The Money Tree

They say that money doesn’t grow on trees. That’s true. It grows in banks.

I’m not talking about compounding interest either. I’m talking about creation of money right out of thin air. It is well known and understood that the Federal Reserve (and other central banks) print money at will. What’s not so well understood is that regular commercial banks essentially do the same thing. To understand this, we have to explore the nature of money, credit, and the modern banking system.

Money can be described in several ways and has a variety of characteristics.We should begin with the Merriam Webster definition: “something generally accepted as a medium of exchange, a measure of value, or a means of payment.” In early simple economies, barter was the principle means of exchange. This ultimately evolved to commodity money. Items which had a useful value on their own, are easily transportable, do not lose value or deteriorate, and are reasonably commonplace would serve as commodity money. Over the centuries, metal coins evolved out of being simple commodity money into serving as government issued currency. Generally, the metal coins face value as issued would be equivalent to the metal’s value independently. Of course, governments were notorious for devaluing the coins in a variety of ways.

Commodity money gave rise to modern fiat monetary systems. This evolution came to past after many centuries and after the introduction of paper currency. The United States ushered in the new era in 1971 when President Nixon “closed the gold window” removing the last link between the U.S. Dollar and gold. Fiat currency has its value because the government declares it to have value. Essentially, a U.S. Dollar as issued in paper (specifically, a Federal Reserve Note) is a debt of the Federal Reserve backed, not by gold or any commodity, but by a debt obligation of the U.S. Treasury (notwithstanding the other assets which the Fed has added to its balance sheet since the onset of the Global Financial Crisis).

Let’s follow the circle: the U.S. Treasury issues debt (bills, notes, or bonds) which is purchased by investors such as large banks; the Federal Reserve buys Treasuries from large banks in return for freshly printed cash; this cash makes its way out to businesses and consumers via transactions with the banks; the money is used to pay taxes going to the coffers of the U.S. Treasury; and, finally, the U.S. Treasury repays the Federal Reserve on its debt obligation ending the circle with the destruction of the currency. This process is how our money derives its value. This complex circuit is important, but it does not tell the entire story. Much of this process is digital. Who pays their taxes by sending paper currency to the IRS? No one. Bank accounts are increased and decreased digitally by computers throughout this entire circuit.

This is where it gets interesting. Throughout this process, the various entities may also use credit as money. When someone uses a credit card or receives a loan, cash is usually not involved in the transaction. And, as most everyone knows, in our system of fractional reserve banking, banks can and do extend credit beyond their cash reserves. The typical example of how this works goes something like this: Joe deposits $1000 with Bank ABC; Bank ABC then lends $900 to Jane maintaining $100 in reserves; Jane spends $900 at the store who deposits the cash with Bank XYZ; Bank XYZ lends $810 to Jack (keeping 10% or $90 in reserves; … and so on. This process expands the money supply without the issuance of new cash. Jack still has $1000 which he can spend on goods and services. But, Bank XYZ also has $810, and everyone else on down the chain. The size of the reserve requirement will determine how much money is created via bank credit. If the reserve ratio is 10%, then this process would ultimately create $9000 if exhausted completely.

However, this is not how the real world actually works. This is the important part of the story. Banks do not wait to receive deposits before they lend out new money. A bank does not need to physically have $250,000 on hand (in cash or even in assets) to issue a loan of such size on a house. If a bank issues such a loan, they simply need to ensure they meet their reserve requirement which can be done by receiving a loan from another bank. This chain ultimately goes bank to the large privileged banks who can access funds directly from the Federal Reserve. The Fed is ultimately reacting to this credit creation cycle in its operations with these banks (as described above). If you want to read more about how banks defy common wisdom and create credit out of this air, visit George Washington’s Blog and read this and this.

We’ve already established that credit is, in effect, money. It does not behave significantly different than cold hard cash. Many economists and fiscal conservatives have rightly criticized the Fed and its expansionary monetary policy. But, what is lost in the argument is that the private banking system has been expanding credit for decades. They have been free to do so via the implicit rules and policies of a fiat-currency, fractional-reserve system. The implication is that the money supply, and its impact on inflation, must be analyzed from the perspective of credit expansion – not the expansion of the Fed’s balance sheet. The Fed has tried desperately to stave off deflation by “printing money” to buy all sort of dubious assets and monetizing the federal deficit. But, this has had little inflationary impact. Why? Banks are still not expanding credit.

Let’s analyze this a little deeper. Why are banks not expanding credit? Largely because consumers are not willing to take on more debt. We have hit the wall. We have had our inflation moment. As we pay down debt (or default) and credit is destroyed, we will experience deflationary forces. Admittedly, this is not the whole story. The international perception of the Dollar is still a major factor in the inflation/deflation debate. But, with the financial challenges of Europe, a Japanese economy which has been stagnant for more than a decade, and no other major economies ready to challenge, the Dollar will reign supreme in the interim.

But, there is another problem with all of this. The banks do have a money tree. They have an implicit license to print money. Sure, they cannot literally print money. But, is this still not counterfeit? Is this still not fraud? They make money on this process by collecting interest. I ask my readers to consider this carefully and study the evidence. If the banking system is engaging in a process that is tantamount to counterfeit, what should be done? This is hardly an example of free-market enterprise. The next time that you begin to reflexively defend banks against reform, vilification, and other abuses in the spirit of free-market capitalism, ask yourself if they deserve such a defense or if they are essentially nothing more than a rouge arm of the Federal government.

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