How the banks create money

[The_Animus]

Let's go back to our little isolated island with 100 money in total. I need 1000 money to build a boat. Can I do it?

Sure. I establish a 1000 money loan with the bank and I pull the money out on 100 money chunks. Today I take out 100 money and pay to have the keel laid. The keel-layer takes his payment and deposits it back in the bank. Tomorrow I take out 100 money and pay to have the ribs installed. The rib-installer takes her payment and deposits it back in the bank. Two weeks from now, I'll have a boat.

And now I have a loan to pay back. Let's make it a really usurious loan -- I have to pay back 1200 money, and there's still only 100 on the island. Can I do it?

Of course I can. That's why I wanted the boat in the first place. I go out every night and catch a fish. I sell that fish to the banker for 5 money. I then pay him back that 5 money against my loan. In 240 days, I'll have paid back the loan, five money at a time. It takes me less than a year to pay back a loan twelve times greater than the total amount of money in circulation on the island.

No. As soon as I pay back the loan, the money that was created via lending disappears.

So at the end of the period, there's 300 money on the island. There's the original 100 money, and there's the 200 money that was created as "wealth" via the lending process. And, of course, the island as a whole is also wealthier by one boat and one deep-sea fisherman, which gives the island access to more and different fish.

In drawing out this scenario this is not what I came up with. So allow me to present your scenario as well as alternatives scenarios of a similar nature.

First off, at the completion of the fishing boat we have the following.
1. The bank has in its possession $100 as Skilled Craftsman#10 (from here on called SC10) deposited it in the bank.
2. You owe the bank $1200
3. The bank owes SC1 through SC10 $100 each, as they have each deposited their $100 in the bank after completing their portion of the work on the fishing boat.

*Alternative Scenario*
You go out to catch fish, hit a terrible storm, your boat sinks, and you die a terrible loanly (get it!) and cold death.

Now the bank cannot and will not ever get its $1200. So the current situation is:
1. The bank has $100.
2. The bank owes a total of $1000 ($100 each to SC1 through SC10)

Christmas is coming and the skilled workers wish to buy their daughters expensive imported gifts. They go to the bank, find out that it doesn't have money to cover what it owes them and they crucify the bank owner.
*End Alternative Scenario*

Back to your original scenario. You catch fish and each day sell one to the banker for $5. After 20 days the banker has no money left, so let us assume every 20 days you repay $100 of your loan. After the final $100 dollars is paid off the situation is as follows.

1. The bank has in its possession $100
2. You have a fishing boat and no money
3. The bank owes SC1 through SC10 $100 each for a total of $1000

Ahoy! You have had a good day of fishing and have caught 100 fish in a single day and are selling each one for $5.
SC1, SC2, SC3, SC4, and SC5 are all staring at your marvelous catch and decide they each want 20 fish. SC1 goes to the bank and gets his $100 dollars and buys the fish. SC2 through SC4 go to the bank asking for their money so they can buy fish as well. Upon learning the bank has no more they cut off each of the bankers limbs and hit you over the head with a rock, killing you, before taking your fish.

*Alternative Scenario*
As above except SC1 pays $100 for 20 fish. You deposit that $100 in the bank. SC2 withdraws his $100 and buys 20 fish. You deposit the money and so on through SC5.

Now the situation is
1. The bank has $100
2. The bank owes $1000, $100 each to SC6 through SC10, and $500 to you

SC1's daughter has turned 18 and decided to offer one night of sexual fun with her for $500. You go to the bank and ask for $500. The bank doesn't have $500 to lend you and the daughter will not take 5 payments of $100. In a fit of rage you kill the banker and the daughter, grind them up into chunks of flesh, and use them as bait in catching further fish.
*End Alternative Scenario*

The moral of this hypothetical experiment is that lending more money than actually exists will at some point result in someone dying a horrible death. Oh and it results in a constant owing of more money (debt) than actually exists.

 

[webb5]

That personal wealth you have created has come from some one else's debt. That is the part you do not understand. re- read the Monopoly Game

As a citizen in your country, you indeed may do well in life, but what ever money you accumellate will always come from debt weather direct or indirect. But what ever the country owes you will owe.

