THE OCCUPY FINANCE BOOK – CHAPTER 3:”How banks create money…and keep it”

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"How banks create money...and keep it"

“How banks create money…and keep it”

Interview with Tamir Rosenblum

by Oriana P. Roerkraeyer

TR: My name is Tamir Rosenblum and I am one of the contributing writers to the Occupy Finance book. I helped with the outlining and had a substantial role in writing chapter three, which is sort of about the running of the banking system and how money is made and things of that nature.

OPR: Why did you guys decide to write this book?

TR: You will probably get different answers from different people but I think that the overall consensus was that this has been a group that studied a lot over the last few years, talked to one another a lot and felt like they had, in many respects coming from a place of not having tremendous knowledge, really learned a lot about what was going on in a way that was useful to share. There were some good writers in the group and we thought that the best way to try to do it was to put together a short book that would try to explain some of the things we thought were the most important ones we learned. And that’s how it came about.

OPR: So like you said you wrote the third chapter and one of the main questions you ask in the beginning is “what do banks do’? What do they do?

TR: There’s a lot of things that they do but what for me was an aha-moment in learning about these things is that, one really important thing that banks do which we don’t think of as doing is literally create our money. I think if you ask most people in the street, often people who probably read some periodicals or things in the Times or the Wall Street Journal about money, probably will give you some account about how money is made that looks at the mint, printing the bills or things of that nature and the reality is that it is primarily through this system by which banks extend loans to customers that are monetary basis is fleshed out and the money that we use is created. So that was one of the main things that we are trying to address in that chapter. But I think in large part, of course that this a really important function, but also a function that we often think of as public. How our money gets created is not a purely private thing, it’s a common good our currency and the facts that banks are doing this is something that we thought was a really critical point that people should be aware of.

OPR: Why do they create this money? Why is it necessary to create this money?

TR: I don’t know if the question is ,…well they create money because money plays a very useful in our society, we probably might want to complain about it. Almost everything that we see happening around us happens to the motivation of people gaining currency. In some ways it’s an accounting system for it, it keeps track of whose turn it is to do the next thing in society and maybe in a smaller community you don’t need that but the notion that it’s something that we need to sort of motivate our actions I don’t think this group is so radical to run away from that. How the money is created and what the rules are surrounding it and how it gets distributed are things that we are very concerned about but I think the need for money is not something that we’re questioning. I think that the fact that it gets created through this very basic process of somebody deposits money, they see it at that moment in their account, let’s say they deposited a $100, there’s a $100 in the monetary base at that point. When the bank takes that money and loans it to another person, say they loan $90 of it, …The first person who made the deposit, of course we are all aware of it but not think about it that often, that person looks at their account and sees $100. Right? Their money is still there but the loan that then gets paid to the next person, well there’s some strings attached to it. That person now has a degree in buying power. Money is created through that very simple mechanism and as continual rounds of lending take place more of that money is created and that really more so than any other mechanisms of the Federal Reserve or The Mint is how our current system gets populated so to speak. It’s a pretty basic mechanism, which I think when we think about it, when we kinda realize what is going on, that money doesn’t have to be created that way and that there’s consequences to the fact that it is created that way. That was one of the initial things we wanted to bring out in the chapter. To sort of get back to the core elements of how this system works and what it’s doing in our society. Creating our money is a big thing.

OPR: So there’s two forms of money, there’s the physical money and then there’s the digital money right.

TR: You can distinguish those two but I think there’s not an as relevant distinction as we probably often would think about. Sort of an interesting fact that amount of sort of hard bills and currency that are in the system really gets moderated by the Treasury depending on our use or our need for it for certain types of transactions. Our weekend activities tend to be more hard currency related, buy beer or what not tends to require more hard currency than if we were gonna use our ATM but for the most part, especially recently, if we go out in society and go shopping, we have x amount of money in our wallet, we have twenties and tens and nickels and we have an ATM card,…we don’t really think of that as going with more or less purchasing power depending on how those two quantities are distributed so….I think one thing the book tries to say that for our practical purposes it doesn’t matter a lot, but for the money creating system it actually matters a whole lot because to the extent that I just have plastic, the money is sitting in the bank account and the money isn’t really sitting in the bank account, it’s being lent out to somebody else, which means there’s somebody else who I might run into at the mall who’s kinda using my money at the same time and there’s a far more money creative dynamic that goes along with plastic and money “staying” in accounts as opposed to being hard bills even though again, the distribution between how much hard currency the Treasury allows to circulate has nothing to do with its control over the monetary base. It’s just having that kinda stuff handy when we need it…like I said, largely on weekends.

