Tuesday, June 14, 2011

How Banks Create Money...Out of Thin Air



Anytime somebody criticizes the Federal Reserve System and tries to point out that the entire system is a private banking cartel masquerading as a "quasi-Governmental" agency, people defend the Fed and it's policies. They conflate any and every criticism of the Fed as "conspiracy theory."

Almost one year ago, I wrote a piece for the Spearhead called The American Dream: 21st Century Serfdom.

In that post, I wrote the following:

Understand that our modern economy is based not on MONEY…but on DEBT. An obligation to promise to paying the bankers – WHO DID NOTHING MORE THAN TYPE A NUMBER INTO A COMPUTER IN THEIR BANK LEDGER SHEET PROGRAM AND – VOILA! – you too can sign up for 21st century serfdom to achieve the “American Dream!”

But don’t look at the Bankers in your local neighborhood bank as your Feudal overlord…he’s just a mid-level overseer of the Lord’s vast estates.

See, his bank, in turn, has to borrow a fraction of their funds from the central banking system so that they can turn around and obligate YOU in your pursuit of the “American Dream.”

Does this sound outlandish or confusing to you?

Apparently, it did.

Here's some quotes from that article:

Richard Brodie:

A bank can’t create $1000 from a $100 deposit. It creates $90, which can then be deposited in another bank and create $81, and so on. There’s a decent Wikipedia article about fractional-reserve banking that seems to agree with me.

Lynch:

This doesn’t make sense to me, could you please elaborate further?

The initial $100 deposit, which could then be used to lend out $90.. that makes sense. The bank makes interest off of what it loans out on the $90, eventually recouping the initial $90 and then some. That’s how I’ve always understood banking to work.

However, when you say the $100 deposit becomes the “reserve” for a $1000 loan.. how does that work? In the first case, the bank takes the $90 from the account. In this second case, where does the missing $900 come from? At some point the borrower gets $1000 (for their car, business, whatever) and spends it. Then they are on the hook for paying it back. The bank still has to give out $1000. How do they do that from someone else’s $100 deposit?

Anti Idiocy:

I too question the accuracy of this analysis. I’m not saying it’s wrong, fractional reserve banking isn’t an area of great expertise for me. But it sounds fishy. My understanding is that if the bank receives a deposit of $100, it can loan out $90 of that. It doesn’t have to keep in reserve more than 10% of total deposits.

Gunn:
Technically this analysis is all wrong.
The $100 deposit is actually a bank liability on its balance sheet, not an asset. Any loans made to customers are assets on its balance sheet, as these represent monies the bank is owed.

ABS:

I’m sure HL means well, but this article really ought to be taken down – its not going to make The Spearhead look good, and really has nothing to do with MRA, guyinism, or whatever one wants to call it. Yes, money is created through the banking system, as some of the commenters have noted, but not in the way described by HL.

That's without even referencing a banker goon who used the handle Dexter Morgan to attack me in that thread.

One year later, I still see the same arguments over at In Mala Fide:

Fractional reserve banking is not exception: if people don’t deposit the money in their bank account, the bank is unable to loan more than what it has already.
The fraction of none is always none.
If they do, what the bank do is to take a loan from the people putting the money in their account and loaning to others.

E.G.
A deposit 100$ in bank –> Bank loan 80$ to B –> B buy 80$ of nails from C
C deposit the 80$ in bank –> Bank loan 64$ to D –> D buy 64$ of wood from E
E deposit 64$ in bank –> Bank loan 51,2$ to F –>…..

The bank, at the end, have received a loan from A, C, E and is able to loan to B, D, F
The resources used by the bank to loan are the initial 100$, the 80$ of nail, the 64 $ of wood, etc.
There is no creation of resources from thin air, only displacement of them in time (and hoping all the takers pay back the loans).

Let's make this really clear and unambiguous.

The Dallas Federal Reserves own website basically admits the truth about how Banks create money "out of thin air."

How Banks Create Money

Banks actually create money when they lend it. Here’s how it works: Most of a bank’s loans are made to its own customers and are deposited in their checking accounts. Because the loan becomes a new deposit, just like a paycheck does, the bank once again holds a small percentage of that new amount in reserve and again lends the remainder to someone else, repeating the money-creation process many times.

