1Since the Federal Reserve only requires private banks to have 10% of the money they loan out actually on hand, isn’t the remaining 90% of money loaned by banks “created out of thin air?”

Private banks cannot create money, per se, they can only create loans.

When a bank loans money, it deposits the money in the borrower’s account (creating a liability for the bank as it’s responsible for the full amount deposited) and it receives an IOU (a loan) from the borrower (which is worth something, therefore, an asset for the bank.)

The loan, in turn, is a liability for the borrower (it has to be paid back at some point), and the money deposited in the borrower’s bank account becomes an asset for the borrower.

In accounting, each liability gets canceled out by each asset, so that happens here and no new money is created.

2Fine, but where does the remaining 90% of the money that is loaned out come from?

When people take out loans, they typically leave the money in the bank, only withdrawing just enough to pay for things over time. Because of this, banks are able to loan the same money they have out multiple times over.

3Ahh, now we’re getting somewhere! Since the banks can loan out up to 90% of the cash they have on hand, they could theoretically loan out a dollar 9 times over, creating $9 in loans out of 1 dollar!  That’s 8 dollars of CREATED money! The “Multiplier Effect!” Hah! How is that NOT new money?

It certainly looks like new money!

But, again, it’s not. The IRS doesn’t tax loans, so the money is not NEW money, it is money credited to accounts as loans. It’s private debt.

4OK, but aren’t all these new loans piling on top of each other creating one big Ponzi Scheme that will come crashing down someday, forcing all of us to revert back to gold?

Well, if the borrowers en mass suddenly couldn’t pay back their loans, well the bank could soon find itself in a pickle and could possibly go out of business.

But, there are a couple things to help minimize the chances of this happening.

For one, the 10% reserve rate that the banks have to hold on to in cash, which we just discussed, but that 10%, while offering a little help, wouldn’t do much if all the people started withdrawing their money at once, which takes us to point two.

The Federal Reserve guarantees depositors up to $250,000 if a bank goes belly up, so that at least minimizes the chances of a “bank run” happening since people won’t have to worry about their money disappearing.

But what really keeps everything afloat is that banks can borrow money from each other, and from the Fed, to make sure they have enough money to cover any new loans, or any cash that its customers want to withdraw. And the amount they can borrow is practically unlimited.

So, as you can see, the 10% requirement doesn’t really do much here, and doesn’t really influence the banks on how much money they loan out.

What banks care about is finding credit-worthy borrowers who will most likely pay back their loans. Once found, they then create the loan, credit the money into the borrower’s bank account, and they then borrow the money from another bank, or from the Fed, if they need to, to make sure that they can cover the loan.

So, when banks loan the same amount of money out many times over, is this creating NEW money?

No, it’s creating new loans.

For additional reading check out: Do Banks Create Money from Thin Air?

 

The government, though, DOES create money (out of “thin air” if people like using that derogatory term) and that money does not have to be paid back, it’s borrowed from no one.

When the government creates money, it gets it into the economy by paying people for goods and/or services, which in turn creates assets that benefit society as a whole. Things like the new roads, protecting the country via the military, maintaining parks, paying government employees and so on. It could pay for higher education for all (educated people are an asset) and even healthcare, if so inclined.

And when the government puts money out there that is “created from nothing”, i.e.: not borrowed – they we all end up with some nice assets in return! It’s a pretty nice transaction actually, because the money spent ends up equaling the nice assets we get in return. It’s pretty much a wash there as well!

The public ends up with something nice, and they didn’t even have to beg, borrow or steal for it!

Pretty cool, huh?

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