Understanding endogenous money (banks create money)

[Cardinal Fang]

So the bank can just pretend like they have the $1000 without having to actually acquire it from somewhere?

That's correct. That's why they call it creating money.

They don't have to get it from the fed or the discount window or from another bank or some other source?

Correct again. They don;t have to get it from anywhere. If they have $100 in new reserves with a 10% reserve requirement, they can just go ahead and lend out $1000. One way banks make money is by having a whole lot of deposits and a whole lot of withdrawals each day, and making just a little more off each of the latter than what they pay for each of the former. All the money the bank actually needs to "have", is the difference between a day's total deposits and total withdrawals times the reserve requirement.

Can you cite a sourced that says that banks don't have to have the money or access to the money that they lend?

Due to the prevalence of fractional-reserve banking, the broad money supply of most countries is a multiple larger than the amount of base money created by the country's central bank.

Fractional reserve banking - Wikipedia

And when that $1000 loan gets repaid, then they don't have to disappear the money that they conjured up, they can just keep it as pure profit (plus the interest)?

As was already noted above, loan repayments reduce the money supply, just as disbursements increase it. The typical bank however simply lends the dollars you paid back to somebody else. The bank makes money on outstanding balances, not on cash sitting in its vault.

Somehow I'm not buying that.

You haven't on any of the three or four other occasions that it's been explained either.

 

[Cardinal Fang]

They acquire it alright, but they do it after the fact. So if they can't get the money from some market or through interbank lending they do through the fed reserve. When they take from the fed reserve that is money creation, everything else is velocity as you said before.

Velocity is the number of times an average dollar in circulation changes hands over a given period of time. A new loan does not increase velocity at all unless the borrower has a higher propensity to spend quickly than does the population as a whole. Banks have no control over this and do not rate their loan applicants on likelihood-of-spending-quickly.

When banks borrow in the overnight federal funds market, it is for the short-term purpose of bulwarking reserves. The loans are paid back the next morning. Banks may borrow through the discount window for the same purpose, or for bridging short-term cashflow deficiencies. Reserves themselves are part of vault cash -- money that the bank holds for its own account. They are not in circulation and are therefore not part of the money supply under typical definitions. A bank borrowing via the discount window for operational purposes would presumably be dealing with some sort of liquidity issues and might therefore have a reason for putting the proceeds into circulation (thus increasing the money supply) very quickly.

But by far the primary means by which commercial banks create money and pump up the money supply is via the one-minus-the-reserve-requirement money multiplier effect.

 

[Cardinal Fang]

Point well taken, but in fact the Fed could impose a penalty for holding reserves over a certain ceiling. Currently there is no down side for the banks not to loan despite meeting the reserve requirements. We could impose on and thus give banks an incentive to loan. This is a bete noire of mine, but I wish the did it to get some credit into the system.

I agree. We put a lot of effort into getting liquidity into the system in a hurry and via every means we could think of because the system was once upon a time starved for it. Made sense. But the liquidity-famine is over. The banking system is fairly awash in the stuff, and while risk is always overpriced in tough times, we are getting to the point of the ridiculous here. The Fed has done about all it can to keep interest rates low, hoping that a little inflation would come along and provide a bonus kick in the pants that would prompt people into putting money to work in the real economy rather than sitting on it, but progress on that front has been painfully slow. As you suggest, yields on reserves and other vault cash could be reduced considerably further by applying various forms of penalty upon their existence. I think we have to see what comes out of the "fiscal cliff" first, but assuming that does not get blown up into yet another steep recession, the time to begin turning some screws on the banks is pretty much at hand here. Use it or lose it, eh boys?

 

[Rhapsody1447]

I agree. We put a lot of effort into getting liquidity into the system in a hurry and via every means we could think of because the system was once upon a time starved for it. Made sense. But the liquidity-famine is over. The banking system is fairly awash in the stuff, and while risk is always overpriced in tough times, we are getting to the point of the ridiculous here. The Fed has done about all it can to keep interest rates low, hoping that a little inflation would come along and provide a bonus kick in the pants that would prompt people into putting money to work in the real economy rather than sitting on it, but progress on that front has been painfully slow. As you suggest, yields on reserves and other vault cash could be reduced considerably further by applying various forms of penalty upon their existence. I think we have to see what comes out of the "fiscal cliff" first, but assuming that does not get blown up into yet another steep recession, the time to begin turning some screws on the banks is pretty much at hand here. Use it or lose it, eh boys?

