3 Theories on How Banks Create Money - this time, with some accounting.

[JohnfrmClevelan]

I came across a paper that compares the three main theories of money creation by banks.

The Financial Intermediation Theory posits that banks are merely intermediaries that facilitate lending between borrowers and lenders. They collect deposits, then they lend them out.

The Fractional Reserve Theory states that banks are (again) merely intermediaries that cannot create money, but through systemic interaction they (collectively) create money.

Finally, the Credit Creation Theory says that banks are specially empowered to create loans out of thin air, and they do so.

The unique thing about this paper is that the author attempts to prove which theory is correct by actually taking a loan out of a small bank, then (with the bank's cooperation) monitoring the bank's account balances. This way, they could see whether the loan disbursement resulted in other accounts being depleted, etc. (He does reach a conclusion, but I will leave it to you to find the answer when you read it.)

It's an interesting read, only 19 pages, not terribly wonky. Understanding how banks actually operate is pretty central to understanding the rest of the economy, so if you aren't willing to read the article and put some effort into learning, please stay out of the discussion.

Can banks individually create money out of nothing? — The theories and the empirical evidence

 

[DaveFagan]

I came across a paper that compares the three main theories of money creation by banks.

The Financial Intermediation Theory posits that banks are merely intermediaries that facilitate lending between borrowers and lenders. They collect deposits, then they lend them out.

The Fractional Reserve Theory states that banks are (again) merely intermediaries that cannot create money, but through systemic interaction they (collectively) create money.

Finally, the Credit Creation Theory says that banks are specially empowered to create loans out of thin air, and they do so.

The unique thing about this paper is that the author attempts to prove which theory is correct by actually taking a loan out of a small bank, then (with the bank's cooperation) monitoring the bank's account balances. This way, they could see whether the loan disbursement resulted in other accounts being depleted, etc. (He does reach a conclusion, but I will leave it to you to find the answer when you read it.)

It's an interesting read, only 19 pages, not terribly wonky. Understanding how banks actually operate is pretty central to understanding the rest of the economy, so if you aren't willing to read the article and put some effort into learning, please stay out of the discussion.

Can banks individually create money out of nothing? — The theories and the empirical evidence

"Fairy dust," don't ya' know. Don't tell the Federal Reserve about this study.

 

[Ahlevah]

Man, have I been out of the loop. This is just astounding to me:

Since the 1960s it has become the conventional view not to consider banks as unique and able to create money, but instead as mere financial intermediaries like other financial firms, in line with the financial intermediation theory of banking. Banks have thus been dropped from economics models, and finance models have not suggested that bank action has significant macroeconomic effects. The questions of where money comes from and how the money supply is created and allocated have remained unaddressed.

Is this really true? I mean, I always took it as a given that when a bank took in demand deposits and lent against them it created money "out of this air," as it were. I assumed that an individual bank didn't create money as a multiple of its deposits but only in a systemic manner with other banks. But now banks have been dropped from economic models? Whose economic models? I'm incredulous.

Also, where does this idea that there is no limit to bank lending or that bank capital is not a restraint on lending come from? Aren't banks required by law to hold in reserve with the Fed a portion of their deposits, thus limiting how much they can lend? I can't connect the dots on this.

Anyway, interesting article. Thanks for posting it.

 

[JohnfrmClevelan]

Is this really true? I mean, I always took it as a given that when a bank took in demand deposits and lent against them it created money "out of this air," as it were. I assumed that an individual bank didn't create money as a multiple of its deposits but only in a systemic manner with other banks. But now banks have been dropped from economic models? Whose economic models? I'm incredulous.

I don't know if it's true or not. I never studied economics formally. I can tell you this, though - the idea that banks can create money out of thin air does not go down easy with most people I debate with.

Also, where does this idea that there is no limit to bank lending or that bank capital is not a restraint on lending come from? Aren't banks required by law to hold in reserve with the Fed a portion of their deposits, thus limiting how much they can lend? I can't connect the dots on this.

These are legal constraints, but not operational constraints. Theoretically, banks only need backup money when something goes wrong. If everybody makes their payments, and flows between banks are pretty equal, they can keep all of the balls in the air indefinitely. Banks use reserves to settle up interbank debts at the end of the day - but there is no (operational) reason why they couldn't just owe each other, using credit to settle up. (Tough to do in real life, though.) Reserve accounts make settling up a simple matter, but you only need enough reserves to cover your net outflows. In that respect, our 10% requirement is probably overkill - other countries have no reserve requirement, and banks keep whatever reserves they feel they need.

