I’m not sure if I’ve understood the “creation of money by banks” concept so clearly. I believe it means that if I’m the bank and lending out money that I’m using other customers’ deposits or money I’ve lent from the Federal Reserve Bank to supply an endless amount of money at a ratio of 1:10 or more (I keep one dollar for every 10 I lend). As a bank can abide by the banking rules because I’m pretty sure of making up any shortfall in my required reserves through continuous deposits. Have I understood this “creation of money” by the banks correctly?
I look forward to your feedback.
davidmich
Suppose you are required to keep 10% of all deposits on hand, and are free to lend out 90%. That means you can satisfy your day to day withdrawals.
So Bob Smith comes in and deposits $100. You keep $10 in reserve, and lend Steve Jones $90 for his new business.
But what does Steve Jones do? He deposits that $90 in the bank–or he spends it, and the people he gives the money to deposit the money in the bank. That means another bank now has $90 in deposits. They keep $9 and lend out $81. And that $81 gets deposited, a bank keeps $8.10 and lends out $72.90, and that $72.90 gets deposited and a bank keeps $7.29 on deposit and lends out $64.61, and so on and so forth. Keep the cycle going and $100 dollars in money gets turned into $1000 when you add up all the additional deposits and withdrawals.
Of course there are frictional losses, money in the form of cash that is not deposited in any account or borrowed or lent. But that’s the basic gist of how banks turn small amounts of money into larger amounts.
But any store that extends credit, or anyone who lends or borrows money is creating money. You buy a loaf of bread from the grocery store with your credit card. You don’t pay the store $1.00 today, instead they get paid some time in the future by the credit card issuer, and some time in the future you pay the credit card issuer. And until you pay off your $1.00 debt there’s an extra $1.00 created out of thin air, which pops like an invisible soap bubble when the debt is paid.
Because of the reverse requirement, banks cannot “supply an endless amount of money” and a 10% reserve does not mean a 1 to 10 ratio, as Lemur866 correctly demonstrated. Any individual bank can lend out a fraction of its deposits, not a multiple of them. It is the movement of that fraction through the economy multiple times that creates new money. If Steve took that 90% home and hid it in his mattress then nothing happens at all. (He loses money because he has to repay the loan with interest, but the bank gains that money, making it a wash.) The sum total of the bank and Steve stays constant.
Money creation doesn’t from from loans, it comes from the result of transactions. Money is an agreement about value. If Steve uses his $90 to pay Mary for something she bought for $40, then and only then has $50 worth of new money been created. This new money can be created by transactions - buying an object, paying for services, renting property - and also by the government creating money to insert into the system so that reserves grow larger. Your OP sounded as if you were conflating these different methods.
As noted, no individual bank is lending more than it holds in assets, and so strictly speaking, banks engaged in fractional reserve banking do not “create” money. (Consider the classic bank run; where’s all that money the bank supposedly created?) Each individual bank is essentially structuring current liabilities against future assets; it’s not creating money but rather letting other people use the same money again and again while you’re not.
I like to think of it as vaguely akin to the notion that perhaps the universe only really contains one electron, moving back and forth in time in order to be everywhere. In theory, you could have an economy with only one dollar flowing back and forth.
Yes, that’s the way the money creation/bank lending process is usually presented in economics 101 textbooks. It’s a useful illustration of the basic mechanics, but it does not represent how money creation actually works.
If you think of a bank, you have to think of it as a balance sheet: Assets on one side, equity/liabilities on the other. Deposits taken in are a liability of the bank, but the money that was taken in (either cash, or money the bank has in its Fed account if it was transferred to it from another bank) as deposit is an asset.
What happens if you take out a loan of $100 from the bank? Does the bank take $100 in cash deposited by another customer to give to you? No, the bank will simply credit your account that you have with the bank by $100. This will increase the liabilities of the bank by $100 ($100 more in deposits, because your account with the bank is a deposit), but it also increases the asset side of the balance sheet by $100, since the bank’s right to demand future repayment is, even though it matures in the future, a present asset of the bank. So the balance sheet is balanced, as it is supposed to be.
Where do the $100 credited to your account come from? Nowhere. The bank simply writes this figure into its ledger (or onto a computer hard drive). This is money creation - not because the bank’s new asset is money (it isn’t), but because the bank’s liability is money: Deposits with a bank are, for monetary policy purposes, money and count towards the usual monetary base aggregates. They are also money from the customer’s point of view, since the credit on an account can be withdrawn as cash or, more frequently, be used for cashless payments to another account, e.g. by means of a check or a direct debit transfer.
