble, and people who are now buying gold could lose much of their money.

In any case, you do basically need to somehow obtain federal reserve notes to buy gold. Theoretically, it is not legal to simply operate in a pure barter economy with other people. Any form of economic exchange is taxed, and you must somehow indirectly render your services to the government to obtain money with which to pay taxes. This was an early controversy in the United States. In the "Whiskey Rebellion", farmers on the western frontier used whiskey as a form of money to make exchanges. The government put a tax on the whiskey, and refused to accept the whiskey as a form of money used to pay the taxes, instead forcing the farmers to pay gold coin. The problem was that the farmers were isolated from the centers of government and gold was not very available to them. Essentially, the government was forcing them to somehow obtain gold as payment for taxes if they wished to barter.

By constitutional law the Bureau of Engraving and Printing is the only entity allowed to manufacture, print, or mint US Monies. The Federal Reserve System is the only entity authorized by the US Government to legally destroy currency deemed unfit for circulation. All currency destroyed must be reported to the US Treasury so new monies can be produced by the Bureau of Engraving and Printing to replace that which has been destroyed. The only means in which the Federal Reserve System can create money is by offering banking institutions additional credit on the reserves held by the Federal Reserve System to those financial institutions in need of additional assistance. These "loans" must be approved by the US Treasury, which theoretically gives the Treasury absolute power over monetary policy, as the Federal Reserve System is required tp operates within guidelines set forth by the US Treasury.

But effectively, much like the Supreme Court, the Treasury is reluctant to exercise its technical power beyond its basic legally mandated responsibilities, so effectively the Federal Reserve is left with a very broad influence over the money supply. It would also be very easy for the Federal Reserve to "fudge" the numbers to get the Treasury to give it almost however much money it wants.

There seems to be several fundamental flaw in the system. Basically, the president is invested with too much power to appoint the governors (this is also true of the supreme court).
And the governors are essentially given free reign over the economy, the Treasury has a very "hands-off" approach and basically goes along with whatever the Federal Reserve wants.

[Puffer Fish]

The question naturally arrises, since federal reserve notes are secured with mortgages and loans, what causes inflation?

This is a complex and controversial subject, but I will try to keep the answer as simple as possible, avoiding potential causes of short-term inflation.

First, one needs to realise that "money" does not only exist in the form of paper federal reserve notes. When someone borrows money from the bank, the bank acts as if the loan obligation it owns is real money, even though it does not actually have the paper notes. This money can then be "loaned" out again, a second time, in the form of recorded money. The people taking out the loans rarely ever actually withdraw paper notes. The recorded money, which does not really exist in a physical form, just moves around to different bank accounts. Some people have difficulty believing that banks actually can get away with this! This is called fractional banking.

As an example, Anders puts 5000USD of paper notes into the bank. The bank then loans out the paper notes to Karl. Anders then decides to buy a car from a used car saleswoman named Gunilla. He writes her a cheque for 5000USD. Gunilla brings the cheque to the bank and the bank then tells her that the 500 dollars have been "deposited" into her account. So Anders gets the car. Meanwhile, Karl takes his 5000 dollars and buys a second car from Gunilla.
Gunilla immediately deposits her money into her bank account, which happens to be at the same bank. Anders and Karl drive off in their used cars. Gunilla has 10,000 USD in her bank account, or so she believes. In fact, the bank only has 5000 USD in paper notes! The next day, Gunilla withdraws 200 USD. The bank gives her the money. So it appears to Gunilla that she can withdraw her money any time she wants to. Of course, Karl owes the bank money. Essentially 5000 of the dollars in Gunilla's account is actually in the form of the money that Karl owes to the bank. But it is very unlikely that Gunilla will ever withdraw out all her money at the same time.

When you put money into a bank, it should be remembered that the bank is not just a giant safe to store your money in. It is an investment. The bank uses your money to make loans. The people who have invested money in the bank can pull their money out any time they wish, provided of course that they all do not pull out too much of their money out all at once. Sometime this does actually happen, which can result in insolvency. When this happens, basically government regulators actually enter into the bank branches, with little warning, and basically take over. The bank employees are required to take orders from a government manager, and the bank then pays out money from a federally-run insurance program, which the banks are required by law to pay fees towards.

