How money supports civilization

Who possesses much silver may be happy;
Who possesses much barley may be glad;
But he who has nothing at all may sleep.

–  Sumerian Proverb  2500 B. C.

If you were going to pack a suitcase with things you will need to live on a desert island for the rest of your life, the last thing you would put in the suitcase would be money. Since you would have no one to trade with, money would be of no use to you at all.  On the other hand, if you plan to spend the rest of your life in a civilized environment with lots of other people, a bag full of money would probably be the best thing you could pack — better than clothes, food or books. You can buy all of these things with the money, and money takes much less room in a suitcase. It is the ideal thing.

Money is a commodity; but it is really very different from any other commodity in the world. It is probably the most useful — and the most useless — commodity there is. It is useful because it can be converted into almost anything. It is useless, because you really can’t do anything with it by itself. You can’t eat it, brush your teeth with it, or wear it.

You often hear people criticize our country for being only interested in money. “Our economy lately is characterized by greed: everyone is after the almighty dollar. In prior years, people were motivated more by spiritual matters.”

Actually, strange as it may seem, civilization has always been based on money. Without money the division of labor would not function; art, music, literature, science, and universities could not exist.

Before there was money, there was direct exchange, or barter. A farmer wanting clothing might take some watermelon to town and try to bargain for a pair of boots. He might find a cobbler who had good boots, but the cobbler might not want watermelon. The difficulty of finding an exact match of items for sale and buyers who want what is being sold makes this kind of trading very cumbersome, and inefficient. In fact, without money, it would be almost impossible to pay for such professions as writers, musicians, artists, lawyers, professors, accountants, and actors.

For this reason, all civilizations have been based on money, which for the first five thousand years of so meant gold or silver.

Before civilization began, 6,000 years ago, mankind lived in small isolated family groups farming the land, fishing, and hunting. They had little contact with each other. There was very little trade, because each group in a given area was making the same products. There was little to trade. When they did contact others, it was often to fight: to fight over the best fishing grounds, or farm land, or hunting areas.

The first civilization that we know about started in Sumer, in what is now Iraq, almost six thousand years ago. About that time, group called the Sumerians invaded the land between the Tigris-Euphrates rivers in search of a better life. It was a rough land with stone-hard baked soil during the summer, and wet winters that turned the land into cold mud. But there were places along the riverbank where in the spring the rising river waters deposit rich layers of topsoil. In the soggy marshes on the edge of the rivers there were millions of fish, hundreds of thousands of waterfowl, and rich grasses for sheep and goats to eat.

The Sumerians came from what is now Iran, conquered the inhabitants, and established the first cities and civilization in the world based on the division of labor. The Sumerians created very impressive art and architecture, social organization, and religion, and invented the first writing system. They wrote hundreds of thousands of documents on baked clay many of which have   survived to the present day.

Although the Sumerians used writing to record their religion, their laws, and their literature, it was trade which caused them to invent writing in the first place. The earliest clay tablets on which they wrote tell the story of inventories and contracts for grain, wool, textiles, gold, silver, lead, timber, ivory, pearls, and salt. What made their civilization grow was the rich soil which enabled them to produce a surplus of grain and wool, which they traded for the other things in the Mediterranean and India that they needed. In their trading, they did not exchange their grain and wool only for immediately useful articles like wine or wood. They also imported gold and silver because they were beautiful and because they came to use these metals as money.

Direct exchange was always possible, of course. A Sumerian farmer could bring a dozen sheep to market in hopes of bringing home some cloth, some timber or some wine. But what if the timber sellers don’t want sheep?

The very nature of trade forces people to search for some generally accepted commodity that can be used to trade for what they really want. Beginning in these early days, gold and silver quickly evolved into the most common form of money. These metals are scarce, they are beautiful, they don’t corrode or rust rapidly, and they can be easily melted and converted into objects of uniform weight and appearance (unlike diamonds or other precious stones.) The Sumerians did not mint coins — that was to come two thousand years later — but they used gold and silver as money.

The Value of Money

Money is a medium of exchange. That means that it is used in trading for other things, not for itself. The money, itself, (whether it is a coin or a piece of paper) has little value as it is since it cannot be used for anything. Once it is melted down to make a ring or a bracelet it becomes useful, but it is no longer money. The value of money really depends on the subjective value which people feel for the goods for which money can be exchanged.

The exchange value of money changes every day, as people’s valuation of goods in the market changes, and the exchange ratios of the goods (their prices) change. The creators of products today do not, normally, produce output for themselves. They produce for others: for the market. The value of their output to them, therefore, is not its usefulness, but its exchange value. A printer is printing books. He is not going to read them. He is planning to sell them. The value of the books to him is their exchange value: what can he get for them in the market. If no one wants to buy the books, they will be worthless to him, and may be carted off to the dump.

The real value of the books, if they have any, must lie in their subjective use-value to someone else. The reason why people pay money for books is because they believe that books will fill a need in their lives of some sort. So, the exchange value of the books (which the printer worries about) is based on the subjective use value of the books to other people.