Anyway, interesting article. Thanks for posting it.

Thanks for replying.

 

[imagep]

Just some of my personal observations on banking, money creation, and lending:

1) Often, when people are claiming that the banking system creates money, they are referring to either the fact that the Federal Reserve can create money and that it uses our system of commercial banks to essentially be the "retailers" of money. So it's not so much the banking system that creates money, as it is directly the fed that creates money.

2) The fed, even without commercial banks as distributors, could still create money, and inject it into our economy, with the aid of fiscal policy and purchasing treasuries.

3) Just simply lending and credit between private parties has the exact same effect of "money creation" as loans made by commercial banks. Money is simply a temporary store of value, an accounting tool, and a means to conduct trade. If I order $1,000 worth of raw materials from a vendor, using my credit with that vendor (based upon the vendors trust in my willingness and ability to repay), we (me and the vender) have effectively created $1,0000 in new money - ALMOST EXACTLY THE SAME WAY THAT BANKS DO.

4) Some of the "Mx" official measures of our money supply are based on assumptions which are not valid (mostly the multiple counting of the same money, and ignoring claims against that money), and they have few if any practical uses.

5) The "reserve banking system" actually serves to restrain the money supply, not to expand it. it's the "reserve" part of "reserve banking system" that is significant, meaning that the bank can't lend 100% of it's deposits, which it would be able to do without the reserve requirement.

Now putting all of this together, the reality is that aside from the Federal Reserve Bank's ability to create money, there is nothing at all special about our banking system which allows it to LITERALLY create more money. However, our banking system certainly does help facilitate a faster velocity of money, by aggregating unused money and putting it in the hands of people who will immediately use it. This facilitation of a higher velocity mimics the existence of a larger money supply, and it just makes it SEEM like there is more money, but the reality is that it is the same amount of money, just circulating faster and more efficiently.

Of course I fully expect to be told that I am wrong about all of that.

EDIT - PS

I totally get that banks are reserve or deposit constrained. Banks, like pretty much any business, are only constrained by the number of customers they can find. And the can loan money that they don't have on hand because our banking system is setup so that they can acquire any shortages overnight, 100% of the time, automatically.

However, there are lot's of people, particularly tea party types, who are very distrustful of our banking system, the federal reserve, and our government regulating such. When people post that "banks can print money out of thin air", that just feeds into this mistrust, and it doesn't convey a proper understanding of our banking system to the public. There are way too many people who believe that if they deposit $100, the bank is then allowed to poof up another $900 to lend out, and that's not accurate. the truth is, the bank can poof up money anytime they can find a qualified borrower who is willing to pay whatever i-rate the bank asks for, however that money IS being acquired from another source, the bank isn't literally printing money.

And, in defense of the banking conspiracy type people and the tea party folks, there was a time when private commercial banks were allowed to literally print their own dollar, so while these are misconceptions about today's systems, their origin isn't totally from fantasy land.

 

[JohnfrmClevelan]

I'll apologize right up front on this, because my own understanding of this has evolved even since I started posting here 8 months ago. I used to make a bigger distinction between govt.-created dollars and bank-created credit than I do now.

1) Often, when people are claiming that the banking system creates money, they are referring to either the fact that the Federal Reserve can create money and that it uses our system of commercial banks to essentially be the "retailers" of money. So it's not so much the banking system that creates money, as it is directly the fed that creates money.

No, banks really do create money. The only difference is that when the government creates a dollar, they hold the corresponding liability, and the dollar enters the economy free and clear. When banks create dollars, the liability stays in the private sector. But these liabilities are not directly attached to the dollars they originally were born with - liabilities can be extinguished with any dollar. When you receive a dollar, paper or electronic, there is no way of knowing if that dollar originated with the government, or with a bank loan. They are the same thing.

2) The fed, even without commercial banks as distributors, could still create money, and inject it into our economy, with the aid of fiscal policy and purchasing treasuries.

Correct.

3) Just simply lending and credit between private parties has the exact same effect of "money creation" as loans made by commercial banks. Money is simply a temporary store of value, an accounting tool, and a means to conduct trade. If I order $1,000 worth of raw materials from a vendor, using my credit with that vendor (based upon the vendors trust in my willingness and ability to repay), we (me and the vender) have effectively created $1,0000 in new money - ALMOST EXACTLY THE SAME WAY THAT BANKS DO.

Sort of. You have created credit and debt, this is true. But that credit you created cannot be transferred, spent, etc., like a dollar can. (And of course, it won't count as part of the money supply.)