 

[webb5]

That personal wealth you have created has come from some one else's debt. That is the part you do not understand. Re- read the Monopoly Game

As a citizen in your country, you indeed may do well in life, but what ever money you accumulate will always come from debt weather direct or indirect. But what ever your country owes you will owe.

 

[drkitten]

In drawing out this scenario this is not what I came up with. So allow me to present your scenario as well as alternatives scenarios of a similar nature.

Rather silly alternatives, but whatever....

First off, at the completion of the fishing boat we have the following.
1. The bank has in its possession $100 as Skilled Craftsman#10 (from here on called SC10) deposited it in the bank.
2. You owe the bank $1200
3. The bank owes SC1 through SC10 $100 each, as they have each deposited their $100 in the bank after completing their portion of the work on the fishing boat.

*Alternative Scenario*
You go out to catch fish, hit a terrible storm, your boat sinks, and you die a terrible loanly (get it!) and cold death.

That's right. Lending is risky, and the bank arguably should not have lent out as much of it's capital to a single borrower as it did. Of course, in a more realistic situation, the bank could and would have lent to dozens of potential fishermen, enough that the loss of any single fisherman would not cause a catastrophic failure, and would also have insisted that I carry insurance that could pay the bank off in the event of a terrible storm. The cost of the insurance would probably end up eating in to my profits; instead of making $5/fish, I'd only make $4/fish (and pay $1 to the insurance company) and would take 20% about 270 days instead of 240 to pay the loan off.

Christmas is coming and the skilled workers wish to buy their daughters expensive imported gifts. They go to the bank, find out that it doesn't have money to cover what it owes them and they crucify the bank owner.

That's not the banker's problem, but a problem with the national mint. The banker can issue a cashier's check to the workers that they can use to buy their daughters whatever they want. You'd have the same problem in the real world if you decided, for whatever reason, that you insisted in being paid in cash instead of with a cashier's check when you sold your house.

Back to your original scenario. You catch fish and each day sell one to the banker for $5. After 20 days the banker has no money left, so let us assume every 20 days you repay $100 of your loan.

That's not my original scenario. My original scenario paid the banker $ daily.

But, continuing....

After the final $100 dollars is paid off the situation is as follows.

1. The bank has in its possession $100
2. You have a fishing boat and no money
3. The bank owes SC1 through SC10 $100 each for a total of $1000

Ahoy! You have had a good day of fishing and have caught 100 fish in a single day and are selling each one for $5.

SC1, SC2, SC3, SC4, and SC5 are all staring at your marvelous catch and decide they each want 20 fish. SC1 goes to the bank and gets his $100 dollars and buys the fish. SC2 through SC4 go to the bank asking for their money so they can buy fish as well.

And they get cashier's checks, which I accept, knowing the bank will redeem them.

As above except SC1 pays $100 for 20 fish. You deposit that $100 in the bank. SC2 withdraws his $100 and buys 20 fish. You deposit the money and so on through SC5.

Now the situation is
1. The bank has $100
2. The bank owes $1000, $100 each to SC6 through SC10, and $500 to you

SC1's daughter has turned 18 and decided to offer one night of sexual fun with her for $500. You go to the bank and ask for $500.

Which I get in a cashier's check and sign over to SC1's daughter.

The moral of this hypothetical experiment is that lending more money than actually exists will at some point result in someone dying a horrible death. Oh and it results in a constant owing of more money (debt) than actually exists.

And both of those morals are wrong.

You're confusing the money supply of a society with the amount of currency in a society. The money supply is usually vastly larger than the amount of currency, precisely because it's so much easier to use checks and whatnot. As of April 2008, for example, there was about $800 billion in US currency floating around, about $600 billion in checking accounts and traveller's checks, for a total M1 money supply of about $1.4 billion. The M2 money supply, which includes savings accounts, money market funds, and whatnot, was about five times larger. So we're actually in the situation you feel is so horrid here in the real world; there's more money in the savings accounts of American citizens than there is currency to redeem the balances.