The case of money is different. Money is never valued for its subjective use value, but only for its exchange value. Money is neither a consumer good, nor a capital good. It is really in a third class by itself. Production goods derive their value from their ability to produce other goods. The more capital a society has, the richer it is. But increasing the money supply of a society does nothing at all for its welfare. If an increased money supply did improve our welfare, we should all stop planting crops, manufacturing automobiles, and writing literature, and concentrate on printing money. We would all soon starve to death!

Money, however, can bear fruit. If it is loaned out to people who use it to accumulate capital with which they produce goods, they can turn the money into more money which they can use to repay the loan with interest.

The Marginal Utility of Money

The value of goods and services is determined by their usefulness to the owner, or the prospective owner. What determines the value of money?

Clearly, money is valuable to a person if it can get for him the things that he really wants: things that have subjective value for him. To a hermit on a desert island, money has no value. If you are dying of an incurable disease, money may also have little value to you, unless you can buy something with it that can ease your suffering, or make your heirs happy.

The quantity theory of money

For many years economists believed in a quantity theory of money. The theory goes this way:

Money is needed for transactions. Imagine a small country where in a given year $200 million worth of goods and services change hands. If in this country, the total amount of money is only $20 million, then we can say that the average dollar changed hands 10 times during the year ($200 million divided by $20 million.) The velocity of money is said to be 10. If there were 5 million transactions during the year, we can say that the average transaction involved $40 ($200 million spent on 5 million transactions = $40 per transaction).

All of this can be put into a formula:

GNP  =  MV  =  PT

Gross National Product = Money Supply times velocity

$200 Million      =       $20 Million x  10

= Average sale price times transactions

$200 million      =        5 million  x  $40

This is the first part of the quantity theory which, on the face of it, cannot be disputed. The problem comes about with the next step, which is very much in dispute.

Economists have studied the velocity of money over the years, and many have come to the conclusion that in the short run (within five years or less) it tends to be relatively constant. Look at the velocity of money in the United States in a recent period:

his shows that even though the quantity of money increased very much from 1980 to 1991, the annual velocity of money hovered between 1.0 and 2.25 during the entire time without much change. If you think about it, this makes sense. You get a pay check every two weeks. You spend it on rent, food, car payments, electricity, and transportation. At the end of two weeks, the money is gone and you begin to work on the next paycheck. You couldn’t really spend money any faster than you are spending it now — nor could you spend it much slower. You are like everyone else: on a treadmill, doing much the same thing week after week. So the velocity tends to be relatively constant.

Economists take this fact (the constant velocity of money) and turn the quantity equation around like this:


M  = GNP/V (and V is constant)

Therefore, since V is somewhat constant, GNP has to vary directly with (be a function of) M. If M goes up, GNP has to go up. If M goes down GNP has to go down.

This means that “He who controls the money supply, controls the entire economy.” You can make the economy (the GNP) go up by printing and distributing money.

There are several weaknesses in this idea. Let’s take them apart.

In the first place, the theory ignores inflation. Look at the complete equation:


P stands for the price levels, and T stands for the transactions taking place. Now transactions tend to have the same type of permanence that velocity does. After all, you write about the same number of checks every month as you did last month — and so does everyone else. Only people who have just moved, or just had a baby, or are on vacation or something like that tend to vary their spending patterns. So transactions (whatever they are) should tend to be somewhat stable in the short run.

If this is so, then the formula becomes:

M = PT / V  (with both V and T being somewhat stable).

This means that when M is increased, it is Prices that go up, not the real GNP. Does this make sense?

Of course. Imagine an economy that consists entirely of bananas (people growing them and people eating them). Let’s say that people eat in total 200,000 pounds a year, at $1 a pound or $200,000 GNP per year. The money supply, let us say, is $40,000, so the velocity is 5. If the average sale is 20 lbs, or $20, then the number of transactions in a year is 10,000.

GNP      =         M*V   =     P*T

$200,000 =  $40,000 * 5  =  $20 * 10,000

Solving for M:  M = PT/V   M = $40,000 = ($20 * 10,000) / 5

If the money supply were doubled to $80,000, and the velocity and number of transactions tended to be constant, then the price level would double. P (the average sale price of 20 lbs) would become $40 instead of $20, and the price of bananas would go to $2 per pound.

The quantity theory then would prove that if the money supply doubles, the price level might double (and possibly the GNP would also double), but the actual production in the economy might stay about the same.

Many economists still believe this today, and teach it in their textbooks. But in real life, the picture is somewhat different. The money supply in most countries is controlled by the central government. In our country, it is controlled directly by the Federal Reserve System. When the Fed (as it is called) increases the money supply, the new money does not go automatically to everyone in the country at once. It goes to a few people (often those who borrow money from banks). These people spend the money on things that they want and need. If the money supply has gone up enough, this spending will increase the prices of the things that these people are buying — not all at once, but gradually as they spend the increased money. Why is this?

