The Money Supply and the Federal Reserve System
(Part C)
by
Charles Lamson
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How Banks Create Money So far we have described the general way that money works and the way the supply of money is measured in the United States, but how much money is there available at any given time? Who supplies it, and how does it get applied? We are now ready to analyze these questions in detail. In particular, we want to explore a process that many find mysterious: the way banks create money. A Historical Perspective: Goldsmiths To begin to see how banks create money, consider the origins of the modern banking system. In the fifteenth and sixteenth centuries, citizens of many lands used gold as money, particularly for large transactions. Because gold is both inconvenient to carry around and susceptible to theft, people began to place their gold with goldsmiths for safekeeping. On receiving the gold, a goldsmith would issue a receipt to the depositor, charging him a small fee for looking after his gold. After a time, these receipts themselves, rather than the gold that they represented, began to be traded for good. The receipts became a form of paper money making it unnecessary to go to the goldsmith to withdraw gold for a transaction. At this point, all the receipts issued by goldsmiths were backed 100 percent by gold. If a goldsmith had 100 ounces of gold in a safe, he would issue receipts for 100 ounces of gold, and no more. Goldsmiths functioned as warehouses where people stored gold for safekeeping. The Goldsmiths found, however, that people did not come often to withdraw gold. Why should they, when paper receipts that could easily be converted to gold were "as good as gold"? (In fact, receipts were better than gold---more portable, safer from theft, and so on.) As a result, goldsmiths had a large stock of gold continuously on hand.  Because they had what amounted to "extra" gold sitting around, goldsmiths gradually realized that they could lend out some of this gold without running out of gold. Why should they do this? Because instead of just keeping their gold idly in their vault, they earned interest on loans. Something subtle, but dramatic, happened at this point. The goldsmiths changed from mere depositories for gold into banklike institutions that had the power to create money. This transformation occurred as soon as goldsmiths began making loans. Without adding any more real gold to the system, the goldsmiths increased the amount of money in circulation by creating additional claims to gold---that is, receipts, which entitled the bearer to receive a certain number of ounces of gold on demand. Thus there were more claims than there were ounces of gold. A detailed example may help to clarify this. Suppose you go to a goldsmith who is functioning only as a depository, or warehouse, and ask for a loan to buy a plot of land that costs 20 ounces of gold. Also suppose that the goldsmith has 100 ounces of gold on deposit in his safe and receipts for exactly 100 ounces of gold out to the various people who deposited the gold. If the goldsmith decides he is tired of being a mere goldsmith and wants to become a real bank, he will loan you some gold. You don't want the gold itself, of course; rather, you want a slip of paper that represents 20 ounces of gold. The goldsmith in essence "creates" money for you by giving you a receipt for 20 ounces of gold (even though his entire supply of gold already belongs to various other people). When he does, there will be receipts for 120 ounces of gold in circulation instead of the 100 ounces worth of receipts before your loan, and the supply of money will have increased. People think the creation of money is mysterious. Far from it! The creation of money is simply an accounting procedure, among the most mundane of human endeavors. You may suspect the whole process is fundamentally unsound, or somehow dubious. After all, the banking system began when someone issued claims for gold that already belongs to someone else. Here you may be on slightly firmer ground. Goldsmiths-turned-bankers did face certain problems. Once they started making loans, their receipts outstanding (claims on gold) were greater than the amount of gold they had in their vaults at any given moment. If the owners of the 120 ounces worth of gold receipts all presented their receipts and demanded their gold at the same time, the goldsmith would be in trouble. With only 100 ounces of gold on hand, people could not get their gold at once.  In normal times, people would be happy to hold receipts instead of real gold, and this problem would never arise. If, however, people began to worry about the goldsmiths financial safety, they might begin to have doubts about whether their receipts really were as good as gold. Knowing there were more receipts outstanding then there were ounces of gold in the goldsmith's vault, people might start to demand gold for receipts. This situation leads to a paradox. It makes perfect sense to hold paper receipts (instead of gold) if you know you can always get gold for your paper. In normal times, goldsmiths could feel perfectly safe in loaning out more gold than they actually had in their possession. But once you (and everyone else) start to doubt the safety of the goldsmith, then you (and everyone else) would be foolish not to demand your gold back from the vault. A run on a goldsmith (or in our day, a run on a bank) occurs when many people present their claims at the same time. These runs tend to feed on themselves. If I see you going to the goldsmith to withdraw your gold, I may become nervous and decide to withdraw my gold as well. It is the fear of a run that usually causes the run. Runs on a bank can be triggered by a variety of causes: rumors that an institution may have made loans to borrowers who cannot repay, wars, failures of other institutions that have borrowed money from the bank, and so on. As you will see in a later post, today's bankers differ from goldsmiths---today's banks are subject to a "required reserve ratio." Goldsmiths had no legal reserve requirements, although the amount that they loaned out was subject to the restriction imposed on them by their fear of running out of gold.  *CASE & FAIR, 2004, PRINCIPALS OF ECONOMICS, 7TH ED., PP. 479-481* end |
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