“If, a bank can loan $9000 against a $1000 deposit, what are they doing besides creating money out of thin air?”

If a baker can buy $100 worth of flour and sell $1000 worth of bread, I suppose you think he’s creating money out of thin air too?

Not at all: the banker, like the baker, are only setting the prices at which they value their work (turning the flour into bread or giving you some money now in return for more money later).

I’m not talking about the Fed inflating the monetary supply by lending to institutions at low rates; that *is* creating dollars out of thin air in a sense, but it has nothing to do with fractional reserve banking. It’s simply a special case because the Fed is ‘lending’ something that is not finite–exactly as if I were to lend you one million JonFranceBucks, US dollars exist by pure government fiat.

And yet, as I said above, even under a gold standard, even under bartering, people get paid for their labor, be it producing goods or providing services. What form they get paid in is ultimately up to them, but society tends to form a consensus on these matters, and we’re currently using dollars (for better or worse). But the baker’s business model, and the banker’s, would not have to change if we had a finite currency.

Amen, brother. Laissez fair and libertarianism CAN work if we don’t let the government bastardize the whole principle.

You can try these resources:
1- The GRUNCH of Giants by R. Buckminster Fuller.
2- The Creature From Jekyll Island by G. Edward Griffin.
and (3), the Robert Kiyosaki new book, free on internet at this address: http://www.conspiracyoftherich.com/ where RK skillfully simplifies and clarifies a complex subject.

Hope that helps
Fred

FRB is a dirty business, but I’m not saying it should be outlawed or regulated. I’m saying it should be unregulated, and the government should get out of the business of massively reducing risk for these financial institutions.

If the banks were less protected (or unprotected!), they would be forced to aggressively manage risk. FM/FM? Everyone in the industry knew they’d never fail. Reserves? That’s what the FDIC is for. Wait a minute, NO RISK! LOAN TO ANYONE WOOHOO!

The Austrian Economists have this one right guys.

http://www.lewrockwell.com/rothbard/frb.html

LewRockwell.com and Mises.org are great resources for economic theory and the Austrian business cycle.

Here’s my source…
http://mises.org/books/desoto.pdf
page 182

The distinction I don’t think any one has made is that there are two forms of deposits. A deposit LENT to the bank for a period of time and a deposit given for safe keeping. Some examples would be a Certificate of Deposit and a Checking account respectively.

Now If I get a $1000 CD I am lending that money to my bank for say 1yr. They know when I will be asking for this money so they can do what ever they want with it as long as they have it when the year is up. In this situation there is only $1000. It trades hands a couple of times but no money is created.

The issue of money creation comes into play with the second form of deposit. A deposit for safe keeping.

Lets say I go to my bank and open a checking account with my $1000 instead of a CD. The bank tells me that I have $1000 setting in my checking account. According to fractional reserve banking they only need to have 10% on hand. They take the extra $900 that they aren’t required to keep on hand and loan it out to some one. My bank tells they guy getting the loan that he has $900 more than he had before, but my bank is still tell me that I have $1000 in my account. The bank now tells us that there is $1900. I only gave them $1000 so they created $900 out of thin air.

Here’s the line from the pdf. (m.u.= monetary units)
“there has been an increase in the amount of money in circulation in the market, due to beliefs held simultaneously and with good reason by two different economic agents: one thinks he has 1,000,000 m.u. at his disposal, and the other believes he has 900,000 m.u. at his disposal. In other words, the bank’s appropriation of 900,000 m.u. from a demand deposit results in an increase equal to 900,000 m.u. in the aggregate balances of money existing in the market. In contrast, the loan or mutuum contract covered earlier involves no such occurrence.” – Jesus Juerta De Soto

I thought I knew how frb worked but this discussion prompted me to check it out for myself. Thanks!

My apologies for the long reply but this is the easiest way I could think to explain it.

1- sometimes congress pays the teachers instead of buying tanks and bullets.

2- King Henry is now retired and BigLiar Geithner (not quite his real name) is in charge of the IRS that will put you in prison if you don’t pay your taxes.

