CHAPTER III

HOW IS MONEY CREATED?

41. What is the fractional reserve method of banking?
The fractional reserve method of banking originated with the goldsmiths—the predecessors of our present bankers. It is the method of banking in use today. Briefly, it is a system whereby bankers maintain as reserves only a fraction of the amount needed to meet all the claims against them. (The vast bulk of the claims against the banks are the deposits you and I hold. These are obligations which the bank must pay upon our demand.) The goldsmiths struck upon this method by noticing that the people who deposited gold with them for safekeeping only claimed a small portion of this gold at any one time. Therefore the goldsmiths realized that they could lend out a good portion of the gold left with them. They then made loans, which in fact were not of gold but warehouse receipts for gold. These receipts circulated as money. Notice, the gold—actually the certificates of ownership—being loaned by the goldsmith was not his to lend. He did not own it. In other words, the goldsmith wrote receipts to people who were not depositing gold, i.e., to borrowers. So receipts for more gold than the goldsmith actually had in his vaults were circulating. The goldsmith had only a fraction of the amount of gold needed to meet the claims against him. This is the fractional reserve system. When the banks of the United States kept their reserves in gold, their reserves amounted to only a small fraction of the amount of money they had issued, all of which was guaranteed to be redeemable in gold.

42. What are the advantages of the fractional reserve system?
Fractional reserves provide banks with a source of funds which they may invest in sound economic projects, and thus encourage business activity and economic growth.

43. What is the major weakness of the fractional reserve system?
Since no bank can meet all the claims on it at any one time, fractional reserve banking leaves individual banks vulnerable to runs. This is why a system of central bank reserves—with facilities to lend and transfer reserves in time of need—is necessary.

44. What are reserves in modern American banking?
Reserves in modern American banks are deposits—demand deposits—held by commercial banks at the Federal Reserve.

45. Where did the commercial banks obtain their reserves?
By and large the bulk of commercial bank reserves were created by the Federal Reserve and credited to the account of the various commercial banks which are Federal Reserve “member” banks. The Federal Reserve creates these reserves just as a bank creates checkbook money. By various devices, either loans or other means, the Federal Reserve credits a bank with bankers deposits—“reserves.”

46. Who determines how much checkbook money a bank can create on the basis of its reserves?
The Federal Reserve System sets reserve requirements; that is, the ratio of reserves to deposits that the individual member banks must maintain. This in turn determines how many loans a bank can make, and how many securities it can buy.

47. Where does the Federal Reserve get the money with which to create bank reserves?
It doesn’t “get” the money, it creates it. When the Federal Reserve writes a check, it is creating money. This can result in an increase in bank reserves—a demand deposit—or in cash; if the customer prefers cash he can demand Federal Reserve notes, and the Federal Reserve will have the Treasury Department print them. The Federal Reserve is a total moneymaking machine. It can issue money or checks. And it never has a problem of making its checks good because it can obtain the $5 and $10 bills necessary to cover its check simply by asking the Treasury Department’s Bureau of Engraving to print them.

48. Who gave the Federal Reserve the power to create the money necessary to cover its checks?
The Congress. Because this power to create money is given by the Constitution to Congress, only the Congress can delegate this power. And this it has done in creating the Federal Reserve System—an agency of Congress authorized to create money.

49. How does the Federal Reserve change the money supply?
First, by increasing or decreasing the amount of bank reserves which the member banks of the Federal Reserve System have to their credit on the books of the Federal Reserve banks. Second, by regulations which tell the member banks the maximum amount of bank deposits they may create per dollar of reserves.

50. What is the formula that determines the maximum amount of money available to business and consumers?
Expressed mathematically this is a simple formula A x B = C where: A = Amount of bank reserves; B = Number of dollar deposits member banks may create per each dollar of reserves; and C = Total bank deposits.

51. Can the Federal Reserve authorities change the money supply formula?
Yes. They can change either or both parts of the formula at anytime and they frequently do change one or both parts. There are certain limits set by time Federal Reserve Act to the changes the authorities can make. But these limits are extremely wide.

52. Does it make any difference which part of the formula the authorities change when they wish to increase the money supply?
Yes. Although the effect on the money supply of changing either part of the formula may be the same, the total economic effects differ depending on which part of the formula is changed. For example, when the Federal Reserve lowers reserve requirements, all of the new money is created by the commercial banks through their lending and investing activity. This obviates the necessity of transferring Government securities from private to public hands. On the other hand, when the Federal Reserve increases reserves by, say, purchasing U.S. Government securities, the interest income on these securities goes to the Federal Reserve System. Since the Federal Reserve turns over to the U.S. Treasury most of its earnings, the net effect of increasing the money supply by increasing reserves is to favor the private banking system. So, when the Federal Reserve officials decide to increase the money supply, whether they favor the U.S. Treasury or the private banks does make a difference—millions of dollars of difference—in the amount of taxes you, I, and all other taxpayers must pay.

53. As bank reserves rise do private banks “deposit” their reserves with the Federal Reserve?
Collectively, private banks do not deposit a penny of their own funds, or their depositors’ funds with Federal Reserve banks. Reserves are transferred from bank to bank, but nothing the banks can do will increase the total amount of reserves in the system. Practically, only the Federal Reserve System itself can do this or to permit it to occur from a gold inflow. Increasing or decreasing reserves is a conscious act of the managers of the Federal Reserve.

