No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Eleven: Money, Money, Money! 268 provided by the Fed are multiplied as they work through the banking system and loans are generated; so the end result of money creation is much greater than the reserves created by the Fed. There were some unstated assumptions in our previous analysis— banks don’t want to hold excess reserves, and consumers won’t increase their cash holdings but deposit their money in banks. In the real world the money multiplier is much less than 10, but is still high powered! Another important facet of this process is the role of the banking system in creating money. Notice in our first example, the Fed bought $1,000 of securities; the ultimate result with the first bank was the creation of $1,000 in checkable deposits. So the first bank did not really print money “out of thin air;” the Fed had done that job for them by providing the initial reserves. But subsequently, Bank of Narnia loaned $900, while Bank of Texas loaned $810, and so on, without any additional reserves provided by the Federal Reserve. It is the fractional reserve process rather than the central bank which provides the most inflation in our economy. But the process itself cannot begin without the central bank providing the initial reserves. In the end—however imprecisely—the central bank controls how much money is created in our economy. DEBT-BASED MONEY Another very important change to notice in the evolution of money is the changing status of new money. In an early economy, the most marketable commodity was somebody’s asset. Someone owned the cow, the beads, or the silver coin. To acquire that asset, someone had to work and forgo consumption. All new money was created by production and savings. Even if you had a significant increase in the money supply (say a new major gold discovery), someone had to work to dig it out of the ground, and once out, it was someone’s asset and no one’s liability. When we changed to fractional reserve banking, all new money can only be created by the banking system creating new debt. As you saw in our T-Account process earlier, each time someone was willing to take on debt by taking on a loan at the bank, new money was created. This is one of the major reasons that the financial system has increased instability with fractional reserve banking; debt is not a guaranteed asset—people and nations default on debt and loans all the time. If many people default on their loans at the same time, the fractional reserve banking system works in reverse—with money being destroyed at a high rate (which is exactly what happened in the banking crises during the Great Depression). The money supply dropped by one-third during the Great Depression, and prices fell accordingly. The scope of this monetary contraction could not have taken place if the money supply was based on a commodity without fractional reserves (i.e., a 100% reserve system). We will review the Bible’s commentary on debt when we get to the chapter on finance; but for now, let’s just say debt is to be avoided if possible. Debt-based money is