Banks, money and thin air

An urban myth is circulating on the internet that banks have been creating money out of thin air.

Those who have seen the cult film Zeitgeist and its sequel Zeitgeist Addendum, popular amongst conspiracy theorists and others suspicious of governments and banks, will have heard recounted the argument that banks can somehow create money out of thin air by the stroke of a pen or, these days, by the touch of a computer keyboard.

In Zeitgeist Addendum this argument is based on what is stated in an educational booklet published by the Federal Reserve Bank of Chicago. Entitled Modern Money Mechanics it first came out in 1975 and has gone through several editions.

Zeitgeist Addendum begins by describing how it thinks the Federal Reserve Bank (the “Fed”) creates money. If, it says, the government wants more money then, through the Treasury, it creates Treasury bonds which it exchanges with the Fed for currency notes of the same face value; as the government has to pay interest on the bonds this adds to the National Debt and so is “debt money”. Both the Treasury bonds and the currency notes have been created out of thin air.

This is one way of putting it but it is misleading. It is rather the other way round in that the initiative to create more currency comes from the Federal Reserve Bank. Once it has decided that more notes are needed it asks the Treasury to print them (for which the Treasury charges). The normal way these get into circulation is by the commercial banks converting into currency some of the reserves they are obliged to lodge with the Fed. Modern Money Mechanics explains:

“Currency held in bank vaults may be counted as legal reserves as well as deposits (reserve balances) in the Federal Reserve Banks. Both are equally acceptable in satisfaction of reserve requirements. A bank can always obtain reserve balances by sending currency to its Reserve Bank and can obtain currency by drawing on its reserve balance” (p. 4).

In any event, both the Treasury and the Federal Reserve are part of government so we are talking about internal state accounting arrangements. It is, however, true that the new currency has been created out of nothing. Since it is not backed by gold and convertible on demand into a pre-fixed amount of gold, it is what in the US is called “fiat money”, that is, money created by a mere act of State.

Modern Money Mechanics does not in fact have much to say about currency creation but concentrates on what it calls “money creation”. It draws a distinction between “currency” and “money”. This is explained clearly enough on the first page of the booklet where money is defined as currency plus bank accounts with a cheque or debit card; which is M1 in the jargon (“In the remainder of this booklet, ‘money’ means M1”).

Congressman Ron Paul, from Texas, a critic of “fractional reserve banking” and advocate of a return to a gold-backed currency, has an even wider definition of “money”:

“”M3 is the best description of how quickly the Fed is creating new money and credit. Common sense tells us that a government central bank creating new money out of thin air depreciates the value of each dollar in circulation.” (27 April 2006, see http://www.lewrockwell.com/paul/paul319.html).

M3 includes other types of bank deposits and liabilities not included in M1. In claiming that all new money created by the Fed depreciates the dollar he is overstating his case. All the US currency (but, as we shall see, not bank deposits) is created “out of thin air” but an increase won’t lead to a depreciation of the dollar as long as it corresponds to an increase in the amount required by the economy for its various transactions (paying for goods and services, settling debts, paying taxes, etc). It is only currency issued in excess of this that will cause a decline in its value and so a rise in the general price level.

Everybody accepts that cash (currency, notes and coin) is money. Some might be prepared to include cash deposited in banks as well. But Modern Money Mechanics definition of bank deposits is wider than this. It doesn’t mean just deposits by people of the money they already possess but any account for which the holder has a cheque or debit card, i.e. including credit lines granted to those who banks have lent money to (so enabling Zeitgeist to go on talking about “debt money”):

“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 banks are credited to borrowers’ accounts” (p. 3, emphasis added).

So, when it talks about “money creation” it is not talking about currency creation but mainly about “bank deposit” (in the above sense) creation.

The Federal Reserve booklet goes on to explain what “fractional reserve banking” involves and how it can lead to the creation of more “money” in the sense of more bank deposits. Banks, it explains, have learned that when cash has been deposited with them they only need to keep a part (a “fraction”) of it as cash as a “reserve” to deal with likely cash withdrawals; the rest they can lend out. What this fraction is depends on the circumstances, but historically it has been around 10 percent.

On the booklet’s definition, in making a loan a bank is “creating money” as their loans will take the form of creating a new bank deposit as a credit line which the borrower can draw on as if they had made a deposit of their own money (except they will be paying interest on it). The booklet then asks “What Limits the Amount of Money Banks Can Create” and answers that this depends on the cash reserves it has decided to hold or is required by law to keep.