The level of total excess reserves in the banking system is almost entirely determined by the size of the Fed's balance sheet, not by the lending activities of commercial banks. While an individual bank may be able to decrease the level of reserves it holds by lending to firms and/or households, the same is not true of the banking system as a whole. No matter how many times the funds are lent out by the banks, used for purchases, etc., total reserves in the banking system do not change. The only exception to this is if lending constitutes a sharp rise in physical banknote withdrawals from the system. Or for that matter if commercial banks begin to store reserves in physical banknote form rather than on deposit at the central bank so as to avoid negative charges. Whether commercial banks let the reserves they have acquired through QE sit “idle” or lend them out in the interbank market 10,000 times in one day among themselves, the aggregate reserves at the central bank at the end of that day will be the same.

If imposed, negative rates would be have to be enforced via the base money market. Which ever way you look at it, the move would ultimately be contractionary rather than expansionary because it would lead to base money destruction, or wider credit destruction as banks hand over credit to cover charges. The excess reserves the central bank created with one hand would be wiped out with the other — creating an overall tightening effect unless new base money was continuously created to compensate for the contraction. Additionally, the minutes from an FOMC meeting last year reported that “many participants voiced concerns that reducing the IOR rate risked costly disruptions to money markets and to the intermediation of credit, and that the magnitude of such effects would be difficult to predict.” Essentially, a negative IOER could spur potentially risky financial innovations, cause problems in money market funds and treasury auctions, and could potentially disrupt the flow of credit to creditworthy borrowers.

 

[Cardinal Fang]

The level of total excess reserves in the banking system is almost entirely determined by the size of the Fed's balance sheet, not by the lending activities of commercial banks.

Neither is actually relevant. We would like to see more lending to responsible borrowers and more overall economic activity as the result. The position of the Fed's balance sheet and the level of excess reserves across the banking system can remain as flat as they want. These are stocks. Let's see some flows, as in let's see some money out the door. If it comes back in again next week, that's fine...we can simply get it kicked it back out there again.

Additionally, the minutes from an FOMC meeting last year reported that “many participants voiced concerns that reducing the IOR rate risked costly disruptions to money markets and to the intermediation of credit, and that the magnitude of such effects would be difficult to predict.”

Actually, a number of participants judged that a reduction in the IOR rate would result in marginally lower money market rates and could help stimulate bank lending. Imagine that. Cutting the IOR is not a standard policy tool however, so the meeting adjourned with agreement that participants needed more information on the likely effects of a reduction before judging its usefulness as a policy tool in the current environment.

Essentially, a negative IOER could spur potentially risky financial innovations, cause problems in money market funds and treasury auctions, and could potentially disrupt the flow of credit to creditworthy borrowers.

No one has spoken yet about a negative rate (and your cites look only at rates of 50 basis points or more below zero). The suggestion raised above was for a less positive rate.

 

[imagep]

They acquire it alright, but they do it after the fact.

They don't come up with $900...

Getting loans to cover those assets come from us or the discount window.

They don;t have to get it from anywhere.

All the money the bank actually needs to "have", is the difference between a day's total deposits and total withdrawals times the reserve requirement.

Hey guys, either the bank DOES have to acquire the money that they lend (doesn't matter what the source is), or they DONT have to get it and they are allowed by law to lend money that is not in existance anywhere. It's one or the other, you can't state that the bank gets it from somewhere, and then argue that it doesn't have to get it.

You haven't on any of the three or four other occasions that it's been explained either.

You guys are just playing games.

If banks either have to already have money to lend or acquire (by the end of the business day) the money to lend, then bank are obviously not allowed to create money. If banks don't have to have the money and don't have to acquire it, then banks do create money. When a bank borrows from another bank or from the discount window or directly from the fed, that is acquiring money. Cardinal you can play semantics all you want, it doesn't change the facts.