4) Some of the "Mx" official measures of our money supply are based on assumptions which are not valid (mostly the multiple counting of the same money, and ignoring claims against that money), and they have few if any practical uses.

I don't agree here. For one, where do you think dollars are counted twice? As to counting claims against money, you are thinking of net dollars. That's M0, dollars that the government has created. But counting M1, M2, etc., is still useful. When the economy is booming, businesses are borrowing, and M1 will be larger. When we all have more money in our accounts, that usually indicates that things are going well, even if we have a lot of debt. That just indicates a greater movement of money.

5) The "reserve banking system" actually serves to restrain the money supply, not to expand it. it's the "reserve" part of "reserve banking system" that is significant, meaning that the bank can't lend 100% of it's deposits, which it would be able to do without the reserve requirement.

First, banks don't lend out of deposits. Second, when the Fed policy is to provide any necessary reserves upon request (and that is the policy), then banks are not constrained by the amount of reserves they hold. Reserves make loans more expensive, because banks have to either pay the interest on reserves borrowed from the Fed, or they have to pay interest to their depositors (because deposits bring reserves with them).

What actually limits bank loans is the demand for loans. At some point, loans will not be profitable for the bank, because not everybody is going to be able to make their payments. So banks don't make loans that they think will not be profitable for them.

 

[JohnfrmClevelan]

(cont.)

Now putting all of this together, the reality is that aside from the Federal Reserve Bank's ability to create money, there is nothing at all special about our banking system which allows it to LITERALLY create more money. However, our banking system certainly does help facilitate a faster velocity of money, by aggregating unused money and putting it in the hands of people who will immediately use it. This facilitation of a higher velocity mimics the existence of a larger money supply, and it just makes it SEEM like there is more money, but the reality is that it is the same amount of money, just circulating faster and more efficiently.

In the experiment, the author took out a $200,000 loan (maybe it was in pounds or euros, but it doesn't matter). Then he (and the bank) monitored the bank's balances. What they demonstrated was that instead of somebody else's funds being used for the loan proceeds, and instead of some fraction of the loan resulting in new dollars (with a resulting change in reserves), the bank's balances showed that the whole $200,000 was added to the total (in both assets and liabilities). No other funds were used, and no reserves had to move.

Meaning - no previous funds were needed, and no reserves were needed. The bank created the full $200,000 out of thin air.

This is a hard concept to get over, especially when you have to consider our reserve requirement, which would seem to be a limitation. But it's not. Reserves are handy accounts for settling up with other banks, and capital requirements are there for when the bank has to eat the loss of a bad loan. But neither are operationally necessary for the bank to create the loan. They are safety nets - but lack of a safety net doesn't stop you from walking the tightrope.

I totally get that banks are reserve or deposit constrained. Banks, like pretty much any business, are only constrained by the number of customers they can find. And the can loan money that they don't have on hand because our banking system is setup so that they can acquire any shortages overnight, 100% of the time, automatically.

But they don't acquire the funds for the loan after the fact - they only acquire any reserves necessary to comply with the 10% requirement. If we (like a number of other countries) had no specific requirement, there would be no need to bother with this step. Banks would only keep as many reserves as they needed to settle up with other banks at the end of the day - which very well might be zero, if the traffic between banks is balanced.

However, there are lot's of people, particularly tea party types, who are very distrustful of our banking system, the federal reserve, and our government regulating such. When people post that "banks can print money out of thin air", that just feeds into this mistrust, and it doesn't convey a proper understanding of our banking system to the public. There are way too many people who believe that if they deposit $100, the bank is then allowed to poof up another $900 to lend out, and that's not accurate. the truth is, the bank can poof up money anytime they can find a qualified borrower who is willing to pay whatever i-rate the bank asks for, however that money IS being acquired from another source, the bank isn't literally printing money.

The bank isn't doing the printing, but they are basically the ones who order the government to do whatever printing they need. If there is a big demand for cash (like at Christmas), it isn't the government that decides how many banknotes to print up - that is decided by the demand from banks. And it's really only private banks that deal with banknotes - the government doesn't deal in cash. They ship it to banks in return for electronic dollars.

On the issue of Tea Party types, I don't know what to say to them, except to get real and learn how your country actually works. If you told them the truth - that private sector demand is what really determines the amount of money in play - I'm sure they would find a conspiracy in that, too.