In the USA, the Federal Reserve has been appropriated the power, by law, to require all banks to deposit a certain percentage of paper federal reserve notes into the Federal Reserve Bank for every dollar that exists in their bank accounts. This effectively limits how much money banks can "create".
However, even this limit does not apply to certain types of other financial institutions or smaller banks. Essentially banks with less than $10.7 million in their accounts do not have any reserve requirement, while those with less than $58.8 million only need to have a liquidity ratio of 3%. Since 1990, savings banks holding the accounts from other financial institutions has not been subject to any reserve requirements.

As of 2008, there was only about 853.2 billion US federal reserve notes and US coins in circulation, about 60% of it being held abroad, and it is thought that a significant portion of it being held in huge money hoards by criminals.
However, it is thought that there exists about 8.4 trillion US dollars of "money", due in large part to fractional reserve banking. The US debt, by comparison, is 14 trillion dollars! This debt is in the form of treasury bills and bonds, which in many ways act like another form of money. The more debt the United States gets into, the more loan obligations will be floating around, and this will cause inflation. By the very act of promising to pay paper money in the future, the government is effectively "creating" money now. Of course, people do not typically go around buying things with treasury notes, but if there are mone treasury notes for people to hold, the wealthy investors tend to hold onto less money in bank accounts.
And banks can also hold treasury note/bonds instead of federal reserve notes to fulfill their reserve requirements.

Obviously there is the question "How is the government ever going to pay off its debts?".

Remember, the Federal Reserve "supposedly" is not supposed to print more money unless it holds more collateral. And there is obviously more US debt than there are federal reserve notes. The IRS (part of the US Treasury) collected $1.061 Trillion in taxes in 2010.

The Federal Reserve system is also the only agency that is not financed by direct taxation; it actually orders the treasury to print a little extra money for the specific purpose of paying its own expenses! Every other government agency is funded by the taxes which the Treasury collects. Even the Treasury itself does not print its own money to pay for its own expenses!
Many of you may likely be a little outraged by this, but that is how things work. Richard Branson commented that in the 1980's the commercial property industry in Texas hit hard times. There were plenty of vacant large office buildings, and the rents fell to bargain levels. Despite this, the Federal Reserve ordered the construction of a new 200 million dollar marble-coated branch office in Dallas.

The Federal Reserve is not audited by the Internal Revenue Service, or by the Securities and Exchange Commission, but rather by a private "independant" auditer, Deloitte and Touche LLP. Let's hope they have more integrity than the Arthur Andersen accounting firm, which let Enron get away with massive fraud. Oh wait! Deloitte and Touche were also the auditors for Bear Sterns, which was at the heart of the whole mortgage backed security scandal before the firm collapsed! http://www.finalternatives.com/node/4043

Bear Stearns stock was artificially collapsed so that illegal insider traders would make billions and J.P. Morgan would be paid $55 billion of US tax payer money to shore up themselves and buy Bear Stearns at bankruptcy prices. http://www.optionsforemployees.com/arti ... php?id=130

It is the government (IRS) which audits individual taxpayers, and the government (SEC) which audits publicly traded corporations. Why is the government not the one auditing the Federal Reserve Bank?

As of 2010, the audit showed that the combined Federal Reserve banks hold 2.4 trillion dollars in assets. About 1 trillion of that is in the form of Treasury bonds. Another 1 trillion is in the form of government-backed mortgage securities (mostly issued by Fannie Mae and Freddie Mac). 968 billion dollars of the above assets are being held by the Federal Reserve from other banks as a reserve requirement.

There are supposedly 941 billion dollars worth of federal reserve notes (regular dollar bills).

The Fed is supposed to have collateral to back up all its federal reserve notes. But the Fed is using Treasury bonds as collateral. It has 1 trillion dollars worth of treasury bonds in fact.

