Great Post, Lemur! Another key good, as I understand from prison movies, is the cigarette.
Hey Lemur866 that summed it up perfectly.
Now then what am I gonna do with all these friggin’ chickens
Thanks, Lemur. I understand all that, but it doesn’t answer my questions.
- When a bank makes a loan, is it giving its depositor’s money to the borrower, or is it creating money? To my understanding, the Fed (or the Treasury, or whoever) stands ready to trade currency to banks on a 1:1 basis whenever the banks ask. So was George Bailey lying? Or did things work differently back then?
And if banks do use created money to make loans, how do they ever go out of business? I mean, if a bank’s loans go bad, it’s created money that’s lost, not depositor’s money. Is it purely an accounting issue? Or a regulatory one?
- I understand banks create money. And I realize newly created money is indistinguishable, once it’s created, from ‘old’ money. But the process has to start somewhere. Where did the ‘old’ money come from?
Another way to ask the question is this: The money supply grows from one year to the next. It grows indefinitely. But banks’ ability to create money is not indefinite - in theory, it’s limited by the reserve requirement. At some point, the banking system’s ability to create money is exhausted. So where does new non-bank money come from?
- Finally… if all money (or almost all money) is debt-based (created when someone goes into debt), does prosperity come from debt? Are we dependent on ever-increasing levels of debt?
Someone said earlier that wealth is created by the stock market. But that isn’t true. Every stock market transaction has a buyer and a seller. Whenever a stock is traded - whatever the price - someone is always poorer to exactly the same number of dollars as someone else is richer. There is never an aggregate increase of wealth from buying and selling assets. People feel richer, but the total amount of money is unchanged. Where does wealth come from?
The depositor retains a deposit in his/her checking account. Deposits in a checking account are considered money under most definitions, because they are so easily converted into cash or goods. Ergo, the bank creates money, since both the depositor and the borrower have money whereas only the depositor had it before.
I don’t know what you mean by this. Trade what for what?
No, George Bailey spoke the truth–fractional reserve banking worked the same then as now.
Yes, but the depositor’s money is borrowed by the bank. They must be prepared to repay it, in currency, on demand. When too many loans go bad, they find themselves unable to do so and must be liquidated, which results in the shareholders losing their equity.
Under a specie standard, “base” money is dug up out of the ground by miners. Under fiat money, it’s created by the government. As users of currency we rely on our respective governments not to create too much of it. Government monetary creation most often takes the form of transferring digits into the accounts of large securities brokers in return for stocks and bonds, under the direction of the Federal Reserve Open Market Committee.
See above.
As should by now be clear, base money isn’t debt-based.
You’re correct; the stock market doesn’t create wealth, businesses do. The stock market is the mechanism by which gains in wealth created by businesses can be measured and traded.
In the most basic sense, money is information about how much value a party has saved up. It’s important to see that this is not so much about value as it is about information about value. To illustrate, let’s consider that we don’t have money. Instead, we barter, by necessity, when we trade. Let’s say you have a table, and I have a lamp, and we consider them to be of nearly equal value. We trade them. Okay, so far, so simple.
Now money is a convenient way of handling that arrangement using a system of “value markers” instead of your memory. Let’s say the table is heavy, so I can’t get it to you until next week. But you give me the equally-valued lamp now. So…we have to remember that I have “-1 lamp’s worth, to you” and you have “+1 lamp’s worth”. You have 1 lamp of credit…and in a week’s time, when I drop off the table, you will accept it as payment on my debt of one lamp.
Until then you have a credit of “1 lamp” that you could instead give to someone else for, say, a bushel of carrots. You could have me deposit that table to someone else. Here it’s getting tricky, though. Maybe that bushel of carrots is not worth a table to someone else! Well, okay, you resolve that by getting fewer carrots. Or what if you only wanted half a bushel, and you need change of “1/2 a lamp”? Okay, so they’ll owe you 1/2 a lamp. But over time, with more trades, this get more confusing. Better to use a standard item that everyone values nearly the same.
In early history, that’s what happened. People used grain and cattle as fair exchange of value. Seems reasonable…everyone needs, but can only eat so much, food per year. In the case of grain, in some early societies there would be a “granary” where you could deposit grain and get a grain receipt. People would trade the grain receipts, because it would stand for the grain.
In essence, the “bank” was a large deposit of grain with a database of who owned how much grain…so the money was really a database of information about how much value everyone had accumulated.
Note how this is very similar to the gold standard - in fact that’s where the gold standard evolved from. The banks hold the gold, everyone agrees the gold is valuable, and everyone trades either gold or gold receipts. From here we get all the issues that people worry about with gold-backed currency, e.g., counterfeit receipts, gold that has been diluted in some way, or gold inflation by printing more receipts for the same gold.