3- Inflation is always a monetary phenomenon, price fluctuations are only a consequence of an increase of the quantity of money – if you heard of Quantitative Easing recently, that is it – an increase of the quantity of money.
Inflation is VERY REAL and it is only a matter of time before it hits you! Are you prepared?

4- If the above (post 29) does not make sense, it is because IT DOES NOT!
The monetary system is an awful joke, a maze of smoke and mirrors and obfuscation where the serfs (read citizens) are by designed being smoked and dumbed down… Don’t believe me?
Okay, what did you learn at (the Government’s) school about money? …not much, right? But you are expected to spend most of your life working FOR MONEY, right?

5- Agreed, teachers are not well qualified to teach about money – if they were, they would have some… sounds plausible this time. Still, NOTHING YOU ARE TOLD ABOUT MONEY IS TRUE, at least not at school or mainstream media, or your bank or your financial planner (that likely does not have a clue himself… he learned what he knows from… school!)…

6- Don’t worry, everything will turn out fine, no need to understand how these things work, it is toooo much very much complicated and better leave all these difficult things to the professionals…
…if you understood, it would be a lot more difficult to pick your pockets, plunder and rape you!

7- Above point 6 is… ironic, don’t believe it and start educating yourself RIGHT NOW!

8- Tar, feathers and pitchforks will soon be in a raging bull market!

That’s it, I’m done!

1- ALL “money” is debt – take a dollar bill and read: FEDERAL RESERVE NOTE… yes, note! a debt.

2- How is it created: there are two mechanisms; the first is between Treasury and FED – the Treasury (ex King Henry now replaced by BigLiar Geithner) writes a bond on a nice piece of paper & gives it to the FED in exchange of a check for the principal of the bond written on other nice pieces of paper, the aforementioned FRNs.
Second, Treasury gives the notes (dollars) to congress that does what it does best: it spends it (say on military equipment to invade foreign lands), while the FED writes the treasury issued bond in their reserves.
The FED turns around, sees it now has “reserves” (the Bond – debt from treasure, congress and in the end, you!) and decides to write another check to the commercial banks. The check is 10x the value of the reserves (remember, that is the fractional part of it) this is the high power money part of the FRB.
Now to the second stage of FRB: The commercial banks receive the check from the FED and write it in their “reserves”, turn around, see that they have reserves and decide to write more checks to you – this is called a LOAN – at that moment, the bank can lend 90% of the money in “reserve”.

…But it does not stop there:

While the Fed was writing checks, congress paid for its tanks (remember, the war against cavemen in Afghanistan?) and the tank manufacturer deposited the proceeds to its bank that wrote it in its reserves… At the same time, you were using the new loan from the bank to purchase a house (or whatever stuff to fill up your garage!); the house seller received “your” money, deposited it in the bank that – you know now – wrote it in its reserves… Reserves that can be lent out for 90%, go in the economy, come back to the bank and hop again for another turn…
This is low power money – it can still be lent up to 9 or 10x the reserves, but needs several turns to get there…

All the while, ONLY the PRINCIPAL of the loans have been created (loan to BigLiar Geithner, loan to buy your house, etc…) No amount of the money needed to repay the interest exist…

So how do you pay the interest?
Interesting question: It is called competition – the system is designed so IT IS YOU OR ME! Either through wits, cunning or skill, I outsmart you and take enough of your money to service my loans, in which case you cannot repay and you go bust; or it is you that outsmart me and then I go bust.

- BY DESIGN, ONE OF US MUST GO BUST! –

…that is precisely where we are now in the cycle… The precise moment where the masters of the bankers harvest 25 to 30 years of planning, before we start again on a new cycle!

No, actually you would rather us get paid in silver/gold coins, bags of salt, cow chips, or whatever other commodity you deem worthy. I vote for the silver/gold coins, cow chips really start to stink sitting in a vault.

