Money: Why understanding its origin is important today – 4

November 23, 2008

Fast Forward to the 20th and 21st Centuries: Where Do Banks Get Their Money?

Bankers know how to create money out of thin air. In fact, banks are money factories. Banks exist to make money. You might think that banks are in business to provide services such as banking accounts and loans to their customers. It’s true that banks provide essential financial services. However, the reason that the banks provide such services is that banks need money to use as raw material to create more money. Where does this money come from? It comes from customer deposits. In other words, it comes from the money you and I deposit into the bank.

Notice very carefully, banks “create” money. It’s not simply that banks “earn” profits when they provide bank services and loans. Banks actually “create” new money that did not exist before.

Here is an example of how banks create money. You deposit $100,000 into a one-year Certificate of Deposit at 5% interest. The bank now can use your money to create loans.

Federal Reserve rules allow the bank to make five to six loans based on a deposit. Each loan creates an additional asset. We’ll stop at three loans, review the process, and add up how much money the bank has created, going by the rule that a bank can lend upto 90% of an asset.

You deposit $100,000 into a CD. The bank creates three loans based on the original $100,000 deposit. Loan /Asset #1 = $90,000 Loan/Asset #2 = $81,000. Loan/Asset #3 = $72,900. The total = $243,900 in assets for the bank. This is $243,900 in new money.

When you cash out your CD, you get your $100,000 deposit back, in addition to the $5,000 interest. Meanwhile, the bank has created $243,900 of new money. After it pays you 5% interest, the bank has made a tidy profit of $238,900. ($243,900 – $5,000 = $238,900.) If the numbers are confusing, go over them again until you see how magical this process is. This is how banks create money.

Money, Social Reformers and Revolutionaries:

Sooner or later, every social reformer or revolutionary gets the same idea. If it’s so simple, why not just keep on printing money. By getting enough notes to everyone, poverty can be eliminated and the good life can begin not just for a few but for all.

Does it work? Here are three examples.

(Extracts from “Money: Whence it came, where it went” by JK Galbraith)

  1. “Paper was similarly to serve the Soviets in and after the Russian Revolution. By 1920, around 85 per cent of the state budget was being met by the manufacture of paper money. In that year or not long after, a Harvard graduate student in economics visited the Soviet Union. In accordance with counsel of similar adventurers of the time he took in his pockets a pad of toilet paper. On a densely crowded streetcar in Moscow one day he felt the hand of a thief in his hip pocket. He noted with amusement and satisfaction that it was the pocket that contained not his money but the toilet paper. The latter the pick-pocket deftly remove. Only later did the young scholar come to realize that the gentle produce that was stolen was more valuable than the packet of notes in the other pocket. In the aftermath of the Revolution the Soviet Union, like the other Communist states, became a stern defender of stable prices and hard money. But the Russians, no less than the Americans or the French, owe their revolution to paper.
  2. Not that the use of paper money is a guarantee of revolutionary success. In 1913, in the old Spanish town of Chihuahua City, Pancho Villa was carrying out his engaging combination of banditry and social reform. Soldiers were cleaning the streets, land was being given to the peons, children were being put in schools and Villa was printing money by the square yard. This money could not be exchanged for any better asset. It promised nothing. It was sustained by no residue of prestige or esteem. It was abundant. Its only claim to worth was Pancho Villa’s signature. He gave this money to whosever seemed to be in need or anyone else who struck his fancy. It did not bring him success, although he did, without question, enjoy a measure of popularity while it lasted. But the United States army pursued him; more orderly men intervened to persuade him to retire to a hacienda in Durango. There, a decade later, when he was suspected by some to be contemplating another foray into banditry, social reform and monetary policy, he was assassinated.”
  3. “By the mid thirties there was also in existence an advanced demonstration of the Keynesian system. This was the economic policy of Adolf Hitler and the Third Reich. It involved large-scale borrowing for public expenditures, and at first this was principally for civilian works – railroads, canals and the Autobahnen. The result was a far more effective attack on unemployment than in any other industrial country. By 1935, German unemployment was minimal. ‘Hitler had already found how to cure unemployment before Keynes was finished explaining why it occurred.(17) In 1936, as prices and wages came under upward pressure, Hitler took the further step of combining an expansive employment policy with comprehensive price controls.

The Nazi economic policy, it should be noted, was an ad hoc response to what seemed over-riding circumstance. The unemployment position was desperate. So money was borrowed and people put to work. When rising wages and prices threatened stability, a price ceiling was imposed. Although there had been much discussion of such policy in pre-Hitler Germany, it seems doubtful if it was highly influential. Hitler and his cohorts were not a bookish lot. Nevertheless the elimination of unemployment in Germany during the Great Depression without inflation – and with initial reliance on essentially civilian activities – was a signal accomplishment. It has rarely been praised and not much remarked. The notion that Hitler could do no good extends to his economics as it does, more plausibly, to all else.”


2 Responses to “Money: Why understanding its origin is important today – 4”

  1. What is common to all three examples?

    They are all command economies, where every aspect of the economy is rigidly controlled. As against this, genuine growth and equitable distribution of wealth is believed to be better achieved in a lightly controlled market economy.

    Obviously, the latter is not entirely true, just as the former isn’t either.

    What might have been thought acceptable for a few million people, for economies/nation-states whose population numbered somewhere in that scale, is patently ridiculous to imagine will be acceptable when we have countries the size of India, and going beyond that, to a global economy on which the lives of six billion plus lives depend.

    Theoretical constructs are no longer acceptable as solutions. The impact of the meltdown we currently witness is horrifying, and the thought of experimenting with a bandaid approach, as appears to be the case in both Europe and the US, is equally reprehensible. Not only must our suggestions appear workable, they must hew to a higher sense of values than has been the case till now.

    If we are to use this forum to make suggestions, therefore, it behooves us to work out detailed methodologies, as well as ensure that the metaphysical value base is consistent and inclusive.

  2. Murali Murti Says:

    My purpose in posting Money-1, 2, 3 and 4 was as follows:

    1. To clarify the historical evolution of money as we understand it today from barter and coinage.
    2. To show how greed is inescapable in economic dealings, which is why Gresham’s Law still stand validated even today.
    3. To show that many of the things we consider new today have in fact appeared in one form or the other during the long history of money. For instance, in addition to John Law’s notes, John Law’s shares in the Mississippi Company were also exchanged freely as equivalent to currency as long back as 1719 – virtually in the same way that derivatives of various descriptions have been exchanged, and in the process multiplied, in the past twenty years. With, one might add, the same basis in real estate and the same bubble, boom and bust effects.
    4. To show how money is not created as equivalent to barter, but is in fact created literally out of “thin air” through the printing of money.
    5. To show how solutions to economic problems have always existed and have been found to work, but not necessarily according to the standards of human right, values etc, that are mandatory today, and to demonstrate that economic policies often have the objective of the management of greed.

    It is nobody’s case, least of all mine, that we should go back to the command economies of the Nazis or the Soviets. But let us give credit where credit is due and recognize that they found a way out when it was necessary.

    My posts were in no way intended as any prescriptions or recommendations, but only as information. As I mentioned in the beginning, since I am not the author of these extracts, the writing should at least have been found correspondingly more entertaining.

    As for the specific issue of the use of airtime as a form of specie, I would only say, at this point in time, that this falls squarely into the ongoing debate about the gold standard vs. the dollar-linked floating exchange rate, about which so much writing has already taken place in the past couple of months.

    Having said (and posted) so much, I will now step back and request the others to contribute their share if so inclined. Personally, I would like to get back to Paul’s three critical factors of Consumption, Investment, and Labour, and the interlinking between the three.

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