By Franklin Sanders
The ongoing financial crisis has spawned a tempest of talk about credit, bank reserves, loans, bad loans, savings, and the banking racket in general. As I mused on all that, a light bulb came on in my brain: all credit is not equal. Neither are the children of credit.
Lending real money
When silver & gold money – real money – are used, credit (loans) can only be extended out of savings. The lender lends, and the borrower borrows, money. Substance. Real stuff. Even under our fiat money system, we are in a similar situation.
If you ask me to borrow twenty bucks, I can’t lend it to you unless I first have saved it in my pocket.
What happens when the loan is made? No loan made out of savings increases the money supply. The loan merely causes the money to change hands. The money supply remains unchanged.
What happens when the loan is paid off? Money is returned to the lender. The money supply remains unchanged.
What happens when the borrower defaults?
The lender loses his loan, and his net worth is reduced by the amount of the loan. The lender suffers a genuine loss.
Lending fiat money
Our system works completely differently. When fractional reserve banking makes loans, it creates the credit out of thin air. The bank does NOT lend money: it lends its credit, something altogether different.
Think about how the loan is made. Joe Blow goes to the bank and asks for a $25,000 loan to buy a pickup. Shirley, the loan officer says, “Joe, you’ve always been a faithful bank customer. You’ve always paid your loans on time, so we’ll be glad to make the loan.”
Shirley turns around, picks up the telephone off her credenza, and calls upstairs to Louise in accounting. “Louise, our good customer Joe Blow wants to borrow $25,000. Please credit his account with the loan.”
Under Liabilities in the bank’s books, Louise enters “$25,000” in Joe Blow’s checking account. Under “Assets” she makes another entry, namely, “Loan for $25,000 to Joe Blow.” By the miracle of double entry bookkeeping, the bank’s books still balance.
But what did the bank lend to Joe Blow? Not money, but credit, the bank’s credit. No bank employee went into the safe, wrote up a “cash-out” ticket for $25,000, counted out $25,000 in hundred dollar bills, and took it upstairs to Joe Blow – any more than when you deposit $100, they put the bill in an envelope, write your name on it, and place that securely in the vault.
Where was the money five minutes before Joe Blow asked for the loan?
Nowhere. It didn’t exist.
The bank created the loan, out of thin air, by double entry bookkeeping, and with it, created the “money.”
The loan increased the entire money supply by $25,000. Bank credit forms the largest part of the money supply; every loan increases the money supply.
Banks did not lend “money,” not even currency in the form of green Federal Reserve notes. Banks loan their credit, which circulates in the United States as a form of privately created money. Do you doubt it? You take checks, don’t you?
Checks are not money; they are only orders to transfer credit on the bank’s books. Sure, a very few checks are cashed, and banks keep a very little bit of “cash” on hand, but that’s only the veneer that makes the system appear solvent and respectable.
The vast majority of transactions are credit for credit.
Therefore, a bank cannot “lose money” in the sense that any other business “loses money,” because a bank is creating the very money (“credit”) that it lends out. If someone fails to repay a loan to a bank, it makes a difference on the bank’s ledger, but in fact the bank hasn’t “lost” anything because its ability to create credit approaches the infinite, and that credit costs it nothing. The bank only gets into trouble when its balance sheet doesn’t meet legal regulations, but no bank is “solvent” in the sense of an ordinary business, i.e., able to pay every liability it owes.
Bank capital requirements serve only as a regulator, a safety valve, to keep the system from exploding.
Therefore to apply the standards of ordinary accounting to banks is like applying the sizing of women’s dresses to elephants — makes no sense at all. Unless they borrow credit from another bank, they actually have no “cost of funds” other than the expense of hiring accountants,buying computers, and building fancy buildings.
Nor is the bank’s profit accurately measured by the difference between what it pays for credit and what it charges for loans. Rather, the bank’s profit is that, plus the value of all the credit it creates and then pretends is money.
What I mean is, the principal of the loan represents a real profit to the bank. That is the value of its government-created franchise to operate.
