A peculiar view of money [Archive]

Nobbit

13th September 2010, 12:04 PM

Recently, while hunting the web for a good article on the mechanics of bank lending (see forums.randi.org/showthread.php?p=6310210 and later posts), I came across a curious article by the Institute for Economic Democracy (IED) titled "Private Banks Creating Money is Really Only a Circulation of Money":

ied.info/articles/an-honest-bank-is-so-simple-you-can-run-it/logical-reasons-proving-private-banks-do-not-create-money

The main claim of this article seems to be that private banks do not, as money theorists claim, create money; instead, private banks merely increase the circulation of money that already exists.

To me, as an armchair money theorist who would assert that banks do indeed create money (by creating new bank deposits to fund loans), the IED's argument sounds rather odd. At first it seems that they are just choosing to define money as "base money only", thus excluding bank deposits (which are usually included in definitions of the money supply). If they stuck to that approach consistently, it would be true and fair enough. Banks certainly do not (and are not allowed to) create base money. However, no money theorist I know of claims that commercial banks do create base money, so what exactly is the IED arguing about?

The article also lists "12 logical reasons" that it claims prove that banks do not create money. It's here that one begins to suspect that the author is very confused both about what money theorists actually say, and about the supposed evidence that contradicts them. Here are some samples of the "logical reasons":

3. The creator of money owns that representation of value. If a bank could create account deposit money this easily, banks would have tons of money and never go broke. Yet they are going broke all the time.
Here the author seems to think that a bank "creating account deposit money" is a bank "making an immediate profit". When a bank makes a loan, that loan (an asset) is balanced by a corresponding liability (the borrower's bank deposit). This obviously does not make the bank any richer; its capital (assets minus liabilities) does not change.

5. The same money theorists that claim private banks create money push for 100% reserves (cash in the vault to back all deposits). If deposits had not been loaned out, that money is still in the bank—available by check, credit card, or debit card—and 100% reserves are already in effect.
This is a "logical reason"? I can't even figure out what point is being made here. Is it claiming that we already have 100% reserve banking??? I can't tell.

6. In the current (2007-08) worldwide liquidity-solvency crisis, banks all over the world are in trouble. Because they cannot, none have created money to solve their problem and central banks are pouring newly-created money at them.
Same error as in (3) above. Banks cannot create money to increase their capital, and no sane money theorist claims that they can.

10. The fundamental principles of double entry bookkeeping does not permit it.
By this point you realise that it's time to stop giving the author the benefit of the doubt.

All in all, the article seems like an elaborate attempt to prove the unprovable by sheer verbosity and by redefining "money" and "money supply". Unless I've missed the whole point. Have I?

drkitten

13th September 2010, 12:22 PM

tensordyne

15th September 2010, 06:54 AM

drkitten

15th September 2010, 07:29 AM

:boxedin: This is curious. I am not sure anymore exactly how the flow of money works in Fractional Reserve Banking. One thing most sources I read seem to agree on is that money is created from nothing during the FRB loan process.

No, that's not true.

Lets for the moment assume that is true, new money is loaned into existence that is.

That, however, is true. Do you see the difference? New money is created from old money.

If that is the case, then there seem to be two different possibilities (others?)

1. When the loan is payed back the bank gets to keep the loan principle and interest as its own profit.

2. When the loan is payed back the bank gets to only keep the interest on the loan as the principal is drawn down through accounting (since accounting is how the original checkbook money was created for the loan principal, there is no reason to suppose necessarily that the same can not be negated in a similar manner).

The second is correct.

As a general note I never liked the way people go talk about FRB and appeal to assets and liabilities. What I would love to see is some authoritative way to explain FRB based on which economic actors owe money to what other actors and what they are allowed to do as per the accounting rules of FRB.

Perhaps this analogy from this post (http://forums.randi.org/showthread.php?postid=5972504#post5972504) will help:

Fractional reserve banking simply recognizes that money, like a lawn mower, spends most of its time not being used. Suppose that I have a nice lawn mower and you don't. Instead of buying your own, you simply ask me "can I use it?" and I say "sure, what the hell." I use it about an hour a week and you use it about an hour a week, which means it still sits in the garage unused for most of the time. I could probably let anyone on the block who wants it use it and it would still be sitting around most of the time.

Does this mean I'm creating lawnmowers out of thin air? Does this mean I can "borrow lawnmowers at will" from the factory? No, it just means that most of the time the lawnmower is just sitting there.

Now, of course, I don't have to let you use the mower for free. It needs gas, oil, and occasional repairs. And so I decide that you can use the mower any time you like but you have to return it to me full and you owe me an annual fee of $1 to pay for the oil and repairs. That's interest.

That's basically the system we had in place in 1900 in banking. Every bank had its own lawnmower and its own set of people that could use it. The problem arose when several people wanted to use the same mower at once, which caused a run on the mower.

The Federal Reserve and later the FDIC and whatnot solved that problem by making lawnmowers available for lending to people who already owned them but lent them out (like me), so if two people wanted to use my lawnmower at once, I'd just borrow one from the Fed.

Back to your post:

In both scenarios 1. and 2. the banks in the end get more profit then the people making loans to the bank (in the form of deposit accounts). What is worse is that for both of the scenarios in the end there is less money "created" then there is money contractually owed back to the Bank, from what I can tell.

That's right. The bank insists you pay back more than you borrowed. Read any of the new credit card statements if you want that in numbers; if you make the minimum payment on your card, you'll probably pay back twenty or thirty times as much as you borrowed.

But that's the fee you pay for the convenience of being able to spend money now that you won't have until later.

If you want to buy a house, you can pony up $100,000 several years from now, or you can pay about $200,000 over the next thirty years. The extra money what you're willing to pay for the convenience of having your own house to celebrate Christmas 2010 in.

And if it's a business loan, the idea is that you can make more money with the borrowed money and still come out ahead. Sure, you pay 6% to the bank, but you earn 15% in additional revenue by adding the car wash to your gas station, so you still end up better off.

tensordyne

15th September 2010, 08:55 AM

This is curious. I am not sure anymore exactly how the flow of money works in Fractional Reserve Banking. One thing most sources I read seem to agree on is that money is created from nothing during the FRB loan process.

No, that's not true..

What part? Please excuse me for feeling a little annoyed at the prospect of having to read your mind on this one drkitten, but it seems to me a little more writing needs to be done by you to make what your saying "is not true" clear. Let me hazzard a guess however.

The first and second sentence, as they stand, certainly seem to be out of the running altogether. The last sentence seems to be at issue. Now as a matter of logic, how do you know what sources I have read and what they have said? Let me forgive you for calling me a liar on things you could not possibly know about and try and interpret your statement in the best possible light. That being the case, I will take it you mean that contrary to whatever sources I might or might not have read, you are saying that money is not created from nothing during the FRB loan process? Is that right?

PLEASE don't be lazy and just type one-liners like the above as a response to this if you choose to respond. Unless both of us are agreed on major points of interest, writing in the above way only invites confusion and general pissed-offedness when someone tells you that you are wrong about something they could not possibly know about (being whether the sources I read say that money is created from nothing during the FRB process which IS the original sentence and not what my guess is as to what you were trying to imply by the one-line response was. See the difference?).

Lets for the moment assume that is true, new money is loaned into existence that is.

That, however, is true. Do you see the difference? New money is created from old money.

Wow, you got me on this one, I have no idea exactly what you are referring to. New money is created from old money? What, does money have kids or something? Sorry for sounding snide, but I am just really at a loss as to what you mean.

Perhaps we should first agree on terms and some general ideas, otherwise I am not sure whatever explaination you might provide will have any meaning to me. Definition (my own perhaps): A zero-sum exchange is one where if economic actor 1. has X money and actor 2. has Y money initially, then at the end of the exchange the amount of total money between both actors is X + Y. Anything else is not zero-sum. Of course one should add as a caveat that the exchange works like so:

1. has X money and 2. has Y money initially. 1. Gives 2. an amount A of money.

Before exchange: 1. has X, 2. has Y, both together have X + Y.
After exchange: 1. has X - A, 2. has Y + A, both together have X + Y.

Now, in the "new money is created from old money" idea, is that a zero-sum exchange or not? Lets look at the next part of the post to maybe glean the answer.

If that is the case, then there seem to be two different possibilities (others?)

1. When the loan is payed back the bank gets to keep the loan principle and interest as its own profit.

2. When the loan is payed back the bank gets to only keep the interest on the loan as the principal is drawn down through accounting (since accounting is how the original checkbook money was created for the loan principal, there is no reason to suppose necessarily that the same can not be negated in a similar manner).

