How the banks create money

[Sceptic-PK]

I am curious though how you think Fractional Reserve Banking works Startz. Your second sentence should have in it effect and not affect (as far as I understand the difference of meaning in the two words...). I for instance have been trying to affect a greater understanding of FRB in Sceptic-PK and have found the task futile with the effect that nothing has changed.

Mr Irony!

Suffice it to say, loans do not come from deposits, they are limited by what deposits and reserves are according to reserve requirements.

Wrong. Wrong. Wrong.

 

[psionl0]

Suppose that required reserves are 10% and that the bank balance sheet is $9,000 in loans, $1,000 in reserves, and $10,000 in deposits. The bank can't make any loans by increasing deposits or giving out reserves, since that would put it out of compliance.

100% correct although this is a legal requirement rather than the bank evaluating whether its reserves can take another hit if it creates more money.

But I'm still curious as to your view as to what would be determined by some understanding of the source of funds that banks loan out.

The source of the created money is "thin air". The money that gets added to a bank account when a loan is made does not come from any other account. The two things to remember are that bank account balances are money in their own right and banks reserves only get involved when money is spent not created.

 

[Sceptic-PK]

The source of the created money is "thin air". The money that gets added to a bank account when a loan is made does not come from any other account. The two things to remember are that bank account balances are money in their own right and banks reserves only get involved when money is spent not created.

The level of obtuseness in these sentences is truly amazing, Startz. The “new money” isn’t really new at all, it is merely the money the bank has on deposit being loaned to another customer. This, of course, creates new deposits in the banking system, because stagnant money is being loaned to other people to be spent. Banks do nothing that anyone else can’t do with regards to “money creation”.

 

[Startz]

I am curious though how you think Fractional Reserve Banking works Startz. Your second sentence should have in it effect and not affect (as far as I understand the difference of meaning in the two words...). I for instance have been trying to affect a greater understanding of FRB in Sceptic-PK and have found the task futile with the effect that nothing has changed.

You're right about the grammar of course. It amazes me how often I switch "affect" and "effect."

 

[Startz]

The source of the created money is "thin air". The money that gets added to a bank account when a loan is made does not come from any other account. The two things to remember are that bank account balances are money in their own right and banks reserves only get involved when money is spent not created.

I'm very puzzled as to why there is disagreement about the mechanics of fractional reserve banking. (That's different than disagreements about whether or not it's a good thing.)

If a bank does not have excess reserves, it can't make a loan in the form of giving someone a deposit. Yes bank deposits are money. But they have to be backed by required reserves.

None of this has much to do with whether banks create money from thin air. If the Federal Reserve makes more reserves available to the banking system, the banks can increase deposits (and therefore the money supply) by some multiple of the increase in reserves. Perhaps one would say the banking system has created money out of thin air, but it's important that this does NOT change the wealth position of the banks. Their loans (an asset) have increased by the same amount as their deposits (a liability).

 

[psionl0]

I'm very puzzled as to why there is disagreement about the mechanics of fractional reserve banking. (That's different than disagreements about whether or not it's a good thing.)

There is no disagreement. It's just Sceptic-PK attempting to derail every thread I post on.

If a bank does not have excess reserves, it can't make a loan in the form of giving someone a deposit. Yes bank deposits are money. But they have to be backed by required reserves.

See, nobody is arguing against this.

None of this has much to do with whether banks create money from thin air. If the Federal Reserve makes more reserves available to the banking system, the banks can increase deposits (and therefore the money supply) by some multiple of the increase in reserves. Perhaps one would say the banking system has created money out of thin air, but it's important that this does NOT change the wealth position of the banks. Their loans (an asset) have increased by the same amount as their deposits (a liability).

Of course! When banks create money they create an additional liability for themselves. From a public point of view however, there is more money in circulation.

 

[psionl0]

It’s the same issue, neither the IOU nor the “I will loan you $10” is actually worth anything until “reserves” are accessed.

So now we can all throw out our economic and bookkeeping textbooks. We have it on no less than Sceptic-PK's own authority that these books are wrong.