Here is the problem. The United States government is paying private investors to borrow the money it is printing. Since the collateral being held for this money is just an obligation from the government, it is not even as if the government is actually borrowing anything of physical value. The government could save billions of dollars if it just printed its own money and stopped paying interest to the Fed to use money.

The Treasury is printing money for the Fed, the Fed only has to pay the cost of printing, which is 12 cents for a 100 dollar bill. Because the government spends more than it collects in taxes, the Treasury needs to borrow some of that money. The Treasury gives the Fed treasury bonds, which are basically IOU's.
The Fed does not need to hold any other collateral to order the printing of that money, since the Treasury bonds themselves can be used as collateral.
Basically, to summarise, the Fed gives the US government 12 cents. The US government prints 100 dollars for itself to spend. But the US government also has to give the Fed a 100 dollar IOU, because since the money is actually a "federal reserve note", it has to be "borrowed" from the Fed. When the US government finally gets around to collecting the taxes to pay for all its irresponsible spending, it will have to pay back the IOU, with interest, to the Fed. Remember, the Fed is privately owned. The interest payments are profits that will be paid out as dividends to the stock owners of banks affiliated with the Federal Reserve. The Federal Reserve had 81.7 billion dollars in profits in 2011. And that is if we are to believe the audit done by Deloitte & Touche, the same private corporation that let Bear Sterns (which was at the heart of the mortgage crisis) get away with fraud before it finally collapsed.*
Meanwhile, the 100 dollar bill given to the Fed must either be immediately lent out, or destroyed, because the Fed is not supposed to have, or have issued out, more money than the value of assets in holds in collateral. So the Fed uses the money to buy mortgages. The mortgages themselves are loan obligations, which are considered collateral assets.

Theoretically, Federal Reserve notes are supposed to be a liability for the Federal Reserve. This means that federal reserve notes are, at least by definition, an IOU from the Fed for the assets it holds as collateral. The problem is that the Fed is collecting interest on this money. Imagine if you went to the bank to borrow money and they paid you the interest to borrow the money, instead of the other way around! Yet this is exactly what the Fed does.

*since 1978, when congress passed the Federal Banking Agency Audit Act, the Fed has also been audited by the Government Accounting Office.

[Puffer Fish]

The Fed can increase the money supply simply by buying treasury bonds!
All the Fed has to do is spend some of its money to buy treasury bonds from the Treasury. Then it uses those bonds as "collateral assets" to order the printing of more money from the Treasury. So basically, the Treasury gives the Fed their original money back! (minus miniscule printing costs)

About 1 Trillion of those "assets" held by the Federal Reserve are actually Treasury bonds.

One real potential for corruption is the interest that the "Federal Reserve Bank" in America pays out to manipulate the market interest rates. When it wants to increase the interest rate, all that money goes to wealthy investors with much money in their bank accounts. When the Reserve Bank "attempts" to decrease the interest rate, it has to borrow the money from somewhere else, to just relend it out again at a lower interest rate, again loosing money. The problem is where the Reserve bank gets the money to do this. Essentially from the interest the USA government is paying them to borrow money that the USA Treasury itself printed (since American dollars are just notes from the privately-owned Reserve Bank, not directly backed by the USA government). the Reserve Bank also gets plenty of money by expanding the money supply while overvaluing its collateral assets. In other words, it is ordering the printing of more money from the USA Treasury than it is actually using to buy the additional collateral assets. The Federal Reserve Bank's buying of bad residential mortgages was one example of this.

"Since 2007, the Federal Reserve has expanded its balance sheet by $1.2 trillion and taken on substantial credit, interest-rate and foreign exchange risk. It has... guaranteed substantial liabilities of Citigroup... big banks... have a substantially lower cost of capital through an implicit government backstop... This lower cost of capital - at government expense... "
from USA congress members Alan Grayson and Ron Paul to the Senate Committee on Banking


More money could be printed without inflation if the central banks issuing the notes backed it with sufficient reserve assets. But this is not what is happening.

It is just like a publically traded company issuing a new round of corporate stock below the market price. It would dilute the value of the original stock.

