Basic Money Magic

Preface to Senior Center Study Group

R.W. Zimmerer

My intention is to explain the barest essentials of our US financial structure. I have avoided complex technical details and unfamiliar language of the official Handbook of the Federal Reserve System (Ref. 1) and Prof. Mishkin’s attempts to explain it in many editions of his book (Ref. 5). A successful attempt by the Chicago Fed (Ref. 3) to explain money creation by Fractional Reserve Banking is no longer in print but still available on the Internet! David Bazelon writes a witty history and explanation of money in The Paper Economy (Ref. 6) revealing how banks and governments create and manage our money supply. Ellen Brown writes the most recent history and explanation of money in The Web of Debt (Ref. 2) and posts frequent commentaries about today’s ongoing financial crisis on her own and other web sites.

How money is created, enters commerce, and becomes part of the money supply as here explained implies many consequences and invites suggestions how a new financial structure could be constructed to avoid frequent financial collapses. “Basic Money Magic” is a work in progress. Comments are welcome.
It could be helpful to first read excerpts of several references I include before reading my brief essay.

Basic Money Magic

Money supply is here defined as legal tender, coins and federal reserve notes (cash), together with vastly larger amounts of money held in checkable deposit accounts, whose checks can be cashed for legal tender upon demand of the deposit owner. Citizens and corporations each own small portions of this money supply as cash in hand and in checkable deposit accounts.

The words loan, debt, credit, capital, interest, profit, even wealth, are loosely used in ordinary conversation. When one loans a neighbor a garden hose the use of that garden hose has been transferred temporarily to the neighbor. One garden hose can only be used by one homeowner at a time. You confidently “credit” the neighbor that he will return the borrowed hose. If you loan the neighbor $129 he gets to spend it not you. $129 will be returned but not the exact same $129 (as with a borrowed garden hose) for the money was spent into the economy. To repay you the neighbor transferred back to you a different $129 and you regain the right to spend $129. In either case $129 remained part of the money supply; only its ownership was being transferred: from you to neighbor to merchant back to you from neighbor.

When a bank loans your neighbor $125 it gets a formal commitment in writing, a contract, agreeing he will repay the bank the full amount of $125. This contract is a debt, a financial asset to the bank which can sell it to a willing buyer and a liability to your neighbor. It has value beyond returning $125 because it earns interest to whomever owns the contract, the debt.

The credit card today has been called plastic money replacing the bank check in everyday shopping. It illustrates much of how banks manage the money supply. A credit card gives its owner a “line of credit,” a pre-approved amount of money which can be loaned to the owner by the bank underwriting his credit card.

The Ambiguities of the Word “Swiping”

When making a purchase the card is “swiped” and a receipt is printed out for the owner’s signature much like he signs a personal check. The merchant accepts it like cash. The underwriting bank makes good on the cash value of the merchant’s receipt depositing that amount into the merchant’s bank account, transferring money to the merchant. The card owner acquires a debt to the bank of the amount of the purchase. This has been a bookkeeping activity, no cash has actually changed hands.
The bank could deposit its own money in the merchants account, transferring its ownership to the merchant. When the card owner pays-off his debt the bank recovers its money paid to the merchant. Money was moved among bank accounts, a bookkeeping exercise. The money supply at no time increased or decreased. This is the common understanding of all bank loans. Savings & Loan banks (Thrifts) did it this way lending S&L depositors’ money to build houses in the community. Commercial banks do not lend depositors money. They loan new money into existence – they create money. This is derogatorily called printing money. It has long been the legal business of commercial banks to create new money by a bookkeeping act.

When a commercial bank deposits the amount of the credit-card charge into the merchant’s bank account it creates that money by its government-given legal authorization to create money out of nothing by a bookkeeping entry. The money supply is increased by the amount of the purchase charged. The owner can pay off the loan with a check on his bank account or maintain it as debt upon which he will pay interest.

In the first instance the card owner transfers money from his account to the bank’s account, “extinguishing” his debt. The debtor has effectively repaid his loan with the money the bank had created and added to the money supply. Paying off the debt has increased the bank’s ownership share of the money supply by the amount of the repaid debt. The bank has printed its own money!

In the second instance a debt to the bank is created, a claim on the money supply which earns the bank interest until it is paid-off. The bank has a money-earning asset of some financial value which it can sell. The money supply increases with each swiping (loan) because the underwriting bank is creating new money with each swipe, which is “balanced” (a bookkeeping concept) by a corresponding debt on the bank’s books. The bank is creating money “backed” by new debt. If this growing credit card debt were paid off ownership of that portion of the money supply would be transferred to holders of the credit card debt, the underwriting bank.