OPR: I think most people really think that the digital money is backed by the physical money but in reality it’s only a percentage. Would you know the percentage?

TR: I don’t know how much it is. I think the whole idea of one being backed up by the other is a mistake. They are what they are. This notion that people have this sense that “well, at the end of the day I can turn this in for something” is really just mistaken. There was a time in our monetary history it was gold that technically you could redeem for your currency but at this point it’s cheaper to have this stuff in digital form but there’s still some commerce that takes place more easily when having the hard form and so our monetary regulators make sure we got some of that stuff around and probably and increasingly small percentage of the amount of overall money is represented by that kind of currency but again neither one is backed up by the other. They are just two representations of this unit that we, in either case, comfortably utilize. We really make purchases using either and it’s wrong to think of one as more primary than the other.

OPR: So they are not backed up by anything?

TR: They are not, which I think sometimes troubles people. They feel like therefore it’s a broken system because it works that way. I don’t think that’s our account. I think if you had gold backing it up, well gold has value also, we give it value and it has a certain use in society and prestige in our thinking but ultimately if that’s all you had left is gold, you would have trouble surviving in the desert and you would have trouble defending your house with a block of gold so it’s no more prime really in terms of something of value than any other representation we would create. I think our take in the book is really to look at the rules about how money is created. Recognizing that it is a social thing. It’s something that is always gonna have value based on how we deal with it and how it gets distributed and the kinds of things you can use it for and take that as a given and not sort of look for some ultimate truth that you can redeem money for. It’s gonna be a social thing but in it being a social thing there’s also nothing right about the way we distribute it now. We have this modern sense that there’s objectivism to it. Someone has a lot of money, well then they must be doing something right, well..if the rules of how it’s created are very much a part of a political process then that political process is gonna change the distributor results and hopefully that message comes through in the book and I think to try to convey it we sorta go back to first principles about how this stuff comes into existence in the first place.

OPR: Some people say we should abolish money altogether and we should go back to a society based on exchange or a resource based society. What do you think of that?

TR: I’ve heard people talk about a gift economy, maybe even people in our group. Personally I don’t think that it’s a good idea at all. I think the complexity of some of the transactions that happen between and among us are really only attainable through having a monetary system. There’s a book that came out a few years ago by Matt Ridley who talks about the fact that there’s really nobody in our society who knows how to make a pencil from scratch. It’s an incredibly complicated process, it’s not environmentally friendly no doubt, but it involves bits and pieces happening all over the world come together to have this end result. And it takes a substantial accounting system to make that happen. So I think we need …if somebody wants to go back to some bygone age of living in some tribal community where everybody can remember who’s done what for whom recently …I think that that sounds like some kind of nirvana but it’s nothing we’re gonna reach anytime soon and I don’t think we should be shooting for it because …it probably supports a lot smaller population in the world if we had those small communities so that is certainly not the take of the book and I think it was important not to look like we’re trying to be incredibly nostalgic about past periods in history and we have to make things simpler and go back to these bygone eras because it’s a big complicated world and we’re not trying to run from that but that doesn’t mean that the current distributive outcomes are in any way fair or right or not politically influenced.

OPR: How does the Federal Reserve influence the supply of the money?

TR: There’s two main ways it does this. The first one is going back to the basic notion that we talked about that the bank lending is what causes it so the Federal Reserve’s typical function is to be the lender of last resorts. So when a bank is hard pressed to issue loans because they are low on capital or they are low on reserves, they have this special relationship with the Federal Reserve and the Fed will essentially lend them money at a very preferred interest rate and therefore create more reserve for the bank to be in a position to lend more. And in a way, even though I think a lot of people don’t view it as obvious that it’s this lending process that creates money, we do hear a lot about the Federal Funds Rate and the Discount Window and all of these are interest rates that the Fed makes available to facilitate lending by banks. So that’s the first way it does, just by pumping this or try to incentivive this lending cycle that happens with the commercial banks that creates money the way we just talked about. More recently, which is a remarkable thing, The Fed has just been literally creating money by pushing buttons on a digital computer and having additional units of electronic currency enter our system through the Quantatative Easing Program, where it is going into the market and buying up US treasuries or mortgage backed securities with money that it literally called into existence by having the liberty to type on a computer and say that there’s e.g. $45 billion suddenly coming into existence and they will be utilized to purchase a particular thing, mortgage backed securities for example. So, that’s a very important function, how that ends up causing wealth to get distributed in society has huge consequences. Not something we have gotten directly into in chapter three but something as a group we talked about a lot. Whether that really does result in equal distribution of this new money. I mean you could say you could make negative comments about how money came into existence in medieval France when you had to pay soldiers and they would create new coins to pay the soldiers. At least in that case it was going to common people, to regular soldiers who were the first point of entry of the money into society. Here it’s large banks that hold mortgage backed securities…mmm..I don’t know if that’s the most fair redistributive result.