And, in defense of the banking conspiracy type people and the tea party folks, there was a time when private commercial banks were allowed to literally print their own dollar, so while these are misconceptions about today's systems, their origin isn't totally from fantasy land.

Which brings up another point - it is useful to think of private banks as agents of the Fed, with some powers delegated by the government. Banks can create dollars (or, if you like, dollar-denominated credit and debt), and have a direct channel to the Fed. In your earlier example of businesses creating money, that is what is lacking. Without that delegated power (or the help of banks), the business cannot convert its credit into dollar form.

 

[JohnfrmClevelan]

Another very good source (the Bank of England) that explains the same thing. Plus, as a bonus, there is a very good, very short explanation of how QE actually works.

Money creation in the modern economy

 

[JP Hochbaum]

Here is the most basic way that I like to see it.

Demand for loans, and credit worthy people, create money on the monetary end of it. Fed policy can make it easier and cheaper for loans to occur by lowering interest rates.

 

[imagep]

...No, banks really do create money....

Again, only in the way that any lender does, maybe my next statement will explain this better.

You have created credit and debt, this is true. But that credit you created cannot be transferred, spent, etc., like a dollar can. (And of course, it won't count as part of the money supply.)

The money created by my credit account with my vendor absolutely can be transferred, it's done every day. A good many years ago, I purchased at auction all of the assets of a competitor which had gone out of business. On that particular day, I didn't have a penny in the bank. I sold my accounts receivables to cover the check that I wrote to the auction company, took me less than two hours to arrange for this transaction.

I don't agree here. For one, where do you think dollars are counted twice? As to counting claims against money, you are thinking of net dollars. That's M0, dollars that the government has created.

Yes, I agreee.

But counting M1, M2, etc., is still useful. When the economy is booming, businesses are borrowing, and M1 will be larger. When we all have more money in our accounts, that usually indicates that things are going well, even if we have a lot of debt. That just indicates a greater movement of money.

Exactly, those measures of our money supply account for VELOCITY of money, which is making it feel like the actual money supply is larger. Now what good those metrics do to any business, I can't imagine.

First, banks don't lend out of deposits.

They absolutely do. Money is fungible. You don't think that banks litterally keep all the checks and cash that they receive as deposits in boxes with the name of the depositor on them do you? to the bank, the money they obtain from deposits is no different (aside from the reserve requirment) and lends just as well as money from any other source.

Second, when the Fed policy is to provide any necessary reserves upon request (and that is the policy), then banks are not constrained by the amount of reserves they hold. Reserves make loans more expensive, because banks have to either pay the interest on reserves borrowed from the Fed, or they have to pay interest to their depositors (because deposits bring reserves with them).

What actually limits bank loans is the demand for loans. At some point, loans will not be profitable for the bank, because not everybody is going to be able to make their payments. So banks don't make loans that they think will not be profitable for them.

Absolutely. I think I actually stated that.

 

[imagep]

(cont.)

In the experiment, the author took out a $200,000 loan (maybe it was in pounds or euros, but it doesn't matter). Then he (and the bank) monitored the bank's balances. What they demonstrated was that instead of somebody else's funds being used for the loan proceeds, and instead of some fraction of the loan resulting in new dollars (with a resulting change in reserves), the bank's balances showed that the whole $200,000 was added to the total (in both assets and liabilities). No other funds were used, and no reserves had to move.

Meaning - no previous funds were needed, and no reserves were needed. The bank created the full $200,000 out of thin air.

It feels like that, but that's not really what happens.

Let's say that I take out a loan for $200k to purchase a new house. Typically, that $200k is never even going to go in my bank account, it goes straight to the seller at closing, all I do is sign the check over to the seller. It then goes into the sellers bank account, which more often than not is going to be at a different bank. At this time, the sellers bank has an extra $200k, which it then may lend back to my bank to cover the check. So my bank has to ACQUIRE that $200,000 from the sellers bank (or some other source), it doesn't litterally print the $200k out of "thin air".

And in most cases, the seller is not going to simply let that money sit there, he will probably shortly pay his bills or even pay off his mortgage. So his bank would then have to go to another bank and acquire enough money to honor the claims against the $200k that was deposited and lent to the buyers bank, and on and on. No money has been created, just the velocity of that money has increased.



But they don't acquire the funds for the loan after the fact - they only acquire any reserves necessary to comply with the 10% requirement. If we (like a number of other countries) had no specific requirement, there would be no need to bother with this step. Banks would only keep as many reserves as they needed to settle up with other banks at the end of the day - which very well might be zero, if the traffic between banks is balanced.

