It was definitely a lot more stable after the creation of the Federal Reserve System.
The money supply must increase as the economy grows or we get deflation, which is much worse than inflation.
But when the money supply grows, the amount of debt must also grow (since money is created by lending, and lending = debt). Which would mean that in order for the money supply to grow, people must take on ever-increasing amounts of debt. At some point the amount of money owed (plus interest) becomes unsustainable. (The money owed, is always greater than the amount of money there is, because of interest). Then people can’t pay off their debts, and you get a financial crisis.
No, this is completely wrong. The $100,000 had to be deposited by someone. Wells Fargo must actually have $100,000 in an account somewhere to lend it to you. They do not create it from thin air; it must be drawn from deposited money. *You do not understand fractional reserve banking if you don’t realize a loan must come from a deposit.
*
If in fact a bank could simply create money, **why would they charge interest? ** There’s no reason to if you’re just poof!ing money into existence. Hell, why not charge negative interest? Well Fargo could make ten trillion dollars by simply making $10.1 trillion appear out of nowhere - poof! - and then giving it to me on the condition of repayment of $10 trillion in one day. I could then give them bank $10 trillion the next day, keep $100 million, and we’d both be richer! Poof! Except of course that if banks could just poof! money into existence they’d be doing this every millisecond of every day and by now a loaf of bread would cost a quadrillion quadrillion dollars.
Well, the first question you have to ask is where where does money come from? We know depositors don’t create money - that would be counterfeiting. So if banks don’t create money, where does it come from?
But to answer your question directly, the reason banks don’t lend at negative interest rates is that they’d go bankrupt. If they lent 11 to you today on condition you pay them 10 tomorrow, they’d be 1 poorer tomorrow than they are today. A bank that did that would be losing money, and would be shut down by the Fed. (Plus, the whole point is of having a bank in the first place is to make money, not to lose it.)
More fundamentally, the money the bank lends you is a liability on the bank, not an asset. That’s the nature of money: it’s always a liability to someone (in this case the bank that lent it) and an asset to someone else (the borrower). Conversely, the note that you signed when you borrowed the money is a liability to you, and an asset to the bank. Moreover, that note you signed promising to pay them back is only as valuable as your willingness and ability to follow through with your commitment. If you demonstrate you’re not going to pay them back, the note becomes worthless. In that case the bank takes a loss. (That’s why banks set aside money for loan losses. It’s a way to try to estimate how much money borrowers are not going to pay them back.)
So banks’ ability to create money by “poofing” it (actually lending it) into existence is limited by their ability to find creditworthy borrowers.
To take your example, Wells Fargo is not ten trillion dollars richer when you pay them back, because you forgot to subtract the 10.1 trillion liability it created when it lent you the money in the first place. When you pay them back, they’re 100 billion poorer than they were before.
I think three, largely unrelated issues get conflated in these discussions.
(1) “Fractional-reserve banking”
(2) Choice of monetary base
(3) Government regulation
My comments:
(1) The use of “paper” obligations to expand the money supply has been around since thousands of years before the invention of paper! If car buyers couldn’t borrow from banks, car dealers would accept their IOU’s. Just as it’s convenient to have barber-shops (instead of wandering around asking if anyone’s in the mood to cut hair), so banks are very convenient. Trying to ban “fractional reserve” would be cutting off the nose to spite the face.
(2) Interestingly, it’s often the same folks espousing gold who espouse Bitcoin! (The idea is to let the free market decide whether gold is appropriate or not. Expect to see a Glitcoin soon!) I’ll leave discussion to the experts, beyond noting that, given what we’ve witnessed of Wall St. perfidy, if I had my choice of accepting a banknote issued by the U.S. Government and one issued by “Jamie Dimond’s Consortium of Bankers and Tanning Salons”, I’d go with the USG.
(3) Government regulation is the important topic, IMO. Left to its own devices, private players tend to be over-optimistic in boom times, and over-pessimistic in bust times. I think economists across the spectrum agree that government action is appropriate to smooth business cycles; the difference is in the details. Either Keynesians or monetarists could have “solved” the Great Depression, but neither side was aggressive enough.
But, as others point out, once the government starts guaranteeing deposits, there is risk of moral hazard. Guaranteeing $100,000 to individuals is less of a big deal than guaranteeing billions of dollars of foolish bets made by AIG. Yes, the outrageous practices of the 1990’s and early 2000’s may have meant that the taxpayers needed to salvage the financial system, but there was no need to make all equity holders whole, and certainly no need to encourage more of the same Wall St. “Heads we win, tails the taxpayer loses” behavior.
It is a stupid canard that the U.S. Treasury is recouping its bailout losses. First, the Treasury and FRB still carry low-quality paper on their books at par value. Second, if someone like Warren Buffett had stepped forth to inject capital into an insolvent bank, do you think he’d be happy with 5% profit, or whatever bailout supporters are bragging about?