The problem with this is…not all value that is in the world is in gold or grain! Every time someone creates value (and a capitalist would say this is when labor is employed - though that’s another debate), essentially another good is created for which things can be traded. In capitalism, this includes the stock market, i.e., the shares of value in a company, but it clearly can’t be all value! Some companies are not public, and some value is not sold by a publicly-traded corporation.
In reality, when someone in China makes a pair of jeans, they have created a new item for sale…something that wasn’t there before. And when you mow your lawn, you’re improving the curb appeal of your home…it is more valuable. The trouble thus becomes…money must inflate in “supply” in order to trade more goods. But in reality, the only “supply” that has increased is the sum total of value. We have a flawed system. In reality, anyone who creates something of value now has essentially minted “money” by making something new.
Some people have proposed a system of credits that would be “minted” by the creator of a good or service when someone else wants to trade for it. This has its own problems, of course, such as verifying the true value of something traded, or preventing massive corruption. But either way, we need a system in which we don’t have a supply of “money” but a supply of “value”. Not so easy, though we have shoe-horned a debt-based system of inflation on top of everything in order to deal with it, and somewhat imperfectly, one might say.
To clarify something, people should realize that the same accounting trick that allows banks to create money also destroys that money. Yes, a certain proportion of money is created by banks. Realize, however, that the principal on a loan that was winked into existence also winks out of existence when the principal is paid back. Essentially, the bank is collecting a fee on principal that only exists from the time someone wanted financing until the time they have financed it themselves.
So on the question of…what happens if everyone pays back all their debts? Well, yes, there could be a contraction of money supply. But maybe not. Theoretically speaking, all debts are simply credits to someone else. On a practical level, the debt you pay off essentially reduces the cash flow of a bank but increases its lending power. Or the debt that a bond issuer pays back decreases its interest cost, and decreases its savings. Wherever the principal ends up, someone will be encouraged to spend it on debt-based investments. Directly or indirectly, this includes the stock market.
So where did that original value come from? The easiest answer is that it used to be gold. Legally, gold is generally considered a commodity, and dolalrs are now legally a store of value in their own right…but essentially, yes, this is a combination of what originally was backed by federal gold reserves and what we agree has value.
But the more complicated answer is that it came from our agreement on what a certain amount of gold was worth. Right now it’s an approximation of how many dollars our GNP is worth. Or how many more dollars this year it is. Or something like that. (Insert conspiracy theory here).
Freddy, you said, “The depositor retains a deposit in his/her checking account.”
But you also said, “the depositor’s money is borrowed by the bank.”
Which is it? Is the depositor’s money retained, or is it lent out by the bank?
In the first scenario, the depositor’s money is at the bank. In the second scenario, the money is not there, and if too many depositors show up to withdraw their money at once, the bank won’t be able to pay them.
The second scenario is consistent with the George Bailey scene. The first scenario is consistent with my understanding of how banks work today.
Please note that the Bailey problem was not loans going bad, it was depositors wanting to take their money out. Thus, “Your money is not here - it’s in Joe’s house.” But if the depositor retains his deposit, his money is there, whether it’s there in currency or not.
You asked, “I don’t know what you mean by this. Trade what for what?”
What I mean is the Fed stands ready to exchange book-keeping credits for paper banknotes. So a modern George Bailey could tell the townspeople, “I’ve already called the Fed, and they’re sending a truck full of banknotes.” He wouldn’t have to tell them, “Your money’s in Joe’s house.” Even if he didn’t have enough currency to pay everyone, he could always call up the Fed.
Now I realize once his depositors had withdrawn their deposits, he’d be in violation of fractional reserve regulations. But that’s a regulatory issue - not an issue of not having enough money at the bank.
You said, “Government monetary creation most often takes the form of transferring digits into the accounts of large securities brokers in return for stocks and bonds, under the direction of the Federal Reserve Open Market Committee.”
When you say “transferring digits” you mean the Fed is creating money, and then transferring it to securities brokers in exchange for T-bills, right?
You said, “As should by now be clear, base money isn’t debt-based.”
What do you mean by “base money”? When I google it, I come up with, “The total amount of a currency that is either circulated in the hands of the public or in the commercial bank deposits held in the central bank’s reserves.” That’s not how you’re using it, though, is it?
Thanks for your response.
I don’t think you understand what George Bailey meant. When a person puts money into a bank account they are lending the bank money, the bank is borrowing the money. Imagine someone lends you some money, and you use the money to buy a house. The next day someone comes up and demands their money back, and you say, “I don’t have your money, it’s been turned into a house!” The problem isn’t that you don’t have the pieces of paper to give them anymore, it’s that you spent the money on some good, and now you have the good rather than the money.
