Where Banks Get All That Money To Lend

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.     

The Siege of Fort Texas and Its Future Civil War Generals

In August 1845 the 5,000 man American Army under General Zachary Taylor encamped at Corpus Christi, Texas as the "Army of Observation" when the American annexation of Texas threatened war with Mexico. In April 1846, Taylor marched his army to the Rio Grande as the "Army of Occupation" and hostilities commenced. There, Taylor constructed a large, earthen fort across the river from the town of Matamoros. On Friday, May 1st, Taylor marched the bulk of his army east 26 miles to his supply base at Point Isabel leaving about 500 men of the 7th US Infantry regiment under Major Jacob Brown and companies of the 3rd and 5th US Artillery regiments under Captain Allen Lowd to defend the unfinished fort. In addition to its garrison, the fort housed handfuls of wounded soldiers, women, children, civilians, and Mexican prisoners. Taylor named the structure Fort Texas.

On Sunday, May 3, 1846, the Mexican Army, across the river, launched a cannon barrage against the fort. Inside Fort Texas, the 7th Infantry's company commanders under the direction of engineer Captain Joseph K. F. Mansfield busily supervised the continued construction of bombproofs while the artillerymen on the parapets returned fire with their small assortment of 18 and 6-pounder cannon. The Mexican shells did little damage at first as they thudded harmlessly into the dirt sides of the fort - harmlessly except for one shell that hit and killed infantry sergeant Horace A. Weigert. The Americans knocked out a Mexican gun emplacement on the bank at Matamoros then reduced their fire in order to preserve their ordnance.

There were ten companies of 7th Infantry at Fort Texas: Co A under Gabriel Rains, Co B under Francis Lee, Co C under Theophilus H. Holmes, Co D under Richard H. Ross, Co E under Dixon Miles, Co F under Richard C. Gatlin, Co G under Washington Seawall, Co H under Edgar S. Hawkins, Co I under Gabriel Paul, and Co K under Daniel P. Whiting. All the company commanders were captains except for Paul who was a 1st Lieutenant filling in for Captain Stephen W. Moore who had days earlier decided to resign from the army rather than fight in the Mexican War. The artillery units were manned by 1st Lieutenants Braxton Bragg, George H. Thomas, Arnold Elzey, John Reynolds and others.

The Mexicans soon crossed the river and surrounded the fort, even as their mortar and cannon fire kept pressure on the American soldiers inside. The Mexicans kept up a steady but ineffective rifle fire that failed to unnerve the Americans who held their ammunition and their ground.

On day three, Wednesday, May 6th, a cannon ball took Major Brown's left leg off. As Brown lay there mortally wounded, Mexican General Ampudia sent a surrender delegation to the fort, but new acting commander Captain Edgar A. Hawkins gathered his fellow officers and by unanimous vote chose to reject the Mexican capitulation demand. The Mexicans then charged the fort from the rear but Lt. Bragg's 6-pounder battery dispersed them with canister shot.

Another day passed under fire while inside the fort the soldiers remained on alert and a tall, angular young civilian laundress named Sarah Borginnis took on the task of tending to the sick and wounded, cooking, and comforting the other civilians. The same day 2nd Lt. Earl Van Dorn of Co K dashed out of the fort and, dodging rolling cannonballs and whizzing bullets, raised a US flag that that had come off its lanyard.

On  Friday, May 8th, Taylor and his army arrived back from Point Isabel and the bulk of the Mexican army set out to meet him. Taylor defeated the Mexicans at the Battle of Palo Alto that day and, on May 9th, he defeated them again at the Battle of Resaca del Palma. The Mexicans re-crossed the Rio Grande, fled from Matamoros, and abandoned the six-day Siege of Fort Texas. Major Brown and Sergeant Weigert were the only American deaths and only a handful of soldiers were wounded. The 500 men of Fort Texas had held against a 2,000 man Mexican force and much superior firepower. The fort was immediately renamed Fort Brown in honor of its gallant commander, and the city of Fort Brown later grew up around it. The American army went on to defeat the Mexicans again in late September 1846 at Monterrey, where Captain Gatlin was wounded in the shoulder while leading his company in street-to-street combat. Most of the defenders of Fort Texas took part in that campaign and others until the end of the war in January 1848. 

