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/ There are ten CHAPTERS and the original press release. Link to them here -- I • II • III • IV • V • VI • VII • VIII • IX • X • press release
HOW IS MONEY CREATED? CHAPTER III of "A Primer On Money" / continue to Chapter IV
(the paragraphs below have been numbered by M. Carbone In order
to make communication about this chapter easier for readers who
are communicating about this page)
This page << http://www.primeronmoney.com/chapters/chapter3.html >> -- on the internet
will take you through Patman’s “Primer On Money” if you click, sequentially through all
the Chapter numbers at the top of the page.
BEWARE -- Although Patman certainly means well and we are quite sure he did his best,
much of what he has written here is completely incorrect or very misleading. That is not
surprising, because all he had to go on was what the Federal Reserve publications said --
and they lied (and still lie) regularly.
For instance -- at # 126 below -- Patman says banks could not meet demands for cash if all the
depositors asked for their deposits at once. That is more-or-less meaningless and not true.
Most all depositors have signed an agreement that they must allow 7 days for the cash to be made
available. And since the “cash” is now Paper-Money -- that could easily be managed. At one time,
in history the statement at 126 would have made some sense -- but whan we started using government-
issued paper money that statement became meaningless.
We think Patman was somewhat confused, and he was thinking of all depositors asking for gold,
which they could have done when goldsmith bankers were running the banks. Of course they could
not all have actually received gold back then -- but the change to paper money not backed by gold
essentially eliminated the problem of bank runs catching the banks short.
One of the biggest problems the general public has in understanding the basic truth of money and
banking is that many of the “truths” were established when Paper Money was created privately by
goldsmith bankers who were running a scam by trying to convince everyone that every paper dollar
was backed by a “dollar’s worth of gold”. Those fears have remained in the general consciousness
and memory of the public.
Once the country switched to government-issued issued Paper Money backed by “legal-tender” laws
and the therefore essential backing of all the wealth of the nation -- gold became fairly insignificant
and anybody with a brain in their head should have realized that the game had changed for the better
for the public.
It appears however that even the Fed. and the law, as written by Congress, did and does not understand
that they were playing a new game and they kept using words like “reserves” and “fractional reserves”
even when paper money made those words useless artifacts of antiquity. We still use those words regularly
-- and they regularly lead us astray (as of 2009) -- to the benefit of nobody.
All the references to “reserves” in the following is totally misleading in my opinion -- as far as I can tell,
“reserves” have no practical function in the context of modern banking.
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(the paragraphs below have been numbered by M. Carbone In order to make communication about this chapter easier for readers who are communicating about this page)
1) Where does money come from? This is a question few of us ever think about. Not having thought about the matter, most people tend to assume that money has always been here and that some law of nature guarantees a fixed and unchanging supply of it. In any case, it seems that the less people know about money, the more strongly they feel that the whole subject should be left alone. When any public figure suggests that the money system should be improved in some respect, or perhaps that there should be more or less money, many people react as though he were proposing to meddle with nature or perhaps make the sacred profane.
2) These attitudes, of course, simply reflect confusion about one of the Government’s most essential activities. The amount of money in the Nation at any time is as much a decision of Government as anything else the Government does. And this decision is, of course, an important one. It determines the general level of interest charges for carrying a home mortgage or financing a new school or other community facility. It is true that the Federal Government does sometimes make decisions where decisions are not absolutely called for. There are things that should be left alone. But not the money supply. This is something which the Government must decide about. If it did not do so, economic chaos would result.
3) There are many reasons why the general public doesn’t really understand our monetary system. In the first place, money is something that people tend to get emotional about. After all, money involves, and always has involved, something closely akin to a religious faith -- which probably explains why in many past societies the money system has been in the hands of a priesthood, the subject of magical rites, and the ceremonial services of the tribe’s medicine-man.
4) Then, some of those who do understand the workings of our monetary system seem to feel they are in possession of secrets which cannot be revealed safely to the public. Unraveling the mystery, they feel, would somehow destroy a money system built on exchanges of paper and not “real” goods such as gold or silver. For this reason, it has been traditional for bankers and other private managers of money to cloak the working of the money system with the mantle of secrecy. And many of our high public officials share this view. Although they are appointed to represent the public interest they seem to feel that it would be somehow dangerous to talk about our monetary system in ways that let the public understand who does what, and why. These officials seem very partial to the turns of phrase that imply that the supply of money -- and interest rates -- are subject to powerful economic laws over which men have no control.
5) But, of course, money has not always been here. It was certainly not here when the first settlers arrived. Furthermore, the supply of money in the country on any given day has almost always been greater than it was a few years before. For example, in 1914, when the Federal Reserve System was organized, the total supply of money in the country was $12 billion. By 1929 it was $26 billion (total demand deposits adjusted and currency outside banks). If the supply of money in the United States had not grown since 1914, there would not have been enough to accommodate the larger population and volume of production and trade in 1929, to say nothing of today’s still larger population and tremendously large volume of production. Where has the extra money come from? It has been created -- manufactured. And not by the impersonal forces of nature, but by men.
6) In this chapter we will discuss the ways money has been created, as well as the part played by those who decide how much money is to be created. As might be imagined, our present system of money creation is the result of a long evolutionary process. So perhaps the easiest-and, undoubtedly, the most interesting-way of describing the mechanics of our present system is to begin with some questions and answers about the ancestors of our present bankers, the goldsmith bankers. For they originated the basic principles underlying the modern monetary machine.
7) Who were the goldsmith bankers?
They were private bankers who did substantially all of the banking business in Western Europe during the 17th century and before.
8) How did the goldsmiths get into the banking business?
It became customary for people who had gold to deposit it with the goldsmiths for safekeeping. The goldsmith then gave the depositor a “claim check,” or a receipt, for his gold. In time these receipts became transferable. Anyone having possession of a receipt was supposed to be able to go to the goldsmith and claim the gold. What actually happened was that these receipts for gold began circulating as money. People learned that they could carry on trade and commerce by passing goldsmith’s receipts from hand to hand without ever drawing out the gold. This led the goldsmith to a discovery which has been the principle of banking ever since -- “fractional reserves.”
NOTE -- everything in this booklet about “reserves” and “fractional reserves” is incorrect as explained at #9 below.
9) What is the” fractional reserve” method of banking? (mrc comment -- although this answer was written and published by Patman in 1964, Patman’s words below refer to a system used by goldsmith Banking that was obsolete when it was written and has been obsolete ever since. Although the words “reserve” and “fractional reserve” are still used in text books and the law, I contend those words are antiquated artifacts of a system that no longer exists. Stated simply, reserves were originally a certain amount of gold kept in reserve in the goldsmith’s vault to back the goldsmith’s receipts for gold on a one-to-one basis. Later it was discovered that a one-to-one relationship between the paper receipts and the gold was not needed and it became OK to keep only one dollars’ worth of gold as a reserve for every ten dollars’ worth of gold receipts. At that time it seems that thoughtful people must have begun to realize that a nation’s sovereign money was not dependent on the amount of gold the nation had -- but was really dependent on legal tender laws and the amount of wealth within the nation that could be purchased by the amount of money in circulation. I believe that everything written below is incorrect because of the facts in this paragraph. Everything written in every textbook and in the law that does not take these facts into consideration is equally incorrect.
Few people who held the goldsmith’s receipts came in to claim their gold. As the goldsmiths realized this, they also realized that they could make loans of the gold which had been left in their safekeeping. That is, they could write out receipts for gold to borrowers who, in fact, were not depositing new gold but borrowing the ownership of gold already in the goldsmith’s possession. This gold -- actually the certificates of ownership -- being loaned by the goldsmith was not his to lend. He did not own it. But so long as the calls for gold by the original depositors were so infrequent, the goldsmith felt he could lend without undue risk and earn interest on a certain portion of the deposited gold.
