Modern Money Mechanics: How To Make and Destroy Money

Some years ago the Federal Reserve Bank of Chicago published a workbook on bank reserves and deposit expansion entitled, “Modern Money Mechanics.” The pamphlet describes the process of money creation under fractional reserve banking and gives unparallelled insight into the failings of our monetary system.

“Money, like anything else, derives its value from its scarcity in relation to its usefulness. Assuming a constant rate of use, if the volume of money grows more rapidly than the rate at which the output of real goods and services increases, prices will rise. This will happen because there will be more money than there will be goods and services to spend it on at prevailing prices. But if, on the other hand, growth in the supply of money does not keep pace with the economy's current production, then prices will fall, the nation's labor force, factories, and other production facilities will not be fully employed, or both. (Pg 2-3)”

It is often subconsciously assumed in our society that a person who grows, for example, 200 pounds of soybeans, also creates the purchasing power for 200 pounds of soybeans. Of course this is untrue, as is the fallacy that there is collective purchasing power available somewhere to buy all the world's goods at retail prices. The fact is that the cycles of production for money and material goods are carried out in large part irrespective of each other and certainly have no direct mathematical relation. An increase in real goods does not necessitate an increase in the total money stock, nor does an increase in the money stock necessarily create an increase in real goods. As a result of the separation of these two cycles, what is physically possible is a function of what is financially possible and not vice versa.

As prices must be higher than costs, and costs represent permanent flows of purchasing power to the public, it can be proven that the collective purchasing power of the world from stable sources is far smaller than is needed to generate profits in a capitalist system. The gap between what is needed to maintain cycles of economic activity, and what is provided by said economic activity, is filled by credit created by banks. As any observer of the current crisis can attest, when credit freezes, so does the economy. It is precisely because of these reasons that a thorough understanding of the processes of credit creation are vital for any person seeking to restore fiscal sanity to Washington.

“The bank must be prepared to convert deposit money into currency for those depositors who request currency. It must make remittance on checks written by depositors and presented for payment by other banks (settle adverse clearings). Finally, it must maintain legally required reserves, in the form of vault cash and/or balances at its Federal Reserve Bank, equal to a prescribed percentage of its deposits. One of the major responsibilities of the Federal Reserve System is to provide the total amount of reserves consistent with the monetary needs of the economy at reasonably stable prices. (pg4)”

The FED's ability to set reserve ratios and sell reserves allows it to have near total domination over credit creation. For most transaction accounts, the reserve percentage is ten percent, however when dealing with AAA bond ratings or government entities, the requirements can be as low as one or even zero percent. What occurs during this credit creation or deposit expansion process is detailed below.

Open Market Reserve Expansion and Credit Creation

1. The FED buys $10,000 in government securities from an authorized dealer and instructs the designated bank to credit $10,000 to the dealer's account in exchange for an increase of $10,000 in the bank's federal reserve balance. With a ten percent reserve ratio, $1,000 is isolated and the other $9,000 is made available as the basis for new loans.

2. This $9,000 is loaned out to business A, who immediately deposits it back into the bank. This $9,000 is another addition to the bank's reserve balance. Ten percent, or $900, is isolated and $8100 remains as the basis for new loans.

3. The process continues until all excess reserves are loaned out. With a ten percent requirement, $10,000 can support $90,000 in expansion of bank credit and $100,000 of deposit expansion.

The above is admittedly a simplification, but it is one contained in the FED's own publication (pg 6-8) and believed by the FED to be an accurate representation of the current system. In effect the FED has the power to create money through nothing more than an electronic bookkeeping entry. Whether the initial injection stays with the same bank, as is assumed above, or whether it changes hands, is irrelevant;

“It does not really matter where this money is at any given time. The important fact is that these deposits do not disappear. They are in some deposit accounts at all times. All banks together have $10,000 of deposits and reserves that they did not have before. However, they are not required to keep $10,000 of reserves against the $10,000 of deposits. All they need to retain, under a 10 percent reserve requirement, is $1000. The remaining $9,000 is "excess reserves." This amount can be loaned or invested (pg 6). ”

It is a common perception on the part of the public that excess reserves themselves are loaned out. This could not be farther from the truth;

“Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) both rise by $9,000. Reserves are unchanged by the loan transactions. But the deposit credits constitute new additions to the total deposits of the banking system (page 6-7). ”

From the facts presented thus far, several things should be apparent:

• The deficiency between purchasing-power and collective retail prices is cured by the creation of bank credit

• The refusal to create new credit is enough to cripple production and consumption

• Collective growth in loans is directly related to collective growth in deposits. When loans are paid back, deposits are destroyed

Asset Destruction and Credit Contraction

1. The FED sells $10,000 of treasuries to a dealer and receives payment in the form of an electronic check drawn on Bank A's reserve account. As a result the FED's holding of securities and bank reserves both decrease by $10,000. This constitutes a decline in the money stock

2. The amount of reserves freed by the decline in the deposits is $1,000. This leaves the bank with a reserve deficiency of $9,000

3. Under a ten percent requirement, unless the bank borrows money to cover the gap, the deficiency would lead to a $90,000 reduction in deposits and $80,000 reduction in loans or investments

It has been established that a $10,000 injection of reserves into the banking system in the form of a securities purchase may result in the expansion of up to $90,000 in loans and $100,000 of deposits. However, when $10,000 of reserves is removed from the system, the credit it sustains must contract, to the extent that any excess reserves are not utilized. This is the ripple effect that results from loan defaults and house foreclosures. As bank assets loose value or disappear, so do their equivalent representation in bank reserves. The default of $10,000 on a bad loan could cause up to $100,000 in losses.

“The central bank, by purchasing and selling government securities, can deliberately change aggregate bank reserves in order to affect deposits. There are two other ways in which the System can affect bank reserves and potential deposit volume directly; first, through loans to depository institutions, and second, through changes in reserve requirement percentages. A change in the required reserve ratio, of course, does not alter the dollar volume of reserves directly but does change the amount of deposits that a given amount of reserves can support. Any change in reserves, regardless of its origin, has the same potential to affect deposits (pg 15-16). ”

The system of fractional reserve banking administered by the Federal Reserve and its member banks is essential a “ponzi” scheme of the largest magnitude. Initial investors are paid with money from later investors and in fact all of this “money” has its origins in nothing more than electronic entries in a quasi- governmental agencies' hard drive. The Federal Reserve is not a federal entity, it is not subject to oversight by the government, members are appointed to twenty year terms by the president and confirmed by the senate. The regional boards are elected by regional banks. They are not subject to any audit; private or public. Our entire economic system is mortgaged to the banking sector, immediate reforms are needed to take the power of credit creation away from private interests and place it back into the hands of the US government as prescribed by the constitution. Failure to act and bring this issue to the forefront will only further burden future generations with unnecessary debt created as a result of an unnecessary system. Alternative methods of credit creation exist, they will be discussed in subsequent works.


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