Including the future adversaries in the critical Battle of Chickamauga, Braxton Bragg and George H. Thomas, at least seventeen future Civil War generals were among the Fort Texas defenders, eight for the Union and nine for the Confederacy. The future Union generals were Joseph K. F. Mansfield (killed at Antietam), John F. Reynolds (killed at Gettysburg), George H. Thomas (the Rock of Chickamauga), Samuel B. Hayman, Napoleon J. T. Dana, Henry B. Clitz, Gabriel Paul, and Joseph Potter. The future Confederate generals included: Braxton Bragg, Arnold Elzey, Gabriel Rains, T. H. Holmes, Lewis Henry Little (killed at the Battle of Iuka in Mississippi in 1862), Franklin Gardner, LaFayette McLaws, Earl Van Dorn (murdered by a jealous husband in 1863 in Tennessee), and our own Richard C. Gatlin. In addition, Dixon Miles, as a Union colonel, was mortally wounded by Confederate cannon fire at Harpers Ferry in 1862. Also, Gatlin's good friend and fellow Fort Texas defender Daniel P. Whiting rose to the rank of colonel in the Civil War Union Army. There may not have been another such compact concentration of future Civil War generals in any US Army engagement prior to the Civil War. 

Postscript: The six-foot tall heroine of Fort Brown, Sarah Borginnis (or Bowman, her subsequent married name), became a legend in her own right as she continued to serve the US Army for twenty more years. Her nickname was "The Great Western" and following her death in 1866 she was breveted an honorary Army colonel and buried with military honors in the Fort Yuma cemetery.  

Facebook Debate Requires One More Attempt at Reasoning With Doubters

Here is another shot at what is becoming a tedious subject for me and probably for some of you who may read this blog.

Virtually all of my friends and correspondents cling to the ideological certainty that the federal government spends too much and will soon go broke because of it. They cannot conceive of the idea that the federal government does not need tax money in order to spend. They also are convinced that the government must borrow money in order to spend, thus digging itself into deeper and deeper debt that we, the taxpayers, must eventually cough up the dough to repay.

Why, I ask you, would a nation that has full Constitutional authority and financial wherewithal to "print" (that is, to create and issue) money need to tax and borrow other peoples' US dollars in order to get money to spend? Is it absurd to think that the US government creates money? No, even my doubting Thomas friends and correspondents readily admit that the government can and does "print" money. Still, they cling to the paradigm of the US government having the same financial constraints as a business or household. Why is that?

Okay, there are constraints, two of them, but both are self-imposed by Congressional dictate as a means of, I guess, controlling inflation. I will get to those two constraints in a minute, but first let me tell you how the federal government creates US dollars (and it does not "print" them and scatter them to the wind for people to latch onto).

First, the federal government issues a check or an electronic deposit and voila, someone's bank account balance is increased. Simultaneously, the central bank (the Fed) marks up the receiving bank's reserve balance. The reserve balance is the number of on-account dollars the receiving bank has with the Fed to clear checks. The Fed creates those reserve balance dollars out of thin air when the government spends. That is how banks get the money to cash and clear checks. They do not use depositor dollars for those purposes. By authorizing the Fed to create reserves, the federal government creates money when it spends.   

Now let us look at the two self-imposed and arbitrary artificial constraints on the monetary system. The first is that when the government runs a spending deficit, the Treasury must "borrow" money in an amount equal to that deficit by selling bonds, notes, and other security types to the public. The federal deficit is the amount the government spends in excess of tax collections in a given year. For example, if the government spends $4 trillion in a year and collects $3 trillion in taxes, the deficit equals $1 trillion and the Treasury must sell $1 trillion in securities. On the surface, it would seem that the government "borrows" the money from the sale of securities in order to pay for what it spent in excess of its tax "revenue". This is not really the case because the government had already created the money and paid for what it spent. The Treasury, therefore, does not spend the money it receives from the sale of securities. The securities money really goes into the buyers' (investors) accounts at the Fed as safe and secure investment savings. The Fed returns those savings to the buyers (investors) along with some newly created interest dollars when the securities expire. The purpose of selling Treasury securities is to take dollars out of circulation thus offsetting any inflationary pressure federal spending might have triggered, not to acquire money to spend.

