It all started in England in the seventeenth century, when merchants would leave their gold in the hands of goldsmiths for safekeeping. At any given time, it was unlikely that every merchant would arrive to retrieve his (we're talking the 1600s, so the merchants were almost universally men) gold, so the goldsmiths began lending a percentage of the gold out to other merchants - at a healthy interest rate, thus earning interest twice on the same capital. The portion that they held back against withdrawal requests - their reserve - started out at around 50%, but then shrank as the goldsmiths grew more bold. This was the first modern banking scam; lending the same money twice (and sometimes three times).
Also, since the goldsmiths had a virtual monopoly on credit, they were able to charge exorbitant rates, sometimes on the order of 30%. Add to this the relative scarcity of gold, and the situation was fairly disastrous for England in the late seventeenth century. Merchants were starved for capital, and the entire economy was being crunched. The king of England was deep in debt and struggling to finance a myriad of wars which bled hard currency (gold) to the continent.
The king got around these problems by establishing a national bank (financed by an enterprising team of businessmen). The bank lent 1.2 million pounds to the King, and then lent the same 1.2 million pounds to the public, only instead of lending out gold to the public (which the bank no longer held), it lent out banknotes - essentially IOUs which were theoretically redeemable for the gold they represented. This move accomplished two things:
it immediately made a lot more capital available to the economy, and
it legally entrenched the "double dipping" scam of the goldsmiths, in effect yanking their business out from under them. In fact, even though the banknotes were redeemable for gold, few people bothered since, being authorized by the crown, the banknotes were almost universally regarded as being "good as gold."
As long as lenders had confidence in the bank, this scam could run in perpetuity. In the real world, panics and crises regularly triggered runs on the bank, as worried noteholders tried to redeem their banknotes for gold that simply didn't exist. Unfortunately, while the history of banking has taken a number of interesting turns since that time, the system presently in place shares the same basic principles as the scam which precipitated the whole thing - with two major differences.
With the advent of central banks (e.g. the Federal Reserve in the U.S. or the Bank of Canada in Canada) in the 1930s, the central bank was given a monopoly on creating currency, and so the private banks - chartered or otherwise - had to keep legal tender as a reserve rather than gold. The reserve rate has been steadily declining. By the turn of the 20th century, U.S. banks were keeping a reserve of 1/4, so the same money could be lent out four times. By the 1950s the reserve rate was 1/8 - the same money could be lent out 8 times.
Today, the reserve rate is around 1/20. In Canada, many types of transaction have no cash reserve requirement at all.
Perhaps a little additional clarification is in order. A bank licence is literally a licence to create money. The Bank of Canada, for example, which is the only entity in Canada which has the right to create money, licences out that right to private banks, who are only too glad to create money "out of thin air" as it were and then lend it at the prevailing interest rate to borrowers.
This can be illustrated with an example. You go into a bank to take out a mortgage for a house. The bank approves a $200,000 loan and the money is transferred into your account, and then to the builder. You start making monthly payments with compound interest. By the time you're finished paying the mortgage, you will probably pay close to double the original principle.
This is the bank's reward for all their hard work in collecting such a some of money to lend to you, right? Wrong. When you are approved for the mortgage, the bank creates the money and transfers it electronically to the builder, who uses it to pay for material, administration, financing payments, labour, etc., etc. The money truly is created out of thin air. The key is that the money is all created as debt issue, with a compound interest rate on the order of about 10%.
An excellent example of how this has gotten out of hand is a recent offering by banks. You can borrow money from the bank at prime or better - let's say at 5% - with the proviso that you give the money back to the bank to invest in a mutual fund. The mutual fund generates an annual return of 15%, so after you pay the interest on your loan to the bank, you get to keep the differnce - 10%. It's a win-win situation: you get money for nothing, and so does the bank. Banks can't create money and lend it to themselves - that would be too much a conflict of interest - so this is a way to get around it. The big problem, as it has been for the last 300 years, is the relationship between real interest rates and real rates of growth. If almost all of the money is being created by private institutions as debt issue (let's say for the sake of argument that all money is created at a prime of 5% - clearly most of the debt is issued at a much higher interest rate, so I'm being extremely conservative in this scenario), and if the economy as a whole is growing at 3% per annum, then the total indebtedness of the economy is increasing faster than the total value of the economy. Eventually, the debt burden becomes unsustainable and the economy experiences a crash where debts are obliterated suddenly and disruptively.
The great hand-wringing over the last decade about government debt levels has more or less ignored this deeper problem. Even as public debt-to-GDP ratios are stabilizing and in some cases going down, the consumer and corporate debt-to-GDP ratios are going up. Even the fairly robust rates of growth we've had the last few years - in the range of 4-5% - are not enough to outstrip the more dramatic rates of interest.
And yet, there is nothing intrinsically wrong with money being created out of thin air. Money is ultimately a shared abstraction (some would say a shared lie), so the only important thing is how the creation of money affects the functioning of society. There is no reason, for example, why the central bank couldn't excercise its right to create money and lend it to the government really cheap, so that the government can afford to maintain adequate social spending. This was what was done earlier in this century, and it worked wonderfully.
Unfortunately, mainstream business thought is virulently opposed to this so-called "funny money". The common complaint is that GCM is somehow "inflationary", as if privately created money could not be. One way around this is to find ways to constrain the creation of private money to account for the extra GCM circulating in th economy. An easy solution is to raise the cash reserve requirements of the private banks. Compare this to the current monetarist practice of bloodymindedly pursuing a high interest, high unemployment money policy that causes tremendous disruptions in the lives of people who just want to work and make a decent life, while producing a windfall for bondholders.
This page fully complies with the W3C standard for HTML 4.01 Transitional and uses Cascading Style Sheets (CSS).