Thursday, January 20, 2011

Creating Money out of Nothing

After the previous post, the conceptual difference should now be clear between money coined or redeemable in silver or gold, and money redeemable only in more of the same, i.e., paper. The former is a thing of the past: we are never likely to see it return in our lifetimes. So just forget about it. Our desire for convenient money has trumped our need for concrete money. "We all accept paper dollars now."

Suppose you have a small retail business, in which you have accumulated a bunch of paper currency amounting to nearly $350.00. You don't want to keep that much cash lying around, and so you gather $250 of it to deposit in your bank. You make out a deposit slip with your account number on it, and you hand it, together with the cash, to the teller, who stamps your deposit slip, and gives you a receipt. What have you (and the bank) accomplished by these actions?

You have traded the Fed's paper promises to pay (in more paper) for the bank's promise to pay you, at your request, all or any part of the $250, again in paper dollars. In fact, if your account pays interest, then you have lent the Fed's paper promises to the bank, in exchange for its promise to pay you regular interest at a specified rate, plus the principal on demand.

The bank now has $250 more in cash, which it puts in its vault, where it eventually will become commingled with all of the other currency in its possession. It keeps this currency on hand to meet the day-to-day cash withdrawal needs of its depositors. On average, those needs are far less than the total amount of deposits in the bank.

The bank's promise to pay you back your money is now a liability on the bank's books, expressed in the credit it gives to your account in the amount of $250.00. That credit, however, is simply an electronic transaction, accomplished with a few keystrokes. Although banks will rent you a safety deposit box in which to store your valuables, which remain segregated there and hence your own, the dollars which you deposit vanish immediately into the bank's holdings of currency, and are no longer "yours." You have no legal right to get back the same physical Federal reserve notes you handed over to the bank (unless you put them into your safety deposit box).

Electronic money differs from paper money in the ease with which it can be transferred instantly from one place to another -- the bank "wires" the money to another bank, for instance. Trillions of dollars are moved around the world every day in this manner, and no physical cash changes hands, but only electronic debits and credits. The sheer convenience of electronic money has led to its dominance in our banking system.

Make no mistake, however: electronic promises to pay are twice removed from the original source of the promise to pay. They represent a bank's promise to credit you with a certain amount of money, which it will satisfy upon your request to be given paper currency in exchange -- which then leaves you free of the bank, and with only the Fed's promise to redeem your currency in denominations of like kind.

But if a bank only took in deposits, which create liabilities on its books, then how would it acquire any assets to offset those liabilities? Well, if it kept all the depositors' cash in its vault, then that amount of cash would offset the liabilities owed to the depositors. But then the bank could never make any money -- with which to pay you interest on your deposit, for example.

As we all should know by now, no bank keeps 100% of its depositors' total deposits around in cash in its vaults. It loans out money to borrowers, and charges them interest, so that they have to pay back to the bank considerably more than what they borrowed (on a long-term loan). The extra which the bank thus earns allows it to pay (a lower rate of) interest to its depositors, pay its expenses, and earn a net profit.

The reason why a bank's cash on hand never equals the total deposits on its books is quite simple to understand, once you realize how a bank operates. For a bank's deposits do not consist just of money that has been brought in to the bank by people with currency to deposit. Every time a bank makes a loan to a borrower, such as to purchase a car, or a house, the bank simply creates the loan amount electronically in the borrower's account, with no actual cash ever changing hands. When the borrower writes a check on his account to pay for the car, for instance, the seller deposits that check with his bank, which then electronically exchanges debits and credits with all the other banks, through the auspices provided by the Federal Reserve System. The same thing happens with paper checks which are deposited in the bank -- an electronic credit is generated to the account in the amount of the check, and no cash ever changes hands.

Thus, the actual amount of money circulating in the economy at any one time is far greater than just the total of all currency and coins outstanding. But where does all this electronic money come from in the first place? Are there no limits to the amounts that banks can create electronically by lending?

