What about “hard assets” (real estate, mines, factories, etc.).
If a prolonged recession undermines Apple’s ability to sell it prodcts, its value will certainly drop. Suppose Apple shares dropped from $500/share to $200/share-the shareholders have lost wealth. But the people who sold their shares at $500 have retained wealth.
So it is incorrect to say that “wealth is destroyed”-it just changes hands.
Or a loser like KODAK-now that film photography is (almost) dead, KODAK shares are nearly worthless-where did its “wealth” go? Into the pockest of the people who (wisely) saw its demise coming, and sold out.
It’s a trick question that depends on how it’s phrased. For example, say three banks loaned money to a hotelier. The hotelier realized he borrowed too much, and gave the additional funds to a bellman to return to the banks…
…
I’m not seeing how “wealth is destroyed” is incorrect. Not all wealth is destroyed (some people do make out), but a great deal of wealth seems to have disappeared, particularly in the housing market. Consider someone who owned a home in a neighbourhood full of $500,000 houses (owned it outright; no mortgage to confuse things). Post-crash, the average selling price in the area is now $250,000. Is a person’s house not part of their wealth? If someone buys the house for $250K, the seller’s cash/wealth is only $250K. The buyer may have gotten a (relatively) great price, but if that’s their only asset you cannot say their wealth is anything more than the $250K. Where did the difference go? Damn bellman again!
But the real question is what is the impact of zombies on the money supply?
Banks have to meet reserve requirements at the Fed. They may also control their liquidity and solvency in certain ways also.
But it is still the case that banks directly create new money in the economy by increasing the borrower’s account without decreasing any other account. They don’t lower any depositors account. They don’t lower their reserve account at the Fed, although they do create money somewhat proportional to their reserve account, which is basically the digital version of the money multiplier.
The new money becomes a liability on the bank’s balance sheet because it’s a potential claim for legal tender. The new debtor becomes an asset of the bank. In this way the banks balance sheet expands.
All agreed so far?
If a debtor repays a loan his/her current account decreases, no one else’s account increases. The reserve account stays the same. The current account money no longer exists.
Again, looking at it from the bank’s balance sheet, when a loan is repaid the bank no longer has that debtor as an asset. They no longer have that current account balance as a liability and again the money no longer exists.
The money supply figures do decrease occasionally internationally at the same time and loan repayments effectively deleting digital money is the reason why.
How did people imagine a lowering of the global money supply occured?
Sure, as long as the debtor just leaves the loan proceeds on deposit with the bank and doesn’t try to withdraw them.
As long as the debtor just uses the money in the account to repay his own loan without ever withdrawing any of it.
Just to quibble, the debtor is not an asset, the debtor’s note is an asset.
But unless the bank cultivates a clientele that just wants to take out loans and leave the money on deposit at the bank, as soon as the borrower demands some of his money, the bank has to pay over fed funds (reserves) to the bank where the borrower’s check is cashed or has to pay the fed to obtain greenbacks to satisfy the borrower’s demands.
Nearly every single statement you have made in this entire thread is incorrect. I can promise you that banks practice double-entry bookkeeping. Banks do not create money by increasing a borrower’s account and not decreasing anyone elses; that is preposterous. They increase the money supply via our system of fractional reserve banking.
Banks create money by receiving deposits from customers (loans from the bank’s point of view) and lending out a large percentage of them (assets from the bank’s point of view) while only maintaining a small percentage of them as a reserve.
A bank could theoretically create offsetting assets and liabilities (loan a person money to sit in an account at that same bank), but why would anyone actually want such a product? People get loans to use the money. You get a loan to purchase an asset or some other useful similar purpose.
I am aware of how fractional reserve banking operates.
Decades ago when banks gave loans in the form of cash over the counter they did lend out other people’s deposits and kept a portion on reserve.
However today when recieving a cashless loan the borrower leaves with a higher bank balance, not cash. The bank doesn’t reduce any other account.
Banks can only increase the borrower’s account in proportion to their reserve account at the Fed so I’m not denying the money multiplier or fractional reserve banking. However the modern day equivalent of the cash version of loaning a fraction of depositors money as cash over the counter is what I’ve described above. Bank’s credit the borrower’s account, if they meet reserve requirements at the Fed but don’t reduce any other account. What account do you imagine they reduce?
I do describe the double entry bookkeeping processors above.