OPR: So you say it’s a whole system of lending? That’s basically what you are saying….

TR: It is and one of the things that we try to bring up is that ….lending is very important, but ultimately the system is not indifferent to how the money is utilized and that to the extent that money creates something which …something of value makes a big difference. So for example I had to pay back a loan and decided to do so by stealing somebody else’s money, that would clearly have a different net effect on the quantity of money in society than if for example I started a small…it’s called a small business, but in the book we use a very sort of, almost fabelistic narrative where what goes on is that there’s two people who initially are taking turns bringing water from a well and somebody else wants to come and introduce a cooperative activity of retrieving wood. The first two were just sharing a coin to keep track of who’s turn it is next and now they want to engage in this other enterprise of having people take turns recovering the wood…you need an additional coin to do this effectively. In using the coin to do something productive like this you’re actually creating in some sense a business. If other people were to come and want to partake in this activity you can see the beginning of what becomes a small business that by itself has value and the notion of securitization, of another form of money coming into existence puts value on these types of communal activities. So spoken of it like that it’s a benign thing, it’s a good thing, people are using the money for productive purposes. A big theme in the book is that that process of securitization, of your stocks or trading in credit is something that is very necessary to the system to work and doesn’t actually to make the system work need to create new things of value. It can work just as well if you feed on existing public coöperative activities that we traditionally think of as government functions. There’s a lot of talk in the book about how that end of the money making cycle doesn’t get satisfied with new business type operations or new communal activities but of us finding that more and more things are privatized. We are at the point where our prison system for whatever it did, did not create money, now when you have private prison companies that have stocks trading on the stock exchanges all of a sudden that process is creating securities, which is an elemental part of how the whole system works and is something we should be really really careful about when we see this happening. Because it’s something that the current system needs but it’s really not creating anything of new value, it’s just sort of acting in a predatory fashion on existing communal operations.

OPR: You say the system is predatory but is it sustainable to the predators?

TR: I think something we try to bring out a lot is that right now as this happens there’s certain big winners that are occurring. As certain institutions are able to engage in this privatization whether it’s through charter schools, taking over public schools, whether it’s water systems being now taking over by venture capital firms, whether it’s by the private prison companies having an increased value by 700% since 2001, there’s certainly near term winners about this. Now there’s only so many public institutions that you can privatize right, because if you are not creating new ones then existing ones are getting privatized and you’re moving in that direction longterm?….I don’t think that that’s any kind of solution. I don’t think that anybody who looks at it from the perspective we’re trying to cause people to lo…subok at it would see it as a longterm viable system.

OPR: So they are basically making decisions based on short-term vision.

TR: Again, I think all of us operate in an economy …substantially looking at our role in the economy …I think one thing we hopefully don’t do is attribute some grand designer actor who’s created this whole system. So the private prison operator, he’s got his business, he’s running his business, I take all kinds of fault of what he’s doing, but I’m not claiming that there’s one guy there and I don’t think we’re claiming that there’s one guy who puts this whole thing into motion in a short sighted manner. No, the system works it does right now. There’s good money to be made by people engaging in the system and it’s our responsibility as the 99% to recognize how predatory the system is and take political action, cause political education in a way that causes changes to that system. That’s how it’s gonna change. It’s not based on convincing some grand designer of the system that there’s a better way to do this.

OPR: Thank you.

Section 2. How We Got Here

Chapter 3. How Banks Create Money … and Keep It
(a discussion of the basic mechanics of our financial system, and how they are failing)

“Money makes the world go round.”

John Kander and Fred Ebb
Line from the song “Money, Money”
– from musical Cabaret.

Because the Financial Sector keeps growing as a portion of our economy, it is important to ask ourselves, “What do banks do?” Most of us think (to the extent that we think about it at all) that commercial banks serve some pretty basic functions like holding our money, making it easier to use, and lending to customers. If I buy a pack of gum at my local bodega, I’ll probably pay in cash. But having a bank account that allows me to make easy ATM withdrawals, write checks, and have a debit or credit card makes it easier to spend money more often and in bigger chunks. Similarly, if I need money to buy my first home or open a small business, the bank is a good place to go for the loan.

