How the banks create money

[marplots]

A lot of the disagreements here seem to revolve around different uses of the word money. One meaning seems to be "cash" and the other seems to be "that by which I measure value".

The confusion comes in (for me) when the use of money as a standard is used to measure money itself.

For instance. Say I make rope. I use "inches" to measure my production. I currently have a certain number of inches of rope in stock. Let us say, by coincidence, I have the same length of rope as I have measuring tape to measure it with. Now, when I make more rope, I am creating, in a sense, "more inches" from one point of view, but in another, I still have the same number of tapes to measure with, so that number doesn't change. It's the difference between the meaning of "inches" as a unit of measure, and "inches" as a physical thing. The first is infinite and the second expands and contracts.

But all that aside, I have another question. There are mechanisms to add cash to the system as the economy grows -- to keep the amount of cash in circulation balanced with the size of the economy. This, I think is what has been referred to as "creating money". Are there mechanisms to reduce the amount of cash when the economy shrinks? Is there an opposite function somewhere that would allow me to say, "X destroys money" in the same sense?

For instance, with the housing crash, plenty of virtual money went bye-bye. A fictional gazillionaire lost a trillion dollars or so. Is there a way to remove physical cash from the larger system to compensate for this?

 

[psionl0]

You are just about asking for an entire lesson in economics - something that is difficult to answer in a paragraph or two (but I'll try).

Basically, there is no such substance as money. It is an abstract concept that attempts to measure the relative VALUE of things (what somebody will give for something else). Money can basically be represented by tokens (notes and coins usually) or promises (IOUs).

The difference between a unit of measurement such as a Dollar and a Mile is that the Mile is based on a fixed physical unit while the "value" of a dollar depends on how many dollars there are and what is being traded. For example, the direct distance between Washington DC and New York will always be 204 miles (Answers.com) but the bus fare between Washington DC and New York is constantly varying over time.

Under the current banking system, money is created when a bank lends out money and destroyed when the loan is repaid. If a borrower defaults on a loan then the bank sells the debt for what it can get and makes up the difference out of its profits (indirectly through its other depositors).

If a bank loses too much money causing its depositors to run and withdraw their savings then either of two things happen: the bank collapses in a heap and the money in its depositors' accounts vanishes or it is bailed out by a higher level bank or the government.

Critics may now start demolishing me

 

[Tippit]

We need to increase the money supply by $2 to keep pace.

On what basis do you make this assumption?

 

[drkitten]

On what basis do you make this assumption?

Because otherwise the resulting deflation will crash the economy and result in food riots.

Or, more tersely, because he understands more economics than you.

 

[psionl0]

On what basis do you make this assumption?

It's an oversimplified assumption. I am assuming that there is a permanent increase in the supply of goods and services of $2. If the existing money supply remains the same then the same amount of money has to purchase more goods and services. That is a deflationary pressure.

This is one reason why tying money to a fixed commodity like gold is not a good idea. Even with FRB there is still a limit to the amount of money in the system. When production gets too high, we either need to pursue deflation (resulting in loss of jobs and decreasing production) or dilute the fractional reserve ratio (increasing the money supply). Neither is a satisfactory solution. In particular, diluting the FR ratio makes banks more vulnerable to failure.

I know we could talk about stock and flow of money, multiplier and accelerator effects but I don't think that is helpful.

 

[marplots]

You are just about asking for an entire lesson in economics - something that is difficult to answer in a paragraph or two (but I'll try).

Sorry. I'll try to get more specific. To do that, I'm going to cut up your post to what I think is the essential bit in these discussions.

Basically, there is no such substance as money. It is an abstract concept that attempts to measure the relative VALUE of things...

Contrasted with this:

Under the current banking system, money is created...

I hope I'm making the problem clear. On the one hand, "there is no such substance as money" and on the other, "money is created".

Are the banks creating value then? From what I've read hear, I think the answer is yes. My best analogy might be with music. There is no such "thing" as music, but it has a value and can be created. One might also say it is destroyed when it falls out of favor and loses it's value (social value, not monetary value here).

