SPGB Meetings (1973)

Party News from the December 1973 issue of the Socialist Standard

Greasy Pole: The mass debaters (2008)

The Greasy Pole column from the February 2008 issue of the Socialist Standard

Who will win the race? Which horse is your money on? Will we notice when they win?

The excitement is killing me. Who has seen whiter, glossier, teeth and lies whiter and glossier still than those that were bared on television during the recent debates between Democrats and Republicans? The race culminating in the presidential trophy in late 2008 is solidly on, with these wealthy members of the capitalist class vying for leadership of the world’s most prosperous land, brought to them by the generous contributions of our dear readers’ unpaid surplus value.

These sellers of capitalist reforms are so impeccably dressed and groomed, so charming and witty, so passionate in their determination to give a structurally exploitative society a new lease on ideological life, that it might well take an Odyssean resistance to temptation on your part to keep from falling for their well-oiled sell, written and rehearsed with a large team of marketing professionals from behind the curtains.

Obama

Senator Obama, for all his oozing liberal rhetoric and strong likeability factor, while an Illinois Democratic senator has always supported a free market system. Isn’t that the one in which most of us must work so hard to produce free surplus value for our employers that we don’t even have enough free time to ourselves? One of the most popular bills that he signed in 2007, the Shareholder Vote on Executive Compensation Act, also known as “Say On Pay,” allowed shareholders to limit the inflated salaries of corporate CEOs but while this was easily and incorrectly perceived as a Robin Hood move, the reality was that studies in the Wall Street Journal had previously demonstrated that poorer CEO performance was correlated with more inflated salaries, and also that in economically troubled companies, worker morale suffered the most when CEOs were receiving pay of exceptionally bloated dimensions. In short, fiscal policies and laws must attempt to look after the interests of the capitalist class as a whole, even at the minor expense of individual capitalists. Behind each liberal dream sits a wallet somewhere waiting to bulge.

Obama was further criticized and praised last year for spending $18 billion on promoting merit pay of the nation’s teachers by cutting costs from the NASA Constellation Program, delayed now by 5 years. On the surface, noble and caring, no? Well, in capitalism the only nobility are the ones who still own parts of the land, and even the most caring sentiment finds a way out of the heart and into the coffers of the rich. His plan to improve merit pay for teachers was harshly criticized by the National Education Association (the largest labour union in the U.S.), the Urban Institute and the Cato Institute, on the grounds that merit pay could actually end up favouring schools in better neighbourhoods whose track records were stronger as a result of the inflow of local resources, could lower the morale of teachers owing to the resulting competition between them, and could create a new expensive bureaucratic superstructure overseeing the programme itself. Isn’t it sickening that in capitalism resources cannot be directly accorded to those who deserve it the most, our children’s teachers, without producing such negative consequences upon the institutions and atmosphere in which our children are learning?

Obama is also on record for stating that he is not opposed “to all wars, only dumb wars” (famous Fall 2002 speech at the anti-war rally at Chicago’s Federal Plaza). While urging for a date by which de-escalation of the militarization of Iraq should begin, Obama has also consistently refused to actually cut funding for the Iraq War. Capitalism makes it hard for seemingly honest, intelligent and good-intentioned politicians such as Obama to take a solid stance against the murder of the innocent (who are always the ones in war to die in greater numbers than the intended targets), even for those politicians who would likely come across as largely anti-war in a private conversation (if they too openly challenge the status quo, they may be attacked for undermining the war on terrorism – and as a result of their careful public manoeuvring, their platform always seems unpredictable and inconsistent).

Clinton

Hillary Clinton lost the Iowa caucus but won the Democratic Party primary in New Hampshire. She is thus very much in the race to become her party’s presidential candidate at this time, with the biggest next date that may tip the scales in favour of Clinton or Obama what is dubbed by the press Big Tuesday on February 5th (something to get so excited about when we get home from work that day). Clinton is garnering a lot of support for her life-long struggle to medically insure all Americans, however she no longer advocates a single-payer insurance system as she once did and as all other capitalist nations around the world presently provide. Another example of the compromise she had to make to remain a viable leader of the Democratic Party, and a perfect example of how the needs of capitalism so taint the original ideals of those running for big offices that by the time they arrive there, they look, smell and sound like anyone else in the White Lie House. Indeed, the only Democratic Party candidate who does presently advocate a single-payer insurance plan is John Edwards, who is presently tailing significantly behind the other two in the race.

