John Tamny in Forbes writes that it is a "myth" that banks create currency out of thin air (that is, that they do legalized counterfeiting). He's wrong.

John Tamny at Forbes comments in a blog post titled “Ron Paul, Fractional Reserve Banking, and the Money Multiplier Myth” that

there are those, most notably Rep. Ron Paul, who believe that no reserve requirement is enough. Their view is that fractional reserve banking – whereby banks lend out the vast majority of their deposits on hand – is the height of moral hazard such that banks should operate under 100% reserve requirements.

Paul’s intellectual mentor in this area is the late Murray Rothbard who proclaimed that “Fractional reserve banks…create money out of thing [sic, ‘thin’] air. Essentially they do it in the same way as counterfeiters.”

About Rothbard’s assertion, underlying it is a fanciful belief that the alleged “money multiplier” is fact as opposed to fiction. It’s the latter. Indeed, wise minds should quickly understand that there’s no such thing as a money multiplier such that Bank A can take in $1,000,000 and lend out $900,000, Bank B can then lend out $810,000, then Bank C can lend out $729,000 such that $1 million in deposits miraculously turns into nearly $2.5 million.

In truth, just as there are no sellers without buyers, there are no borrowers without savers; thus rendering the very notion of a money multiplier moot.  $1 million doesn’t multiply into $10 million if it changes hands enough times; rather for someone to borrow someone else must be willing to cease using money in the near-term so that they can. That such an absurd bit of witchcraft has so long transfixed so many bright minds is one of life’s great mysteries. So while banks doubtless commit all manner of errors – capitalism is about both failure and success – the fact that they lend out the funds put in their care does not make them counterfeiters….

It’s certainly true that banks could maintain 100% of funds deposited, but if so, they wouldn’t be banks. Instead, they’d be warehouses for money, and those warehouses would charge depositors a fee for the right to deposit with them.

Thus, Tamny’s understanding of fractional reserve banking is that banks merely “lend out the vast majority of their deposits on hand”, and since they are just lending money they already have, no new money is created. Tamny believes that every dollar borrowed from a bank by one person must be a dollar that was saved and deposited at the bank by another. It is a self-evident “myth”, he contends, that banks effectively counterfeit money by creating it out of thin air. It is a “fanciful belief”, a “fiction”, and talk of “witchcraft” to suggest that there is a “money multiplier” effect in fractional reserve banking, in which banks “miraculously” create more money than they have on deposit. Apparently, in Tamny’s view, if you believe this, you might as well believe in Santa Claus or the tooth fairy.

Indeed, Tamny is correct about one thing: if banks merely lent out funds that they actually had, it would not make them counterfeiters. Unfortunately, however, Tamny is grievously ignorant of how fractional reserve banking actually works. Ron Paul has tried to explain it to him, and Murray N. Rothbard has, as well—and a right fine job of it he did, too, in his book The Mystery of Banking, which our skeptical Virginia has quite obviously never read. We might agree that it is “an absurd bit of witchcraft”, but it happens to be true that banks do indeed create money out of nothing and increase the money supply by loaning out money they don’t actually have.

Let’s turn to The Mystery of Banking and take a closer look at what it is that Tamny is trying to “debunk” here. To illustrate how fractional reserve banking works, Rothbard showed how “T” account entries work on a bank’s balance sheet, with an example of a $50,000 gold deposit from Jones in the Rothbard Bank. So $50,000 in gold coin is entered into the asset side of the bank’s ledger, and $50,000 in warehouse receipts (demand deposits) is also entered into the liabilities side. The bank now has 100% reserves.




$50,000 (gold)$50,000 (warehouse receipts)


However, as Rothbard explained:

The irresistible temptation now emerges for the goldsmith or other deposit banker to commit fraud and inflation: to engage, in short, in fractional reserve banking, where total cash reserves are lower, by some fraction, than the warehouse receipts outstanding…. [T]he banker will either lend out the gold, or far more likely, will issue fake warehouse receipts for gold and lend them out, eventually getting repaid the principal plus interest. In short, the deposit banker has suddenly become a loan banker; the difference is that he is not taking his own savings or borrowing in order to lend to consumers or investors. Instead he is taking someone else’s money and lending it out at the same time that the depositor thinks his money is still available for him to redeem. Or rather, and even worse, the banker issues fake warehouse receipts and lends them out as if they were real warehouse receipts represented by cash. At the same time, the original depositor thinks that his warehouse receipts are represented by money available at any time he wishes to cash them in. Here we have the system of fractional reserve banking, in which more than one warehouse receipt is backed by the same amount of gold or other cash in the bank’s vaults.

