....The process by which banks create money was explained by the Chicago Federal Reserve in a booklet called “Modern Money Mechanics.” It states:
The actual process of money creation takes place primarily in banks.” [p3]
“[Banks] do not really pay out loans from 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 in exchange for credits to the borrowers’ transaction accounts. Loans (assets) and deposits (liabilities) both rise [by the same amount].” [p6]
“With a uniform 10 percent reserve requirement, a $1 increase in reserves would support $10 of additional transaction accounts.” [p49]
A $100 deposit supports a $90 loan, which becomes a $90 deposit in another bank, which supports an $81 loan, etc.
That’s the conventional model, but banks actually create the loans FIRST. (Picture how a credit card works.) Banks need deposits to clear their outgoing checks, but they find the deposits later. Banks create money as loans, which become checks, which go into other banks. Then, if needed to clear the checks, they borrow the money back from the other banks. In effect, they borrow back the money they just created, pocketing the spread between the interest rates as their profit. The rate at which banks can borrow from each other in the U.S. today (the Fed funds rate) is an extremely low 0.2%.
How the System Evolved
The current system of privately-issued money is traced in “Modern Money Mechanics” to the 17th century goldsmiths. People who left gold with the goldsmiths for safekeeping would be issued paper receipts for it called “banknotes.” Other people who wanted to borrow money were also happy to accept paper banknotes in place of gold, since the notes were safer and more convenient to carry around. The sleight of hand came in when the goldsmiths discovered that people would come for their gold only about 10% of the time. That meant that up to ten times as many notes could be printed and lent as the goldsmiths had gold. Ninety percent of the notes were basically counterfeited.
This system was called “fractional reserve” banking and was institutionalized when the Bank of England was founded in 1694. The bank was allowed to lend its own banknotes to the government, forming the national money supply. Only the interest on the loans had to be paid. The debt was rolled over indefinitely.
That is still true today. The U.S. federal debt is never paid off but just continues to grow, forming the basis of the U.S. money supply.
The Public Banking Alternative
There are other ways to create a banking system, ways that would eliminate its ponzi-scheme elements and make the system sustainable. One solution is to make the loans interest-free; but for Western economies today, that transition could be difficult.
Another alternative is for banks to be publicly-owned. If the people collectively own the bank, the interest and profits go back to the government and the people, who benefit from decreased taxes, increased public services, and cheaper public infrastructure. Cutting out interest has been shown to reduce the cost of public projects by 30-50%.
In the United States, this system of publicly-owned banks goes back to the American colonists. The best of the colonial models was in Benjamin Franklin’s colony of Pennsylvania, where the government operated a “land bank.” Money was printed and lent into the community. It recycled back to the government and could be lent and relent. The system was mathematically sound because the interest and profits were returned to the government, which then spent the money back into the economy in place of taxes. Private banks, by contrast, generally lend their profits back into the economy, or invest in private money-making ventures in which more is always expected back than was originally invested.
During the period that the Pennsylvania system was in place, the colonists paid no taxes except excise taxes, prices did not inflate, and there was no government debt........