Whatever the current interest rates are in the open market, the Federal Reserve is obliged to pay a 4% return on the reserve deposits of all its member banks. If open market interest rates are higher than this, the member banks will lose out on a portion of the interest they could be making. But if open market interest rates are lower, the member banks can earn extraordinary profits on their reserve deposits. The idea is that this is all supposed to even out, and that the rate of return over many years would average about 4 percent. But one could suppose there is a potential for abuse.

What is interesting right now is that the Federal Reserve has been intentionally and artificially holding market interest rates down towards 1%. It takes money to "hold interest rates down". The Federal Reserve has to print money to loan out at whatever reduced interest rate it is targeting, taking a loss. This loss results in a devaluation of all the other Federal Reserve notes. In other words, the cost of keeping down interest rates is inflation.

And what about the member banks? They can borrow money from investors at a 1% interest rate, then take that money and get a 4% interest rate from the Federal Reserve, making a guaranteed 3% profit. So naturally they have an incentive to put more of their money than usual into their reserve deposits with the Federal Reserve (they can play around with their reporting numbers). When residential and commercial real estate investments are doing awful, a guaranteed 3% profit from the Federal Reserve is much more desirable.

The Federal Reserve is lending out money at a 1% interest rate. In order to do this, they had to print more money.
The member banks are borrowing this money, and then plowing it back into the Federal Reserve as their reserve requirements to get a 4% interest rate.

You do not see the problem? The banks are making 3% interest on as much money as they can borrow and relend back to the Federal Reserve.

(I would not be too immediately concerned about this, however. I've taken a look at the numbers and done the calculations, and the actual profit that banks are deriving from this is pretty miniscule and insignificant compared to the money overall. A potential cause for concern, but no one really unfairly advantageously benefiting from this right now)

So what exactly is backing this new money? The Federal Reserve is using the loans from the banks it lends to as the reserve assets to back the new money. And the banks can use their reserve deposits held at the Federal Reserve to back the accounts. So essentially, the new money being printed by the Federal Reserve is just backed by itself! So where is all that interest coming from?

If the Federal Reserve is obliged by law to back all of the new money it prints with new reserve assets, how are they managing to give the banks free money?

Take a look at the solvency of the U.S. Treasury. Half of the dollar is Treasury bonds. Do your really think all that government debt is sustainable?

Do realize that to some extent the Fed funds rate is influenced by the going market rates?
The Fed doesn't just arbitrarily set their rates to whatever they want. The Fed's Board of Governors is well aware that trying to set a target rate that deviates too much from the market rate for too long will eventually result in "inflationary pressure".

Right now the national debt stands at nearly 20 times the amount of currency in issue, so the Fed would not be able to buy up all the government debt.
Well, hypothetically it could, but then we would have a 2000% inflation!

[Puffer Fish]

Let's not forget that this money (or wealth, to be more exact, because that's what it represents) has to come from somewhere. The government can't spend money without taking it from somewhere else.

Even the Central Bank (i.e. the Federal Reserve in the U.S.) can't create wealth out of nothing. They can "expand" the money supply as much as they want, but that does not change the total worth of all the money they have put into circulation. In fact, even the a change in the tax rate would be unlikely to change the value of money, so long as the government spent the same amount they received in tax revenue.

What the Central Bank can do, and is doing, is to make the money worth less and less by subsidizing low interest rates for government debt. If it wasn't for the Fed, the immense levels of government debt would be driving interest rates up in the economy. Let me be clear, this isn't just diluting the value of the dollar by adding more dollars into the economy; rather it's creating inflation without adding more dollars (amount of dollars remains the same, but they're all worth less). Because when the Fed buys up government debt at inflated prices (which is really what it is, since the interest rates on that Treasury debt are so low) it debases the Reserve Assets on their balance sheet - the reserve assets that back all U.S. dollars.

