How Banks Work
Money is an interesting thing (pun soon to be intended). I know MD's, PhD's and
lots of other really intelligent folks that melt like ice in a hot skillet at
the mention of money, finance, or taxes.
This of course makes discourse very hard. Some are way too prideful in this
area (yes, you know who you are). This too, makes discourse on this subject
Well, we are in a pretty dire economic situation and we need discourse (Nov, 2010).
First we all need to at least have a baseline understanding of money at a macro
If I lend you $100 at 10% simple interest you are on the hook to pay me back
$110. Now, lets assume we each have $100 to begin with. Essentially this
transaction creates a transfer of weath from one party to another. After the
transaction is complete I now have $110 and you have $90.
In macro finance involving a central bank that creates the money suppy it
works a little different. We will still use simple interest
and our $100 for this example. The Treasury department cranks up the proverbial
printing press and creates $100. They send it over to the Federal Reserve. In
turn, the Fed lends this money to a Bank though what is know as the Federal
Reserve Discount Rate. Lets use 10% simple interest again as our example. The
bank borrows the$100 at 10%. They now have an obligation to pay back the Fed
$110. The Banks job is to make money by lending the money it just borrowed to
others (people or business). The Bank is also required to keep a portion of the
money they borrow in reserve. For sake of this discussion we will say this number
is 10%. This means the banks has $90 to lend. In order to make money the bank much
charge a higher interest rate than they borrowed the money at. Lets assume they
loan the $90 at 20% simple interest. When all their loans are paid the Bank makes
$18. They pay the Fed their $10 interest and now have $108 in capital. They still
have to keep 10% in reserve. But, they now have about $98 to lend.
I think everyone can wrap their head around this example. Sure, when we factor in
compound interest, and time variations in paying back the loans and all the other
factors. But, the example I have provided is essentially how it works without all
Two things we now need to note. First, where did the $100 the Treasury printed come
from? What was it backed by? Second, the interest rates set by both the Government
and the Bank creates new (non-printed) money in addition to the $100. In our example
it created another $28.
Now, I want to add one other Banking scenario in play before continuing. The bank
can also make loans based upon other deposits they have on hand. In other words if
you put $100 into a savings account the bank can lend $90 of your money to others.
The scenario works essentially the same as above.
The fact is that interest rates are a major factor in increasing the money supply
and wealth. The current Federal Funds Discount Rate is .75%. Historically
(since 1971) these rates run much higher. Besides taxes, the Federal Funds Rate can
be a major source of revenue for our Federal Government.
As a quick example. One trillion dollars at the current rate of .75 nets the
Government 7.5 billion dollars. At 4% the yield would be 40 billion dollars. The
money supply that is subject to this yield is around ten trillion dollars.
A 4% Federal Funds rate is not unreasonable. In fact from 1971 until 1990 the
Federal Funds rate never went below 4.75%! From 1990 until 2000 it hovered from
3% to 6%. In the past decade it has wildly fluctuated from .5 to 6%. So by slowly
raising the Federal Funds Rate back up to 4% the Government would collect $400
billion in revenue.
Our current nations deficit (11/23/2010) is 13,797 trillion dollars.
US Debt at USTreasury.gov
Of this staggering amount 4,591 trillion is Foreign held. If we could balance the
Federal Budget, raise the funds rate to 4% and apply the money towards the foreign
portion of our deficit we could eliminate our foreign debt obligation in about a