 

[imagep]

Velocity is the number of times an average dollar in circulation changes hands over a given period of time. A new loan does not increase velocity at all unless the borrower has a higher propensity to spend quickly than does the population as a whole.

People who save money have less propensity to save than people who are going into debt. So maybe lets say that you are a saver, you save $1000 and you burry it in the back yard, then that money has been taken out of circulation. But maybe you realize that the worms may eat it, so you dig it up and deposit it in a bank for safe keeping. The bank then lends some or all of it to me, and I use it to purchase something with, which is of course typically what borrowers do. The velocity of the money has gone from zero, to something above zero. So lending increases velocity.

What hasn't happened is the creation of new money.

Thats why I say that lending increases velocity, but doesn't result in the creation of new money (unless the fed lends which can be a mechanism for creating money).

The Fed is the only entity that can lend money that it either doesn't have or doesn't have a need to acquire from an outside source.

 

[Cardinal Fang]

Hey guys, either the bank DOES have to acquire the money that they lend (doesn't matter what the source is), or they DONT have to get it and they are allowed by law to lend money that is not in existance anywhere. It's one or the other, you can't state that the bank gets it from somewhere, and then argue that it doesn't have to get it.

Banks have to obtain the money needed to cover their required reserves each evening. That's all. They most definitely do not need to have cash on hand to cover the entirety of their liabiliaties. That would be equivalent to a reserve requirement of 100%. Keep in mind that for actual banks, the volume of deposits and withdrawals tends to be about equal each day. For each check cleared out to another bank, a check from another bank is also being cleared in. If you receive $102 on Monday but have to pay out $105, you don't need $105 to make the payment. You need $3. You can always borrow that if you need to, but it's only that little difference at the margin that you need to have access to in order to remain solvent.

You guys are just playing games. If banks either have to already have money to lend or acquire (by the end of the business day) the money to lend, then bank are obviously not allowed to create money. If banks don't have to have the money and don't have to acquire it, then banks do create money. When a bank borrows from another bank or from the discount window or directly from the fed, that is acquiring money. Cardinal you can play semantics all you want, it doesn't change the facts.

I have probably over-invested in trying to explain to you what are actually rather basic financial concepts. These are explained in the same terms that I have used in dozens of places all over the internet. They are explained in intro-level money, credit, and banking textbooks. This is the way the world works, whether you allow yourself to understand the matter or not.

Transactions within the banking system are meanwhile with respect to amounts that are not in circulation. These are not part of M1 or M2, the measures typically thought of as representing the money supply. They operate in their own little world instead. If you can keep those two worlds distinct, you'll likely have a better shot at all this.

 

[Cardinal Fang]

People who save money have less propensity to save than people who are going into debt. So maybe lets say that you are a saver, you save $1000 and you burry it in the back yard, then that money has been taken out of circulation.

No, it hasn't. Since I am not a bank, it is still in circulation. I'm just not spending it.

But maybe you realize that the worms may eat it, so you dig it up and deposit it in a bank for safe keeping. The bank then lends some or all of it to me, and I use it to purchase something with, which is of course typically what borrowers do. The velocity of the money has gone from zero, to something above zero. So lending increases velocity.

Lending increases the money supply. I still have the $1000 that I finally put in the bank, and you now have something up to $1000 to boot. If velocity increases as the result, it is only because you artificially set mine to zero to begin the example.

What hasn't happened is the creation of new money.

Wrong. Again...I started with $1000 in cash (part of M1), and I now have a $1000 checking account balance (part of M1). You started with $0 (not part of anything), and now have a checking acoount balance of something up to $1000 (part of M1). The new M1 is larger than the old M1. Money has been created.

Thats why I say that lending increases velocity, but doesn't result in the creation of new money (unless the fed lends which can be a mechanism for creating money).

Yes, I know, but the saying of it is unfounded and irrational. And as was already noted, Fed lending to banks does not in and of itself increase the money supply (M1/M2). It increases vault cash held by that bank which might be used to make loans that would increase the money supply. but that does not happen automatically.

The Fed is the only entity that can lend money that it either doesn't have or doesn't have a need to acquire from an outside source.

No, lending institutions of all sorts do this every day.

 

[imagep]

Banks have to obtain the money needed to cover their required reserves each evening.

