How Banks Work

Let me tell you in overly simplified terms how banks work. In simplified terms, banks make money by making loans. Depositors put money into the bank and the bank lends the money out to a borrower. The banks charge a higher interest rate on the borrower than the rate it pays to the depositor. This difference is known as spread.

Banks can lend more money out than they have. In other words, they can lend out money that they don’t actually own. What? Yes. Let’s see how that works.

Money Creation

How much they can lend depends on the reserve required given by the central bank (for example, the Federal Reserve). This is typically 10%. A low reserve rate magnifies the amount of money banks make from lending money. The fact that banks don’t have to keep 100% reserves but only a fraction of that is called fractional reserve banking.

Suppose you deposit $10,000 in your account. The bank has a reserve ratio of 10%. It has to keep 10% of your deposit or $1,000. It is free to lend the rest 90% or $9,000 at interest. The person who borrows it will spend it somewhere and the money ultimately gets deposited again. From that new deposit of $9,000, the bank again keeps $900 and lends $8,100. This process is repeated over and over. Each time the bank gets money, it keeps 10% and lends out the rest at interest.

This process is repeated as many times as possible. Ultimately your $10,000 can become up to $100,000 in the overall money supply. You can calculate this by dividing the initial deposit of $10,000 by 10%. The total money supply of in the economy increases as banks make loans. Therefore, for every $1 that is deposited, up to $9 new money can be created on top of it. This process is called the money multiplier.

It works with the Federal Government as well. The government wants to borrow $10 billion. It prints bonds and gives them to the Fed. The Fed in turn prints $10 billion worth money and gives it to the government in exchange of those bonds. It was all created out of thin air. The government then deposits this money into a bank. The bank keeps 10% or $1 billion of this in required reserves. It has an excess of $9 billion in reserves which is lends out. Here’s the twist:

      The Federal Government borrowed $10 billion

      The bank holds a fractional cash deposit of $1 billion

      The bank lent out the rest $9 billion

Now, it is important to recognize that the $9 billion is created on top of the $10 billion. It comes on top of the existing money supply. Where did that new money come from? It was created out of thin air because of the fractional reserve system. New money comes into existence in loans.

This leads to an interesting outcome.

Inflation

When a person needs money, it borrows money from the bank. The bank lends the person the money. That money is debt. The loan principal has to be paid back with interest. Almost every single dollar must be paid back with interest as well. The interest must come from the existing money supply.

But wait a minute! All money comes from central banks. It is expanded by commercial banks through loans. The principal is the money supply. Where is the money that is needed to cover the interest?

It doesn’t exist. It needs to be created.

In the economy, the money that is needed back to the banks (principal + interest) will always be more than is available in circulation. New money must be created to cover the interest. An increase in money supply leads to inflation.

This is why inflation is a constant in the economy. Money is debt. The game of modern capitalism is: Who is indebted to whom? In times of inflation, savers are losers and debtors are winners.

As an academic side note, which is almost too boring even for me (rare occasion), I know that some of the people reading this are keen to point out this: Inflation is actually an increase on the money supply and that it is the increase that leads to higher prices. Inflation is the devaluation of the currency and leads to higher nominal prices. I am aware of that. For simplicity’s sake, we will define inflation simply as higher prices. In other words, the money is worth less. Things cost more.

The Fed Creates Inflation

Who is in control of the money supply in the United States? It’s the Federal Reserve. Interestingly enough, the Federal Reserve is accountable to no one. It has no budget. It is subject to no audit. Nobody can truly supervise its operations. It is in almost total control of the nation’s money supply. Yet its chairman Ben Bernanke was never elected by the general public and he thinks that printing money at will is a good idea. It may be, but for whom?

The fact that it is accountable to nobody is trumpeted as a virtue. Still, it is the Fed that is responsible for money creation and thus creating inflation. They’re happy to create $700 billion out of thin air to bail out their banker friends in Wall Street and more, much more as we have already seen.

Who Pays The Price?

Who pays the price in taxes? Who’s left out dry with the upcoming inflation from that money creation? Who gets the short end of the stick?

It’s the taxpayer. It’s the average Joe Blow on the street. It’s you and me. Such is life and it’s getting sucher and sucher all the time.

Who Profits?

That’s why getting financial education is so important. Unfortunately, you don’t get it in school. We have dedicated this website for your future. Please take the time to educate yourself and learn how you can ride the upcoming inflation waves instead of be run over by them. You can survive and profit handsomely, if you know the rules of the game.

So how do we survive? How do we profit? Which asset classes thrive on inflation?

For starters, get your FREE Money, Markets and Milestones report at www.theMMMreport.com

We will give to you for no cost at all.

Jaakko

It is easy to see that people really hate the economy.  The statement that the consumer confidence is great is a big and ugly lie. Let’s face it. The economy stinks and people know it. You know it by looking around.

Have a look at the bond markets. In times of strong belief in own economy and job security, people put their money on the stock markets not in the bonds. Bonds are for scary people. If you are ready to lock your money for 20 years to get next to no yield, how much optimism do you really have? How much faith? NONE! That’s right. ZIP, ZERO,NADA. You simply want to put your money some safe place because you are scared of the Armageddon.

The second evidence is NIKE earnings. People are not spending anymore. They are saving. They are not investing. They are saving. Just have a look at TLT chart every now and then and you get the feeling what people think of their jobs and the overall economy.

Money flowing to bonds is all bad news and money flowing to the stock markets is telling the story of strong consumer confidence. Don’t believe the lies. Go for the truth. 

Peace,

Matias