How the banks create money

[Loss Leader]

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.

Not yet, but if I use my $100 to help pay for my tuition, or to buy myself a warmer jacket so I can deliver more papers, or to pay a man to paint my car, which is labor he wouldn't have done otherwise, then I've improved the economy's output, staved off inflation, and created something new.

Don't ask me why I place value in having my car be a different color. That's the kind of question economics can't answer.

 

[Captain.Sassy]

Not yet, but if I use my $100 to help pay for my tuition, or to buy myself a warmer jacket so I can deliver more papers, or to pay a man to paint my car, which is labor he wouldn't have done otherwise, then I've improved the economy's output, staved off inflation, and created something new.

Don't ask me why I place value in having my car be a different color. That's the kind of question economics can't answer.

yes, if you take that 100$ and buy a jacket so you can work in the winter, then you are increasing your output and the economy grows by however much your output increased.

 

[drkitten]

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.

Because there's a long history of dislike of the middleman.

Look at some of the portrayals of the medieval miller if you want to see how this works (Chaucer's Reeve's Tale as well as the description of the miller in the General Prologue is a good example.) Even when millers operated honestly, the peasants still generally resented the cut that they took of the final product.

The miller is in the same position as the banker; flour is more valuable than grain, but the process of adding value isn't free and the miller charges what he can for it. Since the miller generally is in a position of some power over your average peasant (there are lots of farmers, but only one mill), he can charge "fees" that your average peasant considers extortionate, but has little choice to pay. He's enriching himself by taking an unjust share of what the peasant has labored for, and typically lives much better than that peasant by virtue of that share.

Does this sound like modern banker envy to you?

 

[Floyt]

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.)

Okay, makes sense. But it seems in the case of the really large money movements (or the ones that come in bundles large enough to have economic impact), the "person" is a nation, i.e. the personal growth in income is just said national economic growth. And when a nation "retires", we deem it a catastrophe for all involved.

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.

Borrowing from the future has been a good bet historically in that for most of that time we were only starting to make a dent into the resources that enabled the future to do what was expected of it.

The population-ecological view is applicable insofar as this bending of all efforts towards growth is a wonderful strategy as long as there are plenty of resources to tear into, but for the organism involved, it invariably means live fast, crash hard (usually when the space runs out). Then the equilibrium communities take over. Humans have been having splendid success as first-stage colonizers, but what we want to be (because we don't fancy crashing) is a long-term, equilibrium species. I.e., we have to switch life histories at some point. A case can be made that that point is approaching or already here, because we can see the resource-gobbling lifestyle getting harder to sustain. (This is just the practical phrasing of what every environmentalist agenda is getting at.)

In that case the growth-acceleration techniques are no longer appropriate, and to keep promoting them because "it worked fine in the past" seems to miss the point.

The optimistic approach is of course to think that we can keep doing so because we will manage to boldly find new space to expand into. E.g., develop cold fusion, breed Hi-Octane Oil Trees, and colonize Mars. Which is another bet, and a bit more risky.

All of this might seem like unnecessary doomsday drama when we were just talking about some financial practices. But what concerns me is that underlying philosophy (I couldn't care less, and couldn't judge, whether a bank is technically fraudulent or not when it snaps virtual greenbacks into existence).

 

[drkitten]

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.

Except that there is new money, which is why the price of beer rises. Before, you could have bought the last case of beer in the store for next to nothing, because you were the only one with any claim to it. Now there are four of us with equal claim.

 

[drkitten]

Okay, makes sense. But it seems in the case of the really large money movements (or the ones that come in bundles large enough to have economic impact), the "person" is a nation, i.e. the personal growth in income is just said national economic growth. And when a nation "retires", we deem it a catastrophe for all involved.

Shrug. Macro vs. micro. It doesn't even have to be national-level; when a company "retires" we get things like the collapse of Bethlehem Steel, which couldn't compete with the new upstarts.

But while it's a catastrophe for those personally involved, it's not generally a disaster for the economy as a whole. In a no-growth economy, growth is a zero-sum game (for every winner, there is an equal and opposite loser), which makes borrowing an inherently risky proposition since you've basically got a 50/50 shot of being in an improved position to pay it back. Which is why bankers want to see stuff like business plans before they make business loans, so they can judge whether you'll be a winner or a loser down the road.

Borrowing from the future has been a good bet historically in that for most of that time we were only starting to make a dent into the resources that enabled the future to do what was expected of it.