10) In other words, the goldsmith wrote receipts for people who were not depositing gold. These receipts. too circulated as money. So receipts for more gold than the goldsmith actually had in his vaults were circulating. The goldsmith had only a fraction of the amount of gold needed to meet the claims against him. This is the fractional reserve system. In the same way when the banks of the United States kept their reserves in gold, their reserves amounted to only a small fraction of the amount of the money they issued, all of which was guaranteed to be redeemable in gold.
11) What are the advantages of the “fractional reserve” system?
In the goldsmith period of banking, most Western European governments neglected to provide adequate monetary systems. Frequently, the government controlled the coins, and nothing more. Since this was a period of rapid economic expansion, with the New World being explored and settled, more money was needed than the governments provided. The main advantage of the fractional reserve system, as the goldsmith bankers practiced it, was that it was a source of money for enterprises which the goldsmith bankers considered reasonably safe and sound.
12) What are the dangers of the “fractional reserve” system?
Under the goldsmith system, the money supply could balloon with the needs for money but the balloon could collapse for reasons that had nothing to do with business’ need for money. This is because the goldsmith banker was at times “playing the odds,” gambling that not all his receipts, or even a high proportion of his receipts would be presented in demand for gold at the same time. If this did happen, he could not, of course, honor the claims on him because he could not make quick collections from the people to whom he had lent money. The whole structure would collapse. His money, i.e., receipts, would become worthless, individual savings, the deposits of gold he held, would be wiped out; healthy business enterprises would be forced into bankruptcy, when money they had accepted in good faith became valueless; and the whole economic life of the community would, for a time, be paralyzed.
13) Since most people who accepted the goldsmith’s money -- except for the more knowing -- believed that the goldsmith had enough gold to pay off his receipts 100 cents to the dollar, the mere suspicion that the goldsmith did not have enough gold was enough to start a “run” on the bank and the very collapse which was feared. At one time, a banker of Amsterdam, an important center of European goldsmith banking, proposed a law making it a hanging offense to start a run on a goldsmith. This immediately produced just such a run. Of course, the goldsmith could not pay. The customers ended up hanging the goldsmith.
14) This kind of disaster was not the only shortcoming of the goldsmith system. A serious problem was posed because the goldsmith’s money -- his receipts -- was usually acceptable only in the locality where he himself was known. Businessmen and traders who wanted to make large transactions in foreign commerce or between regions often made large withdrawals of gold for this purpose. This too could bring about a collapse. Also, like powerful bankers who came after them, some of the bigger goldsmith bankers were not free of suspicion that they deliberately precipitated depressions at times. At such times, when business firms were forced into bankruptcy, valuable assets could be bought up at bargain prices by those who possessed sufficient money -- or could create it for themselves. Most of the banking laws and regulations which governments have enacted in the centuries since the goldsmith bankers, have been aimed at safeguarding against the dangers inherent in the fractional reserve system.
15) What percentage of “reserves” did the goldsmith bankers keep?
No one knows. There were no regulations on the subject, and the question of how many dollars the goldsmith issued on each dollar of gold was left up to the good -- or bad -- judgment of the individual goldsmith. The U.S. Chamber of Commerce has widely circulated a little booklet on money which reviews the history of goldsmith banking. In this booklet, the chamber declares the goldsmiths found they could “safely issue $10 for each $1 of gold.” This is presumptive history. The bankers in the chamber of commerce have long been agitating to have their required reserves against demand deposits reduced to 10 percent; this has probably influenced, unconsciously, their interpretation of the past.
16) What became of the goldsmith bankers?
At about the beginning of the 18th century, the governments of Great Britain and the other countries of western Europe created banks -- such as the Bank of England -- which took over the function of holding bank reserves and regulating the issue of money. Other countries saw the establishment of private commercial banks, which developed into some of the leading banks in Europe today.
17) Where did the goldsmith bankers obtain their reserves?
As has already been indicated, the goldsmith bankers obtained their reserves when the owners of gold deposits left their gold with the goldsmiths. Although it is a long historical step from the goldsmith bankers to the present day, the logical development is quite short. For our modern system is only a refinement of “fractional reserve” banking developed so long ago.
18) Broadly speaking, the modern banking system, as it exists in the United States today -- it varies from country to country -- is a two-layered system. At the lower layer are the commercial banks where the public’s checking accounts are held. At the upper layer is the Federal Reserve System -- for convenience consider it as a monetary authority or agency -- which creates something called “reserves” that play the role in our banking system played by gold for the goldsmiths.
19) “What are these reserves? And how do they work as the base of a money-creating pyramid?
Well, in the first place, reserves are money, just like any other money -- with one distinction. They are deposits -- demand deposits owed to the commercial banks by the Federal Reserve. (Warning: there are some refinements here about reserves which are being ignored for the sake of clarity. The details will be added later.)
20) There are, then, two important types of deposits to keep in mind. Ordinary checking deposits kept by the public in commercial banks. And commercial bank deposits -- reserves -- on the books of the Federal Reserve. (I have not looked into this, but I suspect and am quite sure that these reserves are of the same dubious value as the reserves “held” by commercial banks. In my opinion, neither of these reserves are the least bit important to the banking system. The system works for a variety of other reasons. It is simply an error to think that the reserves protects anyone or any thing in any way. If I am wrong on this -- please tell me precisely how the reserves protect anyone in any way. Reserves are a gimmick -- or a Razzle Dazzle, designed to deceive everyone and make banking seem way more complicated than it is. -- Martin R. Carbone (mrc)
21) Where do the commercial banks get these reserves ?
By and large, the vast bulk of the reserves are created by the Federal Reserve and credited to the account of the various commercial banks.
22) Created by the Federal Reserve?
(a) Yes, and this should not be too much of a mystery, when Mr. John Jones of chapter II and the invaluable goldsmith bankers are brought back into the picture. For the Federal Reserve is the banker’s bank. It is the bank which creates bankers’ deposits -- reserves -- just as the bank which loaned money to Mr. Jones created $50 of money, or the goldsmith bankers created circulating paper money when they made a loan. When a bank borrows from the Federal Reserve, the Reserve increases the amount of the bank’s reserve account with it by the amount of the loan -- and new bank reserves are thereby created. (Where the Federal Reserve itself gets the money to lend or the power to create reserves is another matter, which will be discussed shortly. For the moment, simply accept the existence of a bank which can lend money to -- create deposits for -- the commercial banks.)
(b) Note by Martin Carbone -- I have never seen a contract betwen the Federal Reserve and a commercial bank so I am piecing this conjexture together from available information. I do not believe the "Created Reserves" are lent to the Commercial bank by the Fed. I am quite sure the Fed. simply makes the bank's checks good when the Bank lends that created money to the borrower. The bank pays no interest to the Fed. -- but the bank does charge the borrower standard rates -- typically 5 to 6% and keeps that money for doing its job of finding a borrower and servicing the loan. I come to this conclusion because in the event of a home foreclosure where the borrower does not pay the loan and the home is repossesed, it is the lending bank that takes title to the home -- clearly showing the bank has title to the home and the interest that has been paid and is still owed. See 24(b) below.
23) Now the first step into the money fabricating mechanism can be taken.
24) How can an increase in the money supply come about?
