The Feel of Money

The Federal Reserve System has the ability create virtual dollars with the stroke of a key. They also issue the physical bills of U.S. currency ($1, $1, $2, $5, $10, $20, $50, and $100). The actual manufacturing of the bills for the Fed is done by the federal Bureau of Engraving and Printing.

Wouldn’t it be nice if you could just print up a bunch of $100 notes yourself? Well, the feds have already thought of that, and include an ever-growing array of features to make it hard to duplicate these bills.

Counterfeiting of dollar bills has a long history. Following a distasteful experience of runaway inflation with paper money during the Revolutionary War, the U.S. remained primarily on a gold standard for most of its existence. The first major issuance of paper money was in 1862, to help finance the Civil War. Counterfeiting of these bills soon became a major problem, with up to half the dollars in circulation being phony. A primary mission of the U.S. Secret Service when it was founded in 1865 was to combat counterfeiting.

During World War II, the Nazis in “Operation Bernhard” succeeded in producing enough counterfeit British money that the U.K. had to switch production of banknotes to a different format. The work was carried out by prisoners at concentration camps. Later in the war, the prisoners were tasked with counterfeiting U.S. currency as well. Due to the security features in the dollars, this was a more complex task. Also, the prisoners realized that their chance of being killed was higher after they succeeded in devising a process for making counterfeit dollars, so they slowed the work down as much as they could.  The $100 bill has been a frequent target of more recent counterfeiters, including the British Anatasios Arnaouti  gang and (allegedly) North Korea.

Modern U.S. currency includes numerous feature which make it difficult to duplicate. Only about 1 note in 10,000 in circulation is fake. You can click this link

The Seven Denominations | U.S. Currency Education Program

to zoom in on each of the seven denominations of U.S. currency and see the current security features for each one. The more valuable bills get more sophisticated. The $100 bill has color-shifted numerals and bell image, a 3-D security ribbon with shifting images of bells and 100s, a security thread which glows under ultraviolet light, and subtle watermarks. Magnetic features are also included.

But it turns out that one of the most reliable and hard-to-duplicate features of dollars is the feel in your fingers, a result of the material they are made from and the printing process which gives a 3-D texture:

Perhaps the most difficult-to-duplicate counterfeit deterrence feature of U.S. banknotes is its unique yellow-green paper, manufactured under close security by a single U.S. firm from a mixture of 75 percent cotton and 25 percent flax. When combined with intaglio-printed images and numerals, this gives the notes a unique “feel,” which surveys have reported is the most common method of counterfeit detection by the public and bank employees.

So, if you want your own $100 bills, it looks like you will have to earn them, or wait for the next stimulus check to arrive.

Where Does Money Come From?

Money can be simplistically defined as “A medium that can be exchanged for goods and services and is used as a measure of their values on the market, and/or a liquifiable asset which can readily be converted to the medium of exchange”.  Earlier we described the amounts of various classes of “money” in the U.S.      Here is a chart showing the amount of currency in circulation (coins and bills; lowest line on the chart) for 2005-2020, and also M1 (green), M2 (upper curve, purple) and “monetary base” (currency plus reserves at the Fed; red line).

To recap what M1 and M2 are:

M1: Physical currency circulating outside of the Fed and private banking system, plus the amount of demand deposits, travelers’ checks and other checkable deposits. This is highly “liquid” money, i.e. accepted and used for transactions in the private economy.

M2: M1 + most savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits (certificates of deposit of under $100,000).

 The funds in these additional savings and money market accounts can in general be easily transferred to checkable accounts, and thus could go towards making purchases if desired.

Physical currency is made and put into circulation by the government or quasi-governmental agencies (the Treasury mints coins, and the Federal Reserve prints bills). But what about all the other money (M1, M2, etc.), which dwarfs the physical currency? How does it grow?