The population-ecological view is applicable insofar as this bending of all efforts towards growth is a wonderful strategy as long as there are plenty of resources to tear into, but for the organism involved, it invariably means live fast, crash hard (usually when the space runs out). Then the equilibrium communities take over. Humans have been having splendid effect as first-stage colonizers, but what we want to be (because we don't fancy crashing) is a long-term, equilibrium species. I.e., we have to switch life histories at some point. A case can be made that that point is approaching or already here, because we can see the resource-gobbling lifestyle getting harder to sustain. (This is just the practical phrasing of what every environmentalist agenda is getting at.)

Yeah. The problem is that scientists, historically, keep finding more resources for us to gobble. Just as an example, the amount of energy available from the uranium in coal ash dwarfs the amount of energy in the coal in the first place; the garbage of the 19th century could more than power the 21st.

All of this might seem like unnecessary doomsday drama when we were just talking about some financial practices. But what concerns me is that underlying philosophy (I couldn't care less, and couldn't judge, whether a bank is technically fraudulent or not when it snaps virtual greenbacks into existence).

Well, yes, it seems like unnecessary doomsday drama.

But beyond that, I'm not even sure what "technically fraudulent" means. "Fraudulent" is a legal term, which means that we as a society can define any activity we like as being "fraudulent" or not.

Snapping virtual greenbacks into existence "simply" devalues the ones that already exist. Since the value of a greenback is also "whatever we want it to be," there's no problem with this, either. Society, in general, likes a steady growth of money, even in a no-growth economy, because inflation encourages investment which in turn is more likely to produce growth. (Yes, investment is a bet, but it's a bet where we can shift the odds in our favor by how we set it up.) If we didn't let banks inflate the currency via virtual greenbacks, we could also do it simply by printing more money at the mint, but it's a lot cheaper and easier to put it in the hands of the bankers....

 

[tkmikkelsen]

Let me come with a little scenario.

If I where to start a new country and we start out with having 1000 money. I get my first citizen, but he/she needs some starting cash so he/she goes to me and say; "Hey, can I borrow 1000 money?". I borrow him/her the 1000 money at 5% interest rate per year over 1 year. Which means that in a year he owes me 1050 money, but my country only have 1000 money, so where do the 50 money come from. Are we going to get them from abroad?
In order for him/her to make some sort of good use out of the money I borrowed him/her. The economic growth in my country has to be over 5%.

In most countries today the economic growth is usually lower than the average interest rates for loans. Doesn't that propose a problem or is there something I am completely missing?

 

[aleCcowaN]

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.

Again, not true, non sequitur.

The first paragraph speaks about time value of money in general, the attitude of many loan subscribers, and why some people lend money. In the sentence "Money is created because you're picking your own pocket forward in time (with the help of the bank)" that because can be parallel to "We'll win because God is great", and the sentence "The money isn't so much created as moved backwards in time" reveals lack of a proper definition of money.

The second paragraph stirs pretty much the same stew. The epistemology here seems to be something like "as you are hungry you hunt a bunch of deers and kill one so the ones which escape are clearly future hunger".

First, decide what is money, then explain how is created. You seem to disregard the reality check of a system creating exactly the same money in a context of time value zero or at a rate of 50% a month. Maybe you can explain how is created the money to pay the interests (and while doing, you'd realize why you're wrong)

 

[aleCcowaN]

Let me come with a little scenario.

If I where to start a new country and we start out with having 1000 money. I get my first citizen, but he/she needs some starting cash so he/she goes to me and say; "Hey, can I borrow 1000 money?". I borrow him/her the 1000 money at 5% interest rate per year over 1 year. Which means that in a year he owes me 1050 money, but my country only have 1000 money, so where do the 50 money come from. Are we going to get them from abroad?

From the same source that makes yours a, say, $350,000 home (show me the money). Most of economical questions can't be answered without imparting some propaedeutics and according uniform understanding of terminology.

There's not an instant match for M1, M2, M3 and M4 nor for anything that has a nominal value or a market plausible value. So this thread is going astray as not only all money is not made equal but people shouldn't make a salad from money as a mean of exchange, money as a temporary deposit for value and money as a countable unit. Dressing the salad with mechanism for money creation, economical growth and even international commerce (that is the way $100 magically disappeared in a previous post, while the debate centered in the remaining IOUs) makes it a completely indigestible one.

There's a saying among economy teachers that says something like this -in English- "if you have to resort to all of the economical science to explain how a part of the system works or what it is, you don't know neither the part nor the science".

 

[Captain.Sassy]

Except that there is new money, which is why the price of beer rises. Before, you could have bought the last case of beer in the store for next to nothing, because you were the only one with any claim to it. Now there are four of us with equal claim.