Any time buyers have more money in their hands, but the things they are buying do not increase, you get a tendency for prices to rise, as rich bidders fight over scarce supplies. So prices rise gradually. The money these people spend goes to the suppliers of the things that they buy. These suppliers, in turn, will spend this new money on things that they want, which will increase those prices gradually. After a while, when the money has spread throughout the economy, all prices will have gone up. The early people had their real income go up. They bought before the prices went up. The last people in the chain lost. They bought after the prices went up.

Does the increased money supply make production go up, or just prices?  It probably affects both.  Price rises stimulate producers to produce more. Price rises stimulate buyers to buy less.

The trouble with the quantity theory of money is that it does not take into account the subjective valuations of individuals. If the quantity of sugar in the world were to become 100 times as much as it is now, would 100 lbs of sugar then have the same value then as one pound does today? Of course not. The marginal utility of sugar for many people would be much different. By the same token, as the quantity of money changes, it introduces a dynamic factor into the economic system.

Every change in the quantity of money will cause individuals to check their judgments as to the subjective value to them of money and of the things that money can buy.

How exchange values change subjective values

Suppose you are thinking right now about the things that you want most for dessert. You have thought of four things, in this order (the order of what is most appealing to you right now):

  • Apple
  • Piece of Cake
  • Glass of Lemonade
  • Pear.

Before you can take any action, someone tells you that he will gladly trade your pear for his piece of cake. This changes things for you. You now value your pear more highly than the glass of lemonade (because of its exchange value — a piece of cake –  not its use value — a pear.) The pear is now like money.

Every change in the value of any one good (like the change in the value of the pear), must affect the value of other goods.

Let us say that you and your spouse own three cars: two modern ones, and a forty year old pickup. You no longer use the pickup, and plan to sell it to a friend for $500 so you can use the money to buy a new living room rug. Your subjective use value scale looks like this:

1. Car #1

2. Car #2

3. New Living Room Rug

4. Old Pickup

Before you sell the pickup, another friend tells you that forty year old pickups, in good condition, sometimes can be sold for as much as $10,000. All of a sudden your value system changes. You forget about the living room rug, and think about getting your recreation room finished professionally — something that was out of the question before.

There can be no numeric, quantitative formula for an individual’s value scale, such as this one. Everything is just a question of personal order of priority today. Since this is true of the individual, it must be true also of society as a whole which is just the sum of all the individuals — each with their own unique value scale which is changing every day.

If you do decide to part with your pickup, it will be because your subjective valuation of the pickup is lower on your scale than the $10,000 you may get for it. To the person who buys your pickup, it is clearly higher on his value scale than the $10,000 he will give you for it.  How much higher, neither he, nor anyone else knows, because there can be no quantitative scale for such things.

If it is impossible to measure subjective use value, then we cannot ascribe a quantity to it. There is no such thing as abstract value. If you do sell the pickup for $10,000 can we say that that is what it is worth?  How can we say that when yesterday you were prepared to accept $500 for it? Suppose the buyer turns around and resells it the next day for $15,000. Is that its worth?

Money as a scale of values

From this, you can see that it is unscientific to assume that money is a measure of value. Subjective value is not measured, but graded.

What money makes possible is the arrangement of one’s personal values on some scale that makes sense. Money makes calculation possible.

Indexing of Prices

The exchange value of money, therefore, is always changing for many different reasons. Here are three good ones, right off the bat:

  • People’s subjective valuations of the things that can be bought with money are changing all the time.
  • The quantities of things that are produced and available for sale is always changing
  • The quantity of money in a country is always changing.

Because the exchange value of money is changing, money cannot really serve as a measure of value (as some economists would argue) since money is not a stable commodity. To try to determine the value of money (its purchasing power), the Bureau of Labor Statistics compiles the Consumer Price Index, the Producer Price Index, and scores of other price indexes on a monthly basis. They keep shopping for the same market basket of goods and finding out how much everything costs. This will tell you whether the price of eggs is going up or down in Cleveland (and 20 other cities) every month. They compile an index for the price of eggs. This is useful information.

But, from this useful and correct information, some people try then to determine the objective exchange value of money from one year to the next.  This is a misleading and faulty idea. All index numbers are based on the idea of measuring the utility of a certain quantity of money. Is a dollar more useful today than it was at some time in the past? We can assume that a dozen eggs have the same food value over a long period of time. But people’s subjective ranking of eggs in relation to other commodities changes from time to time.

Probably the biggest mistake in the idea of using indexes of the prices of commodities to determine the value of money is that this idea neglects the fact that the quantity of money is changing as well as the quantity of commodities.

Things are more expensive in New York

You often hear people say that everything costs more in New York, or Washington, or Alaska, or some other place — as compared with St. Louis, or wherever they call home.  You, yourself, must have noticed this phenomenon. But why should that be if there is a free market? With a free market, goods should all have the same price, because a higher price in one area will prompt entrepreneurs to transfer goods from a low price area to a high price area. The result will be that the prices in the two areas will become the same, and the entrepreneur will make a profit.

