I’m sorry but you’re absolutely wrong. Explain to me how you think a bank making a loan ‘creates’ money?
This is the definition from Wikipedia of the M1 money supply:
M1: The total amount of M0 (cash/coin) outside of the private banking system plus the amount of demand deposits, travelers checks and other checkable deposits
This is the definition from Paul Krugman’s macroeconomics textbook, second edition.The United States has several definitions of the money supply. M1 is the narrowest monetary aggregate, containing only currency in circulation, traveler’s checks, and checkable bank deposits.
This is the definition from Stephen Williamson’s macro textbook, the fifth edition.What is defined as money is somewhat arbitrary, and it is possible that we may want to use different definitions of money for different purposes…
The quantity of M1 is obtained by adding currency (outside the U.S. Treasury, the Fed, and the vaults of depository institutions), travelers’ checks, demand deposits, and other transactions accounts at depository institutions.
I was been travelling lately and I don’t have more macro textbooks readily available, but if you wait a few days, I should have my others. Or if those aren’t good enough for you, this is the definition from the Federal Reserve (you might have to hit the “Notes” tab to see this definition): M1 includes funds that are readily accessible for spending. M1 consists of: (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler’s checks of nonbank issuers; (3) demand deposits; and (4) other checkable deposits (OCDs), which consist primarily of negotiable order of withdrawal (NOW) accounts at depository institutions and credit union share draft accounts.
My previous post had two different cites, but they weren’t directed specifically at you, and you obviously missed them. You responded to that post with a lazy contradiction and zero cites, and not even the slightest attempt at an argument. That means I don’t know exactly where your comprehension problems lie. So now I have to ask questions.
Do you realize that the M1 is one definition of money, broadly defined?
Do you realize that the M1 contains private bank liabilities? That is, do you know what a checkable deposit is?
Do you know any basic accounting? Do you know what a debit is and what a credit is? Do you know that checkable deposits are liabilities for banks?
If the answer is “yes” to all the above questions, then I can easily explain how a bank loan creates money (increases the M1 stock of money). But if you are still stuck on some of these definitions, then point out where you’re having trouble and I can try to fill in the gaps first. If you don’t have the foundation in place, as seems likely, you won’t understand the answer.
I’ll look at your cites when I have some time, but in answer to your basic questions. Yes. I have spent 20+ years in banking and finance so I know what I’m talking about. (Admittedly not in the US, but not materially different enough I wouldn’t have thought.)
At first blush I think you’re applying high level macro-economic concepts to an OP which I took to be very much rooted in micro concepts, where the terms and concepts used where fundamentally wrong.
Sorry to quote myself.
Upon reflection, perhaps I’m the one who presumed a lower level of knowledge or discussion intent from the OP than is there. Which I think came from them using terms like creating and destroying ‘money’, which to my mind didn’t equate to a discussion about the money supply.
In all honesty I didn’t read your full original reply Hellestal, where you responded to me as well, which I know is poor form in GD, and just dropped a drive by, rather than stopping to realise that you were talking about the money supply. Mea Culpa.
I am not surprised by this. Many people who work in banking know their stuff quite well, but still don’t have a macro perspective on money. For a memorable example from an old book, here is an interesting paragraph from Peter Bernstein’s Primer on Money, Banking, and Gold from 1965.
Bernstein was a financial historian who worked for a time at the New York Fed.
A bank that approves a new loan will debit its assets and credit its liabilities. That credit to liabilities is by definition money. The creation of the loan creates money.
Like the banker in Bernstein’s example, you’re focused on the next step. The most likely destination for any newly printed loan check is to be deposited at an entirely different institution. The bank must absolutely have the monetary base on hand (what the banker thinks of as money) when that loan is deposited elsewhere. But from a broader perspective, the story remains the same: the commercial bank created money. As long as the check is deposited somewhere within the banking system, rather than cashed, then the net effect will be exactly the same: the loan will have expanded the (broad) money supply. There will be more total deposit liabilities afterward than there had been before, and those deposit liabilities are counted as part of the money supply.
I’m using US definitions, but international definitions aren’t substantively different.