Sure, the person who lent you the money still “has” the money, they have an IOU from you that says you’ll pay them back the money you borrowed. Except you probably can’t pay them back on demand unless you have cash sitting around to cover all the money you borrowed. But if you have the cash just sitting there, why would you borrow money in the first place?
A bank works by borrowing money from depositors and lending it out to borrowers. And the bank itself can have some capital of its own. So the bank doesn’t just not have the physical paper notes to pay back all the people with accounts in the bank if they decided to withdraw all their money, it literally doesn’t have the money any more because it’s lent the money to other people. If everyone demanded their money back at the same time the bank could not pay them back unless it borrowed the money to pay them back.
Of course, if the bank could demand the money it lent out, then it could pay back everything. Except, typically, a bank can’t just demand that borrowers pay it back right away, instead the borrower is only obligated to pay back the loan at a particular time. Because the borrower can’t pay back the bank right away either, because he doesn’t have the money anymore either, he used it for whatever reason he needed the loan for. Nobody takes out a loan and keeps the money in a sock drawer, they take out a loan for a reason.
So the bank is in the awkward position of being obligated to pay back the depositors on demand, but cannot get the money it lent to its borrowers on demand. And this is how bank runs happen, money lent out by a bank is not liquid. In the usual course of things the bank has plenty of money on hand to pay cash to whoever needs it, because it is getting regular payments from the people it lent money to, and this money is used to pay the people the bank has borrowed money from. But if everyone demands the money back, the bank is screwed, see “Mary Poppins”. And of course, if people think the bank is going to fail, they’ll rush to the bank and demand their money back before the bank fails, but if everyone does this the bank is sure to fail. Of course, nowadays banking laws allow the bank to temporarily suspend payments for a short time, and deposits up to $100,000 are insured by the Federal Government, so even if the bank fails you’ll get your money back.
George Bailey can’t call up the Feds and get them to send him a truck full of banknotes, because how would he pay for the banknotes? This doesn’t happen any more than if you’re late on paying your bills, you can’t call up the Feds and get them to send you a truck full of money. There IS enough money to pay everyone back, but only if all the bank loans are liquidated. And the trouble with that is that the bank might not be able to get full market value for the loans. Just like if the credit card company could demand you pay back your full balance TODAY, you might have enough assets to pay it off, or you might not, and if you have to sell your Pokemon card collection before midnight tonight you might only get pennies on the dollar.
LinusK, perhaps this example will help. Suppose you have a $20 bill, and I’m broke. You lend me your $20 bill, and in return I give you a note saying “Freddy the Pig owes LinusK $20.”
In this example, no money is created. You had $20 before, and I have $20 now. You have my promissory note, which is worth something . . . but no economist would call it money. You can’t take it to the store and buy stuff with it; the store would laugh at you. It has value, but it isn’t worthy of being called money.
But suppose you lend the money to a different person, say Cecil Adams. Suppose Cecil is so well respected, and so well known, that his promissory notes are accepted without question absolutely anywhere, just like $20 bills. Cecil has never been known to refuse payment on one of his notes, so stores treat them just like currency.
In this example, money has been created. Cecil has the $20 which you lent him, and you have his promissory note, which is as good as cash.
The equivalence between Cecil’s notes and cash will last only as long as people are confident that they can be exchanged for cash at any time. Should this confidence waver–for example, should rumors about Cecil having a really bad day at the track appear in the tabloids–people will stop accepting the notes, they will no longer be considered “money”, and money will actually be destroyed.
Banks work like Cecil. When you open a checking account, instead of giving you promissory notes, they give you a book of checks and allow you to draft notes in any amount you wish. Almost any store will accept those notes, with proper identification, because they know the bank will make the notes good. This is why deposits in a checking account are considered money–not cash, not currency, but a different form of money.
So when you deposit money in a checking account, you have the account, which is one form of money, and the bank has your cash (which it lends out, save for the reserve requirement), which is another form of money. From one form of money, we have two. Money has been created.
Nowadays the depositors most likely wouldn’t come asking for their money, because they have federal deposit insurance. If they did, then yes, the regional Federal Reserve Bank would help the bank over the short term problem. There was no deposit insurance during the Great Depression, and the Fed was more limited in power (and fairly incompetent in using the powers that it had) and allowed huge numbers of banks to fail.
Yes.