The second is correct.

Another shocker to me. What proof do you have of this assertion? I have looked pretty hard myself (maybe not hard enough to be sure), but could not find any definitive proof of 1. or 2. or some other possibility. I am highly curious what evidence you have to back up such a claim, if you do want to back it up that is. No skin off my back either way.

Not responding too much to the rest. Analogies are not my bag when it comes to this topic. I prefer cold-hard equations based on referrences as compared to stories about lawn mowers and such, however eloquant that story might be. As for the OPM (other peoples money) and the car wash, I already knew about such setups. Maybe it helps someone else though.

OK, that is more then enough grist for the grindwheel (haha, is that the actual phrase?).

All the best to everyone.

drkitten

15th September 2010, 09:12 AM

What part? Please excuse me for feeling a little annoyed at the prospect of having to read your mind on this one drkitten, but it seems to me a little more writing needs to be done by you to make what your saying "is not true" clear. Let me hazzard a guess however.

The first and second sentence, as they stand, certainly seem to be out of the running altogether. The last sentence seems to be at issue. Now as a matter of logic, how do you know what sources I have read and what they have said? Let me forgive you for calling me a liar on things you could not possibly know about and try and interpret your statement in the best possible light. That being the case, I will take it you mean that contrary to whatever sources I might or might not have read, you are saying that money is not created from nothing during the FRB loan process? Is that right?

That's right. New money is not created from nothing; it's created from old (deposited) money that's re-loaned.

A banker can't simply walk in one day and say "Hmm, I think I need new money -- Mrs. Frizzbin, write me a check for seven million dollars." But a banker can have Mrs. F. write a check for seven million dollars against the ten million dollars of deposits he holds, while still holding those ten million dollars in deposits.

Perhaps we should first agree on terms and some general ideas, otherwise I am not sure whatever explaination you might provide will have any meaning to me. Definition (my own perhaps): A zero-sum exchange is one where if economic actor 1. has X money and actor 2. has Y money initially, then at the end of the exchange the amount of total money between both actors is X + Y. Anything else is not zero-sum.

You can't just track "money," if you're going to do this properly. That's why double-entry bookkeeping and similar things exist. Assets and liabilities need to be tracked separately.

Actor 1 doesn't give money to actor 2, she lends it. Which means she has less cash-on-hand, but has an IOU which is still freely usable as money. So she's got exactly as much money as she had before. Actor 2 has more cash-on-hand, but he's also got the IOU to pay off.

When you're calculating the money supply, the IOU counts as money for the holder/lender, not for the borrower (because the lender can trade it for value to someone else, but the borrower can't). So the effect is that there's just as much base money in circulation, but more "money supply."

Nobbit

15th September 2010, 09:25 AM

New money is not created from nothing; it's created from old (deposited) money that's re-loaned.
I think that's a strange and misleading way to describe money creation. While it's true that in order to advance a loan, a bank must have some money (capital) to begin with, I don't see how that means that new money is created from old. To say so implies that there is some kind of relation between one and the other. What kind of relation do you have in mind?

drkitten

15th September 2010, 09:28 AM

I think that's a strange and misleading way to describe money creation. While it's true that in order to advance a loan, a bank must have some money (capital) to begin with, I don't see how that means that new money is created from old. To say so implies that there is some kind of relation between one and the other.

That is exactly the case. That's the function of reserves.

You can't lend out more than some fraction of your capital (or to put it another way, you must always have some fraction of your capital in reserve to meet legal requirements which ostensibly are set to limit risk to depositors).

If you have no capital -- or if you don't have enough capital -- you need to raise more capital in order to create more loans.

Nobbit

15th September 2010, 10:26 AM

If you have no capital -- or if you don't have enough capital -- you need to raise more capital in order to create more loans.
As I see it, the only relation between the old money and the new is a relation between the quantities of each (which are constrained by reserve requirements and capital requirements). I'm just saying that "new money is created from old" strikes me as an odd way to describe that relationship.

lomiller

15th September 2010, 11:31 AM

As I see it, the only relation between the old money and the new is a relation between the quantities of each (which are constrained by reserve requirements and capital requirements). I'm just saying that "new money is created from old" strikes me as an odd way to describe that relationship.

I look at it as a multiplier. If banks keep a 10% reserve the process of loaning out and depositing money effectively multiplies the base money supply by ~10X .

Say you start off with $10 million and loan out 90%. The money you loan out doesn’t stay buried in their back yard it gets re deposited, so you still have $10million in reserves but owe $9 million to depositors. Since you still have sufficient reserves you can lend out $8.1 million which again gets deposited keeping your reserve at $10 million.

This can go on until you have the original $10 million and owe $100 million to depositors and can't lend out any more due to reserve requirments. The money creation comes in because the deposits behave very much like cash. So your $10 million is original money has become $100 million in deposits that people are using like cash.

Nobbit

15th September 2010, 11:52 AM

tensordyne

15th September 2010, 07:26 PM

From "Modern Money Mechanics"

"If business is active, the banks with excess reserves probably will have opportunities to loan the $9,000. Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) both rise by $9,000. Reserves are unchanged by the loan transactions. But the deposit credits constitute new additions to the total deposits of the banking system."

The $9,000 in the above quote comes from an earlier part of the document where $10,000 was obtained as part of the purchase of a treasury bond. The $9,000 is 90% of the $10,000 as per the reserve requirement of 9:1.

The italicization and emboldening of the text are due to me to point out particularly relevant sections.

Finally, I note that so far no one on this thread has provided any kind of referrences to show that their arguments are true. I am not making any claims myself (except perhaps claims on what others are claiming/saying), but it seems to me that self-evident arguments should not apply to how FRB and our current money system (Central Banks + FRB and so on) work. Unless you are a banker yourself who is intimately aware of how the system works and can show that by some means, claims made without the benifit of referrences (the posts so far), do not to me constitute any kind of real argument. They are just oppinion -- possibly uninformed oppinion at that.

If the above quote is true, then the main thing needed to complete the picture - at least for myself - is to know what happens, in as exact a manner as possible, when the loan is payed back. The above quote seems clear enough to me as to what is going on when the loan is created if the source is true.

All the best to everyone!

tensordyne

16th September 2010, 05:11 AM

Bit of math for anyone who might care. Reserve requirements are usually stated in a manner like 9:1, 20:1 and so on. Really this is just a way to say a number between 0 and 1 with the number having to be greater then 0. If the ratio is expressed as Y:X with X and Y usually integer, then the percentage an FRB bank can lend up to is

r = Y / (X + Y).

So you start with some ammount of money G. Then the bank loans into existence up to an ammount rG. From that ammount a new bank can loan up to r^2 G of that and so on. In practice these banks are not fully loaned out but for the sake of argument if all the banks loaned out as much as they could and the reserve requirement staid the same, the ammount of new money that would be created would be

G + r G + r^2 G + ... infinity = G (1 + r + r^2 + ...) = G / (1 - r) = GM

where M is the money multiplier. For 9:1 you get M = 10. That is the reason for the previous statements about ~10 from lomiller. Clearly the closer r is to 1 the higher the value that M will be. Since banks also loan at interest, if the interest is i (number between 0 and 1 but should be closer to 0), if each bank in this example charged i percent the total that would be owed back to all of these banks would be

(1 + i)G + (1 + i) rG + ... = (1 + i) GM.

Since (1 + i)GM > GM for any i > 0, it is clear that banks are always owed more money contractually then they create, thus setting up a situation where the only way to pay off the banks at least temporarily is to get more loans, which causes...

That is, if what I have read is true.

Nobbit

16th September 2010, 05:34 AM

Finally, I note that so far no one on this thread has provided any kind of referrences to show that their arguments are true.
If you are looking for references that explain how banks create (and destroy) money, a decent textbook on economics may be the best place to look. David Begg's "Economics" has a chapter on money and banking. If I remember correctly, it's pretty comprehensive.

The best online resource I've found that discusses money and banking is here:

wfhummel.cnchost.com

For a lightweight but entertaining summary of money matters, see here:

straightdope.com/columns/read/719/how-much-money-is-there

Nobbit

16th September 2010, 05:44 AM

Since (1 + i)GM > GM for any i > 0, it is clear that banks are always owed more money contractually then they create, thus setting up a situation where the only way to pay off the banks at least temporarily is to get more loans, which causes...
That situation (and why it's not as bad as it sounds) is explained here:

wfhummel.cnchost.com/timebomb.html

ETA: I can post links now!