What an absolute load of crap. If you had any courage in your convictions you would take all your worthless paper money, buy commodities, and stick them in your basement (which I know some people have).

Fiat currency is not the problem. It is the SUPPLY of fiat currency that is the problem. Whether you use dollars, wood chips, gold, salt, or dirt, currency (means of exchange) is really nothing more than PERCEIVED VALUE. I agree we can’t let our government debase the value of our currency, but let’s not get crazy. I LIKE paying my bills via online banking. I DON’T WANT to pay my mortgage by wheelbarrowing 100 lbs of salt.

If, a bank can loan $9000 against a $1000 deposit, what are they doing besides creating money out of thin air?

[Note: Trent has misstated that banks lend only $900 against a $1000 deposit. He should correct that at once!]

If every dollar is debt, there can never be enough dollars to service the debt and its usury.

FRB can work in a truly free market (which we’ve not had for at least a century now). But, in a centrally planned and overregulated market, such as ours, FRB is prone to failure due to government manipulation of risk and excessive malinvestment. In a free market, lenders would be forced to aggressively estimate and manage risk. So called “stated income” loans for half a million dollars (or any amount) could never exist in a free market!

@almost there (17) and @Fred (21), I agree with both of you.

These banks take deposits and invest the money. They use a portion of the returns on these investments to pay your interest dividends.

Ponzi scheme – he didn’t invest the money. He pretended he did and hid that fact by sending “false” dividends earned back to his investors.

Lenders do earn their profits, because they provide money ahead of time, and people are often willing to accept having less money now rather than more money later–especially when starting out and the ’seed money’ is necessary to get one’s start. Anyone who borrows accepts to pay the lender for the service he provides (although not all borrowers realise this as clearly as they should).

Obviously the system can and has been abused, but in itself it is a sound and legitimate system–which would operate the same way independently of whether you have a fiat or gold-based, or even a bartering economy.

Money

– A societies most liquid (easy to trade / in high demand) asset (an object of value).

Historically this was gold or silver, but today it is usually some type of government bond. Keep in mind government bonds have value because a government has the ability to seize (tax) almost any asset.

Currency

– A piece of paper that represents a claim on a store of money.

Fiat Currency (e.g. a Federal Reserve Note)

– A type of currency issued by a government.

By law, usually the only type of currency allowed in a given country.

In response to Stephen Waits comment:

“The problem with FRB is that it creates new money out of thin air.”

This is a common way of explaining FRB (I’ve even had economics teachers describe it this way) but it is a little misleading. The term “money” here really has a different definition than the way most people use the term. What Stephen is talking about here is just the sum total of all the deposits that different banks are obligated to pay.

Instead of thinking of dollars in an abstract sense, think of something physical like gold coins.

So..

Bob Deposits 1000 coins in Bank A. Bank A holds 100 coins, and lends 900 coins to Mary.
Mary Deposits 900 coins in Bank B. Bank B holds 90 coins and lends 810 coins to Tom.
Tom Deposits 810 coins in Bank C. Bank C holds 81 coins and lends 729 coins to Sue.

…. and so on.

At the end of the day, there are still only 1000 coins. However the sum total of all the bank deposits (e.g. checking accounts, saving accounts, CD’s etc.) is often 10 times that amount.

Economists call the initial 1000 coins the “monetary base”.

The total of all the bank deposits is called the “money stock”

If you want to know these amounts for the US FRB system, you can find them here:

http://www.federalreserve.gov/releases/

The monetary base is in the report entitled “Aggregate Reserves of Depository Institutions and the Monetary Base” – H.3

Look for a column entitled “monetary base” under Table 1.

The money stock totals is in a report entitled “Money Stock Measures – H.6″

Look for a column entitled “M2″ under Table 1.

See footnote 2 in Table 1 for a technical definition of the term “M2″.

I also wanted to thank you for the very thought-provoking article, very well done. Keep up the good work.

