Posted on 09/02/2011 7:50:17 PM PDT by Tolerance Sucks Rocks
A recent piece from Foreign Policy Journal’s Jeremy Hammond offers a rare analysis on how money is created in the nation’s financial system — and also why not to expect very much in the way of fiscal responsibility and spending cuts from Washington, D.C. any time soon.
The issue boils down to capital requirements — how much a financial institution must hold in reserve versus how much it can lend. Say the capital requirement for a financial institution is 10 percent.
Usually, one might think that means that for every dollar of capital, it can lend out 90 cents and 10 cents must be kept in reserve, and there is no increase in the money supply. This is the Jimmy Stewart version of banking.
But according to Hammond’s analysis, “banks don’t really loan currency that way.” Instead, keeping with the 10 percent capital requirement example, for every dollar kept in reserve, the bank or financial institution can create $9 to lend — out of thin air — with the dollar itself held in reserve.
If true, all common conceptions of prudential financial standards are thrown out the window. Then, the banks are practically speaking nine times larger than they would be under a conventional understanding of what a bank is. That is not a fractional system at all.
In fact, balance sheets — i.e. all the loans — are subject to multipliers beyond deposits, instead of a fraction of those deposits. The perversity of this standard cannot be overstated. It means the dollar is based on a debt standard. “Under this system, money is debt,” writes Hammond.
This explains how obscene amounts of leverage were fed into the system leading to the market crash of 2008. Firms like Bear Stearns and Lehman Brothers were overleveraged by factors as much as 30 to 1.
American Enterprise Institute scholar Edward Pinto found that Fannie Mae and Freddie Mac “only needed $900 in capital behind a $200,000 mortgage they guaranteed”. That’s leveraging by 222 to 1.
This is how treasuries are kept in reserve to serve as capital boosters. If an institution holds AAA-rated bonds, they can be used as collateral to leverage even more money to buy other financial instruments, or to make loans.
This is the manner that money is created under the Keynesian system. Everyone from a bank to an investment firm to an individual investor buying stocks on margin essentially has access to their very own printing presses.
That’s why the U.S. has over $50 trillion of total debts but only $6 trillion of savings deposits.
The more-than $13 trillion of mortgages are but the tip of the iceberg in terms of the total lending that is taking place. When all the financial instruments are compounded, the $700 trillion figure for the derivatives market projected by the Bank for International Settlements comes into full view.
According to Hammond, because when debts are paid, the money supply decreases — and thus is deflationary — “the Federal Reserve monetary system requires that the U.S. government never be able to pay off its debt.”
This is most likely why Keynesians are Keynesians — the only way the economy can grow under such circumstances is for yet more debt to be created. Why? Because debt repayment on a massive scale would result in rapid deleveraging that would destroy trillions of dollars of notional wealth.
Hence Congress’ preference for annual deficit-spending at the federal level, and the resistance to even small spending cuts.
This explains why the national debt has grown every single year since 1958. Lawmakers fear that debt repayment would cause a tremendous economic contraction beyond reckoning.
In other words, Congress is not allowed to cut spending.
But, if gargantuan amounts of debt were the recipe for prosperity, the U.S. would be living in an economic utopia right now. Instead, we are in a dystopian state of decline where the national debt grows by more than 10 percent but the economy is only growing at a little more than 1 percent.
Making matters worse, a recent study by Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard University found that “median growth rates for countries with public debt over 90 percent of GDP are roughly one percent lower than otherwise; average (mean) growth rates are several percent lower.”
That’s bad because at $14.684 trillion, the national debt is already 97.9 percent of the $14.996 trillion Gross Domestic Product. The effects of excessive debt are already being felt.
This is why the system of perpetual debt creation is unsustainable: 1) beyond certain levels of debt, the economy stops growing; and 2) soon the debt becomes so large it cannot possibly be repaid, making default the only option to restore the nation’s balance sheet.
Therefore an alternative system is needed. One that is sustainable, fosters long-term economic growth without requiring credit expansion, and does not give the power to create money out of thin air to a banking cartel.
Jeremy Hammond is to be applauded for bringing attention to just how overleveraging by financial institutions — the way money is created — is wrecking the economy. To get back on track, we need a return to sound money.
Robert Romano is the Senior Editor of Americans for Limited Government.
Watch “The Money Masters” DVD.
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Thanks for the facts. Great posted article.