These are, in fact, functions of banks, but this is certainly not the whole story. Perhaps the most critical and often overlooked thing that occurs via these seemingly ordinary processes is that banks are creating pretty much all of our money, and that is a really powerful function. As one of our more under-appreciated Presidents, James Garfield, once correctly observed, “he who controls the money supply of a nation, controls the nation.”[1]

Some Common Misconceptions about the Source of Our Money

We often think of American money as being made at the U.S. mint by craftsmen mixing special dyes while large machines engrave metal plates. In fact, because the mint gives banks new coins and bills in exchange for old ones or transfers of digital money, the kind of work that goes on at the mint doesn’t have much to do with the overall money supply. Hard currency, like bills and coins, is the most traditional form of money, but it is hardly the only one or, at this point, even the most common. For example, because the purchasing power represented by the numbers on our ATM screens is pretty much the same as that of the bills and coins in our pockets, we don’t usually even think of the cash form of money as having priority over the increasingly predominant electronic forms money takes. We tend to move our money back and forth between these two forms without much thought, our main consideration being what it is we are looking to do. For instance, if we are headed for a cash-only restaurant, we want our money in that form; but if we anticipate buying a sandwich on a flight that only takes credit or debit cards, we prefer the electronic kind.

And note—there is no stockpile of bills and coins in banks’ basements or anywhere else equivalent to all of the electronic dollars and cents shown on all of our bank account web pages. The Treasury Department runs the mint and the Federal Reserve then makes sure enough bills and coins are available for us to engage in the kinds of transactions that require them. The Fed lets the rest of the money exist in purely digital form. The Federal Reserve’s decision about how many bills and coins to have in circulation is not driven by concerns about the overall money supply. Rather, the Fed’s interests are so mundane that it focuses on problems like making sure there is adequate cash available on weekends (when we apparently tend to use more of it) as opposed to weekdays (when we seem to use more plastic). The mint and the Fed are just trying to keep the right amount of old fashion bills and coins around to facilitate the kinds of transactions that need hard currency; neither is the hub where money is made.[2]

It would also be a mistake to assume that the Federal Reserve has other tools by which it creates all of our money. There is no doubt that the Federal Reserve has extraordinary powers to influence the amount of money circulating in the economy, and, as will shortly be explained, at times it creates money out of thin air. However, the notion that the Fed is the main engine for our money’s creation is also wrong. Before explaining more about the kinds of things the Federal Reserve regularly does to influence the supply of money, let’s first explain how the real creators of our money, private commercial banks, get it done.

How Commercial Banks Create Money

We know how bank loans basically work, but it takes a little thinking to realize that money is created in the process. If Jill has $100 in a jar of coins she is saving to open her first bank account, before she goes to the bank those coins represent — yes — 100 units of the total U.S. money supply. Jill (correctly) feels the coins could be used to buy $100 worth of goods and services in society; that is, the coins have $100 worth of purchasing power. And, as suggested above, when she goes to the bank, gives the coins to the teller, and checks her ATM a moment later to see an account balance of $100, we might think that nothing much has changed.

But, in fact, things immediately change because the bank does not just leave Jill’s money sitting there; it loans a large portion of it (for big banks, up to 90%) to someone else. So assume that the bank increases its total portfolio of loans by $90 based on Jill’s $100 deposit by extending a $90 loan to Jack, for example. There is now literally more money in society because of the $100 deposit. Jack is going around understanding that he has $90 in purchasing power that was not there before. At the same time, Jill (oddly, perhaps) does not feel any poorer for having put her money in the bank with the full knowledge that someone else (Jack) is effectively going to have access to “that money” as well. This is really no different than if we were in a position to lend a friend $90, and, having done so, continued to walk around a mall feeling as if it was still in our pocket. Make no mistake about it, it’s good to be a bank. A bank license enables a bank to participate in this genie-like “fractional reserve” system whereby you can credit accounts with money while at the same time giving a high fraction of that (same) money to someone else by way of a loan. In the process, this is how almost all of our money is created. In our example above, Jill’s deposit of her $100 worth of coins and the bank’s resulting $90 loan to Jack created 90 units of new money, increasing the money supply from $100 to $190.

There are a number of things to understand about these transactions. First, obviously, is that whether this new money stays in the economy or shrinks back to the original $100 (or less), is going to have something to do with what Jack does with it and, specifically, whether he can pay it back. But before we go there, it is important to stress that in a fractional reserve system, the mere fact of both the deposit and the loan immediately creates money, regardless of what Jack does with it. Because even if Jill or Jack (or both) do not use the money, the money supply is higher while the loan is outstanding, as reflected by adding up all the “money” shown on their respective ATM screens. Jill is showing that she has $100 to spend (or more if she has overdraft privileges) while Jack sees that he has $90 which he can, and probably will, use too.