(a) One way -- there are others as will be seen -- is to have the Federal Reserve make a loan to a commercial bank. When the Reserve does this, the commercial bank’s deposit with the Federal Reserve increases, and the commercial bank is now richer. It has more money, equal to the value of the loan on deposit with the Federal Reserve. Technically, the bank’s “reserve account” increases. Its reserve account deposits are “high powered” dollars for they have the power to create a multiple expansion of money; i.e., currency plus demand deposits.
(b) Note by Martin Carbone -- I do not believe the preceding information is true. Note in the second sentence it is written "the commercial bank is now richer". If the Fed had made a loan to the commercial bank -- the commercial bank would not be richer. When any entity leds money to another entity, neither entity is richer or poorer -- the lender has simply exchanged cash for an account receivable and the borrower has simply exchanged an account payable for cash. The truth must be that the Fed. did not lend the bank the value of the loan. The value of the loan was passed through to the home buyer and ultimately to the home seller. The home seller kept the price of the home and the commercial bank keeps the interest on the loan. What would give the Fed the right to that loan money or the interest thereon? The "high powered" dollars are really no different than other dollars. The bank used those dollars just like they used any other dollar in their business -- they lent them out at a commercial interest rate.
25) With an increase in its reserves, the bank can now increase its own lending. And the reason it can is that ours is a “fractional reserve” system, with reserves substituting for the goldsmith’s gold. When a bank’s reserves increase, it can increase its lending by some amount. And these loans -- remember Mr. Jones -- take the form of increased demand deposits at the commercial bank -- an increase in “checkbook money.” So, by an increase in reserves, the money supply can be increased.
26) Turn from the money supply, for the moment, back to the reserve creating mechanism. The example of reserve creation ran in terms of a loan from the Federal Reserve to the commercial bank. Actually the Federal Reserve has alternative ways of increasing reserves. A most important one is by the purchase of securities -- specifically U.S. Government securities. This is what happens: When the Federal Reserve buys, say, $1 million of Government securities from a nonbank bond dealer, it gives the bond dealer a check in the amount of $1 million, drawn on the Federal Reserve. The bond dealer will deposit this check with his bank. The bank will credit the dealer’s checking account with $1 million and, at the same time, send the check in to the Federal Reserve, where this bank’s reserve account will be credited with $1 million. (Again, how the Federal Reserve obtained the $1 million is for later discussion.) Reserves have increased by $1 million through the securities purchase by the Federal Reserve.
27) Now let us return to the question of how the money supply increases after the Federal Reserve has created new bank reserves.
For the sake of simplicity, it is useful to make a most unrealistic assumption at this stage. Assume there is only one commercial bank in the United States, and that all the commercial banks in existence are actually only branch offices of it. (This assumption will be scrapped quickly enough.) This one bank can increase the money supply by making a loan, i.e., creating a demand deposit. It can also increase the money supply by purchasing a security. For when it purchases a security, from Mr. Smith this time, it writes out a check to Mr. Smith for the value of the purchase. And Mr. Smith? He deposits the check, in the one big bank, which now credits the Smith checking account. Where did the bank get the money for the purchase? Nowhere. It created the money just as It did for the loan. That is, no other deposit was drawn down for the purchase and Mr. Smith’s deposit increased. This is the second of the two basic ways loans or investments -- a bank can increase the money supply.
28) Well, since the bank makes its profits from the interest it receives from its loans and investments, why doesn’t the bank simply create an infinite amount of money-making every loan it can place and gobbling up all legitimate securities offered? One reason is that the bank must plan for the possibility that a sizable fraction of its deposit liabilities will be cashed in some day. This limits the deposit-creating process because the bank cannot create 10 times as much in deposits as it has in cash reserves if the fraction that may be cashed in is one ninth. Additionally in our economy no bank is allowed to do this. For if it were allowed, there would then be no limit to the money supply, and a vital control over our economic system would be rendered useless.
29) In our money system the Federal Reserve -- an agency of the Government -- exercises control, by setting a limit to the amount of money the bank can create, a limit that prevails until the Federal Reserve authorities decide on an increase or decrease. There are certain rules of the game written into law, but the Federal Reserve has authority to modify the rules from day to day -- within broad limits -- as it sees fit.
30) Under the basic rules laid down by Federal Reserve System, the bank may create several dollars of bank deposits for each dollar of the reserves which are at the moment credited to its account on the books of the Federal Reserve. Let us illustrate what this means with some simple arithmetic. Say that the Federal Reserve has credited a bank with $5 of reserves. And suppose the bank is permitted to create $10 of deposits for each dollar of reserves. This would mean that the bank (which, by assumption, recall is the only bank in the country) can now create bank deposits (by making loans and investments) up to the point that deposits reach $50. At this point, the bank could make no more loans or investments- except, of course, to replace previous loans being paid off or to replace securities being sold. Under the rules, the Federal Reserve can Impose a fine on the hank if it goes beyond its allotted amount.
31) This is how the money supply could be increased if there were a single bank: the Federal Reserve would increase the reserves of the bank, and the bank, having to have only a fraction of its deposits covered by reserves, would increase its deposits by the amount permitted. Now, the one big bank assumption can be dropped and an important refinement added. The discussion of the single bank used the phrase “creating several dollars of bank deposits for each dollar of reserves.” This is a perfectly acceptable statement “when dealing with the fictional single bank system. But it covers up a somewhat complicated process that takes place in the actual world of numerous banks.
32) Consider the bank around the corner. Assume it has just borrowed some money from the Federal Reserve - $1,000 - or sold a $1,000 security to it. Either way its reserves increase. But the corner bank does not rush out and increase its loans and investments by some multiple of the reserve increase, as the single bank would. Why not?
33) Here is the refinement. The Federal Reserve limits bank lending by saying that the local bank and, for practical purposes, all commercial banks must keep a certain percent of their outstanding deposits -- ”checkbook money” held at the bank-in a reserve account at the Federal Reserve bank. Say the limit is 10 percent. And, say, your local bank merely loaned out only the increase in reserves -- $1,000 to some merchant. As the merchant used the money to pay wages and bills for merchandise, checks would be going to people who bank elsewhere, out of the neighborhood, and out of the State. When the recipients of these checks deposited them, their own banks would send them to the local bank for collection. How does the local bank pay these other banks? By transferring money out of its reserve account ‘With the Federal Reserve’ into the reserve accounts of the other Banks. In other words, banks pay one another by shifting funds from their own deposits -- their deposits at the banks’ bank, the Federal Reserve.
34) The local bank, then, would be in a jam if it rushed out, loaned $10,000 on the basis of its $1,000 of new reserves, and shortly found it had to transfer $5,000 to $6,000 of its reserves to other banks. By this process it would lose rather than gain reserves as a result of its loan from the Federal Reserve.
35) Roughly, what actually happens is that the local bank has some idea, after years of experience, about the percentage of a loan (or a security purchase) which will ultimately wind up at other banks. Say the percentage is 90 percent. Then, with a $1,000 increase in reserves, the bank could lend approximately $1,100. After the drain of reserves and the loss of 90 percent of the newly created demand deposits to other banks the local bank, would have approximately $11 in reserves against $110 of deposits which remained at the bank. It could lend no more.
36) But the local bank has created $1,100 in money, now scattered throughout the commercial banking system. Further, it had fed about $990 into the reserve accounts of other banks who would proceed to lend against their new reserves. They would each go through the same process as the local bank, finally emerging with deposits increased by 10 times “whatever the amount of the new reserves they managed to cling to. Eventually, the process would end as the voyaging reserves grew smaller and smaller with each round. In the end total deposits throughout the banking system would increase by $10,000 and the $1,000 in reserves would be finally distributed. In this fashion, the banking system as a whole does what no bank can normally do: create the multiple expansion of money permitted by a given increase in reserves.