Yes, that’s how I’m using it. It’s money that isn’t created by banks. Under a specie standard, it would be actual gold or silver. Under fiat money, it’s green pieces of paper with Presidents on them and computer digits indicating bank reserves.
He’d pay for them with book-keeping credits, which is how banks pay for currency. If reserves are the only credits the Fed accepts in lieu of cash, then you’re right. Once his reserves ran out, the Fed would stop taking his calls.
Suppose I go to the First Bank of Cecil, and deposit $20. Cecil hands me a promissory note, and lends my $20 to you. You jump a train to Mexico, and when I go to Cecil, hoping to exchange my note for currency, he says, “Sorry your money’s not here. It’s in Mexico.”
Now suppose I deposit $20 with Cecil, and he lends a promissory note to you, and you jump a train to Mexico. In the second case, Cecil still has my $20, and could, if he wanted to, return it to me.
Maybe it’s a distinction without a difference - but that’s the distinction I’m asking about.
But paper money is created by banks, isn’t it? In the sense that paper money and bank money can be - and is - exchanged on a regular basis by the Fed. (I know banks don’t print money, but the money they create is indistinguishable from currency, isn’t it?)
No, banks work the first way–the depositor/lender gets the checks (promissory notes), and the borrower gets the cash. When you take out a loan from a bank, they don’t give you a check book–they give you a check.
The reason your first scenario doesn’t usually play out is because of the law of large numbers. Banks deal with huge numbers of depositors, and all of them won’t usually want to close their accounts and convert their deposits back into cash at the same time. By keeping a percentage of each depositor’s cash on hand, as reserves, they can loan out most of the deposits and still have enough left to cover an ordinary amount of withdrawals.
During pre-deposit-insurance bank runs, banks would be faced with an extraordinary amount of withdrawals–people would lose confidence in the bank, and everybody would want their cash back at once. No bank can withstand such a run without outside help, because most of their money (all except reserves) is out in loans.
Paper money is created by the government. American paper money is physically printed by the Bureau of Engraving and Printing and enters circulation via the Federal Reserve Banks (central banks operated by the government) and commercial banks.
Commercial bank-created money is in the form of “demand deposits”, commonly known as “checking accounts”.
Except if the promissary note is as good as cash, he can say, “Here’s a promissary note for $20.” Except you already have a promissary note.
The basic point is that a bank can’t just call up the Feds and have them deliver a load of banknotes for free any more than you can.
The bank absolutely does not have enough cash on hand to pay out to all their depositors. If every depositor wants their money back today, the bank is ruined, because they don’t have the money.
Let’s take another example. You borrow $20 from Cecil. You spend $20 on Pokemon cards and start a Pokemon trading business. Every month your Pokemon business makes $2. If Cecil comes to you tomorrow and demands his $20 back, you can’t pay him back. You don’t have the money anymore, you spent it on Pokemon cards. But you CAN pay Cecil back, because you have an income stream. If every month you use $1 for living expenses, and pay Cecil $1, after 20 months you’ve paid off the principle. Cecil gets his money back. But if he demands the money NOW he can’t get the money back, you don’t have it, you’ll have to liquidate at a loss and will lose that income stream.
Now, you may be thinking that Cecil is the bank. But in my example YOU’RE the bank, and Cecil simply has a deposit with you. In real life, banks have thousands of customers, and so they can pay of depositors on demand. But in a bank run situation where every depositor demands their money back, the bank can’t pay.
In ancient times this means the bank would collapse and nobody would get their money. Nowadays the bank can just borrow money from other banks, or the bank would be bought out by a bigger bank, which is almost the same thing.
I guess I still don’t understand your question. Is the question: If banks can create money through fractional reserve lending, can they get unlimited amounts of paper money to represent the money they created? If this is the question it doesn’t matter, because paper money is only a small fraction of the money a bank deals with. Sure, they take in cash and pay out cash, but they will never be in a situation where they need to liquidate all their accounts into a giant pile of cash and start handing out the cash to their customers.
Even if every customer wants to withdraw their money, the bank can write them checks that can be deposited in another bank, or simply transfer the money to the customer’s new bank.
If the question is: Why couldn’t George Bailey pay off all the Building and Loan customers, it’s because he had lent that money out to other people. Sure, the bank had assets greater than liabilities, but those assets weren’t liquid, George would have to foreclose on all the mortgages. Or borrow more money. Or, the premise of the movie, sell the bank to Mr. Potter, who had the money to pay the depositors off and would then own all the assets of the Building and Loan, namely, all those mortgage loans.