I am fairly confident that the OP is using the same macro perspective that I am using.
Your numbered list:
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yes
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the money is not destroyed.
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yes and no. In a world without the Fed and FDIC, banks could not be reckless and stay in business. This would lead to banks having larger reserve ratios and being less risky in their loan activities. Banks were stable during the era of the Suffolk Bank in early American history. The Suffolk bank served as a clearing house and kept smaller banks from issuing too much paper.
The Fed and FDIC breed the illusion of stability. The last collapse is proof of that. See Bastiat, Hayek, Nassim Taleb, etc.
- nope. Dollars are money. Money is a medium of exchange. It arises on the market spontaneously a la Carl Menger. It is a good that has widespread appeal.
One thing that has always confused me is how currency is considered a debt to the Federal Reserve. Suppose I have a $1 bill. That represents a debt to the fed. So, I take that $1 bill to the Federal Reserve in Washington, D.C., knock on the door and ask to trade the bill for what I am owed.
Assuming I don’t get arrested, and the law allowed me to “redeem” my bill, what would the Fed give me to satisfy its debt?
Back in the day? Gold.
Today? They have nothing to offer you but handcuffs.
The liability was recorded by the Fed accountants when that dollar was first created,* and it was recorded in exactly the same way it was done in the past when the notes were backed by gold. The core bookkeeping hasn’t changed in the slightest. Back in the day, people could take their gold to the Fed and receive the banknotes, in the same way that we today take our currency to private banks and receive deposit balances. The liability is recorded in identical manner.
Under FDR, the government devalued gold and stopped paying it out to individuals. But foreign finance ministries and central banks could still claim gold after the war, if they had the Fed notes to trade for the metal. The notes were still an obligation, but the obligation had become limited: the Fed only had to pay up to other governments. Then under Nixon, the gold window was closed entirely and nobody at all could ever again claim jack shit for the paper. The laws changed. But accountants don’t like change. They continue their jobs exactly as they did before, regardless of what had happened. They happily record the very same “obligations” in ledgers when the money is created, in the very same way, although the legal obligation to pay metal no longer exists. (The government accepts central bank money for taxation, but that’s it.)
But the central bank bookkeeping is vestigial, like the eyes of those fish that live in pitch black caves under the earth. The eyes no longer function, no longer see, but the eyes still exist. So it is with central bank monetary liabilities. They do not serve the purpose they once did, but they still exist.
If you show up with a dollar and demand that it be redeemed, you will be escorted to the door. They will spend the rest of the day laughing about it.
*More precisely, the liability was recorded when the electronic dollar was created in the computerized bank ledgers. Later a private bank decided to exchange the electronic version of the dollar for a paper version. Private banks are allowed to do that at any time, if they own the electronic version to make the trade. It’s legally the same green dollar, regardless of whether it’s on a hard drive or in a bank vault.
This makes it sound as though when money was backed by gold it was somehow more real than now, and it’s a bad thing we dropped it. But at best it was just a stabilizing factor (at least while the supply and demand of gold is static…)
If I’m using gold purely as a store of wealth then it may as well be tokens to me; I’m not going to do anything with it. I’m just assuming someone else will want that quantity of gold enough that I can trade it for useful things. Same with fiat money.
Didn’t mean to give that impression. I think gold is the dumbest thing to ever dumb a dumb. Its purpose is firmly in the past. Do a search, and many previous SDMB threads will attest to my opinions on this.
Fed accounting works fine today. It functions. No need to change what ain’t broken. But Fed liabilities simply do not have the meaning they used to have, and I think we should be honest about that.
EDIT: Or put it another way, one reason I often bring up gold is that the easiest way to understand how things work today is to dig out the reasoning for how they worked in the past, when things were simpler. We start simple with gold, and then progress our understanding so that we have a better idea of how the modern system works.
I think it would actually be fun to be a guard at the Fed and, on day, bring $1 worth of gold and actually redeem some nutbar’s dollar bill. Then watch hordes of them show up the next day.
Of course, $1 in gold would be… well, you could lose it in your pocket. Gold is running about $1100 an ounce, and 1/1100th of an ounce of gold is about the size of a grain of rice.