37) This is the moneymaking mechanism in a nutshell. But there is still one mystery left to unlock. Where does the Federal Reserve get the money with which to create bank reserves? Answer: It doesn’t “get” the money, it creates it. When the Federal Reserve writes a check for a Government bond it does exactly what any bank does, it creates money. The only difference is that the Federal Reserve’s check ends up an as increase in reserves for the banking system-an increase in bank deposits with the Federal Reserve-as well as an increase in some private bondholder’s checking account at his commercial bank. A Federal Reserve purchase creates two increases in deposits at once-a bank’s deposit with the Federal Reserve, and a deposit with a private commercial bank.
38) Unlike the commercial bank, the Federal Reserve does not have any money of its own deposited somewhere else on the basis of which it makes its loans or security purchases. It creates money purely and simply by writing a check. And if the recipient of the check wants cash, then the Federal Reserve can oblige him by printing the cash -- Federal Reserve notes -- which the check receivers commercial bank can then hand over to him. The Federal Reserve, in short, is a total moneymaking machine. It can print money, if that is what is demanded, or issue checks. It never has a problem of making its checks “good,” because, of course, it can itself print the $5 and $10 bills necessary to cover the check.
39) Obviously, this power to create and print money could only be given to the Federal Reserve by Congress. This is the case: The Federal Reserve System is an agency of Congress authorized to create money.
40) All of the examples were Illustrations of the manufacture of money. But the banking system can also destroy money. The process is the exact reverse of money creation. When a bank repays a loan to the Federal Reserve, it writes a check to the System which “collects” the check by deducting the amount of money from the bank’s deposit with the Federal Reserve. The bank’s reserves are then decreased and the bank must begin contracting deposits -- calling in loans or selling investments to get back within the permitted deposit limit for its shrunken reserves. And the calling of loans or selling of investments will start a deposit contraction process, the reverse image of the expansion process described earlier.
41) Or the Federal Reserve can sell a security, say, to Mr. Smith, who writes a check to the Reserve in payment. “The System collects from Mr. Smith’s bank by deducting the amount of the check from the bank’s deposit it is holding. Here again is the reduction in reserves. In turn, Mr. Smith’s bank deducts the amount of the check from his deposit. Here again is the first step in the multiple contraction of deposits.
42) Perhaps it is now clear why the banking system was called a two layer system earlier in the chapter. Expansion or contraction of the money supply occurs first through a change in reserves which the commercial banks hold, and, second, by the commercial banks responding to their changed reserve situation by changing the amount of “checkbook money’ outstanding.
43) With a two-part system, the Federal Reserve can change the money supply by operating on anyone of the two layers. For example, It can increase reserves. Alternatively, it can leave reserves unchanged, but can decrease the amount of reserves required to be held against each dollar of demand deposit outstanding. With the “reserve requirement” decreased, the unchanged level of reserves can support a larger stock of “checkbook money,” and the banks will proceed to employ their “excess” reserves by making new loans and investments.
44) All this can be expressed in a formula.
45) What is the formula that determines the maximum amount of money and credit available to business and consumers?
The formula consists of two parts. One is the amount of bank reserves which the member banks of the Federal Reserve System have to their credit on the books of the Federal Reserve banks. The second part is a regulation, which the Federal Reserve Board issues from time to time, telling the member banks the maximum amount of bank deposits they may create per each dollar of their reserve deposit. Expressed mathematically this is a simple formula-
A x B = O / where: / A = Amount of bank reserves; / B = Number of dollars of deposits member banks may create per each dollar of reserves; and / O = Total bank deposits.
46) Can the Federal Reserve authorities change the money supply formula?
Yes. These authorities can change either or both parts of the formula at any moment, and they frequently do change one or both parts. The Federal Reserve Act does specify certain maximum and minimum limits within which these authorities may change either part of the formula, but these limits are extremely wide.
47) Consider the two-part formula further. Suppose the Federal Reserve has created $100 of bank reserves and has issued regulations which tell the banks, in effect, that they can create $5 for each dollar of their reserves. Bank deposits have thus reached $500. The banks are “loaned up “-they can make no further loans and make no further investments except, of course, as customers pay back their previous loans or as the banks sell some of their securities. Suppose also that the Federal Reserve wishes to permit the banks to expand the money supply-that is, to make additional loans and investments. The Federal Reserve authorities do either of two things: They create more bank reserves, or they issue new regulations, telling the banks they call create a greater number of dollars per dollar of reserves already in existence. If the Federal Reserve wished to double the amount of bank credit available to business and consumers, it could create another $100 of reserves, while maintaining its reserve regulation at 20 percent. The banks could then expand their deposits to $1,000, from the previous $500 simply by making $500 of loans or investments.
48) Alternatively, the Federal Reserve authorities might issue new reserve regulations, telling the banks they need to “keep’ only 10 percent of their deposits in reserves. This would mean that the banks could then create $10 of deposits for each dollar of their reserves instead of only $5 as previously. Consequently, in this way they could also increase their deposits to $1,000, simply by making $500 in loans and investments, although their reserves were still $100 as before.
49) Whichever part of the formula the Reserve managers decide to alter is totally arbitrary as far as the total supply of money is concerned. But the alternate routes to the same increase in the money supply are not otherwise equal in their effects on the economy.
50) When the Federal Reserve increases the money supply by lowering reserve requirements, all of the new money is created by the commercial banks through their lending and investing activity. On the other hand, when the Federal Reserve uses the increased reserves route, by purchasing a Government bond, some of the money is created by the Federal Reserve. The Reserve-created money is the amount the Reserve pays out for the bond-an amount which is added to the money holdings of the bond seller without drawing down any money holding elsewhere. The rest of the money is created by the banks using their increased reserves from the bond purchase.
51) This may seem a rather fine technical point to emphasize. But actually it has at least one very practical consequence. The Federal Reserve officials can always decide to create a large portion of any increase in the money supply themselves, though, of course, a larger portion of the supply will always be provided by the private banks under present law. Still the larger portion of Reserve-created money, the more the U.S. Treasury benefits-because all income of the Federal Reserve after expenses reverts to the Treasury. Thus the Treasury receives a good share of the income earned from the Government securities purchased in Reserve money-creating operations.
52) On the other hand, if the Federal Reserve officials decide that the increase in the money supply they want is all, or substantially all, to be made by the private banks, the private banks acquire and hold more Government securities than in the first case, and the interest payments on these securities go into bank profits.
53) So, whether the Federal Reserve officials decide to favor the U.S. Treasury or the private banks does make a difference -- millions of dollars of difference -- in the amount of taxes you, I, and all other taxpayers must pay. After all, one of the biggest items of expense of the Federal Government is the interest it must pay on its debt. We will return to this subject later.
54) Another technical nicety with important dollars-and-cents consequences is the fact ,that the Federal Reserve System itself creates high-powered money or bank reserves, just as the banks create customer deposits. This seem to be little understood, even among “experts.” In truth, the customary explanation of the source of bank reserves, an explanation appearing even in many college textbooks, has produced much confusion and misunderstanding on the subject.
55) In explaining how the commercial banks manage to own bank reserves the usual college textbook begins by assuming that “money” comes into being first, in some unexplained way, and is then deposited in a bank. The bank must then take a certain portion of this money and send it to the Federal Reserve bank where it is kept, in compliance with the reserve requirement. Thus, a typical explanation runs this way: John Jones deposits $100 in cash with his bank. The bank is required to keep, say, 20 percent of its deposits in reserves, so the bank must deposit $20 of this $100 as reserves, with a Federal Reserve bank. The bank is free to use the other $80, however, to make loans to customers or invest in securities. The expansion of money thus begins.