It should be clear that modern fractional reserve banking is a shell game, a Ponzi scheme, a fraud, in which fake warehouse receipts are issued and circulate as equivalent to the cash supposedly represented by the receipts.

Returning to the ledger, suppose that the Rothbard Bank, from the $50,000 deposit, now issues $80,000 in warehouse receipts and lends them to Smith, who must repay the $80,000 plus interest. The assets side of the bank’s book now shows $50,000 in gold deposits from Jones plus the $80,000 IOU from Smith, for total assets of $130,000, while the liabilities side shows $130,000 in warehouse receipts for gold. The bank has increased the supply of money by the amount of additional receipts it issued (the $80,000), and the bank now has a reserve ratio of $50,000/$130,000, or 5/13.




$50,000 (gold)$50,000 (original receipts)
$80,000 (IOU)$80,000 (newly created receipts)
Total: $130,000 (reserves plus loans due)$130,000 (warehouse receipts)


Now suppose that Smith uses his $80,000 in warehouse receipts to buy widgets. The seller of the widgets now has the receipts, which the Rothbard Bank must redeem for him on demand, just as it must redeem Jones’s receipts for his $50,000. But while the bank has liabilities in the form of receipts for gold to the tune of $130,000, it actually only has $50,000 in gold in its vault. If the widget seller attempted to redeem the full amount of his receipts, the insolvency of the bank would immediately become apparent, and the fraud exposed. As Rothbard put it:

Thus, fractional reserve banking is at one and the same time fraudulent and inflationary; it generates an increase in the money supply by issuing fake warehouse receipts for money. Money in circulation has increased by the amount of warehouse receipts issued beyond the supply of gold in the bank….

Where did the money come from? It came—and this is the most important single thing to know about modern banking—it came out of thin air. Commercial banks—that is, fractional reserve banks—create money out of thin air. Essentially they do it in the same way as counterfeiters. Counterfeiters, too, create money out of thin air by printing something masquerading as money or as a warehouse receipt for money. In this way, they fraudulently extract resources from the public, from the people who have genuinely earned their money. In the same way, fractional reserve banks counterfeit warehouse receipts for money, which then circulate as equivalent to money among the public. There is one exception to the equivalence: The law fails to treat the receipts as counterfeit.

That is to say, fractional reserve banking is just legalized counterfeiting. Rothbard continued:

Another way of looking at the essential and inherent unsoundness of fractional reserve banking is to note a crucial rule of sound financial management—one that is observed everywhere except in the banking business. Namely, that the time structure of the firm’s assets should be no longer than the time structure of its liabilities. In short, suppose that a firm has a note of $1 million due to creditors next January 1, and $5 million due the following January 1. If it knows what is good for it, it will arrange to have assets of the same amount falling due on these dates or a bit earlier. That is, it will have $1 million coming due to it before or on January 1, and $5 million by the year following. Its time structure of assets is no longer, and preferably a bit shorter, than its liabilities coming due. But deposit banks do not and cannot observe this rule. On the contrary, its liabilities—its warehouse receipts—are due instantly, on demand, while its outstanding loans to debtors are inevitably available only after some time period, short or long as the case may be. A bank’s assets are always “longer” than its liabilities, which are instantaneous. Put another way, a bank is always inherently bankrupt, and would actually become so if its depositors all woke up to the fact that the money they believe to be available on demand is actually not there.

Hence the problem of a “run” on the banks. A bank run is problematic because it exposes the bank’s inherent insolvency. As Rothbard wrote:

Bank runs instruct the public in the essential fraudulence of fractional reserve banking, in its essence as a giant Ponzi scheme in which a few people can redeem their deposits only because most depositors do not follow suit.

