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sented by depositors. The “fractional reserve” banking scheme con-
cealed the fact that there was insufficient gold to redeem all the notes
laying claim to it. Today, Federal Reserve Notes cannot be redeemed
for anything but more paper notes when the old ones wear out; yet
the banks continue to operate on the “fractional reserve” system, lend-
ing out many times more money than they actually have on “reserve.”
The reserve requirement itself is becoming obsolete. According to
a press release issued by the Federal Reserve Board on October 4, 2005,
no reserves would be required in 2006 for the first $7.8 million of net
transaction accounts. At a zero percent reserve, there is no limit to
the number of times deposits can be relent. There is really no limit in
any case, as the New York Fed acknowledged on its website. After
explaining the exercise in which a $100 deposit becomes $1,000 in
loan money, it obliquely conceded:
In practice, the connection between reserve requirements and
money creation is not nearly as strong as the exercise above would
suggest. . . . [T]he Federal Reserve operates in a way that permits
banks to acquire the reserves they need to meet their requirements
from the money market, so long as they are willing to pay the
prevailing price (the federal funds rate) for borrowed reserves.
Consequently, reserve requirements currently play a relatively
limited role in money creation in the United States.
It seems that banks can conjure up as much money as they want,
whenever they want. If a bank runs out of reserves, it can just borrow
them from other banks or the Fed, which creates them out of thin air
in “open market operations.” That is how it seems; and to confirm
that we have the facts straight, we™ll turn to that most definitive of all
sources, the Federal Reserve itself . . . .




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Chapter 18
A LOOK INSIDE
THE FED™S PLAYBOOK

“I guess I should warn you, if I turn out to be particularly clear,
you™ve probably misunderstood what I™ve said.”
“ Federal Reserve Chairman Alan Greenspan
in a speech to the Economic Club of New York, 1988




M odern Money Mechanics” is a revealing Federal Reserve

manual that is now out of print, perhaps because it revealed
too much; but it is still available on the Internet.1 It was published in
1963 by the Chicago Federal Reserve, which as part of the Federal
Reserve system naturally wrote in Fedspeak, so some concentration is
needed to decipher it; but the effort rewards the diligent with a gold
mine of insider information. The booklet begins, “The actual process
of money creation takes place primarily in banks.” The process of
money creation occurs, it says, “when the proceeds of loans made by
the banks are credited to borrowers™ accounts.” It goes on:
Of course, [banks] do not really pay out loans from the money they
receive as deposits. If they did this, no additional money would
be created. What they do when they make loans is to accept
promissory notes in exchange for credits to the borrowers™
transaction accounts. . . . [T]he deposit credits constitute new
additions to the total deposits of the banking system.
The bank™s “loans” are not recycled deposits of other customers;
they are just “deposit credits” advanced against the borrower™s promise
to repay. The booklet continues, “banks can build up deposits by
increasing loans and investments.” They can build up deposits either
by making loans of accounting-entry funds or by investing newly-
created deposits for their own accounts. (More on this arresting
revelation later.) The Chicago Fed then asks, “If deposit money can be
created so easily, what is to prevent banks from making too much?” It
answers its own question:
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Chapter 18 - A Look Inside the Fed™s Playbook