56) This kind of explanation not only leads to misunderstanding, it also leads to misguided Government policies and rather constant agitation on the part of bankers for other such policies. Many of the smaller bankers, who are, on the whole, not as well versed with the mechanics of the money system as they might be, actually believe that they have deposited a portion of their money, or their depositors’ money, with the Federal Reserve. Thus they feel they are being denied the opportunity to make profitable use of this money. Accordingly, there is always agitation to have the Federal Reserve pay the banks interest on this money which they think they have “deposited” with the Federal Reserve.
57) Furthermore, they are quite certain that the Federal Reserve System has “used” their money to acquire the Government securities which the Federal Reserve may buy in the process of reserve creation. Believing this, the bankers naturally feel that they are entitled to some share of the tremendous profits which the System receives from interest payments on its Government securities.
Many bankers know better. The leaders of the bankers’ associations certainly do. But some of these leaders have not hesitated to play on general ignorance and misunderstanding to mobilize the whole banking community behind drives that are nothing but attempts to raid the Public Treasury.
58) The truth is, however, that the private banks, collectively’ have deposited not a penny of their own funds, or their depositors funds, with the Federal Reserve banks. The impression that they do so arises from the fact that reserves, once created, can be, and are, transferred back and forth from one bank to another, as one bank gains deposits and another loses deposits.
59) As was shown earlier, if a depositor transfers $100 from his checking account with one bank to another, the first bank loses $100 in reserves and the other gains $100 in reserves. Similarly, when a new bank comes into a banking business, it is required to “deposit” a certain amount of reserves with the Federal Reserve bank, to begin operation. Say the new bank makes an initial deposit of $100 with the Federal Reserve bank. How did the bank get the $100~ From the members of the new bank who probably shifted $100 out of their checking accounts at other banks and paid the sum to the new bank as part of its initial capital. The other banks, of course, lose $100 of reserves when the)’ settle their debt to the new bank. In one way or another, then: this $100 comes out of the reserve account of some bank already in business.
60) In short, new banks may come into business, old banks may go out of business, and reserves may be transferred from one bank to another in countless ways. But, nothing the banks can do will increase the total amount of reserves on high-powered money in the System; and nothing the banks would care to do can decrease the total amount of reserves in the System. Practically speaking, only the Federal Reserve System itself can do this. Increasing or decreasing bank reserves is a conscious act of the managers of the Federal Reserve.
61) Officials of the Federal Reserve System recognize, of course, that the idea that the banks make some kind of physical deposit of money they have received with the Federal Reserve banks to accumulate their reserve is nonsense. For example, Under Secretary of the Treasury Robert V. Roosa, formerly a Vice President of the Federal Reserve Bank of New York, while testifying before the House Committee on Banking and Currency in 1960, described the misconception as follows:
There is another misconception which occurs much more frequently -- that is, the banks think that they give us the reserves on which we operate and that, too, is a misconception. We encounter that frequently, and, as you know, we create those reserves under the authority that has been described here.’
62) The writer has had a couple of personal experiences which “have provided some am using confirmation of the fact that the source of bank reserves is not deposits of cash by the member banks with the Federal Reserve banks. Having seen reports that the Federal Reserve System had, on a given date, Government securities amounting to approximately $28 billion, I went on one occasion to the Federal Reserve Bank of New York where these securities are supposed to be housed, and asked if I might be allowed to see them. The officials of this bank said, yes, they would be glad to show them to me; whereupon they opened the vaults and let me look at, and even hold in my hand, the large mound of Government securities which they claimed to have and which, in fact, they did have.
63) Since I had also seen reports that the member banks of the Federal Reserve System had a certain number of millions of dollars in “cash reserves” on deposit with the Federal Reserve bank, I then asked if I might be allowed to see these cash reserves. This time my question was met with some looks of surprise; the bank officials then patiently explained to me that there were no cash reserves. The cash, in truth, does not exist and never has existed. What are called cash reserves are simply bookkeeping credits entered into the ledgers of the Federal
Reserve banks. These credits are first created by the Federal Reserve and then pass along through the banking system.
64) On another occasion, in the spring of 1960, I paid a visit to the Federal Reserve Bank of Richmond, along with several other Members of Congress, and in the course of the visit asked the President of that bank if I could see the cash reserves which the member banks had on with that bank. Here the answer was in substance the same. There is no cash in the so-called cash reserves. In other words, the cash making up the banks’ “cash reserves” with the Federal Reserve bank is just a myth.
65) Just how much in the form of bank reserves has been created by the Federal Reserve System, and what use has been made of them ~ Officials of the Federal Reserve System have answered these questions on several occasions over the years. One answer was given by the Federal Reserve Board in a letter from Chairman Martin in response to my questions on behalf of the Joint Economic Committee of the Senate and House of Representatives. The answer was given in early 1960.
66) • Hearings before Subcommittee No.3 of the Committee on Banking and Currency, House of Representatives, 86th Cong., 2d session H.R. 8516 and H.R. 8621, pt. 1. p. 119.
67) The story, in brief, is this: At the end of 1917, when the first financial report dealing with reserves held at the Federal Reserve System was made, the banks of the System had reserve credits amounting to $1.5 billion.
68) Between the end of 1917 and the end of 1959, the Federal Reserve System had created gross additions to bank reserves amounting to a total of $47 billion. Over the years the banks had drawn down their reserve accounts by $28 billion, by taking out currency (which was printed to meet their requests), leaving them with a net reserve balance $18.5 billion.
69) Let us assume for a moment, just for the sake of analysis that the $1.5 billion of reserves which the banks of the System had to their credit in 1917 came about through actual deposits of cash by the banks. We may say, then, that in return for this $1.5 billion of cash, the banks have been paid back, in cash $28 billion. They still have left another $18.5 billion in their reserve accounts, a circumstance which entitles them to have outstanding seven times that amount of bank created money. With this money they have acquired seven times that amount of Government securities and other interest-paying securities and loans.
70) So far there has been a deliberate haziness-to prevent more clutter than necessary-about the methods the Federal Reserve can use to create reserves. It is time to clear away the fog.
71) What are the methods by which the Federal Reserve creates and extinguishes bank reserves?
There are four methods. Two of these are carried out by the New York Federal Reserve Bank, acting as agent for the whole System. They are (1) “open market” operations and (2) purchasing gold as agent for the U.S. Treasury. Most reserves are created by these two methods but there are two other methods carried out by 12 regional Federal Reserve banks. They are (3) making loans (usually secured by Government bonds) to commercial banks-specifically “member banks,” a term which will be explained later, (4) purchasing “eligible paper” from “member banks” (almost never used).
72) What are “open market operations”?
“Open market operations” refer to the Federal Reserve System’s buying and selling of Government securities in what is called the open market. In these buying and selling operations, the Federal Reserve Bank of New York acts as agent for the entire System. The other 11 regional Reserve banks are later informed of changes in the System’s portfolio and, as a corollary, of their respective portfolios. The purpose of buying or selling Government securities is to expand or contract bank reserves and, hence, to expand or contract the amount of money and credit available to business and consumers. In this the Federal Reserve Bank of New York acts to carry out policies laid down by the Federal Open Market Committee, a Committee which will be described in a later chapter.
73) What is the “open market”?
The so-called open market consists of 21 private dealers in U.S. Government securities with whom the Federal Reserve Bank of New York trades. Several of these dealers are big New York and Chicago banks. The other dealers are firms centered in the Wall Street area, which specialize in buying and selling securities. The bond dealers, incidentally, may have purchased the bonds from an insurance company, from an individual, an industrial corporation, a commercial bank, or any other financial institution, or from the U.S. Treasury.