In fact, though, prices remain more expensive in New York. Why? The answer is that in reality prices are uniform all over. The goods and services in New York are different goods and services in St. Louis than the apparently similar ones are in New York.  Water, for example, may be plentiful in one area, and hard to get in another. It would cost too much to move the water. So the prices stay different because the water is different.  A part of the subjective value of any commodity is its location. Real estate men are fond of saying that the three most important factors in the exchange value of land are “location, location, and location.”

The Risk in Lending Money

When you get a mortgage to finance your house, the lender is taking a big risk — much bigger than the one you are taking. The risk is not just that you will fail to make good on your payments. That he can handle. He is also running the risk that the money you use to pay him back with may be worth much less than the money he has loaned you. Money can decrease in value (because the quantity has increased more than the output of goods and services has increased). All loans are serious speculations for the lender.  Part of the cost of this speculation may be built in to the interest rate charged for the loan.

Foreign trade can also be a very big gamble — bigger than most people think. If the international value of the dollar goes down (for some reason) this will make U.S. goods seem cheap to foreigners, and they will buy more of them. This will put a lot of people to work here, making goods for export. Everyone will think that this is good: lots of work and jobs. But is it good? In fact, we may be selling the goods for less than it cost us to manufacture them — we may be giving our capital away.

What is Money?

The Sumerians failed to make the important discovery of coining money. They used lumps of metals, rings and bars. The idea of adjusting a lump of metal to a fixed weight and stamping it with a mark was first invented about 650 BC by the Lydians living in what is now Turkey. The first Lydian coinage was developed by private individuals — goldsmiths, bankers, merchants — not by authority of the Emperor. Lydia, a major industrial power, needed the coinage system as a reliable medium of exchange. After that, coinage caught on fast. Every important country created its own coins which became a matter of national pride.

Paper money is much more recent. The earliest known paper money was issued by the Ming Dynasty in China in 1368 AD. This was probably not the first such, however, because the note carries a stern warning to counterfeiters. The first paper money issued in North America was that printed in 1690 by Massachusetts to pay a group of soldiers, when the colony was short of ready cash. The success of this issue led other colonies to do the same for the next hundred years.

From the earliest days, many banks issued notes which were used as money in England, the United States and throughout Europe. The system, which today seems rather disorganized — used as we are to a single government-issued currency — worked rather well. In the early days, bank notes circulated at the same time that gold and silver coins also circulated. Bank notes were exchangeable for gold or silver at any time. This kept the banks on their toes. If a bank did not have the gold to make its notes good, the bank would fail. Banks receiving the notes of a rival bank would be quick to return them to the issuer to get paid in “specie” (gold or silver coins).

Today, in the United States paper money is issued only by the Federal Reserve System. The money is “fiat money”, in that it is not backed up by anything, other than the authority of the government. The notes simply say “This note is legal tender for all debts, public and private.” A dollar bill is not redeemable in gold or silver or anything other than another dollar bill. There is no legal limit on the number that the Federal Reserve can issue. In fact, the real limit is the public desire for dollar bills.

Paper money is a commodity. People need so much of it for transactions. If they accumulate too much of it, they will deposit the excess in a bank. If the Federal Reserve printed a few billion more dollar bills, they could not get the public to accept them, any more than a shoe manufacturer could get people to buy more of his shoes by stepping up his production.

The really large quantity of money today is the money in bank accounts.

What is the money supply?

Up until quite recent times, the money supply consisted of gold or silver coins. For the last 300 years, paper money has become common. Money is made up of coins and paper currency. But it also consists of demand (checking) accounts in banks. After all, when you take $100 and deposit it in the bank, it does not cease to exist. It is still available to you. In fact, it may be more useful to you in the bank than it would be in your wallet. You can write checks on it, and safely mail them to other people (which can be risky with cash). These, then, are the three basic components of the money supply: coins, currency and demand deposits in banks.

Measures of the National Money Supply

Besides these big three components of the money supply, there are obviously many other things in common use that seem to have the same function as money: credit cards, traveler’s checks, savings accounts on which you can write checks, and money market fund accounts, to mention only four. For this reason, many economists have set up different measures of the national money supply which they use in estimating changes in the economy. They are:

M1 is the basic measure: coins, currency, travelers checks, and checkable deposits (checking accounts and savings accounts on which you can write checks.

M2 — a broader definition — includes M1 plus:

  • Overnight Repurchase Agreements  A customer buys a U. S. government bond from a bank one day, and sells them back to the bank the next day at a price that includes the interest earned overnight. Companies that have extra cash one day, and need it the next, do this to earn a little extra money.
  • Overnight Eurodollar Deposits are dollar deposits held in banks abroad.
  • Money Market Mutual Funds invested in Treasury bills and short term bonds permit holders to write limited checks.
  • Small time deposits are certificates of deposit (CD’s) which earn a fixed interest for a fixed length of thime. Small is less than $100,000.
  • Money Market Deposits are accounts at banks and savings and loans. They have a limit on the checks and minimum balances.

