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XI. Central Banking: The Process of Bank Credit Expansion

1. EXPANSION FROM BANK TO BANK

Up till now, we have simply asserted that the banks, in the aggregate, will pyramid on top of their reserves in accordance with the money multiplier. But we have not shown in detail how the individual banks pyramid on top of reserves. If there were only one commercial bank in the country, with a few million branches, there would be no problem. If the Fed buys $1 million of securities, and bank reserves increase by that amount, this monopoly bank will simply lend out $4 million more, thereby driving its total demand deposits up by an increased $5 million. It will obtain the increased $4 million by simply creating it out of thin air, that is, by opening up deposit accounts and allowing checks to be written on those accounts. There will be no problem of interbank redemption, for every person and firm in the country will have its account with the same monopoly bank. Thus, if the monopoly bank lends $2 million to General Motors, GM will spend the money on some person or firm who also has an account at the same bank. Therefore, the $1 million in new reserves can readily and swiftly sustain an increase of 5:1 in loans and deposits.

But suppose, as in the United States, we have a competitive banking system, with literally thousands of commercial banks. How can any one bank expand? How does the existence of the Fed enable the banks to get around the ironclad restrictions on inflationary credit expansion imposed under a regime of free banking?

To see the answer, we have to examine the detailed bank-to-bank process of credit expansion under central banking. To make it simple, suppose we assume that the Fed buys a bond for $1,000 from Jones & Co., and Jones & Co. deposits the bond in Bank A, Citibank. The first step that occurs we have already seen (Figure 10.9) but will be shown again in Figure 11.1. Demand deposits, and therefore the money supply, increase by $1,000, held by Jones & Co., and Citibank’s reserves also go up by $1,000.

FIGURE 11.1 — THE CENTRAL BANK BUYS SECURITIES

At this point, Citibank cannot simply increase demand deposits by another $4,000 and lend them out. For while it could do so and remain with a required minimum reserve/deposit ratio of 20 percent, it could not keep that vital status for long. Let us make the reasonable assumption that the $4,000 is loaned to R.H. Macy & Co., and that Macy’s will spend its new deposits on someone who is a client of another, competing bank. And if Citibank should be lucky enough to have Macy’s spend the $4,000 on another of its clients, then that client, or another one soon thereafter, will spend the money on a nonclient. Suppose that Macy’s spends $4,000 on furniture from the Smith Furniture Co. But the Smith Furniture Co. is the client of another bank, ChemBank, and it deposits Macy’s Citibank check into its ChemBank account. ChemBank then calls on Citibank to redeem its $4,000. But Citibank hasn’t got the $4,000, and this call for redemption will make Citibank technically bankrupt. Its reserves are only $1,000, and it therefore will not be able to pay the $4,000 demanded by the competing bank.

Figure 11.2 reveals the straits of Citibank, imposed by the existence of competing banks:

FIGURE 11.2 — REDEMPTION OF ONE BANK FROM ANOTHER

In short, when Citibank’s demand deposits were owed to Macy’s, its own client, everything was fine. But now, not from loss of confidence or from a sudden demand for cash, but in the course of regular, everyday trade, Macy’s demand deposits have been transferred to ChemBank, and ChemBank is asking for reserves at the Fed for redemption. But Citibank doesn’t have any reserves to spare and is therefore insolvent.

One bank, therefore, cannot blithely heap 5:1 on top of new reserves. But if it cannot expand 500 percent on top of its reserves, what can it do? It can and does expand much more moderately and cautiously. In fact, to keep within its reserve requirements now and in the foreseeable future, it expands not by 500 percent but by 1 minus the minimum reserve requirement. In this case, it expands by 80 percent rather than by 500 percent. We will see in the figures below how each bank’s expanding by 80 percent in a central banking system causes all banks, in the aggregate, in a short period of time, to expand by the money multiplier of 5:1. Each bank’s expansion of 80 percent leads to a system or aggregate expansion of 500 percent.

Let us therefore go back to Figure 11.1, and see what Citibank does in fact do. Instead of lending $4,000 to Macy’s, it lends out 80 percent of its new reserves, or $800. In Figure 11.3, we see what happens after this first step in bank credit expansion across the banking system.

First, the total money supply, which had increased by $1,000 after the Fed’s bond purchase, has now increased by $1,800. There has already been an 80 percent further expansion in the money supply, in the form of demand deposits.

