Thanks to a number of feudal style privileges the banks are engaged in a peculiar business of creating money and loans out of nothing which they manage with a profit. The creation of new money dilutes the purchasing power of the existing money and has the business cycle with recurring booms and busts and waste of resources as a grave side effect. To understand the process of money and credit creation it is illustrative to go through an example in detail:
We consider a society with small banks A, B, C, D, E and economic agents x1, x2, x3, x4,..
We use the reserve ratio c=0,1. This means the bank has an amount of 10% of its depositors money in their vaults. ( If their depositors reclaims more the bank will be unable to refund their customers money. )
x1 goes to bank A and deposits K=1.000.000 monetary units (m.u). The deposit maybe physical money like gold or silver or todays unvaluable paper which to government has made money by force.
X1’s purpose of the deposit is safeguarding and possibility to pay bills by instructing the bank to transfer the money. X1 thinks he has deposited his money for safeguarding but the bank consider it a loan. In fact the bank consider it a loan with no fixed pay back term which gives the money the character of a gift from the banks perspective.
- Bank A set of to make a profit of their gift and grants a loan to x2 of 900.000 m.u (=K*(1-c)) on which they can earn interest.
- X2 spends his loan paying x3 who deposits his money 900.000 in his bank B.
- Bank B lends out 90% of the money x3 deposited to their customer X4 = 810.000 m.u. (=K*(1-c)(1-c))
- x4 spends his loan paying x5 who deposits his money 810.0000 in his bank C
- Bank C lends out 90% of the money x5 deposited to their customer X6 = 729.000 (=K*(1-c)(1-c)(1-C))
- X6 spends his loan paying x7 who deposits his money 729.000 in his bank D
- and so it goes…
The final result of this process is that X2, X4, X6 has a number of loans =
K(1-c) + K(1-c)(1-c) + K(1-c)(1-c)(1-C) + ..+ .. This is a converging geometric series which converge with the sum K(1-c) \ (1-(1-c) = 0,9K \ 0,1 = 9K
X1 x3 x5 has a number of deposit accounts =
K + K ( 1-c) + K (1-c) (1-c) + .. +.. which converges with the sum 10K.
From the perspective of the depositors money in the bank account is just as good as physical money in the pocket. The end result of the process is that the banks has created
9.000.000 m.u of loans and 9.000.000 m.u. of money out of the originally deposited 1.000.000 m.u.
In reality there is a limited number of banks. But this does not change the end result. It might then be that x3 is a customer in bank A so that A can lend out even more. In reality also there will be depositors like x1 in all the banks A, B, C, but this also does not change the essence of what is happening.
Modyfying factors will be lenders not fully using their loans. If x2 keeps 20% of his loan in his deposit account then also 90% of this might be lent out by the bank keeping the same reserve ratio c.
This means that Bank A can increase their loans considerably with
Deposit x2 * (1-c) = K(1-c)*0,2*(1-c)= 162.000 m.u
So that total loans from bank A will be 900.000 + 162.000 = 1.062.000 out of the originally deposited money.
Also this effect will spread out through the banking system.
An effect reducing the banks ability to make money out of nothing is people keeping their physical money in their pockets. So the banks will try to make people pay electronically as much as possible keeping the use of physical money to a minimum.
We see that from the perspective of an individual bank it is profitable if the money from granted loans ends up back in the banks vaults. The likelihood of this will increase with the size of the banks. This explains the tendency for mergers in the banking sector.
When contemplating all this it is important to understand the difference between money and wealth. Wealth are real goods and services that satisifes real human needs. Money is just a medium of exchange. When the banks creates money out of nothing they create nothing satisfying human needs. The banks is not doing a normal sound business exchanging valuable products and services with other businesses and consumers. The banks are rather redistributing wealth at the expense of the depositors for the profit of themselves and the lenders ( which cruically includes the governements). In the example above the depositor x1 sees the purchasing power of his money reduced to 1/10.
Modern banking is large scale legalized robbery which should be brought to an end removing the privileges of the banks turning them into normal businesses.