From "The Flaw"

Looking at a small piece of "The 'Mathematical Flaw'" from G. Thomas Woodward's "Money and the Fed" (see yesterday's post for the link):

A popular theory about the Fed and money creation in the United States is built around the notion of a "mathematical flaw" inherent in introducing money by means of "lending" as opposed to "spending." This theory starts with the observation that money in the United States (and most other countries) is placed into circulation through the purchase of interest-bearing debt.

To inject money into the economy, the Fed buys federal securities, thereby acquiring an asset that pays interest. In the second round of money creation, banks, S&Ls, and credit unions, through the fractional reserve banking system, earn interest on the loans they hold as a consequence of creating checking account money.

Given that we distinguish between the public and private sectors... When the federal government borrows, it takes sedentary money from the private sector. And when the federal government spends, it puts circulating money into the private sector.

The government desires to do this, enough to be willing to pay interest to do it.

I am trying to look at what happens, without passing judgment on it.

When the Federal Reserve wants to increase the quantity of money in circulation, it buys an asset from the private sector. The Fed gets the asset, and the private sector gets the money. Note, however, that the asset itself was sedentary. The person or business that owned it, didn't need that money for gas and groceries.

Maybe circumstances changed, and now the money is needed for gas and groceries. Or maybe not. Maybe the person selling the asset has decided to change the way he holds his savings. In other words, the new money created by the Fed may not go into circulation at all. It may go directly into some form of savings, some sedentary money. That would defeat the Fed's purpose.

But all that aside... When the federal government borrows, it takes sedentary money from the private sector and replaces it with federal securities. When the Federal Reserve increases the quantity of money, the Fed gets those federal securities. The Fed ends up holding these government securities.

So the interest paid by the federal government on those securities is paid to the Federal Reserve. The Fed uses about 5% of that income to meet its expenses. The rest of the Fed's income is turned over to the Treasury. That money goes back to the federal government.

There is a name for the cost associated with the creation of money: seigniorage.

The interest on U.S. government debt held by the Federal Reserve, is money paid from one part of government to another. Five percent of that money is seigniorage. The rest goes back into the U.S. Treasury. Therefore...

The "popular theory" of which Woodward writes, where there is "a 'mathematical flaw' inherent in introducing money by means of 'lending' as opposed to 'spending'"... There is much less to this theory than meets the eye.

Say the interest rate on government debt is six percent. Then the seigniorage, the cost of creating that money, is five percent of that six percent interest cost. That comes to 0.3%, less than one-third of a penny per dollar created. Less than meets the eye.

The same cannot be said, however, for the "second round of money creation, [where] banks, S&Ls, and credit unions, through the fractional reserve banking system, earn interest on the loans they hold as a consequence of creating checking account money."

This is why it is important to distinguish the public and private sectors, and why it is important to consider "sectoral balances."

And this is how monetary imbalance is corrected: by using the unique features of public sector finance to make adjustments to private-sector finance.

The growth of federal debt since 1974 has been an attempt to make the correction. It failed, because it failed to prevent the continuing increase of private debt.