This is How It is Done
March 16, 2012 in Finance
Yesterday, I wrote about one of my first accounting clients. I called him Johnny. I told you how he covered the checks that hit his overdrawn business bank account. He wrote checks to his employees so they could cash them at the local grocery store. Then, the employees brought the cash to Johnny so he could put it into his bank account.
He literally created money out of thin air by using the time it took for the checks to clear to run his business another day.
Intuitively, Johnny understood something that he didn’t understand consciously.
Banks do a more sophisticated version of this every day.
I had heard stories about how banks create money out of thin air. I had heard the term “fractional banking.” I didn’t know how it worked.
Now, thanks to the booklet found at this link, I do.
Modern Money Mechanics, printed for a while by the Chicago Federal Reserve, explains how banks create money. It demonstrates how a purchase of ten thousand dollars in government securities, such as United States Treasury Bills, may be converted into one hundred thousand dollars in assets, including ninety thousand that may be loaned or invested outside the bank.
I quickly realized that, even with a seventy-five percent failure rate, banks would at least break even on their investments. A failure rate of fifty percent would bring healthy profit. A failure rate of twenty percent would produce phenomenal profit.
I ran the numbers on a twenty percent failure rate and the results looked like this:
- Buy ten thousand dollars in T-Bills
- Loan out ninety thousand dollars over thirty years at a modest 5% interest rate
- Receive payment in full on only eighty percent of the loan.
- The total repaid is $139,144.16
That’s not bad for a ten thousand dollar investment. It earns an annual percentage rate of forty-six percent while the monthly payments received by the bank are being invested into something else.
Modern Money Mechanics explains that the system isn’t completely mechanical and that other variables enter into the picture. However, the implications are clear. The odds are clearly stacked in the banks’ favor.
As I gained understanding of this process, my emotions ranged from euphoria to anger, joy to disgust.
The euphoria and joy came from the childlike realization that money can be created from thin air. I understood that no one needs to be poor, that anyone can create wealth, and that abundance is available for everyone.
The anger and disgust came from realizing that those who control this system have not made these resources available to everyone via a level playing field.
I recognized these emotions as the ones that I have seen in people’s faces as they protested across our country, denounced the one percent, and willingly stood against riot squads lobbing tear gas canisters and dispensing pepper spray into their peaceful assemblies.
In addition, I picked up a major piece to the puzzle over why we are experiencing a mass exodus from the banking and financial sectors.
I’ll update that story tomorrow.