Hillary Clinton is assuredly not going to be making the world any safer from war, either. It is true that she has worked to improve the medical and psychiatric treatment benefits available to veterans, thus leading one to assume that she is more willing to improve in the patching up of those who fought abroad than in preventing their being massacred physically and emotionally there in the first place. However, as the potential leader of one of the world’s great powers, her job will be to make sure that she protects the economic interests of this country’s industries and their standing in the marketplace as a whole. Rather than attempting to make the world safer from war, her own website recites the same sort of patriotic dribble one finds frothing out of the mouths of every other leader running for president, in her case: “every member of our armed forces will receive a fair shot at the American dream when their service is over.” We all know, of course, how “fair” the American dream is, especially the millions of American presently failing to pay off their mortgages at a landslide rate, and the volunteers at the 51,000 food pantries across our “fair” land that are presently providing food assistance to the millions of extra customers turning up at food banks in recent years (according to America’s Second Harvest “2006 Hunger Study”).

Ron Paul

Ron Paul, a Republican presidential candidate, actually came out in the recent debates the strongest opponent of the Iraq War. His opposition seemed partially fiscal in nature, as he deplored the $300 billion spent on it thus far. But it was also ideological, as he felt the arming of groups who later turn against the United States (e.g., the Kosovars who aided Islamic terrorists, or the Afghan jihadists themselves, and their friend Osama bin Laden) had acted to fuel increased national insecurity rather than security, and increased terrorism rather than less. And of course, Ron Paul is probably right on this score, surprisingly coming from a member of the Republican Party, the party that always advocates small government but seems in each office hell-bent on creating a bureaucratic gigantean proto-fascistic war economy state.

However, Ron Paul, like the rest of the Republicans or Democrats, feels that capitalism can somehow behave more rationally than it does – or at least they want us to believe that with our vote they can transform its foul waters to fine wine. The reality is quite the opposite, as history shows again and again. Tensions between nations are always present over shifts in political allegiances between countries that may benefit some better than others. Global politics is a macrocosm of the local economy, with each company vying to get as much of the business as it can, such as trade, material resources and opportunities for future economic growth. From the perspective of a capitalist enterprise or a nation, the planet is a great big hamburger to chow on, with the unneeded parts thrown away on the landfill – children, nature, women, the elderly, education, health, and common sense. It is, at the bottom-line, a violent and wasteful way for humans to treat both each other and their world. It benefits only those in control of the resources and keeps the rest of us in a state of emotional tension about the relative lack of security that exists around the planet, at any time potentially plunging us all into another world war or terrorist attack. It is a world gone mad.

Daniel Vogel,

WSPUS

Fractional Reserve Banking Refuted (2012)

From the October 2012 issue of the Socialist Standard

Since the financial crisis first erupted in the summer of 2007, there has been a renewed interest in what is now commonly called ‘fractional reserve banking’. This is mainly from those who contend that it is the root cause of the problems besetting the world economy. But is this idea really plausible? Both logic and the available evidence would indicate not.

Fractional reserve banking (the idea that the banking system can lend out vast multiples of what has been deposited with it) is not a new theory. It is also – and perhaps more accurately – sometimes called ‘credit creationism’ as it assumes banks can create almost endless amounts of credit from what has been deposited with them by savers. Ever since the MacMillan Report into Finance and Industry in the UK in 1931 gave it credence, variants of this theory have been taught to students in universities and colleges across much of the world.

In truth, there are two versions of the theory –the initial crude one, and a more sophisticated version which on some readings isn’t really credit creationism at all, even if it uses some of the same terminology. We will examine both versions, starting with the original, crude one.

