Breaking News Emails
Get breaking news alerts and special reports. The news and stories that matter, delivered weekday mornings.
Oct. 25, 2018 / 11:35 AM GMT
By Erik Sherman
President Donald Trump has again attacked his appointee, Federal Reserve Chairman Jerome Powell, complaining that former President Barack Obama got “zero interest” rates that let the economy expand.
But early in his administration, Trump reportedly suggested, “Just run the presses — print money” to lower the national debt, according to the Bob Woodward book, “Fear: Trump in the White House.”
However, higher interest rates are one mechanism for lowering the debt. To see why, you need to understand some basics about monetary policy and the difference between money and the cash in your wallet.
“Money is something that satisfies three properties,” said James Johannes, a professor of banking at the Wisconsin School of Business. “The first one is that it’s a medium of exchange. People use it to buy stuff. The second one is a standard of value, something everyone keeps their [accounting] books in. Third, it keeps its value.”
The U.S. dollar is an example of money. You can buy things or sell them and use the money you get to purchase something else. The dollar lets consumers, businesses, and investors compare the value of things. If you get a dollar bill today and put it in a piggy bank, it remains a dollar no matter when you take it out.
As the country’s central bank, the Federal Reserve tracks currency in checking accounts and household savings at banks and credit unions, amounts of less than $100,000 in deposit accounts like CDs and money market mutual fund shares.
But that isn’t all the money there is.
Cash isn’t king
Money is a token that everyone accepts. So long as people trust the entire system, everything works. And banks regularly create more money tokens than currency issued by the government.
Banks take deposits of currency. They keep some in their vault and deposit the rest with various regional Federal Reserve branches. Then the banks lend money to individuals and companies. But the amount they lend is far more than the total deposits they have.
“If they’ve got $100, they’re probably lending out about $90 of it,” said Rob Baumann, chair of the economics department at College of the Holy Cross. And then the $90 ends up in other banks, which lend out another $81, keeping $9 in reserve. The $81 then gets deposited in yet a third set of banks, and so on. The result is far more money lent than on deposit. Banks don’t have the cash to satisfy everyone who has deposited their currency — and that can become a problem.
Banks don’t have the cash to satisfy everyone who has deposited their currency — and that can become a problem.
“If I go to the dry cleaner and they say, ‘We can’t find your sweater,’ I wouldn’t panic,” said Sheila Tschinkel, a visiting economics professor at Emory University who has previously worked for the Federal Reserve and the International Monetary Fund. “If the bank says, ‘Come back next week,’ I would panic.”
When all a bank’s customers come in and demand their money at the same time, it’s called a run on the bank, something you’ve likely seen only in a movie, like “It’s a Wonderful Life.” Before the current monetary and banking system, they were a fact of life.
Federal law requires banks to maintain minimum reserve levels of 10 percent. Banks also keep extra at certain times like the holiday season when consumers take more out of their accounts. If a bank is short of cash, it can borrow from other banks or from the Federal Reserve to satisfy depositors’ demands.
To complicate things, even individuals can effectively create money. A credit care is an option the bank gives consumers to borrow when they want. When consumers spend, the bank has to create money to cover the transactions.
Higher interest rates
The Fed tries to “provide financial conditions that will lead to full employment and stable prices,” said William English, a professor of finance at Yale. The Fed’s major tool is interest rates: Lower rates stimulate the economy by making borrowing less expensive and spending easier, which drives up inflation as sellers raise costs because people have more to spend.
Trump wants lower interest rates because, in theory, they would help speed the nation’s economic growth. But higher interest rates would help retire long-term national debt.
Since 1971, all paper currency has been issued as Federal Reserve notes, which are short-term government debt obligations that don’t pay interest.
Higher interest rates drive up prices. People and businesses need more money — currency, in this case — to put into their accounts. One thing they do is sell Treasury securities they previous purchased. The securities are how the government finances long-term debt. These do pay interest.
The Fed can buy those securities with currency, trading long-term debt for short term. “Then the Treasury, which was writing checks to the public, is now writing checks to the Fed,” English said. “But the Fed’s income after expenses goes to the Treasury, so the Treasury is in effect paying itself.”
However, do this too much and the economy stalls.