Thursday, September 18, 2008


(Week 8 - Friday, Sept. 18)

In yesterday's column I described how the 15th century goldsmith banker held a minimum quantity, "fractional reserve," of gold in his vaults, relative to the much greater face value of the receipts or claims for that gold that he had issued, to serve as a hedge against not being able to redeem a receipt in a time of unusually high demand (which would signify his operation's bankruptcy). I also asserted that a pseudo version of the goldsmith's method, recreated in our time as the so-called "fractional reserve system," has planted the seeds of the present collapse of the financial sector.

The "fractional reserve system" of the modern banking era operates according to a formula that defines two-levels of money creation, the second being constructed upon the foundation of the first.

Level 1: "High-powered money" is the bankers' term for money created and put into circulation as a result of "borrowing" from the Federal Reserve itself by our Federal government.

Level 2: "Credit money" is money which is created and enters into circulation through the private-bank-loan transaction by which participants in the economy (except the Federal government) "borrow" money from private banks.

Creation of "High-Powered Money":

When the Federal government determines that it needs to "borrow" money, the Treasury Secretary (or his agent) approaches the Fed, and asks for a loan. The Fed agrees to "loan" the money, but requires security (collateral) in the form of bonds offered by the Federal government and signed by the Secretary of the Treasury.

The government prints and delivers the bonds to the Fed in exchange for newly created dollars being credited to its account at the Federal Reserve. These bonds, then, act effectively as "loan contracts" between the government and the Fed. It is critical to note that the Fed created this money out of nothing ("thin air") at the moment it credited the account. In addition, the face value of the bonds (the value printed on their face indicating the amount due the holder upon maturity) is much greater than the amount of money the government "borrowed." This is due to the "interest" charges which accrue from the date the bond is issued to when it is redeemed (paid off).

As the Federal government spends these new funds they end up on-deposit in the bank accounts of those contractors, builders, suppliers, service providers, employees, etc. to whom the money was paid. For purposes of this illustration, let us ignore the relatively small amount that circulates as pocket cash, and assume that all of it winds up on deposit in the banking system.

This new money "borrowed from" (in actuality "created by") the Fed and on-deposit in banks is referred to as "high-powered" money. The total quantity of high-powered money on deposit in the banking system, combined with a number known as the "fractional reserve ratio" mandated by the Federal Reserve Board of Governors, determines how much "credit money" the banking system can create through the bank-loan process. The formula that governs the procedure works basically as follows.

The "Fractional Reserve Ratio":

Let us assume that the "fractional reserve ratio" has been set by theFed at 1/10 (10%). In mathematical terms, this means that the banking system as a whole (The Fed and the private banks it oversees combined) have the potential of creating an amount of money that is the quantity of high-powered money on deposit, times the inverse of the "fractional reserve ratio." If the ratio is 1/10th, this allows the banking system to create overall an amount of money which is a multiple of the inverse of that number (i.e. 1 ÷ 1/10), which equals 10.

Simply put, this means that if borrowing and spending by the Federal government causes a billion dollars of "high-powered money" to be created and put on deposit in the banking system, the private banks can use this billion dollars as a foundation ("fractional reserve") to create another nine billion dollars of new "credit money." The total amount of new money, "high-powered" and "credit," that can be created through this process, is equal to what the Federal government "borrows" and spends into circulation, times ten (in this case, ten billion dollars).

Creation of "Credit Money":

To show how the process unfolds, let us suppose that $10,000 dollars of high-powered money has wound up on deposit in a given bank. The banker at this institution has thereby gained $10,000 dollars in new "reserves" against which he can create new money to "loan" out. The question is, how much can he create?

Since the banker in our example has $10,000 dollars of "reserves" on deposit, he can create up to $9,000 dollars in new money to "loan." Let us suppose that someone comes in and asks for a $9,000 loan, and his application is approved. The banker writes a check for (or electronically credits an account in the amount of) $9,000 dollars, and gives it to the "borrower." According to the way bankers think about this process, the banker in our scenario has just "loaned out" $9,000 dollars, and has, as required, left $1,000 "in reserve" as a hedge against the bank becoming "insolvent" (i.e. going broke).

At first glance, the process described in the above paragraph looks very much like the method the goldsmith banker used to protect his bank from becoming insolvent. Common sense dictated that he keep in reserve in his vaults an amount of gold which represented a reasonable percentage (fractional reserve) of the face value of gold receipts he had issued that were circulating as money in the economy, as a hedge against an unusual level of demand for the redemption of those receipts by his clientele who, overall, had been "loaned" the same gold several times over. Similarly, the rule governing modern banking which requires banks to keep in "reserve" a certain "fraction" of their money when they create loans, would seem to be a common sense measure to provide a margin of insurance against the possibility that the banks might find themselves in the position of not being able to redeem their depositors' accounts for cash at the teller window.

These two scenarios have, upon cursory look, a very similar appearance. If one examines more closely what is really happening, however, it will be found that these respective processes are very different, and have, not similar, but virtually opposite effects. The fractional reserve practice of the goldsmith banker lent a measure of stability to their system, but the so-called "fractional reserve" formula of modern banking is the very source of its chronic instability. In tomorrow's column we will continue with the description of how the "fractional reserve formula" unfolds, and take up the thread of how it is at the root of the collapse in the financial markets at present.

Richard Kotlarz

The complete set of columns from this series is posted at the following websites:

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