Credit Where Credit Is Due: The Direct Approach to Fixing the Credit Crisis

Letter to the bank – Dear Sirs, In light of recent developments, when you returned my check marked “insufficient funds,” were you referring to my funds or yours?   

Economist John Kenneth Galbraith famously said, “The process by which banks create money is so simple that the mind is repelled.”  If banks can create money, why are we suffering from a “credit crunch”?  Why can’t banks create all the money they can find borrowers for?  Last fall, Congress committed an unprecedented $700 billion in taxpayer money to reversing the credit crisis, and the Federal Reserve has already fanned that into $8.5 trillion in loans and commitments.  But the bank bailout has proven to be no more than a boondoggle for a handful of lucky Wall Street banks, without getting credit flowing again.

To understand the real cause of the credit crisis and how it can be reversed, we first need to understand credit itself – what it is, where it comes from, and what the real tourniquet is that has limited its flow.  Banks actually create credit; and if private banks can do it, so could public banks or public treasuries.  The crisis is not one of “liquidity” but of “solvency.”  It has been caused, not by the banks’ inability to get credit (something they can create with accounting entries), but by their inability to meet the capital requirement imposed by the Bank for International Settlements, the private foreign head of the international banking system.  That inability, in turn, has been caused by the derivatives virus; and only a few big banks are seriously infected with it.  By bailing out these big banks, the government is actually spreading the virus by furnishing the funds for them to take over smaller regional banks. 

A more effective alternative than trying to patch up the hopelessly imperiled derivatives positions of these few Wall Street banks would be to simply create another credit system with a pristine set of books.  We don’t need to fix the Wall Street disease; we can bypass the whole problem and create a new, healthy, parallel system.  A network of public banks (federal and state) could create “credit” just as private banks do now.  This credit could be extended at low interest rates to consumers and at very low interest to local governments, drastically reducing the cost of public projects by reducing the cost of funding them. 

That is not a radical proposal.  It is what private banks themselves do every day.  But bankers will dispute it, and most people have trouble believing it.  So to make a compelling case for this solution, the first thing that needs to be established is that . . .

Banks Create the Money They Lend

Bankers will tell you that they do not create money.  At a 10% reserve requirement, they simply lend out 90% of their deposits.  The catch is that their “deposits” include the money they have written into their customers’ accounts as loans.  That is how loans are made: numbers are simply written into the accounts of borrowers, as many reputable authorities have attested.  Here are two of them, dating back to when officials were either more aware of what was going on or more open about it:

“[W]hen a bank makes a loan, it simply adds to the borrower’s deposit account in the bank by the amount of the loan.  The money is not taken from anyone else’s deposit; it was not previously paid in to the bank by anyone.  It’s new money, created by the bank for the use of the borrower.”

        – Robert B. Anderson, Treasury Secretary under Eisenhower, in an interview reported in the August 31, 1959 issue of U.S. News and World Report

“Do private banks issue money today?  Yes. Although banks no longer have the right to issue bank notes, they can create money in the form of bank deposits when they lend money to businesses, or buy securities. . . . The important thing to remember is that when banks lend money they don’t necessarily take it from anyone else to lend. Thus they ‘create’ it.”

        –  Congressman Wright Patman, Money Facts (House Committee on Banking and Currency, 1964)                                 

The process by which banks create money was detailed in a revealing booklet put out by the Chicago Federal Reserve titled Modern Money Mechanics.2  The booklet was periodically revised until 1992, when it had reached 50 pages long.  It is written in somewhat difficult prose, but here are a few relevant passages:  

“The actual process of money creation takes place primarily in banks.” [p3]

Translation: banks create money.

"In the absence of legal reserve requirements, banks can build up deposits by increasing loans and investments so long as they keep enough currency on hand to redeem whatever amounts the holders of deposits want to convert into currency.” [p3] 

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