Nobbit

16th September 2010, 07:03 AM

What's worth bearing in mind is that the reserve requirement is not a predictor of the ratio of aggregate reserves to aggregrate deposits (across the entire banking system).
I wasn't thinking (or explaining) straight here. What I meant was that the reserve requirement is not a predictor of eventual aggregrate deposits given a starting amount of base money B (bank reserves).

The reason it's not is that between starting out with a bunch of base money B, letting the "money multiplier" do its thing, and ending up with a money supply M, the amount of base money in existence will have changed. The money supply M ultimately depends on consumer demand and the banks' lending capacity. The fact that bank reserves generally tend towards the minimum reserve requirement is just a reflection of the banks' distaste for excess reserves: reserves earn no interest, so excess reserves are exchanged for other assets.

tensordyne

16th September 2010, 07:31 AM

That article had an interesting sentence: "Interest payments on the increasing debt to banks is therefore draining the money supply, and will eventually drive the economy into the ditch."

How do interest payments to banks drain the money supply? If the only way to pay off debt is to get a loan (down the line and in the aggregate as it were to cover previous debts based on interest), then as long as banks continue to create loans and spend money there would be an ever increasing and not decreasing supply of money. That is how debt based money works, no?

Plus, I do not buy his argument that ever increasing debt can not cause problems. The US is now so far up in hock to its creditors who knows what will happen. Anyways, the article makes it sound as if the amount of money created is some nicely linear curve; it is not, the curve is exponential. Exponential curves have a funny way of coming up quick on you and biting one in the ass.

Finally, lets say that banks through FRB really do set up some quasi-stable economic system. That would be OK (in a perverse sense), except banks (so far as I can tell) get to keep the principal on the loans they make. If it is also true that banks credit borrowers accounts in exchange for IOU's without debiting the total money they have control over (the article seems to say the same) and if banks do get to keep the principal on a loan, then it is a scam. If I counterfeit $10 and loan it to you at interest you would say I was a crook. On the other hand, banks do mathematically the same trick (subject to some accounting rules such as reserve requirements and so on) all the time. Banks therefore would be stealing the wealth from society in the same way as loaning counterfeiters would, it is just called banking instead. No argument on the supposed stability of FRB banking would change that either. At most it would just let the stealing continue on indefintely. And yes I do think there is a big difference between moral and legal. Very immoral practices in the past have been perfectly legal, such as slavery.

Note, I base this on the supposition - that may be wrong - that banks create money from nothing during a loan, get to charge interest on it, as well as get the interest and principal back as repayment of the "loan". I am not yet confident enough to claim this is definitely true, but the sources I have read indicate this is the case. I base this on the wikipedia entry on FRB as well as "Modern Money Mechanics". I am definitely open to other sources.

Thanks for the link to the site. I will go over it with a fine-toothed comb. Happy for you that you can link. This forum definitely makes people not welcome at first by disallowing you such simple things as linking, creating an avatar and so on.

drkitten

16th September 2010, 07:36 AM

Nobbit

16th September 2010, 07:51 AM

Note, I base this on the supposition - that may be wrong - that banks create money from nothing during a loan, get to charge interest on it, as well as get the interest and principal back as repayment of the "loan".
This is not completely accurate. Interest payments on loans are pure income for the bank (an asset with no corresponding liability). Principal payments are not income: they decrease the value of the loan asset, but leave the bank no better or worse off.

ETA: See http://wfhummel.cnchost.com/bankingbasics.html

lomiller

16th September 2010, 09:16 AM

What's worth bearing in mind is that the reserve requirement is not a predictor of the ratio of aggregate reserves to aggregrate deposits (across the entire banking system). It sets a lower limit only. What ultimately constrains a bank's lending capacity is not the reserve requirement, but the capital requirement.

I wasn't thinking (or explaining) straight here. What I meant was that the reserve requirement is not a predictor of eventual aggregrate deposits given a starting amount of base money B (bank reserves).

The reason it's not is that between starting out with a bunch of base money B, letting the "money multiplier" do its thing, and ending up with a money supply M, the amount of base money in existence will have changed. The money supply M ultimately depends on consumer demand and the banks' lending capacity. The fact that bank reserves generally tend towards the minimum reserve requirement is just a reflection of the banks' distaste for excess reserves: reserves earn no interest, so excess reserves are exchanged for other assets.

Yes, reserve requirement is a limit only, not the final determining factor. This is why I said approximately in my previous post, not the reason tensordyne gave. Another part of the equation you didn’t touch on is that the Fed is also responding in part to consumer demand when it creates base money.

I don’t think you are seeing the more extreme version of the arguments tensordyne is making, but it wouldn’t surprise me if they come up sooner or later. Generally they present banks and FRB as one big evil scam that ultimately doom the economy. This typically involves a lot of conflation between base money and how it’s created and how bank deposits act as forms of money in their own right. In some forms they have they banks outright printing their own money. The article in your OP seems to be trying to target this type of argument by drawing a cleaner distinction between how base money comes to be and what happens within the fractional reserve system.

Nobbit

16th September 2010, 10:30 AM

I don’t think you are seeing the more extreme version of the arguments tensordyne is making, but it wouldn’t surprise me if they come up sooner or later. Generally they present banks and FRB as one big evil scam that ultimately doom the economy.
I think I know what you're referring to. If you google "how banks create money", most of the results come from websites that present banks and FRB as you describe: a big scam or conspiracy theory. Which is a shame, because that kind of presentation puts most people off, and leads people to dismiss the content - which is fundamentally correct, but exaggerated and sensationalised - as the unreliable rantings of a madman.

lomiller

16th September 2010, 11:03 AM

These people may be more prevalent then you think. A fairly high percentage of Ron Paul supporters tend to subscribe to these ideas and I would not be surprised to see Rand Paul get the tea party to move in that direction as well.

tensordyne

16th September 2010, 07:05 PM

:boxedin: I've done you the favor of pointing out where your own sources answer your question.

Which question, I have asked many questions in the thread so far.

Loans (assets) and deposits (liabilities) both fall by $9,000, since you need to deposit money into the bank to pay off the promissory note.

I do not follow how the quote just above works. Maybe you can make some equations with a story to make this clear.

Here is my own story with equations. Now I would suppose banks have accounting entries that correspond to a checking account with themselves (it does not earn interest however). Lets call P the checking and savings accounts values and so on that are liabilities to the bank due to deposits. Call B the account the bank has with itself that corresponds to the bank's profits.

Now, I do not want to make any moral arguments about FRB until a clear picture in how the loan process works in it is assured. I am not sure how your logic works in the above last quote I must admit. Let me share with you my current understanding of FRB. I will take a few simplifying assumptions that I hope still capture the essential characteristics of the loan process.

Simplifying assumptions.

a. There is only one loan that the bank makes for the duration of the story.

b. The interest rates for the loan to the bank P and the interest the bank gets for making the loan are constant over time.

c. Everyone else except the bank of the Mr. Public hold off making loans. This assumption is made so that one of the variables (U) will not change over time.

d. Transfers of money only occur to satisfy contractual demands of the loan. This is to capture profits or losses accrued over time for all parties.

So the story goes like so. The Bancor bank makes a loan to J. Q. Public that has a checking account with Bancor valued at P initially. The loan amount is L. Now I have to include one more actor: everyone else except the Bancor bank and Mr. Public that I will call the universe. Lets say that the money everyone else has initially is U.

That being the case, the total amount of money in existence when the story starts is U + P + B. Mr. Public wants a loan for L. Bancor checks if it can make the loan according to its reserve requirements and if it wants to. Without getting into the specifics of how the bank decides if it wants to and can make the loan for the purposes of the story Bancor makes the loan because otherwise there is no story to tell about loans.

Let the interest rate for P be iP and for the loan L be iL. I hope we can all agree that iP < iL on real loans. The interest compounds in steps for P. To give the FRB based system - as I understand it - the best possible benifit of the doubt, let's let the loan be based on simple interest. To keep things short, let there be two payment steps. U(1) is the amount of money everyone else except Bancor and Mr. Public has at Bancor. P(2) is the amount of money in Mr. P's account at Bancor at step 2. I hope you get the picture. Let T(k) be the total money at step k which is the money parts of
P(k), B(k) and U(k) summed together.

Step 0. P(0) = P, U(0) = U, B(0) = B, T(0) = U + P + B.