The expansion of the money supply, of course, works the same way on the bank’s books if Jones’ deposit is not in gold, but in currency, such as Federal Reserve Notes, a.k.a. “dollars”.

Furthermore, apart from the fraud involved in fractional reserve banking, the expansion of the money supply, or inflation, also robs people of their wealth through the loss of purchasing power of their dollars:

As the new money pours into the system and ripples outward, demand curves for particular goods or services are increased along the way, and prices are increased as well. The more extensive the spread of bank credit, and the more new money is pumped out, the greater will be its effect in raising prices. Once again, the early receivers from the new money benefit at the expense of the late receivers—and still more, of those who never receive the new money at all. The earliest receivers—the bank and Smith—benefit most, and, like a hidden tax or tribute, the late receivers are fraudulently despoiled of their rightful resources.

Thus, fractional reserve banking, like government fiat paper or technical counterfeiting, is inflationary, and aids some at the expense of others.

And just as the $80,000 loaned to Smith was created out of thin air, when Smith eventually repays that loan, that $80,000 vanishes back into thin air:

The repayment of the $80,000 loan means that $80,000 in fake warehouse receipts has been canceled, and the money supply has now contracted back to the original $50,000.

This has implications for the “business cycle” of booms and busts, as Rothbard also elaborated:

[F]ractional reserve bank credit expansion is always shaky, for the more extensive its inflationary creation of new money, the more likely it will be to suffer contraction and subsequent deflation. We already see here the outlines of the basic model of the famous and seemingly mysterious business cycle, which has plagued the Western world since the middle or late eighteenth century. For every business cycle is marked, and even ignited, by inflationary expansions of bank credit. The basic model of the business cycle then becomes evident: bank credit expansion raises prices and causes a seeming boom situation, but a boom based on a hidden fraudulent tax on the late receivers of money. The greater the inflation, the more the banks will be sitting ducks, and the more likely will there be a subsequent credit contraction touching off liquidation of credit and investments, bankruptcies, and deflationary price declines. This is only a crude outline of the business cycle, but its relevance to the modern world of the business cycle should already be evident.

Now, Tamny has simply dismissed Ron Paul’s and Murray Rothbard’s attempts to educate him. All of the above information from The Mystery of Banking was simply made up, Tamny would apparently have us believe. Rothbard’s book belongs not on the nonfiction shelf in the economics section, but alongside The Lord of the Rings or Harry Potter in the fantasy section, for this is all a “myth”, a “fanciful belief”, a “fiction”, “absurd”, talk of “witchcraft”.

Very well, then, let’s turn to a source Tamny might be less likely to simply dismiss offhand, a source he might perhaps be more willing to trust as a reliable source for information on how fractional reserve banking works. Let us turn to the Federal Reserve itself.

The Federal Reserve Bank of Chicago has long since published a booklet called Modern Money Mechanics (still available online, such as here and here), which we may turn to in order to see what the Fed itself has to say about Tamny’s belief that it is a “myth” that banks create money out of thin air through fractional reserve banking. The booklet begins by stating its purpose:

The purpose of this booklet is to describe the basic process of money creation in a “fractional reserve” banking system.

Hmm… The process of “money creation”, did you say? Further on:

Money, like anything else, derives its value from its scarcity in relation to its usefulness….

Control of the quantity of money is essential if its value is to be kept stable….

Well, now, that sure sounds a lot like what Mr. Rothbard wrote about how inflation robs people of their wealth by devaluing the currency, doesn’t it? Continuing:

The actual process of money creation takes place primarily in banks….

In the absence of legal reserve requirements, banks can build up deposits by increasing loans and investments so long as they keep enough currency on hand to redeem whatever amounts the holders of deposits want to convert into currency. This unique attribute of the banking business was discovered many centuries ago.

