How the banks create money

[Floyt]

They're not creating it out of nothing. They're borrowing it from the future on the premise that future labor will be more efficient and will create greater return than at present.

Which does not seem like a particularly resilient concept because it bets on perpetual economical growth. IANA economist, but (or probably rather that's why) this makes me uneasy.

ETA - I AM an ecologist, and we wallow in cycles and tipping points. Being part of an economy that believes in eternal increase makes me feel like early-succession stage species.

 

[aleCcowaN]

I'm not understanding how fractional reserve banking is creating money from nothing. The assets and liabilities still balance, right? Borrowing money from consumers at almost no interest and re-lending it at a higher interest rates doesn't "create" more money than was already in the system. What am I missing?

An extremely simplified artificial example, without interest rates and a 0% reserve.

-You go to the bank and deposit $100 for one year, that is, you can't ask your money for one year but you can transfer your deposit certificate.
-The bank knows Jack that needs to borrow $100 for one year the same day you deposit your money. The bank lends the money.
-Now Jack have a note of $100 and you have a certificate of $100 that can be used like cash (not really, but its negotiable). Then, there are $200 in the streets. The system created money. The system is not the bank; it includes the bank, Jack, you and your society.
-Suppose Jack wanted the money to buy some item that costs $100. Suppose you want the same item but you think "Bummer, I deposited my money ... wait a minute, I have my negotiable certificate" and you bid for the same item. The merchant sees the avid demand and says "the item is now $150"; you have inflation led by monetary creation -secondary creation-.

Of course you won't use your deposit certificate -or the system could prevent you from using it-, there are interest rates, fees, taxes and mainly there is delay in the system. Surely Jack will use the money he borrowed and the chap who got it will go to another bank to deposit the money again ... and the wheel is moving.

This can go on to the infinite, flooding the streets with means of payment. That's why "fractional": suppose the bank can lend 80%, the multiplier will be 100/(100-80) = 5, for each $100 note there will be another $400 created by the whole economic system. If $500 is too much, there will be inflation. The central bank -or federal reserve- by creating or destroyng a $100 bill regulates the system.

 

[Captain.Sassy]

An extremely simplified artificial example, without interest rates and a 0% reserve.

-You go to the bank and deposit $100 for one year, that is, you can't ask your money for one year but you can transfer your deposit certificate.
-The bank knows Jack that needs to borrow $100 for one year the same day you deposit your money. The bank lends the money.
-Now Jack have a note of $100 and you have a certificate of $100 that can be used like cash (not really, but its negotiable). Then, there are $200 in the streets. The system created money. The system is not the bank; it includes the bank, Jack, you and your society.

Neat. So say I lend you 5$ and you write me an IOU for 5$.

Now I have a 5$ IOU and you have a 5$ bill.

We just created money! You don't even need the bank.

 

[drkitten]

Which does not seem like a particularly resilient concept because it bets on perpetual economical growth. IANA economist, but (or probably rather that's why) this makes me uneasy.

Not really. It's not so much that the economy in particular will grow, but that your personal income will grow.

Which, unless your income is completely divorced from your skill level, it will. Even if you shine shoes for a living, you will be a more skilled shoeshine boy ten years from now than you are today, which means that you'll be able to service more customers faster, better anticipate and fill their needs, and earn more tips per customer with more customers.

But this doesn't mean that "shoeshine boy" as a career is growing, just that you yourself are better at it. The people who are the Grand Old Men of the field today are earning the big bucks, but ten years from now they'll be retired, and you'll be the big dog. (And twenty years from now you will be retired.)

 

[drkitten]

Although I mostly agree with all recent posts, what has to do the time value of money with the money multiplier in a fractional-reserve banking system?

The time value of money is what lets money be "created"; you're spending money NOW that you won't get until LATER.

Fractional reserve is what limits the process. Without some sort of fractional reserve requirement (remember that 1/1 is a fraction), banks could lend money out indefinitely and create limitless amounts of money. So could individual people, for that matter. I can lend out as much money as I have and then spend the IOUs.

Setting the reserve requirement to 100% would prevent banks from overlending by preventing them from lending at all. There's a bit of a baby-to-bathwater issue there, I agree.

 

[aleCcowaN]

The time value of money is what lets money be "created"; you're spending money NOW that you won't get until LATER.

What is before the semicolon is clearly not true; what is after, a non sequitur.