Step 1. The loan is made. Mr. P signs the IOU and the bank puts L into Mr. P's account after which Mr. P buys something with it from the universe of other actors. To capture the fact that Mr. P gets something from the deal let [car] represent the non-monetary aspect of Mr. P's gain. [work] is the work Mr. P does to get the loan repaid. If you have a problem with me mixing apples and oranges and so on then just think of each of each of these terms as a vector with a money and non-money component. Now in terms of agreements, [work] = [car], as Mr. Public agrees that the work he would need to do to get the car is the same as the work that the car makers have to do to make the car (in non-monetary terms, the monetary terms are covered by the other variables). I do not include the work the bank does because in most loans the person getting the loan does a lot more work then the bank does in keeping track of the loan, but it does exist.

P(1) = P + [car], U(1) = U + L, B(1) = B, T(1) = U + L + P + B

Step 2. Interest first starts coming into effect. Mr. P does half the work he needs to pay for the car. The universe pays him (L/2)(1 + iL) for him to pay off the simple interest loan. Mr. Public then pays the Bancor bank this amount. Mr P. earns some interest as well.

P(2) = P(1 + iP) + [car] - [work]/2,
U(2) = U + L - (L/2)(1 + iL),
B(2) = B + (L/2)(1 + iL)
T(2) = P(1 + iP) + U + L + B

Step 3. Mr. Public earns some more interest and does [work]/2 again. As [work] = [car], this cancels out the work components for Mr. P. The universe pays Mr. P (L/2)(1 + iL) again with Mr. P then giving it to Bancor to pay off the loan.

P(3) = P(1 + iP)^2
U(3) = U + L - (L/2)(1 + iL) - (L/2)(1 + iL) = U - iL * L
B(3) = B + (L/2)(1 + iL) + (L/2)(1 + iL) = B + L(1 + iL)
T(3) = P(1 + iP)^2 + U + B

Disagree? Fine by me. I am not yet claiming that this model captures the main aspects of FRB yet, but it is my current understanding. Please keep in mind this is a model. Models are meant to be simpler then reality and yet capture some essential aspect of how reality works.

tensordyne

16th September 2010, 07:16 PM

errata. T(3) = P(1 + iP)^2 + U + B + L

Nobbit

17th September 2010, 06:40 AM

B(2) = B + (L/2)(1 + iL)
If that's supposed to represent the amount of money in the Bancor bank after Mr P has paid off (L/2)(1 + iL) of his loan, then I think it's a mistake.

That loan repayment should be split into an interest portion (q, say) and a principal portion (p, say). The interest portion (q) is income for the bank, but the principal portion (p) is effectively destroyed, so it should be:

B(2) = B + q

drkitten

17th September 2010, 07:33 AM

I do not follow how the quote just above works. Maybe you can make some equations with a story to make this clear.

Here is my own story with equations.

Step 0. P(0) = P, U(0) = U, B(0) = B, T(0) = U + P + B.

Step 1. The loan is made. Mr. P signs the IOU and the bank puts L into Mr. P's account after which Mr. P buys something with it from the universe of other actors.

P(1) = P + [car], U(1) = U + L, B(1) = B, T(1) = U + L + P + B

Not quite.

The Bank at this point actually has less money by L, but it also has a promissory note with a face value of L+iL. So, superficially, B(1) = B - L + (L+iL).

This is superficial because, while the promissory note has a value, it's not worth it's face value. This is for two reasons -- one, Mr. P might not pay off the note (he might declare bankruptcy, die, or simply skip town), and two, money now is always more valuable than money later. So the note actually has a value of V, where L <= V <= L+iL.

So more accurately, the value of the bank at time 1 is B - L + V.

But depending on how you do the accounting, the money the bank has can be treated as any combination of the factors. The amount of money the bank has available for loans is B - L. The amount of base money the bank has is B. The bank's assets are B + V (with L being in a different, liability, column).

Step 2. Interest first starts coming into effect. Mr. P does half the work he needs to pay for the car. The universe pays him (L/2)(1 + iL) for him to pay off the simple interest loan. Mr. Public then pays the Bancor bank this amount. Mr P. earns some interest as well.

P(2) = P(1 + iP) + [car] - [work]/2,
U(2) = U + L - (L/2)(1 + iL),
B(2) = B + (L/2)(1 + iL)
T(2) = P(1 + iP) + U + L + B

No. If Mr. P pays back half of the loan (and half of the interest), then the bank has more cash on hand, but the value the promissory note is also halved [slight simplification].

The value of the bank is therefore B - L + V +[L+iL]/2 - V/2

More cash on hand, less value in promissory notes.

And similarly at stage 3, B(3) = B - L + V + [L+iL] - V.

After cancelling everything, we get B(3) = B + iL.

The bank made the interest on the loan; the loan repayment added cash that offset the decrease in value of the IOU.

drkitten

17th September 2010, 07:35 AM

If that's supposed to represent the amount of money in the Bancor bank after Mr P has paid off (L/2)(1 + iL) of his loan, then I think it's a mistake.

That loan repayment should be split into an interest portion (q, say) and a principal portion (p, say). The interest portion (q) is income for the bank, but the principal portion (p) is effectively destroyed, so it should be:

B(2) = B + q

I think trying to account for front-loaded interest is probably an oversimplification. Assume that Mr. P pays off half the principal and half the interest.

That's where the (L/2)(1+iL) comes in. That's probably more clearly written as (L + iL)/2 or as L/2 + iL/2.

Half the principal, half the interest.

drkitten

17th September 2010, 09:19 AM

Not quite.

The Bank at this point actually has less money by L, but it also has a promissory note with a face value of L+iL. So, superficially, B(1) = B - L + (L+iL).

Ooops. It appears I made a mistake in understanding tensor's symbolism. I was interpreting 'i' as the interest rate and 'L' as the loan balance, hence "iL" == i*L == the amount of interest due in nominal dollars.

It appears that he's using "iL" to represent the interest rate. So wherever I have iL, that should be (iL)(L).

tensordyne

17th September 2010, 09:21 AM

:boxedin: Nobbit, do you have any evidence for your last post (I am asking this in the most sincere of ways. Please believe me)?

As I have said before, I am only somewhat sure of the story I gave up to a point. That point is up to step 1 if you are interested. My evidence is from the publication "Modern Money Mechanics", a publication of the Federal Reserve. Please carefully read the quote below if you do not believe me.

"If business is active, the banks with excess reserves probably will have opportunities to loan the $9,000. Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) both rise by $9,000. Reserves are unchanged by the loan transactions. But the deposit credits constitute new additions to the total deposits of the banking system."

Challenge to Nobbit, drkitten, lomiller or anyone else: recreate my story with the steps but using whatever you think happens. I must say though that I like that you guys used equations (Equations, like words, can lie; it is just that equations lie in a more concise and succinct manner). I ask this to honestly be able to follow the logic (of Nobbit and drkitten especially). Sorry if I am dense on this, but I just still do not see exactly what rules are being followed by anyone on this post. Are the rules in the story I gave clear at least?

On the story if you wanna do it: I understand if you would want to change the simplifying assumptions, but I would hope you do not make them more complicated then necessary and I really hope you keep the simplifying assumption that the only transfers considered are those needed to fulfill the contract of the loan and nothing else. I say this because I am interested in earnings and losses accrued by each respective party over the life of the loan.

Which gets me to a little realization all my own. For some reason I always had a problem with how FRB is usually covered. It was something about the whole liabilities versus assets thing. It seemed like it was not telling the whole story. So last night after writing my version of the loan process (the story) I figured out what I thought was missing: an explaination of earning and losses for all actors over the life of the loan.

Quick question to all on the thread, do you agree with the story up to step 1? drkitten, it seems, does not. Here is my breakdown of the thread where he indicates diagreement up to the first step. Sorry if you wanted me to do the rest, but if we are not in agreement about the first step, the rest of the steps will not matter in a sense. Here it is.

Not quite.

The Bank at this point actually has less money by L, but it also has a promissory note with a face value of L+iL. So, superficially, B(1) = B - L + (L+iL).

I think the quote from my referrence from the Fed does not concur with this picture. It is possible, surely, that I have misinterpreted that quote, but as the quote says that: "Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts." I think I will make that my signature.

