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Leverage and the creation of money

June 4, 2011

Recently a buddy of mine (D) mentioned that Money is just debt. This is mostly of a true statement.
If I deposit a single dollar with my bank – they pay me 1% int. they then lend it out for 5%. Ok, everything seems fine. But the truth is for each $1 deposited at your bank – the bank lends out $10. Poof – $9 in debt is magically turned into hard coin in the economy.
The beauty of fractional reserve banking – banks have $10 out on loan they only need to keep a fraction on reserve to cover ($1 dollar) but if I withdraw my $1 – the bank needs to find another source of funding or call back the $9 in loans.
It gets better
Instead of taking my $1 and lending out 10 – the bank can instead invest $40 in mortgage backed securities. These investments turn into profits increasing the banks reserves and ability to lend / create money.
If the investments go sour – this decreases the amount of reserves and available to lend. The money supply decreases and the economy suffers.
At the end of the day – you have private institutions minting money. This creates a reliance on these institutions to remain profitable in order to lend and create money. If banks are unprofitable and unable to lend – the supply of money decreases and so does GDP.
Banks understand this reliance which creates moral hazard. This needs to end. Break up the banks.

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