Magic money?
This version of the theory was the one put forward in the MacMillan Report itself and is based on a simplified ‘one bank’ model of the banking system. The MacMillan Committee assumed that this bank would hold a cash reserve of 10 per cent of their deposits to meet any likely withdrawals from customers (today the cash reserve held by banks is a lot less, usually 2-3 per cent). Into this bank a customer places a deposit of £1,000 in cash. Operating with the 10 per cent cash reserve, the bank would then be able to lend out £900 to another customer which is withdrawn by cheque before being returned to the bank as a new deposit. So in this way the initial £1,000 had grown to £1,900 (the initial £1,000 cash plus the cheque that had been deposited for £900 from the loan granted). This is a process the MacMillan Committee argued could then be repeated nine more times assuming the 10 per cent cash reserve, with the bank therefore lending out £900 to each of ten customers in total. It would lead to a situation after all these transactions had been completed whereby £10,000 in deposits was balanced by £1,000 in cash plus £9,000 in loans owed by borrowers. So, as if by magic, an initial £1,000 deposit had become £10,000.

This type of credit creation theory has been put forward by many modern critics of capitalism (including Zeitgeist and some in and around the Occupy movement) who claim society is being enslaved by bankers and the ‘debt-money’they create. It is used to illustrate the view that banks have special powers to create wealth and that the banking system is inherently fraudulent and corrupt. This outlook also has its echoes on the political right, such as in the views of Representative Ron Paul in the US. Shorn of its overtly political implications, it gets an airing in some standard economics textbooks too. For instance, a typical textbook aimed at undergraduate university students like An Introduction to Modern Economics by Hardwick, Langmead and Khan describes a similar, crude credit creation process as if it were fact. Imagining a one-bank economy where the bank operates a 10 per cent cash reserve, with £10,000 in deposits and £1,000 of this in cash, they say:

  ‘suppose now a customer deposits an extra £2,000 in cash . . . Notice now that the ratio of cash to deposits is no longer 10%, but is now as high as 25% [i.e. £3,000 out of £12,000]. Given that the bank’s desired cash ratio is 10% and that the bank wishes to maximize its profits [by making  loans at interest], it will increase its total deposits to £30,000 so as to restore the desired ratio. The bank does this by granting new loans amounting to £18,000 . . . the cash deposit of £2,000 has led to an increase in loans and investments of £18,000 so that total deposits have risen by £20,000 –that is, by ten times the amount of the cash deposit’. (5th edition, pp.439-440).

In this way banks are allegedly able to magic up money they don’t really have, by either the stroke of a pen or push of a button.

Logic deficit

There are a number of reasons why this one-bank model of credit creation is flawed, both theoretically and empirically. The main ones are these:

• Just because a theory is explained or advocated in some economics textbook doesn’t mean it carries any weight. Economists famously cannot agree amongst themselves and economics isn’t called ‘the dismal science’ without reason. Conventional economics has consistently failed to explain all sorts of contemporary phenomena within the market economy (unemployment, recessions, inflation, etc) and there is no reason to suppose it has it right about banks and credit. Furthermore, as we shall see, most modern economics textbooks have moved away from the crude credit creationist views outlined above as they know they are intellectually indefensible. Why might this be so . . . ?
• The model assumes a certain cash reserve (10 per cent in the examples quoted, though a lower cash reserve makes the potential for banks to ‘create credit’ even greater). But is also assumes something else. It assumes that this cash reserve is never actually accessed by anyone in the entire series of transactions, and so is totally unrealistic. In other words, taking the example used by the MacMillan Committee, the initial £1,000 cash is completely untouched throughout. This is interesting, because if credit creation can multiply £1,000 into £10,000 at a stroke of a pen, the equal but opposite effect would come into play if anyone actually withdrew any cash! It would only need one of the borrowers to access their new deposit by demanding cash rather than a cheque to blow the model apart. So the model is not only unrealistic but logically flawed.
•  The model also confuses the apparent ‘creation’ of credit or money with what is merely standard double-entry book-keeping. If someone withdrew £10,000 from their bank and lent it to a business associate with an account at the same bank, the total amount of deposits held by the bank would be unaffected –£10,000 would merely go out of one account and into another. However, if the bank, when acting as an intermediary, did the same thing (i.e. the person concerned left the £10,000 on deposit and then the bank took £10,000 from its deposits to lend to the businessman) then in this instance the bank deposits and loans recorded by the bank would have increased by £10,000. Yet the only difference is that the bank has lent the same amount of money itself. Nothing else has materially altered and the bank hasn’t ‘created’ anything –the apparent difference is merely the product of the way balance-sheet records are kept.
• If banks really could create multiples of credit from a given deposit base then no bank would ever go bust. If a borrower failed to repay a loan, they could merely write this off and create more credit from their deposit base to make another one. Or, more directly still, the credit ‘created’ in this way could be used to buy additional assets. Lehman Brothers, Bear Stearns, Northern Rock, HBOS, Landsbanki and all the other banking disasters testify in a very practical way that this just doesn’t happen in the real world.
•  If banks could create vast multiples of credit from their deposit base in the way supposed, they would never have any financing issues and a need to seek any other sources of capital aside from the deposits they have from savers. Yet this is not the case. When Northern Rock imploded it had £113 billion of loans outstanding, but only £24 billion of this was backed by deposits i.e. less than a quarter. Did this mean the difference in these two figures was due to their ability to create credit over and above the £24 billion of deposits? No. The rest was financed from the money markets, where banks, building societies, companies, governments, local authorities and other organisations buy and sell short-term loans to finance their economic activities. When interest rates rose this put Northern Rock under pressure because the interest payments it was receiving on the loans and mortgages it had granted was barely covering what it had to pay in interest on the money markets to get the capital to lend out in the first place. And when the money markets started to seize up in late 2007, Northern Rock was doomed, having no more access to capital. Similarly, HBOS’s deposits covered only 44 per cent of the loans on its books before the crisis, the rest being financed from the money markets –and with most of this being short-term finance, it had a similarly disastrous result. Indeed, until the financial crisis broke the tendency within the banking sector had been for an ever greater proportion of banking capital to come from the money markets rather than deposits. This was because of a competitive drive to expand their capital so they could lend more and hence increase their revenue and profit. Until recent decades this was only ever done at the periphery of banking practice as to ‘borrow short’(via short-term loans on the money markets) while ‘lending long’(granting long-term loans and mortgages) was considered too risky.
• If banks really were able to increase purchasing power in the economy at the stroke of a pen or push of a button, there would be clear and observable consequences of this. For instance, many credit creation theorists have expected prices to rise alongside the expansion of bank credit, yet there is no observable correlation between the two. Prime Minister Margaret Thatcher gave up on this view in the mid 1980s when she realized the theory didn’t match the facts. Furthermore, while so-called ‘credit creationism’ is as old as banking itself, persistently rising prices (that have been left unchecked) have only been an economic phenomenon since the Second World War.
•  If banks were able to flood the markets with credit it would, other things being equal, drive interest rates down, and this is the opposite of what banks want to happen. If this phenomenon were a reality, banks would be caught in a ‘Catch 22’ situation where near endless credit creation would push interest rates down towards zero. But the rates banks charge have invariably been very healthy (for them), even during the crisis.
•  If banks can create vast multiples of credit from the savings that have been deposited with them, then so could other financial intermediaries. Building societies and even credit unions could do it, as the same principles would apply.  But nobody seriously suggests they can –if a credit union lent out more than had been deposited with it, it would go bankrupt (as, in reality, would a bank, the only difference being that a bank can also normally access the money markets for capital).
• The bankers themselves have explicitly stated that they cannot magically create credit in the way the theory supposes. For instance, Walter Leaf , Chairman of the Westminster Bank in the years leading up to the publication of the MacMillan Report was one of many who said so explicitly:    ‘The banks can lend no more than they can borrow –in fact not nearly so much. If anyone in the deposit banking system can be called a ‘creator of credit’ it is the depositors; for the banks are strictly limited in their lending operations by the amount which the depositors think fit to leave with them’. (Banking, 1926, p.102)