Example: 10,000 people deposit an average of $1,000 at 1% (above what most banks pay, sadly). The bank now has $10,000,000 in available capital, around 80 to 90% of which it can loan. Assuming the bank loans “only” 80% at 5%, after one year the bank has earned $400,000 in interest on the loans and paid $100,000 in interest to the depositors. The remaining $300,000 is the bank’s gross profit, assuming no defaults. If a debtor does default, the bank takes possession of any collateral and attempts to sell it to recover some of their loss. The rest is taken from the $300,000 gross profit, leaving the net profit for the bank.

For years banks had very careful guidelines on who they considered creditworthy, based upon a number of criteria. By following those guidelines, the banks were usually able to make loans with relatively few defaults, which meant that relatively little of the banks’ gross profits were eatten up by bad loans.

But over the last decade or so, the banks have been encouraged to ease their lending criteria, both by the government who wanted to increase home ownership and by the bank’s investors who wanted the banks to earn high profit margins. The banks made riskier (sub-prime) loans that tended to have a higher interest rate. At first this increased the banks’ profit margins because the relatively few borrowers who had problems repaying their loans could usually just resell their house at a profit and pay off the loan.

Then the bubble on house prices “popped” and borrowers who ran into trouble found they couldn’t simply sell their houses to repay loans they couldn’t afford. At that point default rates started to increase until the losses from defaults surpassed the banks’ gross profits, leading to losses. Making the situation harder is the fact that the loans had been bundled to be resold to investors. The investors know that a significant portion of the loans in these bundles are going to default, but no one really knows just how many – 2%? 5%? 20%? No one knows. So investors stopped buying the bundled loans.

But again, even this wouldn’t have necessarily forced the banks to their knees. They could have written down the lost value in these assets over number of quarters or years until the situation stabilised, but for a rules change passed in 2007 called “Financial Accounting Standards Board (FASB) Statement No. 157″, also known as “Mark to Market”. What this federal rule did was force all financial institutions (such as banks, insurance companies, etc.) to have to restate the value of their assets based upon the current market value. A reasonable requirement, and one that wouldn’t be a big problem *if* those assets could be valued. But with investors refusing to purchase these huge loan bundles, their market value has plunged from hundreds of billions of dollars to zero, literally overnight.

As a result, banks that would have been able to weather even a couple years of higher defaults were suddenly forced to write down hundreds of billions of dollars in assets. As these banks suddenly reported massive paper losses it led to a freeze on even lending between banks (since Bank A can’t tell for sure if Bank B really has enough assets to pay back an inter-bank loan). Don’t forget, most of the loans in these bundles are NOT defaulting, so the bundles really do have some value, but no one is able to say exactly how much, so the banks have to treat them as essentially worthless.

Banks also stopped loaning money to individuals and companies because they needed to preserve what remaining working capital they had left, so car loans, credit cards and lines of credit to individuals and companies all ground to a halt, spreading the problem outside of the banks and igniting a recession that’s pretty much hit every country in the world as the effects of the sudden halt in credit spreads.

None of this was necessarily the fault of Fractional Reserve Banking. Instead we’ve got a series of changes that has fed one into the next:

1. The housing price bubble finally burst and house prices started to drop.
2. The higher than normal number of risky loans outstanding led to more defaults
3. Thanks to the combination of FASB 157 and the bundling of these loans, banks had to write off huge losses than faster they would have otherwise, often before many of the loans even went into default.
4. Lending almost completely dried up as the banks tried to preserve their remaining cash
5. And as loans stopped flowing the rest of the economy stalled into world-wide recession.

George Bailey’s explanation in Its a wonderful Life is outdated. Banks don’t operate that way any more, issued loans are now sold as tradeable securities (MBS, CDO & the like) against cash that replenishes the reserves and can be leveraged into new loans at once.

MONEY IS DEBT – it is borne into existence by your (or the USTresaury) signing of loan documents (Mortgage or TBonds).
The irony is that 99.99% of the people spend MOST OF THEIR LIVES working for money, without knowing what it is.

Obama is betting on “The Character” of the American people, drawn from a history of hardships… We’ll see!