Sorry, let me be more specific here. Expanding the money supply and putting more dollars into circulation does not necessarily cause any inflation, if the Central Bank actually managed their portfolio like a normal investor (which they don't do). Who cares if there's more dollars in circulation? There's also more assets on their balance sheet. It balances out, and that's theoretically how it's supposed to work. But when the Central Bank subsidizes government debt, and by doing so is effectively giving them free money, that is what is going to cause inflation. The increase in money they have issued is not fully matched by a corresponding increase in the real value of the assets on their balance sheet. When the Central Bank says their assets are worth more than they are, that is exactly what they become worth. And then all the money becomes worth less.

There is an intrinsic market cost to lending the government money. The Central Bank can't just temporarily expand the money supply to give someone an interest free loan and contract back the money supply to what it was before. If the central bank buys an asset out of the market, they have to account for the interest that asset would have generated. What I mean is that if they just print more money to buy something and then sell it back a few years later, that act is going to inflict a lingering cost of inflation onto the economy, even though the money in circulation at the end of this scheme is exactly the same as it was before. There's no way for the Fed to take "free money" out of the economy.

Yes, can all be very complicated and difficult for ordinary people in the public to grasp. And unfortunately there is a lot of money at stake and the people in control may be taking advantage of the people and politicians who are not able to understand what's going on.

[Puffer Fish]

Many people think that paper currency is intrinsically worthless, but here's what they don't understand:
Currency derives it's value, in large part, from taxation.

Here is a very simplistic example that may help you understand:

There are 1000 houses.
There is an annual tax of 1% on the market value of each house.
There are 1000 units of currency in circulation.

That essentially means that each house owner has to give up 1/100th of his house every year.
Altogether, all the homeowners have to essentially give up 10 houses every year (or rather the equivalent of 10 houses in currency).
Since people only need the currency to pay the tax, the entire amount of currency in circulation is only worth 10 houses.
This means that 1 unit of currency is worth 1/100th of a house, and that the market price for 1 house will become 100 units of currency.

The currency becomes worth something because people need it to pay taxes.

Without taxation, and without any type of backing, the dollar would be a pure fiat currency, kind of like those giant stone wheels found on the island of Yap. Primitive tribes also used strings of seashells as money.

"Money" is backed by debt, but that debt is still denominated in Federal Reserve notes.
Over the long-term the "money supply" can just adjust to whatever the currency is worth, so the Fed does have direct control over what the inflation will be.
Long-term non-adjustable debt throws a debacle into that idea though, can make things more complicated.

Still, what many economists apparently fail to realize is that inflation is not simply determined by the quantity of money in circulation, but by what is backing it. As long as the backing increases in proportion to the increase in money supply, theoretically there will be no inflation. (although for large changes it is not entirely a linear relationship, but that would mostly only apply in the case of hyperinflation)

The "money supply" becomes pretty much irrelevant if the underlying currency changes in value.
The one exception is in the case of a bubble where the market thinks there is more backing the "money" than there actually is. In that case it's not even "real" inflation but "apparent" inflation (or rather price inflation due to market irrationality).

It should also be mentioned that U.S. currency also gets its worth from the Reverse assets on the Federal Reserve Bank's balance sheet, but I did not want this to get too complicated. Basically these Reserve assets are intended to provide backing for the dollar (albeit in an indirect sort of way), but now we basically have an absurd situation where most of these "assets" are just government obligations to pay more dollars. Assets backed by debt backed by those same assets, kind of circular. But again, this is just another form in which taxation makes the dollar worth something!

Let me try to lay it all out for you:

Physical house backs bank mortgage.

U.S. dollar is Federal Reserve Bank note. Federal Reserve Bank note backed by Reserve assets. Reserve assets on the Fed's balance sheet at this time are about half residential mortgages and half U.S. Treasury bonds.

U.S. Treasury bonds are government debt.
Future obligation to pay dollars back government debt. Future obligation to pay dollars backed by future taxation and value of individual unit dollar.
Individual unit dollar backed by Reserve assets divided by the number of dollars in circulation (Federal Reserve Bank notes outstanding).

"Money" backed by bank promise to pay dollars.
Bank promise to pay dollars backed by bank mortgage and value of individual unit dollar.

So what do we see? Basically the entire money supply is essentially backed by physical property and taxation.

It's a little more complicated than just this of course, but I believe this pretty much sums up the system.