Which brings up another point - it is useful to think of private banks as agents of the Fed, with some powers delegated by the government.

I believe I covered that also.

Banks can create dollars (or, if you like, dollar-denominated credit and debt), and have a direct channel to the Fed. In your earlier example of businesses creating money, that is what is lacking. Without that delegated power (or the help of banks), the business cannot convert its credit into dollar form.

Except that banks can't actually create the dollars, and the fed can. Banks just increase velocity of money, and make it more util, just as any credit arrangement does.

 

[imagep]

I suspect that the reason it's so hard to understand that banks aren't literally creating money, that they are just increasing the velocity, is that money is such an abstract thing, as is anything that can exist in concept but doesn't have to be physical. Kinda like love, or religion.

So let's replace money with shovels, and it makes it much more clear that lending shovels doesn't actually create more shovels.

So I have a shovel, and I lend it to my neighbor. Now we both have some claim to a shovel, he has a claim to the shovel because he physicallly posesses it, and I have a claim to that shovel as it's my property. But if we counted shovels, how many would we have between us? Obviously two claims, but just one shovel. And the reason there can be more than one claim to the same shovel is because we forgot to subtract for the offsetting claims.

Now what if he lent it to his neighbor, who lent it to his neighbor, and it eventually was lent to everyone in my 100 person neigborhood. Do we have 100 shovels in our neighborhood? Nope, just 100 claims, of which 99 are offset by offsetting claims, and there is still just one shovel, that has circulated 100 times.

 

[JohnfrmClevelan]

The money created by my credit account with my vendor absolutely can be transferred, it's done every day. A good many years ago, I purchased at auction all of the assets of a competitor which had gone out of business. On that particular day, I didn't have a penny in the bank. I sold my accounts receivables to cover the check that I wrote to the auction company, took me less than two hours to arrange for this transaction.

But to convert to dollars, you had to use a bank.

In your other example, when your vendor extended you credit, he created something akin to money. Nothing had to change hands, but a debt was acknowledged and recorded. (It didn't even have to be in dollars.) If you received materials on credit, you might have paid back with services, and the debt extinguished that way. Or, you might have written out an I.O.U. for the vendor - "I owe you a debt equal to one case of t-shirts."

If that vendor later used your I.O.U. (since you are well-known in this area) to trade for some groceries, the grocer now holds your paper, and you owe the debt to him. The grocer asks, and you satisfy your I.O.U. by, say, mowing his lawn. Again, no capital has changed hands, and no previously-existing money was necessary for these transactions. Just a web of debts that all balance out. But until you have extinguished your I.O.U., the holder had a pocketful of debt that he knew was worth something.

Now, add private banks to the picture (still no government involved). They operate by being debt vendors. If your town is big enough that your good name doesn't register with everybody, the bank can be the trusted name. You borrow from the bank to buy t-shirts from the vendor, and the vendor's account gets marked up. Now, the vendor is whole, and you owe the bank.

If the vendor wants to use his earned I.O.U.s from the bank, he can either ask the bank to transfer his funds to another person's account, or the bank can print up some of its own I.O.U.s, mark his account down, and hand him the paper. Anybody who accepts these bank I.O.U.s as payment for services can go to that bank and deposit them into an account, and the bank will owe them that much, for later use.

People continue to work in exchange for I.O.U.s, and bank balances grow. As does the debt, which is perfectly O.K. Debt = money. As long as there are no panics, the bank can do this indefinitely, skimming their cut from interest.

So far, no hard assets have changed hands, only I.O.U.s. Also, no government is necessary. The bank continues to build up its own I.O.U.s from interest charges. If things go south, they can use their profits to cover bad loans, etc.

Now add in the government, with all of the special powers that being a government brings. They declare that they are creating their own central bank, their own unit of debt (the dollar), and lay down a bunch of other rules concerning banking - banks must have a reserve account at the Fed (or access one through another such bank), the Fed will act as the banks' clearinghouse, etc. Now, you have a universal currency, trust between banks, etc. You also have, for the first time, a source of debt-free dollars.

The point of all this is that nothing the central bank has done here has eliminated the banks' ability to create I.O.U.s on their own when they create loans. The only change is that, instead of banks printing their own particular paper, that job (printing banknotes) is now done by the government. Instead of banks printing on their own and adjusting their books to reflect those I.O.U.s that have been released into the wild, banks now buy those banknotes from the government. But the accounting all works out the same. If a bank creates a loan for $200,000, then there are $200,000 brand-new I.O.U.s in existence, whether they are paper or merely electronic blips. It is not old money being moved around.

