A government big enough to give you everything you want is a government big enough to take from you everything you have . —Gerald Ford

The following article builds on the concept of commercial bank lending that was set forth in my December 3rd article, Fractional Reserve Banking: How to Create and Destroy Money. If you missed it, please take a moment to review before proceeding, as it will help clarify parts of the discussion below.

For those of you who may be wondering where all this is headed, please bear with me. While interesting (at least to me) and educational, this series is intended to provide a foundation from which future actionable investment advice will be based. If I were to jump directly to some of the forthcoming conclusions, I would probably receive a plethora of Are you nuts!? emails. So first we learn, then we earn.

To summarize briefly, the last article discussed our fractional reserve banking system and how money is created whenever a bank makes a loan. We discussed the concept of a reserve requirement and how it influences how much lending, aka money creation, can take place when starting with base money. The basic premise that was described is often referred to as the money multiplier model, based on how money multiplies through bank lending.

It is important to understand the money multiplier model because it is taught at universities, used by economists, and frequently referenced in economic and financial analysis. However, as we’re going to find out now, this model is incorrect. As blasphemous as this may sound, the money multiplier model is outdated, relies on assumptions that do not hold and does not accurately represent the modern banking system.

With that, further down the rabbit hole we go.

Reliance on the money multiplier model implies three conclusions which, as I will demonstrate, don’t hold true in practice:

First, is the idea that banks must wait for deposits to be made before they can lend.

Second, the money multiplier model implies that central banks can control the amount of money in an economy by changing the amount of base money in the economy.

Third, and perhaps most importantly, is the concept that the total possible amount of money in an economy is limited as a function of the amount of base money in the economy and the reserve ratio.

As we discuss the true nature of banking and money creation below, you’ll see how perplexing the system is and why it is so widely misunderstood.

Let’s begin with the seemingly clear notion that a bank must have deposits in excess of its reserve requirements in order to lend. Say I walk into a bank and request a loan for $10,000 and this bank has no excess reserves — meaning it has lent out all available funds except what it must keep on hand to satisfy the reserve requirements. In theory, the bank could not lend me the money, but it will (as long as I’m credit worthy), and here’s why it can.

An institution’s reserve requirements are calculated during an overnight maintenance period. As long as the actual reserves meet or exceed the bank’s average required reserves over that period, the bank has complied. This means that it is acceptable for a bank to drop below the reserve ratio momentarily, as it would in our example. So what happens when the bank lends me the $10,000 and needs to meet its reserve threshold? Simple, it borrows the excess reserves it needs from another bank, via the interbank lending market.

You might be wondering, What if no other banks have excess reserves? Great question. The answer is simple, yet opens another realm of discussion. The simple answer is that the bank would borrow the excess reserves it needs from the central bank. But wait a minute, that means.

Yes. The central bank will supply whatever reserves are needed by the system. Did I lose you here? Probably. I myself was lost here for a long time.

Reserves play an integral role in the creation of money, but not in the way most people have come to believe. In the money multiplier model we discussed earlier, it is thought that reserves constrain lending. That is logical, but incorrect. In reality, the amount of reserves supplied to the system is a function of interest-rate targeting. The quantity of reserves in the system is what determines the federal funds rate. Remember this is the rate that banks charge each other when they borrow reserves from each other to satisfy reserve requirements. The Fed sets an interest rate target, then uses monetary policy to implement that target. Monetary policy operates by increasing or decreasing the amount of reserves, and thus the supply and demand functions to determine the actual market federal funds rate. This is how they ensure that the federal funds rate is in line with their announced policy rate.

When excess reserves are constrained, as in commercial banks need to obtain more reserves to support their lending, the demand for reserves increases. This means the federal funds rate would increase unless the supply can be compensated to adjust for the increased demand. So, to repeat, the central bank will supply whatever reserves are needed by the system. If it didn’t, the central bank could not maintain the interbank rate which is foundational to our monetary system.

Here’s the crux of the matter. Reserves, including excess reserves, cannot be lent out. It’s an impossibility. That’s not how the system works. This is why the massive increases in reserves from QE, have not caused hyperinflation or anything of the sort. In addition, the idea that — if banks start lending out all those reserves we could see hyperinflation — is also completely false. Bank lending never was, and is not now, constrained by reserves. The central bank will always supply reserves when required, and does so, not with the intention of increasing lending and thus the money supply, but as a byproduct of managing short-term interest rates.