Indeed, many of the signatories of the MacMillan Report in 1931 (mainly the bankers and economists) later repudiated the theory they helped popularize. These included Reginald McKenna, Chairman of the Midland Bank, and most significantly of all John Maynard Keynes, who was the main author of the Report. In his seminal General Theory in 1936 Keynes stated:

  ‘The notion that the creation of credit by the banking system allows investment to take place to which ‘no genuine saving’ corresponds can only be the result of isolating one of the consequences of the increased bank-credit to the exclusion of others’(p.82)

In recent years the 2011 Vickers Report (the Independent Commission on Banking) has explicitly stated that banks are ‘financial intermediaries’that ‘bring together savers and borrowers’, without giving any indication that banks can create vast quantities of credit out of what is deposited with them.

• Many who are critical of capitalism as an economic system take inspiration from Marx’s ideas and his analysis of the market economy, but Marx took the view that banks are financial intermediaries between savers and borrowers who don’t create purchasing power: ‘A bank represents on the one hand the centralization of money capital, of the lenders, and on the other hand the centralization of the borrowers. It makes its profit in general by borrowing at lower rates than those at which it lends’(Capital, Volume 3, p. 528). For Marx, wealth and purchasing power arise through production, not the sphere of circulation and exchange. Banking profit does not, in Marx’s view, arise mystically out of financial conjuring, but as a portion of the surplus value created when the working class of wage and salary earners is exploited. This surplus value is then turned into industrial profit, ground rent, and banking interest.

In the light of all these arguments and the empirical evidence, it seems reasonable to conclude that the crude credit creationist viewpoint has little if anything going for it.

Second theory
A recognition of this has led to the popularization of the second, and more sophisticated, version of the theory. This is the version that argues that even if the one-bank model of credit creation isn’t plausible, the banking system when considered as a whole can effectively do the same thing. This was the view for years elaborated in standard economics textbooks by the well-known American academic Paul Samuelson and is perhaps the version that is most common today.

Samuelson dismissed the argument that an individual bank could lend more than had been deposited with it as ‘false’ and went on:

  ‘According to these false explanations, the managers of an ordinary bank are able, by some use of their fountain pens, to lend several dollars for each dollar deposited with them. No wonder practical bankers see red when such power is attributed to them. They only wish they could do so. As every banker knows, he cannot invest money that he does not have; and money that he invests in buying a security or making a loan soon leaves his bank.’ (Economics, 5th edition, 1961, p.331)

The argument he put forward is that when someone deposits £1,000 into a bank when there is a 10 per cent cash reserve ratio, the bank keeps £100 cash and lends out the other £900. This will then be spent by the borrower and will find its way back into the banking system more widely, which will then keep £90 of the £900 as a cash reserve and lend out the remaining £810, and so on.  Eventually, after these deposit and loan circuits have been completed, this leads to a situation whereby the initial £1,000 deposit in a particular bank has multiplied to £10,000 across the banking system as a whole.

Although it is an obvious oversimplification, in some respects this theory is sound. The key issue though is that it is not an example of ‘credit creation’at all. All this theory demonstrates is that money circulates and that for every loan that has been created, a deposit (that is greater than the subsequent loan) has also been made. In some ways it is little different to the concept underpinning the circulation of a bank note, whereby a £20 note can be used many times over a given period to facilitate transactions that, when aggregated, are many times the face value of the individual note.

No special powers
Given this, socialists say that ‘fractional reserve banking’ or ‘credit creation’ are myths. The crude version of the theory is illogical and at variance with any serious knowledge of banking practice, while the watered-down version most commonly found in modern economics textbooks isn’t really a credit-creation theory at all and proves nothing beyond the accepted fact that accepted means of payment circulate within the economy. In reality, banks can only lend out what they have received in deposits (or borrowed on the money markets), making their profits by levying higher interest rates on the loans they grant than they pay depositors (or pay to the money markets).

