“Money makes the world go round.”
John Kander and Fred Ebb
Line from the song “Money, Money” – from musical Cabaret.
Because the Financial Sector keeps growing as a portion of our economy, it is important to ask ourselves, “What do banks do?” Most of us think (to the extent that we think about it at all) that commercial banks serve some pretty basic functions like holding our money, making it easier to use, and lending to customers. If I buy a pack of gum at my local bodega, I’ll probably pay in cash. But having a bank account that allows me to make easy ATM withdrawals, write checks, and have a debit or credit card makes it easier to spend money more often and in bigger chunks. Similarly, if I need money to buy my first home or open a small business, the bank is a good place to go for the loan.
These are, in fact, functions of banks, but this is certainly not the whole story. Perhaps the most critical and often overlooked thing that occurs via these seemingly ordinary processes is that banks are creating pretty much all of our money, and that is a really powerful function. As one of our more under-appreciated Presidents, James Garfield, once correctly observed, “he who controls the money supply of a nation, controls the nation.”
Some Common Misconceptions about the Source of Our Money
We often think of American money as being made at the U.S. mint by craftsmen mixing special dyes while large machines engrave metal plates. In fact, because the mint gives banks new coins and bills in exchange for old ones or transfers of digital money, the kind of work that goes on at the mint doesn’t have much to do with the overall money supply. Hard currency, like bills and coins, is the most traditional form of money, but it is hardly the only one or, at this point, even the most common. For example, because the purchasing power represented by the numbers on our ATM screens is pretty much the same as that of the bills and coins in our pockets, we don’t usually even think of the cash form of money as having priority over the increasingly predominant electronic forms money takes. We tend to move our money back and forth between these two forms without much thought, our main consideration being what it is we are looking to do. For instance, if we are headed for a cash-only restaurant, we want our money in that form; but if we anticipate buying a sandwich on a flight that only takes credit or debit cards, we prefer the electronic kind.
And note—there is no stockpile of bills and coins in banks’ basements or anywhere else equivalent to all of the electronic dollars and cents shown on all of our bank account web pages. The Treasury Department runs the mint and the Federal Reserve then makes sure enough bills and coins are available for us to engage in the kinds of transactions that require them. The Fed lets the rest of the money exist in purely digital form. The Federal Reserve’s decision about how many bills and coins to have in circulation is not driven by concerns about the overall money supply. Rather, the Fed’s interests are so mundane that it focuses on problems like making sure there is adequate cash available on weekends (when we apparently tend to use more of it) as opposed to weekdays (when we seem to use more plastic). The mint and the Fed are just trying to keep the right amount of old fashion bills and coins around to facilitate the kinds of transactions that need hard currency; neither is the hub where money is made.
It would also be a mistake to assume that the Federal Reserve has other tools by which it creates all of our money. There is no doubt that the Federal Reserve has extraordinary powers to influence the amount of money circulating in the economy, and, as will shortly be explained, at times it creates money out of thin air. However, the notion that the Fed is the main engine for our money’s creation is also wrong. Before explaining more about the kinds of things the Federal Reserve regularly does to influence the supply of money, let’s first explain how the real creators of our money, private commercial banks, get it done.
How Commercial Banks Create Money
We know how bank loans basically work, but it takes a little thinking to realize that money is created in the process. If Jill has $100 in a jar of coins she is saving to open her first bank account, before she goes to the bank those coins represent — yes — 100 units of the total U.S. money supply. Jill (correctly) feels the coins could be used to buy $100 worth of goods and services in society; that is, the coins have $100 worth of purchasing power. And, as suggested above, when she goes to the bank, gives the coins to the teller, and checks her ATM a moment later to see an account balance of $100, we might think that nothing much has changed.