I can't say it any plainer than the Dallas branch of the Federal Reserve does right there.

21 comments:

Grim said...

I think the part that's hanging people up is the fact the federal reserve loans money to bank anytime they need it to cover withdraws. There used to be limits on how much capital they needed to reserve to cover deposits but I believe those where removed in 2003 or 2004 and the fed simply lends money whenever they ask.

sth_txs said...

I remember reading over 10 years ago The Case Against the Fed and What Has the Government Done to Our Money. I had to read them both at 2x to get it.

But yes, this kind of ignorance is astounding. Oh well, most of us will be living in filth, stench, and pestilence soon enough. I've talked to people from Latin American countries that have been through currency problems; not fun.

Anonymous said...

Yes, withdrawals are the key - at least for honest confusion. Willful stupidity's another matter entirely; there's no cure for that but letting the banksters enslave them and their kids.

When you say that 'on a $100 deposit, a bank lends $90 and keeps $10 in reserve', you need to stress that the money creation aspect of this is that the depositor can write a check for the full $100, not the $10 the bank actually has, and someone else simultaneously has $90. (And so on and so forth down the line of borrowers/depositors.) There would be no money creation if the depositor couldn't write a check for more than $10 until the $90 loan was repaid. That's the answer to Lynch's question of where the missing $900 comes from.

Anonymous said...

This is the kind of thing you study in the first year economics class at any university. Yes, a high-functioning society needs a managed monetary system. It doesn't matter whether it's paper, gold, or credit (savings of others to pay for their spending later). This whole "OMG it's all a scam!!!" destroys your credibility. Yes, of course it's a scam. A scam we are all choosing to go along with, to make life better, facilitate exchanges, obtain thing we can't pay for outright in furs and vodka. That's where the whole civilized society thing comes in.

Anonymous said...

Long, long ago, a fellow worker told me if the reserve rate was 10% and I deposited $100, the bank could loan out the $900, keeping the $100 as the 10% reserve. I told him he was not only a liar but a damned fool. When I checked it out, I had to eat massive amounts of crow.

Anonymous age 69

Anonymous said...

You are correct. The banks can create $1000 out of a deposit of $100.

The misunderstanding occurs because most people understand that the bank lends out $90 of a $100 deposit with a reserve ratio of 10%.

What most do not understand is that that is not how it actually works. The bank accepts your $100 deposit, and treats that $100 as the 10% to be kept on reserve.

Since the bank has $100 in reserves, it uses it to create the other $900 (i.e., 90%)...

Shark said...

This is somewhat un-related, but I recently saw The Zeitgeist Movement; interesting take on the banking industry

Corban said...

The fractional banking alchemy works on a math principle called "limit of a geometric sequence sum": The sum of money in the system is equal to 1/Reserve Ratio * Deposits.

For 5% on 2,000, that's 40,000
For 10% on 100, that's 1,000.

Just as money is created, it is destroyed. This is a form of leverage that magnifies wealth. Deleveraging, its opposite, utterly implodes it. Ashes to ashes, dust to dust.

Anonymous said...

I think his main point is that "the masses" don't get to enjoy this wealth magnification of leveraging , fractional banking, alchemy only the bankers do.

Anonymous said...

"Most of a bank’s loans are made to its own customers and are deposited in their checking accounts."

Why would anyone borrow money at >5% and put in into a checking account making <1% much less "most" of the people borrowing money. That makes no sense.

Anonymous said...

How do people not see this? This is why you (and Vox and Athol, etc.)need to keep up the good fight There are noobs (like me!) who have just taken the red pill and need massive amounts of information in a short time to prepare.

Traveller said...

So if bank lends me money, the bank created money from my borrowing.

Let's guess I give the money back to the bank immediately without spending it. The bank will have it immediately. So why should my presence mandatory for creating money?

Ok this is not my field so I am not expert of this stuff. Any link book or video to recommend to study this matter more?

johnnyshornofplenty said...

The best material I have ever read on this subject is by Murray Rothbard. I strongly recommend "The Mystery of Banking" which I think is available on PDF as a free download. Google it.

Atlas said...

I have been studying this a bit lately. This is a great youtube video that works though all the particulars:

http://www.youtube.com/watch?v=7auQEXTWomA&feature=related

Anonymous said...