Without getting into all the weeds, it turns out that the major driver of money creation in modern economies is the process of bank loans.  The vast majority of money in countries like the U.S. is not created directly by government or central bank operations, but is created in the private sector when commercial banks make loans.   When individuals or companies decide to take out more loans (including loans for cars, houses, or business investment), the effective money supply in the nation increases. This is true for other modern economies. For instance, the Bank of England states:

There are three types of money in the UK economy:

3% Notes and coins

18% Reserves

79% Bank deposits

A typical scenario of how bank lending increases money might go something like this: Fred would like to add an enclosed back porch to his house, but doesn’t have the money in hand to pay a carpenter to build it for him. So the base case is no payment to the carpenter and no porch for Fred. However, Fred realizes he can go the bank and get a loan to pay for the porch. So he obtains a $20,000 loan from the bank, which first shows up as a $20,000 credit to Fred’s checking account. The bank credits Fred’s account, and in exchange obtains a contract from Fred promising that Fred will pay it back, with interest.

Fred writes a check for $20,000 to the carpenter, who in turn pays $10,000 to a lumberyard for materials and keeps the other $10,000 as his fee. The lumberyard is able to pay its workers for that day, and order replacement lumber from a mill. The workers spent their pay on various items.  The carpenter puts $5000 of his $10,000 fee in a savings account, and pays the rest to a car dealer for a used car.

The initial loan to Fred set off a chain of spending and economic activity, which would not have otherwise occurred. Fred has his porch, the lumberyard workers continue to be employed and supporting their local merchants, the carpenter gets a second car, and this money keeps ricocheting around until it gets drained away into stagnant savings, or is used to pay down prior debt. Although they are not aware of it, part of the lumberyard workers’ pay for that day came out of the debt incurred by Fred.

The granting of that loan created $20,000 of spending capability, i.e. money.  As far as the economy is concerned, that $20,000 did not exist as effective money prior to the loan. Thus, the money came into existence simultaneously with the debt associated with the loan. Fred received the capacity to spend $20,000 today, but in turn accepted the obligation to pay back this money, with interest. It is assumed that Fred had a stable income, such that he would in fact be able to pay back the loan in the future.

In general, increasing debt increases the money supply, and paying down debt extinguishes money. For simplicity, suppose Fred repays the $20,000 loan (with $2000 interest added) in one big lump, two years later. In that year, he will presumably spend into the economy something like $22,000 less than he would have otherwise. Thus, his paying down of his debt will act as a decrease in the circulating money.

In normal times, as one person is paying down his loan (and thereby shrinking the money supply), someone else is taking out a new and even larger loan, so total debt and the amount of money in circulation stays about the same, or grows somewhat. A feature of the 2008-2009 recession, however, was a big drop in consumer demand for credit; folks decided to pay down debts and not borrow so much money to buy stuff. The effect was a big drop in spending and thus in overall economic activity (GDP) and in employment.

Where was that $20,000 before Fred borrowed it? We might think that it was sitting unused in the bank vaults, just waiting to be borrowed. That turns out to be an incorrect picture of the lending process.

Bank loans differ in key ways from, say, an interpersonal loan. If I lend you money, I might draw down my checking deposit and give you a check which you would deposit in your bank account. No new money is created. You may hand me an I.O.U. slip stating when you will pay me back and with what interest, but that would still be just the same funds being traded back and forth between the two of us. I would have to have the money in my account to start with before I could loan it to you.

Bank lending is different. A bank can lend money and hence create a new deposit, which amounts to brand-new money, even if the bank does not have that money to start with.  This is counterintuitive. In a later post we may flesh out this seemingly magical aspect of bank lending. See  Overview of the U. S. Monetary System for a more complete discussion.

How Much Money Is There?

It is not straightforward to define what “money” is in a modern national economy. Simply tallying the amount of coins and paper currency is inadequate. Most buying and selling is now done by shifting numbers between abstract bank accounts, not by pushing a bundle of bills across a table.  Thus, these bank accounts serve the functions of money (medium of exchange and store of value). The question then arises as to which of these financial accounts to regard as money.

Among financial assets, there is a broad spectrum of liquidity. Typically you can write a check on your checking account which, when it clears, provides immediate and final settlement for a purchase.  On the other hand, if you want to tap your brokerage account with its holdings of Apple stock to buy a television, you would typically have to sell (liquidate) your stock. A third party would have to be willing to give you something more money-like (e.g. credit your money market fund at your brokerage) in exchange for the stock at some negotiated price. Then you might have to transfer the funds from your brokerage fund into your bank checking account before you can actually buy that TV.  Because of all these intermediate steps, and the fluctuating value of the stock before you complete the sale, the stock holding would not be counted as “money”, even though its value enabled you to ultimately make your purchase.