That the U.S. government learned no lesson from the 2008 crisis and allows too-big-to-fail banks to continue their profligate behavior will be seen as one of the greatest stupidities of our time.
Interesting question but you’re dodging my central point. You claimed a bank creates money “poof!” out of thin air when it lends it TO ME. Nope. Wrong.
No they wouldn’t, they’d be 10 richer, *if it worked the way you describe it. * Let me quote you again:
Wrong, wrong, wrong. The bank cannot lend out a dollar unless someone has first deposited a dollar.
But according to you, they just poofed! the money into existence. So how are they poorer? (And since when was a loan a liability to the lender? Are you serious?)
What you don’t get is that to lend me $10 trillion, someone (or many someones) would first have to deposit that much money at Wells Fargo. The money is NOT poofed into existence by a commercial bank. It is taken from a Wells Fargo account.
LinusK has been mistaken about an enormous numbers of topics. After these errors are pointed out, he just repeats them in a new thread. He is utterly indifferent to any factual information that doesn’t snuggle cozily up with his countless erroneous preconceptions. I actually recommend the whole threads if you have time. He reminds me of Sideshow Bob with the rakes. The threads are a hoot.
Yet he is not entirely wrong in his statement here.
Don’t take this as an endorsement. He’s overstated his case, like he always does, and he’s said some other shit in this thread that’s just not right, like he always does. But in this one case, you’re pretty clearly misinterpreting his statement.
If we were to ask a small-town banker who hadn’t thought much about the general monetary system, then they would agree with you completely: Commercial bankers don’t create money. But if we were to be more cosmopolitan in our conception of money, then we’d have to admit that commercial bank deposits are a form of money included in the broader measures of the money supply like the M1 or the M2. And once we do that, we have to admit that commercial banks do create this kind of money out of nothing. Deposit liabilities are just entries in their ledgers. That is literally all that they are. So when a bank wants to bank a new computer, or meet its payroll for its employees, it’s going to cut a check drawn on a new deposit liability. The bank buying a new computer is creating new money.
DEBIT Assets (computer)CREDIT Deposit liabilitiesAnd voila. The bank has arbitrarily expanded the M1. When a bank issues a new loan, the process is extremely similar. When a bank meets payroll, they’re also creating new money but this time debiting their equity accounts (in the final analysis, after everything else is completed) instead of debiting their asset accounts. When a bank buys nearly anything, they’re creating new money.
Interest is charged and received. Banks want monetary base, not their own deposit liabilities. They want central bank money. All of these “loans”, including the deposit liability itself, are promises to pay monetary base. A bank that creates more M1, more deposit liabilities, has to pay its depositors an interest rate. The bank can’t just do that forever, or they’ll run out of currency to pay withdraws and they’ll go bankrupt. They need to have interest incoming, too, in order to make a profit. But even so, the definition of broad money is clear, and it’s still safe to say that commercial banks create money out of the air. There are regulations and so on, but that’s still what happens.
Now obviously, a check that is cut for a new loan is most likely going to end up somewhere else. The bank needs the “money” available to pay that loan, meaning central bank money. Maybe the person who receives the check will cash the whole thing, in which case, the M1 is expanded for a very brief time before it’s collapsed again and there is no net change. But if the check is deposited at a new bank, then the net result of the loan was to expand the broader money supply. This is not a guarantee – the check could have been cashed – but in this sense, we can safely say that the loan expanded the money supply because of the corresponding ledger entry. And if you look at it in an accounting sense, then yes, the loan and the new money (M1) were created at the same when they were recorded by the accountants in their books. It’s just that we don’t yet know, at that point, whether the person who receives the check will prefer currency.
The standard textbook explanation is wrong and shouldn’t be taught. This is, I think, one of my better posts on the topic. That thread was supposed to be about the personal saving rate, and I never quite got there. I started with National Saving and then the conversation meandered. But from an information standpoint, it’s still pretty decent.
Ah, I got the M1 wrong again. I make this mistake all the time when I’m writing up something quickly. The problem is that definitions can be context dependent.
The M1 is often defined as currency in circulation plus demand deposits, but “currency in circulation” can mean either all existing banknotes or coins, or all existing banknotes and coins outside of bank reserves, and for the M1, the latter is how it’s defined. So if a bank makes a loan, that increases the M1 because it’s a deposit liability. And when the check is cashed, the M1 technically stays the same, because “currency in circulation” (for this particular context) increases by the same amount that the deposit account decreases.
The broader definitions of money always have an element of arbitrariness to them. I’m pretty sure the Fed updated their own definition on their graph to avoid this very kind of confusion. Near positive it used to say “currency in circulation”.
