Last time we looked at the banking system in the United States and the emergence of the Federal Reserve System (The Fed) and its 12 Federal Reserve Banks. At the end of the article, we examined a current dollar bill (paper), noting that it says “Federal Reserve Note.” In the United States, this is legal tender, meaning that it is valid for meeting a financial obligation. But as in most countries, it has no backing by precious metals or other commodities and has value only by fiat (per Merriam-Webster, “an authoritative or arbitrary order”). So how is money created?
In the United States, money is printed by the Bureau of Engraving and Printing, a part of the Treasury Department. The Fed, independent of the Treasury, manages the economic functioning of the country. The Fed can receive printed money from the Treasury to replace worn out or damaged currency or to provide it to a Federal Reserve Bank based on financial assets (treasury bills, government bonds, and so forth) it may receive. This is a bit like the clay tokens in Uruk 5,000 years ago. The Federal Reserve Banks receive money from the Fed and, in turn, lend it to other banks. The banks at all levels are required to keep a percentage of the “borrowed money” on hand to meet obligations, but can lend in multiples of the amount received as long as they maintain a specific reserve.
In simple terms, let’s say a bank grants some loans for manufacturing and expanding operations. The total is $10 million. The banks borrows from the central bank a sum to finance the loans plus maintain its reserves. The next day $10 million plus dollars are NOT delivered. Instead, some ones and zeros are flipped overnight to change accounts appropriately and the receiving bank has a new asset that counts in its balance sheet. The same thing happens for the accounts of the corporate borrowers except that the loans are liabilities. This is seen collectively as broad (M2) money. In December 2010 the US broad money supply was $8.853 trillion, but only $915.7 billion existed as coins or paper money. Well managed, a system such as this can ensure the stability of a country’s financial system. One might question if the system is so good, why did the financial crises of the Great Depression and 2007-2008 occur? The answer is that population attitudes strained the complex bank management system and (fortunately) the system was able to respond.
Now take a look at the euro, the name officially adopted on December 16, 1995 in Madrid, Spain by 19 of the 28 member states of the European Union, established in 1992 by the Maastricht Treaty. The euro is the official currency of the Eurozone. It went into physical circulation on January 1, 2002, becoming the day to day operating currency of the first 19eurozone member states and by May 2002 replaced their former currencies.
The European Central Bank (ECB) based in Frankfurt, Germany manages and administers the euro and the Eurosystem. Each country in the Eurozone has a central bank, a system somewhat similar to the Federal Reserve System but with a very major difference. The United States is a single nation state and the Fed is the single “national” banks system. The Eurozone is an amalgamation of many independent countries (nations-states) that print the euros and govern independently. Essentially, these countries have agreed to share economic risk without real, central control. Each country has an independent government that can set its own economic policies even though it agrees to certain “united” principles.
As John Lanchester wrote in The New Yorker in “Euro Science” on October 10, 2011:
“The guiding principles of the currency, which opened for business in 1999, were supposed to be a set of rules to limit a country’s annual deficit to three per cent of gross domestic product, and the total accumulated debt to sixty per cent of G.D.P. It was a nice idea, but by 2004 the two biggest economies in the euro zone, Germany and France, had broken the rules for three years in a row.”
So is the euro bad, risky, or shady? Simply put, NO. It is used across Europe and many countries have pegged their currencies to the euro. Many countries hold euros as an international reserve currency. In 2000, the euro accounted for 27 percent of reserve currency while the US dollar was at 64 percent and the Yen was at 3.3 percent. Was all of this reserve currency held as paper money or ones and zeros? Mostly the later. Is this scary?
Till next time and a purely imaginary coin….