 

[JohnfrmClevelan]

Exactly, those measures of our money supply account for VELOCITY of money, which is making it feel like the actual money supply is larger. Now what good those metrics do to any business, I can't imagine.

I'm sorry, I'm just not latching on to your velocity idea here.

They absolutely do. Money is fungible. You don't think that banks litterally keep all the checks and cash that they receive as deposits in boxes with the name of the depositor on them do you? to the bank, the money they obtain from deposits is no different (aside from the reserve requirment) and lends just as well as money from any other source.

Banks could lend this way. But they don't.

You can follow what happens to money that is deposited into a bank. Cash goes into the drawer, where it immediately becomes reserves (vault cash). If the bank has an excess of cash, they can deposit their excess cash with the Fed, and their Fed reserve account gets marked up. Checks become part of the web of debt - if the check is drawn on the same bank, they just adjust those individual accounts. If the check is drawn on a different bank, then some reserves will be transferred from that bank's Fed account to this bank's Fed account.

Here's how you know that the bank does not lend out of deposits: nobody's deposit account goes down when the bank creates a loan. Not even the bank's. For a $200,000 loan, balances (and debts/accts receivable) only go up. Even if the check is deposited in a different bank, total reserves don't go up. Reserves just move from one bank's acct. to another.

 

[imagep]

But to convert to dollars, you had to use a bank.

In your other example, when your vendor extended you credit, he created something akin to money. Nothing had to change hands, but a debt was acknowledged and recorded. (It didn't even have to be in dollars.) If you received materials on credit, you might have paid back with services, and the debt extinguished that way. Or, you might have written out an I.O.U. for the vendor - "I owe you a debt equal to one case of t-shirts."

If that vendor later used your I.O.U. (since you are well-known in this area) to trade for some groceries, the grocer now holds your paper, and you owe the debt to him. The grocer asks, and you satisfy your I.O.U. by, say, mowing his lawn. Again, no capital has changed hands, and no previously-existing money was necessary for these transactions. Just a web of debts that all balance out. But until you have extinguished your I.O.U., the holder had a pocketful of debt that he knew was worth something.

So for all practical purposes, to any extent that facilitating trade is the same as creating money, our debt transaction just created money, in the same way that banks create money. Which proves my point that there is nothing special about the banking system which "creates" money, it can happen without banks, through normal trade practices.

...If a bank creates a loan for $200,000, then there are $200,000 brand-new I.O.U.s in existence, whether they are paper or merely electronic blips. It is not old money being moved around.

There is $200,000 additional IOUs in the system, but there is an offseting claim to those IOUs, thus there is no addition to the net money supply. It just seems like there is more money, because more than one transaction was facilitated by using the same money.

I think we are just going to have to agree to disagree on this.

 

[austrianecon]

I don't know if it's true or not. I never studied economics formally. I can tell you this, though - the idea that banks can create money out of thin air does not go down easy with most people I debate with.

Banks don't create money, they create credit out of thin air which you and I pay someone with and then that credit becomes money..

These are legal constraints, but not operational constraints. Theoretically, banks only need backup money when something goes wrong. If everybody makes their payments, and flows between banks are pretty equal, they can keep all of the balls in the air indefinitely. Banks use reserves to settle up interbank debts at the end of the day - but there is no (operational) reason why they couldn't just owe each other, using credit to settle up. (Tough to do in real life, though.) Reserve accounts make settling up a simple matter, but you only need enough reserves to cover your net outflows. In that respect, our 10% requirement is probably overkill - other countries have no reserve requirement, and banks keep whatever reserves they feel they need.

There are two types of requirements for banks. Capital requirement and then Reserve requirement. The latter really means nothing as some countries don't have them but their regulators are hardnosed about the Capital requirement. Thus it's Capital where it matters. So much so, there is an International Standard called Basel III. Wanna do business with International Firms, you need to be Basel compliant.

Not operational constraints? Banks are required by law to have capital reserves AT ALL TIMES. They are also required under Basell II/III agreements to have specific capital ratios. Basel III kicks in in 2019 and as 2019 comes along these ratios will be going higher, I think 15% is the target of Total Capital ratio. Then you have LCR (Liquuidity Coverage Ratio) which in 2017 US Banks will need 100% coverage for 30 days at all times. Meaning they need to be highly liquid on the short term which means less and less short term lending.

If you (the bank) don't meet Basel standards, you are required to raise capital (issuing stock or increased earning), if not they are seized by regulators. Period.

