In the Beginning

I want to show the banking system as it exists today, but its current complexity lies beyond the extent of this presentation. So, we must jump into a hypothetical hybrid model created from an historical banking system and the highly unstable banking system we live with today.

Our tale begins with the creation of a number of new banks in what I will refer to as The Fantasy Banking System. Although the founders of modern banks would not begin with contributions of gold, these banks bridge the past and the present by starting their banks with contributions from their own store of gold plus some securities (we assume government securities) from their private holdings.

Beginning with gold also allows using a unit of measure other than dollars. People tend to get bug-eyed and confused when they start hearing about dollars. So everything in this banking system will have the denomination of oz. (for ounces). For assets other than gold, e.g. securities, the unit oz. does not indicate value. It indicates the gold oz. equivalent price paid for those assets.

After I introduce The Fed, I will separate oz. into two categories: 1. Money oz. (M-oz.), 2. Reserve oz. (or R-oz.). I will explain the difference between money oz. and reserve oz. when I get to that segment of the presentation.

Definition of Money

You might find it helpful to keep the following definition of money in mind while viewing the rest of the pages in this presentation:

Money consists of any economic good, or any claim on such a good, that serves as a general medium of indirect exchange and that acts as a final means of payment.

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Money Aggregates

These three popular monetary aggregates all meet the definition of money given above.

M1

Currency, traveler’s checks, demand deposits, and other checkable deposits

M2

M1 plus retail money market mutual funds, savings, & small time deposits

MZM (Money Zero Maturity)

M2 less small-denomination time deposits plus institutional money funds.

Of these three monetary aggregates, I believe that MZM represents the most accurate quantification of the money supply. It includes all the deposit liabilities to which consumers have immediate access for the purpose of making purchases.

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Introductory Note

In the pages that follow I frequently refer to banks buying notes rather than saying that they make loans. I do this with the specific intent of directing your attention to the fact that what we refer to as loans amount to just another form of exchange, like all economic activity. When a bank makes a loan it exchanges current goods (i.e. money) for future goods (also in the form of money, but in the future).

• All economic activities consist of exchanges.
• Loans—amount to a form of exchange:
  • Future Goods (Including Money)

    exchanged for

  • Current Goods (Including Money)

I want to dispel the notion, held by many, that bank loans have a unique character related to the money creation process. Banks can, in fact, create money with the purchase of any economic good. Bank regulation, however, restricts them from doing that on any significant scale.

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