How the banks create money

[Sceptic-PK]

So, is anyone going to answer my question I’ve posed on at least a couple of occasions? If banks don’t lend excess reserves, why when a loan is transferred do the reserves go down by that exact amount?

 

[psionl0]

[*]People entrust me with their cash and I record their "deposits" in my accounting software. When you want to borrow money from me you give me a promissory note and I also record this in my accounting software (ie I start up my own bank).

This would be the closest approximation to what I’m saying. There’s nothing stopping you taking somebody’s money and lending it to somebody else (refer stevea’s earlier example about the mattress. This is how FRB works, though obviously the overall process differs).

 

[Sceptic-PK]

Of course, I have no idea how the strawman account relates to reserves. Could you explain a little psi? Have you redeemed your strawman? Lulz.

 

[psionl0]

Of course, I have no idea how the strawman account relates to reserves.

Probably the same way as your strawman arguments do.

Since my previous response was too subtle for you, I will spell it out for you. Your post was a maze of contradictions. You picked option 3, immediately switched to option 1 by way of explanation (or is that exposition?), said this is FRB then said it is different.

In short, you made a complete dog's breakfast of your explanation.

 

[psionl0]

Sorry, I missed this part. One doesn’t have to be a bank in order to do this.

This is true. You don't need to be a building with vaults, computers and tellers to set up a banking operation.

But how do you set up a bank without setting up a bank?

 

[Sceptic-PK]

I don’t care if you still don’t understand FRB, or if my admittedly amateur explanations are too hard for you. I’ve answered the same f’n question repeatedly through this thread champ. Let me know when you’ll address even one of mine.

 

[tensordyne]

So, is anyone going to answer my question I’ve posed on at least a couple of occasions? If banks don’t lend excess reserves, why when a loan is transferred do the reserves go down by that exact amount?

Very well, you have asked an honest question. The answer is because the reserves are collateral for the loan held at the bank. A bank serves two purposes. The first purpose is as a business. The next purpose is as a trust for society.

When reserve money is moved around, the trust function of a bank goes to another bank. Since all of the banks are trusts, it does not matter whether a loan eventually gets transferred from one bank to another, or stays at the originating bank, since all banks are trusts with the same stewardship rules.

Really, I do not think about things in these terms specifically (who is putting what on the line, why, and for what risks and rewards, but there is nothing wrong with thinking about it this way), I think more in mathematical terms when I can help it. In this case the reserve in conjunction with the various ratio requirements just acts like a limit on the number of loans that can be made. The additions to deposits allow the loan to be repaid (barring interest considerations) because it is matched the by the loan repayment amount.

So I said the reserves is collateral, but why? Perhaps it is more clear that when a loan is defaulted on (the purpose of having collateral is in case a loan defaults, after all) and a transfer occurs, that the bank that originates the loan, will have to take a haircut somehow. But even if the reserve money stays in the same bank, when a loan is defaulted on, the originating bank will still have to go through the same steps, sell the house, zero out the principal on the loan, etc. etc. If you check the math, it all comes out the same either way, as far as I can tell.

So, there you have it. As collateral in a trust and as a way to limit loans. That is my best explanation for now.

 

[tensordyne]

Oh yeah, the collateral is held in trust with the central bank, for that is what reserves are, an account a bank has (in FRB) with it's central bank. The central bank never changes deposit accounts with this money, so the changes in reserves happen in parallel with other changes in various entries. You have to compare apples to apples and oranges to oranges kind of thing.

 

[tensordyne]

What is the point????



And, one more thing. Sceptic-PK, for the love of whatever you might love, if we all agree on how the steps in FRB work in terms of the differences and minuses, ratios and so on, it does not matter what interpretation we put on top of it. Mathematics is precise in a way that various phrases can not ever be (unless your language is as precise, which English as a language, often is not).

So, do you agree with the mathematics or not? Your other points are really irrelevant (unless they take a different view on the math). Mathematics (and I am not requiring you to do any equations here, just know what the steps are that are allowed for in FRB, in an algorithmic sense) is what counts. So far, an Economist says the mathematics of psionl0 is correct, so,

What in the world is the Point!

Show me the beef Sceptic-PK!