The government defines the federal "debt", currently approaching $19 trillion, as the total dollar amount of outstanding Treasury securities at any one time. This leads us to the second self-imposed and arbitrary artificial constraint on the monetary system - the debt ceiling. Even though Congress requires the Treasury to sell securities equal to the deficit as described above, it also imposes a limit on the total amount of Treasury security dollars in existence at a given time. Thus, if Congress sets the debt ceiling at $20 trillion and the deficit becomes $1.5 trillion, the Treasury must sell securities equal to $1.5 trillion. Selling that amount of securities, however, would cause the outstanding treasury security balance to exceed the $20 trillion debt ceiling. Congress would have has painted itself into a corner (and frequently does) with its two conflicting rules. Congress creates a deficit by spending more than it gets in taxes, but does not tie its spending to the debt ceiling until after it has already spent. That is why Congress must periodically raise its arbitrary debt ceiling. The fact that Congress has spent the money before selling the securities is ample proof that the government does not depend on borrowing in order to spend.

These two arbitrary constraints on the federal monetary system have caused untold waste and rancor in Congressional debate. They have also bamboozled the American public into believing that the US government must borrow money in order to spend, even from competitor nations such as China, which itself invests its extra US dollars from its trade surplus into Treasury securities for safe-keeping and to earn interest. Neither constraint is necessary now that the US monetary system is no longer on a gold standard and no longer runs the risk of insolvency. The whole premise that the federal government accrues "debt" from spending and borrowing is pure fabrication.

The US dollar is itself a debt - that is - it is an IOU of the federal government to pay the holder of that dollar another US dollar, nothing else. It is simply a permanent or temporary accounting liability. The other side of that liability, the asset, belongs to the holder of that US dollar. Those asset holders are we in the private sector.

Do not federal taxes pay for federal spending, you might argue. No. The receipt of federal tax dollars by the Treasury removes those assets from the holder and removes the liabilities from the government. Tax dollars simply go out of existence, even though ledger entries continue to show their amounts.

In summary, the federal government creates US dollars by spending. It destroys US dollars by taxing. It neutralizes US dollars by parking them in Treasury securities. The government does not tax or borrow in order to spend but I will bet that you, the reader, and most of Congress do not believe it.

I Still Say the Federal Government Does Not Borrow

My understanding of treasury securities operations are rudimentary at best, and I invite comments, but from my exposure to Monetary Sovereignty and MMT I presume that the federal practices of taxation and treasury security sales function not to fund federal spending (as the government and most economists would have us believe) but to neutralize the inflationary impact of federal spending,

Here is what I mean. Assume the federal government spends (disburses) $4 trillion in a given fiscal year. Assume also that federal tax collections for the year are $3 trillion (federal taxes, as we know, are dollars removed from circulation and accounted out of existence). Because, by definition, federal spending over and above tax collections constitutes a "deficit", that leaves a federal deficit of $1 trillion for the fiscal year. In accordance with a federal ruling (which I am unable to cite), the treasury must sell securities equal to the deficit amount, in this case $1 trillion. The treasury sells the securities and parks the $1 trillion paid for them into accounts at the Fed, thus removing the $1 trillion from circulation. Consequently, for the fiscal year, the entire $4 trillion spent by the federal government goes out of circulation. The $3 trillion in taxes is gone forever and the $1 trillion spent on securities will reenter circulation on expiration of the securities but, in all likelihood, will roll into new securities. Bank reserves, of course, remain in play for the $1 trillion in securities, but bank reserves do not circulate.

My observation, then, is that federally spent dollars float in circulation for a year and disappear into taxes and securities accounts leaving only bank-created dollars in circulation. By that reckoning, I conclude that any money supply influence on inflation comes from only the amount of bank-created money in circulation. The federal rules, laws, mandates, statutes, or whatever, that require the Treasury to sell securities to match the deficit seem to dictate the removal of federally spent dollars from the hands of private sector spenders.

From this, I conclude that tax collections are not spent, that selling treasury securities is not really federal borrowing, and, because selling treasury securities does not constitute borrowing, that the federal debt is not really debt. And for those inflation-phobes who fear federal money "printing", I propose that there is more likelihood that the private sector will "print" too much money than there is in the federal government sector doing so.

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