Banks create Money OUT OF THIN AIR

The battle to reform the American banking
system needs to include reimposing the
barrier between investment banking and
depository banking (Glass-Steagall), pay
incentives based on what is best for
Americans and not just the top executives,
the end of too big to fail, and other changes
which are frequently discussed by financial
writers. These are vital issues.

But there is more to the battle for reform
than you might know.

New York Versus the Rest of the Country

If you are happy with the banking system, and
don't think it needs to be reformed, then you
probably work for one of the banks
headquartered in New York.

Indeed, the banks outside of New York have
acted much more conservatively, used more
conservative capital ratios and less leverage
and gotten less involved in credit
derivatives and other speculative
investments.

Buy a banker in the Midwest a drink, and he
will probably rail against the giant New York
banks for causing the financial crisis,
costing the smaller, better run banks a lot
of money and huge fees, and driving many
smaller banks out of business.

And even within the Federal Reserve, what the
New York Fed and Bernanke are saying is
wholly different from what the heads of the
regional Fed banks are saying. The Fed banks
in Philadelphia and Kansas City and Dallas
and elsewhere disagree with what the New York
Fed and Fed's Open Market Committee are
doing. See this and this.

So the battle isn't between bankers versus
outsiders. It is between the giant New York
money-centered banks and the rest of the
country.

Reserve Requirements

Congresswoman Kaptur said last week:

We used to have capital ratios. We need
to get back to them. Ten to one. For every
dollar in your bank, you can lend ten. You
know what J.P. Morgan did? A hundred to one.
And then with derivatives, who knows how
much?

Remember, Milton Friedman - the monetary
economist worshipped as the guy with all of
the answers in the latter part of the 20th
century - advocated for 100% reserves.

Friedman has been deified as the economist to
follow. But his views on reserve requirements
have been completely ignored.

Goldman Using Taxpayer Dollars to Buy Stock
in China?

As everyone knows, Goldman became a "bank
holding company" in September, to be able to
access funds from the Fed at essentially zero
percent interest.

But in a new interview with Bill Moyers,
Simon Johnson noted that in August of 2009,
Goldman switched again - to a "financial
holding company".

What's the difference?

Johnson says that being a financial holding
company means that Goldman can borrow money
from the Fed at essentially no cost, and then
invest it in any thing it wants. For example,
Johnson says that Goldman has bought a large
share of the stock of a Chinese automaker.
Johnson says that if the investment succeeds,
Goldman will reap the profits; but if it
fails, the taxpayers are on the hook.

Banks Have the Power to Create Money

Congresswoman Kaptur also said last week:

Banks have the power to create money. And
decide how much that is worth.

What is Kaptur talking about?

Here Comes the Judge

Well, in First National Bank v. Daly (often
referred to as the "Credit River" case) the
court found that the bank created money
without having the reserves:

[The president of the First National Bank
of Montgomery] admitted that all of the money
or credit which was used as a consideration
[for the mortgage loan given to the
defendant] was created upon their books, that
this was standard banking practice exercised
by their bank in combination with the Federal
Reserve Bank of Minneaopolis, another private
bank, further that he knew of no United
States statute or law that gave the Plaintiff
[bank] the authority to do this.

The court also held:

The money and credit first came into
existence when they [the bank] created it.

(Here's the case file).

Nobel Economists, Congressmen, the Fed and
Treasury Agree

Still confused?

Well, let's hear from some top economists.

As PhD economist Steve Keen pointed out
recently, 2 Nobel-prize winning economists
have shown that the assumption that reserves
are created from excess deposits is not true:

The model of money creation that Obama.s
economic advisers have sold him was shown to
be empirically false over three decades ago.

The first economist to establish this was
the American Post Keynesian economist Basil
Moore, but similar results were found by two
of the staunchest neoclassical economists,
Nobel Prize winners Kydland and Prescott in a
1990 paper Real Facts and a Monetary Myth.

Looking at the timing of economic
variables, they found that credit money was
created about 4 periods before government
money. However, the .money multiplier. model
argues that government money is created first
to bolster bank reserves, and then credit
money is created afterwards by the process of
banks lending out their increased reserves.

Kydland and Prescott observed at the end
of their paper that:

Introducing money and credit into growth
theory in a way that accounts for the
cyclical behavior of monetary as well as real
aggregates is an important open problem in
economics.