M3 — an even broader definition — includes M2 plus:

  • Large Time Deposits over $100,000.
  • Term Repurchase Agreements  – longer than overnight.
  • Term Eurodollars   – longer than overnight.
  • Institutional Money Market Funds — owned by a pension fund, life insurance company, or other institution.

California IOU’s

In 1992 the State of California failed to pass a budget by July 1, when their fiscal year began. In a fight between the governor and the legislature, there was an $11 billion deficit that they could not decide on how to finance. To keep the government going in the following weeks, the State government printed more than $1 billion worth of IOU’s — pieces of paper that said that the State of California would pay to the bearer a certain sum of money. State employees took these IOU’s to their banks and deposited them. The banks honored them as money. Some people cashed them at grocery stores.

Then the market wised up. It became clear that the fight between the Governor and the Legislature would go on for some time. Meanwhile the state would pay nothing on the IOU’s. The holders found it difficult to pass them on to others as money. They were rejected by the market.

The lesson: the market, not the government, decides what is money. Americans have had government printed money that was accepted by the market by over 100 years. The idea that the market would reject a U.S. $1 bill is really inconceivable to most people. But if you lived in many countries in Africa or the former USSR, you might find that government currency is accepted for only a fraction of its face value, because, like the California IOU’s, the market has rejected it.

The History of Banking.

Banking is as old as money in the form of coins.  Some of the first banks known were located in Babylon in what is now Iraq more than 600 BC. Private people deposited their funds in these early banks. They received interest on their deposits, and the bankers loaned out money at rates from 10 to 30 percent per year. The banks today are not that different.

In the United States on March 31, 2011 there were 6,453 banks in the United States. That is about half of the number that there were twenty years ago.  Their total assets were more than $12.6 trillion dollars. Their basic functions are the same as those of the banks 2,500 years ago:

  • Accepting deposits (on which checks can be written).
  • Making loans (on which interest must be paid).

Commercial banks do many other things, of course, offering safe deposit boxes, traveler’s checks, savings accounts, etc. But their basic functions are deposits and loans.

How Banks Work

A bank is a safe place to store your money. But it differs from a public warehouse which stores people’s furniture and property. In warehouses, you can go to inspect your property to make sure it is still there. Banks can let you do that if your valuables are in a safe deposit box in the bank, of course. But the central function of banks for twenty five hundred years has been to put the money on deposit into a central pot, and to loan some of it out.  In such a situation, you cannot go down to the bank to see your money. It isn’t there. It has probably already been loaned out to someone else. The bank assumes that most of their depositors won’t ask for the money back (withdraw it) on any given day. They can safely loan the money out, and make some profit on the interest. Some money is kept on hand to meet daily withdrawals or emergencies. This money is called reserves.

A Bank Balance Sheet

Investors created the bank by buying $1,000,000 worth of stock. Once the bank was open for business, it was able to attract $10 million in deposits. Of this $10 million, the bank keeps $2,000,000 in cash reserves, and loans out $8,000,000. In addition, the desks, furniture, computers, and other assets are valued at $1,000,000.


What is the purpose of the reserves? Basically, because a bank has to be able to pay cash to their depositors if they come in at any time and ask for it.


The profit that the bank makes comes from the interest on their loans.  The more they loan out, the more profits they make (assuming that the loans are repaid). To be profitable, therefore, the bank’s first job is to attract a lot of depositors (because that is the money that they use to loan out). Some banks pay interest on money on deposit as a method of attracting deposits. Others give away TV sets, offer free checking, free checks, etc.

How Checks are Cleared


The check clearing system is one of the marvels of the modern market. It is one of the reasons why the market works so well. Here is how it works:

As a part of the bank’s service, they permit their depositors to write checks on their accounts. Let us assume that Robin Baumgartner with an account in the Rock Bridge National Bank buys a sofa from the Hecht Company in Philadelphia, and gives them a check for $750. The Hecht Company deposits the check in the Franklin National Bank. Franklin gives the Hecht Company a credit in their account for $750. Franklin then sends the check to the Federal Reserve Bank in Philadelphia (there are 12 Federal Reserve Banks located throughout the United States).  The Federal Reserve gives Franklin a credit of $750. They do this by increasing the Franklin bank’s reserves (on deposit at the Federal Reserve Bank) by $750.


The Federal Reserve Bank in Philadelphia sends Robin’s check to the Federal Reserve Bank of Richmond (which is closer to Robin’s bank). This bank will now reduce the reserves of the Rock Bridge National Bank by $750, sending the check on to them. Rock Bridge will deduct $750 from Robin Baumgartner’s account. All of this takes place in less than a week — sometimes in only a day or two.

