We have all heard the saying – “money doesn’t grow on trees.” It’s actually much simpler than this. Money grows by tapping keys on a computer.

As the above video by the Philadelphia branch of the US Federal Reserve Bank (the Fed) indicates, money is created out of thin air by the private banking industry through a process called “fractional reserve banking.”

We all find this difficult to believe. It defies our “household budget” logic. How can money be created out of nowhere? Let us take time to look at how the centuries old practice of fractional reserve banking led to current practices where, by law, private banks are only required to physically possess 10 percent of the money they have actually generated as loans.

This process of money creation dates back to the days of the goldsmiths and silversmiths. Because gold and silver were beautiful, easily worked, but rare metals, they had a natural, real value. As such people began using them – especially gold – as a medium of exchange for other goods and services. But this meant gold needed to be protected from theft or other possible loss. This became one of the functions of the goldsmiths.

Goldsmiths built vaults. Heavy, non-transportable, hard to open vaults where gold could be safely stored. People began bringing their gold to the goldsmith for safekeeping, and in exchange the goldsmith gave the people a paper I.O.U. (carefully protected from counterfeiting by the goldsmith’s difficult to reproduce “seal”) which could be redeemed for the gold upon demand. In effect, the goldsmith became the “bank.”

As this process evolved and people found it was much easier to carry and protect paper I.O.U.’s than gold, the paper note itself began being used as a medium of exchange in the marketplace. This is how paper money was born and it opened a huge door.

When the goldsmith/banker saw that his I.O.U.’s were being used as money, he came to a great revelation. He realized, since only a small percentage of the people holding gold certificates ever wanted to redeem them for the precious metal at any one time, he actually only needed to store a fraction of the gold required to cover all of gold I.O.U. certificates in circulation.  The goldsmith/banker realized in fact, that he could create even more money by simply printing more paper certificates that were “as good as gold,” and lending them to people at interest. The goldsmith/banker was now creating money “out of thin air” and collecting interest on funds he never had to begin with. Fractional reserve banking had come to life. Bankers were making money on imaginary money.

Fractional reserve banking is now standard legal practice throughout most of the world. The “gold standard” was wisely and necessarily abandoned in the US and most other nations long ago, but private banks still loan out – at interest – roughly 9 times more money than they actually possess. Today it is digital money created out of thin air on computer screens, but it is legal money just the same.

It is critical to understand that almost all of our money is now created as interest bearing debt, and this interest roughly doubles the cost of everything people, businesses, and governments purchase with money borrowed from private banks. Half of what we spend for houses, factories or schools goes to pay off interest on money lent by banks that the banks never had in the first place.

The merits (or demerits) of fractional reserve banking could certainly be debated, but it is the system we have lived with – and are likely to continue living with – for a long time. The real questions are – why not use fractional reserve banking to our own advantage? Why not use municipal or state monies to capitalize our own public banks to serve the public good? Why not use fractional reserve banking to create money where the interest is paid back to “we the people” rather than leaving our communities and states to enrich large Wall Street banks? These are questions we will seek to address in subsequent units.

Unit II will address: The Cost of “Interest”