How the banks create money

[drkitten]

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?

Because most of the time you don't borrow to the hilt.

 

[Captain.Sassy]

So demand for borrowing drives the money supply?

 

[drkitten]

So demand for borrowing drives the money supply?

Borrowing is one of the major things that creates new money, yes. If there's no demand, there's no new money created.

 

[Captain.Sassy]

So then this is why they refer to monetary policy as a string, i.e. it's easier to pull on the string and cool the economy by reducing money supply than it is to push on the string and generate demand?

 

[drkitten]

So then this is why they refer to monetary policy as a string, i.e. it's easier to pull on the string and cool the economy by reducing money supply than it is to push on the string and generate demand?

More or less. You've just defined a "liquidity trap," which is why Bernanke and his friends are trying so hard to stimulate the economy and get us out of the deflationary stagnation we're now in. Because merely making cheap money available is demonstrably not doing it....

 

[webb5]

Re- how the banks create money

Hi guys sorry to take so long to reply. Yep Australia has been lucky so far. We have survived this crash from trading with China. China is Australia largest trading partner we export large amounts of commodities especially from the mining sector.

By the way we have a housing bubble of our own in Australia. Houses are well and truly over priced and the housing market could go any time. Demand on housing from high immigration and incentives to first home buyers and investment incentives have artificially raised house prices to record levels. Will it go? Who knows?

Any way back to fractional reserve banking. The banks do froudently create money and lend it out to us as debt. Did you ever wonder where all this money comes from?

All money created by the banks is created as debt. This has put us in an impossible position as the ability to pay both debt and interest is just not possible. There is never enough money in the world to cover the combined debt with interest as the banks did not create the interest part. This leads to spiral debt. Economies around the world continue to borrow further to cover this missing sum of money over and over again. If they did not borrow more, the money supply would simply run out.

 

[tkmikkelsen]

All money created by the banks is created as debt. This has put us in an impossible position as the ability to pay both debt and interest is just not possible. There is never enough money in the world to cover the combined debt with interest as the banks did not create the interest part. This leads to spiral debt. Economies around the world continue to borrow further to cover this missing sum of money over and over again. If they did not borrow more, the money supply would simply run out.

This is pretty much what I tried to illustrate in my little scenario earlier. It has since I was teenager always baffled me how interest works, because it is value added out of nothing.

 

[Sceptic-PK]

All money created by the banks is created as debt. This has put us in an impossible position as the ability to pay both debt and interest is just not possible.

Oh really? How did I pay off my car loan? How do I pay off my credit cards? How am I paying off my houses?

 

[timhau]

Oh really? How did I pay off my car loan? How do I pay off my credit cards? How am I paying off my houses?

You're faking it.

 

[tkmikkelsen]

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.

The problem with all of the value you added here is that it is of no value. It is all conveniences that could be nice to have. Value added would be buying a tractor, because then I can harvest more crops, so I can sell more and therefor make more money.
Inflation is good if it is due to more productivity, meaning we are getting better and more efficient at producing stuff so we can sell more stuff.
Inflation is not good if it is just due to interests. Interest creates artificial inflation, there is no way they can not, because you have to pay back more than you took out. Only way to do that is to sell more or sell more expensive. Inflation driven by selling more expensive in order to pay off your interest rates is not economic progress, that is stagnation.

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.

Then again you would never sell a car until the resale value is great than the amount owed would you?
I know I wouldn't. Again interest is not need in order to loan out money against future.

Let me put it to you in a way that most people tend to understand. Say that you are down on your luck one month and can't pay your rent. You ask your dad (or some other relative) if you can borrow the money from. They say sure, but there is a 5% interest on the loan, so you borrow $1000 for your rent, but have to pay back $1050 to your relative. How would you feel about that?
That is exactly what the banks are doing.

 

[tkmikkelsen]

Oh really? How did I pay off my car loan? How do I pay off my credit cards? How am I paying off my houses?

I take it that you have never seen a foreclosed house or a car that was repossessed or a credit card that was closed.

Stop thinking of these things on a personal level. You might be able to pay off everything you owe and might be able to do that right now, but not everyone can do that and it is not possible that everyone do that, because our debt is higher than our total amount of money, thanks to interests.

 

[Sceptic-PK]

I take it that you have never seen a foreclosed house or a car that was repossessed or a credit card that was closed.

Of course I've seen those things. Completely and utterly irrelevant.

Stop thinking of these things on a personal level. You might be able to pay off everything you owe and might be able to do that right now, but not everyone can do that and it is not possible that everyone do that, because our debt is higher than our total amount of money, thanks to interests.

I'm off to bed now and I hope someone deals with this by the time I get to work tomorrow, but I just wanted to say that this is complete and utter nonsense.

 

[AvalonXQ]

Let me put it to you in a way that most people tend to understand. Say that you are down on your luck one month and can't pay your rent. You ask your dad (or some other relative) if you can borrow the money from. They say sure, but there is a 5% interest on the loan, so you borrow $1000 for your rent, but have to pay back $1050 to your relative. How would you feel about that?

