A number of years ago, the central bank of the United States, the Federal Reserve, produced a document entitled “Modern Money Mechanics”. This
publication detailed the institutionalized practice of money creation as utilized by the federal reserve and the web of global commercial banks it
On the opening page the document states its objective. The purpose of this booklet is to describe the basic process of money creation in a fractional
reserve banking system. It then precedes to describe this fractional reserve process through various banking terminology.
A translation of which goes something like this:
-The United States government decides it needs some money.
-So it calls up the federal reserve and requests say 10 billion dollars.
-The FED replies saying: “sure, we’ll buy ten billion in government bonds from you”.
-So the government takes some pieces of paper, paints some official looking designs on them, and calls them treasury bonds.
-Then it puts a value on these bonds to the sum of 10 billion dollars and sends them over to the FED.
-In turn the people of the FED draw up a bunch of impressive pieces of paper themselves, only this time calling them federal reserve notes, also
designating a value of ten billion dollars to the set.
-The FED than takes these notes and trades them for the bonds.
-Once this exchange is complete, the government than takes the ten billion in federal reserve notes, and deposits it into an bank account.
-And, upon this deposit the paper notes officially become legal tender money.
-Adding ten billion to the US money supply.
And there it is! Ten billion in new money has been created. Of course, this example is a generalization. For, in reality, this transaction would occur
electronically, with no paper used at all. In fact, only three percent of US money supply exists in physical currency. The other 97 percent
essentially exists in computers alone.
Now, government bonds are by design instruments of debt. And when the FED purchases these bonds with money it essentially created out of thin air, the
government is actually promising to pay back that money to the FED. In other words, the money was created out of debt.
This mind numbing paradox, of how money or value can be created out of debt, or a liability, will become more clear as we further this exercise.
So, the exchange has been made. And now, ten billion dollars sits in a commercial bank account. Here is where it gets really interesting. For, as
based on the fractional reserve practice, that ten billion dollar deposit instantly becomes part of the banks reserves. Just as all deposits do. And,
regarding reserve requirements as stated in “Modern Money Mechanics”: “A bank must maintain legally required reserves equal to a prescribed
percentage of its deposits”. It then quantifies this by stating: “Under current regulations, the reserve requirement against most transaction
accounts is ten percent”. This means that with a ten billion dollar deposit, ten percent, or one billion, is held as the required reserve. While the
other nine billion is considered an excessive reserve, and can be used as the basis for new loans.
Now, it is logical to assume, that this nine billion is literally coming out of the existing ten billion dollar deposit. However, this is actually not
the case. What really happens, is that the nine billion is simply created out of thin air on top of the existing 10 billion dollar deposit. This is
how the money supply is expanded.
As stated in “Modern Money Mechanics”: “Of course they” (the banks) “do not really pay out loans for 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” (loan contracts) “in
exchange for credits” (money) “to the borrowers transaction accounts.” In other words, the nine billion can be created out of nothing. Simply
because there is a demand for such a loan, and that there is a 10 billion dollar deposit to satisfy the reserve requirements.
Now let’s assume that somebody walks into this bank and borrows the newly available nine billion dollars. They will then most likely take that money
and deposit it into their own bank account. The process then repeats. For that deposit becomes part of the banks reserves. Ten percent is isolated and
in turn 90 percent of the nine billion, or 8.1 billion is now available as newly created money for more loans. And, of course, that 8.1 can be loaned
out and redeposited creating an additional 7.2 billion to 6.5 billion… to 5.9 billion… etc…
This deposit money creation loan cycle can technically go on to infinity.
The average mathematical result is that about 90 billion dollars can be created on top of the original 10 billion. In other words: For every deposit
that ever occurs in the banking system, about nine times that amount can be created out of thin air.
Source: Modern Money Mechanics