the level of this multiple.
You will find that most central banks, including the Federal Reserve, generally set these minimum reserve requirements for the banks. This ensures that banks maintain at least a minimal amount of their on demand deposits in cash reserves. In such a way, the money creation performed in the commercial banking realm is controlled by the Central Bank or Federal Reserve.
This is also intended to make certain that banks possess sufficient available on hand cash to deal with typical withdrawal demands. Even though these fractional reserve minimums are intended to prevent them, difficulties can become evident if a great number of bank depositors attempt to pull out their money at once. This leads to bank runs on rare occasions. If the problems are exaggerated to banks throughout a region or are severe, it can also cause a systemic crisis in the banking system.
To help alleviate these types of difficulties and protect the system, the Federal Reserve oversees and closely regulates such commercial banks. It furthermore functions as a true lender of last resort for them. Besides this, another body, the FDIC, or Federal Deposit Insurance Corporation, insures commercial bank customers’ deposits.
Because banks are allowed to lend out a certain multiple of the deposits that they actually have, they can be utilized by the Federal Reserve to create additional money. You have already seen that they can lend out a multiple of the deposits that they have on hand. Another way of putting this is that the Federal Reserve only requires them to keep a certain percentage of loans that they make as reserves.
Typically, this fractional reserve number is ten percent. This means that for every $1 that they have in reserves, a bank is allowed to loan out $10. They are given a money multiplier of ten to one with this reserve.
So when the Fed purchases Treasuries by crediting a financial institution’s account, they are electronically increasing the reserves’ value of the bank in question. The bank is then not simply able to loan out these deposits that are magically credited to them digitally, but instead the full fractional reserve multiplier of what is typically ten to one.
This means that the Federal Reserve creates not only the money that they use to purchase treasuries with, but also the ten to one in new money that is created by a bank loaning out up to their fractional reserve requirements.
Every modern bank in the United States operates on this system of fractional reserve lending. This whole explanation may come as a shock to you, as it does to most Americans when they learn of it. Reality is that far more money is loaned out than the banks literally keep in reserves. Although there are restrictions to how much money the banks can create, you have already seen that the restrictions are mostly limited to the ten percent fractional reserve requirement.
Should the Federal Reserve Bank desire it, they can lower the reserve still further, allowing yet more money to be created as if by magic from thin air. This has profound implications for your money and its value. Later in the chapter we will examine what this means for you and your paper and electronic dollars.
From Something to Nothing – Your Money Now
In the good old days of the 1800s through 1971, money proved to be as good as gold. This is because until Nixon took the United States off of the gold standard, money was literally exchangeable for gold. This led to an incredibly stable period in the value of the dollar and other major world currencies that lasted for literally more than a hundred and fifty years.
When you look at the value of the dollar against gold from 1792 to1862 when the Civil War had begun, you see that gold closed each year in that seventy year period in the range of $19.39 per ounce to $21.60 per ounce. You witnessed a deviation of no more than 11 percent in the value of gold and hence the dollar in seventy years.
Another way of putting this is that in seventy years, the dollar had only declined around 11 percent against fixed asset gold. Similarly after the Civil War ended and recovery ensued, from 1870 to 1932 the dollar against gold remained steady around $20 to $22 per ounce. This proved to be another more than sixty year period where the dollar had no more than a ten percent deviation in value.
Money started its gradual descent to increasingly worthless currency when the government began to play with the gold standard.
The first real instance of this proved to be in 1933 when President Franklin Roosevelt decided to intentionally devalue the dollar against gold.
When he declared gold to be worth $35 per ounce against the dollar, he started a depreciation that caused the dollar to fall almost 70 percent from the closing values in 1932 to 1934. It did not matter that the President did this intentionally. This proved to be the biggest single decline in the dollar in its history to that point.
Still, the gold standard last another forty years for the United States, and so long as the government did not interfere with the dollar gold convertibility, the dollar held its value remarkably well once more. From 1935 to to 1971, gold closed every year in a range of $35 to $43.50. These were far more tumultuous years, but the dollar still held its own over the thirty six year period, declining by not even 25 percent despite the challenges of the Great Depression, World War II, and the Korean and Vietnam Wars.
The fatal moment for the dollar and other world currencies has already been described earlier in this chapter. President’s Nixon’s unilateral decision to withdraw from the gold standard started a stampede for the exits. The gold standard died an ignoble death over the next few years. This is exactly the point where currency value stability ended, in particular for the U.S. dollar.
From 1970 to 1983, the dollar dropped sharply against gold. It went from a 1970 closing value of $39 to a 1982 closing value of $447, at one point touching a mind blowing $850 per ounce. In thirteen years, the dollar, once a bedrock of stability and value, dropped 1,046 percent.
The fortunes of the dollars value waxed and waned with economic news and cycles from 1971 forward. The currency had become a paper instrument whose only value lay in the faith and credit of the U.S. government.
This meant that the value would lie entirely in how creditworthy the U.S. economy and how trustworthy the U.S. government appeared from this point forward. In the years from the 1970 last year of the gold standard, to the prices as of the first of October 2010, the dollar has steadily declined in value over time, despite periodic bounces.
Today’s dollar is valued at $1,320 dollars per ounce. Remember that this level has been reached from $39 per ounce in 1970. The last forty years have represented the most shocking collapse in the value of money in modern history.
The dollar, and most of the other now paper currencies around the world, has plummeted a staggering 3,285 percent.
To put that in concrete terms for you, had you seen the writing on the wall regarding the gradual devaluation of paper currencies, you might have sunk your money into gold to maintain its real value. Your actual thousand dollars in 1970 would today be worth a mind numbing $32,846.
This does not represent investment gains that you would have made in stocks, bond, real estate, or other speculative investments. It is simply how far the paper dollar has declined in value since it officially lost gold’s blessing and backing forty years ago. Can there be any doubt as to paper money’s gradual descent to worthless currency?
Daisies and Dollars – Beautiful to Look At, Impossible to Eat
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