Out of Thin Air

A singularly difficult idea for people not in the banking industry to wrap their minds around is that private banks create new money 'out of thin air,' as the saying goes. As hard as it is for us to see how this could work, and as unfair as it is that they are allowed to do so, the fact is that's exactly how our fiat money is created. The 99% have to earn their money. The 1% do not. It's a fact that the Occupy Wall Street movement wants to change.

If you or I attempted to create new money out of thin air, we would soon be arrested for fraud (or counterfeiting, if we did it with paper and printing). If we write a check without first having deposited sufficient money in the checking account, the check bounces. Because creating money is illegal for ordinary people and businesses, and we know these laws are enforced, the logical assumption is that creating money is illegal, period. Our instinct is to reject the "thin air" assertion as simply impossible.

It is not impossible. The law is different for banks.

Let's repeat that, to give it a chance to soak in. The law is different for banks.

The central bank - in this country, the several private banks governed by the Federal Reserve Board, collectively called "The Fed" - creates money simply by making an entry on its records. The Fed puts this new money into circulation by recording it as a loan to a commercial bank or as a purchase of "securities" from a bank or other financial institution. Among the institutions from which the Fed purchases securities is the Treasury Department of the United States. The Fed is empowered to do this by law; specifically, by the act of Congress which, in 1913, created the Federal Reserve System. When the Fed purchases Treasury notes, this is called "monetizing the national debt."

The law is different for commercial banks, too. If we want to loan money to someone, we first need to have it. If we don't have the money and we can't borrow it, then we can't spend it or loan it. That's how it works for households and ordinary businesses, but not for commercial banks. They are not limited to loaning out just the money they have received as deposits. If they were so limited, that would be called a "100% reserve requirement."

Private commercial banks do not have a 100% reserve requirement. They have a fractional reserve requirement - typically 10%. This number may change. The typical 10% figure comes from a booklet was originally produced and distributed by the Public Information Center, Federal Reserve Bank of Chicago. This booklet is available for free download from http://www.rayservers.com/images/ModernMoneyMechanics.pdf.

With a 10% reserve requirement, a commercial bank bank is allowed to loan out $90,000 on the basis of holding $10,000 in reserves. Now, the bank may not be able to loan out the entire $90,000. It may only loan out %50,000 or %60,000. Whatever the amount, the loans are not loans of money on deposit. The loans are of money created by the commercial bank. When these loans are repaid, the bank is not just making a profit from the interest collected. The entire repayment, less expenses, is profit for the bank. That's how banks can afford a large and well-paid bureaucracy, luxurious buildings and total losses on some loans, while still showing significant profits.

Commercial banks and central banks alike are empowered by law to create money out of thin air. The rate at which commercial banks can do this is limited by reserve requirements. The Federal Reserve has no reserve requirements and in fact, money created by the Federal Reserve can be counted as reserves. The rate at which the Federal Reserve creates money is limited only by political considerations. For instance, if the Fed creates too much money too fast, a politically undesirable amount of inflation may result. (Italics indicate a revision for clarity made a month after the original posting of this article.)

You can buy gold, silver and other precious goods with dollars, but our money is not backed by anything except "the full faith and credit of the United States." In the case of other fiat currencies, the Euro, Renminbi or Rial is backed by the full faith and credit of other nations.

There was a time in the history of the United States when the function of creating money and controlling the nation's money supply was directly the responsibility of the federal government. The Union side in the Civil War was financed through "Greenbacks" issued directly by Lincoln's Treasury Department. The money so created did create a certain amount of inflation while it was greatly stimulating the economy of the northern states. It also allowed the war to be conducted without a great increase in taxes on the population of those northern states. All the new money created by the Treasury was owned by the US government, not by private banks.

If the Federal Reserve, which was created by act of Congress, were to be abolished by a new act of Congress, the right to control the money supply and the power to create money could once again be transferred directly to the Treasury. The benefits of creating money could go to the government, instead of to the Federal Reserve. Increasing reserve requirements for commercial banks would transfer a portion of the benefits from those banks to the government.

Of course, in order to accomplish any such thing, political control of local, state and federal government by banks and other corporations will have to be ended. The two-party system in which both parties are controlled by banks and other corporations will have to be discarded. How to do this is the main question the Occupy movement will have to answer. Understanding the basics of how the banking system works is just one of the important things Occupiers need to do.

Art Myatt