But Macy’s, of course, has not borrowed money to sit on it. It uses the $800 to purchase something, say furniture, from the Smith Furniture Co. The Smith Furniture Co., we assume, has its account with ChemBank, and deposits its $800 check drawn on Citibank with ChemBank. ChemBank now calls upon Citibank for redemption, that is, for shifting $800 of its reserves at the Fed to ChemBank. But Citibank now has ample reserves, for it can afford to pay $800 out of its $1,000 new reserves, and it will still have $200 left to offset the $1,000 demand deposit owed to Jones & Co. (It doesn’t have to offset the Macy’s deposit any longer because that has already been transferred to ChemBank.) Figure 11.4 shows what happens as the result of the loan of $800 to Macy’s, and the spending by Macy’s of $800 on the Smith Furniture Co. which deposits the check in ChemBank.

FIGURE 11.3 — CREDIT EXPANSION WITH COMPETING BANKS: THE FIRST BANK

Note what has happened. Bank A, Citibank, having expanded the money supply by 80 percent on top of $1,000, is now out of the picture. Ultimately, its increase of the money supply is back to the original $1,000, but now another bank, Bank B, is exactly in the same position as Citibank had been before, except that its new reserves are $800 instead of $1,000. Right now, Bank A has increased the money supply by the original reserve increase of $1,000, but Bank B, ChemBank, has also increased the money supply by an extra $800. Note that the increased $1,000 in total reserves at the Fed has shifted, so that there is now a $200 increase to Bank A and an $800 increase to Bank B.

And so ChemBank is in the exact same position as Citibank had been, except to a lesser extent. Citibank had enjoyed a new reserve of $1,000; ChemBank now enjoys a new reserve of $800. Where the reserve came from is unimportant. ChemBank proceeds to do exactly the same thing as Citibank had done before: expand on top of its new reserves by another 80 percent. That is, ChemBank makes a loan of $640 to someone else, by writing out an increase in the latter’s deposit account. Suppose that ChemBank lends $640 to Joe’s Diner. ChemBank’s balance sheet is now as shown in Figure 11.5.

FIGURE 11.4 — CREDIT EXPANSION WITH COMPETING BANKS: THE FIRST AND SECOND BANKS

The analogy with Figure 11.3 is clear. ChemBank has expanded on top of its new reserves by 80 percent, lending that out to Joe’s Diner.

But Joe’s Diner, too, does not borrow in order to stay idle. It takes the $640 and, say, purchases a new counter from the Robbins Appliance Co. The Robbins Appliance Co. keeps its accounts at Bank C, the Bank of Great Neck. The $640 of deposits from Joe’s Diner gets transferred to Robbins, and is in turn deposited in the Bank of Great Neck. Figure 11.6 shows what now happens to Banks B and C:

FIGURE 11.5 — THE SECOND BANK EXPANDS

FIGURE 11.6 — THE SECOND AND THIRD BANKS

Clearly, what happens is a repeat of what happened to Banks A and B, as seen in Figure 11.4. When the Bank of Great Neck cashed in $640 in reserves from ChemBank, it left ChemBank with $160 worth of reserves, just enough to satisfy the 20 percent reserve requirement from Smith’s demand deposits. In the same way, Citibank was left with $200, just enough to meet the reserve requirement for the increased demand deposit of $1,000 to Jones & Co. Bank B is now out of the picture, having contributed $800 to the expansion of the money supply, just as Bank A is out of the picture, having received the initial impact of $1,000 of new reserves on the banking system. Bank C is now, after the operations of this process, in the same position as Banks A and B had been before, except it now has fewer new reserves, in this case $640.

We can now sum up the results of the process so far, looking, in Figure 11.7, at the balance sheets for Banks A, B, and C, as well as the Federal Reserve Bank.

Thus we see that any increase in reserves (whether from increased deposits of cash, loans by the Fed, or open market purchase) must take place in one particular bank. That bank, in a competitive banking system, cannot itself increase its loans and deposits by the money multiplier. But it can and does expand by 1 minus the reserve requirement, in our example 80 percent. As it does so, the process of bank credit expansion has a ripple effect outward from the initial bank. Each outward ripple is less intense. For each succeeding bank increases the money supply by a lower amount (in our example, Bank A increases demand deposits by $1,000, Bank B by $800, and Bank C by $640), each bank increases its loan by a lower amount (Bank A by $800, Bank B by $640), and the increased reserves get distributed to other banks, but in lesser degree (Bank A by $200, Bank B by $160).

The next step will be for Bank C to expand by 80 percent of its new reserves, which will be $512. And so on from bank to bank, in ever decreasing ripple effects. As the ripples widen, each bank in the process will increase its demand deposits by 80 percent of the preceding bank’s.