The point is that the equations in this post by drkitten pay out the loan from the reserves the bank has (or more correctly the earnings account the bank has which is different from the total reserves which is B + P), in direct contradiction to the above statement (By the Fed!). The only other possibility that I can think of that could make drkitten's statements correct is if "Modern Money Mechanics" was written by some tinfoil hat wearing conspiracy nut in a basement somewhere. This seems unlikely to me as it is filled with all sorts of arcane and obstruse information with a decidedly neutral to positive stance when it comes to the Fed. So my question is, do you have any evidence of your assertions up to step 1 drkitten?

Just one thing about the next part, the V is weird. Why should I care about the value of the promissary note when we are talking about the earnings and losses accrued to the bank? The promisary note is not money (although it is often exchanged for money). The note is merely an instrument to secure future earnings and nothing more. Banks do not pay their staff with loan promissary notes after all. Perhaps I should just follow my own advice on concentrate on things just up to step 1 and not stir up more hornets nests then necessary.

Lastly, while I have not been able to find any authoritative referrences to provide evidence that the last steps match reality, I think it would be odd if the bank, through some accounting mechanism perhaps, decided not to take the whole value of a check given to it -- don't you? I think we have made progress though. After reading the posts after my story post I am a little more clear about how Nobbit and drkitten are thinking about things, which is good. So perhaps for now if you care to continue the discussion with me about this we should maybe concentrate debate about things up to step 1.

All the best to everyone.

drkitten

17th September 2010, 09:40 AM

I think the quote from my referrence from the Fed does not concur with this picture. It is possible, surely, that I have misinterpreted that quote, but as the quote says that: "Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts." I think I will make that my signature.

Um, what do you think happens to the credits to the borrower's transactions accounts?

The borrower more or less immediately withdraws the money and does something with it.

You need to distinguish between "the bank's money" and "the money that the bank is custodian of."

In this situation, the bank owns (i.e. has cash assets of) B = B(0) and Mr. P makes his initial cash deposit of P = P(0) into the bank.

The bank now carries B+P in cash reserves on its books, but also carries a depository liability of -P on its books, so it's net assets are still B. It owns B, but is custodian for B + P.

Mr. P applies for a loan and gets it. The bank gives him L dollars, which are put into another account associated with Mr. P. The bank now has B + P dollars in cash reserves (no cash has yet changed hands), B + P + L dollars in deposits, P + L dollars in depository liabilities, and V dollars in promissory notes.

Mr. P withdraws the money in cash and buys a car with it. (Presumably the car dealer will re-deposit the cash soon, but we're not tracking that part of the transaction.) The bank no longer has the cash because it physically left the bank with Mr. P. The bank now no longer has L dollars in cash, but it also no longer has L dollars in depository liabilities for that cash.

The Bank now has B + P - L dollars in gross cash assets, B + P + L - L dollars (or B + P dollars, simplified) in deposits, and P + L - L (or P) dollars in liabilities.

Net cash assets (gross assets - liabilities) are B - L because the P's cancel. But, of course, they've got the cash-denominated asset of the promissory note, so the banks' total assets are B - L + V.

Does that make more sense?

Just one thing about the next part, the V is weird. Why should I care about the value of the promissary note when we are talking about the earnings and losses accrued to the bank?

Because it's a cash-valued asset of the bank. And tracking the loan value shows exactly how money is "created" (the money supply is increased by the loan value, temporarily) and "destroyed" (when the loan is repaid, its value drops to zero).

Nobbit

17th September 2010, 10:21 AM

:boxedin: Nobbit, do you have any evidence for your last post (I am asking this in the most sincere of ways. Please believe me)?
If you're referring to how interest payments and principal repayments affect a bank's balance sheet, I can point you at the following online reference:

http://wfhummel.cnchost.com/bankingbasics.html

First, that an interest payment increases a bank's capital (its own money):
If the borrower pays interest from an outside source, A [assets] and R [reserves] increase while L [liabilities] remains unchanged.
In this case, A - L (the bank's capital) increases by the value of the interest payment.

Second, that a principal payment leaves the bank's capital unaffected:
If the borrower repays the loan from an outside source, R [reserves] increases while A [assets] and L [liabilities] remain unchanged.
In this case, A - L (the bank's capital) remains the same. However, since the principal repayment is removed from circulation (by being paid in to the bank), the total money supply is reduced by the amount of that principal repayment (i.e. the money is destroyed).

drkitten

17th September 2010, 10:45 AM

Lastly, while I have not been able to find any authoritative referrences to provide evidence that the last steps match reality, I think it would be odd if the bank, through some accounting mechanism perhaps, decided not to take the whole value of a check given to it -- don't you?

How would this be done?

Remember that the money lent out is (largely) the depositors' money.

Imagine a bank with a million dollars in owner's capital, and I put a million dollars in deposits into the bank.

The bank then lends some third party one and a half million dollars. At this point, if I ask to withdraw my money, the bank is in serious trouble; it technically has the money (in assets) but only as the form of a promissory note, and I want cash. In this case, the bank either would have to close, or borrow from the Fed against the promissory note (which is one reason the Fed exists in the first place).

But let's assume that I don't need the money yet. The third party repays the money in full, plus interest. (For simplicity, $100,000 in interest.) And now I want to withdraw my money.

Can I do it?

If the bank "kept" the principle and interest, then the bank's money is now $2,600,000 in a bank with assets of only $2,100,000. Somehow, the million I deposited has turned into a $500,000 loss; I would need to deposit another $500,000 just in order to keep the bank solvent.

In other words, I've had the entire loan value stolen from me.

But this doesn't happen. That's because the $1,500,000 the bank lent out wasn't from the owner's capital, but from the bank's working capital as a whole, some of which belongs to the owner and some of which belongs to the depositors. And so the money is returned to the working capital, not specifically to the owner.

What really happens is that the bank (the owner's capital) earns all the interest on the loans -- the owner's capital just went from $1,000,000 to $1,100,000. The deposit amount, of course, stays at $1,000,000. But the bank (the owner's capital) also pays all the expenses of the bank (everything from tellers' salaries to renting a building) and also eats any losses incurred through bad loans. So if the third party had declared bankruptcy and paid back only $1,000,000, the effect would be that the owners had lost $500,000.

If the third party had declared bankruptcy and paid back nothing at all, the owners would have incurred a paper loss of more than they put up. In this case, they'd either have to pony up more from private funds, or else the Fed would step in, close the bank, and pay me off up to the limits of the FDIC insurance.

tensordyne

17th September 2010, 09:51 PM

:boxedin:Um, what do you think happens to the credits to the borrower's transactions accounts?

As I have already answered that in the story I gave I do not think it is necessary to answer it again.

The borrower more or less immediately withdraws the money and does something with it.

That misses the point. The money of the loan is credited to the "borrowers" account. I say borrower in quotes because if I borrow $10 from you then you are out $10 and I have $10 for the moment. Not so with FRB. My evidence? Again, the quote I gave, that is in my signature now and I will even go so far as to provide multiple internet links to if desired. Let me break my quote down into parts and tell you how I interpret it. Bold is the quote, intalics is my interpretation.

1, Of course, they do not really pay out loans from the money they receive as deposits. That is odd, then where do they create it from?The banks total deposits in my story is B + P. There are two deposits, the banks deposits with itself (or local fed bank), and its customers deposits.

2. If they did this, no additional money would be created. Fair enough.

3. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Ah, here is the most important statement. The bank takes an IOU and in exchange adds a number (the loan amount) to the borrower's transaction account.

You need to distinguish between "the bank's money" and "the money that the bank is custodian of."

I did make the difference. Bank's own money to do what it wants (initially) is B. Money bank is custodian of initially after deposit by Mr. Public of P is
B + P. I could go into reserve requirements and so on but I have a feeling that drkitten would agree with the above. My evidence in this case is the wikipedia entry on the topic of FRB. drkitten I have yet to see any evidence provided by you for any of your claims however. Please give referrences or other evidence if you can. I mean, this is a skeptic's forum after all. Why should anyone just believe what anyone else says?

Nobbit has provided evidence but unfortunately I do not think it is authoritative. It is a website by a guy who looks pretty smart to me (at the very least he could probably do circles around me in circuit analysis) but the referrence is not from the ABA (American Banker's Association) or the Fed or something of that order. Nobbit's ref's are from a guy who writes essays explaining how he thinks things work. Since the guy does not give much in ref's himself, I can only conclude that the essays are his oppinion. I am not interested in oppinions. (I wonder, does Nobbit == Mr. Hummel B.S., M.S. the guy running the site Nobbit refers to? That would be kind of funny.)

In this situation, the bank owns (i.e. has cash assets of) B = B(0) and Mr. P makes his initial cash deposit of P = P(0) into the bank.

