HOW CAN BANKS FAIL WHEN THEY
CREATE MONEY OUT OF NOTHING?
© 2010 May 1 by G. Edward Griffin
I recently received the following letter with a question that I think may be of interest to others.
To say that you have been instrumental in my transition from a habitually asleep "Right Wing" party line spouter to an open minded cognitive thinking individual would be a tremendous understatement. Thank you for all the time and effort you have spent on trying to help your fellow man understand the issues that surround us all.
I do have a question for you involving banking. If a bank makes money out of thin air via the fractional reserve banking system and new money is created by the stroke of a pen by an approved loan applicant, the bank obviously has nothing of value "on the line". As icing on the cake, they are then expecting a percentage of that loan every month as even more profit, i.e. interest on the money created out of nothing. If this is the case, then how on Earth do they go bankrupt, or for that matter, even lose money?
If I had a business of my own where I only had to wait till a "customer" came in, filled out some paperwork and as soon as they signed it, the product I sell automatically appears out of thin air, I can't see how I COULD go out of business. Throw in the icing (interest) as stated above and I am in what they call "hog heaven".
I have spent many hours in discourse trying to figure out how these people could ever lose money. The only thing we came up with is that these banks make other "investments" with the "money" and then lose it. Please help us understand.
Doug Dee
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THIS WAS MY REPLY:
There are several factors that make this possible:
(1) High overhead expenses for sophisticated accounting systems;
(2) Plush facilities and advertising to create the image of stability;
(3) High salaries for top executives;
(4) Bad loans that must be written off the books.
The last factor is the most important. It must be remembered that, even though banks create money when they make loans, they un-create it when loans are repaid or if they are written off as bad debts. One of the characteristics of fiat money is that it is constantly being created and extinguished at the same time. In times of economic stability or growth, the amount of new money being loaned into existence is always equal to or greater than the amount of old money going out of existence. In times of economic downturn, when banks must write off a large share of their portfolios as bad loans or "toxic assets," the amount of money going out of existence is greater – often much greater – than new money being loaned into existence. This is when the moment of truth arrives, because all of those bad loans now literally must be paid off from the hard assets of the banks and, in most cases, they have not set aside anywhere near a sufficient contingency fund to cover the losses. Bankruptcy is the result.
Here is another way of looking at the process. When banks create money, it appears on their accounting ledgers as both an asset and a liability. It's an asset because someone owes it to them and it's a liability because, if they are not repaid, they have to pay it themselves. Simply writing off both assets and liabilities as a bookkeeping entry is not sufficient, because that would leave the money in circulation without any way for it to be removed from the money supply. Eventually, we may come to a point where letting the money supply grow without any requirement for redemption actually could be instituted as the banking system struggles to survive; but, in the meantime, the system requires all money to be backed by debt. Therefore, if debt is eliminated, either by repayment or write-off, banks are required to remove the amount of that debt from their cash assets so it can be removed from circulation. When they run out of cash assets to do that, it's bailout time.
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