The result of this clearing process is that the Franklin National Bank has gained reserves and the Rock Bridge Bank has lost reserves. As a result of the reserve shift, Franklin can (and will) make more loans. The Rock Bridge bank will reduce its loan portfolio.  Of course, this one check is a drop in the bucket. Billions of checks are cleared through this process every week. If people in one area (say Alaska) buy more products from another area (such as New York) than New Yorkers buy from Alaska, there may be an increase in reserves in New York banks and a reduction in reserves in Alaska banks. Alaska banks will make fewer loans; New York banks will make more (unless offset by reserves that may have shifted to other states).

All National Banks (chartered by the U. S. Government) and most large state banks (chartered by individual states) are members of the Federal Reserve System, and keep their reserves on deposit with a Federal Reserve Bank.  Because of these reserves, most banks don’t need to transfer money between themselves. Money movement takes place on the books of the Federal Reserve (deduction from one bank, and increase in the reserves of another.)

How Safe are Banks?


Banking always involves a risk. Loans may not be repaid for a variety of reasons (borrower loses his job, his business may fail, etc.) If a bank makes too many bad loans, they may not have the money to pay their depositors when they write checks on their accounts.


During the early history of the United States bank failures were quite common. In 1933, more than 4,000 banks closed their doors — many of them never to reopen. When banks failed, their depositors often lost everything. After the disastrous bank failures of 1929-1933, the Congress passed the Banking Reform Act setting up the Federal Deposit Insurance Corporation which insured all depositors against loss both in most banks and savings and loans (with the FSLIC).

The result of this insurance is that banks have been absolutely safe for depositors (up to $100,000). But the insurance permitted many bank and saving and loan managements to conduct their institutions in a risky or illegal way which caused them to fail, and forced the federal government to take them over to protect the insured depositors.

Many banks and savings and loans made risky loans on real estate which lost its value. Some banks loaned money (illegally) to their directors or officers. Before government insurance, depositors would worry about such things. They would withdraw their money from a risky bank. Once the government began insuring all banks and savings and loans, the public did not have to worry. If their bank failed, they would lose nothing, so why worry? The government regulators, on the other hand, did not worry much either. Each regulator had hundreds of banks for which he was responsible, which he could not possibly visit and inspect properly. The result was massive dishonesty in some banks and savings and loans, and just plain incompetent management in others. Thousands went bankrupt leaving the U. S. taxpayers paying the bills.

One lesson of the savings and loan (and bank) disaster which took place in the late 1980′s is that institutions under pressure take more risks. Those that were failing or insolvent were especially prone to take excessive risks. Once their equity capital was wiped out, they were playing with other people’s money. Some built up debts of billions of dollars before federal regulators caught up with them and shut them down.


The savings and loan and banking problem is a direct cause of the federal insurance programs. Sound institutions pay the same insurance premiums as risky and insolvent ones. Federal regulation prevents banks from diversifying or merging with other institutions which might spread the risk. As long as the government stands ready to bail out any institution that gets into trouble, more and more banks and savings and loans will get deeper and deeper into trouble. Outside regulators cannot possibly keep up with the inside workings of hundreds of institutions with millions of accounts.


As a long term policy, one solution would be to eliminate federal insurance altogether, letting private insurance companies take on the responsibility. The result would be that the private insurers would watch their investments more closely than the federal government can do, since it would be their own money at stake, and they would not be subject to the political controls that hamper the effectiveness of federal insurance operations.

How Banks Create Money

The fact that banks can loan out most of their deposits (and maintain only “fractional” reserves) results in the banks creating billions of dollars’ worth of money which is based on the credit of banks. To understand this process, let’s trace a scenario. Tracy Anderson’s aunt Laura in Cincinnati dies, leaving Tracy as her sole heir. When Tracy goes to Aunt Laura’s apartment, she finds $10,000 in cash hidden under the mattress. Tracy deposits this $10,000 in her bank.


Since the bank can legally loan out 80% of its deposits (we will assume), soon after the deposit, the bank will loan out $8,000 (80% of $10,000) for the purchase of a car by a piano teacher. The piano teacher pays the $8,000 to the auto dealer, who deposits it in his bank. His bank can loan out 80% ($6,400) and promptly does so by financing a pickup truck for a plumber. The plumber gives the check to the truck dealer who deposits the $6,400 in his bank. His bank quickly loans out 80% ($5,120) to a fisherman who needs a new boat. The boat dealer deposits the check in his bank which soon loans out 80% ($4,096).  Before we go further, let’s see what has happened to Tracy’s $10,000. At this point, the deposits in the banking system total $33,616, and they are still growing. Where will they stop?


Clearly, the movement of deposits to banks, and the loaning out of a portion of the deposits will go on and on until there is really nothing left to loan out. There is a formula that computes how much the money supply will grow as a result of a new deposit. The formula is:

dM = D * 1 / RR

Where RR = the reserve ratio, D = Deposit and dM = Change in Money Supply.

dM = $10,000 * 1 / .20  = $50,000

So the money supply will grow by a total of $50,000 (including Aunt Laura’s original $10,000).