"The time value of money is what lets money be 'created' " = "Electricity is what lets theater to exist"

I don't think so. It's just mixing up secondary creation of money with the reason of having an interest rate. Creation of money follows its inherent ability to flow -if not, it wouldn't be "money"- while time value of money is related with an opportunity cost and there are as many values as people (including many market standards).

Of course, as it's all related within a system, anybody can torture economical concepts long enough for them to confess to be whatever.

 

[drkitten]

What is before the semicolon is clearly not true; what is after, a non sequitur.

Money is created because you're picking your own pocket forward in time (with the help of the bank). You're spending money now that you won't have until later, but someone lends it to you with the expectation that you'll pay it off later. The money isn't so much created as moved backwards in time.

That's the time value of money. Money now is more valuable to you than money later, which is why you want a loan in the first place. We can quantify it (via interest rates), but you don't need to to see what's happening.

 

[marplots]

Would the people who are upset about fractional reserve feel better if we called it 'value added'?

A guy who mines limestone and turns it into cement is adding value. He sells the final product for more than he paid. If he's a good businessman, he sells it for quite a bit more. He has also added to the economy and increased the GDP by turning limestone into cement. He has created money in the form of cement.

How well does the analogy hold up for banks? I am willing, for instance, to pay for the convenience of getting a pile of money in my mitts -- so I pay interest. I also sell money to the banks and they pay me, although, in truth they are still doing me a service by keeping my money safe, but they do pay me to do it.

Now, say I am selling refrigerators and I extend you credit. I use that credit on my balance sheet to further finance other stuff. For instance, I show my books to my suppliers and they extend me credit as well. Am I doing the same thing the bank is doing? Am I creating money? Remember, this is all numbers I'm flipping around.

What about if I offer stock? Here I'm creating what is supposed to be a percentage of value in my company, but after the IPO, the price floats. Have I created money? I have created value out of thin air... somehow.

My point is that dissing the fractional reserve system as if it were some grand scheme/conspiracy seems too easy a target. Let's get all the buggers!!

 

[drkitten]

Would the people who are upset about fractional reserve feel better if we called it 'value added'?

Not really. They're not generally upset about the fact that interest is charged on loans. They're generally upset about the fact that interest is charged on the loan of other people's money.

I mean, you don't object to paying taxi drivers for their services. But you'd be pretty upset if an airport parking lot valet took your car and used it as part of a limousine service.

A lot of people are pretty annoyed at middlemen in general; they seem to offer nothing and charge enormously for it. For example, temp agencies charge a huge fee for work that I do for you, without lifting a finger themselves. And everyone's got a horror story about a real estate agent that did absolutely nothing and still insisted on being paid a percentage when the homeowner found a buyer him/herself. I've even seen people annoyed at stockbrokers -- why should I need to pay a third party if I want to buy stock in a company? Why not just deal directly with the company?

 

[Sword_Of_Truth]

What is this 'Social Credit' of which you speak?

Part economic theory/part anti-banking conspiracy theory first espoused by Clifford Hugh Douglas. Various political movements have sprung up around social credit, the most successful of which was the Alberta Social Credit Party.

I sat on the board of the Alberta socreds from 1996 to 1998, ran for the party in the 1997 provincial general election and left when the looney-tunes faction won control of the party from its mainstream conservative faction ending its brief resurgence in the 90's.

 

[Captain.Sassy]

Fractional reserve is what limits the process. Without some sort of fractional reserve requirement (remember that 1/1 is a fraction), banks could lend money out indefinitely and create limitless amounts of money.

I thought fractional reserve meant that the bank had to have cash on hand to meet that fraction of its deposits; so if the fraction was 10%, the bank could lend out 90% of the value of deposits made with the bank; if the fraction was 0%, the bank could lend out 100% of the value of deposits. I don't see how the bank 'makes limitless amounts of money' in this circumstance.

 

[drkitten]

I thought fractional reserve meant that the bank had to have cash on hand to meet that fraction of its deposits; so if the fraction was 10%, the bank could lend out 90% of the value of deposits made with the bank; if the fraction was 0%, the bank could lend out 100% of the value of deposits. I don't see how the bank 'makes limitless amounts of money' in this circumstance.

Fractional reserve requirements are what limits the amount that the bank can lend out. Without fractional reserve requirements, there would be no reserve requirements whatsoever, and banks could lend the same dollars out until the numbers wore off.

With a 0% limit (which is what you get without fractional reserve requirements, as there is no actual requirement), the bank could lend $1000, accept a re-deposited $1000 and lend it out, repeated without limit. $1000 in deposits could support hundreds of billions of dollars in loans.

