Money Owed and Owned

We have developed a slide presentation we call "Money Owed and Owned" which is approximately 75 minutes in length. It is described in more mathematical detail in Part II of The Two Faces of Money.

The money creation system that we focus upon in both our slide presentation and our book (which is "debt-free" at point of issue) is based on the "Public Credit Money System" as laid out by Thoren and Warner in The Truth In Money Book.

Slides 22 through 34 of this slide presentation as well as our book The Two Faces of Money describes fractional reserve deposit expansion as being a part of our current "credit-as-money" system. However, relatively recent changes in banking practices requires a bit of additional discussion concerning "fractional reserve deposit expansion" which was laid out decades ago in Modern Money Mechanics, an informational workbook put out by the Federal Reserve Bank of Chicago. The opening paragraph is key to understanding the "deposit expansion" concept within a more "modern" adaptation of fractional reserve banking:

The purpose of this booklet is to describe the basic process of money creation in a fractional reserve banking system. The approach taken illustrates the changes in bank balance sheets that occur when deposits in banks change as a result of monetary action by the Federal Reserve System the central bank of the United States. The relationships shown are based on simplifying assumptions. For the sake of simplicity, the relationships are shown as if they were mechanical, but they are not, as is described later in the booklet. Thus, they should not be interpreted to imply a close and predictable relationship between a specific central bank transaction and the quantity of money.

Similar to our own explanation, well known economist Anna J. Schwartz offers the following explanation in an online article about the money supply, under the sub-heading titled What Determines the Money Supply:

If the Federal Reserve increases reserves, a single bank can make loans up to the amount of its excess reserves, creating an equal amount of deposits. The banking system, however, can create a multiple expansion of deposits. As each bank lends and creates a deposit, it loses reserves to other banks, which use them to increase their loans and thus create new deposits, until all excess reserves are used up.
If the required reserve ratio is 10 percent, then starting with new reserves of, say, $1,000, the most a bank can lend is $900, since it must keep $100 as reserves against the deposit it simultaneously sets up. When the borrower writes a check against this amount in his bank A, the payee deposits it in his bank B. Each new demand deposit that a bank receives creates an equal amount of new reserves. Bank B will now have additional reserves of $900, of which it must keep $90 in reserves, so it can lend out only $810. The total of new loans the banking system as a whole grants in this example will be ten times the initial amount of excess reserve, or $9,000: 900 + 810 + 729 + 656.1 + 590.5, and so on.

This explanation notwithstanding, former IMF economist Dr. Michael Kumhof cites numerous sources going back to 1969 stating that banks create loans first (creating deposits in the process) and look for reserves later. The implication, particularly for the "modern" era, is that the deposit expansion (or money multiplier) model provided by Modern Money Mechanics and other sources applies less to today's modern central banks, due to the fact that todays' economic environment requires central banks to be committed to supply as many reserves (and cash) as banks demand, and are relying on minimizing reserve requirements and maintaining low interest rates to do so. Technological advancements also play a role, more about which later.

Today, the Federal Reserve has no reserve requirements for banks with assets of less than $15.5 million, but irrespective of whether banks are constrained by central bank reserves requirements, they still must pay attention to reserves needed to maintain their own profitability and solvency. Hence the growing dependence on a separately functioning "split circuit" system of money circulation, described by Dr. Huber below, which explains how banks are increasingly able to "look for reserves later."

Manipulation of interest rates, along with the amount of available reserves and reserve requirements, are the primary methods by which central banks exert control over the credit-as-money creation system. In recent years, central banks are increasingly being forced to choose historically low interest rates as the prime method for dealing with an economy that has become dangerously overburdened by debt relative to money with which to pay off said debt. (Importantly, the dollar has been undergoing continuous and systematic devaluation due to accumulated and growing debt. This is precisely why a 1910 dollar could be used to obtain far more goods and services than the same dollar of today. It all has to do with the well known mathematical law of exponential increase, or as Economist and Historian Michael Hudson puts it, the "Law of increase.")

The Federal Reserve System utilizes two different interest rate mechanisms through which it controls the availability of credit aka "bank money." The first is the Fed Funds Rate which is "The interest rate at which banks and other depository institutions lend money to each other, usually on an overnight basis." The Fed Funds rates in turn "can be viewed as the base rate that determines the level of all other interest rates in the U.S. economy."

The second interest rate tool employed by the Fed is the Discount Rate, which is "the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility--the discount window." A Federal Reserve essay on monetary policy explains that "When the Federal Reserve lends [through its discount window], all else equal, the total amount of deposits of depository institutions increases."

This same essay also says that "an increase in the Federal Reserve's holdings of securities also raises the level of deposits [reserves] of depository institutions."

During the past several years the Fed has acquired several trillion dollars in securities through its various "QE" programs, which it is slowly "unwinding" through its tapering program, thus reducing acquisition of securities which are in turn used as "reserves." In addition the Fed's interest rate policies have kept the Fed Discount Rate at roughly double the Fed Funds Rate, which then means that member banks will do what they can to avoid borrowing from the Fed's "discount window."

Essentially the Fed is utilizing this interest rate policy as a means by which to encourage banks to get more money aka "bank money" into circulation. Externally imposed reserve requirements have become almost a non-issue particularly for smaller banks (which tend to serve the main street economy). Thus as Kumhof concludes, "the quantity of reserves in modern banking has become a consequence and not a cause of bank lending and money creation." Kumhof explains how this works.

Professor Joseph Huber, who is considered by many to be among the top monetary reform economists in the world, has added another element to discussions concerning how modern banking has shifted away from the 2-tier banking structure (fractional reserve or money multiplier model). The traditional explanation he says is dead wrong because it conceals an important fact about how the two tier structure actually now involves a "split circuit" of money circulation.

Echoing Dr. Kumhof and others, Huber asserts that "money" (or what he calls bank money) creation has been increasingly bank led, with the central bank adding reserves only when needed by the commercial banks. This trend has been developing over the last several decades as improving technology allows for speedier transfers of money.

As Dr. Huber explains, reserves represent the first tier or circuit of money circulation, which is completely separate from the second tier or circuit involving "demand deposits" (short term savings, checking accounts and so forth). Each circuit operates completely independently of the other, although the 2nd tier or circuit is, as of old, dependent on the first tier or circuit where "reserves" circulate back and forth between banks as they settle their accounts each day, this due to increased velocity permitted by modern technology.

Since the money represented by the first circuit (reserves) circulates much faster than "bank money" which is often parked in savings accounts, etc. in the second circuit, fewer reserves are needed to settle accounts than previously. Bottom line though, what Huber calls "bank money" has over the past one to two centuries very nearly driven out sovereign money. Huber's discussion, which includes a chart showing the gradual increase of "bank money" versus "sovereign money" over the last 100 years, is well worth watching.

Keeping in mind today's monetary crisis it may also be worthwhile to consider the still useful basic precepts taken from Modern Money Mechanics and other sources. Or as explained by Investopedia the "money multiplier effect" of reserve requirements is only a way to represent the possible impact of the fractional reserve system on the money supply. As such, while it is useful for economics teachers, it is generally regarded as an oversimplification by policy makers.

In terms of alternative money systems, we come down firmly on the side of the Jeffersonians, the late nineteenth century Populists and a very long line of others throughout our history in support of government-issued money, which needs to be debt-and-interest free at the point of issue. Although other alternative and "debt Free" money creation systems have been and are yet being proposed we chose the "Public Credit Money System" because we believe it to be tailor made for the American system of government. As stated elsewhere on this website, by far and away the best, most Constitutionally faithful and well-designed piece of legislation to have ever been introduced to Congress has been The NEED Act.