I’m not 100% on this, but I’m pretty sure there were times in US history when you could do exactly that: walk into a bank with a pound of gold, and get a fixed quantity of paper money. Now, we’re talking 19th century here, so it would not be “Federal Reserve Notes”. (There was no Federal Reserve.) It would be paper notes printed by the bank itself. You could then go out and spend the paper notes, if you wanted, which would probably be easier than chipping off pieces of your pound of gold, and then arguing about how much the pieces were worth.
At the same time, people who were holding bank notes could go to the bank and exchange the notes for gold. (Unless too many people showed up at once, in which case the bank would probably go under, and all of its notes would become worthless.)
In our current system, federal reserves and Federal Reserve Notes (currency) are the “gold” of our era. You can walk into a bank with currency, and get a checking account equal to the worth of the currency. Conversely, if you have a commercial bank account, you can withdraw from it, and get paper dollars at a 1:1 ratio.
I want to state for the record, I am talking about money here. There are other ways to “save” besides saving money.
But, speaking strictly in terms of saving money, one country can only save more if it accumulates assets from other countries. For example, Germany might save more than it spends if it accumulates money from other countries (Greece, Spain, Italy, for example). Similarly, China might save by accumulating US assets. There’s nothing inherently wrong with one country producing more than it consumes, or another country consuming more than it produces.
But it can create problems, especially if a country is borrowing in someone else’s currency, or a currency the country itself does not control (for example, Greece does not control the euro.) It can also create problems if the borrowing country is not self-sufficient: in other words, it can’t itself produce the things it needs: food and energy, for example.
If China decided to “cut us off” tomorrow, it really wouldn’t be a problem. Our (The US’s) debts are denominated in dollars. We (meaning the American government - specifically the Fed) has the legal authority to create as many dollars as we want. If China decided to stop exporting to us, that would similarly make relatively little difference. We still (I assume) have the ability to produce most or all of what China sells to the US, and if we couldn’t buy those things from China, there are plenty of other countries that would be happy to sell us what China sells us now.
Greece, on the other hand, is in a completely different situation. Their debt is denominated in euros, and the Greek government does not have the legal authority, itself, to “print” them (on paper, or electronically). They are, (to my understanding) not very self-sufficient. They import a significant amount of the food they eat and the energy they use.
Ultimately, the only way for Greece to pay off its debt is to export more Greek products, or to import euros through tourism (French, or Germans or whoever bringing outside currency into the country and spending it in Greece for Greek products or services).
In other words, they need a positive flow of money coming into the country, so that they can turn around and pay that money back to their creditors. That means more Greeks need to do more work, and export their work (or the products of their work) to other countries. Instead, austerity has resulted in fewer Greeks working: the unemployment rate is 25%.
What Greece really needs is to devalue their currency, so their products and services would be more competitive in global markets. And, of course, more tourists would come, because vacations in Greece (for outsiders) would become cheaper.
But they can’t do that, because they’re on the euro.
This is not, strictly speaking, true. A country can save more by being productive - by growing its economy. If its outputs exceed its inputs (as is in fact the case in the average country) then savings can increase.
I think you’ll find PRACTICALLY speaking most countries that save are net exporters, but it is not actually axiomatic that you must be a net exporter to save more. The Earth, taken as one economy, has increased its savings quite a lot, but has no trade with other planets. There’s no mathematical reason a country could not be the same.
Well, there are a couple ways I could respond. I could just say, “Nope, you’re wrong. Banks create money by lending. Similarly, money is destroyed when bank loans are paid off.”
I could also talk you about credits and debits.
Commercial bank deposits are not assets for commercial banks. They’re liabilities. Similarly, loans are not liabilities to banks, they’re assets. So an extremely simplified bank balance sheet might look like this:
Assets: $2 million in outstanding loans.
Liabilities: $1.5 million in customer deposits.
(Of course a real bank’s balance sheet would be much more complicated. This is just an example.)
What you see is the bank’s net worth is $0.5 million. That’s the difference between the value of the loans outstanding, and the amount the bank owes customers with bank accounts there.