It started with goldsmiths. As early bankers, they initially provided safekeeping services, making a profit from vault storage fees for gold and coins deposited with them. People would redeem their “deposit receipts” whenever they needed gold or coins to purchase something, and physically take the gold or coins to the seller who, in turn, would deposit them for safekeeping, often with the same banker. Everyone soon found that it was a lot easier simply to use the deposit receipts directly as a means of payment. These receipts, which became known as notes, were acceptable as money since whoever held them could go to the banker can exchange them for metallic money.

So far so good. (Notice that at this point these early banks were essentially warehouses, still with 100% reserves. So Tamny would say they were by definition not “banks”. Since the Fed obviously does consider these goldsmiths to have been “bankers”, we must necessarily question Tamny’s own personal definition of what it means to be a bank.) But now here’s where things begin get really interesting:

Then, bankers discovered that they could make loans merely by giving their promises to pay, or bank notes, to borrowers. In this way, banks began to create money. More notes could be issued than the gold and coin on hand because only a portion of the notes outstanding would be presented for payment at any one time. Enough metallic money had to be kept on hand, of course, to redeem whatever volume of notes was presented for payment.

In other words, the goldsmiths, a.k.a. “bankers”, discovered early on that they could simply counterfeit their receipts for gold, as long as they kept enough gold on hand to prevent their fraudulent scam from being found out. Here’s how Murray Rothbard explained the exact same history, albeit a bit more bluntly than the way the Fed put it:

The English goldsmiths discovered and fell prey to this temptation in a very short time, in fact by the end of the Civil War. So eager were they to make profits in this basically fraudulent enterprise, that they even offered to pay interest to depositors so that they could then “lend out” the money. The “lending out,” however, was duplicitous, since the depositors, possessing their warehouse receipts, were under the impression that their money was safe in the goldsmiths’ vaults, and so exchanged them as equivalent to gold. Thus, gold in the goldsmiths’ vaults was covered by two or more receipts. A genuine receipt originated in an actual deposit of gold stored in the vaults, while counterfeit ones, masquerading as genuine receipts, had been printed and loaned out by goldsmiths and were now floating around the country as surrogates for the same ounces of gold.

Returning to Modern Money Mechanics, the Fed explained:

Transaction deposits are the modern counterpart of bank notes. It was a small step from printing notes to making book entries crediting deposits of borrowers, which the borrowers in turn could “spend” by writing checks, thereby “printing” their own money.

That is to say, banks create “money” by simply punching some keys on a computer and inputting digits into the account of a person who has taken out a loan. The Fed remarks on how “deposit money can be created so easily”—just like that, out of thin air.

One role of the Fed is that it “replaces the reserves absorbed by currency withdrawals from banks”, which is to say it acts to prevent the fraud from being exposed by acting as lender of last resort and coordinating the banks’ counterfeiting operations so that they can all inflate the money supply together. There are limits to how much “money” can be created out of thin air through this process, however:

For example, if reserves of 20 percent were required, deposits could expand only until they were five times as large as reserves. Reserves of $10 million could support deposits of $50 million. The lower the percentage requirement, the greater the deposit expansion that can be supported by each additional reserve dollar. Thus, the legal reserve ratio together with the dollar amount of bank reserves are the factors that set the upper limit to money creation….

Thus, the Federal Reserve, through its ability to vary both the total volume of reserves and the required ratio of reserves to deposit liabilities, influences banks’ decisions with respect to their assets and deposits.

The booklet goes on to explain how the Federal Reserve expands the money supply through what are known as open market operations:

How do open market purchases add to bank reserves and deposits? Suppose the Federal Reserve System, through its trading desk at the Federal Reserve Bank of New York, buys $10,000 of Treasury bills from a dealer in U.S. government securities. In today’s world of computerized financial transactions, the Federal Reserve Bank pays for the securities with an “electronic” check drawn on itself. Via its “Fedwire” transfer network, the Federal Reserve notifies the dealer’s designated bank (Bank A) that payment for the securities should be credited to (deposited in) the dealer’s account at Bank A. At the same time, Bank A’s reserve account at the Federal Reserve is credited for the amount of the securities purchase. The Federal Reserve System has added $10,000 of securities to its assets, which it has paid for, in effect, by creating a liability on itself in the form of bank reserve balances. These reserves on Bank A’s books are matched by $10,000 of the dealer’s deposits that did not exist before.

