What I didn’t know about money in the USA

I distinctly remember watching a “cartoon” that explained about money in the USA. The cartoon was probably made in the late 1940’s to early 1950’s. In the cartoon, it explained how when the public put their money in the bank in savings, the bank would in turn, either loan the money to business’s or to investors that in turn loaned money to businesses. It stressed very clearly how, in order for business to expand, investment was needed from the public via savings. Of course, the public could side-step the bank and invest directly, but that wasn’t the norm in 1947. The moral seemed to be that banks needed the money saved by its patrons in order to make loans. About two weeks ago, at the age of 46, I learned that it was not true. Banks do not loan out the money they take in from savings. Tied to that reality then, is just how money is “made” in the USA these days. Before I go on too far, understand that I am still figuring this all out in my head, I am not in finance for a living. My advice is to read this and look elsewhere to see if it can be disproved.

The Federal Reserve System
The Federal Reserve System is a “tightly held” private corporation. In order to become a part owner you must be a nationally chartered bank. In reverse then: the US Federal Reserve is OWNED by banks. The Federal Reserve or “The Fed” is broken up into twelve districts; banks in each district then determine the money supply for their district. Before we go much further we need to mention the US Treasury. The Treasury actually “prints” or “coins” the cash money. The Treasury is run by the US government. Banks make a request to the Treasure for money, and the Treasury supplies the cash money. But estimates are that only 2% of the US money supply is in “cash”. So where is the other 98%???

Banking 101 in 2009
For a bank to be a member of the Fed they must put up capitol, a pool of money deposited with the Fed. The bank earns 6% interest on that money and they are then allowed to loan out 9 times the amount held at the Fed. Its that “9 times” bit that caught my eye. First question to ask is; in a time that banks are loaning money at 5.5% interest for houses, why would they do that when they can get a guaranteed 6% with the Fed with zero risk? They wouldn’t and they don’t. The banks want to keep as much cash as possible on deposit with the Fed so that they can multiply its effects by that 9-times figure. Well if a huge percentage of their patron’s money is itself on deposit with the Fed, then where does the money come from that banks loan? Basically thin air. The bank is allowed to loan money it does not have, up to 9 times what is on deposit with the Fed. The money does not exist until a potential borrower comes in to borrow the money. When the loan “go through” the borrowers account is credited with the amount of the loan. If need be the bank simply calls up the Fed, and asks for some paper cash. The Fed charges a small printing fee (7 cents per bill) and the money is sent to the bank. But the real “money” does not exist or if it does then it exists “as debt”. Welcome to the new world. Money = debt (of someone else). Now for myself, I think they went too far, but here is what I understand their thinking is.

The money supply (available credit) should be equal to the current money supply plus productivity for some period plus some percentage (lets say 2%). So when you hear the nightly news tell that the US government has declared that the US productivity has risen by 2% for the last quarter (three months) that means there was 2% rise goods and services. Banks then can loan what is already out plus 2% plus 2% or four percent, as long as it is under the 9 times factor that any one bank has on deposit at the Fed. What does it cost the bank to loan money? As far as I can tell NOTHING. (Not entirely true, the member banks must give 3% of revenues to the Fed) A 5% loan is means a 5% (100% of the 5%) profit on whatever amount was loaned. Given that, a bank would be stupid to loan out money that patrons put in savings! Instead it deposits that money with the Fed and loans out free money available to it via Fed rules.

I would doubt all this, except how would one explain that banks loan out money 5%(risky) at less than what the Fed will give 6%(zero risk) and that banks will only pay 1% or 2% on deposits. There is no way that deposits equal loans in the US. All this makes for certain results. For example, in good times when there is productivity, the money system can supply all the money needed to continue to fuel a robust and growing economy. But when productivity shrinks the system does not work so well. It does not like contractions, or even non-growth. With out borrowers, the money supply cannot grow. This is why congress agreed to borrow the money. Borrowing money “creates” money, and experts hope to “jump-start” the system by having the government itself borrow money. Unfortunately for the tax payers, we have to pay it back plus interest.

The system also creates inflation. My understanding is that the experts seem to think that a small amount of inflation is a good thing. This is probably because the looseness of the money allows for even only marginal businesses to try their hand in the market. From what I have read if inflation is equal to productivity then you’re pretty much at a wash. 2% inflation for 2% growth would mean you simply stayed in the same place economy wise. But for those holding on to money any inflation means you lost purchasing power of your money for that time period. Only if your productivity rose by as much as inflation would you make any gains. By having a 9 to 1 ratio and by allowing loans to exceed money supply by 2% inflation is guaranteed. The scary thought being that those number may be determined by the Fed, and thus I assume they can be changed also!

And then the housing bubble came...