There are a number of measures of money in modern economies. In the U.S. some of these are:

M0: The total of all physical currency (coins and paper bills).

MB (“Monetary Base”): The total of all physical currency (coins and bill) plus Federal Reserve  Deposits (special deposits that only banks can have at the Fed). This is money essentially created by the government plus the Federal Reserve, which does not necessarily enter the private economy to be spent.

M1: Physical currency circulating outside of the Fed and private banking system, plus the amount of demand deposits, travelers’ checks and other checkable deposits. This is highly “liquid” money, i.e. accepted and used for transactions in the private economy.

M2: M1 + most savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits (certificates of deposit of under $100,000). The funds in these additional savings and money market accounts can in general be easily transferred to checkable accounts, and thus could go towards making purchases if desired.

MZM: “Money Zero Maturity” is one of the most popular aggregates in use by the Fed because its velocity has historically been the most accurate predictor of inflation. It is M2 – time deposits + institutional money market funds.

Below is a chart showing the growth in the U.S. in the past fifteen years of M0 (total currency, labeled “currency in circulation), MB, M1, and M2. The grayed areas are recessions, i.e. 2008-2009 and the present.  [1]

Various Measures of “Money” in the U.S.

The M1 money supply (green line) was about $1.4 trillion ( $1,400 billion on the chart) in 2005, was fairly steady for several years, then started a steady ramp up to $4 trillion by January, 2020. Due to the extraordinary events associated with the Covid-19 shutdown (government stimulus package plus Fed purchases of securities), M1 jumped up to $ 5.4 trillion by August of this year. M2 followed similar trends, though on a much larger scale, rising to$18.3 trillion this year. This compares to a current U. S. total GDP of about $21 trillion.

The lowest line on the chart is the physical currency (blue line), which has grown slowly but steadily. The “Total MB” (red) line, was essentially on top of the blue line up until the 2008-2009 recession. Since MB = physical currency plus reserves, this meant that the amount of money in the reserve balances at the Fed of the private banks was nearly zero before 2008. The reserves jumped up (difference between the red and blue lines) in 2009, with the onset of massive purchases of securities by the Fed (“quantitative easing”). The Fed buys these securities from the banks, and credits their reserve accounts. The Fed has tried to taper down its holdings in recent years (red line declining 2015-2019), but suddenly purchased trillions more this spring (red line jumping up in 2020).  Most pundits hold that all this Fed money injected into the financial system has been the major cause of the enormous rise in stock prices in the past decade, especially in the past six months.

[1] Chart produced on the St. Louis Fed “FRED” site, https://fred.stlouisfed.org/categories/24 . This site has a wealth of economic data. Unfortunately, it is not easy to change units, so I was stuck with “billions” instead of “trillions” for the axis labels. Also, the M0 and MB numbers were only available in “millions”, so I had to divide those numbers by 1000 to get them to fit on the plot with M1 and M2. The grayed out spots on the graph labels is where I blotted out the “ /1000 ” which the plotting software put in. It would have been cleaner, in retrospect, to have exported the data to Excel and replotted it there.

Money as a Social Construct

Wikipedia offers the following definition of “money”:

Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given socio-economic context or country. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value.

To illustrate why all advanced societies use money, let us consider a village which operates on a barter system. (Many primitive cultures probably operated on a basis of mutual gifting rather than strict barter, but that does not affect the point at hand). Suppose the baker has produced two loaves of bread that will go stale in a day, so they would be best sold today. The baker would like a pair of sandals from the cobbler. They agree this is a fair trade, but the cobbler is backed up and will not be able to make the sandals for a couple of days. Thus, they cannot immediately make a swap. For this mutually advantageous transaction to proceed, the cobbler must agree to the obligation to deliver something (namely, a pair of sandals) in the future, in return for the loaves of bread today. The baker must believe that the cobbler will deliver on his promise.