All of which is to say that the Fed buys U.S. Treasury securities, or government IOUs, with “money” created out of thin air, which the American taxpayers must then pay interest on.

We now come to the Fed’s own explanation of “How the Multiple Expansion Process Works”. (Keep in mind Tamny’s declaration that the “money multiplier” effect is a “myth”.)

If the process ended here, there would be no “multiple” expansion, i.e., deposits and bank reserves would have changed by the same amount. However, banks are required to maintain reserves equal to only a fraction of their deposits…. Under current regulations, the reserve requirement against most transaction accounts is 10 percent….

[Banks] 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 $1,000. The remaining $9,000 is “excess reserves.” This amount can be loaned or invested….

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.

Did you get that? It bears repeating: banks “do not really pay out loans from the money they receive as deposits”. Recall that Tamny’s understanding of fractional reserve banking is that banks only lend out money from “deposits on hand”, so that no new money is created out of thin air. Tamny is wrong. He doesn’t know what he is talking about.

As the Fed has pointed out, banks do not just loan out depositors’ money, in which case “no additional money would be created”. Modern Money Mechanics continues:

What they do when they make loans is to accept promissory notes in exchange for credits to the to the borrower’s truncation 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.

Modern Money Mechanics similarly illustrates how this all works in “T” account entries. The Federal Reserve begins by buying $10,000 in U.S. Treasury securities (which are really taxpayer IOUs) from a dealer, which shows up on the assets side (we’ll ignore the interest for simplicity). It pays for those securities by creating money out of thin air, which appears on the liabilities side of the Fed’s account, and which shows up in the dealer’s bank, Bank A.


Federal Reserve



Total: $10,000 (taxpayer IOUs)$10,000 (“money” created out of thin air)


Bank A



Total: $10,000 (reserves at the Fed)$10,000 (demand deposits)


The “money” might not stay at Bank A. It could be transferred to other banks in whole or in part. The Fed debits the accounts of paying banks and credits the accounts of receiving banks. Regardless, the banks collectively now have $10,000 in reserves with the Fed on the assets side and $10,000 in demand deposits on the liabilities side. Let’s just stick to talking about Bank A, though, for simplicity.

Bank A thus has “excess” reserves of $9,000, which it may loan out “by crediting the borrower’s deposit account, i.e., by creating additional deposit money.” In which case, an additional $9,000 in IOUs will appear on the assets side and an equal amount in deposits that were created out of thin air on the liabilities side, so that total assets equal $19,000 and total deposits have risen to $19,000.


Bank A



$10,000 (reserves at the Fed)$10,000 (initial demand deposits)
$9,000 (loan)$9,000 (newly created demand deposits)
Total: $19,000$19,000


So let’s say Bank A, starting with its $10,000 reserve, issues a $9,000 loan to Bill. It now has $19,000 on both sides of its “T” account, as just explained. Say Bill buys a car from Ted with the money he borrowed. Ted then takes the check Bill wrote and deposits it into his own bank, Bank B. So $9,000 is debited from Bank A and credited to Bank B by the Fed. Bank A now has $10,000 on both sides of its ledger, still maintaining a 10% reserve ratio, and Bank B has $9,000; so from the initial $10,000, there still exists between the two banks $19,000.


Bank A



$10,000 (reserves at the Fed)$10,000 (initial demand deposits)
$9,000 (loan to Bill)$9,000 (deposit in Bill’s account)
-$9,000 (debited by the Fed)-$9,000 (check written by Bill to Ted)
Total: $10,000 ($1,000 reserves plus $9,000 IOU)$10,000 (demand deposits)


Bank B



$9,000 (credited by the Fed)$9,000 (check deposited by Ted)
Total: $9,000 (reserves at the Fed)$9,000 (demand deposits)


But now Bank B has $8,100 in “excess” reserves, which it then may lend out through the same process.


Bank B



$9,000 (reserves at the Fed)$9,000 (demand deposits)
$8,100 (loans)$8,100 (new deposits created out of thin air)
Total: $17,100 (reserves plus IOUs)$17,100 (demand deposits)


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.