There have been diaries and comments recently about creating money, some of them confused. Before we deal with that confusion, we have to ask what money is.
Money is an asset which passes current.
And by "passing current" I mean 'acts like money.' Okay, a little more explanation. If something is available for acquisition, then it can be acquired for anything which passes current. If you want a pair of shoes, you don't bring some cans of tuna fish to the store and ask how many cans the clerk wants for the shoes. You bring dollars. You can get shoes or tuna fish for dollars; you can't get tuna fish for shoes; you can't get shoes for tuna fish.
(Some years ago the second "Adam Smith" wrote a book called Super Money. He pointed out that corporations could buy up other corporations with their stock. It was, however, not super money, but a remarkably inferior money. They could acquire a new subsidiary with their stock but they couldn't pay their workers or their suppliers with it. What would be your response if -- on payday -- your employer handed you some stock certificates instead of the pay you had expected?)
Now, People accept money because people accept money. Less cryptically, you will accept money for what you have to sell because the people from whom you want to buy will accept money for the goods you want. Money is entirely a social convention.
Years ago, people thought that others accepted money because they thought that it stood for a certain quantity of gold (or silver). Adam Smith (the real one) shared the prejudices of his age, but he had an extraordinary intelligence and an inquiring mind. He asked "Why will a London merchant accept a worn guinea for a full guinea's worth of goods?" A guinea was a gold coin and in passing from hand to hand, some of the gold wore off. A worn guinea contained less gold than a fresh-minted guinea did. Still, it would buy as much as a fresh-minted guinea would. Smith came up with an answer, but not a very satisfactory one. (The merchants had some idea of the amount of gold in an average circulating guinea, and were selling the goods for that much gold.)
Still, even Smith didn't ask the deeper question: "Why did the merchants sell codfish, for which they had an immediate use, for gold, for which they had no immediate use -- and often no personal use at all?" My answer is that they accepted the guinea because they could trade the guinea for what they needed. And, since the next merchant would take the worn guinea, it was worth as much to this merchant as the fresh-minted guinea would be. The Georgian merchants weren't accepting gold, any more than a modern store keeper is accepting paper because he wants paper. The Georgian merchants were accepting guineas, money.
After all, if you go to a grocery store and give him a piece of paper with $20 printed on it (in just the right fashion), he will not only let you have some groceries; he will gladly also give you several pieces of paper of just the same size with $1 printed on each one (in a remarkably similar fashion and by the same organization).
During the Great Depression, prices fell. Some people blamed the continuation of the depression on the falling prices. FDR "took the USA off the gold standard" -- he said the Treasury would no longer pay gold for dollars. It would pay silver for paper dollars, but the president gradually reduced the amount of silver it would pay for a paper dollar. He waited for the prices to rise again since the money was worth less. It didn't. (Prices rose again as the economy recovered, but inflation -- or "reflation" -- didn't march along with the lower amount of silver you could get for a dollar.) At that point, it became clear -- or clear to those with eyes to see -- that money was a social convention, not a convenient way to carry metal around in a wallet.
Some fraction -- about half, currently -- of the amount of money in circulation consists of federal-reserve notes, the green pieces of paper in your wallet. Some people think that this is "real money," while the money in checking accounts is only money in the sense that you could turn it into green paper. This belief is even stranger than the obsolete belief that money was only a substitute for metal. As far as the people handling the money supply are concerned the money is the amount in checking accounts. The paper in your wallets is a concession for consumers who take only a marginal -- although essential -- part in the flow of funds. Checking accounts are the more important part of the money supply.
(Woody Guthrie sang of banks "and the vaults are stuffed with silver that we have sweated for." Woody was a great musician, but he didn't understand banking. The coins, and the paper bills, in a bank's vaults are something that the banker tries to minimalize. It is necessary for his business, just as the guy whose business it is to rent tuxedos has to have tuxedos hanging in his shop. But the only ones which make him money are those outside the shop being worn. In the same way, the bills and coins in the bank are unproductive stock. What makes money for the banker are the checking deposits he has lent to customers.)
Okay. Money is what people will accept as money. How is more money created? Well, you go into a bank and exchange your IOU -- say a mortgage -- for the banks IOU -- a deposit in your checking account. Your IOU isn't money. (If people would accept it, you wouldn't need the bank.) The bank's IOU is money. So that is new money. (You don't do that unless you plan to spend that money. We are looking at it before you spend it, however, to avoid unnecessary complications.) Note, however, that it is not new wealth. Neither you nor the bank have a change in net worth: Your IOU is a new asset for the bank -- the money in your account is a new liability for the bank. The money in your account is a new asset for you -- your IOU is a new liability for you.
There isn't new wealth. There is new money. What makes it money? the willingness of everyone to accept it as money.
Now, how much money does society need? Somehow, at least one person on dKos seems to think that the stock of money must be proportional to the stock of actual goods. The relation between the two is comparatively remote. The exchange of goods is -- almost always -- facilitated by the exchange of money for goods. So the flow of money must match the flow of goods, and the stock of money must be sufficient to enable sufficient flow of money to enable the flow of goods.
But the flow of goods enabled by money depends on the economic structure. If Smith Co. makes rails from steel it purchases from Jones Co. which makes the steel with iron ore it buys from Brown Mining Co., then the economy needs the dollars that Smith pays Jones and the dollars that Jones pays Brown. If US Steel makes the rails from steel it refines from ore it mines, then it clearly doesn't need those dollars. (It does need the dollars to pay its workers, but so do Smith, Jones, and Brown.) So the need of dollars for commerce is increased by the level of economic activity, but decreased by the concentration of establishments.
The need for dollars is also decreased by more efficient economic systems. We need a money flow; we only need the money stock to enable that money flow. A hell of a lot of money flows via electronic transfer these days. The same quantity of money might take part in ten transactions in a single day.