Is this magic? How can $10,000 grow to $50,000? Is this real money? Well it is to all the participants. The piano teacher bought a real car with it, and the plumber got a nice used pickup. All of the depositors (the auto dealer, truck dealer, boat dealer) can check their monthly statements and see that the money is really there (even though, unbeknownst to them most of it has already been loaned out). They have all learned the basic lesson: money is anything that the market accepts as money.

Do Banks Control Interest Rates?

When you go to the bank for a loan, the rate of interest is very much up to the bank. If they say that your auto loan is 10%, it is difficult to haggle. But there may be other banks offering auto loans for 9.5%. You are free to go elsewhere. Banks, of course, would like interest rates to be as high as possible. Why do they reduce them?


The answer is that banks have to loan out money. It is really the only way that they make a profit on their operations. When $10,000 is deposited in a bank, they had better find a profitable use for as much of that $10,000 as they can legally loan out right away, if they want to remain profitable. If the bank with the 10% auto loan money finds not enough takers, they will have to drop their rate of 9.5%.


So banks don’t really control interest rates. The market controls the rates. But that does not really answer the question. What determines the market rates? The Federal Reserve controls all interest rates by buying and selling securities in the market.  But, that is another story.


Financial Intermediaries

Banks are financial intermediaries. On his island, Robinson Crusoe did his own investing: he built his own house, storage shed and tools. Nowadays, the investors are ordinary people who do not have a business of their own. They put their money into the bank. The bank, in turn, loans the money out to entrepreneurs who are accumulating capital to produce goods and services. The investors (the savers who put their money in the banks) are investing through an intermediary (the bank). The investors never get to meet the entrepreneurs who actually do the investing. They just hope that the bank does a good job of supervising the loan so that they will earn a good rate of interest on their deposit.

International Banking

It takes most of a day on a fast jet for a traveler to get from New York to Tokyo. But money can travel that distance in the fraction of a second. Today, all large international banks are linked by computer to each other. Funds can be moved from Paris to New York as an overnight loan, with the money paid back in the morning.

Domestic banks in most countries, like those in the Unites States, are forced to comply with a vast number of detailed regulations (and even so — or perhaps because of them — many fail each year). But offshore banks — small independent banks set up in islands in the Caribbean, and elsewhere, have few regulations. For many years, U. S. banks set up offshore branches in out of the way places to avoid government regulations. In 1981, the Federal Reserve Board allowed U.S. banks to set up international banking facilities (IBFs) in the United States. Overnight, most of the island banks disappeared and came on-shore. These IBFs are not subject to normal banking regulations (reserve requirements, interest rate regulations, etc.) IBFs can receive deposits and make loans to foreigners, and other IBFs.

The largest banks in the world today are French, German, British, Chinese and Japanese. Of the nine largest banks in 2011l only one was American.

With money traveling around the world with blinding speed, it is hard for many people to understand it. Books are written on the premise that some sort of manipulations by evil foreigners will somehow bring down the entire U. S. banking system, leading to a crash like that of 1929. This, however, is very unlikely to happen.

All money is owned by someone. The owner of the money is generally pretty anxious that his capital remain safe, and not lose its value. Any foreigner who owned bank accounts in the United States would be very unlikely to want to do anything to hurt the value of his investment here. The premise, therefore, that a foreigner with evil intentions would act to bring down the U. S. banking system is quite far-fetched.

If, however,  a middle eastern banker decided to pull all of his money out of New York banks overnight, he would have to transfer the money to some other location (such as London). He would write a check and deposit his billions in London. All that would happen in the U. S. is that the owner of the New York bank account would now be a British Bank, instead of a Middle Eastern one. No possible harm would come to the U.S. by this move.


1. Money is a commodity which is useful only to exchange for other commodities. All civilizations have been based on, and could not survive without money. Throughout the first five thousand years of civilization, money consisted only of gold and silver.

2. The Sumerians who lived in Iraq 5,500 years ago were the first civilization, and the first to make extensive use of money. Writing was invented by them — principally as a means of keeping track of inventory and trade.

3. Money is a medium of exchange. The exchange value of money changes constantly as people’s subjective valuation of commodities changes, and as the quantity of money changes.

4. Goods today are not produced for use, but for sale. Their value to the producer is their exchange value rather than their use value. The exchange value is based on the goods subjective use value to other people (shown by the willingness of the people to spend money in the market for the goods). If the goods cannot be sold, they are valueless to the producer (regardless of their apparent usefulness).

5. Money is different. It is never valued for its subjective use value (it has none) but only for its exchange value. Money is neither a consumer nor a producer good.

6. Increasing the supply of money does nothing at all for the welfare of society. If it did, then everyone could become rich by having the government print money.

7. Money can bear fruit. If loaned out to a successful entrepreneur, it can pay a return both to the entrepreneur and the lender.

8. The quantity theory of money states that GNP = MV = PT where M is the money supply, V is the velocity of circulation; P  is the price level and T represents the transactions in a year.

9. The quantity theory is based on the idea that in the short run the velocity tends to be constant, so GNP is a function of the money supply. But the money supply also can just raise prices (and not increase transactions — real output) if it goes up.

