Introduction to Money Creation by the Government

When people think of a government using money it doesn’t have, they often envision a scenario where the government borrows diamonds or silver. However, the reality is far more complex and fascinating. Governments do not actually use money they don’t have; instead, they create money out of thin air through the process of fiat money. This concept is both intriguing and pivotal in monetary policy.

Fiat Money: A Foundation of Modern Currency

Fiat money is the type of currency recognized and used by the public within a government-issued monetary system. Unlike commodity money, such as gold and silver, fiat money has no intrinsic value but is used as money because a government, or collective arrangement of governments, declares it to be legal tender. This definition helps to explain how governments can use money created by the government itself, such as through the Federal Reserve in the United States.

The U.S. Federal Reserve and Money Creation

The U.S. Federal Reserve, one of the most powerful institutions in the world, creates money primarily through a process called open market operations. These operations involve the Fed buying and selling government debt, often from entities like the U.S. government itself. When the Fed buys, it spends money that it creates out of thin air, or ex nihilo, which then enters the economy and becomes usable currency.

Debt as a Mechanism for Creating Money

Debt can be a mechanism for creating money, as the U.S. government borrows money from itself, which can then be used for various government expenditures. This borrowing does not directly create money; instead, it involves using currency that already exists or has been created through other means, such as bank lending. Banks can create money ex nihilo when they lend, leading to the impression that debt creation somehow generates money.

The Value of Fiat Money

According to the U.S. government, the value of the dollar has declined significantly since the Federal Reserve was established. Approximately 95% of the money that now exists in the U.S. was created by the government itself, not by individuals or businesses. This means that 19 out of 20 dollars in cash and bank accounts were created out of thin air by the U.S. government for use in the economy. This reduction in value can be attributed to various factors within monetary theory, though it’s important to note that the specifics are less crucial than the overall picture.

Traditional Money vs. Currency: What’s the Difference?

It is commonly misconceived that the only money governments can use is gold or silver, which must be physically held and managed. However, this is a narrow view. Governments can print and use currency in any quantity they need. This currency creation is not constrained by the physical possession of precious metals but rather by the government's ability to create and distribute it. The process is described as ex nihilo, meaning "from nothing."

Why Use Currency Instead of Gold?

Gold and silver, while valuable, have limitations for governmental use. Gold and silver are physical assets that can be difficult to manage and control in large amounts. Currency, on the other hand, is highly flexible, making it easier for governments to manage and control.

Government Borrowing and Deficit Spending

The second graph, only through 2017, shows that the U.S. government has been engaging in deficit spending for 19 years, with significant increases over the last 75 years. The chart depicts a growing disparity between government expenses and tax revenues, indicating a burgeoning debt.

Future Challenges of Deficit Spending

Borrowing money to fund government spending is a common practice but can lead to challenges in the future. The increasing levels of debt pose several issues, such as rising interest costs and the need for tax hikes and cost cuts. The longer the problem is avoided, the more difficult it becomes to address.

Addressing Future Financial Challenges

In the past, addressing financial deficits often involved cutting costs or increasing taxes. However, with the increasing levels of debt, the government now faces a high probability of having to do both in the near future. This dual approach is necessary to stabilize the financial situation, although it comes with short-term economic costs.

Conclusion

The process of money creation by the government, through the Federal Reserve, and its use in the economy is a powerful and often misunderstood aspect of finance and macroeconomics. Understanding how governments create and manage money can provide valuable insights into economic policies and financial practices. Whether you prefer money or currency, the ability to create it ex nihilo is a key factor in a government’s ability to function and manage its financial affairs effectively.