If there's four times the amount of money and the amount of goods that money can be traded for stays the same (one case of beer), the price of a case of beer should increase four times, no? And if we all spend our 100$ IOU on a 1/4 case of beer, then how do we each pay back the debt we owe?

 

[aleCcowaN]

If there's four times the amount of money and the amount of goods that money can be traded for stays the same (one case of beer), the price of a case of beer should increase four times, no? And if we all spend our 100$ IOU on a 1/4 case of beer, then how do we each pay back the debt we owe?

A close system with a case of beer and four people in it, without any other resources, nor means of production and thus no labour, is not meant to be a monetary economy. No bank note nor IOU has value within that system.

 

[Loss Leader]

In most countries today the economic growth is usually lower than the average interest rates for loans. Doesn't that propose a problem or is there something I am completely missing?

If that were true, economies would be shrinking. Instead, economies are almost always growing in almost all situations almost all of the time. The individual's labor adds value to the system.

 

[Loss Leader]

A case can be made that that point is approaching or already here, because we can see the resource-gobbling lifestyle getting harder to sustain. (This is just the practical phrasing of what every environmentalist agenda is getting at.)

In that case the growth-acceleration techniques are no longer appropriate, and to keep promoting them because "it worked fine in the past" seems to miss the point.

The optimistic approach is of course to think that we can keep doing so because we will manage to boldly find new space to expand into. E.g., develop cold fusion, breed Hi-Octane Oil Trees, and colonize Mars. Which is another bet, and a bit more risky.

All of this might seem like unnecessary doomsday drama when we were just talking about some financial practices. But what concerns me is that underlying philosophy

I agree with you. There has to come a point where resources will not allow any greater efficiency or total work in the system. I have no idea when that point will be.

You point out that we're seeing signs of it now and you may be right. However, a fuel shortage in London 500 years ago led people to believe that the city had grown as much as it could. Technical innovations allowed them to switch their fuel from trees to coal and, suddenly, there was more fuel than people knew what to do with.

You are right that we cannot blindly assume that we'll always experience this kind of last minute save. What should be done about it, though, is an open question.

What happens when a species reaches its tipping point? I imagine that the highest-consuming members die out and the careful, conservative members take over. Perhaps we'll see an evolution into a species of human that doesn't try to eat and burn everything we see the moment we see it. That'd be cool.

 

[stevea]

Why people find this so hard to understand I find utterly baffling.

Fractional reserve banking is where the anti-government paranoia of the right and anti-business paranoia of the left meet. Like all paranoiacs there can be no attempt to understand - it's just unreasoned fear. Perhaps you missed Brainster's comment ....

There ought to be some sort of rule about fractional reserve stupidity. If someone comes to a site and deposits their stupidity, and the site then lends out 80% of that stupidity, eventually there's a lot more stupidity in the world. The good news is that sites will never run out of stupidity.

Further, because of the principle of compounded stupidity, we can never reduce the fraction of stupidity in existence. One stupid comment made 2000 years ago will compound to a Palin-Bernanke unit of stupidity today.

[...]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.

Well - Canada and the UK have no reserve requirement while China and the US do. So a specific fractional reserve req is not the only means of asserting control.

==

I think the blind spot in the vision of the "banks create money" meme is that people don't understand the difference between "high powered money" deposit vs circulating money deposit.
http://en.wikipedia.org/wiki/Monetary_base
At a 10% reserve rates, when the Fed creates $1 of high powered "new money" it can create up to $10 of credit in circulation. OTOH when your employer transfers 1K from their bank to yours as a paycheck, there is no net effect on total reserves and no new creation of circulating money. One bank can decrease their reserve by just as much as the other must increase it.

This same multiplier effect can exist in a barter society without any banks. p I give you 10 fish, and you give me an IOU for 10 fish. You save one fish, and trade the other 9 for 9 fish_IOUs. The new holder saves one fish and trades 8 for IOUs ... eventually we have 10 ppl with one of the original "high powered fish" and also there are 55 fish_IOUs magically created by those evil fish mongers. Assuming we all trust each other for the IOUs then the 55 "low powered fish" are actually worth one fish each in trade too. If you can't understand how we got from 10 fish to 65 tradable fish equivalents then you are too dumb to understand fractional reserve banking.

 

[drkitten]

If there's four times the amount of money and the amount of goods that money can be traded for stays the same (one case of beer), the price of a case of beer should increase four times, no?

Yes. An increase in the money supply is generally inflationary.

And if we all spend our 100$ IOU on a 1/4 case of beer, then how do we each pay back the debt we owe?

