Column #50 BASE COURSES OF THE "FRACTIONAL RESERVE PYRAMID"

(Week 9 - Tuesday, Sept. 23)

In yesterday's column I drew a word picture to help the reader visualize the monetary system as a wall made up of courses of stone (bundled "loans" of money borrowed at "interest" from the banking system) that resembles in shape a sort of tall slender pyramid, whose ends slope towards each other, but also curve in such a way that they reach for the sky, but never quite meet. The nature and shape of the wall is determined by the "fractional reserve formula," which governs how banks create and loan out money.

The foundation stones of the pyramid are Federal bonds, which are essentially the loan contracts for money the Federal government borrows directly from the Fed, that winds up on deposit as the initial "reserves" in the banking system. The second course or layer of stones in our pyramid is the first cycle of "credit money" created by banks and then deposited back into the banking system. From there, each cycle of new money created through the loan process and deposited in the banking system is represented by successive courses.

Each course of stone is theoretically of the same nature in terms of the "debt-based-money" it represents, but they occupy relatively different positions in the structure of the wall. If one or more stones (bundles of loans) of an upper stratum failed, that would not threaten the integrity of the pyramidal wall as a whole, as there is little or nothing in the way of newly created money that is being supported above it (i.e. that it is designated as the "reserves" for). If, however, a stone near or at the bottom were to crumble, it could threaten the integrity of the wall as whole (as a significant portion of the loan bundles above it would have been created using it as the original "reserves"). If a few stones at or just above the foundation course were to disintegrate it, would threaten the wall's very existence.

It is obvious that, structurally speaking, the layer of government bonds supporting the dollar is the most crucial. Accordingly, this "high-powered" base strata cannot be allowed to fail without bringing the whole system down. This is why (it is said) the "full faith and credit of the Federal government", "backed" by the full force of same, stands ready to see that this does not happen. This, then, makes the government bonds "backing" the dollar the logical "investment of last resort" (the one that will fail only after all the others have failed), regardless of whatever else is going on in the financial order (which is why these bonds are selling at a premium in the current crisis).

The next several courses up are made of the "reserves" that are on deposit at the major commercial and investment banks. These represent the first levels of "credit money" created on the basis of the "high-powered money" on deposit from loans to the Federal government. They do not constitute the foundation per se, but are so closely linked to it that for a major bank or banks to fail is deemed to be tantamount to the failure of the system itself. If a big bank fails, by the rules of the game a lot of other loans that piggy-back off the "reserves" its money on deposit represents would, by the rules of the banking system, not be supported. In the prevailing view, monetary liabilities for which the large banks are responsible must be honored so as not to precipitate a fatal undermining of the system. When that possibility seemed to loom, the Federal government has in the past intervened (as with FDR's "banking holiday" and "suspension of gold redemption", the Continental Illinois bailout, and the Mexican "debt-restructuring").

Closely linked to the viability of these bottom courses are the fortunes of the banking system's biggest customers, including large corporations, major public entities (states, cities, bonding districts, etc) and the mega-wealthy. These are the "important players", and confidence in the system rests, it would seem, on the public perception of their remaining able to pay their "debts." This imperative is commonly deemed to be significant enough, depending upon circumstances and the vagaries of the political process, to warrant, supposedly, government rescue from insolvency (as for the Chrysler Corporation and New York City bailouts).

In tomorrow's column I will describe the upper courses of the fractional reserve pyramid, and show how their relative positions in the monetary structure accounts for the evidently scant regard the regular hard-working, bill-paying citizen is receiving in the spate of current proposals designed, supposedly, to save the financial system.

Richard Kotlarz
richkotlarz@gmail.com

The complete set of columns from this series is posted at the following websites:
http://economictree.blogspot.com/
http://www.concordresolution.org/column.htm