In relation to the original post it is also the case that once you instruct the bank to use your current account to pay a debt to them they effectively delete money.
They reduce your account. No one else’s account is increased and the money no longer exists in the economy.
Again, you persist in describing a world where the borrower just leaves the loan proceeds on deposit at the lending bank.
If we imagine a world where borrowers actually want to buy stuff with their loan proceeds (radical, huh?), the bank is going to have to turn over part of their reserves to wherever the borrower sends the money.
Ah, yes, so you are describing a world where borrowers just leave the money in their accounts and return it to the bank after a while.
It is debatable whether money that never leaves the bank ever “exists in the economy.”
Dudes. Peoples. SDMB comrades.
You guys appear to be mostly talking past each other. Ferguson might be ineptly describing the process – and even if so, he’s not the only one – but I can see what he’s trying to say. He’s describing the accounting process with a confusing amount of detail, but his basic point isn’t flat-out wrong (at least, not yet), and I haven’t seen any conspiracy theories from him (at least, not yet). I can try to put more meat on the bones of his explanation. Hopefully. The entire banking system can be treated like one bank for convenience. Let’s say I steal a one hundred dollar bill from the Bureau of Engraving and Printing. That will be the hypothetical money that starts out the following process. It’s going to get multiplied in strange ways, but for now it’s just cash. Total money: $100, cash.
Then I deposit that bill at the bank.
Total money is now $200. 100 is cash, in the bank’s possession, and the other hundred is a $100 balance in my account. The money has been multiplied by the act of depositing it in an account that leaves me easy access to make payments with the account (by writing a check or using a debit card or whatever) instead of having to deal with the hassle of withdrawing the money first to use the cash itself.
Next scenario: Little Susie wants to take out a loan to invest in a new bicycle for her newspaper delivery service.
She wants to buy the bicycle from Fred’s Bike Shop. This is where things get interesting. Normally, when we discuss the multiplier as simply as possible, the whole process is described as if Susie receives $90 of that original cash in a discreet envelop, and she carries that cash to Fred’s Bike Shop, and then he carries the cash back to the bank… but how often does that really happen? The bank can instead issue a check already made out to Fred’s Bike Shop. In order to issue the check, the check must absolutely be drawn on some account. Which account? Not mine. I’m still going to have a balance of 100 no matter how the loan transactions go. No, the bank is going to create an account for Susie’s loan and credit that account. It will simultaneously debit the bank’s assets. The bank will credit the account for Susie’s check, without debiting any other depositor’s account. This is still double-entry accounting! It’s just that the bank is debiting its own asset in the creation of the new loan instead of debiting a depositor’s account. Current money amount: $290 total from this series of transactions. $100 is the original cash, still in the bank’s vault. $100 is my personal account balance. $90 is the account balance for Susie’s check. (In an accounting sense, the corresponding double-entry to this last $90 is not by liquid money, but the non-liquid asset that is the loan itself.)
Fred of the Bike Shop receives the check. Does he take cash? Well, obviously he could. Normally, though, he’s just going to deposit the money. This is the part Ferguson isn’t really describing well.
Total money amount: no change. There is still $100 cash, which hasn’t actually moved since the original deposit. I still have a $100 account balance, and there’s also a $90 account balance from Fred depositing the check. The loan account was emptied out, and Fred’s account was credited, but the total money supply hasn’t changed this time because the new bank-account-money for the loan was created immediately with the approval of the loan, not with the final deposit of the check. Depositing the check just transfers already existing bank-account-money from one account to another.
Final scenario: Susie pays back the loan.
Susie has been receiving income from her employer. She might just have direct deposit. In that case, this income has not been in the form of cash, but in already existing bank-account-money than has been shifted from one account (her employer’s) to her account. She has $90 in her account to pay back the loan. She writes a check to her bank for the loan repayment. Does the bank give cash to… itself? No. It just destroys money. Specifically, it debits her account balance without crediting another depositor’s account balance. This is still double-entry accounting. At the same time that the bank debits her account balance, it credits it own asset sheet and eliminates the loan that was previously on its books. This is the process that Ferguson is trying to describe.
Depositing money in a bank multiplies that money by creating new bank-account-money. Withdrawing money from a bank destroys bank-account-money. The approval of a new loan creates new bank-account-money, while deposing the check from the loan doesn’t change the amount of bank-account-money because the new bank-account-money was already created from the time the loan was approved. Cashing the check from the loan does destroy bank-account-money. And finally, repaying a loan – if the repayment is done from your checking account – also destroys bank-account-money. Just how it works. (If Susie repays the loan from cash she found in her sofa cushions, then repaying the loan does not destroy any bank-account-money.)