Sounds right.

The bank now carries B+P in cash reserves on its books, but also carries a depository liability of -P on its books, so it's net assets are still B. It owns B, but is custodian for B + P.

Trackin'

Mr. P applies for a loan and gets it. The bank gives him L dollars, which are put into another account associated with Mr. P. The bank now has B + P dollars in cash reserves (no cash has yet changed hands), B + P + L dollars in deposits, P + L dollars in depository liabilities, and V dollars in promissory notes.

whoa, whoa, slow down. The bank has B + P in cash reserves? When bankers say cash reserves they literally mean coins and dollar bills held in the vault so far as I have ever seen. If you need evidence of this assertion I am sure I can provide it for you (I hope I am not wrong!!!). Anyhow, "cash reserves" does not square with what was said above because if Mr. P provided his money to the bank to deposit using a check there will be nothing added to the cash reserves in that sense and yet the check is still a deposit.

Lets put that aside though for the moment. Lets say you meant total deposits when you said cash reserves. I agree that after the loan is made and before Mr. P has used it to buy his car then the bank is "custodian" of
B + P + L. I agree the bank has promissory notes valued at V.

Now how does the bank have P + L in liabilities? There are two loans in the story. The loan of Mr. P to the bank -- which is P, and the "loan" the bank makes to Mr. P for L. If the bank is loaning L to Mr. P, how is it their liability? Because that is how FRB works, right? Every loan is double-entry booked and so on. Still, the ultimate goal is to figure out earnings and losses so lets go on.

I guess what I am saying is, I understand where the P comes in from P + L, but how is L really the bank's liability? For it to be a liability the bank has to owe someone it. Who does the bank owe L to in your story? I think itself?

Mr. P withdraws the money in cash and buys a car with it. (Presumably the car dealer will re-deposit the cash soon, but we're not tracking that part of the transaction.) The bank no longer has the cash because it physically left the bank with Mr. P. The bank now no longer has L dollars in cash, but it also no longer has L dollars in depository liabilities for that cash.

The Bank now has B + P - L dollars in gross cash assets, B + P + L - L dollars (or B + P dollars, simplified) in deposits, and P + L - L (or P) dollars in liabilities.

Net cash assets (gross assets - liabilities) are B - L because the P's cancel. But, of course, they've got the cash-denominated asset of the promissory note, so the banks' total assets are B - L + V.

Does that make more sense?

Indeed, it does make more sense to me what rules you are using and how they work as per the story.

Because it's a cash-valued asset of the bank. And tracking the loan value shows exactly how money is "created" (the money supply is increased by the loan value, temporarily) and "destroyed" (when the loan is repaid, its value drops to zero).

A couple points.

1. It is correct I used iL as one variable (like in programming languages). Sorry for the confusion.

2. In the story drkitten gave I did not see earnings and losses to the three actors Bancor Bank, Mr. John Q. Public and the universe, which is really too bad. I can modify my original story to include the actors in a simple way and also include the idea that the amount of loan money created by a bank is also destroyed. Skip to step 3. and for B(3) and T(3) subtract L.

P(3) = P(1 + iP)^2
U(3) = U + L - (L/2)(1 + iL) - (L/2)(1 + iL) = U - iL * L
B(3) = B + (L/2)(1 + iL) + (L/2)(1 + iL) - L = B + iL * L
T(3) = P(1 + iP)^2 + U + B

Or is this correct? Next post I will redo the whole story with the assumption that banks both create and destroy the principal of the loan and see what happens over time.

3. I think drkitten changed the formulas between the post I am responding to here and the post that was given in #26 - which is fine by me, but I do think it is important to mention. I think it shows possibly a change of mind about banks creating money from nothing??

4. It probably does make more sense that banks both create and destroy the principal of the loan. I mean, our current system in the US (this probably applies to many other countries as well) is already inflationary enough (dollar has lost 90+ percent value since the Fed started), it would be downright super hyper-inflationary if banks got to keep the principal on a loan as well as the interest on a loan.

5. I did entertain in the past that banks don't get to keep the principal (sorry that I can't prove it since it was in my own thoughts). The only problem is I have not seen any definitive sources able to show this for certain by showing who earns what over time, which is the real question I have always had about FRB.

6. Even if banks create and destroy the principal on the loan, there are plenty of other criticisms that can be pointed out about the Fed, Central Banking, FRB and so on. Maybe that is for another time though.

7. drkitten, I think it might be a good idea not to say cash when you mean money. I know its a free internet and all but cash is coins and physical notes so far as I have seen. May I suggest saying deposits, credits or money as terms instead.

8. Thanks to drkitten for taking the challenge to write a story.

all the best to everyone.

Nobbit

18th September 2010, 05:28 AM

(I wonder, does Nobbit == Mr. Hummel B.S., M.S. the guy running the site Nobbit refers to? That would be kind of funny.)
No, I'm not Mr Hummel. Now, I know you only have my word on that, but it's true. :D

I still think you should be consulting a decent economics textbook if you want a more "authoritative" source.

whoa, whoa, slow down. The bank has B + P in cash reserves? When bankers say cash reserves they literally mean coins and dollar bills held in the vault so far as I have ever seen. If you need evidence of this assertion I am sure I can provide it for you (I hope I am not wrong!!!). Anyhow, "cash reserves" does not square with what was said above because if Mr. P provided his money to the bank to deposit using a check there will be nothing added to the cash reserves in that sense and yet the check is still a deposit.
Perhaps drkitten just meant reserves when he said "cash reserves", in which case he's right. Depositing a cheque for $P in a bank would increase that bank's reserves by P dollars.

I guess what I am saying is, I understand where the P comes in from P + L, but how is L really the bank's liability? For it to be a liability the bank has to owe someone it.
When the bank lends L to Mr P, it credits Mr P's account with that amount. That amount is a liability of the bank, because the bank owes it to Mr P. Or, to put it another way, Mr P has a claim on that amount from the bank.

tensordyne

20th September 2010, 05:44 AM

:boxedin: No, I'm not Mr Hummel. Now, I know you only have my word on that, but it's true. :D

Yeah, I did not really figure you were, although

I still think you should be consulting a decent economics textbook if you want a more "authoritative" source.

So I consulted my one Econ Textbook I have and it did not cover Banking at all from what I could tell. The book covered Microeconomic "Theory", so maybe I would have to get a Macroecon book if I want to see what the Neoliberal Economists have to say about Fractional Reserve Banking.

Perhaps drkitten just meant reserves when he said "cash reserves", in which case he's right. Depositing a cheque for $P in a bank would increase that bank's reserves by P dollars.

I think he did indeed. If I remember right I read somewhere that banks have an accounting entry called "coin" that covers fed reserve notes as well as pennies, nickles, dimes and quarters.

When the bank lends L to Mr P, it credits Mr P's account with that amount. That amount is a liability of the bank, because the bank owes it to Mr P. Or, to put it another way, Mr P has a claim on that amount from the bank.

Can you tell me what you think crediting his account means to you? Does it mean the amount comes from nowhere (some other number is not subtracted from when adding to Mr. P's account) or whatever happens.

The logic in the last part of the quote does not make sense to me. You have the bank crediting his account (adding money into it) and then the bank still owing it to him? This leads me to think that maybe Nobbit's version of crediting is different then mine...

So I wrote an email to an ABA member with some pointed questions on how loans work with the quote I keep referrencing. If he/she responds I will reproduce it here for everyones consumption.

all the best to everyone.

drkitten

20th September 2010, 05:59 AM

I think he did indeed.

Actually, I believe I specified that Mr. P made his deposit in cash. Similarly, I specified that he withdrew the loan proceeds in cash as well. For the same reason in both cases -- then I don't need to track the process by which checks turn into money.

Can you tell me what you think crediting his account means to you? Does it mean the amount comes from nowhere (some other number is not subtracted from when adding to Mr. P's account) or whatever happens.

It means that the amount in his account is higher than it used to be.

The logic in the last part of the quote does not make sense to me. You have the bank crediting his account (adding money into it) and then the bank still owing it to him?

The bank "owes" you all the money in your account. That's simply accountant-speak for saying that it's your money and that they have to give it to you if you ask for it.

Which is to say, the bank has a liability corresponding to the amount you have on deposit.

Nobbit

20th September 2010, 07:24 AM

I think he did indeed. If I remember right I read somewhere that banks have an accounting entry called "coin" that covers fed reserve notes as well as pennies, nickles, dimes and quarters.
Every commercial bank has an account at the central bank; that account and any currency the bank holds form the bank's reserves. Currency reserves obviously go up and down as people deposit and withdraw currency; the account at the central bank goes up and down as people deposit and draw cheques.