When the OP purports to tell us, "How the banks create money" is this what they are talking about (value)?

I am also interested in the idea that paying back a loan destroys money. It may not be a current trend, but I remember reading about U.S. citizens, para-recession, increasing their savings and paying off credit card debt. Does this mean money was destroyed?

 

[drkitten]

I hope I'm making the problem clear. On the one hand, "there is no such substance as money" and on the other, "money is created".

Money is created, but it's not a substance. That shouldn't be surprising -- tunes aren't substances, either -- but someone who creates (composes) a catchy commercial jingle may add huge amounts of value to a company's bottom line.

But tunes aren't necessarily "value" either. Tunes have value, if the composer is lucky.

Are the banks creating value then?

Not really, but they make it possible for others to create value (by putting money in the hands of people that need it, while not taking it away from others).

With a new sewing machine, I can make a dozen shirts in the time it previously took me to make one. This means that I can sell them for half what I sold them before and still make more than I did previously -- I'm wealthier than I was before. But my customers also spend less on shirts, which gives them more to spend on other things -- they're wealthier than they were before.

When the OP purports to tell us, "How the banks create money" is this what they are talking about (value)?

No, they're being much more literal than that. There were X dollars in circulation in the economy before the loan was taken out, now there are X plus the amount of the loan. Dollars are literally created.

I am also interested in the idea that paying back a loan destroys money. It may not be a current trend, but I remember reading about U.S. citizens, para-recession, increasing their savings and paying off credit card debt. Does this mean money was destroyed?

It does. But the amount of money destroyed pales to the amount lost in the mortgage security mess.....

 

[marplots]

I said, "I am also interested in the idea that paying back a loan destroys money. It may not be a current trend, but I remember reading about U.S. citizens, para-recession, increasing their savings and paying off credit card debt. Does this mean money was destroyed? "

Then you said:

It does. But the amount of money destroyed pales to the amount lost in the mortgage security mess.....

So with the drop in value, money was destroyed? And this is different than the actual supply of money in circulation?

I guess I'm asking about inflation and deflation. My admittedly naive expectation is that the supply of money should match the value "out there" or you get one or the other. I asked earlier about the stock market "creating money" in the same sense that banks do, but in a hugely greater amount. The reason I'm mentioning this is because I have heard the claim that "the banks creating money" is inflationary and to their advantage.

Would it be correct to say that Goldman Sachs creates money when they buy low and sell high and, conversely, that money is destroyed when I buy high and sell low?

 

[drkitten]

So with the drop in value, money was destroyed? And this is different than the actual supply of money in circulation?

No. The drop in value destroyed wealth, but more wealth was destroyed than money, so the amount of money destroyed was relatively small.

There are basically two ways to think about money destruction. Money is created by writing IOUs that are indistinguishable from real money (a check is a check is a check, regardless of whether the bank has the cash on hand to cover it). There are two ways for an IOU to become valueless -- I can pay it back (in which case the IOU turns into a worthless piece of paper), or I can dishonor it (likewise). In the first case, the money is simply destroyed but can be recreated by lending the funds again; in the second, the bank has to tap into its actual wealth to cover the loss.

I guess I'm asking about inflation and deflation. My admittedly naive expectation is that the supply of money should match the value "out there" or you get one or the other.

That's roughly the theory. A more sophisticated analysis would recognize that inflation is not just related to the amount of money, but to its velocity through the economy, which is one way you can get inflation or deflation in an otherwise stable economy.

But you are broadly correct; when I borrow money for investment purposes (i.e. to buy my sewing machine), I am creating more wealth out there; the increased wealth is balanced by the increased money supply. Handled properly, this means that prices will remain roughly stable and that everyone's increasing wealth will be measured by rising nominal dollar values of personal incomes and portfolios.

