An Endless Money Supply

I've been wondering lately: can the Fed print or electrically create money and then spend it, or give it away to somebody else for personal or government spending? My answer to that from reviewing Fed policy and open market actions is that it cannot. The only way for the Fed to let loose newly-created currency would be to lend it out. It can lend it directly through the discount window to banks, with Treasury Bonds as collateral, or it can buy bonds directly, and then either sell them or hold them until the bond matures. In any case, releasing newly created money acts as a loan. No money can be released from the Fed without an expectation it will be paid back. Money dispersed in this way will sooner or later make its way back to the vaults of the Fed.

Now there is a way to game the system: if the Fed knowingly buys a junk bond that is obviously going to be defaulted on, without recourse, then newly minted money has been let loose in the system and is there to stay. Otherwise, all other money minted and lent by the Fed eventually disappears when it is paid back. The only way to achieve a stable money supply is where debt issuance equals the rate it is paid back.

The essence of our money supply is the willingness of people to take on debt. We know this is the case with fractional reserve banking, where loans in this way account for the creation of most of America's money supply. But it looks like a similar principle applies to base money as well. All dollars originate from loans. Whatever the total money supply is, that entire amount is owed back to the banks. If people, corporations, and governments were to stop borrowing, money supply eventually would dwindle to nothing as loans are paid off.

Maintaining a stable money supply depends on regulating the flow of credit. Inflation can be contained if the Fed increases the prime lending rate. Higher borrowing costs would discourage new loans. In a deflationary environment, to maintain stable prices, interest rates can be lowered and borrowing encouraged. We have seen a lot of that lately. But in a society mostly exhausted of credit, lending cannot be forced.

If people cannot take on as much credit as before, then there is no way to expand the money supply. Without a fundamental change in Fed policy enacted by Congress, deflation is the only legal option in America. There is no way now for the Fed to hyperinflate the economy (unless the exception I mentioned in the second paragraph becomes rampant).

We see this already in a recent expansion of base money starting in September of 2008. This base money expansion has been matched exactly by money sitting in bank reserves. The new money isn't being lent—it isn't finding any outlet into the general economy, and it is not creating inflation.

The point here is that the Fed is sitting on a virtual money supply that is infinite. From a supply perspective, the Fed cannot expand money beyond what it already is, because that amount is unlimited. What contains money supply from skyrocketing to infinity is demand for credit. If prices destabilize through expansions or contractions of credit, the Fed can attempt to maintain price stability by regulating interest rates or purchasing bonds. Unlike a gold standard where money is limited by the quantity of gold, our economy has no fixed limit for credit and is constrained only by peoples willingness to borrow from banks, and banks willingness to lend.