The problems that causes? None whatsoever. If you want to spend the money out of your savings account, you don't need to convert it into currency. You can simply arrange a transfer to your checking account and write a check for any amount you like. You can withdraw however much you like in a cashier's check. You can even get an ATM card that draws from your savings or money market account and spend what you like as with a credit card. Currency is neither needed nor expected,... nor even in many cases wanted; I just had some repair work done on my car and the mechanic wouldn't take cash, because of the security hassles.....

 

[drkitten]

That personal wealth you have created has come from some one else's debt. That is the part you do not understand.

There's a very good reason I don't understand it. It'w wrong. Wealth creation does not rely on debt. If I stick a pan in a river and find gold dust, or chop down a tree and make a picnic table out of it, no one has gone into debt for the wealth I've created.

 

[The_Animus]

That's right. Lending is risky, and the bank arguably should not have lent out as much of it's capital to a single borrower as it did.

That's not the banker's problem, but a problem with the national mint. The banker can issue a cashier's check to the workers that they can use to buy their daughters whatever they want. You'd have the same problem in the real world if you decided, for whatever reason, that you insisted in being paid in cash instead of with a cashier's check when you sold your house.

And they get cashier's checks, which I accept, knowing the bank will redeem them.

Which I get in a cashier's check and sign over to SC1's daughter.

Whoa there. First you started a scenario in which only spending and lending of that $100 was taking place. Now you want to suddenly throw in cashier's checks? Can you solve the issues presented in the scenarios while maintaining the same types of transactions as within the original scenario?

Next, if we did use cashier's checks, with what will the bank redeem those cashier's checks? The bank will never, ever have enough money to redeem them all because the money does not exist to redeem it. This was the point of looking at the example. This system only works so long as
1. Everyone is willing to accept payment in the form of I.O.U's or other deferred payment such as cashiers checks.
2. A large majority of people don't need/wish to wishdraw their money at the same time
and
3. That no one ever defaults on their payments.

If any of these happens then someone gets screwed.

You're confusing the money supply of a society with the amount of currency in a society. The money supply is usually vastly larger than the amount of currency, precisely because it's so much easier to use checks and whatnot. As of April 2008, for example, there was about $800 billion in US currency floating around, about $600 billion in checking accounts and traveller's checks, for a total M1 money supply of about $1.4 billion. The M2 money supply, which includes savings accounts, money market funds, and whatnot, was about five times larger. So we're actually in the situation you feel is so horrid here in the real world; there's more money in the savings accounts of American citizens than there is currency to redeem the balances.

The problems that causes? None whatsoever. If you want to spend the money out of your savings account, you don't need to convert it into currency. You can simply arrange a transfer to your checking account and write a check for any amount you like. You can withdraw however much you like in a cashier's check. You can even get an ATM card that draws from your savings or money market account and spend what you like as with a credit card. Currency is neither needed nor expected,... nor even in many cases wanted; I just had some repair work done on my car and the mechanic wouldn't take cash, because of the security hassles.....

I know we are in that situation. That was my point. If there was a bank run a hell of a lot of people would be screwed. If there were a large amount of money that couldn't be repaid, like the recent housing bubble, then it causes a ton of problems.

 

[psionl0]

So at the end of the period, there's 300 money on the island. There's the original 100 money, and there's the 200 money that was created as "wealth" via the lending process.

Therein lies the problem with having a banker decide who gets money and how much they have to pay for it - inflation and overproduction. Multiply this "little isolated island" by the whole world and you can see how this planet is being consumed at an ever increasing frenetic rate in an attempt to match the growth in money caused by banks charging interest on money THEY created.

This "little isolated island" example is tailor-made for a L.E.T.S. style community. Instead of waiting for the banker to "approve" his plans, the boat builder pays each worker 100 money from his OWN credit (sort of like writing IOUs). The negative balance on the boat builders ledger will be evened out as he sells his fish (redeems his IOUs). Since everybody knows this money is good for buying fish, they have no problem with it. Since the boat builder doesn't need to pay interest on the money he paid out (it's his own credit - not the bank's) the inflationary pressures don't exist.

L.E.T.S. communities are operating successfully all over the world. I don't know if a global (or even national) L.E.T.S. system could supersede the banking system but there are variants of this scheme being devised with this object in mind. Digital Coin is one such example.