74) How does the Federal Reserve create bank reserves by open market operations?
The step-by-step details are as follows: Let us assume that the Federal Reserve Bank of New York, acting as agent for the whole System, buys a $1,000 Government bond in the open market. It gives the bond dealer a check for $1,000 drawn on the Federal Reserve Bank of N ew York. The dealer will, of course, deposit this check in his checking account, say, with the Chase Manhattan Bank. The Chase Manhattan credits the dealer’s checking account with $1,000 and then sends the check to the Federal Reserve Bank of New York for payment. The Federal Reserve Bank of New York makes payment to the Chase Manhattan by crediting its reserve account with $1,000.
75) How does the Federal Reserve extinguish or reduce bank reserves through open market operations?
By selling some of its Government securities in the open market. When the Federal Reserve Bank of New York sells a $1,000 Government bond, the process by which it created $1,000 of reserves is reversed. The Federal Reserve bank sells the bond to a dealer and the dealer gives the Federal Reserve bank a check drawn on his personal bank: say, the Chase Manhattan again .. The Federal Reserve bank satisfies its claim by reducing the Chase Manhattan’s reserve account by $1,000. It then sends this dealer’s check to the Chase Manhattan and the Chase reduces the dealer’s checking account by $1,000. Bank reserves are now $1,000 less than they were before.
76) How much money can the private banks create when the Federal Reserve creates $1 billion of bank reserves of high-powered money?
At the present time the Federal Reserve’s rules permit member banks of the Federal Reserve System to create $7 for each $1 of reserves credited to their accounts with the Federal Reserve banks. This means that under the present rules relating to fractional reserve banking, when the Federal Reserve System gives its member banks an added $1 billion of reserves, these banks can create up to $7 billion of new money credited to the accounts of their customers. The banks create this new money by the process already explained.
77) For whom does the Federal Reserve purchase or sell gold?
Only the U.S. Treasury purchases and sells gold. The Federal Reserve handles these transactions, acting as agent for the Treasury.
78) What are the sources of the gold purchased by the Treasury?
To a small extent the Treasury purchases newly mined gold. Most gold is purchased from foreign “central banks” -- just accept the term for the moment-and, similarly, most of the Treasury’s sales of gold are’ to foreign central banks.
79) Why does the Treasury purchase gold?
The small amounts of newly mined gold are purchased by the Treasury to add to the Nation’s monetary gold stock. Since foreign central banks holding any of our currency may call upon the Treasury to convert the currency to gold, it is important to have enough gold to meet any such claims that may be presented.
But, most of the Treasury’s purchases-and sales-of gold are made from and to foreign central banks. These purchases and sales reflect the fortunes of our international balances of payments with foreign countries.
80) How does the Federal Reserve create bank reserves ‘when it purchases gold for the Treasury?
It is a duplication of what happens when the Federal Reserve purchases Government bonds in the open market. When the Treasury buys either newly mined gold or gold from a foreign central bank, bank reserves are expanded by the exact amount of the purchase.
81) Here is an illustration: when the Treasury buys $1 million of newly mined gold from a mining company in this country and the checks have all cleared, the mining company has $1 million more in its checking account at the bank. That bank in turn has $1 million more in its reserve account with the Federal Reserve bank. The commercial bank acquires the reserves when the Federal Reserve transfers $1 million from the Treasury’s account with the Reserve to the bank. The Treasury, on the other hand, has the gold and it has $1 million less in its checking account with the Federal Reserve bank. If it wishes to replenish its account with the Federal Reserve, it may issue gold certificates-currency which can only be held by the Federal Reserve-against the gold deposits.
82) The same is true if the gold is purchased from a foreign central bank. In either case, the commercial banks of this country have $1 million more in reserves than they had before. This means that unless the Federal Reserve takes some other action, they can create $7 million of new bank deposits, by creating bank deposits in exchange for securities or loan notes.
83) How does the Federal Reserve extinguish or reduce bank reserves when foreign central banks purchase gold in this country?
By the reverse of the process already explained.
84) Is the amount of dollars held abroad greater than the Treasury’s gold supply?
Yes, at the present time the amount of dollars held abroad is in excess of the Treasury’s gold.
85) Since foreign central banks can redeem dollars for gold, why don’t foreigners turn in all of their dollars in exchange for gold?
Because money in the form of gold draws no interest; it simply has storage expenses. Foreign central banks would prefer to have dollar credits in this country because these can be invested in interest-bearing securities or dividend-earning stocks.
86) Are total bank reserves reduced when gold goes abroad?
Yes and no. The total amount of reserve available to the banks is decided by the Federal Reserve authorities. Their decision depends upon what they wish the total supply of money and credit in this country to he. The Federal Reserve cannot prevent foreign countries from drawing out gold, and thus reducing bank reserves; but the Federal Reserve can make up the difference in bank reserves by purchasing Government securities in the open market.
87) Does the Federal Reserve create bank reserves by making loans to banks?
Yes; whenever the Federal Reserve makes a loan to a bank it simply creates the money which it credits to that bank’s reserve account. However, a relatively small proportion of the bank reserves in existence at anyone time represents loans to banks. Under present practices, these reserves are promptly extinguished-usually in no more than 15 days. The Federal Reserve authorities have decided to use this method of making bank reserves available to the banks only on a temporary basis.
88) Do the banks have an automatic privilege of borrowing from a Federal Reserve bank?
No. Banks of the Federal Reserve System are eligible to borrow. But being eligible and obtaining a loan are two different things. In practice the Federal Reserve banks lend reserves to a bank only when that bank is temporarily pinched because it has lost reserves. This policy is implemented not by turning aside banks that seek to borrow once in a while but by not permitting continuous borrowing. In other words, as a bank’s customers make purchases and pay bills, and transfer their deposits from one bank to another, a particular bank may gain or lose reserves. If it loses reserves, it will either have to sell securities or call in some loans, to be able to transfer reserves to the banks which are gaining. In these circumstances, the Federal Reserve bank will lend to such a bank, on the theory that, in a few days, it will regain its normal share of reserves. And if the bank is required to call some loans or sell securities, the temporary loan from the Federal Reserve bank gives it time to move in an orderly manner.
89) How are Federal Reserve loans to the banks secured?
The law permits the Federal Reserve System to accept a variety of good collateral to secure its loans. In practice, however, banks borrowing from the Federal Reserve System almost always put up U.S. Government securities as collateral. If the Federal Reserve insists on U.S. Government securities as collateral, this does not work any hardship on the borrowing banks since commercial banks generally keep large portions of their assets in Government securities, and the amount of the loans which the Federal Reserve will, in practice, make to banks is relatively small.
90) Does the Federal Reserve create bank reserves when it buys “eligible paper”?
Yes. When the Federal Reserve Act was passed, Congress intended this to be the main way that the Federal Reserve System would create bank reserves. (“Eligible paper” is a term designating certain kinds of IOU’s signed by a bank’s customers when they borrow.) When this practice was followed, the banks in a particular area could obtain loanable funds in direct proportion to the community’s needs for money. But in recent years, the Federal Reserve has purchased almost no eligible paper. In fact, the Federal Reserve System has made very little credit available to the banks in the individual districts, including that which they have made available in the form of loans. It is now the practice of the Federal Reserve to funnel most of its credit to the banks through open-market operations in New York.
91) Do banks of the Federal Reserve System “pay” for their reserves?
No. Bank reserves cannot be paid for by the private banks. They can be shifted and are constantly being shifted to some extent from one bank to another after they are created. But, to all intents, only the Federal Reserve System Itself can create reserves, and extinguish reserves.