Would it be correct to say that Goldman Sachs creates money when they buy low and sell high and, conversely, that money is destroyed when I buy high and sell low?

No, it just transfers money away from you and into GS's pockets. If all you're doing is buying and selling, then it's just an exchange of stuff-for-stuff using money as a way of keeping score.

 

[marplots]

Thank you for explaining the concepts, you have been remarkably clear (and patient).

I said, "Would it be correct to say that Goldman Sachs creates money when they buy low and sell high and, conversely, that money is destroyed when I buy high and sell low? "

No, it just transfers money away from you and into GS's pockets. If all you're doing is buying and selling, then it's just an exchange of stuff-for-stuff using money as a way of keeping score.

I was less than accurate in my question. I was trying to get at value and money. So, suppose I buy stock in ABC corp at $1 a share. I own 100 shares. Now, for no apparent reason, ABC corp shoots up to $5 a share. My stock is now valued at $500. At this point, I could sell it and, as you say, it would be a dollar-for-dollar exchange with the buyer. But, instead, what if I use this new wealth as collateral? Then, I take it the value wouldn't be realized (in cash to me terms) but would "create money"?

I think I might be getting at the roots of Capitalism here. But do I have the notion right? (And I promise to quit pestering you for awhile.)

 

[Tippit]

Because otherwise the resulting deflation will crash the economy and result in food riots.

Or, more tersely, because he understands more economics than you.

That sounds scary. Do you have any actual evidence to support this? Note that massive deflation due to monetary manipulation (the cause of the Great Depresssion), and large contractions in the money supply by central banks don't count . I don't think anyone is disputing that this type of manipulation will destroy an economy as surely as hyperinflation will.

There is, on the other hand, plenty of evidence that deflation consistent with productivity is compatible with real economic growth, as evident by the last quarter of the 19th century. Prices fell by 1% per annum, and output rose 4% per annum. Of course, these periods in history are quite rare, since it's very profitable for bankers and politicians to perpetually debase the currency. How do you explain this?

Deflation and Economic Growth

 

[drkitten]

That sounds scary. Do you have any actual evidence to support this?

Lots, starting with the Great Depression. Your rather lame attempt to cherry-pick over the data and ignore evidence by manufacturing conspiracies instead of simple economics just makes you look a fool.

Note that massive deflation due to monetary manipulation (the cause of the Great Depresssion), and large contractions in the money supply by central banks don't count .

Yes, they do, since your Magic Evil Economic Pixies don't exist.

I don't think anyone is disputing that this type of manipulation will destroy an economy as surely as hyperinflation will.

No. But every sensible reader will indeed dispute that "manipulation" of the sort you imagine actually happened.

 

[Tippit]

It's an oversimplified assumption. I am assuming that there is a permanent increase in the supply of goods and services of $2. If the existing money supply remains the same then the same amount of money has to purchase more goods and services. That is a deflationary pressure.

This is one reason why tying money to a fixed commodity like gold is not a good idea. Even with FRB there is still a limit to the amount of money in the system. When production gets too high, we either need to pursue deflation (resulting in loss of jobs and decreasing production) or dilute the fractional reserve ratio (increasing the money supply). Neither is a satisfactory solution. In particular, diluting the FR ratio makes banks more vulnerable to failure.

I know we could talk about stock and flow of money, multiplier and accelerator effects but I don't think that is helpful.

I mean, why do you assume that deflation is inherently bad? Yes, the price of labor would fall along with the general price level, but as long as it is allowed to move downward, the impact on jobs would be nil, and the cost of living for everyone would fall in tandem. The aggregate money supply isn't what makes us wealthy, it's the goods and services that we produce.

 

[Tippit]

Lots, starting with the Great Depression. Your rather lame attempt to cherry-pick over the data and ignore evidence by manufacturing conspiracies instead of simple economics just makes you look a fool.

The Great Depression doesn't count, since I already concede that massively contracting the money supply will ruin an economy, just as hyperinflation will. I'm talking about a natural rate of deflation which mirrors the rate of productivity growth. How do you account for the lower prices and robust growth of 1875-1900, no more name calling please, just facts.