 

[webb5]

There's a very good reason I don't understand it. It'w wrong. Wealth creation does not rely on debt. If I stick a pan in a river and find gold dust, or chop down a tree and make a picnic table out of it, no one has gone into debt for the wealth I've created.

The real wealth in this world is in the land and what we make of it, ie farming, building, mining, etc. You are correct in this part only. A monetary value is added to all these things. Which takes us to the role of money.

The role of money is to provide and easy medium to buy and sell things. The only problem here is that this medium is controlled by the banks. Thus the wealth of this world is being manipulated by the banks. That bit of gold dust and that table you made did not cause debt but the money you make from it will come from debt. Maybe one day you will understand.

 

[Mashuna]

Maybe one day you will understand.

I don't think it's very kind of you to hope that Dr Kitten suffers some kind of brain injury.

 

[soylent]

It has since I was teenager always baffled me how interest works, because it is value added out of nothing.

Where's the mystery?

Is it that interest rates can be much higher than GDP growth? There's no great mystery there; some businesses fail, some mortgages default, some credit cards are never repaid and this has to be compensated for by demanding a higher rate of interest.

Is it that interest exists at all? Well, why would anyone lend anything to anyone other than friends and family if there's no interest?

Is it why anyone would take a loan, knowing they'll have to pay interest? That's easy too; that's just time value of money. People value having things now more than they value having the same thing in the future. Sometimes this is merely short sighted(borrowing at a high rate of interest to buy a new TV, say). Sometimes it is a good business decision; imagine a pizzeria that borrows to buy a pizza oven; with this additional oven they bring in enough revenue to pay for the principal, the intrest, the additional pizza ingredients, labour and still come out ahead.

Is it some vague unease at how debt can be paid back if the sum of all debt is greater than the monetary base? Money is reusable; it doesn't just disappear when it is used to pay interest to a bank. The bank pays its employees and owners; it uses the money to make more loans.

 

[drkitten]

Whoa there. First you started a scenario in which only spending and lending of that $100 was taking place. Now you want to suddenly throw in cashier's checks? Can you solve the issues presented in the scenarios while maintaining the same types of transactions as within the original scenario?

No. The bank would have gone bankrupt as soon as it lent out more than its cash reserves in a single transaction if it wasn't permitted to use non-cash transactions. That's one of the inevitable simplifications you need if you're going to have a system small enough to describe in a 300 word forum post.

Next, if we did use cashier's checks, with what will the bank redeem those cashier's checks?

Deposits or loan forgiveness. I accept cashier's checks because I can redeem them against my loan balance. Everyone else accepts cashiers checks because they can deposit them directly into the bank. In a worst-case scenario, people accept them because they can buy fish with them -- or any other goods sold by someone who deals with the bank.

The bank will never, ever have enough money to redeem them all because the money does not exist to redeem it.

Wrong. The only reason your scenarios didn't work is because people wanted all their money right now. Given a realistic time horizon, that's not an issue.

This system only works so long as
1. Everyone A large majority is willing to accept payment in the form of I.O.U's or other deferred payment such as cashiers checks.
2. A large majority of people don't need/wish to wishdraw their money at the same time

since those are, in fact, realistic assumptions that hold in the real world, I have no issue with assuming they hold in our toy one.

and
3. That no one ever defaults on their payments.

Nope. The system is moderately default resistant. The bank has two hundred dollars in spare "money" once I've paid off my debt that it can use to cushion the effects of default; it could write off a debt for 100 money at that point without going bankrupt.

Again, look at a larger scale system. The bank lends to ten wannabe-fishers, charging each of them 20% interest. One fisherman hits a storm and dies with his boat, but the other nine pay off their boats plus interest, for a total of 180% of the cost of a boat. They've created enough wealth to pay for the new boat nearly twice over, and give it to the bank as interest to make the bank not only whole, but profitable despite the default.

There is no problem.

 

[drkitten]

The real wealth in this world is in the land and what we make of it, ie farming, building, mining, etc. You are correct in this part only.

Is this going to turn into a labor-theory-of-value nonsense?

A monetary value is added to all these things. Which takes us to the role of money.

Well, value is certainly added to it. I can use a picnic table in ways that I prefer to ways that I can use a tree. Since I want a picnic table more than I want a tree, it's more valuable to me. Presumably that's true for you as well, or you wouldn't want the table.