 

[JohnfrmClevelan]

So for all practical purposes, to any extent that facilitating trade is the same as creating money, our debt transaction just created money, in the same way that banks create money. Which proves my point that there is nothing special about the banking system which "creates" money, it can happen without banks, through normal trade practices.

Yeah, the debt transaction certainly created something. In practice, you would most likely have carried this out through a bank in some way, either using cash or credit that runs through banks. Each little credit card purchase creates some new money, even if it is quickly extinguished.

But you have to admit that few people/businesses actually do the I.O.U. thing.

The special thing about banks is their connection to the Fed. You or I can't go knocking on the Fed's window, looking to trade I.O.U.s for banknotes.

There is $200,000 additional IOUs in the system, but there is an offseting claim to those IOUs, thus there is no addition to the net money supply. It just seems like there is more money, because more than one transaction was facilitated by using the same money.

I think we are just going to have to agree to disagree on this.

Yes, the debts are still out there - but until they are extinguished, so are the dollars.

Think of your business - if you are doing good, steady business, you are probably buying your supplies on credit, then making your money back (and then some). You borrow $10,000 per month, buy your supplies, make $15,500, pay yourself $5000, and pay the bank back their $10,000 + $500 interest. Before your bill gets paid, you borrow another $10,000 for next month. You are riding a wave of debt.

Scale that up - now, you borrow $20,000, make $31,000, pay yourself $10,000, and pay the bank $21,000. More debt = more money, as long as the demand is there. M1 has gone up $10,000, because your business is doing better. The $20,000 that you owe at any one time is in somebody's deposit account, if not yours. When the economy is hopping, Mx will be higher, because businesses run on debt.

 

[JohnfrmClevelan]

Banks don't create money, they create credit out of thin air which you and I pay someone with and then that credit becomes money..

Tomatoes, tomahtoes. If you take out a loan and simply deposit it in your own account without paying anybody, it still counts as new money.

There are two types of requirements for banks. Capital requirement and then Reserve requirement. The latter really means nothing as some countries don't have them but their regulators are hardnosed about the Capital requirement. Thus it's Capital where it matters. So much so, there is an International Standard called Basel III. Wanna do business with International Firms, you need to be Basel compliant.

Not operational constraints? Banks are required by law to have capital reserves AT ALL TIMES. They are also required under Basell II/III agreements to have specific capital ratios. Basel III kicks in in 2019 and as 2019 comes along these ratios will be going higher, I think 15% is the target of Total Capital ratio. Then you have LCR (Liquuidity Coverage Ratio) which in 2017 US Banks will need 100% coverage for 30 days at all times. Meaning they need to be highly liquid on the short term which means less and less short term lending.

If you (the bank) don't meet Basel standards, you are required to raise capital (issuing stock or increased earning), if not they are seized by regulators. Period.

These are legal constraints. As my example pointed out, it is completely possible to operate a banking system without these standards.

Not that I disagree with these standards - I think they are a good idea. But worrying about these things can get in the way of understanding how money is created.

 

[austrianecon]

Tomatoes, tomahtoes. If you take out a loan and simply deposit it in your own account without paying anybody, it still counts as new money.

It's not tomatoes, Tomahtoes. You still have to pay that loan back plus interest. So that $200,000 deposited still becomes $400,000 plus interest in the system.

These are legal constraints. As my example pointed out, it is completely possible to operate a banking system without these standards.

Not that I disagree with these standards - I think they are a good idea. But worrying about these things can get in the way of understanding how money is created.

They are OPERATIONAL constraints. You don't met them, you don't operate, period. There is no fine, there is no slap on the wrist. It's game over for said bank.

 

[JohnfrmClevelan]

It's not tomatoes, Tomahtoes. You still have to pay that loan back plus interest. So that $200,000 deposited still becomes $400,000 plus interest in the system.

If your deposit gets counted in Mx calculations, then I don't see your distinction here.

Also, the $200,000 does not become $400,000 in the system. It becomes $200,000, and that goes down as it is paid off.

They are OPERATIONAL constraints. You don't met them, you don't operate, period. There is no fine, there is no slap on the wrist. It's game over for said bank.

UNDER THOSE RULES, AND WITHIN THAT SYSTEM. I can still operate a banking system on my own, without their capital requirements. I don't have to do business with them. I can agree to do so, and follow their rules, sure. But capital is not a necessary precondition for a debt-based banking system. Do you understand that I was creating a simplified example for the purpose of demonstrating what was written about in the paper? That banks don't lend out of existing piles of money?