Here is how the Bank of International Settlements (BIS) puts it: . the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly.

The BIS continues, in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system.

Under normal circumstances, the amount of excess reserves entering the system from quantitative easing would hugely upset the supply and demand function that sets the federal funds rate. However, when QE was enacted, that rate was pushed effectively to zero, and so piling on more and more reserves doesn’t change anything. QE could not take place without the interbank rate being pushed effectively to zero.

I bet some of you are squirming by now. And I bet I can make it worse — in a good way.

Deposits are not required for lending, because the act of lending, aka credit creation, simultaneously creates deposits at the same time it creates credit. Huh? OK here we go. For this we need to look at the banking system as a whole, not just an individual bank.

When a bank creates a loan, the bank ends up with a loan asset and a deposit liability, and the borrower winds up with a liability (the loan), and money — the proceeds from the loan. Guess where most of this money is very likely to end up? You got it. back in a bank. As what? you’re right again. a deposit. That deposit will now offset the reserve ratio of the bank it was deposited into, ultimately increasing the amount of excess reserves that bank has, if needed, to lend back to the bank that originated the loan, if and when that bank happens to be short of reserves due to the loan it made. Phew! For those wondering, no, I never studied run-on sentences. And the story doesn’t have to be that complex. On many occasions, especially with large banking institutions, the loan proceeds could be deposited back into the very same bank that created the loan, negating the behind the scenes transfer of reserves.

The quantity of reserves across the entire banking system will stay constant unless one of three things changes. First is the number of banknotes in circulation. The second is if the central bank changes the amount of assets on its balance sheet. And the third way is due to a change in government deposits, which will be detailed later. Notice that the act of commercial bank lending is not one of these three functions.

By now, hopefully you’re beginning to see the importance of understanding money creation. Here are some key takeaways:

• The size of the money supply, which ultimately determines price stability, has no upper bound. Commercial banks could theoretically create money to infinity if there were willing borrowers and a Fed to go along for the ride. Of course the central bank would make this an impossibility by simply implementing tight monetary policy, discouraging borrowers to borrow.
• The central bank has an influence on money creation (lending), but only indirectly through policy measures which impact the desire for banks to lend and for borrowers to borrow. They do not give banks money to lend.
• Quantitative easing is not flooding the money supply with excessive money, or enabling future immense increases in bank lending. Rather it is suppressing interest rates and driving behavior by changing the portfolio balance at large financial institutions. It has also absorbed tremendous amounts of toxic assets through this process, alleviating banks and other institutions from taking major losses.

So what truly drives money creation and destruction? One word. confidence. Confidence by banks, and confidence by consumers. Why? Because confidence is what is required for lending to take place. Confidence increases the desire for banks to lend and it increases the desire for consumers and businesses to borrow. Think about it. A business is unlikely to borrow to invest in capital expenditures unless it is confident that those efforts will be rewarded by more sales. A homeowner is unlikely to borrow unless he is confident the price of his home will remain stable or increase. And banks are much more likely to lend when they are confident that the assets used as collateral will retain their value and the borrower will be able to repay.

And remember this, the Federal Reserve — try as it might — cannot create or instill confidence. It can enact policy measures to try to improve confidence, such as promising zero interest rate policies for years to come, and purchasing toxic securities, but it does not have a magic confidence wand. Confidence, like trust, builds over time. It ebbs and flows much like the business cycle.

Understanding the forms of money creation (central bank vs. commercial lending) is critical as we begin to analyze key topics such as price stability (including the likelihood of hyperinflation), credit market health, chances of another financial crisis, and whether a gold standard could ever exist.

I’m certain that I left many people scratching their heads by trying to pack so much material into one article. Fear not, as we continue to roll along and apply this knowledge, I will re-explain specific topics in more detail. One last thing. In these articles I’m not attempting to place judgement on whether our system is correct, moral or even functioning appropriately. My goal is simply to understand how the system operates to enable more prudent investment decisions.

Now go take some Tylenol for your headache.

The following is an excerpt of Richard Russell’s Dow Theory Letters. To receive their daily updates and research, click here to subscribe.