[A bank] must maintain legally required reserves, in the form of
vault cash and/or balances at its Federal Reserve Bank, equal to
a prescribed percentage of its deposits. . . . [E]ach bank must
maintain . . . reserve balances at their Reserve Bank and vault
cash which together are equal to its required reserves . . . .
The implication is that the bank™s “reserves” are drawn from its
depositors™ accounts, but a close reading reveals that this is not the
case. The required reserves are made up of whatever vault cash the
bank has on hand and something called “reserve balances maintained
at their Reserve Bank.” What are these? Under the heading “Where
Do Bank Reserves Come From?”, the Chicago Fed states:
Increases or decreases in bank reserves can result from a number
of factors discussed later in this booklet. From the standpoint of
money creation, however, the essential point is that the reserves
of banks are, for the most part, liabilities of the Federal Reserve
Banks, and net changes in them are largely determined by actions
of the Federal Reserve System. . . . One of the major responsibilities
of the Federal Reserve System is to provide the total amount of reserves
consistent with the monetary needs of the economy at reasonably
stable prices.
If the “reserves” had come from the depositors, the Fed would not
have the “responsibility” of providing them “at reasonably stable
prices.” They would already be in the banks™ vaults or on their books.
Recall what the New York Fed said on its website: “[T]he Federal Re-
serve operates in a way that permits banks to acquire the reserves
they need to meet their requirements from the money market, so long
as they are willing to pay the prevailing price (the federal funds rate) for
borrowed reserves.”
In short, banks don™t need to have the money they lend before they
make loans, because the Fed will “provide” the necessary reserves by
making them available at the federal funds rate. The banks borrow
from the Fed or other banks at a low interest rate and extend credit to
their customers at a higher rate. Where the sleight of hand comes in is
that the Fed itself creates the reserves it lends out of thin air. (More on this
shortly.)
That is one bit of sleight of hand. Another is that the loan of newly-
created money becomes a deposit, which the bank or its fellow banks
can then relend many times over, multiplying the money supply and
charging interest each time. A source that explains this in easier lan-


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guage than the Fed itself is the informative website by William Hummel
cited earlier, called “Money: What It Is, How It Works.” He writes:
Banks with adequate capital can and do lend without adequate
reserves on hand. If a bank has a creditworthy borrower and a
profitable opportunity, it will issue the loan and then borrow the
required reserves in the money market.2
He uses the example of a bank with $100 million in demand de-
posits and $10 million in reserves “ just enough reserves to meet the
reserve ratio of 10 percent (the approximate amount needed to pay
any depositors who might come for their money). The bank plans to
issue new mortgage loans totaling $5 million for a new housing devel-
opment. Can it do so before it acquires more reserves? Hummel says
it can. Why? Because the bank is allowed to enter the newly-created loan
money as a deposit on its books. The bank™s assets and liabilities increase
by the same amount, leaving its reserve requirement unaffected. When
the borrower spends the money, it is transferred out of the bank into
other banks, so the originating bank has to come up with new money
to meet its reserve requirement; but it can do this by borrowing the
money from the Fed or some other source in the money market. Mean-
while, the banks that got the $5 million now have new deposits against
which they too can make new loans. Since they also need to keep
only 10 percent in reserve to back these new deposits, they can lend
out $4,500,000, increasing the money supply by that amount; and so
the process continues.3
So let™s review: the bank lends money it doesn™t have, and this
loan of new money becomes a “deposit,” balancing its books. (This is
called “double-entry bookkeeping.”) When the borrower spends the
money, the bank brings its reserves back up to 10 percent by borrowing
from the Fed or other sources. As for the Fed itself, it can™t run out of
reserves because that is what “open market operations” are all about.
Like Santa Claus, the Fed can™t run out of reserves because it makes
the reserves.
How this is done was explained by the Chicago Fed with the fol-
lowing hypothetical case. If it seems hard to follow or makes no sense,
don™t worry; it is hard to follow and it doesn™t make sense, except as
sleight of hand. The important line is the last one: “These reserves . . .
are matched by . . . deposits that did not exist before.” The Chicago Fed
states:
How do open market purchases add to bank reserves and
deposits? Suppose the Federal Reserve System, through its
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Chapter 18 - A Look Inside the Fed™s Playbook