 

[imagep]

Yeah, the debt transaction certainly created something. In practice, you would most likely have carried this out through a bank in some way, either using cash or credit that runs through banks. Each little credit card purchase creates some new money, even if it is quickly extinguished.

But you have to admit that few people/businesses actually do the I.O.U. thing.
The special thing about banks is their connection to the Fed. You or I can't go knocking on the Fed's window, looking to trade I.O.U.s for banknotes.

I think we are in agreement about this now. I also suspect that I have opened your eyes a little to the fact that its not actually commercial banks that create money (if you call creating offsetting transactions "creating money"), it's the process of lending.

Think of your business - if you are doing good, steady business, you are probably buying your supplies on credit, then making your money back (and then some). You borrow $10,000 per month, buy your supplies, make $15,500, pay yourself $5000, and pay the bank back their $10,000 + $500 interest. Before your bill gets paid, you borrow another $10,000 for next month. You are riding a wave of debt.

Scale that up - now, you borrow $20,000, make $31,000, pay yourself $10,000, and pay the bank $21,000. More debt = more money, as long as the demand is there. M1 has gone up $10,000, because your business is doing better. The $20,000 that you owe at any one time is in somebody's deposit account, if not yours. When the economy is hopping, Mx will be higher, because businesses run on debt.

Pretty much.

 

[JohnfrmClevelan]

I think we are in agreement about this now. I also suspect that I have opened your eyes a little to the fact that its not actually commercial banks that create money (if you call creating offsetting transactions "creating money"), it's the process of lending.

There's a bit of a schism in the MMT community about which is more important, vertical money or horizontal money. I think it's largely an artificial divide - it's really a matter of what you are talking about. When you are talking about economics, banks and loan creation become the focus, and when you are talking about public policy, government spending becomes the focus. The horizontal money camp insists that, because most money is created by commercial bank lending, private banks should be the focus. I'm not picking any sides, though.

It took me a lot longer to understand the banking side of it (to whatever degree I actually understand it, anyway). I think I'm getting a handle on it lately, but I'm ready to hear that I have it wrong, too.

 

[austrianecon]

If your deposit gets counted in Mx calculations, then I don't see your distinction here.

Also, the $200,000 does not become $400,000 in the system. It becomes $200,000, and that goes down as it is paid off.

And that's why banks and people end up failing. They don't see the difference between credit and money.

Yes, that $200,000 becomes $400,000 in the system because once that $200,000 is deposited, it becomes Capital in banks, those banks can lend up to 90% of that and still meet capital and reserve requirements. It adds up over and over. So while you can claim it doesn't create $400,000, reality states otherwise. For example $100 deposited assuming 20% reserve requirement, will turn into $457.05 deposited, $357.05 lent. It's known as the Money multiplier.

UNDER THOSE RULES, AND WITHIN THAT SYSTEM. I can still operate a banking system on my own, without their capital requirements. I don't have to do business with them. I can agree to do so, and follow their rules, sure. But capital is not a necessary precondition for a debt-based banking system. Do you understand that I was creating a simplified example for the purpose of demonstrating what was written about in the paper? That banks don't lend out of existing piles of money?

Under those rules and within that system? You can't operate independently of it. You need a Banking license to own a bank, States have their rules and then you have Federal rules.

 

[imagep]

...
Under those rules and within that system? You can't operate independently of it. You need a Banking license to own a bank, States have their rules and then you have Federal rules.

I wonder how credit unions operate. I know that they aren't part of the federal reserve, and don't have access to all the resources that commercial banks do, but for the most part, it appears to me that they are pretty much banks.

 

[JohnfrmClevelan]

And that's why banks and people end up failing. They don't see the difference between credit and money.

Yes, that $200,000 becomes $400,000 in the system because once that $200,000 is deposited, it becomes Capital in banks, those banks can lend up to 90% of that and still meet capital and reserve requirements. It adds up over and over. So while you can claim it doesn't create $400,000, reality states otherwise. For example $100 deposited assuming 20% reserve requirement, will turn into $457.05 deposited, $357.05 lent. It's known as the Money multiplier.

And the Money Multiplier is a myth. That is just not how today's banks operate.

Under those rules and within that system? You can't operate independently of it. You need a Banking license to own a bank, States have their rules and then you have Federal rules.

This was a hypothetical situation, created for the purpose of illustrating a point. As an Austrian, you should be well acquainted with hypothetical situations.