"The modern Banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented. Banks can in fact inflate, mint and unmint the modern ledger-entry currency."

- MAJOR L .L. B. ANGUS:

Although we don't generally realize it, we use two types of money: legal tender (cash) and credit. These are generally referred to as government created money (GCM) and bank created money (BCM). To remove any confusion over which type of money is being described, I will use "cash" or "real money when referring to government created legal tender and only "credit" when referring to bank created money.

Creating Credit

Pretend you live in a tiny little country with a population of 10 people and a total money supply of $1,000. Further pretend that you have the entire $1,000 and everyone else is flat broke. This tiny little country is all alone on a tiny little planet, there are no other countries around, just you and your nine other countrymen.

This tiny little country has only a single bank and they manage to convince you to deposit that money with them, promising to pay you 3% interest on the money you have in the bank. The bank's finances look like this:

Along comes one of your fellow citizens who wants to borrow your money to buy a house. The bank writes a $1,000 cheque for the new house, which the citizen hands over to the seller. The bank charges the borrower 6% interest The seller then deposits the cheque back into the bank, making the finances look like this:

This is about as far as most people go when thinking about the loan process but, what happens to the money that was spent? What does the person that sold the house do with the cheque? Why, the deposit it back into the bank of course! Here's the new finances of the bank.

You and the house seller now have $1,000 each yet there is only $1,000 in the entire country. The truth is, the bank did not lend $1,000 in money, it created $1,000 in credit - a promise of payment, not payment itself. Neither you nor the seller can see this directly, you just know what your bankbook says. Banks do not create loans by lending deposits, they create deposits by making loans. Simply put, almost every deposit is someone else's debt.

This is a hard concept for some people to grasp - that banks do not lend deposits but create credit out of thin air instead. Imagine you had $1,000 and you lent it to a friend. You could not reach into your wallet and pull out $20 to go to a movie because you no longer held that cash - it is not available to you. Until you get paid back, you have $0 to spend. When you deposit money in a bank and the bank (supposedly) lends that money out - you can still withdraw money. If the bank had really lent out your deposit, there wouldn't be any money for you to withdraw.

As long as depositors are content to leave the bulk of their money in the bank, everything is fine. Should more than $1,000 be withdrawn, the bank collapses as it doesn't have the money to honour its obligations.

You cannot say that this country has $2,000 of money as only $1,000 actually exists. What you can say is that this country has a money supply of $1,000 and a credit supply of $1,000. However, because both depositors think and act like they have $1,000 of actual money each, the economy will run as if there were $2,000 in actual money. The bank has effectively inflated the money supply to double its previous level.

Look at the deposit table above and tally up the deposits and loans. The bank has $2,000 in deposits and $1,000 in loans - meaning it has an extra $1,000 that it can loan out. Yes, the credit the bank created, which is not even money, now becomes the basis for another loan.

Now the money supply has been inflated to $3,000, $1,000 in cash and $2,000 in credit. Tally up the deposits vs. loans and you'll see that the bank STILL has an excess $1,000 in deposits available to loan! Every time the bank loans out its excess deposits, that money comes around again and is available to loan - a never ending supply of credit. Now what if everyone in this tiny country takes advantage of this readily available credit?

There is now, effectively, $10,000 floating around the country where only $1,000 of cash exists. What do you think would happen to prices while the money supply is inflating like this? Some of this extra money will be used to increase production - more people can afford more goods so the market will attempt to supply more goods. Some of it will result in higher prices - more people are able to pay more so producers take what they can get. Your original $1,000 is now effectively worth only about 1/10th of its original value.

Deflating the money supply

Now we get to the scary part, paying our debts. Remember that the only money in this tiny little country is your $1,000 deposit, the rest is credit, created as a loan. Where do the citizens get the money to pay off their loans? There is only one place: from the deposits.

Remember that before the loan happened, the money for the loan didn't exist. In order to create the credit of +1,000 dollars, an equal and opposite debt had to be created of -1,000 dollars. There is still 0 money here, just promises of payment. Add +1,000 to -1,000 and you get zero. What this means is that when you pay the 1,000 of credit back it cancels out with the -1,000 of debt - and you are again left with zero dollars.

To pay all the debts you must eliminate all the credit that was created when that debt was assumed. All but one of the deposits (the real cash one) must disappear. The country has to go from a money supply of $10,000 back to only $1,000. This deflation of the money supply would be devastating to the economy! Goods that were made at prices dictated by a $10,000 money supply would have to be sold at prices determined by a $1,000 money supply. Wages would not be able to stay where they were with a $10,000 money supply so wages would have to drop. Jobs would have to be lost as employers cut costs to stay in business selling products for less than they cost to make. This is part of what happened during the great depression - though at that time the money supply only shrank by 1/4, not by 9/10ths.

The Interest Bomb

Lets look at the bottom line of the loan chart above:

The amount owed by the debtors is greater than the amount borrowed, due to interest. If every dollar of credit created by the bank and every dollar of interest paid on that credit is used to pay off the debts, that still leaves $270 owing to the bank.  Unless you, the original depositor, the only one with money left, decide to hand over the $240 outstanding, the only place for the debtors to get the money to pay this outstanding interest is from the bank itself - by taking out more loans.

In the real world we don't pay loans off in a single year, we pay only interest and a portion of the principle. The interest payments we make are the income of the bank, that money will circulate through the economy as the bank pays its employees, pays dividends to stockholders, its rent and utility bills, and buys its supplies. The portion of the principle that we pay off does not circulate, it disappears. If all these loans were four year terms, the money supply would have to shrink 25% per year (simplified version). Instead of an instantaneous crash, we get a slower depression of the economy. The only way to keep the economy flat is to borrow more, creating enough new credit to keep the money supply constant. If we want to grow, we have borrow even more money. It is a trap, in order to prosper borrowing must increase, creating higher debt. An ever increasing portion of the total earnings of this country will have to be paid in interest to the bank as the debt expands.

Henry Ford, founder of Ford Motors recognized this absurd situation and he made a rather direct statement about it:

"It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

Multiple Banks

This process is no different when more than one bank is involved. Depositing a cheque withdrawn from one bank into another bank still results in two deposits with insufficient actual money to cover them.

No Reserve

Some of you readers will likely know about compulsory reserve requirements that limit the amount of credit a bank can create and are wondering why I haven't presented the topic here. Simply put, we don't have any reserve requirements in Canada and haven't had any since Brian Mulroney's Conservative government eliminated reserve requirements from the Bank Act in 1991 (phased in over three years). The above is how Canada's banking system works today. The only limits to the amount of credit a bank can create are our willingness to borrow and its ability to keep enough cash on hand to deal with day-to-day withdrawals.

In the USA, there is no reserve requirement for notice deposits (savings) and only a 4% reserve for demand deposits over a certain size (I saw the number in 2005 but cannot remember exactly - I think it was anything over one million). So effectively, there is no reserve requirement in the USA either.

So how has this affected Canada? Read for yourself in the next section: Canada's Inflation