OK, I am correct then. Banks cannot create new money. Thank you for the honest explanation.

 

[Cardinal Fang]

OK, I am correct then. Banks cannot create new money. Thank you for the honest explanation.

No, banks create new money all the time. It's what they do. You've simply fallen/jumped through the cracks of about a dozen perfectly good explanations.

 

[imagep]

No, it hasn't. Since I am not a bank, it is still in circulation. I'm just not spending it.

I think you are again playing games. If you have money buried in your back yard with no immediate plans to spend it in the near future, then the velocity of that money is zero, thus it is not in circulation. Now I realize that you are probably just using some particular technical definition of "in circulation", but few of us care about semantics.

Lending increases the money supply. I still have the $1000 that I finally put in the bank, and you now have something up to $1000 to boot.

No, you just have a claim to that $1000. Remember the shovel example from quite some time back? If you lend me your shovel, we haven't double the number of shovels, there is still just one shovel. Lending shovels may improve value of the shovel as it tends to maximize utility, but it doesn't increase the number of shovels - there is still only one person who can use that shovel at a time.

If velocity increases as the result, it is only because you artificially set mine to zero to begin the example.

Wrong. Again...I started with $1000 in cash (part of M1), and I now have a $1000 checking account balance (part of M1). You started with $0 (not part of anything), and now have a checking acoount balance of something up to $1000 (part of M1). The new M1 is larger than the old M1. Money has been created.

Yes, I started with $0, and I still have $0 as the $1000 that I borrowed is offset by the $1000 that I owe. The M1 metric double counts the same money. Just because some particular metric goes up doesn't mean that the real amount of money increases. I could easily make up some phony metric, and then makeup whatever story I would like, but that doesn't mean that my story would be true or that the metric would have any meaning.

Yes, I know, but the saying of it is unfounded and irrational. And as was already noted, Fed lending to banks does not in and of itself increase the money supply (M1/M2). It increases vault cash held by that bank which might be used to make loans that would increase the money supply. but that does not happen automatically.

I totally get that. The bicycle factory could build a zillion bicycles, but those bicycles might not be counted in the "bicycles possessed by bicycle riders" figure until the bicycle stores have sold them. But that doesn't mean that bicycle retailers make bicycles any more than it means that banks make money. The bicycle factory makes bicycles and the fed makes money - no one else.

I think we both perfectly well understand how this works. You are just trying to defend a misleading belief, I am saying that we shouldn't be spreading such a misleading belief or trying to defend it by pretending that distributing a product is the same as manufacturing it. I'm saying lets clearly define things and then just tell people the truth, straight up with no games. What we are doing when we claim that "banks create money" is we are bundling up all the particular functions of the entire banking system into one three word statement, even though our system is far more complex than three words could ever explain - thus those three words are very misleading.

Maybe a very concise paragraph should be used to explain our banking system and to identify how money is created instead of those three words. Something like:

"The federal reserve is the only entity that is allowed to create money. The federal reserve then supplies commercial banks with a portion of the money that they lend, and thus commercial banks become a distributor of that money. Commercial banks also may utilize bank deposits, loans from other banks and money from investors as their source of money to lend. Lending and borrowing can increase the speed that money circulates, thus making it feel like there is more money in existence than there really is." (feel free to augment or to improve upon this statement)

 

[imagep]

No, banks create new money all the time. It's what they do. You've simply fallen/jumped through the cracks of about a dozen perfectly good explanations.

No, banks act as distributors of money all the time. It's what they do. You've warped and distorted the facts to come to a conclusion that is not accurate.

 

[Cardinal Fang]

Those who insist upon ignorance cannot be taught.

 

[JP Hochbaum]

It is a matter of function.

Without the commercial banks, there would no way be for the money supply to increase. Without the federal reserve the banks can't get new money.

The feds print it, yes, but it doesn't enter the actual money supply until banks lend it. Once banks lend the money it enters the economy. That is how commercial banks increase the money supply. It is a matter of which one has the power and ability to increase the money supply. The fed can't the banks can.

 

[imagep]

It is a matter of function.

Without the commercial banks, there would no way be for the money supply to increase. Without the federal reserve the banks can't get new money.