And then the bank would crash and burn the first time anyone defaulted on any debt whatsoever.

 

[Captain.Sassy]

They're not creating it out of nothing. They're borrowing it from the future on the premise that future labor will be more efficient and will create greater return than at present.

The last sentence I wrote may sound kooky, but it's true.

This is the basis of interest and has nothing to do with fractional reserve banking.

 

[Captain.Sassy]

Fractional reserve requirements are what limits the amount that the bank can lend out. Without fractional reserve requirements, there would be no reserve requirements whatsoever, and banks could lend the same dollars out until the numbers wore off.

With a 0% limit (which is what you get without fractional reserve requirements, as there is no actual requirement), the bank could lend $1000, accept a re-deposited $1000 and lend it out, repeated without limit. $1000 in deposits could support hundreds of billions of dollars in loans.

And then the bank would crash and burn the first time anyone defaulted on any debt whatsoever.

So if I lent you 100$, which you then lent out to someone else, you're saying there would be 200$ of loans of which 100$ would be 'new' money?

 

[Loss Leader]

Which does not seem like a particularly resilient concept because it bets on perpetual economical growth. IANA economist, but (or probably rather that's why) this makes me uneasy.

ETA - I AM an ecologist, and we wallow in cycles and tipping points. Being part of an economy that believes in eternal increase makes me feel like early-succession stage species.

You're not totally wrong about the fact that it is a bet and not a sure thing. However, given what we know of history, it's a good bet. The total value in the system has been increasing for thousands of years.

Some of it is slow and steady - each individual day of labor adds value and there are more people contributing their labor every day.

Some of it comes in leaps - The invention of the steam engine, and of electricity, multiplied the amount of labor an individual could do by many, many times.

Some of it comes in simple investment - spending capital on a larger or faster machine means that more goods can be made in the same amount of time. But the capital must be borrowed. Where is it borrowed from? A future where the machine is already producing more goods and creating more profit.

Ecology may not be the best way to think about the system. A tree or an entire forest of trees really can't promise their future production to obtain current benefits.

 

[drkitten]

So if I lent you 100$, which you then lent out to someone else, you're saying there would be 200$ of loans of which 100$ would be 'new' money?

Yup. Or at least, new since my lending it out. You hold my IOU for $100, which is worth $100 by assumption.

I hold someone else's IOU for $100, which is also worth $100 by assumption.

And, of course, that someone else has $100 cash money.

So there's $300 in circulation.

If that someone else lent his cash money to his sister, he'd have yet another $100 IOU, and she'd have the cash money, and there's $400 in circulation. Et cetera.

 

[Captain.Sassy]

Yup. Or at least, new since my lending it out. You hold my IOU for $100, which is worth $100 by assumption.

I hold someone else's IOU for $100, which is also worth $100 by assumption.

And, of course, that someone else has $100 cash money.

So there's $300 in circulation.

If that someone else lent his cash money to his sister, he'd have yet another $100 IOU, and she'd have the cash money, and there's $400 in circulation. Et cetera.

Kinda new money but more like the same money's circulating around.

If A lends B 100$, then B lends C 100$, the ious cancel out. At the end of the day, if A uses the iou as money they're just transferring the debt that B owes them. If new money is created then it's destroyed whenever the debt is paid back.

 

[drkitten]

Kinda new money but more like the same money's circulating around.

Yeah, but it spends like new money.

All four of us can show up at the Quik-E-Mart and offer up to $100 for the last case of beer.

If A lends B 100$, then B lends C 100$, the ious cancel out. At the end of the day, if A uses the iou as money they're just transferring the debt that B owes them. If new money is created then it's destroyed whenever the debt is paid back.

Yes. And?

 

[Loss Leader]

Kinda new money but more like the same money's circulating around.

Since money is a tangible expression of value, nothing new has been created at all. We've just found a way to express value inherent in the system.

A tree has very little value to an individual as a source of food - wood is inedible. But the invention of fire lets us exploit a value of the tree - its ability to help cook other food - that we had no access to before.

I really don't see why anybody should think that banking, in and of itself, is in any way bad.

 

[Captain.Sassy]

Yeah, but it spends like new money.

All four of us can show up at the Quik-E-Mart and offer up to $100 for the last case of beer.

not prudently... three of us still owe that 100$ to someone else.

I get that the 'money supply' increases in that the money has circulated around to more people, but in terms of 'money' as a claim on the economy's output there's no new money.