What's a "monetary" value versus any other kind of value in this context?

The role of money is to provide and easy medium to buy and sell things.

That's right. Because if you need my picnic table and I need warm blankets, it's much easier for us to trade with money than via barter, especially if you don't have any blankets going spare, but you do have a supply of cheese.

The only problem here is that this medium is controlled by the banks. Thus the wealth of this world is being manipulated by the banks.

In the same sense that the shoes of this world are by definition manipulated by the cobblers, perhaps. If I need shoes, I go to a cobbler, and I pay him for his time and trouble, because I can't make very good shoes myself. If I need money, I go to a banker, because I can't make very good money myself. But that hardly makes our feet into the stuff of conspiracy.

That bit of gold dust and that table you made did not cause debt but the money you make from it will come from debt.

Perhaps. If I sell the picnic table to a moneylender, almost certainly. That's how he makes his money. If I sell it to a sheepherder, it will come from sheep. If I sell it to a cobbler, it will come from shoes.

Maybe one day you will understand.

I certainly hope not. I try very hard not to "understand" things that are not only dead wrong, but stupidly and ignorantly so.

 

[drkitten]

This "little isolated island" example is tailor-made for a L.E.T.S. style community. Instead of waiting for the banker to "approve" his plans, the boat builder pays each worker 100 money from his OWN credit (sort of like writing IOUs). The negative balance on the boat builders ledger will be evened out as he sells his fish (redeems his IOUs). Since everybody knows this money is good for buying fish, they have no problem with it. Since the boat builder doesn't need to pay interest on the money he paid out (it's his own credit - not the bank's) the inflationary pressures don't exist.

No, it won't.

Oh, wait. You think that inflationary pressure is a bad thing, don't you?

What you'll see instead in this situation is a deflationary spiral. Since there's more fish available now, with the same amount of "credit," the price of fish will drop, and I won't be able to redeem my IOUs and will go bankrupt. Other people will see this and decide not to invest in boat building, and the economy of the island will stagnate. No investment, no improvements in productivity, no improvements in quality of life,.... heck, no investments, no investments in maintenance, and quality of life will drop like a paralyzed eagle.

L.E.T.S. communities are operating successfully all over the world.

Not in isolated systems. Without an external market to provide increases in the money supply, you'll end up in a deflationary crash that makes the Great Depression look fun.

I don't know if a global (or even national) L.E.T.S. system could supersede the banking system

I hope not. It seems kind of odd to be trying to devise something that, if successful, would be Fall-of-Rome devastating to everyone including the designer.

 

[Loss Leader]

Every single dollar in existence has been created as debt

This is wrong.

The money we use today has its roots hundreds and hundreds of years ago. When a person gave his gold to a Medici family in Florence in exchange for a certificate, traveled with that certificate to Venice and then, instead of showing up and getting gold from the Venice Medici family, traded his certificate for the services of a scribe (who had expended labor to scribble things), nothing was created by debt.

And those Medici dollars have changed and evolved greatly, but that labor of that service provided by the Medicis and that labor of that scribe is still in the system today. Wealth is created through labor. And labor is not a Ponzi scheme.

 

[psionl0]

What you'll see instead in this situation is a deflationary spiral. Since there's more fish available now, with the same amount of "credit," the price of fish will drop, and I won't be able to redeem my IOUs and will go bankrupt. Other people will see this and decide not to invest in boat building, and the economy of the island will stagnate. No investment, no improvements in productivity, no improvements in quality of life,.... heck, no investments, no investments in maintenance, and quality of life will drop like a paralyzed eagle.

From these remarks, I'm guessing that you have not studied the L.E.T.S. system in any sort of detail. No matter, it will take a radical rethink of the concept of money before something like this could replace banking. Not to mention that the banks might not go along with it.

There is another more mundane possibility for this "little isolated island". The island's government prints enough money to meet the island's needs and spends the money into the community. Some of the islanders will have money to spare (assuming the island is heterogeneous) and invest it in lending institutions. Now the boat builder can borrow money to build the boat and repay the loan and interest by selling fish. The difference is that the overall supply of money will not be affected. The interest will go to the investors who spend it back into the community. The problem is that it won't do the banks much good unless they have a stake in the lending institutions.