But, in fact, things immediately change because the bank does not just leave Jill’s money sitting there; it loans a large portion of it (for big banks, up to 90%) to someone else. So assume that the bank increases its total portfolio of loans by $90 based on Jill’s $100 deposit by extending a $90 loan to Jack, for example. There is now literally more money in society because of the $100 deposit. Jack is going around understanding that he has $90 in purchasing power that was not there before. At the same time, Jill (oddly, perhaps) does not feel any poorer for having put her money in the bank with the full knowledge that someone else (Jack) is effectively going to have access to “that money” as well. This is really no different than if we were in a position to lend a friend $90, and, having done so, continued to walk around a mall feeling as if it was still in our pocket. Make no mistake about it, it’s good to be a bank. A bank license enables a bank to participate in this genie-like “fractional reserve” system whereby you can credit accounts with money while at the same time giving a high fraction of that (same) money to someone else by way of a loan. In the process, this is how almost all of our money is created. In our example above, Jill’s deposit of her $100 worth of coins and the bank’s resulting $90 loan to Jack created 90 units of new money, increasing the money supply from $100 to $190.
There are a number of things to understand about these transactions. First, obviously, is that whether this new money stays in the economy or shrinks back to the original $100 (or less), is going to have something to do with what Jack does with it and, specifically, whether he can pay it back. But before we go there, it is important to stress that in a fractional reserve system, the mere fact of both the deposit and the loan immediately creates money, regardless of what Jack does with it. Because even if Jill or Jack (or both) do not use the money, the money supply is higher while the loan is outstanding, as reflected by adding up all the “money” shown on their respective ATM screens. Jill is showing that she has $100 to spend (or more if she has overdraft privileges) while Jack sees that he has $90 which he can, and probably will, use too.
Second, it is hardly the banks’ practice to make loans, have them paid back, and then shut down their lending practices. To the contrary, banks are in business to make loans with interest, so while Jack’s individual loan will come due and have to be paid back, it is extremely likely that so long as Jill keeps $100 on deposit, someone — be it Jack by rolling over the loan or someone else by getting a “new” loan — is going to have additional purchasing power (money) because of Jill’s deposit. In other words, we don’t expect the bank’s business to simply shrink because a creditor pays back a loan. Banks are in business to lend, and they will continue to do so after Jack pays back his personal loan.
And third, if Jack pays the loan back with the required interest, the bank is actually going to have more money under its control at the end of the loan than before. Suppose, for example, the interest charge over the term of the loan was 10% and, at the same time, Jill kept her $100 on deposit. This means that when the loan is paid back, the bank is now going to have reserves of $109 (Jill’s $100, plus the $9 in interest the bank earned from the loan to Jack). So now the bank can lend $98 of its deposits and investments and still be compliant with the Federal Reserve rule to hold at least 10% in reserve, meaning the money supply will grow even more in the next round of lending. Jill still sees $100 on her ATM screen as available for spending; the holder of a second loan (let’s say it is Jack again), now has $98, and the bank has held in reserve one additional dollar taken from the interest it received from Jack’s first loan, meaning the total money supply went from $100 when the money was in the form of Jill’s initial coins to $190 during the term of the first loan and finally to $199 during the term of the second loan. And the process is obviously unlikely to stop there. As long as the loans are being paid back, the money supply will grow, and grow, and grow, all as a result of the traditional practices of commercial banking.
This hardly completes the story of what banks do. For example, it leaves open the critical question of how a society comes up with the money to pay interest under such a system. But before going there, let’s return for a moment to the activities of the Federal Reserve.
What The Federal Reserve Does
The Federal Reserve is, after all, a bank, too, so it should come as no surprise that it also has genie-like powers of money creation. For example, it recently used these powers on the tremendous scale of up to $85 billion a month through its “Quantitative Easing” program. The way Quantitative Easing basically works is that the Federal Reserve purchases either U.S. Treasury bills (loans Treasury made to private individuals and institutions) or mortgage-backed securities (the complex packages of individual mortgages that were at the heart of the 2008 crisis), in either case using “money” the Fed just literally brought into existence by pushing buttons on a computer. You might find this outrageous, sort of like the way medieval kings paid off their creditors by minting new coins. But in the context of what we now know about how most money is made, perhaps this should no longer seem so troubling. If private banks are permitted to call money into existence by tapping on key-boards with the (thin) justification that they have some reserve deposits (like Jill’s) backing it up, why shouldn’t the Federal Reserve be allowed to do something similar? At least the Fed has some claim to being a public institution, even if the extent of its control by banks and insulation from democratic processes is a whole other (very worthwhile) story.
