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So now from the original $10,000, an additional $17,100 has been created, for a total money supply of $27,100. This process of money creation then continues, as Modern Money Mechanics explains, such that
Carried through to theoretical limits, the initial $10,000 of reserves distributed within the banking system gives rise to an expansion of $90,000 in bank credit (loans and investments) and supports a total of $100,000 in new deposits under a 10 percent reserve requirement…. The multiple expansion is possible because the banks as a group are like one large bank in which checks drawn against borrowers’ deposits result in credits to accounts of other depositors, with no net change in total reserves.
All of this naturally means that even if the original $10,000 was actually printed—that is, even if it existed in the form of currency, i.e., Federal Reserve Notes—most of the so-called “money” that now exists in the system is in the form of credit, created out of thin air, backed by nothing, and existing merely as digits in a computer. As the Fed explains:
Currency is something almost everyone uses every day. Therefore, when most people think of money, they think of currency. Contrary to this popular impression, however, transaction deposits are the most significant part of the money stock. People keep enough currency on hand to effect small face-to-face transactions, but they write checks to cover most large expenditures….
Since the most important component of money is transaction deposits, and since these deposits must be supported by reserves, the central bank’s influence over money hinges on its control over the total amount of reserves and the conditions under which banks can obtain them.
Ah, but we’ve been ignoring one additional factor: the interest that is due on the loans. All of the money created by the banks out of thin air must be repaid to the banks plus interest. This includes the initial $10,000. The government didn’t directly borrow this money from the Fed, but through open market operations, it has issued an IOU for $10,000 plus interest (Treasury securities), which was ultimately purchased by the Fed with money created out of thin air; thus, the $10,000 was in effect simply borrowed into existence, at taxpayer expense.
This means that every “dollar” you carry in your wallet or purse, every digital number in your bank account does not, in fact, represent an asset, but a liability. Under the Federal Reserve system, money is debt. Every single dollar was initially borrowed into existence, and the money supply equals the principle on all outstanding loans.
Which leads us to the question: if the principle amount of all loans is paid off—which, remember, is deflationary—there would be no money in circulation, so where does the money come from to pay off the interest? Well, that, too, must be borrowed into existence. This is why the Federal Reserve sets a target rate of inflation; it must perpetually create more and more money out of nothing so the banks’ loans can be repaid plus interest. This is why the dollar has lost 95% of its purchasing power since the Fed was created in 1913. This is unsustainable, of course. It is a Ponzi scheme, a confidence game.
To sum up, our entire monetary system is a debt-based system, in which every dollar in circulation, whether in the form of currency or credit, was borrowed into existence in the first place when the banks created it out of thin air while at the same time charging interest for its use. But while the money created out of thin air by the banks represents nothing and is backed by nothing, the money it must be repaid with represents actual labor and production of the borrower, something of real value. And, of course, if the borrower is unable to repay the loan, the bank may take the collateral on the loan, such as the borrower’s car or house—again, something of real value in return for something of no value. By such means, the bankers under the Federal Reserve system profit by defrauding the public of their real wealth both through the process of fractional reserve lending and through inflation itself and the loss of purchasing power of the dollar it represents, which inflationary monetary policy also has the additional negative consequence of creating the cycle of artificial booms and recessionary busts. (For more on how the Fed created the housing bubble through its inflationary policy of keeping interest rates artificially low, see my book Ron Paul vs. Paul Krugman: Austrian vs. Keynesian economics in the financial crisis.)
Now all of this, of course, is precisely how Murray Rothbard explained that banks create money out of thin air, i.e., engage in legalized counterfeiting, and this is precisely what Ron Paul has tried to educate people about. This magic of fractional reserve banking, this “witchcraft”, is also precisely what Tamny would have his readers believe is merely a “fiction”. It is most unfortunate than in ostensibly trying to correct alleged misconceptions about the banking system by debunking a supposed “myth”, what John Tamny has in fact done is just the opposite. He has done his readers the great disservice of woefully misinforming them about the true nature of fractional reserve banking.