In Matt’s Ron Paul Endorsement, he subtly mentioned that we are printing money. After a conversation with one of my non-finance friends, it occurred to me that most people don’t realize that we keep printing money.  This friend said that he hadn’t heard about us printing money–surely that would have made the news.

In his Tough Times A’ Coming post, Matt pointed out that the Congressional Budget Office says our federal budget is unsustainable.  I think this is a real recipe for disaster, most people don’t understand how we “print” money and we are in terrible shape with our budget.   So, I decided that I should write a post on how the US government prints money and causes inflation.

Lets start with a little background.  I want to cover the various types of monies, the tools the Federal Reserve has available and how they might be employed and finally the impact that this has on our economy as a whole.

First the various money supplies:

M1:  Real currency (greenbacks you have), travelers checks & checking accounts.
M2: The M1 + savings account and small (under 100k) CD’s
M3: The M2 + large (over 100K) CD’s, balances in institutional money funds, money in foreign banks etc…

Most of us have M1 & M2 money but not M3 money.  M3 is the money the large institutional investors have. But back in 1995, the Federal Reserve (fed) decided it was too expensive to track the M3. This bugged me at the time and still bugs me because it’s a good measure of inflation and tells us what the fed is doing with money.  We can no longer know what the big boys (our government included) are doing with the money.

The fed through it’s various tools controls the supply of money and therefore the interest rates and has a very large impact on the economy.

The fed has three main tools at it’s disposal to do this:

1. Change the reserve requirement
2. Change the discount rate
3. Open market transactions

Changing the reserve requirement is pretty basic, by changing how much money a bank is required to have on hand to cover deposits credit policy can be loosened or tightened.  Think of it like a secured loan, you want to borrow $100 you have to have $10 on hand.  Now, if I changed the requirement to $5 you can borrow twice as much money without any more cash on hand.

Changing the discount rate makes it cheaper for banks to borrow money from the federal reserve.  Think about the explanation of changing the reserve rate above.  if you want to borrow $100 you need to have $10 on hand.  What if you have only $5 on hand? You can either raise more capital or borrow it.  The discount rate is the interest rate the fed would charge to loan you the money.  This does not occur much anymore (too much paperwork).

Lastly there are open market transactions.  The Fed can sell or buy treasuries in the open market with their own money. If the Fed wants to take some money out of circulation it will sell treasuries, if the Fed wants to inject currency into the market it will buy treasuries injecting money into the system.

This open market process creates defines the Fed funds rate. When the Fed says they want to lower rates by a quarter point, the Fed funds rate is usually the rate quoted.  It’s really a target rate, the Fed can target 4.5% but other market trades also impact this rate.  So every day the Fed must buy and sell treasuries in order to keep the rate near the target.

When the Fed says they need to lower rates, the Federal Open Market Committee (FOMC) buys treasuries.  By buying treasuries the Fed injects money into bank reserves, increasing the supply of money. This turns into a simple supply & demand example, more money (supply) means borrowing money (demand) gets cheaper (supply/demand intersect).

When the Fed says they need to raise rates, the Federal Open Market Committee (FOMC) sells bonds.  Buy selling treasuries, the Fed takes money out of banks, decreasing the supply of money.  This is the opposite of the above explanation, less money means borrowing money gets more expensive.

Now that we have gone through the basic explanations, let me ask you a question.  When the Fed wants to buy treasuries, where does the money come from?

This is a pretty simple question to answer.  Either the Fed has the money on hand or it has to print the money.  So lets take a look at some data.  Think back to my explanation of M1, M2, M3 money.

Looking at the data provided by the Fed, we can break up the various money components into pieces for analysis. M1 is the amount of money normal people have, checking accounts, travelers checks etc..  If we take M2 and subtract M1 we get the amount of money in small CD’s and savings accounts. If we subtract M2 from M3 we get the amount of institutional or large investor money.

Looking at this, its pretty clear that more money has been added to the system over time. In order for all three lines to increase, money must be added.  Otherwise one money type would have to go down in order for another line to go up.

Some astute people might point out that M2 could be earning a higher return than M1 and M3 could be earning a higher return than M2, therefore, this just represents growth over time.  Okay, that’s possible however, where do investment earnings come from?  Supply & demand again, if I buy a stock and someone buys it, they have to have money.  In order for that to occur the buyer had to get money from somewhere.  So, where did the money come from?

If the fed did not create more money m1+m2+m3 would have to be a constant number.  Someone had to create more money.  Since we went to the federal reserve system only one entity can create money and that’s the fed.

If you do a little analysis on this data, you will find that M1 grew by 990%, M2 grew by 3645% and M3 grew by…. 160923%.  Annualize it and you get M1 4.98%, M2 7.92%, M3 16.95%.   By way of comparison, the stock market grew at an annualized rate of about 12%.

Remember back at the beginning of this I said that the fed decided to no longer publish M3.  Where do you think the fed keeps their money?  Well, it used to show up in M3, now that M3 is no longer published you kind of have to infer its movement from other data available.  But where?

Well, oddly enough it’s not that difficult. Running over to our data series again lets take a look at some of the data.

It turns out that the CPI can be used as a pretty good predictor of M3.   The CPI and money supplies move together most of the time.  You can see the general direction of the trend going on here.

Now, this is leading me to another question, does the CPI drive the money supply? or does the money supply drive the CPI? Clearly, the two are highly related. The r² of M3 (including M2 & M1) is at 90%.

Statistical correlation is an interesting thing, it can show that the two items are related but it cannot determine a cause/effect relationship.  However, if I go back to my Econ 101 class and think about the supply / demand curve again.  Increasing the supply of currency should drive down the price (value) of the currency.  If currency is the medium of exchange for goods, then the cost of goods will logically increase.

This is what is driving our economy down.  The fed by injecting so much money over time created low interest rates allowing lenders to make poor loans.  It also devalued our currency over the long run and has made everything more expensive (inflation) for you and I.