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"Usually, one might think that means that for every dollar of capital, it can lend out 90 cents and 10 cents must be kept in reserve, and there is no increase in the money supply. This is the Jimmy Stewart version of banking. But according to Hammond’s analysis, “banks don’t really loan currency that way.” Instead, keeping with the 10 percent capital requirement example, for every dollar kept in reserve, the bank or financial institution can create $9 to lend — out of thin air — with the dollar itself held in reserve. If true, all common conceptions of prudential financial standards are thrown out the window. Then, the banks are practically speaking nine times larger than they would be under a conventional understanding of what a bank is. That is not a fractional system at all."
My understanding is that the banks do keep 10% in reserve and loan out 90% and that in itself creates new money. How? Because a large part of that 90% they loan out is deposited on demand, in other words the depositor can legally withdraw it while the bank cannot withdraw the loan it gave on demand. And that depositor will have money that at some point came from another 90% on deposit someplace else on demand and loaned out, and on and on. This is still worth reading. Explains how these bubbles and form.
It would probably be better if someone who knew what he was talking about wrote about these points. Too much of this article is meaningless, jargon-laden gibberish. Note that this has nothing to do with whether some of these points are true or false; it’s that they are neither right nor wrong because they make no sense.
And the article doesn’t even get to the full extent of this debacle: all of the “real” money is also debt, loaned out from the Federal Reserve!
...Not to cool on Federal regulation, but, in the case of Hedge funds and quick buy-sell stock marketeers, those turds need to be squeezed...
Which is why libs believe we can spend our way out of debt.
Of course they gloss over the fact in order to get more money back in to pay off our debt, overall debt has to go up even more.
Guess when the music stops, the one holding the most debt is the biggest loser.
The fractional reserve a bank has to hold varies depending on the size of the bank. Smaller banks may have to hold a higher percentage, bigger banks may be able to hold less as a percentage of deposits.
Thanks, and that makes perfect sense, Obviously when the contraction comes it doesnt help.
before long we're gonna be talkin about real money...billionaires will be worthless street bums...
too big to fail is becoming too big to survive with this political math...
I didn’t say it would help at all. If you didn’t get I think the whole scheme sucks, I guess I was too subtle.
What is the status of your reserve requirement after a capricious government sucks 5 or 10 Billion dollars out of your assets for following their orders?
Actually, it’s simpler than that.
The 90% the banks are allowed to mark as an asset that they can borrow against.
Foreign Policy Journal’s Jeremy Hammond is good and well worth reading.
Romano’s commentary, however, is a bit oversimplified. Romano’s thesis is absolutely correct: “The issue boils down to capital requirements”, but then he goes on to confuse reserves with capital.
Bank reserves are quite different from bank capital. Bank reserves are mostly currency in bank vaults plus deposits at the Federal Reserve Bank. These can be measured entirely objectively. Bank capital is trickier to quantify. On the bank’s balance sheet, bank capital is simply the sum of assets (bank loans net of loss reserves, securities, and other bank assets) minus liabilities (deposits, bonds, and other bank liabilities). The tricky part is in evaluating the appropriate value of those loans net of loss reserves and securities: should these values be based on historic cost and loss statistics or market value?
The extent to which the banks can create money is limited by both reserve requirements and capital requirements, which are entirely different constraints. At present, banks have abundant reserves: never in the history of banking have excess reserves been nearly as high as they’ve been in the past two years. Capital requirements, however, pose operating constraint on money growth. The fact is bank assets are not worth nearly as much in the market as the balance sheets indicate. In fact, many banks are technically insolvent: if they were liquidated, they would not be able to pay their depositors and other creditors. Absent capital, banks cannot lend money and their abundant reserves at the Fed remain sterile.
Bank reserves account for most of the stunning growth of M0, the monetary base, since the 2008 financial crisis. Seeing this truly unprecedented spike in M0, both monetarists and Austrian economists anticipated a spike in inflation rates which has not yet materialized. The reason rates have thusfar been modest is twofold: 1) the world economy is in a profound recession and 2) M0 growth is not the same as money supply growth. The banks cannot do their money multiplier magic with M0 until they have adequate capital. That’s one of the reasons that the Fed has purchased rotten securities from the banks and held down interest rates. By exchanging a security worth $20 for $100 in their Federal Reserve account and by borrowing at 0.05% and lending at 18%, the banks should be able to restore capital adequacy in short order. Taxpayers and savers get to pay the freight. Once bank capital is restored, Katy bar the door because the money aggregates are going to explode even with a historically conservative 10% capital ratio. Savers will see their purchasing power erode every month.
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