Something economists don't talk about is how private institutions actually create money. The myth is that the Federal Reserve is the only institution that can create money by setting interest rates. The Fed supposedly has this form of control over the monetary system, but it's a lot of blarney. Private institutions create money by a variety of mechanisms. This is referred to as the financialization of the economy. Nothing new of material value is created, but games are played with money that creates money, and, once created, all that money is up for grabs. Here are a few of the mechanisms.
The no down payment mortgage. This encourages speculation in real estate driving up the price of houses. Hence much wealth is created. Wealth is created when the equity in your house goes up. If one year your house is worth $200,000. and the next year it's worth $400,000., then $200,000. of wealth has been created, not by the Federal Reserve tweaking interest rates but by the private sector. You can immediately go to the bank, take out a home equity loan, take out the $200,000. and spend it. It's still the same old house. Nothing of material value has been added or created, but a mechanism in the financial system has created wealth. Of course, this is also referred to as a bubble, and the bubble can burst sending the value of your house back to where it was and leaving you $200,000. in debt.
The issuance of stock and stock options. Any corporation can decide at any time to issue stock. This is tantamount to creating money out of thin air. That stock is just sold into the market. This sale may diminish the existing stock price just as the printing of money can cause inflation, but so what if the demand for that stock is high. Then the company can give the money made from that issuance of new stock to whomever it pleases like the CEO, for instance. Stock options also create money out of thin air, but for that matter, the bidding up of a stock's price creates money out of thin air since nothing on the ground has changed. Presumably, those in charge of running the business are doing their best to produce the best widgets and are earning revenues that way, but this has little to do with the value of its stock. The stock price in a sense is just another derivative, a financial instrument that bears merely a tangential relationship with the underlying economic reality which is the production and sale of widgets.
Then we get to the heavy duty derivatives such as short selling, credit default swaps, asset backed securities, collateralized debt obligations etc. Derivatives in general represent the creation of money by the private sector. During the recent economic crisis it was estimated that there were outstanding hundreds of trillions of dollars in credit default swaps. This money was not created by the Federal Reserve. It was created by private bankers, hedge funds and other devotees of exotic financial instruments. All derivatives are essentially bets. So not only is money created. It is also offered up for betting. When these bets go bad on a massive scale, we have the financial meltdown we recently experienced. But the problem in the first place is that private institutions are allowed to create money.
Leveraging creates money. When a bank leverages its funds 100 to 1 instead of a more conservative 30 to 1, that means it can lend out - and receive interest on - that much more money. And interest in itself represents the making of money off of money. It's an expansion of the money supply that has nothing to do with the expansion or contraction of money by the Federal Reserve. Supposedly, the Fed sets interest rates which are reflected in the whole economy. But consider credit cards. They set the interest rate wherever they want to irregardless of the Fed rate. Right now the Fed rate is zero, while some credit card companies are charging 30%.
These are only some of the ways the private sector creates money and wealth and makes money, not from creating, producing and selling a product or service, but off of money itself and off of placing bets on money. The financialization of the economy which has created a casino economy leads to violent boom and bust cycles and places everything of real economic value up for grabs so gamblers can gain control over real economic assets. An example of this is the private equity funds otherwise known as leveraged buyout specialists. They buy out perfectly functioning companies with borrowed money, transfer the debt off their own books and onto the company's books, then eliminate jobs or break up the company into pieces and sell them off, declare special dividends for themselves and otherwise eviscerate the company for their own profit, leaving the company a bankrupt shambles. This happened recently to the venerable Simmons mattress company which had been in business for over 133 years. Employees were left jobless.
Currently, Ford has announced it's profits are up for the third quarter of 2009. Also, coincidentally, it laid off 50,000 or so workers. Interestingly enough, it made it's profits in every continent on earth with the exception of Africa. A big factor in its profits was the profits reported from its financial division. So in other words it made profit from interest charged not from the underlying car itself. Here are two observations. Profits go up as jobs are eliminated and plants are robotized, and profits made in other countries won't be reported and hence paid taxes on in the US. Why should Americans be cheering over this? They are being screwed out of jobs and out of tax revenues.
Countries that don't allow this financial "innovation", which has come about as a result of deregulation of the banking industry, are in much better shape in terms of jobs, real growth and tamping down of boom bust cycles than is the US which continues on its merry quest for short term, stock price driven profits. There has been no real reform of the banking industry which leads me to believe that we will be reliving the current economic malaise again sometime soon even as it continues for the jobless and foreclosed upon.