What is probably just as telling is that, historically, the Federal Reserve most often tries to influence the money supply in ways that explicitly recognize the private banks’ privilege as society’s main money creators. So rather than create money by just pushing its own computer buttons, the Fed will more often adopt policies that make it more or less attractive for banks to be aggressive private lenders, that is, to be aggressive money creators.
The principal strategy most of us have heard about concerns the Fed’s setting key interest rates, known as the “Discount Rate” or the “Federal Funds Rate.” These rates address a critical feature of bank practice we have not yet discussed, namely, what happens when too many people like Jill want their money back all at once so that the bank dips below the 10% reserve ratio the Federal Reserve requires that it maintain? Or worse, what if all the people like Jill (the depositors) cumulatively withdraw more than 10% of their money so that the bank (which, remember, has lent 90% of Jill’s deposit to Jack) is forced to tell them, “Sorry, there’s no money, we’re out of cash,” in which case we’d have a run on the banks.
The Discount Rate is one of the Federal Reserve’s main “solutions” to this problem. It is a special loan, at a very low interest rate, with little to no screening, which the Fed makes available to certain preferred private banks when they find they have loaned out too much of depositors’ money and need to boost their reserves back up to a point where they represent at least 10% of their balance sheets. Similarly, through the Federal Funds Rate, the Fed facilitates banks borrowing cheaply from one another for this same purpose. The Fed constantly evaluates and often modifies these rates in an effort to exercise some influence on the banks’ money-making frenzy, but the fact that these rates exist at all, the fact that the Fed is attempting to control the money supply by moderating the degree of money-making banks engage in, is not a fact to be accepted lightly. Unlike the days when Kings inflated the currency by engraving new coins to pay private soldiers, our monetary authority inflates or deflates the currency mainly by modifying how much it privileges the most wealthy “private” sector participants in our economy, the banks, to generate money.
Why Would Anyone Want Such a System?
Before concluding (perhaps reasonably) that this whole system is nuts — private commercial banks creating the bulk of our hard currency through lending — it is important to at least try to understand why anyone would want such a system.
In attempting to understand this, it is first useful to consider what basic purposes money ought to serve. In other words, if the banks’ principal role is to create our money through fractional reserves, then to be even-handed in evaluating this, we need some criteria for what it means to do a good job of introducing money into an economy. The traditional ingredients for what constitutes well-functioning money are the following (in no special order):
1. The money should serve as a useful “store of value.” That is, if we set aside a dollar earned today, we would like it to be able to purchase about the same amount of stuff for a dollar next year.
2. Similarly, the money should serve as a predictable “measure of value.” That is, if two frequently used household items cost, respectively, one and two dollars last year, and nothing significant happened to the demand for them or the means by which they are produced, money is working well if the relative, and preferably actual, cost of the items stays about the same next year.
3. If groups or individuals in society have good ideas about how to make their communities better — perhaps because they come up with innovative products, needed services, or better ways to support each other — it would be nice if new money could be promptly introduced to facilitate these additional possibilities. In other words, money should be readily available as a “means of exchange.”
This last point is really critical and goes to the heart of some of the problems the 99% has with the current system. Whether we like it or not, money helps us interact with one another. It helps us essentially enter into cooperative ventures with people we do not know, but with whom — with the help of money — we can become engaged in common projects that can result in significant human achievements like airplanes, sewer systems, and pencils (no joke, there is probably no one out there who knows how to make a pencil by herself; it happens in no small part because of money). In fact, a main complaint — perhaps the complaint — we should have with the current financial system is that it is failing, abysmally, to introduce money into our communities for such socially-responsible and community-building purposes.
