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Money Creation: Banks - Crash Course Chapter 7

Get ready for your mind to be repelled
Friday, August 1, 2014, 9:14 PM

Chapter 7 of the Crash Course is now publicly available and ready for watching below.

As a follow-on to the previous chapter explaining the nature of fiat money, this week's video details one of the two methods by which it is created: fractional reserve banking. As John Kenneth Galbraith famously stated "The process by which money is created is so simple the mind is repelled."

Essentially, money is lent into existence though fractional reserve banking. The dollars you deposit at the bank? They turn into nearly 10x that amount as your bank subsequently makes loans using that money as collateral.

As simple as the process is, nearly every American remains ignorant of it and its massive implications. At the heart of the matter is this: our money supply and its related debt obligations MUST continue expanding (thereby devaluing the purchasing power of each dollar ad infinitum) -- forever -- or the entire system collapses upon itself.

Prepare to be repelled...

For the best viewing experience, watch the above video in hi-definition (HD) and in expanded screen mode

Coming next Friday: Chapter 8: Money Creation: Banks

For those who simply don't want to wait until the end of the year to view the entire new series, you can indulge your binge-watching craving by enrolling to PeakProsperity.com. The entire full new series, all 27 chapters of it, is available -- now-- to our enrolled users.

The full suite of chapters in this new Crash Course series can be found at www.peakprosperity.com/crashcourse

And for those who have yet to view it, be sure to watch the 'Accelerated' Crash Course -- the under-1-hour condensation of the new 4.5-hour series. It's a great vehicle for introducing new eyes to this material.

Transcript: 

Here we will explore the process by which money is created.

Let me introduce you to John Kenneth Galbraith. He taught at Harvard University for many years and was active in politics, serving in the administrations of Franklin D. Roosevelt, Harry S. Truman, John F. Kennedy, and Lyndon B. Johnson; and among other roles served as United States Ambassador to India under Kennedy.

He was one of a few two-time recipients of the Presidential Medal of Freedom.

Clearly a pretty accomplished and stand-up kind of guy. About money, he famously said: “The process by which money is created is so simple that the mind is repelled.” We’re about to discuss that very thing.

What he meant was, even after hearing how money is actually created, you won't want to believe it. 

So if you don’t get this segment on the first pass, don’t worry, because money creation is truly a bizarre thing to ponder, let alone accept

But not because it's difficult.  Any normal 10 year old child could understand it.

First, let’s look at how money is created by banks.

Leaving aside for now where this money comes from, suppose a person walks into town with $1000 and, luckily, a brand new bank with no deposits has just opened up The $1000 is deposited in the bank, and now the person has a $1000 asset (their bank account) and the bank has a $1000 liability (the very same bank account).

Now, there’s a rule on the books a federal rule, that allows banks to loan out a proportion, a fraction, of the money they have on deposit to others.

In theory, banks are allowed to loan out up to 90% of what people have on deposit with them, although, as we’ll see later, the actual proportion is much closer to 100% than 90%.

For our example here we'll use 90%.

Regardless of the actual amounts, because banks retain, or reserve, only a fraction of their deposits in reserve, the term for this process is “fractional reserve banking.”

Back to our example. We now have a bank with $1000 on deposit, and banks do not make money by holding on to it – rather, they make their living by borrowing at one rate and loaning at a higher rate.

Since any bank can loan out up to 90%, the bank in our example manages to locate a single individual that wants to borrow $900, and so the bank loans then $900.

This borrower then spends that money by giving it to another person, perhaps his accountant who, in turn, deposits it in a bank Now it could be the same bank, or a different bank, but that really doesn’t change how this story gets told at all.

So let's keep it simple and make it the very same bank.

With this new deposit, the bank has a fresh $900 to work with, and so it gets busy finding somebody who wants to borrow 90% of that amount, or $810

And so another loan, this time for $810, is made, which gets spent and re-deposited in the bank, meaning that a brand new, fresh deposit of $810 is available to loan against.

So the bank loans out 90% of $810, or $729, and so it goes, until we finally discover that the original $1000 deposit has mushroomed into a total of $10,000.

Did you follow that?  We went from a stranger ambling into town with $1000 but now there's $10,000 floating around town.

Is this all real money? You bet it is, especially if it’s in your bank account.

But if you were paying close attention, you’d realize that what we’ve actually got here are three things. First, we’ve got $1000 held in reserve by the bank $10,000 in total in various bank accounts, and $9000 dollars of new debt.

The original $1000 is now entirely held in reserve by the bank, but every new dollar, all $9,000 of them, was loaned into existence and is “backed” by an equivalent amount of debt.

How’s your mind doing? Is it repelled yet?

You might also notice here that if everybody who had money at the bank, all $10,000 dollars of them, tried to take their money out at once, that the bank would not be able to pay it out, because, well, they wouldn’t have it.

The bank would only have $1000 hanging around in reserve. Period. You might also notice that this mechanism of creating new money out of new deposits works great…as long as nobody defaults on their loan.

If and when that happens, things get tricky.. If the debt defaults exceed the fractional reserve lending rate, it's a complete disaster.  But that’s another story for later.