While how much money we need is a matter of constant argument, who makes the final decision is clear: The FRB, The Federal Reserve Bank. (Often called "The Federal Reserve" with "bank" omitted.) Here is how it controls the amount of money in the system:
Each bank must keep a certain small fraction of deposits that its customers make in the bank in a deposit that this bank makes in the FRB or it must borrow some other bank's deposit in the FRB. So, while the FRB has only the weakest control over how much a particular bank has in it's books as deposits, it has complete control over how much the entire banking system has on deposit. The rules are written: "Each bank must have 1/X of its deposits in the FRB." The actual control is: "The total of banking deposits is not more than (and generally pretty near to equal to) X times the amount in the FRB."
When you write me a check on Smith Bank and I deposit it in Jones Bank, then Jones Bank sends it to a "clearing house." The clearing house credits the amount of the check to Jones Bank's account at the FRB, and debits that amount to Smith Bank's account at the FRB. They then send the check to Smith Bank (along with all the other checks drawn on Smith bank that clear that night) for them to debit your account.
If more money is in checks drawn on Smith Bank than is in checks deposited in Smith Bank, then Smith Bank must increase its deposit in the FRB -- its "reserve." Generally the bank can do this in two ways:
1) It can send the FRB a check drawn on another bank (say Brown Bank) that would -- like any other check drawn on Brown Bank -- lead to a decrease in Brown Bank's reserve, its deposit in the FRB. (If Smith Bank were to send the FRB a check drawn on itself, this would be a wash, increasing and decreasing its reserve by the same amount.)
2) it can borrow some other bank's reserve. This is done all the time, and is for one day at an interest rate which is a few percent per year. You can imagine the amounts of money in a typical loan.
Neither (1) nor (2) changes the total amount of the banking system's deposits in the FEB by one penny.
If the FRB wants to increase the total amount of money, it increases the total deposits of the banking system in the FRB. It does this by buying treasury bonds. (The FRB can also either sell treasury bonds or redeem them when they mature -- when they come due. This has the opposite effect from what I'm laying out. That transaction decreases the money supply. Obviously, over time, the FRB increases banks' deposits.) The FRB pays the dealer for those bonds with a check. The dealer deposits the check in a bank (say Green Bank). Like any other check deposited in Green bank it goes to a clearing house. The clearing house increases the deposit of Green bank in the FRB. Since the check isn't drawn on another bank (rather it is drawn on the FRB, itself), it doesn't reduce any bank's deposit in the FRB. So, that transaction isn't balanced, and it increases the total deposits in the FRB of the entire banking system. That results in the amount of possible deposits in banks by X times the price of the bonds (and the actual increase in deposits by almost as much).
(In laying this out, I've been ignoring the complication of currency and coin. Basically, a bank can reduce it's deposit in the FRB by asking for cash. This counts as the bank's reserves until it walks out the door. There is no reason to ask for cash, however, unless the bank expect it to walk out the door. Banks also can turn some currency and coin into the FRB and increase their deposits by doing so. The FRB takes advantage of that to cull the most ragged currency when that happens.)
This allows us to go back to the question of why the bank's IOU is money when yours isn't. The requirements for reserves by the FRB, the insurance for small accounts (and recent laws give quite generous definitions for "small"), and bank examiners all contribute to the general feeling that "money in the bank" is safe. (As I've tried to demonstrate, damn little of the money is "in the bank.") That contributes to the trust we have of checks -- you might doubt that I actually have enough money in the checking account to cover it, but you don't doubt that the bank can cover it. This makes money in a checking account money -- that is, it will pass current -- that is, you and everyone else will accept it.
And, since money in a checking account will pass current, when a bank trades its IOU for your IOU, it creates money.
This leads to two errors of understanding.
Bankers keep chafing at the limits regulators and the FRB put on them. But they can operate only because of the social agreement that their IOUs are money. And that agreement is due, in part, to the limits put upon them.
Some self-identified populists claim that the ability to create money is some privilege conferred on banks by the FRB. What the government and the FRB contribute is limits, not a special license. It is society as a whole, and any part that you might want to do business with, which says that a bank deposit is money and that your IOU is not. The FRB doesn't prevent you from paying your bills with IOUs. (Although any huge surge in people doing so would wreck the FRB's control of the money supply.) It is the people to whom you owe those bills who want a check instead of an IOU.
Notice that all this creation of dollars is done in terms of dollars. It is all circular. What a dollar is worth at the moment is quite clear. Walk into any grocery store, and you can find out what it will buy. A dollar's "intrinsic worth" is less clear, if that concept has any meaning.
Certain gold bugs think that the "legal tender" rule is what keeps currency from collapsing in value. "You have to accept it," they say. "If it weren't for that government imposition, this stuff would be waste paper." That is drastic delusion about the law. Any two parties can make any contract for the payment for anything in Oreo cookies. If you make a contract for payment in dollars, however, and only if you make a contract in terms of dollars, then you must accept Federal-Reserve notes. (I've seen signs on building-management companies that they will only accept payment by check, not in cash. This would seem to conflict with the legal-tender principle, but their reason is clear.)
Paulistas have tried to issue gold coins, but those coins are -- if I understand it -- called "dollars" rather than "rons." If they truly thought that gold money was different from fiat money, you have to wonder why they want to name their gold money after the paper money.
I might note that not only is the notion that: "money in checking deposits is only money insofar as it represents some 'real' bills" an illusion, but money can be used when there are no bills or coins available. I mentioned the guinea gold coins of the Georgian period. They have not been minted in centuries, and they have not circulated in almost as long. Some luxuries in Britain, however, are -- or were recently -- still priced in guineas. If you agree to buy something for 20 guineas, you owe 21 pounds.