Sometimes it is possible to oversimplify something. Over a decade ago, Ben Bernanke, then chairman of the Federal Reserve Board of Governors, sat down for an interview with 60 minutes, the TV show important Americans call when they have important things to say.
Bernanke explained how the Fed reacted to the financial crisis. When it came to asset buying programs, the host asked if the Fed was spending taxpayers’ money.
“It’s not tax money”, Bernanke mentionned. “Banks have accounts with the Fed, the same way you have an account at a commercial bank. So to lend to a bank we just use the computer to mark the size of the account they have at the Fed. The host asked him if the Fed had printed money. “Well,” said Bernanke, “indeed. ”
He was not wrong, of course. It’s Ben Bernanke. You might disagree with his political choices, but he certainly knows how money is created.
This quote from 60 minutes, however, still comes back, often, more than a decade later. When Bernanke simplified what the Fed does, he confirmed to a lot of people the deeply mistaken idea that the Fed just magic dollars out of thin air and then, by executive order, says, “There. It’s money.
There is a problem with the word “fiat”. We use it to describe our current monetary system. Then we teach undergraduates that the word comes from Italian for decree, or edict. We tell them that fiat money is a social convention. It is valuable because the government says it is, and everyone agrees. Cameron Winklevoss, co-founder of the Gemini crypto exchange, said that “all the money is a meme”. That’s what he was taught at Harvard while doing the other thing he’s famous for.
Unfortunately, that’s not how money works at all. The first description I could find of money as “fiat” comes from John Stuart Mill, the English philosopher, in Principles of political economy. Mill proposed a hypothesis: Suppose a government starts paying wages in paper money that cannot be converted on demand to silver or gold. The value of that money, he wrote, “would depend on the decree of authority.”
Well yeah. If the US Treasury Department were to print carnival tickets, spend them in the economy, and call them dollars, the value of those dollars would depend on the executive order of Congress. But that’s not what the treasury does, and that’s not what a dollar is.
If you live in the United States, the dollars that you use the most in your daily life are bank dollars. Your bank creates them when it lends you money, and then deposits them into your account.
Bank dollars have no value just because your bank says so. Your bank has regulators on their books to make sure these loans are solid assets with decent returns. And your bank pays premiums to the Federal Deposit Insurance Corporation, to guarantee your deposits in case it fails anyway. If bank dollars are just a social convention – a meme – then your mortgage is just a meme, too.
Now take the Fed. It’s just a special bank. As Bernanke said, commercial banks have deposit accounts with the Fed. When the Fed lends them money, it marks their accounts with dollars which we call reserves. And, just like when commercial banks lend you money, these reserves are a liability for the Fed. But there is a crucial part of the process that did not come to fruition 60 minutes: When the Fed grosses up these accounts, it also buys assets. He exchanges, one for one: reserves for assets.
When we say that the Fed prints money, we are implying that there was nothing, and now there is something. Ta da! But, that’s not what happens at all. The Fed has to buy something. This is usually a treasury bill, but in an emergency it may be a more questionable asset. Then the Fed credits the reserves. To believe that these reservations are just a meme, you have to believe that the assets are just a meme. But they are not. Don’t take my word for it. The Fed’s assets deliver a return, every year, lean years and fat years, without fail.
OKAY. Now let’s move on to the Treasury Department. He also has an account with the Fed, but he can’t just magically take dollars out of his account. The Treasury can put dollars in its account by collecting taxes, or by selling Treasury bills. There is no decree, no decree. There is no money printer anywhere. It’s all transactions on a balance sheet, assets for liabilities.
Now: You can believe that all of those mortgages and credit card loans are meaningless assets. You may think that the US government will not be able to collect enough taxes to renew these treasury bills. If you are right, then yes, the dollar has no value. But we’re still not talking about trusting anyone. We are talking about credit analysis. So please: let’s stop calling it fiat money. Let’s start by calling it what it is: credit money.