Second, it is hardly the banks’ practice to make loans, have them paid back, and then shut down their lending practices. To the contrary, banks are in business to make loans with interest, so while Jack’s individual loan will come due and have to be paid back, it is extremely likely that so long as Jill keeps $100 on deposit, someone — be it Jack by rolling over the loan or someone else by getting a “new” loan — is going to have additional purchasing power (money) because of Jill’s deposit. In other words, we don’t expect the bank’s business to simply shrink because a creditor pays back a loan. Banks are in business to lend, and they will continue to do so after Jack pays back his personal loan.

And third, if Jack pays the loan back with the required interest, the bank is actually going to have more money under its control at the end of the loan than before. Suppose, for example, the interest charge over the term of the loan was 10% and, at the same time, Jill kept her $100 on deposit. This means that when the loan is paid back, the bank is now going to have reserves of $109 (Jill’s $100, plus the $9 in interest the bank earned from the loan to Jack). So now the bank can lend $98 of its deposits and investments and still be compliant with the Federal Reserve rule to hold at least 10% in reserve,[3] meaning the money supply will grow even more in the next round of lending. Jill still sees $100 on her ATM screen as available for spending; the holder of a second loan (let’s say it is Jack again), now has $98, and the bank has held in reserve one additional dollar taken from the interest it received from Jack’s first loan, meaning the total money supply went from $100 when the money was in the form of Jill’s initial coins to $190 during the term of the first loan and finally to $199 during the term of the second loan. And the process is obviously unlikely to stop there. As long as the loans are being paid back, the money supply will grow, and grow, and grow, all as a result of the traditional practices of commercial banking.

This hardly completes the story of what banks do. For example, it leaves open the critical question of how a society comes up with the money to pay interest under such a system. But before going there, let’s return for a moment to the activities of the Federal Reserve.[4]

What The Federal Reserve Does

The Federal Reserve is, after all, a bank, too, so it should come as no surprise that it also has genie-like powers of money creation. For example, it recently used these powers on the tremendous scale of up to $85 billion a month through its “Quantitative Easing” program[5]. The way Quantitative Easing basically works is that the Federal Reserve purchases either U.S. Treasury bills (loans Treasury made to private individuals and institutions) or mortgage-backed securities (the complex packages of individual mortgages that were at the heart of the 2008 crisis), in either case using “money” the Fed just literally brought into existence by pushing buttons on a computer. You might find this outrageous, sort of like the way medieval kings paid off their creditors by minting new coins. But in the context of what we now know about how most money is made, perhaps this should no longer seem so troubling. If private banks are permitted to call money into existence by tapping on key-boards with the (thin) justification that they have some reserve deposits (like Jill’s) backing it up, why shouldn’t the Federal Reserve be allowed to do something similar? At least the Fed has some claim to being a public institution, even if the extent of its control by banks and insulation from democratic processes is a whole other (very worthwhile) story.

What is probably just as telling is that, historically, the Federal Reserve most often tries to influence the money supply in ways that explicitly recognize the private banks’ privilege as society’s main money creators. So rather than create money by just pushing its own computer buttons, the Fed will more often adopt policies that make it more or less attractive for banks to be aggressive private lenders, that is, to be aggressive money creators.

The principal strategy most of us have heard about concerns the Fed’s setting key interest rates, known as the “Discount Rate” or the “Federal Funds Rate.” These rates address a critical feature of bank practice we have not yet discussed, namely, what happens when too many people like Jill want their money back all at once so that the bank dips below the 10% reserve ratio the Federal Reserve requires that it maintain? Or worse, what if all the people like Jill (the depositors) cumulatively withdraw more than 10% of their money so that the bank (which, remember, has lent 90% of Jill’s deposit to Jack) is forced to tell them,­ “Sorry, there’s no money, we’re out of cash,” in which case we’d have a run on the banks.