Can you tell me what you think crediting his account means to you? Does it mean the amount comes from nowhere (some other number is not subtracted from when adding to Mr. P's account) or whatever happens.
Crediting the account just means the balance of the account is increased. The money doesn't "come from" anywhere; the bank does not decrease its liability to anyone else by $1000 so that it can increase its liability to Mr P by $1000 and thus keep things "in balance". What balances the new liability of $1000 is the loan asset of $1000 that is recorded when the loan is made.

drkitten

20th September 2010, 07:54 AM

2. In the story drkitten gave I did not see earnings and losses to the three actors Bancor Bank, Mr. John Q. Public and the universe, which is really too bad. I can modify my original story to include the actors in a simple way and also include the idea that the amount of loan money created by a bank is also destroyed. Skip to step 3. and for B(3) and T(3) subtract L.

P(3) = P(1 + iP)^2
U(3) = U + L - (L/2)(1 + iL) - (L/2)(1 + iL) = U - iL * L
B(3) = B + (L/2)(1 + iL) + (L/2)(1 + iL) - L = B + iL * L
T(3) = P(1 + iP)^2 + U + B

Or is this correct?

It's better. You're missing the fact that the bank pays Mr. P his interest, which means that the interest [P(1+iP)^2 -P] that P earns is subtracted from the bank's balance.

E.g.
B'(3) = B + (L/2)(1 + iL) + (L/2)(1 + iL) - L - [P(1+iP)^2 -P] = B + iL * L - [P(1+iP)^2 -P]
T'(3) = P + U + B

(The bank paying interest comes out of its money; it's not created. But since iP << iL, the bank pays interest on deposits to encourage people to make their money available for loans, and makes money off the difference. In fact, iL * L - [P(1+iP)^2 -P] is exactly the bank's profit.

tensordyne

20th September 2010, 10:34 AM

It's better. You're missing the fact that the bank pays Mr. P his interest, which means that the interest [P(1+iP)^2 -P] that P earns is subtracted from the bank's balance.

E.g.
B'(3) = B + (L/2)(1 + iL) + (L/2)(1 + iL) - L - [P(1+iP)^2 -P] = B + iL * L - [P(1+iP)^2 -P]
T'(3) = P + U + B

(The bank paying interest comes out of its money; it's not created. But since iP << iL, the bank pays interest on deposits to encourage people to make their money available for loans, and makes money off the difference. In fact, iL * L - [P(1+iP)^2 -P] is exactly the bank's profit.

Oh yes, good point, the bank definitely would have to pay interest given the idea that the bank is leant the money by Mr. P. It is not as if it is not relevant to the numbers here either. By the above quote I take it that the other two numbers P(3) and U(3) are to remain untouched? If such is the case I would be in agreement.

Of course the formulas above use the idea that the bank does not get to keep the principal. It seems then maybe we are all agreed given my quote that the bank does NOT take the loan out of total deposits as is usually assumed. On the other hand, the principal question is seperate and even if the bank does not get to keep the principal it is very much still possible that the resultant kind of system could be unjust or crazy in some sense.

News update: The lady from the ABA I sent the email to responded. She was zero help.

My email ----
I was wondering if you could answer a question of mine. There is a part in a booklet from the Federal Reserve called "Modern Money Mechanics" that says the following.

"Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts."

Could you tell me what this means in simple english? I think it means when a bank makes a loan it creates money from nowhere and puts it into the borrower's account. If that is the case, when the borrower pays back the loan, does the bank under Fractional Reserve Banking rules then get to keep the loan principal as well as interest or just the interest or something else entirely? I have not been able to find any sources online I can trust to explain what happens after the initial crediting of the borrower's account occurs.
----

I took out my contact info on my email only.

her response ----
Hi, I'm not 100% sure, but I think your local bank would be a good place to get this answered. I hope this helps.

Marquita Powell
Communications Manager
ABA Education Foundation
mpowell@aba.com or 202/663-5418
facebook.com/ABAEF
----

I will try a guy on the same list whose issues cover bank legislation and see if he knows the answer. I have some doubts that a local manager at a bank will know the answer (such things will probably be automated) but give it a try anyways sometime soon. The questions I am asking really should be obvious to people in the banking world, so we will see. Basically, I want to hear it from the horses mouth as it were how the "loan" process works. I say loan in quotes because, in any event, the first part of the loan process definitely does not seem to work the way you or I would make a loan. Or is that not an agreed upon point yet?

All the best to everyone.

Nobbit

20th September 2010, 10:59 AM

The questions I am asking really should be obvious to people in the banking world, so we will see.
Or maybe not:
So the answer to question one, "Who creates money?" is that almost all of it is created by commercial banks, although, as Box 1 explains, central banks limit the extent to which they are able to do so. Most people find this answer quite staggering. Even bankers do. Lord Stamp, a director of the Bank of England at the time, commented in 1937: "The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented." As the economist J. K. Galbraith remarked:"The process by which banks create money is so simple the mind is repelled. Where something so important is involved, a deeper mystery seems only decent."
Link (http://www.feasta.org/documents/moneyecology/chapterone.htm)

Basically, I want to hear it from the horses mouth as it were how the "loan" process works. I say loan in quotes because, in any event, the first part of the loan process definitely does not seem to work the way you or I would make a loan. Or is that not an agreed upon point yet?
Well, if I lend $1000 to someone, I will be $1000 out of pocket until the loan is repaid. But when a bank lends $1000 to someone, no one goes $1000 out of pocket. If that's what you mean, then yes, I think we agree on that point.

drkitten

20th September 2010, 12:03 PM

Well, if I lend $1000 to someone, I will be $1000 out of pocket until the loan is repaid. But when a bank lends $1000 to someone, no one goes $1000 out of pocket. If that's what you mean, then yes, I think we agree on that point.

And that's how money is "created"; there's an extra $1000 in the money supply (where "money supply" is basically defined as the entire amount of money that anyone can claim to have) that didn't exist before, and that wasn't taken from anyone's pocket. In this sense, it was created from thin air,... except in a stricter sense, it was created by the bank lending out deposits while still allowing depositors access to their money.

There's also nothing especially magical about banks or the Fed in this regard. Stock brokers do this all the time with regard to short sales. If I sell a stock "short," then that means that I'm selling a stock that I don't own, with the intent of buying it back later (to "cover my short"), hopefully at a lower price.

How do I do this? Simple. I just borrow the stock from someone else and sell it, knowing that I will return the stock when I re-buy it. In actual fact, I don't do any of that -- my broker does. I don't know who I borrowed the stock from, and the owner of the stock may not even know that it's been borrowed. As far as he's concerned, the stock is still sitting there in his portfolio happily earning him dividends. The effect is that there's one more "imaginary" share of that stock out there in the world, a share that my stockbroker and I have jointly conspired to create and will destroy later.

lomiller

20th September 2010, 01:37 PM

I think it’s important to point out that even though the is process collapsed in some cases to make it more efficient nothing is lost from it. The actual process steps still yield the final same final results as the high level idealized version. Banks are not suddenly lending non-existent money, as is sometimes claimed.

It may be fair to ask the question as to whether the streamlined process really does give the same results, but that’s different then taking one element of that process out of context and making claims of fraud, as we sometimes see

drkitten

20th September 2010, 01:43 PM

I think it’s important to point out that even though the process collapsed in some cases nothing is lost from it. The actual process steps still yield the final same final results as the high level idealized version. Banks are not suddenly lending non-existent money, as is sometimes claimed.

I don't think I'm following you.

By "the process collapsed," do you mean "I skipped the step where the bank credited the borrower's account and then he withdrew the money and instead made it sound like they just gave him the money directly", or do you mean "the process for making loans collapsed when Bear Stearns went tits-up, but no one was really hurt because it was all imaginary money that was lost"?

lomiller

20th September 2010, 02:20 PM

I don't think I'm following you.

By "the process collapsed," do you mean "I skipped the step where the bank credited the borrower's account and then he withdrew the money and instead made it sound like they just gave him the money directly", or do you mean "the process for making loans collapsed when Bear Stearns went tits-up, but no one was really hurt because it was all imaginary money that was lost"?

Yeah on reading it again my wording was pretty bad. I edited a bit to hopefully make it clearer.