I've lent money this way, and I've borrowed money this way. So I feel pretty good about it -- it allows a close friend or relative to help you out while still giving them some of the opportunity costs of them tying up cash for you. What's your problem with this?

 

[drkitten]

The problem with all of the value you added here is that it is of no value. It is all conveniences that could be nice to have.

Well, value is defined in economics as "how much people want something." Whether you want it because you need it or simply because it could be nice to have is irrelevant, as long as you're willing to pay money for it.

But you're also missing the point entirely.

Value added would be buying a tractor, because then I can harvest more crops, so I can sell more and therefor make more money.

This, in turn, means that having a tractor now is more valuable than having a tractor five years from now. If I can earn an extra $5000 over and above the costs of operating the tractor, then it's worth nearly $25,000 to me if I'm able to buy the tractor this season instead of in 2015. (I say "nearly" because future money is worth less than current money -- the tractor might break next year and I'd lose all the expected value.)

Inflation is good if it is due to more productivity,

Inflation is never due to more productivity. More productivity means more stuff being made, meaning a greater supply of the stuff, meaning lowered prices.

Interest creates artificial inflation, there is no way they can not, because you have to pay back more than you took out. Only way to do that is to sell more or sell more expensive. Inflation driven by selling more expensive in order to pay off your interest rates is not economic progress, that is stagnation.

Then again you would never sell a car until the resale value is great than the amount owed would you?

I might. Depends on opportunity costs.

Let me put it to you in a way that most people tend to understand. Say that you are down on your luck one month and can't pay your rent. You ask your dad (or some other relative) if you can borrow the money from. They say sure, but there is a 5% interest on the loan, so you borrow $1000 for your rent, but have to pay back $1050 to your relative. How would you feel about that?

I'd be fine with that. Presumably there's a reason that I'm borrowing the money instead of simply moving back in with Dad; I have an expectation that I will be able to make more money in a little bit of time once my new startup business starts rolling or once I can sell my house and tap the equity in it, or whatever. Dad's giving me money NOW so I can pay him back with less valuable money LATER.

That is exactly what the banks are doing.

And good for them.

 

[drkitten]

Stop thinking of these things on a personal level. You might be able to pay off everything you owe and might be able to do that right now, but not everyone can do that and it is not possible that everyone do that, because our debt is higher than our total amount of money, thanks to interests.

That's simply ridiculous. That's like saying there's no way a dentist can have 500 patients because he's only got two dental chairs.

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.

 

[Loss Leader]

There is never enough money in the world to cover the combined debt with interest as the banks did not create the interest part.

That's ... not true.

 

[tkmikkelsen]

That's simply ridiculous. That's like saying there's no way a dentist can have 500 patients because he's only got two dental chairs.

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.

So far so good and I agree.

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?

Actually there is 1100 money on the island the bank just created 1000 money plus the initial 100 money.

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.

The bank only have 1100 money, so where does it get the last 100 money from in order to buy fish of the total value of 1200 money from you?

 

[tkmikkelsen]

Inflation is never due to more productivity. More productivity means more stuff being made, meaning a greater supply of the stuff, meaning lowered prices.

Sorry, my bad got inflation and economic growth mixed up in my head.

Inflation = A general increase in prices on goods and services.

Economic Growth = Increase in the amount of money being produced.

They are 2 different things and I was using them wrong, my bad and I apologize.

 

[Roboramma]

So far so good and I agree.



Actually there is 1100 money on the island the bank just created 1000 money plus the initial 100 money.

Um, if there were only a single 100 money NOTE, the example would still work exactly as laid out, so how is there 1100?

The bank only have 1100 money, so where does it get the last 100 money from in order to buy fish of the total value of 1200 money from you?

At what point are they not going to have the 5 money to give you? Every day you give back the five against what you already owed, so he still has it. At what point does the back look in it's drawer and say, "Oh, ****, we don't have 5 money left!"? Because I can't see any point at which that would happen.

 

[aleCcowaN]

<snip, snip>

Any way back to fractional reserve banking. The banks do froudently create money and lend it out to us as debt. Did you ever wonder where all this money comes from?

All money created by the banks is created as debt. This has put us in an impossible position as the ability to pay both debt and interest is just not possible. There is never enough money in the world to cover the combined debt with interest as the banks did not create the interest part. This leads to spiral debt.

<snip, snip>

So, pal, why don't you propose the creation of the Bank of The People's Republic so any thing it creates would be the people's. As you say banks are creating money surely to earn money -the interest part?-, the same way your People's Republic only needs to cover costs and any benefit will be distributed to the people.

As the state creates money, be it People's Republic, Republic or Kingdom, the money created by People's Republic Bank is just more state money so the state can destroy it at will, for example, by canceling all debts.

Then people can reach their dreams of having their own home and be "a peasant in the morning, a banker in the afternoon, a philosopher or artist in the evening" and everybody will be able to sing "heigh-ho! heigh-ho! heigh-ho, heigh-ho, heigh-ho!" like the dwarfs in Snowwhite and the seven midget economical concepts.