For now, I want you to understand that money is loaned into existence. Conversely, when loans are paid back, money ‘disappears.’

This is how money is created, and I invite you to verify this for yourself. One place is the Federal Reserve itself, which has published a handy comic book from which I drew this fine example.

You may have noticed that I left out something very important here, and that is interest.

You might be asking yourself, Wait a minute, where does the money come from to pay the interest on all the loans?

If all the loans are paid back without interest, we can undo the entire string of transactions, but when we factor in interest, there suddenly isn’t enough money to pay back all the loans.

Clearly that is a big hole in this story, and so we’ll need to find out where that comes from. In doing so, we’ll also clear up the mystery of where the original $1000 came from.

So what was the purpose of all this? Why did we spend these past few minutes studying the mechanism of money creation?

Because in order to appreciate the implications of our massive levels of debt, you have to understand how the debt came into being. That’s one reason.

And the more important one is tied to all those exponential graphs we viewed earlier in Section 3. But we’re not quite there yet.

First we need to travel to the headwaters to find the original source of all money.  Where did that original $1000 dollars come from in our banking example?  To find out, we need to go visit the Federal Reserve; the place where money springs into existence.

Please join me for Chapter 8: The Fed.

Thank you for listening.

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5 Comments

Amanda V's picture
Amanda V
Status: Gold Member (Offline)
Joined: Dec 31 2008
Posts: 262
Information not up to date ...

The money multiplier model described here is outdated and does not work this way.

See The Chicago Plan Revisited - Michael Kumhof - IMF working paper, The bank of england paper "money creation in the modern economy" There are many more.

LesPhelps's picture
LesPhelps
Status: Platinum Member (Offline)
Joined: Apr 30 2009
Posts: 797
Sharknado 2

I figured out why the message isn't getting out.  3.9 million people tuned into Sharknado 2 on the SciFi channel. 

Perhaps if you have zombies and vampires flipping the charts?

Maybe an X-box game version where the viewer has a gun and can shoot holes in the charts and displays as the message is delivered?  You could keep a running score on screen reflecting the viewers acumen with a digital weapon.  That would encourage people to watch the Crash Course Game over and over, trying for a better score.  Who knows, the message might eventually sink in.

Honestly, it's just frustrating where the worlds attention is focused.

cmartenson's picture
cmartenson
Status: Diamond Member (Offline)
Joined: Jun 7 2007
Posts: 5752
On The Money Mechanism
Amanda V wrote:

The money multiplier model described here is outdated and does not work this way.

See The Chicago Plan Revisited - Michael Kumhof - IMF working paper, The bank of england paper "money creation in the modern economy" There are many more.

The laws, as they are written in the books, claim that such a thing as a reserve ratio exists.  As we all know, the only true effective limit to what banks can/will lend is how much borrowing demand happens to exist.  As I hinted at in this chapter by saying:

In theory, banks are allowed to loan out up to 90% of what people have on deposit with them, although, as we’ll see later, the actual proportion is much closer to 100% than 90%.

When your reserve ratio is 0, then there's no limits to the loans.

But for now, telling the tale of bank lending as it's supposed to work and then showing how the Federal Reserve prints money out of thin air (next chapter) seems to work well enough to get people to listen up, and pay attention.

It's always a balance between getting deep into the weeds of the details and keeping attention.  I'm never quite sure of where to draw that line and I suspect that as time goes on we'll be able to move it further and further into detail.

However, regardless of whether we describe it 'close enough' or perfectly, neither mechanism is sustainable as both require infinite compound growth.

m111ark's picture
m111ark
Status: Member (Offline)
Joined: Jul 3 2008
Posts: 9
There's a better way...

Unnecessarily complicated Chris.

Couple of points.

1.  Simply say, banks are not in the lending business, they're in the money creation business.

Every so-called "loan" is in reality a bank simply crediting the borrowers account with newly, created out of thin-air, debt-money. Absent QE, that's the only way money gets created. With QE, the FED buys and HOLDS Treasury debt(bonds, bills, notes). Returning all interest paid by the government, in excess of expenses, to the treasury effectively makes this simple money creation...and in the end, such debt can be simply forgiven. Customer deposits just provide the bank the basis to make "loans"...as in reality, deposits are merely computer transactions.

2.  Ever heard the phrase, "sell the sizzle not the steak." Telling people that banks create money doesn't compute... people can't believe it, then, they can't believe how they've been duped all their lives, then suffering the shame of their ignorance makes them rebel against the very idea that banks simply "create money out of thin air." Tell them the consequences of bank created debt-money. Actually, tell them only one or two of those consequences and tell them to figure out the remaining consequences on their own - gets them engaged, and in the end enraged.

 

 

Arthur Robey's picture
Arthur Robey
Status: Diamond Member (Offline)
Joined: Feb 4 2010
Posts: 3936
The subtleties elude me.

I tried debt once and in was an unpleasant experience-it causes insomnia, depression and a loss of masculine virility.

So I paid down my debt real quick. The Bank was not happy, They could not understand the words" Close that Account." They kept offering me more Debt.

So what is the difference between pushers and banks again? The subtleties elude me.

 

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