92) Sure, when the Federal Reserve purchases a $1 million Government bond and gives some bank credit for $1 million in its reserve account, that bank also credits the bond dealer’s checking account with $1 million. In other words, to acquire $1 million of reserves, the bank also assumes a liability to pay its customers $1 million. If the transactions stopped here, the bank would, of course, come out even, neither gaining anything nor losing anything. But the fact that there is now $1 million more of bank reserves than existed before means that the private banks as a group can create $6 million more money than existed before.
93) In other words, by acquiring this $1 million more in bank reserves, the private banks have the privilege of creating another $6 million of bank deposits) in the process of which they acquire $6 million in interest-bearing securities or loan paper, less an allowance for leakage into the cash (currency) balances of the public.
94) Bank profits come from the difference between the interest they receive on their loans and investments and the interest they pay their customers on their bank deposits. In 1935 Congress passed a law, sponsored by the bank associations, which finally made it illegal for all banks-with a few unimportant exceptions-to pay their customers interest on demand deposits. Since banks pay no interest on demand deposits we have a clear answer to our question: “Do member banks ‘pay’ for their reserves?” It is this: When the Federal Reserve provides the banks with more reserves, this automatically enables the banks to make more profits.
95) Does the money in bank reserves belong to the private banks?
Yes. The banks are privileged to take out their reserves in the form of cash-Federal Reserve notes-any time they choose to do so. Drawing out cash must, however, leave the bank in compliance with the Federal Reserve’s regulation as to reserve requirements.
96) To illustrate, in the example given above where the Federal Reserve bought a $1,000 bond and gave the Chase Manhattan Bank a $1,000 credit in its reserve account, the Chase Manhattan could, if it cared to do so, ask the Federal Reserve bank for its $1,000 in cash that is, in Federal Reserve notes. In this case, however, the Chase Manhattan’s deposit with the Federal Reserve -- its reserve -- would be no greater than it was before. Neither the Chase Manhattan nor the other banks would be able to expand their deposits.
97) How does currency and coin enter into the money supply?
The amount of currency and coin in circulation is pretty much automatic. It normally amounts to about 20 percent of the money supply, with bank deposits accounting for the other 80 percent.
The Federal Reserve authorities know how much currency and coin is in circulation at all times; they should~ of course, take this leakage into currency into account when they decide how much to add to reserves.
98) Who determines how much currency and coin is issued?
This depends on the behavior of individuals and business firms. The amount of currency and coins in circulation depends upon how convenient individuals and business firms find coins and currency, rather than bank deposits, in carrying on trade. Money is created first in the form of bank deposits. And most money remains in this form. But as the economy grows and the money supply grows, business and consumers usually find that they want to keep the same percentage of their money in currency and coin. The percentage has been declining somewhat because more people are using checks to make purchases and pay bills.
99) When someone goes to the bank and asks for currency -- ”cash” -- in exchange for a check, the bank gives him the currency and reduces his checking account by the amount of the check. Then as the bank needs “cash” itself to meet its depositors’ demands, it gets the cash from the Federal Reserve by having its deposit reduced. The bank loses reserves, to the amount of the cash, ,,,whenever it draws cash from the Federal Reserve. When the public wants cash, then, reserves go down. Of course, the Federal Reserve can adjust for this by creating more reserves during a period of a cash drain on reserves.
100) Who determines how much “checkbook money” shall be created?
The Federal Reserve System determines the maximum amount of “checkbook money,” or bank deposits, which may be in existence at any particular time. Specifically, a committee made up of the members of the Board of Governors of the Federal Reserve System and the Presidents of 5 of the 12 Federal Reserve Banks makes this decision. The Open Market Committee -- as it is called -- decides only what the maximum amount of money shall be; it cannot determine that the maximum amount will actually be created. Money is created when the private banks make loans or investments, and the Federal Reserve cannot force the banks to make loans or investments. It would not be a good policy for it to do so. The bankers make loans and investments only to the extent that they consider they are making sound loans or investments, that will be repaid.
101) Can Federal Reserve officials help the U.S. Treasury and U.S. taxpayers without increasing the money supply?
Yes -- by creating more reserves -- that is, by buying more Government securities in the open market-and by raising reserve requirements for the member banks. This means that, for any given supply of money, the Federal Reserve banks would own more Government securities and the private banks would own correspondingly Jess. This would not entail any change of the money supply, and interest rates would not decline very much.
102) Is there a practical example of how the Federal Reserve could adopt a policy less favorable to the private banks and more helpful to the general taxpayer?
Yes. Many practical examples could be given. The table below presents some arbitrary figures which illustrate the effects of two different policies the Federal Reserve might follow, both of which would result in the same money supply-that is, in the same amount of money and credit being available to business and consumers.
103) The figures given for policy “A,” are not drastically different from the facts as they exist today. Furthermore, the figures shown for policy “B” closely approximate the facts -- as they might easily have existed if reserve requirements had not been lowered several times during the 1950’s. The two sets of figures, and the situations they describe, demonstrate that the Federal Reserve authorities have arbitrarily decided that private banks of the country own $20 billion more of Government securities, and the Federal Reserve banks $20 billion less than they would have, had authorities decided things differently.
104) How two different Federal Reserve policies make the same amount of money and credit available to business and consumers but determine whether the public or the private banks own $20,000,000,000 of Government securities [Dollar amounts in billions]
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105) Let us note the figures for what we have called Federal Reserve policy “A” and Federal Reserve policy “B” and consider what they mean.
106) Under both policies the amount of deposits in the commercial banks is the same -- $200 billion. Under policy “A,” the Federal Reserve has created $20 billion of reserves by, say, purchasing Government securities from nonbank individuals on the open market. When the Reserve does this, it immediately creates $20 billion of demand deposits (and, hence, money) at the commercial banks -- deposits which are credited to the accounts of the individuals who sold the securities. This means that along with the creation of $20 billion of reserves, the banks find they have $20 billion of demand deposits against which $2 billion of the new reserves must be earmarked. Only $18 billion of the reserves, then, are free to support deposit expansion. After the commercial banks lend and invest, producing $180 billion in deposits, there will be $200 billion in deposits in the system -- $180 billion of which is commercial bank created, and $20 billion Federal Reserve System created.
107) With policy “B,” the same process occurs. Except this time $40 billion of the money supply is created by the Federal Reserve and $160 billion by the private banking system. In both cases, obviously, the total amount of money and credit available to the economy is the same. Under policy “B,” the Federal Reserve would acquire and hold $20 billion more of Government securities than it is holding under policy “A.” Accordingly, to maintain the same money supply as under policy “A,” the Federal Reserve would issue regulations to the banks telling them they must “keep” 20 percent of their deposits in “reserves.” This would mean that the banks could create only $5 of money per each $1 of uncommitted reserve generated by the Federal Reserve. The total money supply would, however, be the same, as is shown in column 3.
108) The big differences, however, show up in columns 4 and 5 of the table. Under policy “A,” the Federal Reserve would own $20 billion of assets and the private banks would own $180 billion. The combined assets of both the Federal Reserve and the private banks would be the same under both policies -- $200 billion. Under policy “B,” however, the Federal Reserve would own $20 billion more of Government securities and the private banks would own $20 billion less.
109) In other words, the private banks would own a total of $160 billion of interest-bearing loans and investments instead of $180 billion, and the difference would be accounted for by the $20 billion of Government securities acquired by the Federal Reserve.
110) The point to remember is that this $20 billion of Government securities will be acquired by creating money with which to pay for them-whether by the Federal Reserve or by private banks. It is a question of whether the Federal Reserve itself should create the money, in which case it would return the interest to the Treasury, or whether it should instead make it possible for the private banks to create the money, in which case the interest payments go into bank profits.