FIGURE 11.7 — CREDIT EXPANSION UNDER COMPETING BANKS: SURVEY OF THE PROCESS

$1,000 + $800 + $640 + $512 + $410 + $328 + $262 + ...

At the end of 14 banks in this chain, the grand total is $4,780, and it is evident that we are rapidly and asymptotically approaching an increased money supply of $5,000.

In this way, competing banks under the aegis of a central bank can increase the money supply by the money multiplier in the aggregate even though each individual bank expands by only 1 minus the money multiplier. The mystery of the inflation process in the modern world has finally been unraveled.

In this way, competing banks under the aegis of a central bank can increase the money supply by the money multiplier in the aggregate even though each individual bank expands by only 1 minus the money multiplier. The mystery of the inflation process in the modern world has finally been unraveled.

2. THE CENTRAL BANK AND THE TREASURY

We have seen that modern inflation consists in a chronic and continuing issue of new money by the Central Bank, which in turn fuels and provides the reserves for a fractional reserve banking system to pyramid a multiple of checkbook money on top of those reserves. But where in all this are government deficits? Are deficits inflationary, and if so, to what extent? What is the relationship between the government as Central Bank and the government in its fiscal or budgetary capacity?

First, the process of bank money creation we have been exploring has no necessary connection to the fiscal operations of the central government. If the Fed buys $1 million of assets, this will create $5 million of new money (if the reserve ratio is 20 percent) or $10 million of new money (if the ratio is 10 percent). The Fed’s purchases have a multiple leverage effect on the money supply; furthermore, in the United States, Fed operations are off-budget items and so do not even enter the fiscal data of government expenditures. If it is pointed out that almost all the Fed’s purchases of assets are U.S. government bonds, then it should be rebutted that these are old bonds, the embodiment of past federal deficits, and do not require any current deficits for the process to continue. The Treasury could enjoy a balanced budget (total annual revenues equal to total annual spending) or even a surplus (revenues greater than spending), and still the Fed could merrily create new reserves and hence a multiple of new bank money. Monetary inflation does not require a budget deficit.

On the other hand, it is perfectly possible, theoretically, for the federal government to have a deficit (total spending greater than total revenues) which does not lead to any increase in the money supply and is therefore not inflationary. This bromide was repeated continually by the Reagan economists in late 1981 in their vain effort to make the country forget about the enormous deficits looming ahead. Thus, suppose that Treasury expenditures are $500 billion and revenues are $400 billion; the deficit is therefore $100 billion. If the deficit is financed strictly by selling new bonds to the public (individuals, corporations, insurance companies, etc.), then there is no increase in the money supply and hence no inflation. People’s savings are simply shifted from the bank accounts of bond buyers to the bank accounts of the Treasury, which will quickly spend them and thereby return those deposits to the private sector. There is movement within the same money supply, but no increase in that supply itself.

But this does not mean that a large deficit financed by voluntary savings has no deleterious economic effects. Inflation is not the only economic problem. Indeed, the deficit will siphon off or “crowd out” vast sums of capital from productive private investment to unproductive and parasitic government spending. This will cripple productivity and economic growth, and raise interest rates considerably. Furthermore, the parasitic tax burden will increase in the future, due to the forced repayment of the $100 billion deficit plus high interest charges.

There is another form of financing deficits which is now obsolete in the modern Western world but which was formerly the standard method of finance. That was for the central government to simply print money (Treasury cash) and spend it. This, of course, was highly inflationary, as—in our assumed $100 billion deficit—the money supply would increase by $100 billion. This was the way the U.S. government, for example, financed much of the Revolutionary and Civil War deficits.

The third method is, like the first one, compatible with modern banking procedures, but combines the worst features of the other two modes. This occurs when the Treasury sells new bonds to the commercial banks. In this method of monetizing the debt (creating new money to pay for new debt), the Treasury sells, say, $100 billion of new bonds to the banks, who create $100 billion of new demand deposits to pay for the new bonds. As in the second method above, the money supply has increased by $100 billion—the extent of the deficit—to finance the shortfall. But, as in the first method, the taxpayers will now be forced over the years to pay an additional $100 billion to the banks plus a hefty amount of interest. Thus, this third, modern method of financing the deficit combines the worst features of the other two: it is inflationary, and it imposes future heavy burdens on the taxpayers.

Note the web of special privilege that is being accorded to the nation’s banks. First, they are allowed to create money out of thin air which they then graciously lend to the federal government by buying its bonds. But then, second, the taxpayers are forced in ensuing years to pay the banks back with interest for buying government bonds with their newly created money.

Figure 11.8 notes what happens when the nation’s banks buy $100 billion of newly-created government bonds.