The Discount Rate is one of the Federal Reserve’s main “solutions” to this problem. It is a special loan, at a very low interest rate, with little to no screening, which the Fed makes available to certain preferred private banks when they find they have loaned out too much of depositors’ money and need to boost their reserves back up to a point where they represent at least 10% of their balance sheets. Similarly, through the Federal Funds Rate, the Fed facilitates banks borrowing cheaply from one another for this same purpose. The Fed constantly evaluates and often modifies these rates in an effort to exercise some influence on the banks’ money-making frenzy, but the fact that these rates exist at all, the fact that the Fed is attempting to control the money supply by moderating the degree of money-making banks engage in, is not a fact to be accepted lightly. Unlike the days when Kings inflated the currency by engraving new coins to pay private soldiers, our monetary authority inflates or deflates the currency mainly by modifying how much it privileges the most wealthy “private” sector participants in our economy, the banks, to generate money.

Why Would Anyone Want Such a System?

Before concluding (perhaps reasonably) that this whole system is nuts — private commercial banks creating the bulk of our hard currency through lending — it is important to at least try to understand why anyone would want such a system.

In attempting to understand this, it is first useful to consider what basic purposes money ought to serve. In other words, if the banks’ principal role is to create our money through fractional reserves, then to be even-handed in evaluating this, we need some criteria for what it means to do a good job of introducing money into an economy. The traditional ingredients for what constitutes well-functioning money are the following (in no special order):

1. The money should serve as a useful “store of value.” That is, if we set aside a dollar earned today, we would like it to be able to purchase about the same amount of stuff for a dollar next year.

2. Similarly, the money should serve as a predictable “measure of value.” That is, if two frequently used household items cost, respectively, one and two dollars last year, and nothing significant happened to the demand for them or the means by which they are produced, money is working well if the relative, and preferably actual, cost of the items stays about the same next year.

3. If groups or individuals in society have good ideas about how to make their communities better — perhaps because they come up with innovative products, needed services, or better ways to support each other — it would be nice if new money could be promptly introduced to facilitate these additional possibilities. In other words, money should be readily available as a “means of exchange.”

This last point is really critical and goes to the heart of some of the problems the 99% has with the current system. Whether we like it or not, money helps us interact with one another. It helps us essentially enter into cooperative ventures with people we do not know, but with whom — with the help of money — we can become engaged in common projects that can result in significant human achievements like airplanes, sewer systems, and pencils (no joke, there is probably no one out there who knows how to make a pencil by herself; it happens in no small part because of money).[6] In fact, a main complaint — perhaps the complaint — we should have with the current financial system is that it is failing, abysmally, to introduce money into our communities for such socially-responsible and community-building purposes.

We need not imagine highly complex monetary relationships to re-focus — or perhaps focus for the first time — on this critical function of money. So let’s keep it simple. Imagine that Athos and Porthos are members of a far more basic monetary society than ours in which (for the moment) the whole system consists of a single fifty dollar bill. Athos and Porthos, having poor memories, move the fifty dollar bill back and forth between one another to help them remember whose turn it is to get water from the nearby well. One day Athos gets it and Porthos gives him the bill; the next day Porthos gets it and Athos gives him back the bill; and so on. They know whose turn it is to get water the next day by checking who doesn’t have the bill.

But if all of a sudden D’Artagnan seeks to join the monetary system by initiating a similarly cooperative cycle of retrieving firewood from the forest, there will be a problem. The three of them could still make use of the bill to keep track of their patterns of doing favors for one another, but the availability of only one bill would mess things up. Athos might, for example, be holding onto the bill to keep track of the fact that yesterday he brought Porthos water and it was Porthos’s turn to do so for him tomorrow, but D’Artagnan is now asking Arthos to give him the bill if he (D’Artagnan) brings Arthos firewood. Unless the three can find a way to fairly introduce new money into the system, the insufficiency of their “money supply” is going to create confusion, slow things down, and generally result in less reciprocally cooperative behavior.

Now you might be thinking, “Wait, just make change and use $25 to facilitate the water-retrieval and the other $25 for the wood-retrieval.” But that won’t work because then the money will have stopped being a good “store of value” (which, as we mentioned earlier, is important). Under this solution, the “price” of getting water just went from $50 to $25 without any change in the demand for, or cost of, getting it. In an ideal world — assuming having firewood and water are of approximately equal value and take about the same amount of effort and skill to accomplish—the addition of another fifty dollar bill into the economy would keep the price of water retrieval the same, while allowing the wood retrieval to proceed at the same “price.”

Which is why it is nice to envision a really great bank operating under a well-functioning fractional reserve system. So imagine D’Artagnan went to such a bank with his wood chopping idea. The bank recognizes wood retrieval as a great initiative, and, perhaps because other banks know about it too and are prepared to compete for the opportunity to fund this new business, the bank offers D’Artagnan a $50 bill at a negligible interest charge for a long period of time. Under these circumstances, we are unlikely to be too offended by the fractional reserve system. The fact that we know from our encounters with Jack and Jill that this bank loan is predicated on some other person’s earlier deposit and thus is an act of money creation probably does not bother us here given the good result. In fact, if we had a way of being assured that banks would only create money for purposes like this, we probably wouldn’t be so offended if an entity like the Fed frequently created money out of thin air to facilitate good ideas like D’Artagnan’s.