trading desk at the Federal Reserve Bank of New York, buys
$10,000 of Treasury bills from a dealer in U. S. government
securities. In today™s world of computerized financial transac-
tions, the Federal Reserve Bank pays for the securities with a
“telectronic” check drawn on itself. Via its “Fedwire” transfer
network, the Federal Reserve notifies the dealer™s designated
bank (Bank A) that payment for the securities should be credited
to (deposited in) the dealer™s account at Bank A. At the same
time, Bank A™s reserve account at the Federal Reserve is credited
for the amount of the securities purchase. The Federal Reserve
System has added $10,000 of securities to its assets, which it has
paid for, in effect, by creating a liability on itself in the form of
bank reserve balances. These reserves on Bank A™s books are
matched by $10,000 of the dealer™s deposits that did not exist before.
What happens after that was explained in an article by Murray
Rothbard titled “Fractional Reserve Banking,” using a hypothetical
that again is a bit easier to follow than the Fed™s. In his example, $10
million in Treasury bills are bought by the Fed from a securities dealer,
who deposits the money in Chase Manhattan Bank. The $10 million
are created with accounting entries, increasing the money supply by
that sum; but this, says Rothbard, is “only the beginning of the infla-
tionary, counterfeiting process”:
For Chase Manhattan is delighted to get a check on the Fed, and
rushes down to deposit it in its own checking account at the Fed,
which now increases by $10,000,000. But this checking account
constitutes the “reserves” of the banks, which have now increased
across the nation by $10,000,000. But this means that Chase
Manhattan can create deposits based on these reserves, and that,
as checks and reserves seep out to other banks . . . , each one can
add its inflationary mite, until the banking system as a whole
has increased its demand deposits by $100,000,000, ten times
the original purchase of assets by the Fed. The banking system is
allowed to keep reserves amounting to 10 percent of its deposits, which
means that the “money multiplier” “ the amount of deposits the banks
can expand on top of reserves “ is 10. A purchase of assets of $10
million by the Fed has generated very quickly a tenfold,
$100,000,000 increase in the money supply of the banking system
as a whole. Interestingly, all economists agree on the mechanics of
this process even though they of course disagree sharply on the
moral or economic evaluation of that process.4

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In order to pull all this off, the Fed has had to alter the meaning of
certain words. “Reserves” are not what the word implies “ money
kept in a safe to pay claimants. Reserves are accounting entries at
Federal Reserve Banks that allow commercial banks to make many
times those sums in loans. In an article titled “Money and Myths,”
Carmen Pirritano writes that a “reserve account” is basically a second
set of books kept at the Federal Reserve Bank. Thus in the Chicago
Fed™s example, the dealer acquired federal securities from the govern-
ment and tendered them to the Federal Reserve, which “paid” by cred-
iting the dealer™s account, causing new money to magically appear as
numbers at the dealer™s bank. This new “deposit” was then added to
the bank™s “reserve balance” at its local branch of the Federal Reserve.
These reserves were not “real” money kept at the commercial bank
for paying depositors. They existed only as a liability on the Federal
Reserve Bank™s books. Pirritano maintains that the reserve accounts
kept at the Federal Reserve Bank are just a system for keeping track of
how much money commercial banks create. There is no limit to this
money expansion, which banks can engage in to whatever extent they
can get customers to take out new loans. He observes:
“The Federal Reserve System Purposes and Functions” states
that the Federal Reserve requires that all banks (as of 1980) must
“hold a certain fraction of their deposits in reserve, either as
cash in their vaults or as non-interest-bearing balances at the
Federal Reserve.” The term “non-interest-bearing balances at
the Federal Reserve” means that “Reserve Accounts” are nothing
more than bookkeeping tallies representing the portion of the
member banks™ deposit account balances that may be used as a
base to extend new money creation credit. Member banks do
not physically transfer (“deposit”) a percentage of their demand
deposit account balances to their Reserve accounts at their
Federal Reserve Bank branch. . . . I believe these “accounts” were
designed to further the appearance of a gigantic system of “reserves”
mandated by the Federal Reserve System to “force” prudent banking.5
Put less charitably, reserve accounts are a smoke and mirrors ac-
counting trick concealing the fact that banks create the money they
lend out of thin air, borrowing any “reserves” they need from other
banks or the Fed, which also create the money out of thin air. Dis-
turbing enough, but there is more . . . .



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Chapter 18 - A Look Inside the Fed™s Playbook

How Banks Create Their Own Investment Money

The Chicago Fed continues with its example involving Bank A:
If the process ended here, there would be no “multiple”
expansion, i.e., deposits and bank reserves would have changed
by the same amount. However, banks are required to maintain
reserves equal to only a fraction of their deposits. Reserves in
excess of this amount may be used to increase earning assets “
loans and investments.
Recall that the deposits in Bank A “did not exist” until the Fed
conjured them up, something it did by “creating a liability on itself in
the form of bank reserve balances.” At a 10 percent reserve require-
ment, 10 percent of these newly-created deposits are kept in “reserve.”
The other 90 percent are “excess reserves,” which “may be used to
increase earning assets,” including not only “loans” but “investments”
that pay a return to the bank.

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