Honestly, I really don’t think I am, and I think you’re giving him credit for things he didn’t say. He’s not describing (as you go on to do) the phenomenon of fractional reserve banking increasing the money supply. He is literally saying banks create money (“poof!”) without the benefit of deposits.
The deposit-loan-deposit cycle creates money, but you need to have that cycle. It’s not just “Poof! We’re gonna invent money!” As you yourself point out, they have to debit an equity account to create a loan. It’s not “poof!” It’s moving money from Account X to Account Y, and $1 in a loan in Account Y is $1 out of Account X. Where the money is created is not in “poof!” but is in the fact that the Account Y money will (sometimes) then be redeposited, creating Account Z.
Well, a bank COULD create money POOF!-style, except that’s illegal. I could open my own bank, and issue thousands of Lemurbucks, backed by nothing, and if people used them as money they would be money created POOF-style. This is how money gets created via IOUs and such.
And it’s just nonsense to say that all money is created by debt, which is a bugaboo of a lot of left-wing economic cranks. Gold coins can be used as money, and gold coins aren’t any type of debt, they are a commodity. Of course an IOU for a certain weight of gold actually is money created by debt, since we’ve created fictional gold coins that only exist as a debt from one person to another. Any time someone says “I will gladly pay you 5 cacao beans on Thursday for a hamburger today” and the deal is accepted, money is created via debt, cacao beans change hands despite no such cacao beans ever existing.
No, that’s not true. You just have loans that match the term of the deposit.
I can still go into the bank and buy a CD that will lock my money up for a period of time, and the bank can loan that money out for the same period. What I can’t do is have money in the bank that I can withdraw at any time and earn interest on it.
There’s still risk that the loans will not be repaid, but there’s no chance of a run. If every person who has money on demand deposit at the bank goes to withdraw it, the bank has it to give to them.
Yes, that is why bank runs happened.
Except we’ve stopped bank runs, not by doing away with demand deposits, but by insuring deposits.
So what problem are we trying to solve here?
Well, it could be.
In olden days, a fatcat might’ve moved to a Scottish town and made a big theatrical presentation of showing the local folk the brand new vault he was installing. Must be secure, right? Then he could say he’s open for business, and some of the more enterprising citizens might come in for loans. So he writes down the new loan, and gives them some banknotes for them to make their purchases.
DEBIT Loan (asset)CREDIT Banknotes issued (liability)The people who took out those loans then start circulating the banknotes. The people could at any time claim the precious metal from the vault, but the Scottish of the time generally preferred the banknotes over the heavy metal. The banknotes circulate throughout the community without anybody claiming the shiny. In an extreme situation where people relied on the banknotes exclusively, then there would never be any need for gold at all. People would be so accustomed to using the notes that the vault could have been empty from the beginning. In that case, every single banknote that people used would have been injected into the system with a new loan. History was never quite like that, but it’s easy to see where the money-from-nothing notion comes from.
Our present situation is still a very similar idea, except “everyone” writes checks or uses cards. As far as the core idea of the accounting goes, the modern system is exactly equivalent to the old banknote system. The core accounting is not different in the slightest.
It wouldn’t be an equity account with a loan. A new loan is an asset account.
DEBIT New loan (asset)CREDIT New deposit (liability)These are brand new accounts, both of them. It absolutely does not have to be a transfer from a previously existing account. The creation of a new account for a new loan corresponds to the creation of a new account for the deposit created to match that loan. A “deposit”, by definition, is nothing more than a short-term liability of a bank. It means nothing more than that. A new deposit created from a new loan is not likely to sit still for long. The bank needs to be prepared to honor that liability if the check is deposited somewhere else. But even in that case, the banking system as a whole often tends to work like the small town bank in the previous example. The deposit can stay in the system. Many people use their accounts instead of withdrawing currency.
Bank runs haven’t been stopped, they’ve just moved up the ladder.
The death of Lehman was a run on the repo market which they used for short-term financing. After the bankruptcy, the Reserve Primary Fund broke the buck and we saw a run on the money market. Bad juju. These aren’t commercial banks with FDIC-insured deposits, but it still counts. Any time an institution borrows short to lend long, we can see a run.
I would agree with this, but there’s a serious information asymmetry problem with regards to whether a bank is stable or unstable. After all, a bank is stable only until it becomes unstable, and there isn’t any way for depositors to know that until after the fact. So, while removing banking insurance would create additional incentives for executives not to misbehave in theory, the market doesn’t have a good mechanism to enforce those incentives.