There are: the limits are both practical (only so many people want to borrow, and are able to borrow, at any given time), and legal: in the United States, most banks must keep at least ten percent of their outstanding loans in the form of "reserves", which are simply cash on hand, or capital invested, or deposits (electronic credits) with the regional Federal Reserve bank. This means that for every $1000 it has in reserves, a bank may lend out an additional $9000 to borrowers.

That $9000, as we have seen, comes from nowhere. It is created in a few keystrokes in the bank's computer, and credited to the borrower's account. The money is not only not the bank's own (i.e., not what it has in its vault), but it also comes at zero cost to the bank. It does not have to borrow it from any other bank, and so it does not have to pay interest to anyone on it. But it gets to collect interest on the $9000 from those who borrow it.

This is the dirty little secret of our present banking system. The cost of their "money" is zero to counterfeiters, as well (other than the trivial costs of paper, ink and design) -- but they are put in jail for circulating it within our system. Banks, however, by law are sanctioned to create money electronically, up to the limit dictated by their reserves, and to put it freely into circulation so they can earn interest on it.

Money thus created electronically can also be destroyed electronically. How? Suppose you write your bank a check on your checking account to pay an installment of principal and interest due on your car loan. The bank keeps the interest portion of the payment, and credits it to earnings. But the principal amount of your payment reduces the total you have borrowed, and to that extent the bank's loans outstanding have gone down. That amount by which it goes down will never be recreated -- bank loans are made to be paid off in the end. The only way the bank can keep creating new money to replace what is paid back is by making new loans, or by increasing its reserves.

This has been only a surface overview of money and banking -- for a full treatment, I recommend Murray Rothbard's book, The Mystery of Banking, which is available free as a (1.7 MB) .pdf download from this link. It is very clear and succinct, and explains the subject fully.

Now with this and the previous two posts as background, we will finally be ready to look next at how our money system actually operates under the Federal Reserve Act passed by Congress in 1913. There was a reason that Andrew Jackson refused to renew the charter of the Second National Bank of the U.S. in 1836, and we will begin to see why, after the next post in this series.




6 comments:

  1. "Creating Money out of Nothing"

    My Dear Curmudgeon,

    Jus' curious. What do you think of your nay-sayers who think you're an overly gloomy "The sky is falling" Chicken Little who's much too pessimistic? And what do you say to them as a loving warning to them?

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  2. To point out things that people, churches or countries are doing wrong, in a way that lets them see what the legally or morally better ways to do things are, is not to claim "the sky is falling." Chicken Little had no remedy to suggest for the disaster diagnosed, other than running around like a chicken.

    If the diagnosis is correct, then eventually one's reason should follow. After all, insanity is defined as doing the same thing over and over again, but expecting a different result. ;>)

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  3. Mr. Haley

    I have over the past three decades come to realize just how important an understanding of economics is to our ability to make sound decisions, even on what superficially appear to be non-economic issues, and am very grateful for the service you perform by devoting some of your posts to the subject.

    And I am cheered to see you linking to mises.org. The sheer volume of valuable economic references (books and papers), many of them available in Adobe's Portable Document File at that worthy institution is staggering. The link to that library is the Literature tab on their Home Page. It has saved me significant sums of money which I would otherwise have spent purchasing paper copies.

    Pax et bonum,
    Keith Töpfer

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  4. Matt. 6:19 Nolite thesaurizare vobis thesauros in terra ubi erugo et tinea demolitur ubi fures effodiunt et furantur.
    6:20 Thesaurizate autem vobis thesauros in caelo ubi neque erugo neque tinea demolitur et ubi fures non effodiunt nec furantur.
    6:21 Ubi enim est thesaurus tuus ibi est et cor tuum.

    Vade et tu fac similiter. (Lk. 10:37)

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  5. Minor quibble: The PDF I downloaded was only 1.7M. Did you mean to point to a different version, or was the 148M the size of something else?

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  6. That was a typo -- I'm not sure how I got "148" out of "1.7", but the reference has been fixed. Thank you, chrylis -- and enjoy the book.

    ReplyDelete