Best of the Week
Most Popular
1. TESLA! Cathy Wood ARK Funds Bubble BURSTS! - 12th May 21
2.Stock Market Entering Early Summer Correction Trend Forecast - 10th May 21
3.GOLD GDX, HUI Stocks - Will Paradise Turn into a Dystopia? - 11th May 21
4.Crypto Bubble Bursts! Nicehash Suspends Coinbase Withdrawals, Bitcoin, Ethereum Bear Market Begins - 16th May 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.Cathy Wood Ark Invest Funds Bubble BURSTS! ARKK, ARKG, Tesla Entering Severe Bear Market - 13th May 21
7.Stock Market - Should You Be In Cash Right Now? - 17th May 21
8.Gold to Benefit from Mounting US Debt Pile - 14th May 21
9.Coronavius Covid-19 in Italy in August 2019! - 13th May 21
10.How to Invest in HIGH RISK Tech Stocks for 2021 and Beyond - Part 2 of 2 - 18th May 21
Last 7 days
The Federal Reserve and Inflation - 16th Jun 21
Inflation Soars 5%! Will Gold Skyrocket? - 16th Jun 21
Stock Market Sentiment Speaks: Inflation Is For Fools - 16th Jun 21
Four News Events That Could Drive Gold Bullion Demand - 16th Jun 21
5 ways that crypto is changing the face of online casinos - 16th Jun 21
Transitory Inflation Debate - 15th Jun 21
USDX: The Cleanest Shirt Among the Dirty Laundry - 15th Jun 21
Inflation and Stock Market SPX Record Highs. PPI, FOMC Meeting in Focus - 15th Jun 21
Stock Market SPX 4310 Right Around the Corner! - 15th Jun 21
AI Stocks Strength vs Weakness - Why Selling Google or Facebook is a Big Mistake! - 14th Jun 21
The Bitcoin Crime Wave Hits - 14th Jun 21
Gold Time for Consolidation and Lower Volatility - 14th Jun 21
More Banks & Investors Are NOT Believing Fed Propaganda - 14th Jun 21
Market Inflation Bets – Squaring or Not - 14th Jun 21
Is Gold Really an Inflation Hedge? - 14th Jun 21
The FED Holds the Market. How Long Will It Last? - 14th Jun 21
Coinbase vs Binance for Bitcoin, Ethereum Crypto Trading & Investing During Bear Market 2021 - 11th Jun 21
Gold Price $4000 – Insurance, A Hedge, An Investment - 11th Jun 21
What Drives Gold Prices? (Don't Say "the Fed!") - 11th Jun 21
Why You Need to Buy and Hold Gold Now - 11th Jun 21
Big Pharma Is Back! Biotech Skyrockets On Biogen’s New Alzheimer Drug Approval - 11th Jun 21
Top 5 AI Tech Stocks Trend Analysis, Buying Levels, Ratings and Valuations - 10th Jun 21
Gold’s Inflation Utility - 10th Jun 21
The Fuel Of The Future That’s 9 Times More Efficient Than Lithium - 10th Jun 21
Challenges facing the law industry in 2021 - 10th Jun 21
SELL USDT Tether Before Ponzi Scheme Implodes Triggering 90% Bitcoin CRASH in Cryptos Lehman Bros - 9th Jun 21
Stock Market Sentiment Speaks: Prepare For Volatility - 9th Jun 21
Gold Mining Stocks: Which Door Will Investors Choose? - 9th Jun 21
Fed ‘Taper’ Talk Is Back: Will a Tantrum Follow? - 9th Jun 21
Scientists Discover New Renewable Fuel 3 Times More Powerful Than Gasoline - 9th Jun 21
How do I Choose an Online Trading Broker? - 9th Jun 21
Fed’s Tools are Broken - 8th Jun 21
Stock Market Approaching an Intermediate peak! - 8th Jun 21
Could This Household Chemical Become The Superfuel Of The Future? - 8th Jun 21
The Return of Inflation. Can Gold Withstand the Dark Side? - 7th Jun 21
Why "Trouble is Brewing" for the U.S. Housing Market - 7th Jun 21
Stock Market Volatility Crash Course (VIX vs VVIX) – Learn How to Profit From Volatility - 7th Jun 21
Computer Vision Is Like Investing in the Internet in the ‘90s - 7th Jun 21
MAPLINS - Sheffield Down Memory Lane, Before the Shop Closed its Doors for the Last Time - 7th Jun 21
Wire Brush vs Block Paving Driveway Weeds - How Much Work, Nest Way to Kill Weeds? - 7th Jun 21
When Markets Get Scared and Reverse - 7th Jun 21
Is A New Superfuel About To Take Over Energy Markets? - 7th Jun 21
Why Tether USDT, Stable Scam Coins Could COLLAPSE the Crypto Markets - Black Swan 2021 - 6th Jun 21
Stock Market: 4 Tips for Investing in Gold - 6th Jun 21
Apple (AAPL) Summer Correction Stock Trend Analysis - 5th Jun 21
Stock Market Sentiment Speaks: I 'Believe' We Rally Into A June Swoon - 5th Jun 21
Stock Market Russell 2000 After Reaching A Trend Channel High Flags Out - 5th Jun 21
Money Is Cheap, Own Gold - 5th Jun 21
Bitcoin and Ravencoin Cryptos CRASH Bear Market Buying Levels Price Targets - 4th Jun 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

The Connection Between Debt and Money Under Fractional Reserve Banking

Economics / Fiat Currency Aug 16, 2010 - 10:36 AM GMT

By: Robert_Murphy


Diamond Rated - Best Financial Markets Analysis ArticleIs Our Money Based on Debt?