Yes, they do, since your Magic Evil Economic Pixies don't exist.

No. But every sensible reader will indeed dispute that "manipulation" of the sort you imagine actually happened.

Do you deny the fact that the Fed had control over the money supply during this period, and that it in fact contracted the money supply prior to the great depression? Pixies don't seem to exist, but central bankers do. If you don't agree with Ben Bernanke that the Fed did indeed cause the Great Depression (by mistake, of course!), what do you think did cause it? Smoot-Hawley? And if so, what effect do you think contracting the money supply by 33% had on it?

 

[drkitten]

The Great Depression doesn't count,

Yawn. More Magic Evil Pixies.

The nice thing about keeping you around, Tippit, is that anyone who is confused about matters economic can simply note the amount of effort you spend on denying the very existence of the type-specimins for economic theories. You're like a person standing in the middle of the zoo, loudly proclaiming that animals don't exist, and then explaining how "that lion over there isn't an animal; it's a cunningly carved topiary."

Yes, the Great Depression does count, despite your efforts to imagine it away.

Oh, and as a general rule, it's probably safe for you to assume that I deny every word you write. I myself have a more nuanced statement -- I only deny the incorrect statements you write. But those two versions amount to the same thing.

 

[Tippit]

Yawn. More Magic Evil Pixies.

The nice thing about keeping you around, Tippit, is that anyone who is confused about matters economic can simply note the amount of effort you spend on denying the very existence of the type-specimins for economic theories. You're like a person standing in the middle of the zoo, loudly proclaiming that animals don't exist, and then explaining how "that lion over there isn't an animal; it's a cunningly carved topiary."

Yes, the Great Depression does count, despite your efforts to imagine it away.

Oh, and as a general rule, it's probably safe for you to assume that I deny every word you write. I myself have a more nuanced statement -- I only deny the incorrect statements you write. But those two versions amount to the same thing.

The Great Depression doesn't count, because I already concede that contracting the money supply by 33% (what the Fed did) would cause a massive depression. Do you have any explanation for the period 1875-1900, and James Bullard's statement that strong economic performance and mild deflation are wholly compatible? Or do you just have more personal attacks in lieu of substance?

 

[drkitten]

The Great Depression doesn't count, because I already concede that contracting the money supply by 33% (what the Fed did) would cause a massive depression.

Naturally it doesn't count -- it proves my point absolutely, as even you have to admit.

Do you have any explanation for the period 1875-1900.

Yes. The money supply still expanded during that period, although not enough to maintain nominal prices

Basically, I told you that smoking in bed is a bad idea, because it can fires that kill people. You agreed that it it can cause fires that can kill people, but because you found an isolated incident where the fire was caught early enough that no one died,... smoking is a good thing?

If the best argument you have that "deflation isn't bad" is that the economy can sustain a 1% deflation, while at the same time denying the ability of anything to provide any reasonable expectation of keeping deflation at such a low level, then you've proven my point for me. Again.

 

[Tippit]

Naturally it doesn't count -- it proves my point absolutely, as even you have to admit.

No it doesn't, your point would be analagous to saying that water is bad for us because tsunamis have killed people.

Yes. The money supply still expanded during that period, although not enough to maintain nominal prices

Evidence? Are you suggesting that the 4% per annum real growth during this period was because of money printing, and not the second industrial revolution?

Basically, I told you that smoking in bed is a bad idea, because it can fires that kill people. You agreed that it it can cause fires that can kill people, but because you found an isolated incident where the fire was caught early enough that no one died,... smoking is a good thing?

You haven't provided any evidence of any monetary inflation during the 1875-1900 period, and I have provided evidence of general price deflation on the order of 1%, coupled with 4% real output growth. You then attempt to spin this period of prosperity as being due to the monetary inflation that apparently wasn't enough to result in "stable prices". Yet, the fact remains, it was a period of persistent price deflation (over a quarter century) and robust economic growth. You have to resort to lies and poor analogies to deny this truth, because it destroys the lie that we require persistent inflation (let alone mere "price stability") to avoid depressions and food riots.