In all this discussion there is no mention of legal tender, cash. Bank transactions are all accomplished by bookkeeping entries, creating and moving money among bank accounts. Debts earn interest, money ownership being continuously transferred to the debt holder. If commercial loans cease being made, the money supply stops increasing from new debt creation. Interest payments will move ownership shares of the now fixed money supply into the bank accounts of debt holders, concentrating ownership of money from many borrowers to fewer lenders.

In a prospering economy ownership of the increasing money supply derived from increasing debt is spread among businesses, employees, and customers. Is there no limit to money creation by commercial banks making loans (extending credit)?

Underwriting the entire system of money creation and the US money supply is legal tender. It is needed to satisfy that occasional demand for cash and support faith in the US money supply. Only the federal government can manufacture legal tender whether it be gold coins or paper federal reserve notes. The Federal Reserve Bank is the US Central Bank created by an act of Congress in 1913 delegating some of its Constitutional authority for money management to this private bank.
The Fed supplies legal tender manufactured by the US Treasury to private banks as they need it and sets rules limiting money creation by banks. The Fed requires banks to maintain deposit accounts at the Fed and limits the amount of money they can create to a multiple of the legal tender in the money supply. The Fed is one of many federal government departments which examine private bank operations to enforce compliance with Fed rules and regulations. Banks can be fined, closed, or sold, if not complying. The Fed can loan or withdraw legal tender from Fed bank accounts to exercise control over banking activity. It is done by a key stroke on a computer, a bookkeeping act!

A historical note:

US banks originally issued private bank notes redeemable in gold coins manufactured by the US Treasury. They routinely issued more bank notes than they had gold in their vaults to redeem them. Banks were creating money! This expanded the money supply far beyond the gold coins in existence. Public faith in bank notes depended on being able to exchange them for gold coins. Banks would often not accept each other’s bank notes for fear that they could not be redeemed in gold coins. Bank runs were common consequences with bank depositors losing their money. Today there is but one bank note and it is accepted by all banks. It is the Federal Reserve (bank) Note. It is no longer redeemable in anything and stands alone as the physical legal tender of the USA, legal for the payment of all debts.

A Central Bank

The privately owned Fed is the US Central Bank by Act of Congress. It is also the US Treasury’s bank. The US Treasury which is the only source of legal tender borrows money from the Fed. The US Treasury does not simply spend its legal tender to pay the expenses of the federal government. It must first borrow money from the Fed just as do any of the Fed’s private member banks. But Treasury seldom borrows directly from the Fed. Treasury usually sells bonds to the public, which buys them with money from the money supply, so transferring ownership from buyer’s bank account to Treasury’s bank account. The money supply does not change; only ownership changes.

Treasury bonds earn interest from Treasury and have been highly valued as risk free because Treasury can always pay the interest on its debt with legal tender. The Fed manages the money supply by buying these bonds from the public, paying legal tender for them. This is not just new money; it is new legal tender. The money supply increases and decreases as the Fed buys and sells Treasury bonds with legal tender. It also increases and decreases as the Fed changes the required money reserves banks must have and how the Fed defines money reserves.

Treasury can sell its bonds directly to the Fed, so avoiding new publicly-held US Treasury debt. US National Debt. The Fed “earns” interest from Treasury on the Treasury bonds it owns. It pays its operating expenses from this interest and deposits the rest into the US Treasury Fed account. Treasury is paying interest on its bonds to itself when the Fed owns them. If the Fed (US Central Bank) were part of the US Treasury, there would be no need to sell Treasury bonds.

reasury would manage the bank accounts of private banks and write checks on its own account. It could still sell Treasury bonds to provide default proof interest-paying investments for the public.

Commercial banks which create most of the money supply are limited by Fed rules and regulations in how much money they can create to some multiple of legal tender in the money supply. In a prospering economy of growing business activity and a population dependent on borrowing money from commercial banks, the amount of legal tender in the money supply must also increase. To increase legal tender in the money supply Treasury must borrow it so the Fed can buy it. Thus it becomes necessary for the US National Debt to increase.

Treasury borrows most of the money it spends into the economy to pay federal government expenses. Treasury must pay its interest by borrowing more money for interest payments in addition to paying the operating costs of the federal government. According to the historical record US National Debt has increased from $2 billion to $12,000 billion since 1900, averaging 8% a year increase including a 6x jump for WW I and WW II.

In the ongoing world financial crisis starting in 2008, the Fed has been putting legal tender into the money supply by directly “adjusting” the bank reserves of banks and near banks. To save Goldman Sachs, an investment bank, it was quickly converted into a commercial bank so the Fed could “give” it legal tender as it was doing for overextended commercial banks. This new money does not flow from any new appropriation by Congress nor increased US National Debt! It is off-the-books so to speak.


1. Purposes & Function of the Federal Reserve System, This is the Fed’s official handbook on management of the US money supply.