Here we see the importance of credit and debt, which depend on mutual trust, to enable transactions where there is a time lag between the actions of the two parties. The cobbler’s promise may just be a verbal agreement, but now suppose the cobbler writes down on a piece of paper, “The holder of this certificate is entitled to one pair of sandals from me, the village cobbler,” and gives this to the baker. Now this piece of paper is nearly the equivalent of a pair of sandals in value. It has become a store of value. If the baker later decided that he would rather have some candles instead of the sandals, he might be able to exchange this certificate for the candles. Thus, this piece of paper, which started as a statement of a debt between two individuals, would serve the function of money. (In fact, such “bills of exchange” issued by merchants were an important form of money in late medieval Europe).

It would be even cleaner if the baker could simply sell the bread to the cobbler for something that functioned in that village as “money”, such as silver coins. The baker could then use some of the coins to either buy shoes or buy something else, either now or later.  In this case, the coins operate as a convenient medium of exchange and also as a store of value. Both functions enormously aid financial transactions, which is a reason that money is so ubiquitous. Money also facilitates taxation by central governments, so governments have an incentive to put a monetary system in place.

In Money We Trust

For this system of money to work, the key players all have to believe in the value of the silver coins. Thus, money is a mainly social construct, an article of mutual faith.

With the rise of banking in the Renaissance, banks issued paper certificates which were exchangeable for gold. For daily transactions, the public found it more convenient to handle these bank notes than the gold pieces themselves, and so these notes were used as money. People generally trusted that the banks actually did have the gold in their vaults; if people lost confidence in the bank notes, they would all come at once to demand their gold in a “run” on the bank, which usually did not end well.

In the late nineteenth and early twentieth centuries, leading paper currencies like the British pound and the U.S. dollar were theoretically backed by gold; one could turn in a dollar and convert it to the precious metal. Most countries dropped the convertibility to gold during the Great Depression of the 1930’s, so their currencies became entirely “fiat” money, not tied to any physical commodity. For the U.S. dollar, there was limited convertibility to gold after World War II as part of the Bretton Woods system of international currencies, but even that convertibility ended in 1971.

Many older Americans and Europeans have a gut feeling that gold is “real” money. Its main advantage over fiat currencies is that there is only a limited world-wide amount of it, so it cannot be multiplied at the whim of some government or market force. However, even gold is just a shiny yellow metal whose value is whatever people believe it to be.

Money and Social Order

There are “preppers” who hoard gold coins, expecting that in the apocalypse they will be able to purchase goods with gold. But who knows how many gold coins it would take, in such a scenario, to buy a can of beans? Or if you show up in town flaunting gold coins, how long before the local warlord’s gang comes calling at your doomstead? I suspect in such a scenario society would revert back to using “commodity money”, using items with real alternative value, such as AA batteries, food items, or ammo.  In the 1700’s frontier, beaver pelts, which had intrinsic value, were used as a common denominator for pricing and exchange.

If people lose faith in the value of some form of non-commodity money, it will in fact become valueless. For instance, during the American Civil War of 1861-1865 both the North and the South issued paper currency to fund their military efforts, since neither side had enough gold to pay their soldiers and suppliers of military goods. These were both fiat currencies, not at the time redeemable in gold.  The North retained its government and a strong economy, and only a portion of its money stock was paper, so it experienced only moderate inflation. However, towards the end of the war, with excessive printing and with defeat of the Southern Confederacy in sight, the Confederate dollar lost nearly all its value. People no longer wanted to accept Confederate dollars in exchange for real goods, since they (rightly) feared that they would be unable to exchange the “greybacks” for the same amount of real goods in the future.

As long as a given government remains in power and does not issue crazy amounts of money (as in post WWI Germany or recent Zimbabwe), or some catastrophe does not strike, fiat currencies tend to remain in use. The value of fiat money derives in part from a government declaring that it must be accepted as a form of payment (“legal tender”) within that country, for “all debts, public and private”. The government typically requires that its citizens come up with some amount of its currency to pay their taxes, so that automatically creates some level of domestic demand for the currency.

Today, most “money” is not even tangible printed bills, but is in the form of digital entries in accounts “somewhere”. Nearly all of my life savings exists in the form of investments in stocks or bonds of corporate entities, which are held in accounts that I only ever access from my computer. I rely on on-going functional, reasonably honest government to enforce rules on the stewardship of those funds at multiple levels. So I am betting everything on the supposition that law and order prevail.