Every Dollar Matters

How Banks Work

Money is an interesting thing (pun soon to be intended). I know MD's, PhD's and lots of other really intelligent folks that melt like ice in a hot skillet at the mention of money, finance, or taxes.

This of course makes discourse very hard. Some are way too prideful in this area (yes, you know who you are). This too, makes discourse on this subject difficult.

Well, we are in a pretty dire economic situation and we need discourse (Nov, 2010). First we all need to at least have a baseline understanding of money at a macro level.

If I lend you $100 at 10% simple interest you are on the hook to pay me back $110. Now, lets assume we each have $100 to begin with. Essentially this transaction creates a transfer of weath from one party to another. After the transaction is complete I now have $110 and you have $90.

In macro finance involving a central bank that creates the money suppy it works a little different. We will still use simple interest and our $100 for this example. The Treasury department cranks up the proverbial printing press and creates $100. They send it over to the Federal Reserve. In turn, the Fed lends this money to a Bank though what is know as the Federal Reserve Discount Rate. Lets use 10% simple interest again as our example. The bank borrows the$100 at 10%. They now have an obligation to pay back the Fed $110. The Banks job is to make money by lending the money it just borrowed to others (people or business). The Bank is also required to keep a portion of the money they borrow in reserve. For sake of this discussion we will say this number is 10%. This means the banks has $90 to lend. In order to make money the bank much charge a higher interest rate than they borrowed the money at. Lets assume they loan the $90 at 20% simple interest. When all their loans are paid the Bank makes $18. They pay the Fed their $10 interest and now have $108 in capital. They still have to keep 10% in reserve. But, they now have about $98 to lend.

I think everyone can wrap their head around this example. Sure, when we factor in compound interest, and time variations in paying back the loans and all the other factors. But, the example I have provided is essentially how it works without all the mumbo-jumbo.

Two things we now need to note. First, where did the $100 the Treasury printed come from? What was it backed by? Second, the interest rates set by both the Government and the Bank creates new (non-printed) money in addition to the $100. In our example it created another $28.

Now, I want to add one other Banking scenario in play before continuing. The bank can also make loans based upon other deposits they have on hand. In other words if you put $100 into a savings account the bank can lend $90 of your money to others. The scenario works essentially the same as above.

The fact is that interest rates are a major factor in increasing the money supply and wealth. The current Federal Funds Discount Rate is .75%. Historically (since 1971) these rates run much higher. Besides taxes, the Federal Funds Rate can be a major source of revenue for our Federal Government.

As a quick example. One trillion dollars at the current rate of .75 nets the Government 7.5 billion dollars. At 4% the yield would be 40 billion dollars. The money supply that is subject to this yield is around ten trillion dollars.

A 4% Federal Funds rate is not unreasonable. In fact from 1971 until 1990 the Federal Funds rate never went below 4.75%! From 1990 until 2000 it hovered from 3% to 6%. In the past decade it has wildly fluctuated from .5 to 6%. So by slowly raising the Federal Funds Rate back up to 4% the Government would collect $400 billion in revenue.

Our current nations deficit (11/23/2010) is 13,797 trillion dollars. US Debt at USTreasury.gov Of this staggering amount 4,591 trillion is Foreign held. If we could balance the Federal Budget, raise the funds rate to 4% and apply the money towards the foreign portion of our deficit we could eliminate our foreign debt obligation in about a decade.