09.02.2011 0

The Not-So-Fractional Banking System

By Robert RomanoA recent piece from Foreign Policy Journal’s Jeremy Hammond offers a rare analysis on how money is created in the nation’s financial system — and also why not to expect very much in the way of fiscal responsibility and spending cuts from Washington, D.C. any time soon.

The issue boils down to capital requirements — how much a financial institution must hold in reserve versus how much it can lend. Say the capital requirement for a financial institution is 10 percent.

Usually, one might think that means that for every dollar of capital, it can lend out 90 cents and 10 cents must be kept in reserve, and there is no increase in the money supply. This is the Jimmy Stewart version of banking.

But according to Hammond’s analysis, “banks don’t really loan currency that way.” Instead, keeping with the 10 percent capital requirement example, for every dollar kept in reserve, the bank or financial institution can create $9 to lend — out of thin air — with the dollar itself held in reserve.

If true, all common conceptions of prudential financial standards are thrown out the window. Then, the banks are practically speaking nine times larger than they would be under a conventional understanding of what a bank is. That is not a fractional system at all.

In fact, balance sheets — i.e. all the loans — are subject to multipliers beyond deposits, instead of a fraction of those deposits. The perversity of this standard cannot be overstated. It means the dollar is based on a debt standard. “Under this system, money is debt,” writes Hammond.

This explains how obscene amounts of leverage were fed into the system leading to the market crash of 2008. Firms like Bear Stearns and Lehman Brothers were overleveraged by factors as much as 30 to 1.

American Enterprise Institute scholar Edward Pinto found that Fannie Mae and Freddie Mac “only needed $900 in capital behind a $200,000 mortgage they guaranteed”. That’s leveraging by 222 to 1.

This is how treasuries are kept in reserve to serve as capital boosters. If an institution holds AAA-rated bonds, they can be used as collateral to leverage even more money to buy other financial instruments, or to make loans.

This is the manner that money is created under the Keynesian system. Everyone from a bank to an investment firm to an individual investor buying stocks on margin essentially has access to their very own printing presses.

That’s why the U.S. has over $50 trillion of total debts but only $6 trillion of savings deposits.

The more-than $13 trillion of mortgages are but the tip of the iceberg in terms of the total lending that is taking place. When all the financial instruments are compounded, the $700 trillion figure for the derivatives market projected by the Bank for International Settlements comes into full view.

According to Hammond, because when debts are paid, the money supply decreases — and thus is deflationary — “the Federal Reserve monetary system requires that the U.S. government never be able to pay off its debt.”

This is most likely why Keynesians are Keynesians — the only way the economy can grow under such circumstances is for yet more debt to be created. Why? Because debt repayment on a massive scale would result in rapid deleveraging that would destroy trillions of dollars of notional wealth.

Hence Congress’ preference for annual deficit-spending at the federal level, and the resistance to even small spending cuts.

This explains why the national debt has grown every single year since 1958. Lawmakers fear that debt repayment would cause a tremendous economic contraction beyond reckoning.

In other words, Congress is not allowed to cut spending.

But, if gargantuan amounts of debt were the recipe for prosperity, the U.S. would be living in an economic utopia right now. Instead, we are in a dystopian state of decline where the national debt grows by more than 10 percent but the economy is only growing at a little more than 1 percent.

Making matters worse, a recent study by Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard University found that “median growth rates for countries with public debt over 90 percent of GDP are roughly one percent lower than otherwise; average (mean) growth rates are several percent lower.”

That’s bad because at $14.684 trillion, the national debt is already 97.9 percent of the $14.996 trillion Gross Domestic Product. The effects of excessive debt are already being felt.

This is why the system of perpetual debt creation is unsustainable: 1) beyond certain levels of debt, the economy stops growing; and 2) soon the debt becomes so large it cannot possibly be repaid, making default the only option to restore the nation’s balance sheet.

Therefore an alternative system is needed. One that is sustainable, fosters long-term economic growth without requiring credit expansion, and does not give the power to create money out of thin air to a banking cartel.

Jeremy Hammond is to be applauded for bringing attention to just how overleveraging by financial institutions — the way money is created — is wrecking the economy. To get back on track, we need a return to sound money.

Robert Romano is the Senior Editor of Americans for Limited Government.

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