Promissory notes can not be used to settle debts. They must be exchanged for bank reserves. That is why we can't use our plastic cards at the shops and why we can't pay our bills online .......er..........wait

 

[Sceptic-PK]

So now we can all throw out our economic and bookkeeping textbooks. We have it on no less than Sceptic-PK's own authority that these books are wrong.

Promissory notes can not be used to settle debts. They must be exchanged for bank reserves. That is why we can't use our plastic cards at the shops and why we can't pay our bills online .......er..........wait

As explained to you countless times, those debit cards that we use and the paying of bills online = a corresponding transfer of reserves. I am amazed even you are still unable to grasp this.

 

[psionl0]

As explained to you countless times, those debit cards that we use and the paying of bills online = a corresponding transfer of reserves. I am amazed even you are still unable to grasp this.

So can promissory notes be used to settle debts directly or can they only be used to access bank reserves?

I guess the answer is "both" or "either" or "neither" depending on your "thought" processes at the time.

 

[Sceptic-PK]

So can promissory notes be used to settle debts directly or can they only be used to access bank reserves?

I guess the answer is "both" or "either" or "neither" depending on your "thought" processes at the time.

In the context we’re talking, promissory notes (deposits) are only worth something when they’re used to access reserves. When you pay your electricity bill via Bpay, that engenders a transfer from your bank’s reserves to the bank of your power company. I am sure you appreciate this, you already agreed that ‘deposits are worthless without reserves’ so what’s your problem now?

 

[psionl0]

so what’s your problem now?

I already made it clear what the problem is. I can't help it if you can't read for comprehension.

 

[Sceptic-PK]

Dodge noted.

 

[tensordyne]

Example for Startz, just to clear things up.

In the context we’re talking, promissory notes (deposits) are only worth something when they’re used to access reserves. When you pay your electricity bill via Bpay, that engenders a transfer from your bank’s reserves to the bank of your power company. I am sure you appreciate this, you already agreed that ‘deposits are worthless without reserves’ so what’s your problem now?

His problem is you are only seeing half of the way things work, as usual Sceptic-PK (among other errors in reasoning). I am doing the following more for Startz than for you Sceptic-PK, but whatever.

Say a bank starts out this way.

First Bank of Example, USA

Assets:
Reserves: 22,000
Loans: 0
Other: 0

Liabilities:
Deposits: 20,000
Capital: 2,000
Other: 0

Everything is OK, the reserves to deposits ratio is about 105%, which is way more than what is needed to not break the law as per reserve requirements. We also have another bank out there with the following accounting.

Second Bank of Illustration, TX, USA

Assets:
Reserves: 10,000
Loans: 0
Other: 0

Liabilities:
Deposits: 9,000
Capital: 1,000
Other: 0

This bank is OK too as for as reserve requirements go because the ratio of reserves to deposits is 111%. I am dropping the 'other' row from here on out, but it does exist in most banks and is made up of all sorts of things.

Both banks are really just starting out. The First Bank of Example wants to make a loan to a borrower. As per usual we will say for these examples that the reserve requirement rate is 10%. In actuality it is more complex then this, but, whatever.

So, as of right now, First Bank has a reserve requirement of 10% of 20,000 (= 2000) or 10% of deposits at First Bank. First Bank wants to act risky so it makes the maximum loan that is good for it, which is the excessive reserves, which is reserves minus required reserves, or 22,000 - 2,000 = 20,000. The balance sheet then reads

First Bank of Example, USA

Assets:
Reserves: 22,000
Loans: 20,000

Liabilities:
Deposits: 40,000
Capital: 2,000

This is the part that Sceptic-PK either does not believe in, does not care about, or whatever else it is that rolls around up there, it is true though. This is how it works. I can quote you from two publications if you have any doubts about this Startz. So, then the borrower wants to transfer the money to pay for something.

But before that happens, it should be noted that there is nothing in terms of reserve requirements stopping First Bank from making another loan. The ratio of reserves to deposits at this point is 55%. What makes the bank not want to make another loan is that it knows the borrower is likely to transfer the funds of the loan.