111) ‘What is more, when private banks acquire Government securities, the taxpayers not only have to pay the interest on these securities over all the years the securities are outstanding, but, if and when the Federal debt is ever reduced, the taxpayers will also have to repay the principal amount of these securities.
112) On the other hand, it is unlikely that the total money supply of the country will ever be reduced substantially, and, therefore, unlikely that there will ever be any need to reduce bank reserves. This being true, the $20 billion of Government debt would remain permanently in the hands of the Federal Reserve-and the taxpayers would not be called upon to pay either the interest or the principal.
113) In a sense the Government has paid off its debt when the Federal Reserve acquires the security. Specifically, the Government, in effect, exchanges a non-interest-bearing obligation for an interest-bearing obligation when the Federal Reserve acquires a Government security. We will demonstrate this in the next two questions.
114) What is the amount of U.S. Government securities owned by the Federal Reserve System?
As of January 31, 1964, the Federal Reserve System owned U.S. Government securities amounting to $32,753 million.
115) How is the Government paid for the securities purchased by the Federal Reserve?
When the Federal Reserve buys Government securities, it pays for them by giving some bank or banks credit on their reserve accounts. The banks may take these credits in cash-that is, Federal Reserve notes -- at any time they care to do so. The amount of Federal Reserve notes which the Federal Reserve has issued and has outstanding is approximately equal to the amount of Government securities it owns. On January 31, 1064, the Federal Reserve had $33.9 billion in Federal Reserve notes outstanding which had been used for its $32.8 billion of Government securities, plus some part of the gold which the Treasury has acquired. In addition, there was $17.5 billion in bank reserves on the books of the Federal Reserve banks which the banks can convert to Federal Reserve notes if they care to do so. In other words, by buying Government securities, the Federal Reserve System has, in the long run, exchanged a non-interest bearing obligation of the Government (a Federal Reserve note) for an interest-bearing obligation of the Government (a Government bond or other interest-bearing security).
116) What amount of Government securities have the private banks acquired with bank-created money?
On January 31, 1964, all commercial banks in the country owned $62.7 billion in U.S. Government securities. The banks have acquired these securities with bank-created money. In other words, the banks have used the Federal Government’s power to create money without charge to lend $62.7 billion to the Government at interest. However, it is not possible to say what part of the total amount of money the commercial banks have created has been used to acquire Government securities. After a bank creates the money to buy a Government security, it may then sell the security and use the money to acquire a non-Government security or to make loans to its customers. On January 29, 1964, commercial banks had total assets amounting to $304.7 billion, and all of these had been paid for with bank-created money, except $25.4 billion which had been paid for with their stockholders’ capital. In other words, less than 10 percent of the banks’ assets have been acquired with money invested by stockholders in the banks.
117) If the Government can issue bonds, why can’t it issue money and save the interest?
A few clearheaded and firm individuals, such as Abraham Lincoln, have insisted that the Government can. The late Thomas A. Edison once stated the matter this way:
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118) If our Nation can issue a dollar bond it can issue a dollar bill. The element that makes the bond good makes the bill good also. The difference between the bond and the bill is that the bond lets money brokers collect twice the amount of the bond and an additional 20 percent, whereas the currency pays nobody but those who contribute directly in some useful way. It is absurd to say that our country can issue $30 million in bonds and not $30 million in currency. Both are promises to pay: But one promise fattens the usurers, and the other helps the people.
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119) To a small extent the Government does issue money, to buy back the bonds it has already issued, through the Federal Reserve System. However, it has long been one of the political facts of life that private banks must be allowed to create the lion’s share of the money, if not all of the money. Thus there is little opposition to the Government’s printing bonds and then permitting the banks to create the money with which to buy those bonds; but proposals that the Government itself create the money instead of the bonds have always set off tremendous political upheavals. Bankers are politically very powerful, even in wartime. For example, Abraham Lincoln set off a political furor when he insisted upon having the Government issue $346 million in money (the so-called greenbacks) instead of issuing interest bearing bonds and paying interest on the money.
120) What would the Government have paid in interest costs if the “greenbacks” issued in Abraham Lincoln’s administration had been issued as bonds?
Abraham Lincoln’s administration issued a total of $450 million in “greenbacks,” or “U.S. notes,” as it was authorized to do by an act of February 25, 1862. If instead of issuing “greenbacks,” the Lincoln administration had issued interest-bearing bonds, as urged, naturally, these bonds would still be a part of the Federal debt today. Assuming that the Government had paid an average 5-percent interest a year on this amount of bonds, it would have paid out $2.3 billion by 1964, or approximately five times the amount of money the Government would have borrowed. It is a fallacy to think, as many do, that the “greenbacks” were inflationary. In the only sense that matters, the relative or comparative sense, they were not. That is, $450 million in “greenbacks” is no more or less inflationary than $450 million in bank deposits or any other bank money created to pay for $450 million in interest-bearing bonds.
121) If the Government issued more money instead of Government bonds isn’t there a danger that the Government would issue too much money and cause inflation?
Once again, it is no less inflationary for the private banks to create $1 billion of new money to buy $1 billion of bonds than it is for the Government to create $1 billion of new money. Furthermore, an agency of the Government, the Federal Reserve System, decides in any case the total amount of money to be created, and this is what determines whether we have inflation.
122) What ‘is “printing press money”?
All money used in this country and in most countries of the world is of two types. One is “printing press money,” which is money printed by the Government. The other type of money in use is “pen- and-ink money.” Pen-and-ink money is created by the private commercial banks each time a bank makes a loan, buys a U.S. Government security, or buys any other asset. Printing Press money is engraved on special paper and with special inks; and It costs about eight one thousandths of 1 cent per bill, whether a $1 hill or a $10,000 bill. Pen and ink money is created by a private banker simply by making ink marks on the hooks of the bank. However, in recent years many of the banks have installed electronic office machines which make the entries in the banks’ books; so someday we may come to refer to bank created money as “office machine money” or perhaps “Univac money.”
123) When commercial banks don’t create money to buy Government bonds, where does the purchase money come from?
When an individual or a business firm other than a commercial bank buys a Government bond, or any other security, the money comes out of savings. In other words, no new claims to wealth are created and the money spent by the borrowers is money saved by the lenders.
124) As we have previously pointed out, only the Government and the private commercial banks create money. Money lent by individuals, insurance companies, mutual savings banks, building and loan associations, credit unions, and industrial and commercial firms comes out of savings. Whatever individuals and these firms lend reduces the amount which they have left to spend.
125) What determines how much of their reserves the banks will take out in cash?
No bank would normally take its reserves in cash except to the extent that it has to do so in order to meet the demands of its customers for cash, and, of course, to have a small amount of cash on hand so as to be able to meet its customers’ demands on a day-to-day basis. Historically, the reason why the banks do not like to take their reserves in cash is that for each dollar they reduce their reserve accounts by taking cash, their privilege of creating money, to acquire income producing assets, is reduced.
126) What would happen if the customers of a bank all demanded to have their deposits in cash?
The bank would be in much the same difficulty that the goldsmith bankers got into when their customers came in and demanded the gold. As we have seen, in the average bank today, customers’ claims for cash -- that is, their deposit balances amount to about seven times the bank’s reserves. Even if the bank drew out all of its reserves in cash, it would have only one-seventh enough money to pay its depositors.The difference between a member bank of the Federal Reserve System and the goldsmith bankers, however, is that the Federal Reserve will come to the rescue of a bank which gets into such a difficulty and lend it enough reserves to pay off its customers.
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