We need not imagine highly complex monetary relationships to re-focus — or perhaps focus for the first time — on this critical function of money. So let’s keep it simple. Imagine that Athos and Porthos are members of a far more basic monetary society than ours in which (for the moment) the whole system consists of a single fifty dollar bill. Athos and Porthos, having poor memories, move the fifty dollar bill back and forth between one another to help them remember whose turn it is to get water from the nearby well. One day Athos gets it and Porthos gives him the bill; the next day Porthos gets it and Athos gives him back the bill; and so on. They know whose turn it is to get water the next day by checking who doesn’t have the bill.
But if all of a sudden D’Artagnan seeks to join the monetary system by initiating a similarly cooperative cycle of retrieving firewood from the forest, there will be a problem. The three of them could still make use of the bill to keep track of their patterns of doing favors for one another, but the availability of only one bill would mess things up. Athos might, for example, be holding onto the bill to keep track of the fact that yesterday he brought Porthos water and it was Porthos’s turn to do so for him tomorrow, but D’Artagnan is now asking Arthos to give him the bill if he (D’Artagnan) brings Arthos firewood. Unless the three can find a way to fairly introduce new money into the system, the insufficiency of their “money supply” is going to create confusion, slow things down, and generally result in less reciprocally cooperative behavior.
Now you might be thinking, “Wait, just make change and use $25 to facilitate the water-retrieval and the other $25 for the wood-retrieval.” But that won’t work because then the money will have stopped being a good “store of value” (which, as we mentioned earlier, is important). Under this solution, the “price” of getting water just went from $50 to $25 without any change in the demand for, or cost of, getting it. In an ideal world — assuming having firewood and water are of approximately equal value and take about the same amount of effort and skill to accomplish—the addition of another fifty dollar bill into the economy would keep the price of water retrieval the same, while allowing the wood retrieval to proceed at the same “price.”
Which is why it is nice to envision a really great bank operating under a well-functioning fractional reserve system. So imagine D’Artagnan went to such a bank with his wood chopping idea. The bank recognizes wood retrieval as a great initiative, and, perhaps because other banks know about it too and are prepared to compete for the opportunity to fund this new business, the bank offers D’Artagnan a $50 bill at a negligible interest charge for a long period of time. Under these circumstances, we are unlikely to be too offended by the fractional reserve system. The fact that we know from our encounters with Jack and Jill that this bank loan is predicated on some other person’s earlier deposit and thus is an act of money creation probably does not bother us here given the good result. In fact, if we had a way of being assured that banks would only create money for purposes like this, we probably wouldn’t be so offended if an entity like the Fed frequently created money out of thin air to facilitate good ideas like D’Artagnan’s.
Which finally gets us to the point of being able to consider why it is important what D’Artagnan (or earlier, Jack) or any other debtor does with borrowed money. Assume, having gotten the $50 loan, D’Artagnan’s, Athos’s, and Portho’s simple exchange grows into a more complex operation in which the three partners are able to bring more wood to town than they need. This would lead people from other towns to come offer their bills in exchange for this service (assuming their towns had similar rudimentary economies), which, in turn, causes our three partners to accumulate extra money. We can refer to the aggregation of all of these behaviors and the resulting money accumulation as 3Musketeers Enterprise, Inc. Once we do, we can start asking questions like how much should it be worth today for someone to get a share of the future flow of extra bills 3Musketeers will generate? And does it change the amount of “money” in society if we create a document that represents such a claim?