This does not mean the bank can do this process without limits. It must maintain a certain ratio between central bank money (cash and, mostly, reserves held with the Fed) to deposits for various reasons. One of these reasons is the minimum reserve requirement, but it is actually not the most relevant - in fact, some central banks, such as the Bank of England, do not impose a minimum reserve requirement at all, and still there is no limitless money creation in these systems; and even in economies such as the eurozone or the United States where a minimum reserve requirement applies, the actual ratio of bank reserves to bank deposits is far higher than what is legally mandatory under the rules of the minimum reserve requirement. The more practically relevant limits are the bank’s need to stay liquid, i.e., capable of meeting payment obligations at any time. It could be that some deposits fall due at a given time - depositors withdrawing credits for cash, or, more frequently, deposits being transferred away to accounts with other banks through checks or direct debit transfer. Liquidity in relation to these payment demands means central bank money, so the bank must maintain a stack of this to be able to meet obligations.
The mistake many people make is in believing that money is some sort of commodity, of which there can only be a limited amount. It’s better to think of money simply as an obligation owed by a bank to a customer - this obligation takes the form of credit held in a deposit account, or, in the case of a Fed, a banknote, which is treated as a liability on the Fed’s balance sheet. That’s why Tom Tildrum’s statement that the bank is “structuring current liabilities against future assets” is not untrue, but tends to give a false impression: The bank does structure current liabilities (i.e., the deposits which come into existence when the bank pays out a loan to a borrower) against assets (i.e., the bank’s right to demand repayment - this is “future” in the sense that the repayment matures in the future, but for accounting purposes it is an asset now and put as such into the bank’s balance sheet). The liabilities which it structure are money and can be created by the bank.
Conversely, money is destroyed when you repay your loan: Suppose you have $100 in your account, which you use to repay these $100 that you borrowed earlier. The balance sheet will shrink by $100 on both sides: Deposits down $100, assets to (since the claim for repayment is cancelled after fulfilment).
Maybe a few sample balance sheets help to clarify the affair.
Suppose I have $100 in cash, and I set up a bank with myself as the sole shareholder. I establish the bank and put up the $100 in cash as a start. The first balance sheet of my bank looks like this (for the sake of simplification, I will not differentiate between cash and Fed reserves in these examples; the balance sheet treatment would be the same):
Assets:
Cash $100
Equity and Liabilities:
Shareholders’ equity $100
Now somebody (or several somebodies) comes along with $200 in cash and deposits them in my bank. New balance sheet:
Assets:
$300 cash
Equity and Liabilities:
Deposits $200
Shareholders’ equity $100
Now somebody comes along and applies for a $50 loan. Of course I could take $50 out of the cash stock of my bank to give to that borrower, but let’s suppose we conduct the transaction cashless (as is usually done in reality, mind you). New balance sheet:
Assets:
Cash $300
Loans (i.e., the claim for future repayment) $50
Equity and Liabilities:
Deposits $250
Shareholders’ equity $100
Having realised how smoothly that went, I become more and more active in lending and hand out more loans in an aggregate of $1000 (above the $50 I’ve lent already), all credited to people’s accounts with me. Balance sheet:
Assets:
Cash $300
Loands $1050
Equity and Liabilities:
Deposits $1250
Shareholders’ equity $100
I can continue this process up to a point where one of the following applies:
My ratio of cash (which, in our examples, is a placeholder for both cash and Fed reserves in the real world) to deposits drops below a legally required minimum reserve.
My ratio of cash to deposits drops to a level where it is not certain that I will be able to meet depositors’ withdrawals at any time. In a scenario such as the bank run mentioned by Tom Tildrum, that’s exactly what would happen, and this also answers Tom’s question where the money created by the bank went to in the build-up of a bank run: It was, indeed, created by the bank when it lent money in the form of crediting borrowers’ accounts held with the bank. This does not necessarily mean that the bank is insolvent in the sense that its liabilities exceed is assets. Indeed, in the classic bank run (as in our scenario), the bank does hold assets which cover all its liabilities - it’s just that the assets are tied up in the form of loan repayment claims which mature in the future. When a customer with a demand deposit withdraws its money now, I cannot meet this demand in the form of a loan repayment claim which matures in, say, ten years, even though the balance sheet value of the loans may well be enough to cover all demand deposits. It’s the maturity mismatch that creates the problem, not the sheer amount of assets relative to liabilities.
And this is why people get confused about the idea of money being created out of thin air. It is a confusing concept, because money is a special sort of good.
When you go back to the original idea of money, money is just one of any number of goods that are especially suited for exchange. You take cacao beans in payment for you baskets even though you don’t want cacao beans, because you know you can go to any artisan in the market and trade the cacao beans for any good they have. And so cacao beans are used as money in this example.
But even in this simple system we can create money out of thin air. Suppose I sell you a basket. You pay me with cacao beans. But you don’t have the cacao beans on you at the moment, so instead of taking cacao beans I write down “Davidmich owes me 24 cacao beans and promises to pay me next market day”. This piece of paper is money created out of thin air. There were no cacao beans, but somehow the transaction went forward anyway. This is the essence of fiat money.