Thank you Hellestal.
As you pointed out, I couldn’t have said it better myself.
It is a consequence of banks’ double entry bookkeeping that bank-account-money is destroyed through loan repayments.
I doubt anyone conspired to make it so.
But it is an important point in the context of this recession. Reducing personal debt might sound like a good thing for example but we have to be mindful that it reduces the money supply by the same amount.
Regards,
Paul Ferguson
Sensible Money
Hold on a second! You’ve just violated your initial premise. You’ve inserted the BEP into the banking system as a creator of money. You’ve effectively made the BEP function as the central bank does in the real economy, but in your fictional world, you now have two banks: The BEP that prints up money and leaves it laying around for people to steal and a second bank that accepts stolen bills and treats them as money.
To be clear, the bank has $100 in assets (the cash) and $100 in liabilities (your account). You have $100 in assets (your account).
So, this is the Roach Motel of banks. $100 bills flow in from external sources, but they never flow out.
No. The account will be an additional $90 liability to the bank. Susie’s promissory note will be a $90 asset to the bank, which increases the bank’s assets.
At this point: Bank’s assets $190 (the original $100 bill plus Susie’s note), bank’s liabilities: $190 (my account, Susie’s account). My assets: $100, Susie’s assets: $90, Susie’s Liabilities: $90.
Intermediate scenario: The BEP reviews its security tapes, sees me stealing the $100 bill and demands it back.
I go to the bank and say “I want to withdraw that $100 I just deposited.” You say, “We can give you a check.” BEP says “F— your check. We want a $100 bill, it doesn’t have to be the same one, we want a $100 bill and we want it now.” So you return the $100 bill to me. That leaves the bank with $90 worth of assets (Susie’s note) and $90 in liabilities (Fred’s deposit). No reserves. Banking regulators and armed federal marshals arrive at the bank and hang a “closed” sign on the door.
If you are going to allow the externality of the BEP injecting money into your system, you have to allow for the externality of the BEP taking it back out.
OK. Hold on. Where did the employer’s money come from? Your fictional bank has just my $100 in it and just Fred’s $90. You didn’t posit any other accounts in your premise, you can’t magically introduce them half way through the story. You are creating another injection of money into this bank from this employer’s account that just appeared out of nowhere.
In my longer post, the term “total money” is intended to mean, of course, the total amount of money created by this one single hypothetical process, starting with theft merely for the purpose of whimsy. It is not at all referring to the total amount of money in the economy as a whole.
Also, a definitional matter for those who are interested: All checkable deposits are by definition part of the M1 money supply in the United States, part of what I refer to as bank-account-money. A liability that a bank specifically creates for the express purpose of issuing a check for a loan is going to be a checkable deposit liability, and will thus count as part of the M1 money supply.
Okay. So you have one bank which is part of a larger economy outside the bank. How do people in the economy outside the bank do business? Do they trade in $100 bills? Gold Coins? Shells? Let’s just pick one of these and say that they trade in $100 bills (since that is how your example started out).
You’ve created a fictional bank that accepts the medium of the outside economy as input ($100 bills), but provides no mechanism for output to the outside economy. If a loan or deposit customer of your bank wants to buy something from a non-customer of the bank, he has nothing with which to trade. Your bank is only capable of transferring money within itself between its customers. It has no provision for transferring money to the outside economy.
You told us up front that your bank was fictional and you are just trying to illustrate a point. It is entirely understandable if all the loose ends aren’t sewn up. I hope it doesn’t sound like I am coming down hard on you. But I am trying to show where your fictional bank does not correspond to the way Ferguson is trying to convince us that real world banks work. His banks make no provision for any input or output from the world outside the bank. He just keeps repeating the same old scenario where borrowers take out loans and just leave them on deposit at the same bank.
From my post: “Withdrawing money from a bank destroys bank-account-money.” If you withdraw money from a bank, you can use that cash in the economy without needing the bank to clear any more transactions. “Fred of the Bike Shop receives the check. Does he take cash? Well, obviously he could.”; “Cashing the check from the loan does destroy bank-account-money.” After cashing a check drawn on a bank, you can use that cash in the economy without needing the bank to clear any more transactions.
