In a previous post, I began this 3-part series in response to a Tucker Carlson interview with economist Richard Werner, who had argued that private banks “create money” in our current financial system. Although I agree with Werner on this point, I thought he may have misled some viewers into thinking that private banks are just as powerful as central banks in this respect. The point of this 3-part series is to explain the sense in which Werner is correct, but also to demonstrate why I think he (and many of his fans) don’t fully appreciate the limitations of regular banks in the current system.

 

To that end, in Part 1 of the series, I showed the balance sheets of Tesla and then Citibank, as each of them effectively borrowed $100,000 from a household (“Jim Smith”) in order to make a $100,000 loan to a solar panel company. There was a definite sense in which Citibank was more powerful than Tesla, because Tesla needed the money before it could lend it out, whereas Citibank could “create money out of thin air” in the mere act of granting a loan.

 

However, in Part 2, I elaborated on the limitations Citibank would face. Specifically, when granting new “unbacked” loans to applicants, Citibank had to exercise some degree of caution, because the more its clients spent in the community, the greater the amount of claims from other banks that would eventually come calling. When Citi’s clients spent more on the clients of other banks than vice versa, after clearinghouse operations Citi would have to send reserves from its coffers to those other banks. If Citi had been too aggressive in granting “gratuitous” credit, its reserves could hit $0, spelling doom.

 

Finally, in this final installment, I’ll complete the analysis by showing why the Federal Reserve does not face constraints in the way Citi does.

 

Review of Why Citi > Tesla 

To appreciate why the Fed is more powerful (when it comes to money creation) than Citibank, it will actually help to review why Citibank is more powerful (when it comes to money creation) than Tesla. As we spelled out in detail in Part 1, when Tesla makes a loan to a solar panel business, Tesla needs to get the money from somewhere. The solar panel business can’t simply use a Tesla IOU as a substitute for money. Even though a Tesla bond is a valuable and liquid asset, you can’t pay employees with it.

 

In contrast, when Citibank makes a loan to the solar panel business, Citibank doesn’t need to already have that money in its possession. No, Citibank can simply add $100,000 to the checking account balance of the solar panel business. (Of course, Citibank also adds $100,000 to its own assets, reflecting the loan terms that the solar panel business just agreed to.) And in normal circumstances, people in the community do use a Citibank IOU (if it’s in the form of a “demand deposit” aka checking account) as a substitute for money. In particular, if the solar panel business wants to pay its employees or buy something from a supplier, it can simply demonstrate (through checks or debit cards, etc.) that Citibank owes them $100,000, and that is considered acceptable payment, namely to transfer that Citibank liability away from the solar panel company and toward the new recipient of the payment.

 

So to sum up our review: The reason Citibank is more “powerful” than Tesla is that Citibank’s liabilities are treated (in normal times) as being substitutable for genuine lawful money. In most cases, if you want to buy something that is (say) $1,000, you can just as easily write a check on your Citibank checking account as you can hand over ten Benjamin Franklins. In contrast, you can’t typically hand over a Tesla bond, even if it has a current market value of $1,000.

 

Why the Fed > Citibank 

Now that we’ve reviewed the sense in which Citibank is more powerful than Tesla, we can quickly explain why the Fed is even more powerful still. When the Fed wants to make a loan (which it will only do to a select group of institutions), just like Citi the Fed simply increases the amount that the borrower has in its account with the Fed. But the crucial difference is that reserve balances in a Fed “checking account” are legally and economically equivalent to green pieces of official USD currency. After all, if you inspect the pictures of Andrew Jackson or Ben Franklin in your wallet or purse, you will see that they are Federal Reserve Notes.

 

The quickest way to see the crucial distinction is to consider a bank run: Suppose Citibank has $1 billion in vault cash, but its customers show up next Thursday and want to withdraw a total of $1.5 billion. Citibank does not have the power to simply run the printing press and create more physical USD. No, that would be counterfeiting and the Citi officials trying to do it would go to prison. In the event of an actual bank run, it becomes crystal clear that Citibank owing you $1,000 is not literally the same thing as you holding $1,000 in green pieces of US currency in your wallet.

 

In contrast, if a bunch of banks collectively want to withdraw $1.5 billion in currency from their Federal Reserve accounts, the Fed can give the instructions to have that paper money printed up and delivered. Legally and economically, when a commercial bank has money on deposit with the Fed, that is the same thing as if the bank has that in the form of paper currency inside a vault.

 

As I hope this discussion has made clear, there is a very important sense in which the Federal Reserve has the power to “create money” at a more fundamental level than what Citibank or Wells Fargo can do, even though these private banks can “create money” in a way that Tesla cannot.

 

Further Thoughts 

Before Richard Nixon (in)famously ended the Bretton Woods system in 1971, the USD was tied to gold. Under the postwar Bretton Woods scheme, the US authorities had to give other central banks one ounce of gold for every $35 in USD presented for redemption. This peg to gold exercised restraint on the amount of USD that the Fed could create, because if it printed too aggressively, the world price of gold would rise above $35 and allow for an arbitrage opportunity.

 

Yet since this system was closed in 1971, there has been no formal check (or feedback loop) on the Fed’s dollar creation. There is nothing analogous to the limits we explained for an individual bank like Citi, which—if it made too many loans—could have its reserves depleted. 

 

To put it bluntly: When someone thinks he has $1,000 in his checking account at Citi, he can go the teller and ask for the cash. This is why Citi has to be careful with its loan policies, because if its vault cash gets too low, it runs the risk of being empty and unable to satisfy a request. In contrast, if you hold Federal Reserve Notes, there’s nothing that these entitle you to. If you present ten $100 notes to the Fed, they can give you fifty $20 notes of one hundred $10 notes, but they don’t owe you anything other than Federal Reserve Notes. So the Fed doesn’t need to be careful with its “loan policy” in the same way Citibank must be.

 

Conclusion

As a final consideration, keep in mind that in an accounting sense, the Federal Reserve has been insolvent since the fall of 2022. When interest rates were at rock-bottom levels, the Fed loaded up on fixed-income assets (Treasuries and mortgage-backed securities). Then when the Fed started raising rates rapidly, it suffered large (unrealized) losses on its bond portfolio. These losses dwarfed its capital, meaning that the Fed has been literally bankrupt for years.

 

Yet clearly that hasn’t stopped the Fed from operating. This is yet another indication that today’s central banks operate with a higher level of unaccountability (literally) than even private commercial banks.

 

So yes, as Richard Werner explained to Tucker Carlson, private banks can “create money out of thin air.” But their ability to do so is ultimately constrained by the need to keep their own liabilities redeemable in base money at par. In contrast, the central bank’s liabilities are the base money in our post-Bretton Woods era, making them even more powerful engines of inflation than the private banks.

 

 

Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together Whole Life insurance policies and digital blockchain-based issuance.

 

Twitter: @infineogroup, @BobMurphyEcon

 

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