However, private wealth creation is the very feature of Capitalism. When wealth is created, we need a way to monetize it, so we can’t have the government controlling the money supply.
With the current system, the government does not directly control the money supply, but it influences it.
Specifically, money is created at the moment banks in the Federal Reserve system lend it out and put the loan as an ‘asset’ on their books at a rate greater than the debts to them are being paid back.
What happened? The debtor has money in his pocket, and the bank got an entry in its database in return. Money was created.
The sole value of that data base entry lies entirely in the fact that what was created is defined to be legal money by government fiat, plus the fact that the bank can take civil or suggest criminal action for somebody who fails to pay back the money plus interest at some later time.
This is something that a bank is allowed to do that you are not allowed to do.
How does the government influence the money supply? By changing the ability and profitability for banks to lend.
The first, by requiring a certain deposit ratio—a certain fraction of loans must be backed with capital deposited with the Federal reserve, earning no interest. The second, by influencing the rate at which banks can obtain money which “counts” as reserve for the Fed deposit requirement. (This is the Federal Funds rate). This changes the profitability of additional lending and hence money creation by member banks. If profitability (interest spread) is high, the banks will aggressively market loans and increase money supply. If profitability is low, banks won’t. With an inverted yield curve it can be more profitable to keep additional bank capital in Treasuries instead of using it to increase loans.
“The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.”
Imagine a bank fails to maintain the reserve ratio and creates money infinitely at liberty? What is stopping them from doing so? Nothing economically. There is only the fact that the bank’s officers will be arrested and, if convicted, put into prison.
Fiat money is fiat money in the sense that the deal is that if you are a bank which wants to participate in the Fed system (i.e. everybody) you have to accept other bank’s dollars at par (in the 19th century the value of dollars depended on which bank emitted them), and you have to then accept the rules of the Fed on reserve ratio and loan loss reserves.