Which finally gets us to the point of being able to consider why it is important what D’Artagnan (or earlier, Jack) or any other debtor does with borrowed money. Assume, having gotten the $50 loan, D’Artagnan’s, Athos’s, and Portho’s simple exchange grows into a more complex operation in which the three partners are able to bring more wood to town than they need. This would lead people from other towns to come offer their bills in exchange for this service (assuming their towns had similar rudimentary economies), which, in turn, causes our three partners to accumulate extra money. We can refer to the aggregation of all of these behaviors and the resulting money accumulation as 3Musketeers Enterprise, Inc. Once we do, we can start asking questions like how much should it be worth today for someone to get a share of the future flow of extra bills 3Musketeers will generate? And does it change the amount of “money” in society if we create a document that represents such a claim?

Assume that the three original partners “financialized” their operation by creating a piece of paper that gives each a 1/3 claim on all future 3Muskateer’s excess dollar bills. We now have a new tangible representation of the business’ future money-flow, known as a stock certificate, that has no independent use (e.g. it makes an unattractive wall hanging), more or less maintains its value, and can be traded for other things. In fact, it might even be traded for wood itself! In short, while the stock certificate is not traditional currency—and, given its likely price fluctuation, not Grade A money — it is hard not to think of it as another form of money. For example if a 1%’er looks at his stock portfolio and sees a large monetary value associated with it, he will probably correctly tend to think of this as money. On the other hand, if he is running a start-up company that has not yet generated profit, but looks like it eventually will, he may think of himself as in some sense “richer” because he owns the company, but the value of the business is nowhere reflected in the national monetary supply. Only once the expected flow of future profits of the business is represented in a stock certificate that can be traded (by going public) does its newly “securitized” value snap into the monetary system.

It’s critical to the health of the fractional reserve system that a form of money can be added to the economy through “securitizations” that represent and make tradable the value of new businesses, property, or basically anything of quantifiable worth as financial instruments. It means that not all interest on loans has to be paid back by the total amount of lending in society endlessly chasing its own tail to satisfy the interest obligations it creates. Think about it: if money was only created by private banks accepting deposits and extending loans, where would the money come from to pay for the interest on these loans? If virtually all money comes from new loans, there is only one possible answer: still more loans issued just to pay-off the interest obligation on the earlier ones.

If this sounds like a first-rate Ponzi scheme, that’s because it is. While there is good reason to believe that a lot of what fuels financial bubbles and busts is exactly this kind of behavior, there is at least some sense in which loans used to create things of real economic (and securitizable) value are less prone to drive the economy into rapidly destructive spirals. Although we may not often think about the system this way, it is thus the securitization of things of real and quantifiable value which acts as a major moderating financial force to temper the otherwise exponentially expanding system of loans, chasing loans, chasing loans … with each providing the funds needed to satisfy the interest obligations on its predecessors.

Going back to 3Musketeers Enterprises in order to finish the tale: if D’Artagnan’s newly securitized share of the company is of equal or greater value to what he owes the bank in principal and interest, the securitized money (representing the “value” D’Artagnan created in his woodcutting initiative) will be available to pay the bank the principal and interest owed, which sounds a lot more palatable than if the system had to generate the additional money by D’Artagnan, Athos, or Porthos taking out yet another loan just to cover the interest charges on the first loan.

In our 3Musketeers’ fairy tale scenario, the fractional reserve system has worked great. It increased the money supply at the loan stage based on the anticipation of D’Artagnan generating something of societal value, the promise of which was then fulfilled at the securitization stage when the value of 3Musketeers Enterprises snapped into the money supply through the issuance of the stock certificate with sufficient market-value to pay the debt with all the accumulated interest. And because the bank was paid back with interest, it has even greater deposits on-hand to start its next round of loans, which will mean it will likely issue loans in even higher amounts, which will in turn mean the money supply is going to keep growing (and, if the system keeps working like this), growing, and growing. Within the (perhaps peculiar) logic of the fractional reserve system, things are running on all cylinders. But, as we now know, the strong interrelationship between banks’ money-creation through fractional reserve lending and the activity of financial firms in creating money through securitizations more often plays out in ways that are utterly destabilizing to society and impoverishing for the 99%.