The easy answer is there is something north of 70 TRILLION in credit market debt and only a few trillion on deposit.

Anonymous said...

I've done some math on fractional reserve banking. Although my numbers below don't exactly match $1000, you can see the process. Basically, the bank technically could only have $10 in their vault, but be accountable for $899 in case people defaulted(and until principle and interest is received). The following numbers represent the amounts they can loan with that original amount, then the smaller amounts after 10% hold:

$0.27
$0.25
$0.22
$0.20
$0.18
$0.16
$0.15
$0.13
$0.12
$0.11
$0.10
$0.09
$0.08
$0.07
$0.06
$0.06
$0.05
$0.05
$0.04
$0.04
$0.03
$0.03
$0.03
$0.02
$0.02
$0.02
$0.02
$0.02
$0.01
$0.01
$0.01
$0.01
$0.01
$0.01
$0.01
$0.01
$0.01
$0.01
$0.00
Tatal loaned with $10 in the vault = $899.96

Shane

Anonymous said...

Sorry, my numbers got cut off. Here they are again:

$90.00
$81.00
$72.90
$65.61
$59.05
$53.14
$47.83
$43.05
$38.74
$34.87
$31.38
$28.24
$25.42
$22.88
$20.59
$18.53
$16.68
$15.01
$13.51
$12.16
$10.94
$9.85
$8.86
$7.98
$7.18
$6.46
$5.81
$5.23
$4.71
$4.24
$3.82
$3.43
$3.09
$2.78
$2.50
$2.25
$2.03
$1.82
$1.64
$1.48
$1.33
$1.20
$1.08
$0.97
$0.87
$0.79
$0.71
$0.64
$0.57
$0.52
$0.46
$0.42
$0.38
$0.34
$0.30
$0.27
$0.25
$0.22
$0.20
$0.18
$0.16
$0.15
$0.13
$0.12
$0.11
$0.10
$0.09
$0.08
$0.07
$0.06
$0.06
$0.05
$0.05
$0.04
$0.04
$0.03
$0.03
$0.03
$0.02
$0.02
$0.02
$0.02
$0.02
$0.01
$0.01
$0.01
$0.01
$0.01
$0.01
$0.01
$0.01
$0.01
$0.01
$0.00 = $899.96

Shane

Anonymous said...

So in summary: So, this bank only got a $100 deposit. Throughout history 10% reserves are adequate to fill peoples' needs to withdraw their money. But, how banks work is, they've given out $900 in money created out of thin air. They only have $10 in actual reserves in their vaults, but should have at least $90 ($900 times 10%). They'll eventually have $90 plus interest...eventually. This is why banks always fail in hard times. This is why they will fail again. This is called Fractional Reserve Banking. This is the method all banks use today.

Shane

Anonymous said...

Read the book by G. Edward Griffin called The Creature From Jekyll Island.(Ironic name) It's about how the Fed was formed. Very interesting. Last month Glenn Beck had him on his show. Now Glenn Beck does not or will shortly loose his show. I just started the book. Very good read. Lots of research. Best place to buy it is through Midas Resources. They throw in a walking Liberty $1.00 silver coin. One book per family BTW.

Gunn said...

Look, the thing you're missing (wilfully it seems) is that banks must hold equity against loans made (technically, equity is held against risk weighted assets, with different types of loans subject to more or less equity holding requirements).

Equity in this sense is not customer deposits, its actual shareholder equity (or instruments with similar obligations on the holders).

This is what stops banks creating infinite money; their P&L is constrained by the amount of equity they hold. Further, investors look for return on equity, so its a careful balancing act for banks - each new loan is marginally more expensive to make due to the increased equity held, and at some point RoE decreases from increased lending.

I'm also not aware of any banks running advances to deposits ratios higher than 100% (i.e. more loans made than retail deposits held). If you have examples, then sure, I'd agree that those banks are engaging in extremely risky behaviour (they are basically assuming that they have access to liquidity to bridge any short term funding requirements, which is very dangerous; its why the UK's Northern Rock Building Society collapsed for example).

But no Retail Banker could seriously argue that running such ratios was a sound business decision.

Captain No Marriage said...

Americans would rather watch Dancing with the Stars than to pick up a book about finance or economics.