Fractional Reserve Banking
I’m not too sure how common this knowledge is but I am sure many haven’t allowed this to sink in. Commercial banks are only required to have on reserve a fraction of the number of deposits from their customers. The Fed regulates the reserve requirement for its member banks and it is rarely adjusted from 10%. Any amount of cash on reserve in excess of the 10% required would be considered excess that is then loaned out to other customers of the commercial bank. This allows capital to be reinvested and thus expanding the money supply perpetually. For example, John deposits $100K into Chase Manhattan and continues to his everyday life. Chase Manhattan keeps on reserve $10K while the $90K in excess reserve can then be reintroduced into circulation in the form of interest-paying loans. The bank loans the $90K that exists in excess reserves to a credit-worthy customer “B” whom will pay interest on that loan. Credit-worthy customer “B” received a loan for $90K from Chase Manhattan that will find it’s way to be deposited in a bank; that bank will retain 10% of that deposit and loan out $81K to customer “C”. Customer “C” will deposit that money into a bank, which the bank will retain 10% of that for reserves and loan out 90% to customers D, E, F and so on. By the completion of this one deposit of $100K, the banking industry has CREATED $900K in new money for a total of $1 Million.
If you consider that for a moment or read that over again it might appear to you that all of the $900K has been “loaned” into existence and is supported completely by an equal amount of debt. This is known as the money multiplier effect. While this doesn’t have to do with The Fed and monetary policy, it does, however, impact the money supply. This is how our own banking system in and of itself creates money.
If you take a moment and let your brain wander for a moment you will be able to conclude that once all of the loans are paid back in full that the process would work backward and we would arrive at the original deposit by John of $100K, save the interest.
The Federal Reserve and Government Spending
Similar to consumers who use a commercial bank, commercial banks have a bank too. The Federal Reserve is the bank for banks. It is a “separate” and “apolitical” institution from the Federal Government and all its branches and departments. It shouldn’t be a surprise that the biggest customer of The Fed is the U.S. Treasury, which appropriates and collects all expenditures and revenues for the country.
When Congress and the President submit a budget in which spending exceeds revenues or a deficit, the government must borrow money. The budget is submitted to the U.S. Treasury Department (a subset of the Executive Branch) which prints bond certificates that are, more or less, loans. The freshly printed bonds are TYPICALLY shorter-term bonds, such as T-Bills (which reach maturity in less than 1 year) or bonds with maturities less than 3 years. The bonds feature a face value and set at the prevailing rate of interest.
Those newly printed bonds are then delivered to The Fed and are subsequently transferred to the various investment banks such as JP Morgan Chase, Merrill Lynch, and Morgan Stanley. The proceeds from the sale are collected from the banks and deposited into the U.S. Treasury account at The Fed. This allows the country to avoid shut down or default on our payments.
If The Fed is aiming to expand the money supply to encourage banks to loan out more money to their customers, The Fed will "buy" these bonds back from the investment banks. However, when The Fed writes a check, there is no money in their account the check is drawn on. All The Fed does is literally add zeros on the investment banks balance sheet. I hope that you let that sink in.
All money is backed by debt, not gold but debt. Debt that requires interest to be paid. This would mean that the more money we borrow TODAY means the more we are required to borrow TOMORROW. For every dollar of interest incurred on previous outstanding debt, we must create an equal amount of money to service that interest payment. (By create, we already determined would mean take a loan on, which means more interest.) More debt=More Money=More interest=More Money=More Debt=More Money=More Interest.......I think you get the point.
There will always be more debt than money. While the money supply is designed to grow perpetually, the amount of debt also grows exponentially. It keeps going and going and going; energizer money! We are going to go further down the rabbit hole of monetary policy in future posts.
Just a few Things That Matter.