If the best argument you have that "deflation isn't bad" is that the economy can sustain a 1% deflation, while at the same time denying the ability of anything to provide any reasonable expectation of keeping deflation at such a low level, then you've proven my point for me. Again.

Your reading comprehension is poor. Bullard states in his paper: "The average rate of change of prices was approximately negative 1 percent—a 1 percent rate of deflation—while the average rate of growth in real output was just over 4 percent." These reflect average annualized figures for each year during the period, not the entire period. So the economy "sustained" a much larger deflation over the 25 year period (about 22%, .99^25), and output more than doubled (167%).

This proves that inflation and "price stability" isn't necessary to stave off economic doom, it just helps to keep bankers and politicians nice and fat.

 

[drkitten]

You haven't provided any evidence of any monetary inflation during the 1875-1900 period,

I didn't think I needed to. Anyone who didn't just fall out of a tree knows that the money supply was expanding as mining operations took gold out of the ground and put it into coinage. If you have just fallen out of a tree, look at the history of gold mining in Alaska for a single instance. Of course, the US was also able to buy substantial amounts from the South African gold fields as well.

You then attempt to spin this period of prosperity as being due to the monetary inflation that apparently wasn't enough to result in "stable prices".

That's right. Without substantial monetary inflation, the amount of goods in circulation from the second industrial revolution would have been much more than 33% over baseline, which would have produced the net deflation that you yourself admit caused the Great Depression and would have stopped the second industrial revolution in its tracks.

Your reading comprehension is poor. Bullard states in his paper: "The average rate of change of prices was approximately negative 1 percent—a 1 percent rate of deflation—while the average rate of growth in real output was just over 4 percent." These reflect average annualized figures for each year during the period, not the entire period. So the economy "sustained" a much larger deflation over the 25 year period (about 22%, .99^25), and output more than doubled (167%).

My reading comprehension is just fine; if you think that there was no monetary inflation while output more than doubled,..... well, "magic pixies" doesn't begin to touch it.

 

[psionl0]

I hope I'm making the problem clear. On the one hand, "there is no such substance as money" and on the other, "money is created".

I can see why this is causing confusion. Money firmly rules over our lives (it is the reason why one man sleeps in a mansion and another under a bridge) yet it doesn't exist!

Think of money as a number. You can add another number to this number or you can take away from this number. We can also divide this number up. It is just a set of digits that can be written on a piece of paper or stored in a computer. This number has power only because we have all agreed to let this number set the rules on how goods and services are produced and distributed. (I hope this doesn't sound like "magic pixie dust").

Are the banks creating value then? From what I've read hear, I think the answer is yes.

No, only people create "value", or rather, produce goods and services. Banks simply add or subtract to that number we call money. The actions of the banks however make it possible to greatly increase production. (Some would argue that the banks' actions make it necessary to greatly increase production).

I am also interested in the idea that paying back a loan destroys money. It may not be a current trend, but I remember reading about U.S. citizens, para-recession, increasing their savings and paying off credit card debt. Does this mean money was destroyed?

Paying off a credit card debt means subtracting that debt from the number we call money (destroying money) but increasing savings (at least in a bank account) does not.

Your own "Art, Bank, and Chuck -- our own little economy." example (post #253) illustrated the money creation/destruction (addition/subtraction) process perfectly.

"Art deposits $100 in the Bank." So now we have $100 in the system.
"Chuck borrows $50" meaning that the bank added the number 50 to Chuck's bank account. Total money in the system is now $150. (money created).
"Chuck pays off his loan for $50". The number 50 is subtracted from Chuck's bank account (money destroyed).

"At the end, of the original $100 in our economy, Art has $99, the Bank has $1 and Chuck has $0." (Money divided).