In other words, if the conventional view that
excess reserves (stemming either from
customer deposits or government infusions of
money) lead to increased lending were
correct, then Kydland and Prescott would have
found that credit is extended by the banks
(i.e. loaned out to customers) after the
banks received infusions of money from the
government. Instead, they found that the
extension of credit preceded the receipt of
government monies.

Keen explained in an interview Friday that 25
years of research shows that creation of debt
by banks precedes creation of government
money, and that debt money is created first
and precedes creation of credit money.

As Mish has previously noted:

Conventional wisdom regarding the money
multiplier is wrong. Australian economist
Steve Keen notes that in a debt based
society, expansion of credit comes first and
reserves come later.

This angle of the banking system has actually
been discussed for many years by leading
experts:

.[Banks] do not really pay out loans from
the money they receive as deposits. If they
did this, no additional money would be
created. What they do when they make loans is
to accept promissory notes in exchange for
credits to the borrowers' transaction
accounts." - 1960s Chicago Federal Reserve
Bank booklet entitled .Modern Money
Mechanics.

.The process by which banks create money
is so simple that the mind is repelled.. -
Economist John Kenneth Galbraith

[W]hen a bank makes a loan, it simply
adds to the borrower's deposit account in the
bank by the amount of the loan. The money is
not taken from anyone else's deposit; it was
not previously paid in to the bank by anyone.
It's new money, created by the bank for the
use of the borrower. - Robert B. Anderson,
Secretary of the Treasury under Eisenhower,
in an interview reported in the August 31,
1959 issue of U.S. News and World Report

.Do private banks issue money today? Yes.
Although banks no longer have the right to
issue bank notes, they can create money in
the form of bank deposits when they lend
money to businesses, or buy securities. . . .
The important thing to remember is that when
banks lend money they don.t necessarily take
it from anyone else to lend. Thus they
.create. it.. -Congressman Wright Patman,
Money Facts (House Committee on Banking and
Currency, 1964)

"The modern banking system manufactures
money out of nothing. The process is perhaps
the most astounding piece of sleight of hand
that was ever invented. - Sir Josiah Stamp,
president of the Bank of England and the
second richest man in Britain in the 1920s.

Banks create money. That is what they are
for. . . . The manufacturing process to make
money consists of making an entry in a book.
That is all. . . . Each and every time a Bank
makes a loan . . . new Bank credit is created
-- brand new money. - Graham Towers, Governor
of the Bank of Canada from 1935 to 1955

Monetary reformers argue that the government
should take the power of money creation back
from the private banks and the Federal
Reserve system.

Indeed, PhD economist and candidate for
Florida governor Farid Khavari wants to
create a Bank of the State of Florida, to
create credit without burdening the state and
its citizens with high interest charges by
private banks.

The state of North Dakota already has such a
bank.

The bottom line is that monetary reformers
argue that letting banks create credit and
money and then charge high interest rates
creates massive levels of debt for states and
taxpayers. They argue that the power to
create money should be reclaimed by the
government and taken away from the private
banks.

Personally, I agree with the monetary
reformers. But even for those who think this
is too radical a proposition, the question is
whether a system where debt has to constantly
and continually expand to keep the economy
afloat is sustainable.

The Ever-Expanding Bubble

In a hearing held on September 30, 1941 in
the House Committee on Banking and Currency,
then-Chairman of the Federal Reserve (Mariner
S. Eccles) said:

That is what our money system is. If
there were no debts in our money system,
there wouldn.t be any money.

Indeed, Robert H. Hemphill, Credit Manager of
the Federal Reserve Bank of Atlanta, said:

If all the bank loans were paid, no one
could have a bank deposit, and there would
not be a dollar of coin or currency in
circulation. This is a staggering thought. We
are completely dependent on the commercial
Banks. Someone has to borrow every dollar we
have in circulation, cash or credit. If the
Banks create ample synthetic money we are
prosperous; if not, we starve. We are
absolutely without a permanent money system.
When one gets a complete grasp of the
picture, the tragic absurdity of our hopeless
position is almost incredible, but there it
is. It is the most important subject
intelligent persons can investigate and
reflect upon. It is so important that our
present civilization may collapse unless it
becomes widely understood and the defects
remedied very soon.

America's banking system needs to be
fundamentally reformed.