We won't/can't. This is one way that people (and economies) get into trouble. What we should have done is invest the money in something more productive than a case of beer. But having money isn't the same as having brains or even common sense.

Actually, what the first person should have done is figured out what the first borrower wanted to do with the money and made sure that he was a good credit risk. Because if you lend your money out to idiots, you're likely to lose it.

 

[tkmikkelsen]

If that were true, economies would be shrinking. Instead, economies are almost always growing in almost all situations almost all of the time. The individual's labor adds value to the system.

It is true that economies are growing, but say that an economy grows by say 3% per year. Meaning this year we have 100 money next year we have 103 money in our BNP. Now say that on average private loans are given out at 5% per year and for the sake of argument lets just say that all our money was loaned out the previous year, then we started out with a 100 money in debt and a 100 money in BNP, sounds fair enough we can actually pay off our debt. Now we have 103 money in BNP, but a debt of 105 money. Now there is no way we can pay off the debt. Does that mean someone has to foreclose?
And what if our population increased at the same time. Say we started out with 100 people and 100 money, making it 1 money per person. Population grew by 4% so now we have a 104 people, but only 103 money under one money per person. Our economy grew, but our people are poorer than the year before on average.

I think fractional reserves and giving credit is part of why the western world has grown so fast, but I have never understood interests on money, because it is value adding without creating value. Basically you are hoping that if you buy this house for 100 money then the next will somewhere down the line buy it from you for more than 100 money, if they are not willing to do that then the system is left with false value added, because the value only exist in the form of interests, which is of no value in itself.

 

[drkitten]

It is true that economies are growing, but say that an economy grows by say 3% per year. Meaning this year we have 100 money next year we have 103 money in our BNP. Now say that on average private loans are given out at 5% per year and for the sake of argument lets just say that all our money was loaned out the previous year, then we started out with a 100 money in debt and a 100 money in BNP, sounds fair enough we can actually pay off our debt. Now we have 103 money in BNP, but a debt of 105 money. Now there is no way we can pay off the debt.

Sure there is. Just pay it off in installments. Pay off 55 money today, wait until that money circulates back to you, and pay off the remaining 50.

 

[drkitten]

I think fractional reserves and giving credit is part of why the western world has grown so fast, but I have never understood interests on money, because it is value adding without creating value.

This is simply wrong. The value is added by moving money forward in time.

Do you value the convenience of being able to drive wherever/whenever you like instead of having to take the bus? Do you value being able to transport more goods than you can carry in your arms? That's the 'value added' by owning a car, and most Americans (and a substantial fraction of Europeans) consider this to be worth the price of the car.

The next question becomes : do you value having that car today instead of five years from now? That's the value added by banking. You can take out a loan for the money which allows you to spend future dollars today.

But since future dollars are worth less than present dollars (in part because of expected inflation, in part because of expected risk, in part because of opportunity costs), you need to pay more future dollars than present dollars. Translation : interest.

Basically you are hoping that if you buy this house for 100 money then the next will somewhere down the line buy it from you for more than 100 money,

Not at all. Houses are unusual, and even historically, most people didn't expect houses to appreciate. The idea of "investing" in your house is largely a (late) 20th century idea.

Think of it like a car loan instead. You're not buying a car with an eye to resale value. You're buying a car because you like driving over taking the bus. You buy a large-screen TV because you like watching movies. You buy a house because you like living indoors and not being at the mercy of a landlord. In all of those cases, you can (if you like) save up for the money and buy them with cash eventually, or you can buy them now with future dollars that you pay for with interest.

 

[Captain.Sassy]

Apparently, I need to work on my understanding of the money supply. whoops.

Regarding the Bank of Canada and the lack of reserve rates here, this paper seems to address how monetary policy works in this country:
http://www.bankofcanada.ca/en/monetary_mod/reduce/index.html
(will be reading this as part of my effort to understand things better)

Regarding stevea's fish example, it seems to me that for a GDP of 10 fish you have a money supply that is several times larger than the GDP. You don't usually find this in the world, how come?

 

[GreyArea]

On a hunch I searched for part of the original post. Sure enough, it's copied almost exactly from a webpage touting Social Credit. The specific page is here.

Isn't it a violation of JREF rules to cut and paste?

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.

The website's main page begins with a brief explanation of Social Credit and names C.H. Douglas specifically. The introduction is also signed "AC Webb", the same surname as used as the OP's handle.

Am I right to infer from this comment that you are an Aussie? Please stop making us look stupid

The domain appears to have been registered in Australia, and the original page goes into more detail about the Labour Party. So, you may be right.