54. How does the Federal Reserve create and destroy bank reserves?
By four methods: (1) by open market operations; (2) by gold purchases for the U.S. Treasury; (3) by loans to commercial banks; and (4) by purchases of eligible paper from member banks.

55. What are open market operations?
They are the Federal Reserve’s purchases or sale of U.S. Government securities in what is called the “open market”—in order to expand or contract bank reserves and hence the supply of money and credit available. The Federal Reserve Bank of New York conducts these transactions as agent for the entire system.

56. What is the “open market”?
It is composed of about 20 private dealers of U.S. Government securities with whom the Federal Reserve Bank of New York trades. Several of these dealers are big New York and Chicago banks.

57. How much in bank reserves has been created by the Federal Reserve?
The answer was given in early 1960 by Chairman Martin of the Federal Reserve Board. Between the end of 1917 and the end of 1959, the Federal Reserve System had created gross additions to bank reserves amounting to a total of $46 billion. Over the years, the banks had drawn down their bank accounts by $28 billion by taking out currency (which was printed to meet their requests), leaving them with a net reserve balance of $18.5 billion.

58. How does the Federal Reserve create bank reserves by open market operations?
The step-by-step details are as follows: Let us assume that the Federal Reserve Bank of New York, acting as agent for the whole System, buys a $1,000 Government bond in the “open market.” It gives the bond dealer a check for $1000 drawn on the Federal Reserve Bank of New York. The dealer will, of course, deposit this check in his checking account, say, with the Chase Manhattan Bank. The Chase Manhattan credits the dealer’s checking account with $1,000 and then sends the check to the Federal Reserve Bank of New York for payment. The Federal Reserve Bank of New York makes payment to the Chase Manhattan by crediting its reserve account with $1,000.

59. For whom does the Federal Reserve purchase or sell gold?
For the U.S. Treasury.

60. Where does the gold come from?
The gold is either newly mined or else comes from foreign central banks.

61. Why does the Treasury buy gold?
To add to the Nation’s monetary gold stock and assure us enough gold to meet any claims from foreigners who hold dollars.

62. Do banks have an automatic right to borrow from the Federal Reserve bank?
No. Member banks of the Federal Reserve System are eligible to borrow. But being eligible and obtaining a loan are two different things.

63. How are Federal Reserve loans to banks secured?
The law permits a Federal Reserve bank to accept a variety of good collateral to secure its loans. In practice, however, banks borrowing from the Federal Reserve System almost always put up U.S. Government securities as collateral.

64. Do the banks of the Federal Reserve System pay for their reserves?
No. Bank reserves cannot be paid for by private banks. They can be shifted from bank to bank after they are created. But to all intents only the Federal Reserve System itself can create or extinguish reserves. Indeed, when the Federal Reserve creates bank reserves this permits the banks to increase their loans and augment their profits.

65. How do currency and coin enter the money supply?
The proportion of currency and coin in circulation to the total money supply is pretty much automatic. It normally amounts to about 20 percent of the money supply, with bank deposits accounting for the other 80 percent.

66. Who determines how much currency and coin is issued?
Given the total money supply depends on the behavior of individuals and business firms. The amount of currency and coin in circulation depends on how convenient individuals and business firms find currency and coin rather than bank deposits in carrying on trade. As indicated, normally currency and coin make up 20 percent of the money supply.

67. Who determines how much checkbook money shall be created?
A committee made up of the members of the Board of Governors of the Federal Reserve System and the Presidents of the 12 Federal Reserve banks make this decision. The Open Market Committee—as it is called—decides only what the maximum amount of money maybe; it cannot determine the maximum amount which will actually be created. Money is actually created when private banks make loans or investments. In terms of the formula the Open Market Committee determines “A” and “B.” “C” represents the maximum value the money supply can reach.

68. Can Federal Reserve officials help the U.S. Treasury and U.S. taxpayers without increasing the money supply?
Yes. They can create more reserves by buying more Government securities in the open market and by raising reserve requirements for the member banks. This means that, for any given supply of money, the Federal Reserve would own more Government securities and the private banks would hold correspondingly less. This would not entail any change of the money supply. In terms of the formula, “A” would be raised “B” would be lowered, and they would just offset each other so that “C” would remain the same.

69. If the Government can issue bonds, why can’t it issue money and save the interest?
A few clear-headed and firm individuals, such as Abraham Lincoln, have insisted that the Government should.

The late Thomas A. Edison stated the matter this way: If our Nation can issue a dollar bond it can issue a dollar bill. The element that makes the bond good makes the bill good also * * * .
It is absurd to say that our country can issue $30 million in bonds and not $30 million in currency. Both are promises to pay: but one promise fattens the usurer and the other helps the people.

However, it has long been one of the political facts of life that private banks must be allowed to create the lion’s share of the money, even if not all of the money. Thus there is little opposition to the Government’s printing bonds and then permitting the banks to create the money with which to buy those bonds; but proposals that the Government itself create the money instead of the bonds have always set off tremendous political upheavals. For example, Abraham Lincoln set off a political furor when he insisted upon having the Government issue $346 million in money (the so-called “greenbacks”) instead of issuing interest-bearing bonds and paying Interest on the money.

70. If the Government issued more money instead of Government bonds, isn’t there a danger that the Government would issue too much money and cause inflation?
No. It is no more or no less inflationary for the private banks to create $1 billion of new money than it is for the Government to create $1 billion of new money. Furthermore, as an agency of the Government the Federal Reserve System, decides in any case the total amount of money to be created.