Different groups often notice different aspects of the same phenomenon — this is the point of the famous tale of the blind men encountering an elephant. When it comes to the Federal Reserve, Austrians usually focus on how its tinkering with interest rates leads to the boom–bust cycle.

However, plenty of non-Austrians hate the Federal Reserve System too. For some of these critics, one of the most perverse features of our present monetary system is its basis in debt. Specifically, if Americans ever began seriously paying down their debts, the supply of dollars would shrink. In the present article I'll explain this strange fact.

The Connection Between Debt and Money under Fractional-Reserve Banking

In a previous article, we walked through a scenario in which a teenager, Billy, finds $1,000 in currency. He goes to his local bank and deposits it in a new checking account. Then, the bank lends $900 of this money to Sally, who uses it for her business. The following tables show the bank's balance sheet at various stages in this process:

I. Bank's Balance Sheet after Billy's Deposit


Liabilities + Shareholder's Equity

$1,000 in vault cash

$1,000 (Billy's checking account balance)

II. Bank's Balance Sheet after Loan Granted to Sally


Liabilities + Shareholder's Equity

$1,000 in vault cash

$900 loan to Sally at 5% for 12 months

$1,000 (Billy's checking account balance)

$900 (Sally's new checking account)

III. Bank's Balance Sheet after Sally Spends Her Loan on Business Supplies


Liabilities + Shareholder's Equity

$100 in vault cash

$900 loan to Sally at 5% for 12 months

$1,000 (Billy's checking account balance)

$0 (Sally's checking account balance)

IV. Bank's Balance Sheet after Sally Sells Her Products for $1,000 Cash and Deposits the Proceeds in Her Account


Liabilities + Shareholder's Equity

$1,100 in vault cash

$900 loan to Sally at 5% for 12 months

$1,000 (Billy's checking account balance)

$1,000 (Sally's checking account balance)

V. Bank's Balance Sheet After Sally Pays Off Her Loan Plus Interest


Liabilities + Shareholder's Equity

$1,100 in vault cash

$1,000 (Billy's checking account balance)

$55 (Sally's checking account balance)

$45 in bank shareholder equity

For our purposes in this article,[1] the crucial point in the above story is this: when the commercial bank extended a $900 business loan to Sally, it created that money out of thin air. When Sally goes to Home Depot to buy supplies — writing checks drawn on her new business checking account — she pushes up prices even though no one else in the community has had his spending reduced by $900. Billy the teenager still thinks he has $1,000 in his checking account, which he is free to spend as he pleases. In a very real sense, the bank loaned Sally $900 that it created as a bookkeeping entry.

On the other hand, when Sally pays off her loan, that $900 is extinguished just as magically as it had first been created. When the bank's accountants remove the liability of Sally's checking account from the bank's balance sheet, it doesn't show up in someone else's checking account.

This is an important point, so let's try to see it in a different way: There are various definitions of "the money supply." A narrow measure, called "the monetary base," consists of physical currency and bank reserves held on deposit at the Federal Reserve itself. However, every other monetary aggregate — M1, M2, M3, and MZM — has a component consisting of demand (checking account) deposits.

In our hypothetical story above, the monetary base was unaffected. However, all the other monetary aggregates first rose by $900 when the bank made the business loan to Sally, and then contracted by $900 when she paid it off. This is the very real sense in which bank lending can expand or contract "the money supply" in a fractional reserve system.

Don't Take My Word for It

In his discussion of this subtle point, G. Edward Griffin, author of The Creature From Jekyll Island, relates two examples of prominent government officials endorsing our claims above.

The first example is a humorous exchange when a politician learns the truth:

Marriner Eccles was the Governor of the Federal Reserve System in 1941. On September 30 of that year, Eccles was asked to give testimony before the House Committee on Banking and Currency. The purpose of the hearing was to obtain information regarding the role of the Federal Reserve in creating conditions that led to the depression of the 1930s. Congressman Wright Patman, who was Chairman of that committee, asked how the Fed got the money to purchase two billion dollars worth of government bonds in 1933. This is the exchange that followed.

ECCLES: We created it.

PATMAN: Out of what?

ECCLES: Out of the right to issue credit money.

PATMAN: And there is nothing behind it, is there, except our government's credit?