Assume that the three original partners “financialized” their operation by creating a piece of paper that gives each a 1/3 claim on all future 3Muskateer’s excess dollar bills. We now have a new tangible representation of the business’ future money-flow, known as a stock certificate, that has no independent use (e.g. it makes an unattractive wall hanging), more or less maintains its value, and can be traded for other things. In fact, it might even be traded for wood itself! In short, while the stock certificate is not traditional currency—and, given its likely price fluctuation, not Grade A money — it is hard not to think of it as another form of money. For example if a 1%’er looks at his stock portfolio and sees a large monetary value associated with it, he will probably correctly tend to think of this as money. On the other hand, if he is running a start-up company that has not yet generated profit, but looks like it eventually will, he may think of himself as in some sense “richer” because he owns the company, but the value of the business is nowhere reflected in the national monetary supply. Only once the expected flow of future profits of the business is represented in a stock certificate that can be traded (by going public) does its newly “securitized” value snap into the monetary system.
It’s critical to the health of the fractional reserve system that a form of money can be added to the economy through “securitizations” that represent and make tradable the value of new businesses, property, or basically anything of quantifiable worth as financial instruments. It means that not all interest on loans has to be paid back by the total amount of lending in society endlessly chasing its own tail to satisfy the interest obligations it creates. Think about it: if money was only created by private banks accepting deposits and extending loans, where would the money come from to pay for the interest on these loans? If virtually all money comes from new loans, there is only one possible answer: still more loans issued just to pay-off the interest obligation on the earlier ones.
If this sounds like a first-rate Ponzi scheme, that’s because it is. While there is good reason to believe that a lot of what fuels financial bubbles and busts is exactly this kind of behavior, there is at least some sense in which loans used to create things of real economic (and securitizable) value are less prone to drive the economy into rapidly destructive spirals. Although we may not often think about the system this way, it is thus the securitization of things of real and quantifiable value which acts as a major moderating financial force to temper the otherwise exponentially expanding system of loans, chasing loans, chasing loans … with each providing the funds needed to satisfy the interest obligations on its predecessors.
Going back to 3Musketeers Enterprises in order to finish the tale: if D’Artagnan’s newly securitized share of the company is of equal or greater value to what he owes the bank in principal and interest, the securitized money (representing the “value” D’Artagnan created in his woodcutting initiative) will be available to pay the bank the principal and interest owed, which sounds a lot more palatable than if the system had to generate the additional money by D’Artagnan, Athos, or Porthos taking out yet another loan just to cover the interest charges on the first loan.
In our 3Musketeers’ fairy tale scenario, the fractional reserve system has worked great. It increased the money supply at the loan stage based on the anticipation of D’Artagnan generating something of societal value, the promise of which was then fulfilled at the securitization stage when the value of 3Musketeers Enterprises snapped into the money supply through the issuance of the stock certificate with sufficient market-value to pay the debt with all the accumulated interest. And because the bank was paid back with interest, it has even greater deposits on-hand to start its next round of loans, which will mean it will likely issue loans in even higher amounts, which will in turn mean the money supply is going to keep growing (and, if the system keeps working like this), growing, and growing. Within the (perhaps peculiar) logic of the fractional reserve system, things are running on all cylinders. But, as we now know, the strong interrelationship between banks’ money-creation through fractional reserve lending and the activity of financial firms in creating money through securitizations more often plays out in ways that are utterly destabilizing to society and impoverishing for the 99%.
Where Things Go Wrong
The first and perhaps most important thing to recognize is that this whole system has a lot of similarities to a car engine or other constrained dynamic system. You have lots of actors participating who have no interest in the positive outcome the system is supposed to generate. Nevertheless, as the theory goes, their self-interested behavior is still going to yield a good result because the rules of the system pit them against one another in just such a way as to make it so. In other words, the last thing individual commercial banks want is either fierce competition among one another (cartels are far more profitable) or full responsibility for bad loans (it’s much better to have someone else bear the loss while you pocket the gains). Likewise, the last thing individual investment banks want is securitization opportunities that are tightly regulated to avoid the introduction into the system of devilishly clever new forms of money that are prone to blow the system sky-high. But these kinds of restraints are precisely what the system requires to succeed. Just like a car engine needs to be made out of strong metals to contain the activity of the heated gas that drives it, so, too, should we expect that a system (like our financial one) that relies for its “success” on very powerful people acting in blind pursuit of rabid self-interest is going to need very strong structures to contain it, which we surely do not have.