There really is no mystery to this, and the idea that banks have special powers and can hold the rest of society to ransom is consequently unfounded and movements for banking reform misplaced. The real problem in society stems not from what banks do specifically, but from the way society is organized as a whole. In particular, from the fact that the vast majority of people do not own and control the planet’s resources and have to work at the behest of those who do –some of whom are indeed bankers . . . but most of whom are not.

Dave Perrin

Cooking the Books: The yellow brick road to nowhere (2010)

The Cooking the Books column from the February 2010 issue of the Socialist Standard

“In an economy where the currency is not tied to the value of gold, the central bank can simply print more and more money, to fund the expansion of the economy and of central government. Over time, that will erode the purchasing power of the currency, but as long as that happens slowly through moderate inflation, no one seems to mind.” So the Independent (2 December) reported the views of US Congressman Ron Paul who wants to abolish ‘the Fed’, the Federal Reserve, America's central bank, as well as going back to a gold-based currency.

Paul cannot be called a currency crank. as he has a correct understanding of what causes inflation and his solution would work to stop it, if that what was wanted, even if it would be unnecessary, pointless and a waste of resources.

Money originated as a commodity, i.e. something produced by labour that had its own value, which evolved to be the commodity that could be exchanged for any other commodity in amounts equal to the value of the other commodity. Various things have served as the money-commodity, but in the end gold and silver were almost universally adopted. Paul offered a reason: “Most people think gold is beautiful, that's why it's money. It's because it's beautiful and rare and divisible and it lasts a long time. We don't use lead.” Beauty didn’t have much to do with it, but being rare (i.e. requiring more labour to find and extract from nature, so concentrating – unlike lead – much value in a small amount), divisible (so easily coined) and long lasting did.

As capitalism developed it was found that gold itself did not have to circulate, but that paper notes could substitute for it as long as those accepting or holding it could be sure that they could always change them for gold. Up until WWI in most countries the currency was gold coins and paper notes convertible into gold. The Great Depression of the 1930s led to the major capitalist countries abandoning this convertibility. Since then the currency nearly everywhere has been inconvertible paper notes.

With an inconvertible paper currency, the amount of money is no longer fixed automatically by the level of economic transactions, nor is there any limit to the amount of paper currency that can be issued. It is this that Paul objects to because, if the central bank issues more paper money than the amount of gold that would otherwise be needed, then the result will be a depreciation of the currency; the paper money will come to represent a smaller amount of gold with the result that prices generally will rise.

If Paul had his way, the Fed would no longer manage the issue of the currency. This would pass to the Treasury Department which would only be allowed to issue paper money if it had the equivalent value of gold in Fort Knox. This would be a further absurd waste of resources as much more gold would have to be mined – just to store in places like Fort Knox.

Paul thinks that a return to a gold-based currency would eliminate crises such as in the 1930s and today. This is an illusion. There was a gold-based currency up until WWI, yet crises occurred regularly, including a Great Depression in the 1880s and a hundred years ago the same sort of banking crises as today. Capitalism goes through its boom/slump cycle whatever the currency. No monetary reform can change that.

Banks, money and thin air (2009)

From the January 2009 issue of the Socialist Standard

An urban myth is circulating on the internet that banks have been creating money out of thin air.

Those who have seen the cult film Zeitgeist and its sequel Zeitgeist Addendum, popular amongst conspiracy theorists and others suspicious of governments and banks, will have heard recounted the argument that banks can somehow create money out of thin air by the stroke of a pen or, these days, by the touch of a computer keyboard.

In Zeitgeist Addendum this argument is based on what is stated in an educational booklet published by the Federal Reserve Bank of Chicago. Entitled Modern Money Mechanics it first came out in 1975 and has gone through several editions.