ECCLES: That is what our money system is. If there were no debts in our money system, there wouldn't be any money.[2]

Along the same lines, Griffin quotes Robert Hemphill, Credit Manager of the Federal Reserve Bank in Atlanta, who wrote in 1936,

If all the bank loans were paid, no one could have a bank deposit, and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash, or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless situation is almost incredible — but there it is.[3]

Now, we can quibble with the extreme position the Eccles and Hemphill staked out. Strictly speaking, the commercial banks take the "monetary base" (consisting of paper currency, coins, and electronic reserves held on deposit with the Fed) and then create additional money on top of that through issuing loans to their clients. To relate to our story above, when Sally pays off her loan, $900 in money disappears from the system, but no matter what anybody does, that $1,000 in physical currency won't disappear.

Wait — Our Fiat Money Really Is Based on Debt

But hold on a second. Eccles and Hemphill might mean something deeper. There is a legitimate sense in which even the Federal Reserve notes in your wallet or purse are "debt-based money." We have to ask, how did these notes come into existence?

The first thing to realize is that the Fed can control the size of the monetary base, but it can't directly control its composition. Specifically, if the public wants to hold more paper currency — rather than keeping their "money" sitting in checking accounts at the bank — then they can begin withdrawing green pieces of paper either from bank tellers or ATMs.

Seeing their physical currency depleting, the commercial banks then go to the Fed and draw down their reserves, which basically are the banks' own "checking accounts" with Ben Bernanke.

At this point we have reached the top of the food chain; there is nothing backing up the electronic bookkeeping entries in the Fed's computers. The commercial banks' reserves aren't claims on anything else; they are simply units of account, namely dollars issued by the Federal Reserve.

So, when a commercial bank has, say, $1 million on deposit (according to the Fed's computers), and the bank wants to withdraw $200,000 in currency, here's what the Fed does:

  1. It fires up the printing press and creates $200,000 in new currency, such as $100, $50, and $20 bills, and
  2. It changes its computers to reflect the fact that the commercial bank now has only $800,000 on deposit with the Fed.

What all this means is that the composition of the monetary base can shift from being more or less concentrated in bank reserves versus physical currency, based on how much paper the public wants to hold in their wallets and purses. To repeat, the public can't change the total level of the monetary base, but if the public wants to hold more green pieces of paper, the Fed accommodates them by reducing bank reserves and increasing the stock of physical currency.

We're getting closer to our destination. Now we see that the supply of paper dollars in our economy is ultimately constrained by the size of the monetary base; the public can hold more or fewer paper dollars, but these changes are perfectly offset by movements in the commercial banks' total deposits with the Fed.

Now we're ready to ask, what determines the total size of the monetary base? Here is the answer: "open-market operations" by the Fed, as described in a standard (and stultifying) undergraduate lecture in Intro to Macroeconomics.

Specifically, the Fed adds to the monetary base when it writes checks "on thin air" in order to buy assets. Whenever Bernanke buys $1 million in new assets to throw on the Fed's balance sheet, he injects an additional $1 million in new reserves into the banking system. That check will get deposited at some bank, and then, once the transaction clears, that particular bank's checking balance with the Fed will be $1 million higher than it was before. No other bank's reserves will have gone down; the total supply of reserves has increased by $1 million. In principle, if the bank's customers wanted to hold more paper currency, the bank would now have an extra $1 million that it could itself "withdraw as currency" from the Fed.

We've reached the last step, to see the connection between our fiat money and debt. For what is the typical asset that the Fed buys, when it expands the monetary base? The answer is bonds issued by the US Treasury. This is a very complicated process that I explain here. But the gist of it is this: under normal circumstances, the Fed creates new dollars out of thin air and then lends them to the US Treasury.


Hemphill's horror at the "tragic absurdity" of our current financial system was understandable. The government and powerful bankers established a system in 1913 that typically works like this: Every dollar of the monetary base (or "narrow money" or "high-powered money") comes into existence with a one-to-one increase in the public debt, collectively owed by the taxpayers. Then, private banks use that base to create more dollars (in "broad money") that come into existence with a one-to-one increase in private debt.

Going the other way, if people in the private sector ever paid off all of their debts, and the federal government paid off all of its bondholders, then the supply of US dollars would be virtually extinguished.

This is the sense in which our fiat-money, fractional-reserve system uses "debt-based money." Although market prices are flexible and can react to deflation much better than most people realize, it is still true that our system is tragically absurd.

Robert Murphy, an adjunct scholar of the Mises Institute and a faculty member of the Mises University, runs the blog Free Advice and is the author of The Politically Incorrect Guide to Capitalism, the Study Guide to Man, Economy, and State with Power and Market, the Human Action Study Guide, and The Politically Incorrect Guide to the Great Depression and the New Deal. Send him mail. See Robert P. Murphy's article archives. Comment on the blog.

© 2010 Copyright Robert Murphy - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Shelby Moore
17 Aug 10, 02:39

"Every dollar of the monetary base...comes into existence with a one-to-one increase in the public debt, collectively owed by the taxpayers. Then, private banks use that base to create more dollars...that come into existence with a one-to-one increase in private debt"

So I was correct that we are all stealing from each other!

Thank you.

Post Comment

Only logged in users are allowed to post comments. Register/ Log in