Where Things Go Wrong

The first and perhaps most important thing to recognize is that this whole system has a lot of similarities to a car engine or other constrained dynamic system. You have lots of actors participating who have no interest in the positive outcome the system is supposed to generate. Nevertheless, as the theory goes, their self-interested behavior is still going to yield a good result because the rules of the system pit them against one another in just such a way as to make it so. In other words, the last thing individual commercial banks want is either fierce competition among one another (cartels are far more profitable) or full responsibility for bad loans (it’s much better to have someone else bear the loss while you pocket the gains). Likewise, the last thing individual investment banks want is securitization opportunities that are tightly regulated to avoid the introduction into the system of devilishly clever new forms of money that are prone to blow the system sky-high. But these kinds of restraints are precisely what the system requires to succeed. Just like a car engine needs to be made out of strong metals to contain the activity of the heated gas that drives it, so, too, should we expect that a system (like our financial one) that relies for its “success” on very powerful people acting in blind pursuit of rabid self-interest is going to need very strong structures to contain it, which we surely do not have.

Since so much of this book is about how this system has failed, it will hopefully suffice, for now, to consider what signs, akin to those we would see in a failing car engine (such as over-heating, bellowing smoke, fire, and explosions), we should expect to see in a failing financial regime. Here are a few examples:

Competition among banks is so weak that six banks have 64% of all U.S. banking assets.[7]
Dehumanizing rules have been imposed to insulate banks from the risk of losses that would otherwise impose discipline on their lending practices (e.g. the crazy rights banks obtained under the 2005 amended bankruptcy law to make it harder for the 99% to discharge some of its most common forms of indebtedness, like credit card bills and student loans).
Banks are playing a “heads I win, tails you lose” game with our money. Note the vile success they have had resisting even minimal requirements that they should use their own money when placing risky financial bets, despite the obvious fact that, when they blow the deposits of people like Jill, there is a much higher chance of the government (and thus us) footing the bill (think bailout), but when they occasionally get lucky with Jill’s money, it exponentially increases bankers’ rates of returns, which they do not have to share.
Securities firms (which, since the repeal of the Glass-Steagall Act, are often banks), are so pressured to find securitization opportunities to keep the money-creation spiral from too quickly going bust (again) that they search to securitize not just good new businesses, but practically anything: formerly public schools, pensions, water systems, prisons, all forms of higher education (ever hear of a Student Loan Asset Backed Security, literally known as “SLABS”?), Detroit, New Orleans … you name it.
Financial sector capture of both the regulatory and electoral processes to such an extent that there is, as in the car engine example, virtually no more metal confinement of the heated gas; rather, the heated gas and the metal that would surround it become one and the same. Note the appointment of financiers like Robert Rubin and Hank Paulson to hold the highest financial regulatory offices. Also note the Supreme Court’s 2010 Citizens United decision, ruling that the thing we now know banks produce – money – enjoys the full mark of First Amendment constitutional sanctity so that it can be expended without restraint in political contests to essentially defend its own means of creation.
Finally, the grossly high compensation to financial sector executives, often for ephemeral short term results, which indicates that, in the most basic sense, this industry’s work has become divorced from its function of providing money as a means of exchange in our communities in an appropriate manner. Instead, the financial sector uses its money-creating powers for self-enrichment, leaving the communities of the 99% cash-starved, awaiting securitization of their remaining communal assets. The financial sector is living in Richistan … where we are not welcome.
And if we nonetheless maintain lingering doubts about whether this is what is going on, then we should just ask ourselves this question: if a small clique of private individuals had achieved virtually unregulated power to make money, what do we really think they would do?

[1] In a similar vein, Henry Kissinger was even more emphatic, once explaining that “Who controls the food supply controls the people; who controls the energy can control whole continents; who controls moneycan control the world.”

[2] There are excellent explanations of the Fed’s relationship to the supply of currency at both the Federal Reserve and Bank of New York web pages. See and

[3] 1-[98/109] is just over ten percent.

[4] One of the best discussions of this process can be found in The Nature of Money by Geoffery Ingham, 2004. See also the response of in “The power to create money ‘out of thin air’ by A. Pettifor, 2013.

[5] Dunstant Prial “Bernake Offers Possible Timetable for Tapering”, June 19, 2013, FoxBusiness (

[6] Matt Ridley, “Humans: Why They Triumphed”, May 22, 2010, The Wall Street Journal

[7] See FDIC Table of “Top 50 Holding Company by Total Domestic Deposits” as of June 30, 2012; (

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