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Where does money come from?
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Every day you hear about another $1 trillion dollars being "injected" into the financial markets here or $400 billion there. Where does all this cash come from? Does the government actually have an account with trillions of excess dollars sitting in it that they're writing checks against? No, they're printing it. There's nothing sinister about it. It's just the way our system works. Here's a simplified version of the process.
Americans want to trade goods and services. You've got a cow. I've got a calculator. You need a calculator but I don't need a cow. We need some third party, generic tool for exchanging value. Enter the dollar. The dollar is really a universal coupon which gets its value simply from the fact that people are willing to use it as such. It's worth exactly what you'll give me for it. Nothing more, nothing less. It's bolstered by the fact that the supply is tightly controlled and it's difficult to counterfeit. In theory, it represents an obligation of the U.S. government. But, an obligation to do what? If you take your dollar back to the treasury and say "I want to cash this in.", All you're going to get is another dollar.
Now, let's say there are zero dollars in circulation to start with. The U.S. Treasury instructs the U.S. Mint to create 100 dollars. Treasury provides these dollars to the Federal Reserve bank. Now the Federal Reserve Bank owes Treasury $100. The Fed loans the $100 to a commercial bank at 5% annual interest. But how can the commercial bank pay back $105 when there are only $100 in existence?
Here's where most people lose it. The Fed makes lots of loans every day. Banks loan the money to others at higher interest rates than they are paying. Of course, on day one, the obligations to repay the Fed are going to be higher than the total amount of dollars in circulation. One can make the balance sheets work with "cash equivalents" like stocks, bonds, other debt instruments, or Arby's coupons, if you can get someone to accept them as such. But, ultimately the only real cash equivalent is more cash. How do you get around this quandry? Simple: bankruptcy.
Not every plan to take some money and make it into more money is going to work. Companies and individuals are going to take their $100, buy raw materials, hire people, rent space and at some point discover that their business model didn't work. They file bankruptcy and go out of business. The bank does not get its money back. However, that cash didn't disappear. It's now in the hands of the suppliers, employees and landlords, who are under no obligation to pay back the debt on behalf of the failed business. Bankruptcy is an integral part of our system, not only because it allows risk takers to acknowledge failure and get on with their lives, but because it helps facilitate increases in currency supply throughout the economy by eliminating the obligation to send it back to the entity that produced it.
Our current turbulence is the consequence of too many bankruptcies and defaults at once, both personal and commercial. Although bank and investment firms balance sheets showed "cash equivalents" in the form of various debt obligations, the fact was, they were not really cash equivalents. They couldn't sell them to anyone for dollars and they needed dollars to fulfill their obligations to the Fed. Some banks had extra dollars on hand, but they weren't lending them to others because they feared they would not be paid back and would find themselves in the same boat.
This was a big problem. It's not that the Fed or the Treasury was in dire need of getting that money back. They can always print more. It's the system that was in trouble. If you suddenly start telling major banks, "Don't worry about it. Just pay me back whenever." or just forgive their debt, you remove the perceived consequences of not honoring dollar obligations and the whole system breaks down.
Plan A was to print a big pile ($700 billion) of money and give it to the banks in exchange for their most worthless "cash equivalents". That was those infamous mortgage backed securities. The government could just sit on those and either get some money back for them or not. It really didn't matter, so long as it all seemed legitimate. Later it was decided to ditch that plan and get money to the banks by purchasing stock in them. This has fewer perception problems because it looks more like you're exchanging dollars for something of real value. Now, the government has decided to do both; purchasing stock in commercial banks and buying mortgage backed securities from the now government controlled lending institutions, Fannie Mae and Freddie Mac.
In a healthy economy, bankruptcies and defaults still take place, but not at such a rate that people and institutions start hoarding cash and cash equivalents. These "transaction enabling coupons" flow relatively freely and the money supply grows at an orderly rate. People make money by getting involved in the flow and trying to keep a bit for themselves as it passes through. Now the flow has slowed considerably. When people and institutions do get hold of some cash, they are much more reluctant to put it back into circulation. The only way the government can see to rectify the situation is to greatly increase the amount of cash available and change the general perception that there isn't enough to go around.
This can be a positive development if the math works out properly. "Cash equivalents" had composed too much of the total money supply. When their value went down or disappeared, the total supply of money dropped precipitously. Now the difference has to be made up with actual dollars. Serious problems can arise if this is overdone. If the value of many of those "cash equivalents" comes back too far, too fast and the money supply starts to grow faster than the amount of goods and services being traded, the value of the dollar as compared to everything else will begin to drop. Prices go up. If people currently hoarding dollars perceive that they are rapidly losing value, they will stop hoarding and try to exchange them for something else as quickly as possible. That would exponentially increase the circulating money supply and increase the rate of price hikes (inflation). Inflation isn't caused by rising prices. Inflation is caused by an increase in the supply of money in excess of an increase in the supply of goods and services being traded. Rising prices are a consequence and symptom of inflation, not the cause.
Taking no action could lead to deflation. That is a rising value of the dollar as compared to everything else. Prices fall. This could lead to even more bankruptcies and defaults as people and businesses get negative returns on investment and are unable to repay the dollars they borrowed.
The markets will adjust regardless. However, an unstable currency leads to individuals and businesses facing painful consequences that have nothing to do with the merits of the products and services they create. If we're going to benefit from each others hard work, ambition and ingenuity, there has to be confidence in the monetary system that enables reward for said work, ambition and ingenuity. After all, if I put in a 40 hour work week at $12/hour and at the end of the week that $12 only buys half as much as it did at the beginning of the week, I'm not going to work very hard next week. On the other hand, if I pay you $480 to produce goods and services I hope to sell for $700 at the end of the week and it turns out I can only get $350, I'm going to tell you to just stay home next week.
The value of our currency doesn't need to be 100% immovable, it just has to be fairly predictable. It's the foundation of any business model. It's value is determined by us, every time we use it. To properly gauge it, we must know where it comes from and how it's being managed. To date the government has done a terrible job of communicating this information.
