I don’t know why, but for years, ever since I was a kid, I wondered how banks could possibly have enough money on hand to make the kinds of loans they do. For instance, how could a bank afford to loan a bunch of borrowers, say, $250,000 each on home mortgages? How could they do it? I know the interest on home loans is paid ahead of principal and that it amounts to many times the amount of the loan itself. But are deposits and interest enough to keep the banks in cash to make all those big loans over and over? Is there really enough money lying in their vaults to loan out as much as they do? How do you think the banks do it? I didn’t lose sleep about it, but I did wonder.
Here’s the standard story. Banks take in deposits. They keep some of that money from deposits and lend the rest out at interest rates higher than the rates they pay on deposits. In this scenario, if banks don’t receive enough new deposits, they can’t make new loans.
The standard story leads to the fractional reserve story. Here’s how it goes. Banks receive deposits, keep a percentage on hand and lend the rest out as above. But the amounts lent out become deposits at other banks which also keep some and lend out the rest. Let’s say the required amount to keep in reserve is 10%. Thus, Bank A may receive a $100 deposit, keep $10, and lend out $90. Bank B receives the $90 as a deposit, keeps $9.00 and lends out $81.00. Bank C receives the $81.00 deposit, keeps $8.10, and lends out $72.90. This can go on until the original $100 deposit has been lent, deposited, lent some more, deposited some more, until finally the original $100 has become $1000 in deposits in banks around the country. Thus, fractional reserve lending allows banks to create new money in the amount of $X / Y% where $X is the original deposit and Y% is the reserve requirement percent. Example: $100 / 10% = $1000. A whole lot of people are astounded at this. Some so much so that they decry fractional reserve lending as counterfeiting and inflationary, and want to see it stopped.
Trouble is, neither of the stories above is accurate. Banks do not lend existing money. They just don’t. They don’t need to. Why? Because when a bank makes a loan it always, always simply creates new money. Always. All bank loans come from thin air, not from existing deposits or even percentages of existing deposits. Let me repeat – banks always create new money from thin air when they make loans. That’s how they can lend all that money! Eureka!
Here’s how it works. The bank has a customer who wants a loan. If the bank deems the loan a good risk, the bank makes the loan by simply marking up the balance in the customer’s account by the amount of the loan (less any loan fees or charges). Thus, if I take out a bank loan of $100, my account is credited for $100 (an asset to me, a liability to the bank), the bank records a $100 loan on its books (an asset to the bank, a liability to me), and then the bank endeavors to acquire the reserve dollars needed to meet whatever the central bank’s requirements are. And that’s how the bank can make all those big loans – it simply creates the money to make those loans. Is that a bad thing? Some people would say it is, but if banks did not have the authority to create money, our economy would certainly not be as robust as it is. You, for example, might have a very difficult time saving up the money to buy a new car if the bank were not allowed to loan you brand new money with which to buy it.
On the flip side, the loan payment process reverses the loan process and guess what? Your loan payment simply destroys the money created by the loan. When you make a $10 payment on your $100 loan, maybe $1.00 goes to interest and the other $9.00 reduces the amount of the loan. Your deposit asset and the bank’s deposit liability each shrink to $90, your loan liability and the bank’s loan asset each shrink to $91.00, and the bank books the $1.00 interest as capital gain. True, the bank has made $1.00 but what it has really done is transfer some of your assets to itself as the price for making it possible for you to buy that new car.
Two things to note.
First, the bank creates money only in the form of credit. It does not create new US dollars. US dollars are created only by the central bank (the Fed) at the behest of the Treasury. Most money is not in US dollars but simply credit against US dollars. Confusing, but true.
Second, it should be obvious that a money system consisting of only bank lending is unsustainable. There would be no place for interest to come from except new lending. For instance, if you have to pay back your $100 loan with $110, the $100 of loan money goes out of existence, but where is the extra $10 supposed to come from? Since all money would come from new lending, it too would have to come from new lending.
That is why federal deficit spending is the real source of permanent private sector money. When the federal government spends, it also creates new money, like the bank. But the federal government creates both real US dollars (which stay in the central bank) and credit against those dollars (which becomes a deposit in the recipient’s bank account). The critical difference is that, unlike with bank lending, federally spent money does not have to be paid back, thus, it stays in existence unless or until it is taxed back by the federal government. Without federal deficits and an ongoing federal “debt”, we in the private sector would have ever growing debt to the banks. That’s why a national balanced budget (which takes back all federal spending as taxes) would be ruinous to the economy.
Now you know how our monetary system really works, and how banks can make all those big mortgage loans.