Zeitgeist Addendum begins by describing how it thinks the Federal Reserve Bank (the “Fed”) creates money. If, it says, the government wants more money then, through the Treasury, it creates Treasury bonds which it exchanges with the Fed for currency notes of the same face value; as the government has to pay interest on the bonds this adds to the National Debt and so is “debt money”. Both the Treasury bonds and the currency notes have been created out of thin air.

This is one way of putting it but it is misleading. It is rather the other way round in that the initiative to create more currency comes from the Federal Reserve Bank. Once it has decided that more notes are needed it asks the Treasury to print them (for which the Treasury charges). The normal way these get into circulation is by the commercial banks converting into currency some of the reserves they are obliged to lodge with the Fed. Modern Money Mechanics explains:

“Currency held in bank vaults may be counted as legal reserves as well as deposits (reserve balances) in the Federal Reserve Banks. Both are equally acceptable in satisfaction of reserve requirements. A bank can always obtain reserve balances by sending currency to its Reserve Bank and can obtain currency by drawing on its reserve balance” (p. 4).

In any event, both the Treasury and the Federal Reserve are part of government so we are talking about internal state accounting arrangements. It is, however, true that the new currency has been created out of nothing. Since it is not backed by gold and convertible on demand into a pre-fixed amount of gold, it is what in the US is called “fiat money”, that is, money created by a mere act of State.

Modern Money Mechanics does not in fact have much to say about currency creation but concentrates on what it calls “money creation”. It draws a distinction between “currency” and “money”. This is explained clearly enough on the first page of the booklet where money is defined as currency plus bank accounts with a cheque or debit card; which is M1 in the jargon (“In the remainder of this booklet, ‘money’ means M1”).

Congressman Ron Paul, from Texas, a critic of “fractional reserve banking” and advocate of a return to a gold-backed currency, has an even wider definition of “money”:

"M3 is the best description of how quickly the Fed is creating new money and credit. Common sense tells us that a government central bank creating new money out of thin air depreciates the value of each dollar in circulation." (27 April 2006, see here).

M3 includes other types of bank deposits and liabilities not included in M1. In claiming that all new money created by the Fed depreciates the dollar he is overstating his case. All the US currency (but, as we shall see, not bank deposits) is created “out of thin air” but an increase won’t lead to a depreciation of the dollar as long as it corresponds to an increase in the amount required by the economy for its various transactions (paying for goods and services, settling debts, paying taxes, etc). It is only currency issued in excess of this that will cause a decline in its value and so a rise in the general price level.

Everybody accepts that cash (currency, notes and coin) is money. Some might be prepared to include cash deposited in banks as well. But Modern Money Mechanics definition of bank deposits is wider than this. It doesn’t mean just deposits by people of the money they already possess but any account for which the holder has a cheque or debit card, i.e. including credit lines granted to those who banks have lent money to (so enabling Zeitgeist to go on talking about “debt money”):

“Checkable liabilities of banks are money. These liabilities are customers’ accounts. They increase when customers deposit currency and checks and when the proceeds of loans made by banks are credited to borrowers’ accounts” (p. 3, emphasis added).

So, when it talks about “money creation” it is not talking about currency creation but mainly about “bank deposit” (in the above sense) creation.

The Federal Reserve booklet goes on to explain what “fractional reserve banking” involves and how it can lead to the creation of more “money” in the sense of more bank deposits. Banks, it explains, have learned that when cash has been deposited with them they only need to keep a part (a “fraction”) of it as cash as a “reserve” to deal with likely cash withdrawals; the rest they can lend out. What this fraction is depends on the circumstances, but historically it has been around 10 percent.
On the booklet’s definition, in making a loan a bank is “creating money” as their loans will take the form of creating a new bank deposit as a credit line which the borrower can draw on as if they had made a deposit of their own money (except they will be paying interest on it). The booklet then asks “What Limits the Amount of Money Banks Can Create” and answers that this depends on the cash reserves it has decided to hold or is required by law to keep.