You could have the government come in and do routine audits, but the audit isn’t going to reveal chicanery until after the fact, and a public release of audit results could trigger a bank run anyway, even for banks that are more-or-less stable. So, perhaps we should look at deposit insurance as one mechanism to short-circuit bank runs. With insurance, if the government releases a report stating that my bank’s portfolio is on the edge, I’m not going to run down and clear out my account, because it’s insured. But I am going to do that if its not insured.
I don’t have much to add other than to state this isn’t a realistic interpretation of what the Federal Reserve does in its day-to-day interaction with banks.*
They only make those loans to institutions that can meet their very high deposit requirements. If you can make those requirements, you’re probably already essentially a bank to someone. Go ahead and charter yourself.
However, you don’t really want to borrow from the Fed in the first place - banks themselves don’t want to borrow from the Fed. They do it when they’ve made a horrible mistake and cannot do things like meet their reserve requirement, not when they want to issue new credit. See, the Fed may loan the bank the money at that rate today, but they almost always expect to be paid back in full tomorrow. I’m not certain what happens to banks that can’t pay back the Fed, but I imagine it eventually involves a visit from the FDIC if they take customer deposits. If they find things are bad when they visit, they’re not going to jack up the bank’s interest rates, they’re going to shut down the bank.
Chase is extending you an entirely different form of credit when they issue a credit card or an auto loan. It’s a different risk, and it’s not reasonable to compare the rates.
*During the 2008 crisis, the Fed, FDIC and Treasury weren’t functioning “normally”. Whether their diversion from their normal functions was entirely appropriate is debatable.
Cite?
Atkeson and Kehoe looked at 17 countries, each for a period of 100 years. I’ve linked to mises.org. But here I quote from the study:
Now back to the author:
Are you against empiricism in economic analysis?
It’s just not about risk, it’s about benefit as well. What would occur if there was an infusion of low-interest loans to business and start-ups all across the country? Think of the economic activity, new inventions, new discoveries that it can spur. The government already profits millions of dollars off the backs of broke students with “low”-interest student loans; while, at the time, reaping billions of dollars in economic activity because of an educated populace. Just expand the student loan program to cover existing businesses and start-ups.
I am not an economist so I welcome clarification on this. It was my understanding that Chase (or any other bank) can get access to liquidity (“cash”) from the Federal Reserve at a discount rate (currently, at about 0.25%). The Federal Reserve is kind of, in essence, the bank’s Bank (or in other words a middle-man). It was also my understanding the cycle of money went something like:
Taxes from People <-> IRS <-> Treasury Dept <-> Federal Reserve <-> Banks <-> People
The arrows represent the flow of money. If this is correct, the financial services industry are just middle-men that drive up the cost of loans and skim money off the top. My mind would change if financial services industry would provide a decent savings rate (they have not) or supply low-interest loans to businesses and start-ups (they have not).
The requirements are undoubtedly insurmountable to keep Banks as the middle-men.
- Honesty
Well, there you go. If even Hellestal, who hates me, says I’m right about something, you can’t get a better endorsement than that.
Anyway, you didn’t answer the question: where does money come from in the first place? You’re talking about a cycle - the one they teach in Econ 101, I think - but who starts the cycle? The banks, or the depositors?
Take a look at any bill you’ve got in your pocket. It says “Federal Reserve Note” on it. Did you make that note, or did the Federal Reserve make it?
The Federal Reserve is a bank, and like any bank, it created the money - poof - out of thin air, by lending it.
Unlike any bank, however, it’s not just any bank, it’s the government’s bank. So it doesn’t lend to ordinary people like you and me, it lend (mostly) to the government. The government (specifically the Treasury) gives it Treasury bonds in exchange.
Poof! Money out of nothing. It doesn’t matter if it’s one dollar or one trillion dollars, the process is the same. No depositor necessary. One moment the Treasury had zero dollars, the next it had a trillion. And nobody deposited a cent. In fact, if there was no money, before the banks started making it, there would be no cents for anyone to deposit.
The depositing comes after, not before, when the Fed creates an account (a deposit), on behalf of the Treasury, in the amount of one trillion dollars.
And it doesn’t have to be the Fed. If you had one bank, on an island, with no money, it could immediately start creating money by making loans.
Economists - some economists - like to make it seem complicated - like teaching all that fractional reserve banking bullshit to freshmen, for example - but it’s not.
*“The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. The process by which banks create money is so simple the mind is repelled. With something so important, a deeper mystery seems only decent.” *
John Kenneth Galbraith
Depends what country you’re in, but usually the central bank. Of course money is created at SOME point; it doesn’t grow on trees. Naturally, the central bank can and does create money out of nothing; if they didn’t, there wouldn’t be enough money. But the central bank is not the same kind of institution as a commercial bank.
Theoretically, sure. I could set up the Bank of Rick on some uninhabited island and give “loans” of palm tree leaf money to passersby at my whim. That is not how real banks in real countries work.