So let’s clear things up. Under our fractional reserve, fiat money system: What happens when the loan is made?
No “money” changes hands. The bank lends its own credit, creating that credit out of thin air. (Remember “credit” comes from the Latin credo, I believe. It’s not really money, although we all believe it is.) This is what I mean when I keep saying that “all our money is borrowed into existence.” The bank, which collects both principal and interest, is enriched by payment of both principal and interest. Remember that the borrower must somehow rustle up both principal and interest to repay the credit the bank lent him. The borrower puts up, and pays, real collateral for the banks imaginary credit.
What happens when the loan is paid off? The money supply is reduced. Therefore, the debt must be perpetual (in aggregate for the economy), and perpetually growing, or the system will sink into deflation.
There’s another reason for the national debt. What happens when the borrower defaults? The bank suffers no actual loss, only a bookkeeping loss, since it created its credit out of thin air under permission of a government privilege (banking license), but the borrower is bound to the bank for the amount of the credit lent him.
And thus by legal fictions, by artificialities, by nothings, by government privilege, an entire nation has been brought into debt slavery, poverty, and periodic nation-sweeping economic terrors.
Savings? Not needed
If loans must be made out of savings, then it makes sense to worry about how much people are saving (“savings rates”). Under that system, banks are intermediaries, the go-betweens, who find savings that savers temporarily don’t need and lend those savings to borrowers. But when banks operate on a fractional reserve, hardly any savings at all is necessary.
Savings aren’t being lent, credit is. Of all the money deposited, banks only keep a fraction in reserve, and they create the credit.
The banks’ ability to create money out of thin air – whoops! Make that “create credit out of thin air” — is only limited by the government-decreed reserve requirement.
For instance, a 10% reserve requirement requires banks to keep on hand as reserves against customer withdrawals one-tenth of the dollars deposited with them. If a depositor brings in $100, the bank must keep $10 “in vault” against that deposit. (In practice, they maintain the reserve as a tiny amount of vault cash and the bulk as reserves at the Federal Reserve Bank, but that makes no difference to our discussion.)
The truth is much more gruesome, and preposterous.
The reserve requirement is nowhere near ten percent. Before the Federal Reserve stopped publishing M3 money supply statistics, I used to calculate the reserve requirement for the entire banking system. From 1999 to 2002, it hovered around 0.7% (7/10 of one percent).
• For every one hundred dollars deposited in the banking system, banks must keep in reserve about 70 cents [sic].
* For every $100 deposited in the banking system, banks can create $14,285.71 in credit (loans).
Obvious by now
By now it has become obvious, dear reader, why the United States has a banking crisis. The banks have every incentive to lend without restraint, so they do. The economy is a casino where the banks are manufacturing chips and running the game. The villain, as I have said before, is the central banking system which enables and manages the fractional reserve system.
What is not, obvious, of course, is why we have this system. Why have private corporations been granted the privilege of creating credit out thin air, and charging the people to lend it? Why has their money been given the force of legal tender? Why our people have been delivered over by law into servitude to the banks?
And why are the heads of bankers, central bankers, and politicians not smiling down at us from pikes at the city gates?
We live in a colossal replay of “The Emperor’s New Clothes,” but this is not a comedy but a tragedy.
Laugh, if you can, with gallows humour, as the politicians and central bankers and bankers discuss with great solemnity how the nation’s economy is at stake, and therefore the taxpayer must bail out the banks. How they must laugh when they gather in cocktail parties after the hearings, knowing what suckers we are, and what hypocrites they are!
So the Tapeworm is fed, while the host doesn’t recognize why he is dying.
Used by permission. Franklin Sanders is publisher of The Moneychanger, a privately circulated monthly newsletter that focus on gold and silver and the application of Christianity to economics, culture and family life. We have subscribed to this newsletter for more than 20 years, and consider it a must read. Franklin is an active trader in gold and silver (he’ll swap your green Federal Reserve rectangles and give you real money in return). He trades with savers and investors outside Tennessee. Subscribe to his daily price report and market commentary on the website.