Better ETH pt3: The Gang discovers Money creation in the modern economy

The Gang discovers Money creation in the modern economy

Notice of Content and Non-Financial Advice

If you are unfamiliar with how money, or more specifically credit creation actually happens, take the time to read Astley, M and Haldane, A (1995), ‘Money as an indicator’, Bank of England Working Paper No. 35

OK, you could also watch this: MOOC | Lec 5: The Central Bank as a Clearinghouse | Part 2: One Big Bank - YouTube


This is a discussion on how money is created in the modern economy. Most of the money in circulation is created, not by the printing presses of a central bank, rather by the Commercial banks themselves: banks create money whenever they lend to someone in the economy or buy an asset from consumers. And in contrast to descriptions found in some textbooks, the Federal Reserve, Bank of England or any other central bank does not directly control the quantity of either base or broad money.

Credit is Money

To begin with, a pair of definitions: Credit is the promise to pay money, i.e., debt. Money is that contrivance which discharges debt.

Money is a very long story. From the founding of the Republic until 1971, gold and/or silver were money. Value was intrinsic in them. A dollar was defined as a certain number of grains of fine gold–25.8 grains under the Gold Standard Act of 1900. Paper dollars were exchangeable into gold and derived their value from gold.

The Federal Reserve Note

The age of paper money dawned in 1971. To the post-1971 dollar, value is imparted, not intrinsic. It is imparted by the words that the Bureau of Engraving and Printing stamps on the face of each unit of green currency: “This note is legal tender for all debts, public and private.”

The thoughtful reader pauses at the word “note.” A note is a credit instrument, a promise to pay. Yet, under law, Federal Reserve notes are money. What is the nature of this promise? The truth is that it is no promise at all, but an artifact from the era of convertibility. Until 1933, $20.67 could be converted into, or redeemed for, one ounce of gold. The dollar was said to be anchored by gold. As there was only so much metal, there could only be so many dollars. The late John Exter, banker and monetary thinker, acidly described the modern-day Federal Reserve note as an “IOU nothing.”

All of which is preface to the promised translation. We begin at the top of the left-hand column of figures describing the balance sheet of America’s central bank.

The Federal Reserve is a bank: it is highly leveraged and government-dominated, but, still, a bank–and it produces a weekly balance sheet.

Federal Reserve Credit and Liquidity Programs and the Balance Sheet

The Fed, unlike an ordinary bank, is constrained neither by its capital nor by deposits. Leveraged more than 50:1, it acquires Treasury securities and federally insured mortgage-backed securities with newly created dollars. Literally, the Fed materializes those dollars, which constitute most of its liabilities; Treasurys and mortgage-backed securities make up the bulk of its assets. Highlights from the Federal Reserve’s balance sheet are shown on the upper left-hand corner of page 6.

Foreign central banks, too, get into the money-materializing act. Taken together, these institutions own even more U.S. government securities and MBS than the Fed itself. Some $3.3 trillion of this foreign-owned hoard sits in custody at the Federal Reserve Bank of New York.

Devotees of the quantity school of money would have expected a rather bigger bang for the trillions of post-2008 bucks than the effects documented in these pages. But though the central banks may propose, they do not dispose. At the close of 2012, more than $1.4 trillion in idle reserve balances lay fallow on the Fed’s balance sheet. Banks could, if they chose, mobilize those dollars in the work of creating new credit. But, in the wake of the crisis, would-be borrowers are not so keen to run up their debts, and bankers, beset by new rules and capital requirements, are not so eager to lend.[1]

Gresham’s Law Delete shitcoins Law

“Inflation,” according to the monetary adage, “is too much money chasing too few goods.” But trillions of idle dollars may be too fearful to ‘give chase’. Besides, inflation is not so cut-and-dried as the adage suggests. Between Jan. 2002 and April 2006, house prices (as measured by the Case Schiller 20 City Composite Index) climbed by 70.3%, while over the same span of years, the CPI was up just 12.9%. So, there was not much inflation–or was there?