2. The Web of Debt, 3rd edition, February 2008 by Ellen Brown,, is in my opinion the definitive exposition of the failure of the money = debt financial system practiced today. It is the underlying cause of the financial boom and bust cycle of contemporary economies. Chapters can be viewed on her web site where her frequent commentaries on the present financial crisis can be read.

3. Modern Money Mechanics, A Workbook on Bank Reserves and Deposit Expansion was originally produced and distributed free by the Public Information Center of the Federal Reserve Bank of Chicago. It is now out of print but it is available on the Internet at

It is a very readable 38-page explanation of Fractional Reserve Banking by which a deposited $100 check can result in bank deposits, the money supply, increasing $1,000 or more!

A snippet from MMM: “The actual process of money creation takes place primarily in banks. As noted earlier, checkable liabilities of banks are money. These liabilities are customers’ accounts. They increase when customers deposit currency and checks and when the proceeds of loans made by the banks are credited to borrowers’ accounts.

“In the absence of legal reserve requirements, banks can build up deposits by increasing loans and investments so long as they keep enough currency (legal tender) on hand to redeem whatever amounts the holders of deposits want to convert into currency (cash). This unique attribute of the banking business was discovered many centuries ago.

“It started with goldsmiths. As early bankers, they initially provided safekeeping services, making a profit from vault storage fees for gold and coins deposited with them. People would redeem their ‘deposit receipts’ whenever they needed gold or coins to purchase something, and physically take the gold or coins to the seller who, in turn, would deposit them for safekeeping, often with the same banker. Everyone soon found that it was a lot easier simply to use the deposit receipts directly as a means of payment. These receipts, which became known as notes, were acceptable as money since whoever held them could go to the banker and exchange them for metallic money.

“Then, bankers discovered that they could make loans merely by giving their promises to pay, or bank notes, to borrowers. In this way, banks began to create money. More notes could be issued than the gold and coin on hand because only a portion of the notes outstanding would be presented for payment at any one time. Enough metallic money had to be kept on hand, of course, to redeem whatever volume of notes was presented for payment.

“Transaction deposits are the modern counterpart of bank notes. It was a small step from printing notes to making book entries crediting deposits of borrowers, which the borrowers in turn could ‘spend’ by writing checks, thereby ‘printing’ their own money.”

4. Money As Debt is an excellent 47-minute DVD video production which explains in understandable lay terms the flawed “money = debt” system and offers some remedies. It is a wonderful teaching tool to make clear the basics of money creation. It can be ordered on the Internet at and portions can be seen on YouTube.

5. An excellent (attempted) exposition of the Byzantine US money system is Prof. Frederic S. Mishkin’s book, The Economics of Money, Banking, and Financial Markets. The third edition of 1992 is particularly enlightening with many recent examples of bankers’ folly, failures, and rescues by the Fed. Since 1992 many new techniques of money manipulation have become prominent to evade Fed rules and regulations. The abuses of the system we are witnessing today are direct results. These many bank innovations are reviewed in his 4th edition.

Columbia University Prof. Mishkin has been a consultant to many banks and nations. In 2006 Mishkin co-authored a report called “Financial Stability in Iceland.” The report maintained that Iceland’s economic fundamentals were strong. The report was commissioned by the Icelandic Chamber of Commerce in response to critical reporting on the Icelandic economy and certain Icelandic companies in the international business media.

Iceland subsequently experienced a spectacular collapse within a year of Mishkin’s good report.

Britain has called on Iceland to honor its compensation obligations, two days after the Icelandic president vetoed a bill to repay the UK government over the failure of Icesave bank. Icesave was an online subsidiary of Iceland’s Landsbanki bank, which had to be rescued in October 2008 as the global credit crunch hit.
Mishkin was confirmed as a member of the Board of Governors of the Federal Reserve on September 5, 2006 to fill an unexpired term ending January 31, 2014. On May 28, 2008, he submitted his resignation from the Board of Governors, effective August 31, 2008.

6. The Paper Economy by David Bazelon (1963) is a delight to read. He was a corporation lawyer writing from long experience serving the wielders of corporate power. He retired and taught many years at the U. of Wisconsin in Madison. Among his many insights Bazelon defines money.

“For one thing, money is a contract – the freest, most gorgeous contract of them all. Money is somebody else’s promise to pay, to give me what I want, when I want it. What a magnificent conception! The fully alienable contract for anything, anytime, anywhere. If you are at all aware of the history of contract law, you will realize what an immense historical achievement modern paper money represents. Whatever else history may ultimately record of the Western bourgeoisie, this honor most certainly must be accorded them: they perfected modern money, which is a contract with parties unknown for the future delivery of pleasures undecided upon.”

Notice, March 7, 2010

– from Economic Reform, March 2010