These are not unusual methods.
I didn’t explore those options in the hypothetical because that’s not the mechanism I wanted to illustrate. I wanted to demonstrate that it was possible to leave the cash in the banking system the whole time. That doesn’t mean it is necessary, or even the normal state of the world. I wanted to make an important contrast with the normal money multiplier story that’s told – especially regarding the exact point when new bank-account-money is actually created – because exploring old simplified stories from new perspectives can aid understanding. In the normal story, it’s as if Susie gets a loan in the form of a discreet white envelope containing cash from the bank, and she spends the cash on a new bicycle from Fred’s Bike Shop. And then what does Fred do? Maybe he blows the cash on hookers and blow, maybe he purchases and installs a ceiling fan in his daughter’s bedroom, maybe he takes the green and deposits it immediately back in the bank. The point is, for the standard money multiplier story to work, that physical cash must somehow end up back at the bank. What’s interesting about our payments architecture, for those who care about its workings, is that this step is not strictly necessary. Fred can deposit the check instead of cashing it, then use his debit card to buy the ceiling fan, or write a check to buy a bunch of groceries at his local supermarket, or some other method where he uses only his bank account for payment, not physical currency. The physical cash can, in fact, stay where it is in the vault in many circumstances.
Even with multiple banks, the process could still work without much or any physical movement of the cash. Clearing transactions between banks, the money that Bank A’s customers send to Bank B is going to be roughly equal, over time, to the money that Bank B’s customers send to Bank A. If it weren’t roughly equal over an extended period, if there were a small but consistent stream of cash out of Bank A which was never replaced, then Bank A would have a problem. The underlying point here is that even with multiple banks, the amount of currency that each bank keeps on hand can stay fairly predictable, which is how banks like to operate. They don’t want surprises from their deposit base.
I just read Ferguson’s first post in this thread, by the way, which I must’ve missed earlier. Woof. As written, there are some very notable errors, so I want to say, I’m not out to defend his every statement, just the things he actually got right. He’s right that the approval of a new loan will create new bank-money as they prepare the checking account as a liability for paying the loan. He’s also right that paying back a loan can destroy bank-money (if a bank balance is used to pay it). His statements about several other things are incorrect, though, most notably when he says that the “digital money” decreases during a recession. The monetary base, the M1 money stock, the M2 money stock, the currency component. They all go up, even during recessions. (Even if we cancel out the currency component of the broader measures of money, both the M1 and M2 would still be increasing.) The last time the broad stock of money fell significantly was the Great Depression.
The private sector has been deleveraging, paying back debt and destroying bits of bank-account-money little by little… nevertheless, on net, the money supply has still been increasing. That’s one of the purposes of having a central bank, which can still increase the stock of money even during a recession when private banks make fewer loans.
I think we’re all familiar with the idea that banks create money through the money multiplier. This is often explained as someone depositing $100 cash into a bank, the bank keeps $10 in the vault and lends out the other $90. This indirectly creates money since the original depositor can still write checks to the value of $100 while the borrower can now spend $90.
However this description only applies if all bank loans are given out as cash over the counter.
The modern version of the money multiplier is as follows.
The Fed will increase the reserve accounts of the commercial banks through the purchase of assets, often bonds. They purchase these assets with newly created money. They are allowed to type a higher bank balance for themselves and transfer this to any account at the Fed including the banks’ reserve accounts or the Government’s account. Of course they follow the correct accounting procedures. Namely, the additional reserves are recorded as liabilities of the Fed and the purchased assets are recorded as assets of the Fed. The bank, which now has a higher amount of reserves, just exchanges the sold asset for these reserves.
Let’s imagine the bank in question has an additional $100 in its reserve account now. The bank manager can now increase a borrower’s account by $900. No-one else’s account is lowered. When processing a cashless loan, banks have no choice but to just increase the borrower’s account. What account would they lower?
Of course the bank also practices standard double entry bookkeeping. Namely, the $900 of new bank-account money becomes a liability of the bank, and the borrower’s promise to repay is recorded as an asset. But it is still the case that the bank has quite directly created the $900. The total of all bank accounts, and hence the M1 money supply, is now higher by $900.
I think we’re also all aware that if the $900 changes hands between customers of different banks the two banks will have to transfer reserves between them at the Fed.
