How money is made? Most people think that government prints money. Wrong! At least in USA, and in other developed countries, government doesn't.
Economists tell us that the basic equation of money economy is:
M * V = P * Q
Of course, real equations are a little bit more complex, you can look at them here.
M is amount of money in circulation.
V is the velocity of money, or how many times M is turned over within one year.
P is the price of the average transaction.
Q is the number of these average transations.
We can see, that price level P is in direct proportion to quantity of money and money velocity and in reverse proportion to the number of transactions during one year.
So far so good. But where money comes from? Times when money was some precious metal, are long gone. You can forget about it. Currently, all money in circulation, with a small exception of coins, is... debt. Most of money in current economy is just some kind of electronic records. This money comes into circulation when Federal Reserve lends money to banks, which lend it to other banks, which lent it to businesses and population etc. There is also paper money, printed by Treasury. And paper money is debt too, this time debt of government, because paper money doesn't live long. When paper money becomes unusable, government buys it back.
Yes, since 1971 we live in the brave new world. Money = Debt.
This equation, though, has several consequences, obvious and not so obvious.
First of all, if money velocity falls (crisis, like now), economy needs more money, so Fed needs to increase amount of debt. It reduces interest rates, so banks can borrow more money from it. It can also directly inject money into circulation by buying some debt, usually Treasuries. Note, that this debt should be already on the market. If money velocity increases (boom times), Fed, in order to slow down inflation, should decrease amount of money in circulation. So it raises rates and also might sell some of debt tools it's holding.
So far so good. But this machine of money creation can only work in inflationary environment. Because there is no such thing as negative interest rate. If we have deflation, and rates are already at effective zero, like right now, Fed doesn't have the ability to ease credit anymore. It can buy more Treasuries and even some more debt tools, but, again, this debt should be on the market already.
Which means that we have another equation: Public Debt + Private Debt = Money. In other words, if amount of private debt decreases, like it was for the last 18 months, public debt, i.e. debt of federal government and state governments should increase. Looks like this part just can't get into the heads of so-called "Fiscal Conservatives", which want balanced budgets. If you balance budgets on all government levels, economy will collapse in the first crisis.
Deflation is bad. Why? If prices fall, you can buy more stuff, right? If you have a job, of course. And here's the problem. Money = Debt, without debt, economy doesn't have money. In deflation, debt cost interest rate plus rate of deflation. If debt is expensive, less companies take it, decreasing money supply even more. This is called "Deflationary Spiral". It was big part of depressions of 1873-1879 and 1930s. We now have unemployment rate 10%, how about 25% like in 1930s?
That's why all ideas of returning to precious metals, gold standard, etc. are total bunk. I mean, if we want stagnant economy, we can do it. If we want economy growing 2-3% a year, we need growing money mass. You can't increase amount of gold at this rate. I have suspicion that Gold Standard of the end of 19th century and beginning of 20th survived that long (about 40 years, if you take most of the world) only because of discovery of great gold deposits in South Africa.
Another not so obvious consequence: fiscal responsibility, at least defined as "spend less, save more, don't take much debt, if at all" is bad for the economy! It's good for the individuals and, maybe, some businesses, but bad for the economy in the whole. Usually "Paradox of thrift" is explained as the fact that reduced demand harms economy. But there is another explanation: because Debt = Money, people and businesses which take less debt, reduce amount of money in circulation. That's why I'm very angry at our President for calling to spend less and save more.
There is one problem with current money though. Economics, as usual, doesn't completely take equation Debt = Money into account. Economists are looking in rear view mirror, as usual. And the worst phrase I've read about money lately came from Ben Bernanke, our Fed Chairman. He wrote: "Under a paper-money system, a determined government can always generate higher spending and, hence, positive inflation." Year, right, we can see quite opposite in Japan. 20 years of deflation, my deep condolences to the lost generation of that country. I know, Uncle Ben wrote a book on Japanese Depression, but it doesn't mean he can get it right.
We are in a very serious crisis right now. Maybe we avoided depression, only time will tell. But definitely, this time is different. Economics is not an exact science because you can't predict behavior of people. In order for any economic policy to work, people should respond to it right. For example, if Federal Reserve wants to print more money by easing credit, people and businesses should be willing to take credit and banks should be willing to give it. In Japan, that wasn't happening (looks like still doesn't). Bernanke Doctrine doesn't tell us what to do if they give money and nobody comes. Especially naive is an idea of currency depreciation. Japan was trying to that too, you know.