The feds print it, yes, but it doesn't enter the actual money supply until banks lend it. Once banks lend the money it enters the economy. That is how commercial banks increase the money supply. It is a matter of which one has the power and ability to increase the money supply. The fed can't the banks can.

Sure, I understand that. But if we were creating a brand new system that didn't include commercial banks, then I would assume that we would create a different mechanism for the fed to distribute new money.

And if the fed didn't use commercial banks to distribute new money, the fed would use a different mechanism, and we could still have commercial banks, they could lend purely from deposits, investor money, loans from other banks, and proceeds from retiring debt.

The act of lending may under certain circumstances result in the distribute of new money created by the fed, but the act of lending itself doesn't create new money.

 

[imagep]

Those who insist upon ignorance cannot be taught.

We can agree on that!

 

[JP Hochbaum]

Sure, I understand that. But if we were creating a brand new system that didn't include commercial banks, then I would assume that we would create a different mechanism for the fed to distribute new money.

And if the fed didn't use commercial banks to distribute new money, the fed would use a different mechanism, and we could still have commercial banks, they could lend purely from deposits, investor money, loans from other banks, and proceeds from retiring debt.

The act of lending may under certain circumstances result in the distribute of new money created by the fed, but the act of lending itself doesn't create new money.

Yes, every loan is not "new money" but lending is the only vehicle for "new money" to enter.

And yes we could change the system where banks wouldn't be the avenue of money creation, but it is important to acknowledge the system, how it works, and why, in order to understand our economy, inflation, etc.

 

[24107]

Okay let me put it in another way. The federal reserve is the body that physically prints the money. The problem is just printing money doesn't put it into an existence that matters. It would just sit in a room doing nothing, it is just piece of paper at that point.

the banks are the vehicle that take that money and deliver it to the economy. Only then does it actually become money, only then does it effect spending, inflation, etc.

The federal reserve is just the body that prints it, it has no vehicle to deliver money to the economy, unless through central banks, who are the ones that demand it.

This is common knowledge, it's not like your revealing something not well known already.

 

[Kushinator]

This is common knowledge, it's not like your revealing something not well known already.

Given the trajectory of this discussion, it apparently is not something well known.

 

[imagep]

Yes, every loan is not "new money" but lending is the only vehicle for "new money" to enter.

Fiscal policy funded by debt to the fed can also serve as a vehicle to expand the money supply.

It actually may be a better vehicle.

 

[Kushinator]

Fiscal policy funded by debt to the fed can also serve as a vehicle to expand the money supply.

It actually may be a better vehicle.

Question: how does the Fed purchase Treasury debt?

 

[imagep]

Given the trajectory of this discussion, it apparently is not something well known.

Who is it that didn't understand that? I thought that it was pretty clear that all parties that have participated in this discussion were in agreement that the fed supplies our economy with new money by lending it.

The issue is whether or not simply lending money (with no fed involvement) creates new money, and I argue that it doesn't, and all the posters except for you and CF have clearly agreed with me.

 

[imagep]

Question: how does the Fed purchase Treasury debt?

Through the private market, just like everyone else does. But it doesn't have to be done that way, it's just the system that we happen to have. The treasury could start purchasing this debt directly from the fed, or better yet, the treasury could create it's own supply of money by conjuring it up from nothing, which of course would significantly reduce our federal debt.

If we reduced federal spending to the amount of new money that the fed creates each year, we could actually stop taxing, and not have any inflation beyond what we already do. I'm not recommending that, but it could be done, and I am not going to insult your intellegence by claiming that you don't already know this (like you constantly try to do to me), I am just repeating it for the benefit of others.

 

[Kushinator]

Through the private market, just like everyone else does. But it doesn't have to be done that way, it's just the system that we happen to have. The treasury could start purchasing this debt directly from the fed, or better yet, the treasury could create it's own supply of money by conjuring it up from nothing, which of course would significantly reduce our federal debt.

Through commercial banks. Authorized broker dealers (known as primary dealers) are the very banks that take the deposits necessary to purchase sovereigns. It is no different than any other loan, and continues the multiple deposit creation process. If the Fed were to purchase directly from the Treasury, the financial world would lose faith in the dollar rather abruptly. The same goes for congressional control of monetary policy.