So the borrower transfers the 20,000 from the borrowers deposit in First Bank to another deposit account in Second Bank of Illustration. The two balance sheets go like so after the transfer is complete:

First Bank of Example, USA

Assets:
Reserves: 2,000
Loans: 20,000

Liabilities:
Deposits: 20,000
Capital: 2,000

and

Second Bank of Illustration, TX, USA

Assets:
Reserves: 30,000
Loans: 0

Liabilities:
Deposits: 29,000
Capital: 1,000

The 20,000 gets subtracted from the reserves and deposits of First Bank and added to the reserves and deposits of Second Bank. That is how transfers work in Fractional Reserve Banking.

This last part is kind of like the part that Sceptic-PK thinks of as the loan process. It is not how a loan is made though, it is how a transfer is made. Sceptic-PK, to the best of my abilities at analysing nonsense, thinks that loans are the same as transfers, in the sense of the action given above (somewhat, my best guess is Sceptic-PK thinks loans work the same way you balance a chequebook). He says loans come from reserves. This is simply not the case.

Myself, I even have a problem saying Transfers are funded from deposits. The problem is that since both reserves and deposits at the same time go down in equal amount in one bank, and up by an equal amount in another bank's reserve and deposits, there are four sets of things changing. When I fund you money from my pocket there are two things changing. My money goes down and your money goes up.

Either way, this even is only half the story Startz. I have not covered how interest payment and principal payment work, or how they effect the various numbers in the balance sheet. How banks can do certain things to handle liquidity problems. What are all the different types of deposit accounts that can be had. How those accounts effect the reserve requirements (still working on that one myself). Open questions this forum has not lately touched upon such as how high-powered money works in terms of balance sheets. etc. etc. Instead, we have to deal with these very basic problems Sceptic-PK can not seem to get right. It really is getting kind of boring actually.

Sceptic-PK likes to say banks do the same thing we all can do. This is simply not so. If we did the type of accounting above, especially in the loan making part of the steps, we would go to jail. I am not trying to say that to sound all conspiracy theory like, it is simply a statement of fact -- we would probably get caught and end up serving time for breaking some kind of law (Banking without a License?).

That about does it.I hope I got my numbers correct and am, as always, open to further criticism.



All the best to you all!

 

[Startz]

His problem is you are only seeing half of the way things work, as usual Sceptic-PK (among other errors in reasoning). I am doing the following more for Startz than for you Sceptic-PK, but whatever.

Say a bank starts out this way.

First Bank of Example, USA

Assets:
Reserves: 22,000
Loans: 0
Other: 0

Liabilities:
Deposits: 20,000
Capital: 2,000
Other: 0

Everything is OK, the reserves to deposits ratio is about 105%, which is way more than what is needed to not break the law as per reserve requirements.

So, as of right now, First Bank has a reserve requirement of 10% of 20,000 (= 2000) or 10% of deposits at First Bank. First Bank wants to act risky so it makes the maximum loan that is good for it, which is the excessive reserves, which is reserves minus required reserves, or 22,000 - 2,000 = 20,000. The balance sheet then reads

First Bank of Example, USA

Assets:
Reserves: 22,000
Loans: 20,000

Liabilities:
Deposits: 40,000
Capital: 2,000

That about does it.I hope I got my numbers correct and am, as always, open to further criticism.



All the best to you all!

But what stopped the first banks from making a loan of 200,000? It might be imprudent, but it doesn't break any accounting rules or violate the reserve requirement.

First Bank of Example, USA

Assets:
Reserves: 22,000
Loans: 200,000
Other: 0

Liabilities:
Deposits: 220,000
Capital: 2,000
Other: 0

 

[psionl0]

But what stopped the first banks from making a loan of 200,000? It might be imprudent, but it doesn't break any accounting rules or violate the reserve requirement.

Ooh! Ooh! I know!

But before that happens, it should be noted that there is nothing in terms of reserve requirements stopping First Bank from making another loan. The ratio of reserves to deposits at this point is 55%. What makes the bank not want to make another loan is that it knows the borrower is likely to transfer the funds of the loan.

 

[tensordyne]

But what stopped the first banks from making a loan of 200,000? It might be imprudent, but it doesn't break any accounting rules or violate the reserve requirement.