It is here that Modern Money Mechanics, by suddenly shifting from what an individual bank can do to what all banks together (“the banking system”) can, opens the way to the misinterpretation of people like Ron Paul and the makers of the Zeitgeist films that banks too can create “money” out of thin air. The booklet explains that US banks are required by law to keep a “fraction” of deposits as “reserves” in its vaults and/or a balance with the Fed, and says:

“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” (p. 4).

This is a very misleading way of putting as it could suggest that if banks receive total new deposits of $10 million they can immediately proceed to make loans of four times this. This is not so, and not really what the booklet meant to suggest. What it means is that the banks can immediately lend out only four-fifths of $10 million, or $8 million, and that this circulates throughout the banking system leading in theory to new loans totalling in the end $40 million, bringing total “bank deposits” up to $50 million.

Confusingly, the numerical examples the booklet goes on to give to illustrate this are based not on a 20 percent reserve fraction but on a 10 percent one (which is more or less what the law in the US requires for the kind of bank deposits in question). So, to take its example, if $10,000 is deposited in the banking system, initially say in one bank, that bank can make loans (create credit line bank deposits) of $9000. When it is spent this $9000 will be re-deposited in other banks which can then lend out 90 percent of this, or $8100; which in turn will be re-deposited in banks, allowing a further $7290 to be lent out, and so on, until in the end and over the period, a total of $90,000 new loans will have been made.

This shows how the Fed can practise “fractional reserve banking” to control the amount of “money” (currency plus bank deposits) in the economy. This is done via “open market operations” as explained in a section headed “Bank Deposits – How They Expand or Contract”:

“Let us assume that expansion in the money stock is desired by the Federal Reserve to achieve its policy objectives . . . [T]he 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 US 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 . . . 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” (p. 6).

The bank from which the Treasury bills were purchased now has reserves above the 10 percent limit and so can turn the $10,000 into loans, which starts the process described above rolling, leading to an extra $90,000 bank lending.

In theory the Fed could contract bank lending in the same way, but this has never happened. So M1 has gone up and up each year. But what about the currency in all this? It too has gone up but passively and almost automatically. With increased banking activity more currency notes are required, which banks get by converting their reserves into this and which, if it hasn’t enough notes, the Fed just asks the Treasury to print more. But this has consequences -– the depreciation of the dollar and the rise in the general price level Congressman Paul doesn’t like.

But has the banking system really created more “money”? Only if you regard “bank deposits” as money. If you don’t, all that has been shown is that currency has circulated in that the whole process depends on the initial deposit or injection of cash being recycled as further deposits by depositors (as opposed to by banks creating a credit line). So, neither an individual bank nor the whole banking system can lend more than has been deposited with it. By the end of the process, in the example given, the first loan (out of the first deposit of $10,000) of $9000 has been used and used again for genuine deposits totalling $90,000. But all this assumes an expanding economy, since where is the money to repay the loans and the interest on them to come from without being assured of which the banks would not lend the money in the first place?

So the banking system does not create money to lend out of thin air but can only lend out money deposited with it and then only when economic conditions permit it.

Today, bank deposits are not the only source of what the banks lend. They also borrow on the money market (as has been highlighted by the present banking crisis). This means that their reserves are an even smaller percentage of their total loans, only about 3 percent in fact. This figure is mentioned in Zeitgeist Addendum as if this was now the “fractional reserve” and that therefore banks, or the banking system, can “create” loans of up to 33 times an initial deposit. Another silly mistake.

If currency cranks such as the makers of the Zeitgeist films have got the wrong end of the stick about “fractional reserve banking” and imagine that it means banks, whether singly or all together, can create money or credit out of thin air this is partly the fault of the way that booklets like the one produced by the Federal Reserve Bank of Chicago try to explain it. Of course the Fed does not believe the “thin air” claim, but to refute the currency cranks it would have not only to re-iterate that no single bank receiving an additional deposit of $10,000 can forthwith loan out $90,000, but also spell out that the expansion of credit line bank deposits still depends on people making real deposits of their own, unborrowed money (whether in cash or by cheque or by bank transfer). Which would restore a sense of reality and explode the myth that banks can create loans out of thin air.

Adam Buick