It is here that Modern Money Mechanics, by suddenly shifting from what an individual bank can do to what all banks together (“the banking system”) can, opens the way to the misinterpretation of people like Ron Paul and the makers of the Zeitgeist films that banks too can create “money” out of thin air. The booklet explains that US banks are required by law to keep a “fraction” of deposits as
“reserves” in its vaults and/or a balance with the Fed, and says:

“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” (p. 4).

This is a very misleading way of putting as it could suggest that if banks receive total new deposits of $10 million they can immediately proceed to make loans of four times this. This is not so, and not really what the booklet meant to suggest. What it means is that the banks can immediately lend out only four-fifths of $10 million, or $8 million, and that this circulates throughout the banking system leading in theory to new loans totalling in the end $40 million, bringing total “bank deposits” up to $50 million.

Confusingly, the numerical examples the booklet goes on to give to illustrate this are based not on a 20 percent reserve fraction but on a 10 percent one (which is more or less what the law in the US requires for the kind of bank deposits in question). So, to take its example, if $10,000 is deposited in the banking system, initially say in one bank, that bank can make loans (create credit line bank deposits) of $9000. When it is spent this $9000 will be re-deposited in other banks which can then lend out 90 percent of this, or $8100; which in turn will be
re-deposited in banks, allowing a further $7290 to be lent out, and so on, until in the end and over the period, a total of $90,000 new loans will have been made.

This shows how the Fed can practice “fractional reserve banking” to control the amount of “money” (currency plus bank deposits) in the economy. This is done via “open market operations” as explained in a section headed “Bank Deposits – How They Expand or Contract”:

“Let us assume that expansion in the money stock is desired by the Federal Reserve to achieve its policy objectives . . . [T]he Federal Reserve System, through its trading desk at the Federal Reserve Bank of New York, buys $10,000 of Treasury bills from a dealer in US government securities. In today’s world of computerized financial transactions, the Federal Reserve Bank pays for the securities with an ‘electronic’ check drawn on itself . . . The Federal Reserve System has added $10,000 of securities to its assets, which it has paid for, in effect, by creating a liability on itself in the form of bank reserve balances” (p. 6).

The bank from which the Treasury bills were purchased now has reserves above the 10 percent limit and so can turn the $10,000 into loans, which starts the process described above rolling, leading to an extra $90,000 bank lending.

In theory the Fed could contract bank lending in the same way, but this has never happened. So M1 has gone up and up each year. But what about the currency in all this? It too has gone up but passively and almost automatically. With increased banking activity more currency notes are required, which banks get by converting their reserves into this and which, if it hasn’t enough notes, the Fed just asks the
Treasury to print more. But this has consequences – the depreciation of the dollar and the rise in the general price level Congressman Paul doesn’t like.

But has the banking system really created more “money”? Only if you regard “bank deposits” as money. If you don’t, all that has been shown is that currency has circulated in that the whole process depends on the initial deposit or injection of cash being recycled as further deposits by depositors (as opposed to by banks creating a credit line). So, neither an individual bank nor the whole banking system can lend more than has been deposited with it. By the end of the process, in the
example given, the first loan (out of the first deposit of $10,000) of $9000 has been used and used again for genuine deposits totaling $90,000. But all this assumes an expanding economy, since where is the money to repay the loans and the interest on them to come from without being assured of which the banks would not lend the money in the first place?

So the banking system does not create money to lend out of thin air but can only lend out money deposited with it and then only when economic conditions permit it.

Today, bank deposits are not the only source of what the banks lend. They also borrow on the money market (as has been highlighted by the present banking crisis). This means that their reserves are an even smaller percentage of their total loans, only about 3 percent in fact. This figure is mentioned in Zeitgeist Addendum as if this was now the “fractional reserve” and that therefore banks, or the banking system, can “create” loans of up to 33 times an initial deposit. Another silly mistake.

If currency cranks such as the makers of the Zeitgeist films have got the wrong end of the stick about “fractional reserve banking” and imagine that it means banks, whether singly or all together, can create money or credit out of thin air this is partly the fault of the way that booklets like the one produced by the Federal Reserve Bank of Chicago try to explain it. Of course the Fed does not believe the “thin air” claim, but to refute the currency cranks it would have not only to re-iterate that no single bank receiving an additional deposit of $10,000 can forthwith loan out $90,000, but also spell out that the expansion of credit line bank deposits still depends on people making real deposits of their own, unborrowed money (whether in cash or by cheque or by bank transfer). Which would restore a sense of reality and explode the myth that banks can create loans out of thin air.

ADAM BUICK