First Bank of Example, USA

Assets:
Reserves: 22,000
Loans: 200,000
Other: 0

Liabilities:
Deposits: 220,000
Capital: 2,000
Other: 0

You are absolutely correct! We have one who can see psionl0! I have made this very same sort of point myself in the past (I would have to find the post though to prove it). There is nothing by the accounting rules (reserve requirement-wise) to stop this from happening. The reason why banks do not do this is because they know that as soon as a loan is made, it is usually spent (which perhaps is encoded in another accounting rule that the banks decide to follow, which is, don't loan more than excessive reserves).

If that loan of 200,000 was spent, the bank would be in serious trouble. The numbers would then become:

First Bank of Example, USA

Assets:
Reserves: (-178,000)
Loans: 200,000

Liabilities:
Deposits: 20,000
Capital: 2,000

That would be seriously bad for the bank. Just to even things out the bank itself would have to then get a loan of 180,000 = 178,000 + 2,000 from either other banks, companies or new depositors. The board members would not be happy either. The bank could additionally sell some of its loans to the Fed to get back to required reserves.

Excellent!

 

[tensordyne]

Ooh! Ooh! I know!

Yep, I know you know, and then some...

 

[psionl0]

I'm just showing that your post was so well written that I don't need to add anything to it.

 

[tensordyne]

response to a response of the previous response... I am NOT responsible!

{Note: I was working on this when the whole Tippit/Sceptic-PK explosion of posts occurred.}
{I think I should get it out now before too much time passes. The Poor vs. Rich Bank that}
{I hope to analyse will have to wait for tomorrow. I think there is enough in here to be }
{read through already... I hope it is at least marginally enjoyable to you psionl0! }

I would have thought "engineer". Engineers are less likely to be worried about the form of an equation (nor even its validity sometimes) as long as it is useful.

Oh, the form of an equation is what mathematicians definitely care about most. It's particular representation (what letters you use to represent what variables, or statements that are equivalent) do not matter to them, except as something to be noted.

Myself, I am somewhere between being a mathematician and an engineer, also known as a physicist. This makes me remember a joke I have heard.

A mathematician, physicist and engineer are in a field with a rancher. The rancher wants to enclose a bunch of cattle in some fencing. First the engineer takes a whack at it. The engineer estimates feeding space, corrects for the incline of some part of the property, does some other estimates and multiplies the numbers by two. After this the engineer then sets up fencing in a nice and neat square arrangement.

The rancher looks at it and remarks it was a good job, perhaps a little more costly than expected, but workable as a solution.

Then the physicist gets his try. The physicist puts all of the cattle closely together and wraps fencing around them. Then the physicist takes out a ratchet and starts squeezing the cattle into an ever tighter ball until the ratchet just will not let off a single bit more of torque to crush the cattle any closer. "Look, I have minimised the ratio of fencing to cattle mass." The rancher just looks on in despair.

Then the mathematician, feeling left out, takes a very small portion of the fencing, wraps it around where the mathematician is standing and points at the inside of where the mathematician is and says, "Let this be the outside..."

I think the joke is very instructive to the mindsets of each type of person involved. I hope you have not heard of the joke before because it is one of my favourites.

A truly diplomatic solution. Agreed.

You are too kind my friend. Still, I thank you for allowing me to not have to remap my brain as it were.

Sorry to put you on the spot like that. Just making sure I haven't lost you. The caveat is that a bank can only spend money from its capital account if it has excess reserves. This is obvious when the bank A transfers money from its capital account to a demand deposit account at another bank (Bank B):

Bank A: (R1, M1 + S1, L1) -> (R1 - i, M1 + (S1 - i), L1)
Bank B: (R2, M2 + S2, L2) -> (R2 + i, (M2 + i), S2, L2)

This is also true if the bank transfers money to one of its own demand deposit account holders. D = M + S and RR = 0.1 * M (not RR = 0.1 * D).

As you pointed out D = (M + i) + (S - i). Since the amount of money in the demand deposit accounts has increased (M + i), so must the required reserves which can only come from excess reserves.

Hmmm, very interesting. I was actually guessing that something like RR = 0.1 * M must have been what you were referring to, but I included the equation I had anyway because it was how I understood FRB to be up to that point. No worries about putting me on the spot, do so whenever you want.

