Friday, April 22, 2011

Essential reading

In the early 90's the Chicago Federal Reserve bank released a paper entitled Modern Money Mechanics. I didn't go to business school but for readers that did please let me know if this paper was required reading. This paper explains what money is, how it is created and how it is destroyed. As I've stated in the past numerous times that "banks create money" when they make loans readers have erroneously responded with the belief that banks lend out deposits. This is incorrect. Banks do not lend out deposits, they lend out against their deposits. In a fractional reserve banking system, banks keep a certain amount of money on reserve and then are permitted to lend (create) a certain amount of money based on those reserves and deposits. This paper explains the process in full detail and in easy to read terminology.

As many are taking note of the incredible tuition bubble that is taking place, reading AND understanding this process will make things much more clear as to HOW this bubble is taking place in the first place. In addition, as people think about, work, fight, kill, divorce,die and party over money, it makes sense to know what "money" is in the first place.


Here is an excerpt of the paper:

Who Creates Money?

Changes in the quantity of money may originate with actions of the Federal Reserve System (the central bank), depository institutions (principally commercial banks), or the public. The major control, however, rests with the central bank.
The actual process of money creation takes place primarily in banks.(1) As noted earlier, checkable liabilities of banks are money. These liabilities are customers' accounts. They increase when customers deposit currency and checks and when the proceeds of loans made by the banks are credited to borrowers' accounts.
In the absence of legal reserve requirements, banks can build up deposits by increasing loans and investments so long as they keep enough currency on hand to redeem whatever amounts the holders of deposits want to convert into currency. This unique attribute of the banking business was discovered many centuries ago.
It started with goldsmiths. As early bankers, they initially provided safekeeping services, making a profit from vault storage fees for gold and coins deposited with them. People would redeem their "deposit receipts" whenever they needed gold or coins to purchase something, and physically take the gold or coins to the seller who, in turn, would deposit them for safekeeping, often with the same banker. Everyone soon found that it was a lot easier simply to use the deposit receipts directly as a means of payment. These receipts, which became known as notes, were acceptable as money since whoever held them could go to the banker and exchange them for metallic money.

Then, bankers discovered that they could make loans merely by giving their promises to pay, or bank notes, to borrowers. In this way, banks began to create money. More notes could be issued than the gold and coin on hand because only a portion of the notes outstanding would be presented for payment at any one time. Enough metallic money had to be kept on hand, of course, to redeem whatever volume of notes was presented for payment.

Transaction deposits are the modern counterpart of bank notes. It was a small step from printing notes to making book entries crediting deposits of borrowers, which the borrowers in turn could "spend" by writing checks, thereby "printing" their own money.

What Limits the Amount of Money Banks Can Create?

If deposit money can be created so easily, what is to prevent banks from making too much - more than sufficient to keep the nation's productive resources fully employed without price inflation? Like its predecessor, the modern bank must keep available, to make payment on demand, a considerable amount of currency and funds on deposit with the central bank. The bank must be prepared to convert deposit money into currency for those depositors who request currency. It must make remittance on checks written by depositors and presented for payment by other banks (settle adverse clearings). Finally, it must maintain legally required reserves, in the form of vault cash and/or balances at its Federal Reserve Bank, equal to a prescribed percentage of its deposits. The public's demand for currency varies greatly, but generally follows a seasonal pattern that is quite predictable. The effects on bank funds of these variations in the amount of currency held by the public usually are offset by the central bank, which replaces the reserves absorbed by currency withdrawals from banks. (Just how this is done will be explained later.) For all banks taken together, there is no net drain of funds through clearings. A check drawn on one bank normally will be deposited to the credit of another account, if not in the same bank, then in some other bank.

These operating needs influence the minimum amount of reserves an individual bank will hold voluntarily. However, as long as this minimum amount is less than what is legally required, operating needs are of relatively minor importance as a restraint on aggregate deposit expansion in the banking system. Such expansion cannot continue beyond the point where the amount of reserves that all banks have is just sufficient to satisfy legal requirements under our "fractional reserve" system. For example, if reserves of 20 percent were required, deposits could expand only until they were five times as large as reserves. Reserves of $10 million could support deposits of $50 million. The lower the percentage requirement, the greater the deposit expansion that can be supported by each additional reserve dollar. Thus, the legal reserve ratio together with the dollar amount of bank reserves are the factors that set the upper limit to money creation.


  1. I actually enjoy when you post about fractional reserve banking and when you chart the rise in the value of precious metals, relative to U.S. currency. However, my guess is that more than 90% of college grads do not even grasp the concept of a private banking cartel printing and lending money into circulation.

  2. I'm glad you enjoy the posts Nando. It's amazing how few people understand how our money system works. Once you learn you never look at money the same way again. Sometimes when I pay for gas with "money" I tell the gas attendant "here's $30 federal reserve notes" as they give me this strange note. Personally, I believe our money system is the biggest scam of all. A global game of musical chairs where you must listen closely as the music is bound to stop every so often.

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