But note that no actual goods are created. Writing an IOU for 24 cacao beans doesn’t make 24 cacao beans materialize out of thin air. But it does allow you to get the basket today, and perhaps that basket is what you need to harvest your vegetables and bring them to market, which you will sell for the cacao beans you need to repay the loan. And so the fictional cacao beans allow economic activity to occur that really does increase the amount of actual goods and services.
“Yes, that’s the way the money creation/bank lending process is usually presented in economics 101 textbooks. It’s a useful illustration of the basic mechanics, but it does not represent how money creation actually works.”
The textbook vs. reality mechanism of “money creation/bank lending process” is what prompted my question in the first place. Thank you Schnitte for pointing that out.
Thinking of a bank as a balance sheet is a very useful analogy.
These following points get to the heart of the matter for me.
"Where do the $100 credited to your account come from? Nowhere. The bank simply writes this figure into its ledger (or onto a computer hard drive). This is money creation - not because the bank’s new asset is money (it isn’t), but because the bank’s liability is money: Deposits with a bank are, for monetary policy purposes, money and count towards the usual monetary base aggregates. They are also money from the customer’s point of view, since the credit on an account can be withdrawn as cash or, more frequently, be used for cashless payments to another account, e.g. by means of a check or a direct debit transfer.
and
“This does not mean the bank can do this process without limits.”
and
"The mistake many people make is in believing that money is some sort of commodity, of which there can only be a limited amount. It’s better to think of money simply as an obligation owed by a bank to a customer. "
This is an important point for me, because I hear this “money creation” bandied about so much.
As Tom Tildrun noted:
As noted, no individual bank is lending more than it holds in assets, and so strictly speaking, banks engaged in fractional reserve banking do not “create” money.
I think this is the key point which takes the mystery out of “money creation.” When I write an IOU for $50 to my [del]drug dealer[/del] plumber, that piece of paper is in the same class of object as a bank draft or check. The IOU might even be verbal.
Obviously there are important differences. The risk I’ll default on an IOU may be much higher than the chance CitiBank will fail to honor its check. Personal IOU’s are not counted toward the M1 statistic. But if one notes that non-banks writing IOUs is the same type of action as a bank issuing a draft or checkbook, one will no longer view bank’s money creation as something “mysterious” (or even slightly “nefarious”).
Central Bank extends a loan to a commercial bank. New commercial bank money is created. Central bank can also create money by purchasing financial assets"
“Because the loan counts as money, the total monetary supply increases.” So this is money creation then.
What’s confusing me is the way people explain this term “money creation”. Is Wikipedia correct? Please compare with the explanations below. I’m trying figure out the real-world working of this “money creation”
Exapno Mapcase
“Money creation doesn’t from from loans, it comes from the result of transactions. Money is an agreement about value. If Steve uses his $90 to pay Mary for something she bought for $40, then and only then has $50 worth of new money been created. This new money can be created by transactions - buying an object, paying for services, renting property - and also by the government creating money to insert into the system so that reserves grow larger.”
Tom Tildrum
2.“Each individual bank is essentially structuring current liabilities against future assets; it’s not creating money but rather letting other people use the same money again and again while you’re not.”
Schnitte
3." That’s why Tom Tildrum’s statement that the bank is “structuring current liabilities against future assets” is not untrue, but tends to give a false impression: The bank does structure current liabilities (i.e., the deposits which come into existence when the bank pays out a loan to a borrower) against assets (i.e., the bank’s right to demand repayment - this is “future” in the sense that the repayment matures in the future, but for accounting purposes it is an asset now and put as such into the bank’s balance sheet). The liabilities which it structures are money and can be created by the bank. "
This answers my question. http://ecedweb.unomaha.edu/ve/library/hbcm.pdf
“Banks operate under a fractional reserve system which means they are requiredby law to set aside a fraction of their customers’ deposits as required reserves. Banks may lend an amount equal to their remaining reserves which are called excess
reserves. Banks earn revenue and profits through lending and charging interest on loans. They also increase or decrease the checking deposit component of the money supply through lending.
The process whereby banks make loans equal to the amount of their excess reserves and create new checkbook money is known as multiple deposit creation. Each time a bank receives a deposit, it sets aside some of it to meet reserve requirements and may lend an amount equal to the remaining excess reserves. These loans take the form of new checking accounts for the borrower which increases the checkbook portion of the money supply. When the borrower spends the loan, he or she writes a check on the new checking account. The recipient of the check, in turn, deposits his or her funds into another bank. After this second bank sets aside its required reserves againstthe new deposit, it may lend an amount equal to its remaining excess reserves. These loans also take the form of new checking accounts for the borrowers, and each successivecycle of lending generates an increase in the money supply in the form of these new checkbook dollars. Additionally, with each round of new deposit creation, there are fewer excess reserves. The deposit creation process is multiplied throughout the entire banking system until all excess reserves have been absorbed into required reserves.”
It may also be helpful to note that what you’re describing can be seen as a form of short selling (in that you’re selling a commodity you don’t currently own), which is itself analogous to fractional reserve banking in some ways.
