It all boils down to one simple open secret: Banks create deposits by making loans. I know it sounds backwards and that "everyone knows" that deposits create loans, not the other way around, but it is true. We do not have a capitalist economic system at all, we have a debt based economic system. Banks create all the credit in existence (which we erroneously think of as money). Banks have complete control over the economy (every economy in every country) and they use this power to create deposits (or to NOT create them) to boom and bust economies for their own ends.
I say open secret because this is no secret at all. Economic textbooks freely admit that banks create credit (pretend money) far in excess of the actual money deposited at the bank. Visit some Central Bank websites and start reading their papers (not just the PR page describing their mandates) and you'll find lots of explanations of exactly how banks create vast sums of credit out of basically nothing. During the great depression some of the most power bankers in the world came right out and told the truth:
Now on to the nuts & bolts - what the heck am I talking about when I say banks create deposits.
Lets say you live on a tiny little planet with only one country and that country has a total money supply of $1000 (no other money exists and there's nowhere to get more). The entire $1000 is owned by YOU.
I get a brilliant idea and open a bank (I have no money of course, since you have every penny that exists on the entire planet). I approach you and offer to pay you 3% interest on your money if you deposit it in my bank. Being the trusting sort you don't think things through and wonder just how I can pay you 3% on your money when you already have all the money in the world.
I then approach another person (Jack, the guy staying under the palm tree at the beach) and tell him I can lend him $1000 to buy the house that Gustav built as long as he pays me 6% interest. Leaping for joy Jack agrees. I write out a cheque to Gustav and give it to Jack who then presents it to Gustav.
Gustav is overjoyed at getting $1000 and comes running back to me to get his money. I make him the same offer of 3% interest so he deposits the money in my bank.
How much money is in the world now? Most people instinctually say $1000 since, of course, that's all that exists and they are both right and wrong. There still only exists $1000 in money but my bank created $1000 in credit as well. Both you and Gustav have bankbooks that say you have $1000 deposits with the bank. You didn't spend your $1000, or give it away, therefore you still have $1000 as far as you are concerned. Of course Gustav now believe he also has $1000. My bank created $1000 out of thin air.
Read the above carefully and you'll see I've not used an tricks or word games. There is now $2000 in the world because you both KEPT your money AND lent it to Gustav. If you personally had lent the money to Gustav you would have taken the cash out of your wallet and handed it to him and you would be penniless until Gustav started paying you back. By having a bank between the two of you the fact that you kept your money AND lent it out is hidden.
Now for a clarification: I left out one step the bank took to make the explanation as clear as possible. Before the bank could issue a cheque on behalf of Jack, Jack had to have a bank account with a $1000 balance on it. When Jack signed on the dotted line I wrote an entry in the ledger that created an account for Jack with $1000 in it. I didn't transfer the money from your account to Jack's, I just created a deposit with the stroke of a pen. The loan I made created Jack's deposit which was then transferred to Gustav. Your deposit had nothing to do with the loan other than to satisfy the unobservant onlooker that the bank had money to loan.
If either you or Jack withdraw your $1000, the other is left without a penny and the bank goes bankrupt. If you both try to withdraw your money at the same time, you can only have $500 each and the bank goes bankrupt. One or both of you would get the house/half a house. In the real world things would be a bit different - the bank would have to have a bit of money of its own in order to open its doors, it would have more than one deposit and make more than one loan, and it wouldn't hand over a house, it would sell it for what it could get and hand a portion of the proceeds to one/both depositors. The remainder would be my pay for doing all that work (which you cannot touch because I was smart and incorporated the bank).
Now that you know how a bank creates imaginary money (credit) its time to see how banks multiply that credit into vast sums of imaginary money. To demonstrate I'll use a simplistic balance sheet. First, what the bank looks like with your deposit before any loans.
The bank has deposits worth $1000 and no loans. It has $1000 in excess reserves (bank jargon for money laying about not doing anything) so it can make a $1000 loan. Now the sheet showing the loan.
The bank is tapped out, it has no excess reserves and hasn't anything to loan. This is where most of us think the process ends because we think banking loans money just like we would. Now Gustav deposits his $1000 cheque.
The bank has $1000 in excess reserves because it has "lent out" only one of its deposits. The credit it created comes back to it as a deposit which then becomes the basis for creating another loan. So, I sucker another person into borrowing $1000 and the check ends up in Gail's hands who I entice into depositing the cheque instead of taking the money out.
Of course the result is that the bank ends up with $1000 in excess reserves which it can lend out. This process just repeats itself over and over and the money supply grows and grows infinitely (at least in this theoretical world). As long as nobody, singly or in combination, withdraws a total of $1000 or more then bank keeps on operating and the depositors keep on thinking they really have $1000 each in the bank. This is what the talking heads are referring to when they talk about banks having "sufficient capitalization"; having enough actual cash laying around to satisfy withdrawals.
There is (or was, in the case of some countries like Canada) a system for limiting the amount of credit a bank can create called the "Fractional Reserve System". This is a regulation forcing banks to re-deposit a portion of every new deposit with the Central Bank (Federal Reserve, Bank of Canada, Bank of England, etc). After the "New Deal" this reserve requirement was quite high (call it 50% - there are actually different percentages based on types of deposits and amounts). That meant that of your original $1000 loan, the bank retained $500 and the other $500 had to be re-deposited with the central bank. Only $500 of credit could be created. When the $500 cheque came back to the bank, only $250 could be retained and the other $250 had to go to the central bank. Instead of infinite credit creation a bank would be limited to creating a total of $1000 in loans (doubling the money supply). For any reserve requirement you can figure out the number of times banking can multiply the money supply by dividing the capital (real money) by the reserve rate. In this case, $1000 ÷ 0.5 = $2000.
Today's reserve requirements are but a shadow of the New Deal days. In the USA there is no reserve requirement for the vast majority of deposits (those below several million dollars) and 4% to 10% on the remainder.
Just to give you an idea of how much credit exists, masquerading as money, as of November 2008 according to Statistics Canada Canada's total monetary base (bills and coins) was $56.5 billion. That is all the bills and coins in existence. By contrast, Canada's total money supply at the end of 2007 was over 1 trillion dollars - nearly 18 times the amount of bills and coins in existence. Even work, of that $56 billion, only 3.7 billion was held by banks. So with 3.7 billion in actual deposits the Canadian banking system created a trillion dollars in credit - that's 270 dollars of credit for every 1 dollar in bills and coins. You can look the data up yourself (though it costs money - Canada doesn't want normal folks casually finding this data). The source is:
Table 176-0020 - Currency outside banks and chartered bank deposits, monthly average (dollars x 1,000,000)(1)
Google CanSim, then in its search look up "Currency outside banks and chartered bank deposits" and you'll see table 176-0020 in the result list (you can't just go directly to the table).
The system only works as long as the depositors have CONFIDENCE that their money is safe in the bank (which it really isn't since it most of it doesn't actually exist). This is why you keep hearing the talking heads on TV yammer on about "restoring confidence" - the banking system is a CON JOB. Henry Ford gave an apt description (Yes, Mr. Ford Motors).
<to be continued>