Since so much of this book is about how this system has failed, it will hopefully suffice, for now, to consider what signs, akin to those we would see in a failing car engine (such as over-heating, bellowing smoke, fire, and explosions), we should expect to see in a failing financial regime. Here are a few examples:
- Competition among banks is so weak that six banks have 64% of all U.S. banking assets.
- Dehumanizing rules have been imposed to insulate banks from the risk of losses that would otherwise impose discipline on their lending practices (e.g. the crazy rights banks obtained under the 2005 amended bankruptcy law to make it harder for the 99% to discharge some of its most common forms of indebtedness, like credit card bills and student loans).
- Banks are playing a “heads I win, tails you lose” game with our money. Note the vile success they have had resisting even minimal requirements that they should use their own money when placing risky financial bets, despite the obvious fact that, when they blow the deposits of people like Jill, there is a much higher chance of the government (and thus us) footing the bill (think bailout), but when they occasionally get lucky with Jill’s money, it exponentially increases bankers’ rates of returns, which they do not have to share.
- Securities firms (which, since the repeal of the Glass-Steagall Act, are often banks), are so pressured to find securitization opportunities to keep the money-creation spiral from too quickly going bust (again) that they search to securitize not just good new businesses, but practically anything: formerly public schools, pensions, water systems, prisons, all forms of higher education (ever hear of a Student Loan Asset Backed Security, literally known as “SLABS”?), Detroit, New Orleans … you name it.
- Financial sector capture of both the regulatory and electoral processes to such an extent that there is, as in the car engine example, virtually no more metal confinement of the heated gas; rather, the heated gas and the metal that would surround it become one and the same. Note the appointment of financiers like Robert Rubin and Hank Paulson to hold the highest financial regulatory offices. Also note the Supreme Court’s 2010 Citizens United decision, ruling that the thing we now know banks produce – money – enjoys the full mark of First Amendment constitutional sanctity so that it can be expended without restraint in political contests to essentially defend its own means of creation.
- Finally, the grossly high compensation to financial sector executives, often for ephemeral short term results, which indicates that, in the most basic sense, this industry’s work has become divorced from its function of providing money as a means of exchange in our communities in an appropriate manner. Instead, the financial sector uses its money-creating powers for self-enrichment, leaving the communities of the 99% cash-starved, awaiting securitization of their remaining communal assets. The financial sector is living in Richistan … where we are not welcome.
And if we nonetheless maintain lingering doubts about whether this is what is going on, then we should just ask ourselves this question: if a small clique of private individuals had achieved virtually unregulated power to make money, what do we really think they would do?
 In a similar vein, Henry Kissinger was even more emphatic, once explaining that “Who controls the food supply controls the people; who controls the energy can control whole continents; who controls moneycan control the world.”
 There are excellent explanations of the Fed’s relationship to the supply of currency at both the Federal Reserve and Bank of New York web pages. See http://www.federalreserve.gov/faqs/currency_12626.htm and http://www.newyorkfed.org/aboutthefed/fedpoint/fed01.html
 1-[98/109] is just over ten percent.
 One of the best discussions of this process can be found in The Nature of Money by Geoffery Ingham, 2004. See also the response of in “The power to create money ‘out of thin air’ by A. Pettifor, 2013.
 Dunstant Prial “Bernake Offers Possible Timetable for Tapering”, June 19, 2013, FoxBusiness (www.foxbusiness.com/economy/2013/06/19/fed-decision-on-tap/)
 Matt Ridley, “Humans: Why They Triumphed”, May 22, 2010, The Wall Street Journal
 See FDIC Table of “Top 50 Holding Company by Total Domestic Deposits” as of June 30, 2012; (http://www2.fdic.gov/sod/sodSumReport.asp?barItem=3&sInfoAsOf=2012).