 

[psionl0]

When a person gave his gold to a Medici family in Florence in exchange for a certificate, traveled with that certificate to Venice and then, instead of showing up and getting gold from the Venice Medici family, traded his certificate for the services of a scribe (who had expended labor to scribble things), nothing was created by debt.

This is true in the example that you give. However, the goldsmiths also found that they could lend certificates without getting any gold for them. This is most assuredly debt.

 

[drkitten]

This is true in the example that you give. However, the goldsmiths also found that they could lend certificates without getting any gold for them. This is most assuredly debt.

So, in other words, webb's claim that "every single dollar in existence was created by debt" is entirely wrong, and you acknowledge that?

No one disputes that some dollars have been created by debt; lending is one way of creating wealth just as cobbling, mining, or carving picnic tables is. By lending my money to someone, I enable him to use his other resources more productively and thereby create wealth. And, of course, lending is one of the primary method of increasing the money supply, which is necessary to avoid the deflation effect that stifles wealth creation.

 

[psionl0]

So, in other words, webb's claim that "every single dollar in existence was created by debt" is entirely wrong, and you acknowledge that?

A simple statement is either right or wrong. In webb's case, we only need to find a single dollar that was not created out of debt to prove him "wrong" (are there still any greenbacks in circulation?)

The phrase "entirely wrong" is meaningless in this context unless you are arguing that NO money has been created out of debt. Most estimates that I have seen suggest that 90% to 97% of our money has been created out of debt. So it would seem that webb is 90% to 97% correct.

 

[drkitten]

A simple statement is either right or wrong. In webb's case, we only need to find a single dollar that was not created out of debt to prove him "wrong" (are there still any greenbacks in circulation?)

Then we're in agreement. Webb is wrong.

 

[The_Animus]

No. The bank would have gone bankrupt as soon as it lent out more than its cash reserves in a single transaction if it wasn't permitted to use non-cash transactions. That's one of the inevitable simplifications you need if you're going to have a system small enough to describe in a 300 word forum post.

At what point in the scenario(s) did the bank lend out more than its cash reserves in a single transaction? All loans were in the amount of $100, which at the time of the loan it had thanks to a deposit by someone else.

Deposits or loan forgiveness. I accept cashier's checks because I can redeem them against my loan balance. Everyone else accepts cashiers checks because they can deposit them directly into the bank. In a worst-case scenario, people accept them because they can buy fish with them -- or any other goods sold by someone who deals with the bank.

In this scenario, printing and handing out cashier's checks is essentially printing money. The bank only has $100 but owes $1000 and so it prints cashier's checks as if they were $100 bills. Whether the bank just says it owes 10 people 100 dollars, gives them IOU's, gives them a cashier's check, or gives them $100 in monopoly money it is all the same. You may as well say the bank prints new real $100 bills and hands them out to the people it owes because that's exactly the same as using cashier's checks in these scenarios.

Wrong. The only reason your scenarios didn't work is because people wanted all their money right now. Given a realistic time horizon, that's not an issue.

You mean it didn't work because 2 out of the 12 people wanted their money right now? It didn't work because the bank lent out more money than it had and more money than even exists. You can sit and shuffle stuff around for a long time but at some point if any of those 3 conditions fails (and failure at some point is inevitable) then there is a problem.

Nope. The system is moderately default resistant. The bank has two hundred dollars in spare "money" once I've paid off my debt that it can use to cushion the effects of default; it could write off a debt for 100 money at that point without going bankrupt.

At the end of paying back the loans used to build the boat the bank has $100 and owes $1000. Please show me where the bank's spare $200 is.

Again, look at a larger scale system. The bank lends to ten wannabe-fishers, charging each of them 20% interest. One fisherman hits a storm and dies with his boat, but the other nine pay off their boats plus interest, for a total of 180% of the cost of a boat. They've created enough wealth to pay for the new boat nearly twice over, and give it to the bank as interest to make the bank not only whole, but profitable despite the default.

There is no problem.

If you would care to play out this scenario in further detail I'd be happy to discuss it.