Do Banks Really Create Money
Out of Thin Air?
According to some, banks only loan out depositors’ money. But, in fact, they create what they loan out, based on a system known as ‘fractional reserve banking’. This is explained quite succinctly in the following excerpt from the January 1993 edition of National Geographic Magazine, entitled, The Power of Money by Peter T. White, Assistant Editor. (Pages 83-86)
Bills and coins make up about 8 percent of the U.S. money supply — the rest is in bank accounts, including checkbook money; at this writing the sum total is 3.5 trillion dollars, says the Fed — the Federal Reserve System, which is the central bank of the government of the United States — and that is three billion more than a month ago. This is how that happens. Every business day, after a telephone conference call at 11:15 a.m., the Federal Reserve Bank of New York, acting on directives from the Federal Open Market Committee at Fed headquarters in Washington, buys U.S. government securities from major banks and brokerage houses, or sells some — usually U.S. Treasury bills, which in effect are government promissory notes.
Say today the Fed buys a hundred million dollars in Treasury bills from those big securities dealers, who keep a stock of them to trade with the public. When the Fed pays the dealers, a hundred million dollars will thereby be added to the country’s money supply, because the dealers will be credited that amount by their banks, which now have that much more on deposit. But where did the Fed get that hundred million dollars ? “We created it,” a Fed official tells me. He means that anytime the central bank writes a check, so to speak, it creates money. “It’s money that didn’t exist before,” he says. Is there any limit on that ? “No limit. Only the good judgement and the conscience of the responsible Federal Reserve people.” And where did they get this vast authority? “It was delegated to them in the Federal Reserve Act of 1913, based on the Constitution, Article I, Section 8. ‘Congress shall have the power .. to coin money, regulate the value thereof ...’
Now watch how that Fed-created money lets our commercial banking system create even more. The Fed requires banks to put aside a portion of their depositors’ funds as reserves. Say this reserve ratio is set at 10 percent — then for every $1,000 in new deposits, a bank must keep at least $100 in reserves but can loan out the rest, namely $900. On the bank’s books this loan remains as an asset, earning interest until it is paid off. The customer who got the loan is likely to spend it right away, say for a used car. The car dealer deposits the $900 check in his bank, which then has an additional $900 in reserves and can in turn loan out 90 percent of that — $810. And so on and on, until the original $1,000 put into one bank may enable dozens of banks to issue a total of $9,000 in new loans.
Thus a hundred million dollars injected by the Fed into the commercial banking system could theoretically stimulate the appearance of 900 million dollars in new checkbook money — money that didn’t exist before. And it’s all built on the assumption that the system is sound.
By Peter T. White — National Geographic