In movies, the evil Mr Potters want those loans so they can foreclose on the mortgages and force everyone out of their homes. In real life, banks are horrified at the idea of forclosure, because it means they have to find a new buyer for that property or have to hold that property. Which means either the property has to be sold at a loss, or the bank has to hold onto the property while it desperately searches for a buyer. And of course, the money tied up in that property is losing value every year. The money, not the property. Or the bank could try to rent out the property, but then they’re not a bank anymore, but a landlord, and banks aren’t set up to do that.
So in real life, if everyone demanded their money back from the Building and Loan, what would happen is the bank would pay everyone off, and next monday would reopen with a new sign on the front door, Potter’s Bank, and that’s the only difference people would notice, except the bank employees.
An old joke:
Jack Benny and a friend are walking down the street. A robber steps out of an alley and pulls a gun on them, snarling, “Gimme everything you’ve got!”
Benny turns to his friend, hands him some money and says, “Here’s that $50 I owed you.”
I think the nature of mortgages have changed. Fixed 30 year notes with 20 percent down are kinda new, really. In those days, one could call in the note all at once.
Where can I find information on the relative strength of a bank? I think that’s held fairly close to the vest isn’t it? After all, if 9th Security and Trust is going down the tubes, nobody would open an account there would they?
I’ve wondered if FDIC doesn’t have some downsides, because banks may take on riskier loans? Even if I get my money bank, a bank failure can’t be good. Everything gets frozen till examiners get done with it. Still a good thing, but that could be weeks couldn’t it?
Because the Federal reserve lends money into existance, inflation is a natural, and in fact required for the system to work. This can be difficult to explain in an established economy, but becomes very clear if you start from scratch.
Say we start a new currency, we’ll call it…hmm…the Haggis.
The Fed puts 1 million Haggis into circulation by making loans to banks. Since these are loans, the Fed charges interest. It expects to be repaid the origional million Haggis plus interest.
Note that at this point there is only 1 million Haggis in ciruculation…once the principal is repaid, there is no longer any Haggis in circulation, so there is no way for the interest to ever be repaid. The only way the interest can be paid is if the fed keeps recycling the payments it recieves into new loans…and each time it makes a new loan, it is effectivly creating more money. If it did not continually increase the money supply, then the interest on the fed’s own loans would eventually suck all the money out of the system.
But surely you know that there have been long periods in American history were DEFLATION has been a major problem?
Except that that isn’t the primary means by which the Fed puts currency into circulation. They put it into circulation mostly by buying securities, not by making loans.
Actually, thats backwards. With $100 deposit, a bank can lend out $90. wikipedia
Only considering deposit accounts, creation of money still works they same - just not with so much money creation. If I deposit $100, and the bank loans $90 to you, then there is $190 in the economy from an original $100. Furthermore, you can take that $90 and deposit it in your bank, and they can lend out $81 to Lemur866. Wash/rinse/repeat (also noted in wiki link).
Incidentally, I thought Lemur866 and tomoe had great posts. Good job.
LinusK, do you still have questions? or are you good to go?
I still have one question: in the OP, it’s described that “The Federal Reserve tinkers with the money supply by doing ‘open market operations.’ Meaning, they buy and sell Treasury bonds.”
My limited understanding is that the Fed is not the entity that sells Treasury Bonds. That would be the US Treasury, who finances the government’s debt by selling the bonds. The Fed just backs up the banks. Is that right?
Err, I still have questions. I understand how banks increase the money supply. But leaving aside for the moment injections of new money by the Fed, isn’t Kevbo right - that debts + interest > all the money in the economy?
I also have a question about the process by which the Fed exchanges bankers’ book-keeping entries for cash. It appears the Fed only exchanges bank reserves for cash, not other entries (for example - the ones that represent customer deposits). Is that about right? If so, that would explain how bank runs could still occur.
I also don’t exactly have an answer to the question of whether it’s the loan or the deposit the represents the ‘new’ money in process by which banks create new money. But perhaps the question doesn’t have an answer, or the answer doesn’t matter.
Curt… the Fed buys and sells bonds that are already in existence. The trick is, when they buy bonds they use money that didn’t exist before they created it.
No, you can still create money through increased value of some thing, most noticeably, in the stock market. Anytime something increases in value, and that value is liquidated to cash (assuming perfect liquidity, which is why I use my stock example, because it’s pretty close to liquid), any increase in value will translate to increase money (assuming transformation costs are ignored or surpassed). You can say the same thing for houses. While it appears that the money is just created by debt, only so much of it is. The rest is created through appreciation (houses), or increased value (stocks).
I haven’t studied banking since college, but I’m pretty sure that’s not how it works. The wiki example above in Rainwalker’s post should answer this question.
It doesn’t really matter because it all happens so fast, but if you want to be technical, it happens at the deposit.