How The System Works 1

Fractional Reserve Banking and Money Creation

Fractional Reserve Banking or FRB is the system of expanding money through the loan process. Through this process, debt is monetized and put into circulation. In the early part of the 20th century, the Federal Reserve released a book called Modern Money Mechanics. This book explains the process of Fractional Reserve Banking. Which goes something like this,

The United States Government decides it needs some money so for this example they make 1 billion in treasury bonds. When The United States Treasury Issues one billion in U.S. bonds they bring those bonds to Auction. Representatives from the biggest banks show up and buy the bonds from the treasury. Therefore, the government takes some pieces of paper and paints some official designs on them and they call them “Treasury Bounds”. These T-bonds are fancy IOU’s. They are instrument of government debt. The Treasury Places a value of 1 billion dollars on these bonds and sells them to the banks.

Then the banks sell those bonds to the Federal Reserve. The Feds agree to buy 1 billion in government bonds. The Federal Reserve gives the banks a fancy check drawn from nothing and the banking system takes those checks and they create money with it. Now the banks have new money. This process then repeats. The banks buy more bonds from the government and then sells them to the Federal reserve in exchange for a check drawn from nothing. The banks take these checks and turn them into money. The big banks act as middle men between the Federal Reserve and the U.S. Government while taking a cut for their so-called services.

Once this exchange is complete, the government takes the new money it got from the banking system and deposits it into a bank account adding 1 billion dollars to the money supply. These days and in most cases, this exchange with the Federal Reserve happens electronically without any need for paper. About 2 to 3 percent of the money supply in circulation today is actually physical currency. The rest exists on hard drives and computers.

Government bonds are instruments of debt. When the government purchases these reserve notes with bonds, it created this money out of debt and the government is promising to pay back the debt with interest. Therefore, our system today is simply. Money=Debt and Debt=Money.

The billion dollars that is in the account now becomes part of the bank’s reserves. In fact, all deposits become bank reserves. According to Modern Money Mechanics, a bank must maintain required reserves equal to a prescribed percentage of its deposits. The reserve requirements are currently 10 percent.

This means that from our example, the bank has to keep 100 million from the billion dollar deposit. The other 900 million is considered an excessive reserve. It will be used for loans. You might think that the 900 million is loaned from the original billion we started with. However, when this money is loaned it does not actually come out of the original billion. When this 900 million is loaned, it is newly created money on top of the already existing 1 billion dollars for a total of 1.9 billion dollars. This is how money is expanded. Debt is used to create new money!

“Of course, they (the banks) do not really pay out loans from the money they receive from deposits. If they did this, no additional money would be created. What they do is when they make loans they accept promissory notes in exchange for credits to the borrower’s transaction accounts.”  -Modern Money Mechanics

Let’s assume someone goes into the bank and borrows the 900 million dollars. Chances are they take that money and deposit it in their own checking account and the process starts all over. That other bank now loans 810 million as an excessive reserve. They loan that money but they keep 90 million as a reserve. And on it goes! Through this process, the original 1 billion dollars is typically expanded 9 times. An additional 9 billion dollars is created on top of the 1 billion dollars. That’s $10,000,000,000.00 created from debt!

Where does this new money get its value? It steals value from the money that was already in existence. When the total supply of money is increased without regard for the demand for goods and services, prices rise diminishing the purchasing power of each individual dollar. This is why we get inflation when the money supply increases.

Before the Federal Reserve, paper money was a receipt that represented gold that someone had on deposit. After the Federal Reserve took over our money, the system slowly migrated to a system of debt. Today every dollar in your wallet now represents someone in debt. It represents money owed to someone by someone. Our money now comes from debt. If everyone in the country were to pay off all of their debt including the United States, There would not be one dollar in circulation!

The video above shows a great illustration on how this system works. but there are some things that are implied in this video that is not entirely true. However this video is the best explanation of the monetary system I have ever seen. I will now address the things in the video I disagree with.

1. We are left with the impression that the dollar is basically nothing more than a bunch of numbers. We are always told by some gold and silver merchants that the dollar is not backed by anything at all. That is not the case. In fact, about 71.6 percent of the dollar is backed by gold that belongs to the United States. The dollar is no longer redeemable in gold, but that does not mean that there is no gold that backs the dollar.

The Federal Reserve Bank of New York holds 540,000 Gold bars alone. This is not counting the other locations. In fact, the United States has 8,133.5 tons of gold to back the currency. That means that 70.6 percent of U.S, currency is backed by gold alone. bonds make up the rest. The U.S. has the most gold to back their currency. It does not belong to the Federal Reserve, it belongs to the U.S!

Check these links for further proof

 2. We are told that the definition of inflation is an increase in the money supply. This is not true. Increasing the money supply is one of the causes for inflation, but it is not the textbook definition of inflation. The textbook definition of inflation means an ongoing fall in the overall purchasing power of the monetary unit. Inflation means a sustained increase in the aggregate or general price level in an economy. Inflation means there is an increase in the cost of living.

Increasing the money supply is not the only cause of inflation! There are other causes of inflation. If it cost more to produce goods or services then the price of those goods and services are passed on to consumers. An example of this can be found in the cost of fuel. When oil prices went up in 2008 to about 149.00 a barrel, the result was higher gas prices. That in turn resulted in higher food prices because it cost more to bring those goods to market. The cost was passed on to consumers and we had a decrease in the purchasing power of the dollar which has been sustained for quite a while. This is in spite of the fact that huge amounts of debt was erased from the books thus causing a decrease in the global dollar supply.

Another cause of inflation is supply and demand. When demand for goods rise and supply cannot keep up, that causes inflation. An example of this can be found in 2003 through 2007. The cost of housing skyrocketed due to increased demand. Laws were passed to allow anyone the ability to buy a house. Mix that with predatory lending and the end result was a big increase in the demand for housing. The market expanded greatly during this time. After the 2008 meltdown, demand for housing dropped and so did the price of housing.

It is true that there was a housing bubble and that was attributed to the problems in the industry. Never the less, that bubble caused an increased demand for housing which forced the prices up and builders could not build them fast enough. The materials used to build those houses also went up in cost and that was passed on to the consumer.

My only real point here is that the money supply is not the only cause of inflation and inflation does not always translate to an increase in the money supply!

3. It was said in this video that the founding fathers made sure that gold and silver was the only thing that could be used for money. They put it in the constitution because they knew the dangers that are involved with a central bank.

First and foremost the founding fathers actually did write that in the constitution, but it was not because they knew of the dangers that are involved when a central bank is thrown into the mix. America has had 2 central banks before the Federal Reserve. Our first bank was actually signed into law by George Washington himself! It had a 20 year charter. After it expired the charter was not renewed. After the war of 1812 America started another central bank to help finance and pay for the war. The same politicians that would not renew the charter of the first central bank started this one because of the debt America accumulated as a result of the war.

The picture above on the left is a picture of America’s first central bank

Check out these links for further proof

America’s second central bank

To learn more about America’s central banks visit America’s Monetary History