I think you know what I mean by the above. Show me your math. Forget words. Show me the beef, some balance sheets.

OK. Later.

 

[tensordyne]

Sorry, one more thing. One thing you can not do that a bank can do (amongst all sorts of other things), is get an account with your country's (other countries too, no doubt) central bank. Those accounts are reserved for banks and not just your average pay-day loan maker. That is because banks extend credit from society to a borrower instead of pay-day loan operator to borrower.

Apples, meet Oranges.

 

[tensordyne]

What is the point????



And, one more thing. Sceptic-PK, for the love of whatever you might love, if we all agree on how the steps in FRB work in terms of the differences and minuses, ratios and so on, it does not matter what interpretation we put on top of it. Mathematics is precise in a way that various phrases can not ever be (unless your language is as precise, which English as a language, often is not).

So, do you agree with the mathematics or not? Your other points are really irrelevant (unless they take a different view on the math). Mathematics (and I am not requiring you to do any equations here, just know what the steps are that are allowed for in FRB, in an algorithmic sense) is what counts. So far, an Economist says the mathematics of psionl0 is correct, so,

What in the world is the Point!

Show me the beef Sceptic-PK!

I think you know what I mean by the above. Show me your math. Forget words. Show me the beef, some balance sheets.

OK. Later.

 

[psionl0]

And, one more thing. Sceptic-PK, for the love of whatever you might love, if we all agree on how the steps in FRB work in terms of the differences and minuses, ratios and so on, it does not matter what interpretation we put on top of it.

Actually there is one caveat - anytime actual monies get moved, this must be reflected in the mathematics. Of course, our mathematics show that when deposits get transferred from one bank to another, so do reserves. (Loans don't get transferred - that is just Sceptic-PK's misinterpretation of the system).

Sceptic-PK's obsession over when reserves move from bank to bank is not as relevant as he would like to believe it is for two reasons.

The first is that it is not necessary (for FRB purposes) for the banking system to be split up into several individual banks. FRB would work the same way in a single-bank system (except that reserves would not be transferred when money was being transferred between bank accounts).

This is not just some theoretical objection. Nationalizing banks has been a popular notion in the past and since political ideas tend to be recycled from time to time, a single nationalized banking system could be on the cards in the future - especially if tax payers have to start making good on the deposit guarantees.

The other thing is that if an individual bank is worried about the effects of a substantial withdrawal on its reserves, it can take steps to counteract this. There are four basic ways a bank can build up its reserves"

• Borrow money from other banks or corporations.
• Get a discount loan from the central bank.
• Sell some of its securities.
• Sell some of its existing loans.

Interestingly, if you do the mathematics, you will find that none of these measures have any effect on the total reserves held by the banking system as a whole. The only thing that affects the total level of reserves is cash deposits and cash withdrawals.

Since M1 money increases with each new loan and decreases when principal repayments are made, we are well justified in saying that "banks create money".

 

[psionl0]

Show me the beef Sceptic-PK!

It looks like chicken err Sceptic-PK is not up to the task after all. He is trying to avoid you by derailing an ancient thread.

 

[psionl0]

Come Monday my time if I do not see some kind of analysis of a spread-sheet, well, then, what can I say but that I think you do not have the guts to give an analysis of how FRB works relative to objective measures.

Ding Dong! Time's Expired!

In spite of Sceptic-PK's pathetic attempt to "buy time" by saying that football comes first and in spite of your genuine attempt to answer his questions in the mean time, Sceptic-PK didn't have the guts to attempt to "show you the beef".

in fact, he's run away from this thread altogether.

 

[tensordyne]

Ding Dong! Time's Expired!

In spite of Sceptic-PK's pathetic attempt to "buy time" by saying that football comes first and in spite of your genuine attempt to answer his questions in the mean time, Sceptic-PK didn't have the guts to attempt to "show you the beef".

in fact, he's run away from this thread altogether.

Well, he made something of a legitimate point (when properly removed from other mangling notions), which is that total reserves remains constant and that reserves comes from capital and deposits. Yes, time and then some has expired. I guess Sceptic-PK's exposition powers were not up to the task of explaining things in something like mathematical form.