10. When the Federal Reserve System increases the money supply, the increased money does not go to everyone at once. Instead, it goes at first to only a few people, who spend it, increasing the prices of the goods they buy. The receivers spend it also, increasing the prices of the goods they buy. Ultimately the increased money is everywhere. The early receivers gained because they bought before the prices went up. The later receivers lost.

11. Goods are ranked subjectively by people according to their marginal utility to themselves. But many goods also have an exchange value. The existence of an exchange value of goods tends to change people’s subjective evaluation of their value to them.

12. Money cannot be a measure of value. Subjective value is not measured in numbers, but graded (higher or lower) in relation to other things. Money makes possible the arrangement of one’s personal values on a scale that makes sense. Money makes economic calculation possible.

13. The exchange value of money is always changing because a) people’s subjective valuation of the things money can buy is always changing b) quantities of available commodities is always changing c) the quantity of money is always changing. For these reasons, money cannot serve as a reliable measure of value.

14. In a free market, prices tend to be uniform because low cost goods will move to high cost areas. In spite of this, wide cost differences remain. The reason is that part of the subjective value of any commodity is its location.

15. Indexes of prices are useful ways of measuring price differences and money exchange value differences in the short run. They are not reliable over a period of years, because the subjective value of commodities changes greatly over a period of many years, and the quantity of money also changes.

16. When you lend money, you take two risks: the borrower may not pay you back, and the money he pays you may be worth less than the money you lend. Loans are speculations on the exchange value of money. This may raise the interest rates on loans. Foreign trade is also speculation for the same reason.

17. The idea of making silver and gold money into coins was invented by the Lydians in 650 BC. Paper money began in China in the 1300′s. In North America, the first paper money was printed in 1690 in Massachusetts. Paper money was originally issued by banks (“bank notes”). Today dollar bills are “Federal Reserve Notes”. In most countries, only the central government can issue the money. It is called “fiat money” because it has no intrinsic value (as gold would have) and is not backed up by any solid money anywhere (as bank notes used to be). The paper is $1 because the government says it is $1.

18. The quantity of paper money in circulation is decided by individuals who know what they need in their wallets. If they get too much, they will deposit it in a bank. If they have too little, they will withdraw some. The government cannot dictate the quantity of paper money.

19. There are several measures of the money supply. M1 is coins, currency, checkable deposits, and traveler’s checks. M2 is M1 plus overnight RP’s and Eurodollars, Money Market Mutual Funds, CD’s and Savings and money market dollars. M3 is M2 plus larger CD’s, Term RP’s and Eurodollars, and Institutional Money Market Funds.

20. Banks are very old — beginning at least in 600 BC. Basic functions: hold deposits, and make loans. They make their money from the interest on the loans.

21. Banks must keep reserves to pay checks written on deposits. The rest (excess reserves) may be loaned out. The government today determines the amount of reserves that must be held.

22. Check clearing between banks today goes mainly through the Federal Reserve System which holds the reserves of most large banks. Checks are cleared by deducting the amount from the reserves of the losing bank and adding to the reserves of the gaining bank.

23. Banks that gain reserves can expand their loans. Banks that lose reserves must contract their loans.

24. Banks today are safe for the depositors (up to $100,000) because of the Federal Deposit Insurance Corporation (FDIC) which insures all deposits. The insurance has been bad for the banking system, because unsafe and risky banks have relied on the insurance to bail them out. Today this insurance is costing the taxpayers billions of dollars. Federal insurance always involves political considerations which in the long run make it unsound.

25. Banks expand the money supply by a factor of their deposits. The formula is: dM = D x 1/RR  where dM is the change in the money supply, D is the new deposits and RR is the reserve ratio.

26. Banks don’t control interest rates any more than wheat farmers control the price of wheat. Competition in the market combined with the supply of money, and the demand for money determines interest rates. Banks can’t afford not to loan out money — it is their principal source of income.

27. Banking has become worldwide. Of the 9 largest banks in the world, only one is American. Some people feel that international money manipulations could bring our economy to a halt. This is very unlikely. Foreigners owning bank accounts here cannot withdraw them. If a Saudi businessman, for example, pulled all of his money out of a New York bank, and moved it to Paris, all that would happen in New York is that the bank account would shift to a French owner. The money would still be in New York.

About Arthur Middleton Hughes

Arthur is currently Vice President of The Database Marketing Institute based in Fort Lauderdale, FL. Arthur is the author of 11 books, the latest of which is Strategic Database Marketing 4th Edition (McGraw-Hill 2012). A BA graduate of Princeton with an MPA in Economics and Public Affairs, Arthur taught economics at he University of Maryland for 32 years. He is an Austrian Economist.
This entry was posted in Articles and tagged , , , , , , , , , , , , , , , , , . Bookmark the permalink.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>

What is 12 + 8 ?
Please leave these two fields as-is:
IMPORTANT! To be able to proceed, you need to solve the following simple math (so we know that you are a human) :-)