What Is The Difference Between Federal Reserve Bank Money and Private Bank Money?

Modern Money Theory (MMT) says that money created by the Federal Reserve Bank and money created by private banks are not the same thing, MMT calls Federal Reserve created money “high powered money”. I sort of get the idea, but then I struggle with it. I finally realized that the financial crash of 2007-2009 was all the proof that I needed to see the difference between the two kinds of money.

What the private banks create is a promise to pay you “high powered money” whenever you want it. As long as you are happy to leave your money in the bank, you don’t care if that money in the bank is a promise or is the actual thing. It only matters to you and the bank, if you want to take some money out of the bank. From this realization of the bank arose the idea of fractional reserve banking. Over time, banks learn how much “high powered money” their customers will ever want at any one time. All the high powered money the bank needs to have (in reserve) is the maximum amount of high powered money their customers will ever want to withdraw from the bank at one time. Any money that they hold above the reserve requirement can be lent to someone else for a fee.

The only fly in the ointment is that sometimes too many people who have money in the bank want to take it out at the same time. If word gets out that the bank can’t deliver the money on demand, suddenly all bank depositors want to take all their money out of that bank. This is called a run on the bank. It used to happen often enough that people were on the look out for the possibility of happening.

In 1913, the Federal Reserve Bank was created to back-up banks in case a bank had a run. The Federal Reserve Bank, which held a large reserve, could rush high powered money to the bank that was having a run. If people realized that the bank could give them all of their money that they wanted, the run would stop, the banks could repay the Federal Reserve Bank, and business returned to normal.

During the 1930s depression there were so many runs on banks at the same time, that President Roosevelt had to declare a nationwide bank holiday. You could not withdraw your money from a bank while the holiday was in effect. From this experience, the idea of the Federal Deposit Insurance Corporation. With this in place, your money in a private bank was insured by the government as to always be available to you no matter what happened to the bank where it was deposited. With that insurance, there was no need for there to be a run on a bank, and even if there were, the FDIC would come to the rescue. In fact , runs on banks became very rare.

I won’t go through all the details, but by and large this worked well for almost 80 years. In the interim, the USA went off the gold standard, and the Federal Reserve Bank was given the responsibility to create USA high powered money that was backed by nothing other than the full faith and credit of the USA government.

By the mid 2000s, with deregulation of the private economy, banks (and insurance companies, and the shadow banking system) were taking more and more risks. Not only were there bank deposits and loans, there were also CDOs (collateralized debt obligations), liar’s mortgage loans, credit default swaps, and an alphabet soup of money derivatives. Look this up on the internet if you want to know more. When the real-estate market started to decline, too many of these promises of money started to be redeemed. Lehman Brothers Bank collapsed, and the world’s financial system froze up.

What unfroze the situation, among other things, was the promise by the Federal Reserve Bank to create $20 trillion dollars of high powered money to satisfy all the demands. What better indication can we have that high powered money is different from private banks’ promises of money?

Could a similar problem arise with Federal Reserve Bank created high powered money? It is much less likely, but it could happen. Right now, the USA has a trade deficit with the rest of the world. Countries accept USA money for the goods they sell us, but they don’t spend all that money to buy stuff from us. The excess USA money that these countries accumulate sits in accounts at the Federal Reserve Bank (or it is invested in USA Treasury securities). MMT almost says, “no problem, the Federal Reserve Bank can always create enough high powered money to satisfy the demand for this money”. The USA government can always buy whatever is for sale in USA money. Countries holding all this money won’t try to convert all this money into something else like gold or the high powered money of another country. If they did, the USA money would become worthless, and they would lose the value of all the USA money they still held. However, this accumulated money is not being used for anything by these countries. What if they merely said “We have enough reserves of USA money. We don’t need any more, so you can’t buy anything from us with USA money.”?

I think I will leave you with this thought. Use your imagination, or ask experts what the result of this would be. Imagine what the USA could do (or already is doing) that would bring on this refusal to accept our money?

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