This is the modern day version of the money multiplier. This is how cashless loans are processed. I hope we can agree on this much?
If not, how do you imagine a cashless loan is processed.
The next part does take some thinking about.
Just to confirm Alley, the borrower will of course transfer this $900 to other accounts as payment. But when the borrower later has a balance of $900 in his/her account he/she may instruct the bank to use it to settle the debt.
The bank will lower the account to zero, lower the debt to zero and the money no longer exists. The total of all bank accounts, and the M1 money supply, is now lower by $900. And so the money supply is lowered through loan repayments.
Again the bank will practice double-entry bookkeeping. Namely, they will lower their liabilities by $900 and lower their assets by $900. Indeed, This is another way of demonstrating that the $900 no longer exists.
I’d welcome your thoughts.
All of this is true, in an accounting sense.
Personally, I intensely dislike the silly accounting notion that currency/bank reserves are a “liability” of the central bank. That is not true in any practical sense today, with modern fiat money. Back in the day, banknotes could be redeemed for precious metal, which made banknotes genuine liabilities which banks would have to honor. Today, however, banknotes can’t be redeemed for anything. Central banks are under no debt obligation whatever with their issue of currency, and treating that currency as if it were a genuine liability is missing the point. (Central banks have other legal obligations to try to keep them in line.) Marking banknotes and reserves as “liabilities” makes the double-entries balance, and that’s the main reason we continue to do it, but I still don’t like it.
Well, no. That would be way too dangerous.
You’re mostly right in an accounting sense, okay? Let’s assume strict reserve requirements of 10%. (Not actually true, but it makes the conversation easier.) You’re right that $100 of reserves can back a $1000 increase in the checkable deposits of the bank. ($900 isn’t the limit, by the way. $100 is 10% of $1000, not 10% of $900.) A bank theoretically could receive that cash from the Fed, and then immediately increase its checkable deposits by 1k with a loan. But they wouldn’t. In normal times, this bank would already be hard up against its reserve requirement. Banks don’t normally have excess reserves. Which means, when they make a loan, that they must absolutely be prepared for the entire value of the loan to be deposited in another bank.
If they’ve got $100 new cash from the Fed, they’re only going to make a $100 loan, in preparation for the entire loan to be deposited at a different bank. If they make a $1000 loan from $100 of new cash from the Fed, then when the check is cashed or deposited at a different bank, they would be $900 below their mandated reserve requirements when the check cleared.
The next increase in complexity in this story is when you relax reserve requirements, with the Fed targeting a certain interest rate in the Fed funds market, but even in that situation, banks would still have to be careful in certain other ways. Bottom line, it’s completely, utterly unrealistic to make loans of 1000% of your new Fed cash, even if they could temporarily get away with it, because it would be way too risky when the loan money flew out the door.
Why would that not be the case?
If I deposit $1000 in the bank, the bank has a $1000 obligation to pay that back to me at some point in the future. That’s a libability. It also happens to reconcile with the $1000 asset (cash) I just deposited with them.
The fact that it is fiat money only means that there doesn’t have to be $1000 in gold somewhere backing it up.
Normal banks have such a liability. If I have a 100 balance in my account, and I want cash, the private bank has a liability to give me that cash on command. They must give me that portrait of Ben Franklin.
The central bank does not operate under the same principle. That picture of Ben Franklin? That paper banknote itself? That is also considered a liability, in an accounting sense, specifically a liability of the United States Federal Reserve. But why? What’s the reason? If I’m holding that banknote, what exactly does the Fed owe to me? Utterly nothing. Not a god damn thing. In the past, they would’ve had to give me shiny metal on demand. In the past, those central bank bills were genuine liabilities. Today, that is simply not the case. That Franklin banknote is recorded as a liability of the Fed, but merely to balance the double-entries. If I go to one of the Fed branches demanding that that “make good” on that liability, they’ll politely escort me to the door, and then laugh about it later amongst themselves. There’s nothing to make good. Modern fiat cash is not a liability in any normal sense.
And amen to that. I have no problem with the system, I just have a distaste for the accounting procedures that are still used, which are a holdover from a previous era. I’ve found that calling normal fiat cash a “liability” of the central bank often tends to confuse people unnecessarily.
For those of you having trouble keeping up, don’t feel too bad, a figure no less august than Paul Krugman is having similar problems.
well all those houses falling apart or ransacked from being foreclosed = a whole lot of destroyed value.