If he is gone for good this time, oh well. Maybe we can get back into analysing possible instabilities in FRB, or answering one of my own questions of how does high-powered money figure into the mix of balance sheets.

Just glad you are still around psionl0. I think there are a few more kinks left in my understanding of FRB and I would by all means like to iron them out. Good points about how a bank can go back to meeting ratio requirements.

Perhaps my next post will be a response to your 2nd and 3rd equation posts. I know I have been saying that for a while now, but barring Sceptic-PK or Tippit (or similarly deranged entity) showing up, I think we can go back to P/(P+i) issues.

Until then.

 

[psionl0]

Talking about mysteries makes me remember something, I do not know how to account for high-powered money in terms of balance sheets! I saw somewhere that high-powered money literally gets multiplied from the reserve or something...

High powered money is another term for "base" money - bank reserves plus the notes and coins in the hands of the public (M0).

Setting up a balance sheet for a central bank is different to setting up a balance sheet for an ordinary bank. There are no reserves for one thing and the central bank only deals with base money. Mishkin gives a simplified balance sheet as shown below:

Assets
Government Securities:
Discount loans:

Liabilities
Currency in circulation:
Reserves:

The "Reserves" are the reserve accounts of the banks and the discount loans are the monies loaned by the central bank to the banks. These liabilities (combined with coins issued by the treasury) constitute the "high powered money".

In theory, these should balance without having a capital account. Purchasing securities or issuing discount loans increases the banks' reserves by the same amount. Banks exchanging reserves for currency is a zero sum gain. One thing I haven't been able to find out yet is how the balance sheet is affected when a bank goes kaput. Such a bank is likely to owe more in discount loans than is owed in reserves so there will be a net loss of assets not matched by a reduction in liabilities.

 

[psionl0]

BTW I came across an interesting quote while researching Mishkin:

Federal Reserve notes are IOUs from the Fed to the bearer and are also liabilities, but unlike most, they promise to pay back the bearer solely with Federal Reserve notes; that is, the pay of IOUs with other IOUs.

It would have sounded less facetious if Mishkin had also pointed out that the government makes good on these IOUs by forcing your creditors to accept them.

The main thing is that I am not the only person who calls fiat notes IOUs.

 

[Tippit]

BTW I came across an interesting quote while researching Mishkin:It would have sounded less facetious if Mishkin had also pointed out that the government makes good on these IOUs by forcing your creditors to accept them.

The main thing is that I am not the only person who calls fiat notes IOUs.

Fiat money represents no promise to pay anything, therefore, it is not an IOU in any sense, it is a token payment which is never to be redeemed. It must be accepted by decree of law. Its value is derived extrinsically from violence, the threat of violence, and the threat of violence against others. Treasury bills, notes, and bonds are IOUs, as they are all promises to pay with maturity dates. If I hand you a Federal Reserve Note to satisfy a debt then by law it is paid, I no longer owe you anything, therefore, it is not an IOU. I would agree that Federal Reserve Notes depend on the existence of IOUs until the Fed decides to monetize whatever it wants.

This may seem pedantic, but when dealing with a fairly complex topic accuracy in definitions is important. Saying that Federal Reserve Notes are IOUs is as wrong as saying "all money is fiat money".

 

[psionl0]

It is pretty much a "point of view" sort of thing. I merely found it interesting that an economic textbook would state that particular POV and back it up with a balance sheet showing these notes as liabilities.

 

[Tippit]

It is pretty much a "point of view" sort of thing. I merely found it interesting that an economic textbook would state that particular POV and back it up with a balance sheet showing these notes as liabilities.

How is it subjective in any way? If I pay you a Federal Reserve Note to satisfy a debt, I don't owe you anything anymore. The corresponding debt that the FRN originally monetized still exists and is owed by the public, but that has little to do with me, the holder of the FRN. Debt money, or debt-based money is not debt, the debt that was issued in exchange for it is. If Federal Reserve Notes are IOUs, anything can be an IOU and the acronym loses its meaning. Once again, accuracy in definitions is important.

If we used a credit-based money system, for instance, if the Fed simply conjured up money out of thin air and used it to buy vacant houses instead of bonds, would a Federal Reserve Note be an IOU? The answer, in both cases, is no.