Now suppose one of the loans was for $500,000.
For simplicity, lets also say the borrower has an account at the bank with $500,000 in it. Now the customer chooses not to use the money for something else, but to repay the loan. So the transaction is: customer deposits -$500,000. Loan portfolio: -$500,000.
The bank’s balance sheet now looks like this:
Assets: $1.5 million in outstanding loans.
Liabilities: $1 million in deposits.
But what happened to the $500,000?
The answer is it “disappeared.”
It sounds mysterious that money can just disappear, but that’s what happens.
Let’s turn the tables for minute, though. It’s easy to understand that when you pay off a loan, the loan disappears. (You no longer owe any money.)
For a bank, deposits are “money owed to customers”. In the example above, the person who paid off his loan saw his bank balance go from $500,000 to $0. Similarly, his debt went from $500,000 to $0.
Where did the loan go when it was paid off? It disappeared.
Where did the money in the deposit account go? It also disappeared.
The bank literally went into its computers, changed the numbers, and the deposit vanished.
I have a question for you: if money doesn’t originate from banks making loans, where does it originate?
Makes sense, but how can accounting standards allow for the calling of something a liability when you don’t owe anyone anything? “That’s the way we’ve always done it” is not an accepted excuse is most sciences.
Can I do my taxes this way? Yes, IRS, I made $100k last year, but I incurred a $110k “liability” to my friend Joe. What do I owe him? Nothing, really, but since the Fed does it, I can do it too!*
*I’m not really going to try this.
I know you already have your answer. But, just to make this clear for anyone else who is confused by this, let me give an illuminating example.
Say you deposit $100 in the bank. How much money do you have? $100 (plus other assets and cash on hand, which we’ll ignore).
Now the bank loans that $100 to someone, who uses it to pay a contractor to improve his house. The contractor now has that $100.
How much money do you have? $100 in the bank. That’s your money.
How much money did the contractor gain? $100. That’s his money, it’s in his pocket.
Total: $200
Where did the extra $100 come from? The borrower, actually. He gave the bank a promise to pay $100 (plus interest) in the future. Meanwhile, thanks to the wizardry of the bank, that “promise” is circulating: it’s in the hands of the contractor.
Yeah, it’s a gross oversimplification, but it shows how banks expand the money supply (a.k.a. “create money.”)
The fun part is that the contactor then deposits it, and it gets loaned AGAIN, and now we have $300! This could go on and on, right? Nope, due to “fractional reserve” laws. The bank could actually only loan some portion of your $100, so eventually it peters out.
It’s oversimplification to the point of being inadvertently misleading. You’ve shown the expansion - but but none of the contraction.
Accounting is not a science. There are many practices in accounting that are tradition based, but do not follow a strict logic.
I was only intending to show the expansion. How is that misleading?
It’s simple enough, though. The contraction happens when the loan is paid off. The borrower gets money from somewhere (say, the contractor pays $100 to the baker, who pays $100 to the plumber, who pays $100 to the electrician, who is the borrower) and pays off the loan (plus interest, which I’ll ignore here).
Bingo, the “extra” $100 disappears.
I think the correlation between natural resources and national wealth is poor. I mean, natural resources don’t hurt, but other things are more important. Several resource-poor countries are nevertheless rich: Singapore, Belgium, The Netherlands, Japan, Hong Kong (not legally a country, but still rich and resource-poor), Luxembourg, Switzerland, Monaco and South Korea, for example. On the other hand, there are a number of countries with abundant natural resources, that are nevertheless impoverished.
It is quite possible for an economy to grow while unemployment increases, as you said. However, what I meant when I said, “They directly and inevitably make a nation poorer,” was that unemployment and underemployment makes a country poorer than it would have been, had more people been employed. I agree that productivity per person is enormously important. As I said earlier, (I think) the combination of productivity (per person) + the number of people working is equal to a country’s wealth. If you had a lot of people working, but their productivity was low, you’d still have a poor country. If you high productivity per person, but very few working, the county would be poor. The idea (if your goal is to increase wealth) is to both have a lot of people working and have high productivity per person.