We revise the monetary adage thus:

Inflation is too much money or credit. What the redundant (meaning surplus or excess) increment of dollars may choose to chase (meaning “invest” or going long) varies from cycle to cycle (re: the business cycle). It may be goods and services, or it may be stocks and bonds, or even shitcoins or shittokens.[2]

Levers of Policy

Federal Reserve Bank credit is the sum of the Fed’s earning assets:

  • securities held outright
  • loans
  • special crisis facilities such as Maiden Lane
  • currency swaps with other foreign central banks
  • other assets at the Federal Reserve.

Fed credit, in accounting jargon, is the “source” of the monetary base, which is defined as the sum of currency and bank reserves.

Primary dealer repurchase agreements – the Federal Reserve uses repurchase agreements to make collateralized loans to primary dealers in order temporarily to add reserves to the banking system. Most repurchase agreements are overnight, although the Fed can conduct operations as long as 65 days. So doing, the central bank can affect the amount and cost of liquidity at its charges, the commercial banks, without altering the size of its own balance sheet.

The Central Bank versus the Commercial Bank

Attribute CBM CoBM
Who issues it? central bank comm. bank
Who can own it? banks, some FMI everyone
How is it transferred? CB RTGS system various systems
How is it created? asset purchases bank loans
Does it have credit risk? no yes
What does it yield? policy rate LIBOR +//-

This section is omitted for Part 4, but I leave this table in for the more curious reader.

Not Vitaliks Endgame

How long the US can continue as a lender, leader, and reserve currency of last resort?

Longer than you can stay short. The issue with this question is that it presupposes a complete replacement rather than a retrenching of USD dominance globally. USD is the Coca Cola of currency, yet there is always Pepsi[1:1]

  • Finance should be the last pillar to challenge in the global economic order. It cannot be understated that there is significant and non-trivial risks associated with its disruption.

  • Geopolitical risks have increased after the election, posing the biggest potential cause of a US recession.

The US has seen increasing indebtedness since the financial crisis, with valuation gains on the external balance sheet working against the country’s efforts to rebalance its international indebtedness.

The balance sheet dynamics during the 2008 financial crisis highlighted the importance of understanding who owes the liabilities and who owns the assets, as it can have significant implications for stability and potential catastrophic losses in the banking system.

Basis of US monetary power

  • Understanding the basis of US monetary power and the interests of others requires analyzing not only the size but also the composition of the US balance sheet, with Europe and Asia being key counterparty regions.

  • The use of external balance sheets and measures like Net FX can provide valuable insights into a country’s exposure to currency-driven changes in valuation and its level of international financial integration.

  • Countries like China and Korea have a strong interest in dollar strength, but this interest is mitigated by their liabilities in dollars, and as Chinese corporates borrow more abroad, this trend is expected to continue.

  • The US is moving towards a position where it is not long risky assets, but actually closer to being net in balance on the risky asset portion of the external balance sheet and short debt.[3]

  • The US is a more dominant borrowing currency than an investment currency, highlighting the importance of the dollar as a key currency in global borrowing.


Part 4 will wrap this up but for now:



Credit is the product, stablecoin is the feature.


Additionally, we cannot ignore the possibility of government actors in disguise.[6]


Content Disclaimer

Notice of No Financial Advice

The Information on this Post is provided for education and informational purposes only, without any express or implied warranty of any kind, including warranties of accuracy, completeness, or fitness for any particular purpose. The Information contained in or provided from or through this application/website is not intended to be and does not constitute financial advice, investment advice, trading advice or any other advice. The Information on this application/website and provided form or through this service is general in nature and is not specific to you the User or anyone else. You should not make any decision, financial, investment, trading or otherwise, based on any of the information presented on this website without undertaking independent due diligence and consultation with a professional broker or financial advisory.


  1. Jack Daniel’s and Jim Beam may be a better example. ↩︎ ↩︎

  2. In memory of nikolai mushegian ↩︎

  3. While it is true that if the balance sheet is massive, risky assets could drive exchange rate volatility, the point is if the exchange rate is volatile, this may dampen a countries’ willingness to hold a large foreign currency portfolio. ↩︎

  4. ↩︎

  5. ↩︎

  6. i.e. some entity that is capable of conducting operations or activities of assistance to U.S. foreign policy goals that is, “. . . stand-alone . . . self-financing, independent of appropriated monies and capable of conducting activities similar to the ones that 3 letter agencies conduct daily, without impunity”. source ↩︎

1 Like

A most fortuitous comment supporting the timing of publishing this article!

1 Like