FIGURE 11.8 — BANKS BUY BONDS

The Treasury takes the new demand deposits and spends them on private producers, who in turn will have the new deposits, and in this way they circulate in the economy.

But if banks are always fully loaned up, how did they get enough reserves to enable them to create the $100 billion in new deposits? That is where the Federal Reserve comes in; the Fed must create new bank reserves to enable the banks to purchase new government debt.

If the reserve requirement is 20 percent, and the Fed wishes to create enough new reserves to enable the banks to buy $100 billion of new government bonds, then it buys $25 billion of old bonds on the open market to fuel the desired inflationary transaction.1 First, the Fed buys $25 billion of old bonds on the open market; this creates increased demand deposits in the banks of $25 billion, matched by $25 billion in new reserves. Then, the Treasury issues $100 billion of new bonds, which the banks now buy because of their new reserves. Their total increase of new demand deposits is $125 billion, precisely the money multiple pyramiding on top of $25 billion of new reserves. The changes in the balance sheets of the commercial banks and of the Fed are depicted in Figure 11.9.

FIGURE 11.9 — FED AIDING BANKS TO FINANCE DEFICITS

Thus, under the assumed conditions of a 20 percent reserve requirement, the Fed would need to buy $25 billion of old bonds to finance a Treasury deficit of $100 billion. The total increase in the money supply of the entire operation would be $125 billion.

If the Fed were to finance new Treasury bond issues directly, as it was only allowed by law to do for a while during World War II, this step would be wildly inflationary. For the Treasury would now have an increased $100 billion not just of newly-created bank money, but of “high-powered” bank money—demand deposits at the Fed. Then, as the Treasury spent the money, its claims on the Fed would filter down to the private economy, and total bank reserves would increase by $100 billion. The banking system would then pyramid loans and deposits on top of that by 5:1 until the money supply increased by no less than $500 billion. Hence we have the highly inflationary nature of direct Fed purchases of new bonds from the Treasury.

Figure 11.10 depicts the two steps of this process. In the first step, Step 1, the Fed buys $100 billion of new government bonds, and the Treasury gets increased demand deposits at the Fed.

FIGURE 11.10 — FED PURCHASE OF NEW GOVERNMENT SECURITIES

Then, as the Treasury spends the new money, its checks on the Fed will filter down toward various private sellers. The latter will deposit these checks and acquire demand deposits at their banks; and the banks will rush down and deposit the checks with the Fed, thereby earning an increase in their reserve accounts. Figure 11.11 shows what happens in Step 2 at the end of this process.

Thus, the upshot of the Fed’s direct purchase of the Treasury deficit is for total bank reserves to rise by the same amount, and for the Treasury account to get transferred into the reserves of the banks. On top of these reserves, the banking system will pyramid deposits 5:1 to a total increased money supply of $500 billion.

FIGURE 11.11 — EFFECT OF FED PURCHASE ON BANKS

Thus, we see that the chronic and accelerating inflation of our time has been caused by a fundamental change in the monetary system. From a money, centuries ago, based solidly on gold as the currency, and where banks were required to redeem their notes and deposits immediately in specie, we now have a world of fiat paper moneys cut off from gold and issued by government-privileged Central Banks. The Central Banks enjoy a monopoly on the printing of paper money, and through this money they control and encourage an inflationary fractional reserve banking system which pyramids deposits on top of a total of reserves determined by the Central Banks. Government fiat paper has replaced commodity money, and central banking has taken the place of free banking. Hence our chronic, permanent inflation problem, a problem which, if unchecked, is bound to accelerate eventually into the fearful destruction of the currency known as runaway inflation.

  • 1. Not $20 billion, as one might think, because the Fed will have to buy enough to cover not only the $100 billion, but also the amount of its own purchase which will add to the demand deposits of banks through the accounts of government bond dealers. The formula for figuring out how much the Fed should buy (X) to achieve a desired level of bank purchases of the deficit (D) is:
        X = D/MM – 1
        The Fed should buy X, in this case $25 billion, in order to finance a desired deficit of $100 billion. In this case, X equals $100 billion divided by MM (the money multiplier) or 5 minus 1. Or X equals $100 billion/4, or $25 billion. This formula is arrived at as follows: We begin by the Fed wishing to buy whatever amount of old bonds, when multiplied by the money multiplier, will yield the deficit plus X itself. In other words, it wants an X which will serve as the base of the pyramid for the federal deficit plus the amount of demand deposits acquired by government bond dealers. This can be embodied in the following formula:
        MM • X = D + X
        But then: MM • X – X = D
        and, X • MM – 1 = D
        Therefore, X = D/MM – 1
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