So, now I am looking for evidence of the assertion RR = 0.1 * M in MMM. I could be lazy and just ask for it like last time, but I think I should at least try and look before I ask for that. Actually, reading between the lines of MMM already convinces me of the worthiness of RR = 0.1 * M idea. So far you have corrected me twice and for that I thank you very much! Part of the point of going on this forum was for me to gain a better understanding of how FRB works, and now I have that better understanding.

I think I should note that in the version of MMM I have it detail how the Garn-St. Germain Act of 1982, as well as the Monetary Control Act, place certain separate restrictions on the form of the reserve requirements. I am still trying to parse what MMM says in the section quoting all the laws.

Oh yeah, I noticed you used a quadruple in the Bank B formula. I know what you mean but perhaps it should be codified all the same. (R, D, L) for triple and (R, M, S, L) for a quadruple. When writing (R, (A) + (B), L) it means that A = M and B = S, although by context alone it should hopefully be apparent what is meant.

Start of First Draft of Post Covering How FRB works.

MMM stands for Modern Money Mechanics.

Basic FRB Formulas
M = "depository money"
S = "shareholder money"
R = "total reserves"
D = M + S = "Liabilities"
R + L = "Assets"
"Assets" = "Liabilities" so R = D - L = (M + S) - L
RR = r * M = "Required Reserves"
r = n / (n + m); in m:n fractional reserve requirement with r = "reserve ratio percentage"
ER = R - RR = "Excessive Reserves"

The above idealises reserve requirements (see section "Changes in Reserve Requirements" in MMM). In actuality reserve requirements go in tranches and have other considerations.

End of Post.

Of course it is. However, at some point you need to go with the best information you have. Mathematics is better information than the views of any author because it lays bare any fallacious reasoning. In this case, the mathematics is verifying that interest is a problem which was your original claim.

Well, I just feel the problem has not quite been fleshed out with enough rigour for me to feel comfortable yet. I am going to try to do a post soon that takes things hopefully to this point. No promises though. Maybe I will do that post below on the other hand...

My equations analyzed the effect of money being created by the government and demonstrated that it didn't stop debt rising compared to the money supply. (Check those out again).

Oh yeah, that is a good point. I still have to respond to the other two equation posts of yours. I think I will do that next after this post.

The real problem here is not the interest the government may or not pay to the fed (that gets returned to the treasury) but to other bondholders (that is a gift from the taxpayers).

Consider the case where S = 0 (initially) and "R" is paid off as interest:

(R, M + 0, L) -> (R, (M - R) + R, L)

M = R + L so (M - R) = L showing how deposits become less than loans if "R" is paid in interest.

Don't forget that new spending by the government doesn't solve the problem.

I can see more clearly now what you are getting at. First off, man, I am really starting to hate how MMM is written. I am sorry to say that the turn of phrase about having reserves paid into making new loans used above still seems off to me since R does not change. I can see how you can say it eats into excessive reserves however. Maybe I am too literal minded...

Now I think I can get down into hard-core analysis mode though (hopefully that will be something you enjoy psionl0). I have all of the basic formulas, so after this it is just about applying them correctly to come to any relevant conclusions.

I will do that in the next post. I am going to have "The Fed", Rico Bank (bank of the richies) and Almanac Bank (for Poorman's Almanac or bank of poor people). It should be fun.

A case could be made for having a separate thread that discusses interest but this is still tied in with banks creating money so the case could also be made for keeping it in this thread.

It is true that this thread has become large enough that if a question comes up about creating money, we should be able to answer it just by referring to a post number. However, as long as the question of FRB remains unresolved with some members, I would favour a live response instead of a post# so I would prefer to keep this thread alive.

OK, just a thought. I kind of like this thread; it has become sort of homey. For my part, if I had seen a post with the main equations presented up above and some convincing proof based on MMM or other authoritative reference of the validity of those equations, the answer of "How the banks create money" would be done.

I think though high-powered money still needs to be covered to complete the basic picture as it were.

I miss Finsend, where are you at?

 

[tensordyne]

I'm just showing that your post was so well written that I don't need to add anything to it.

Parsimonious in wording and extremely kind in your praise, my only hope is that I can gain through much effort such stolid use of logic matched by such commanding use of wit as you possess naturally, psionl0. I mean that too.