I’m talking about the steps in the entire process of money creation. When you get a loan the bank doesn’t give you cash, which you then take and hand to your car dealership who then take it back to the bank and redeposit it the electronic bookkeeping that happens in the background ends up with the same resulting change in assets/liabilities to all involved.

tensordyne

20th September 2010, 04:56 PM

Yeah on reading it again my wording was pretty bad. I edited a bit to hopefully make it clearer.

I’m talking about the steps in the entire process of money creation. When you get a loan the bank doesn’t give you cash, which you then take and hand to your car dealership who then take it back to the bank and redeposit it the electronic bookkeeping that happens in the background ends up with the same resulting change in assets/liabilities to all involved.

evidence?

drkitten

20th September 2010, 06:22 PM

evidence?

Um, have you ever gotten a loan?

You're not handed cash at closing. You're rarely even handed a check. You sign paperwork and the computers handle it in the back rooms.

tensordyne

20th September 2010, 11:31 PM

:boxedin:Um, have you ever gotten a loan?

You're not handed cash at closing. You're rarely even handed a check. You sign paperwork and the computers handle it in the back rooms.

I was referring to the part where lomiller says "the electronic bookkeeping that happens in the background ends up with the same resulting change in assets/liabilities to all involved." First off, what does -- the same resulting change in assets/liabilities to all involved -- mean and does he have any evidence of such given whatever he means by it?

Yep, I agree, loans are automated. Sign some papers (in a couple places) and the rest is opaque as far as the loanee (loaner???) is concerned. No contest there.

drkitten

21st September 2010, 07:07 AM

:boxedin:

I was referring to the part where lomiller says "the electronic bookkeeping that happens in the background ends up with the same resulting change in assets/liabilities to all involved." First off, what does -- the same resulting change in assets/liabilities to all involved -- mean and does he have any evidence of such given whatever he means by it?

What he means is that the electronic bookkeeping that happens in the background ends up with the same resulting change in assets/liabilities to all involved. The words mean what they say.

Specifically, the net changes from you taking a loan out from the bank are

* You have a new asset in the principal of the loan (or a new asset that you purchased with the loan principal, such as a house or a car).
* You have a new liability in an obligation to repay the loan plus interest
* The bank has a new liability as they agreed either gave you money or gave money to a vendor on your behalf and gave the object to you; if you fail to repay the loan, they're still out that money.
* The bank has gained a new asset in the promissory note, in which you agreed to repay the bank the loan plus interest.

If you really want proof, phone your local banker and ask if you have to repay a loan you take out from his bank. Seriously. How the hell else do you expect the loan system to work?

tensordyne

21st September 2010, 09:02 AM

:boxedin: What he means is that the electronic bookkeeping that happens in the background ends up with the same resulting change in assets/liabilities to all involved. The words mean what they say.

Specifically, the net changes from you taking a loan out from the bank are

* You have a new asset in the principal of the loan (or a new asset that you purchased with the loan principal, such as a house or a car).
* You have a new liability in an obligation to repay the loan plus interest
* The bank has a new liability as they agreed either gave you money or gave money to a vendor on your behalf and gave the object to you; if you fail to repay the loan, they're still out that money.
* The bank has gained a new asset in the promissory note, in which you agreed to repay the bank the loan plus interest.

If you really want proof, phone your local banker and ask if you have to repay a loan you take out from his bank. Seriously. How the hell else do you expect the loan system to work?

I only know about the first part of the loan process. Thanks for clarifying what he meant though. Here is the part to consider I think from the quote by drkitten:

[QUOTE=drkitten;6356876]
* The bank has a new liability as they agreed either gave you money or gave money to a vendor on your behalf and gave the object to you; if you fail to repay the loan, they're still out that money.
[QUOTE=drkitten;6356876]

"Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts."

Quote from page 6 of Modern Money Mechanics, a publication of the Federal Reserve. The they in the quote is Fractional Reserve Banks.

If a bank does not pay loans out from the money they recieve as deposits, that means they must add it to the "borrowers'" transaction account from nothing. What happens afterward I consider open for discussion, but this idea that the bank will loose money because loans are taken out of total deposits (as so many seem to think) is false by the quote above.

A loaning counterfeiter example is a good analogy. You sign a promissory note with a counterfeiter who loans you counterfeited money. Now as I said before, I have no evidence after that to say exactly what happens to the loan (to complete the analogy as it were between FRB and a loaning counterfeiter with evidence), but it seems to me that saying "If you do not pay the loaning counterfeiter, he is out the money he gave you" is disengenuous. The counterfeiter created the money from "nothing" and at much less expense then you have to go through to pay it back (otherwise it would not be worth it to the counterfeiter to make the loan in the first place).

Now, given my quote, how are FRB banks mathematically different then my loaning counterfeiter (at least initially)? They have to follow some more rules maybe (a counterfeiter would not have to follow reserve requirements)? My quote about FRB banks and the example of the counterfeiter start off the same way -- they both loan money created from nothing! Can you do that? I certainly can not.

So, if you do not believe my quote, or interpret it differently, fine, let's debate that. On the other hand, if you think the quote is legitimate, then I do not see how one can conclude that a FRB bank makes loans the same way you or I do, i.e., by having the amount of the loan debited (subtracted) from whatever we already have to give it to the borrower. That is simply not the case according to the quote above, as far as I can tell.

It seems the initial part of the loan is still at issue. I sent another email to a different person at the ABA to see if I can get resolution on the latter parts of the loan process.

all the best to everyone.

drkitten

21st September 2010, 09:10 AM

:boxedin:

I only know about the first part of the loan process. Thanks for clarifying what he meant though. Here is the part to consider I think from the quote by drkitten:

* The bank has a new liability as they agreed either gave you money or gave money to a vendor on your behalf and gave the object to you; if you fail to repay the loan, they're still out that money.

"Of course, they do not really pay out loans from the money they receive as deposits.

I don't think you could be misinterpreting this any harder if you tried.

We've already agreed that the bank does not hand you cash when you take out a loan.

But they do make the money available to you. You now have a new asset, which you can use as you see fit. If the bank did not make the money available to you, you wouldn't be able to use the car loan to buy the car -- the dealer needs and wants his money, and won't give it to you otherwise.

If a bank does not pay loans out from the money they recieve as deposits, that means they must add it to the "borrowers'" transaction account from nothing.

And they add a corresponding liability, because all moneys in transaction accounts have corresponding liabilities.

What happens afterward I consider open for discussion, but this idea that the bank will loose money because loans are taken out of total deposits (as so many seem to think) is false by the quote above.

No, the bank will not lose money by making the loan. It creates a new liability (the new deposits) and a new asset (the promissory note). It only loses money if the promissory note isn't paid off.

If the bank lost money making loans, it wouldn't make loans now, hmmm?

A loaning counterfeiter example is a good analogy.

Not at all.

Now, given my quote, how are FRB banks mathematically different then my loaning counterfeiter (at least initially)?

Because the counterfeiter doesn't have liabilities that correspond to the amounts on deposit -- no one can come up to the coutnerfeiter and demand "his" money prior to the counterfeiter printing it up.

Nobbit

21st September 2010, 09:29 AM

Now, given my quote, how are FRB banks mathematically different then my loaning counterfeiter (at least initially)?
They're not - at least initially. But ultimately - which is what matters - they are different. If someone defaults on a bank loan, the bank is eventually obliged to remove that loan from their books, thus decreasing their assets by the current value of that loan, thus causing a loss. If someone fails to repay a counterfeiter, though, the counterfeiter hasn't really lost anything.

lomiller

21st September 2010, 09:39 AM

"Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts."

Lets start with the idealized version:
1) Bank accepts your loan application for a 1000 dollar loan
2) Bank draws on it’s on-hand cash to give you $1000, reducing it’s cash reserve by $1000
3) At the same time the bank records your debt as an asset, since they have the right to collect $1000 from you
4) You walk back up to the next counter over and deposit the money in your account.
5) The bank takes the $1000 and records a liability. You not have the right to collect $1000 from that account.
6) Since the account is highly liquid you can and do treat it like cash so the money you have in this account is effectively newly created money.

Note that it isn’t really the loan that creates the money it’s the fact you deposited it in an account you can use like money. Of course this would not have been possible if the bank hadn’t given you the loan.

Note 2 there are redundant steps. There is no purpose served by putting giving you cash and sending you though the line again to redeposit it. Process wise these steps are redundant and can be removed by depositing the money directly to you account.

This means the new process is:

1) Bank accepts your loan application for a 1000 dollar loan
2) Bank records your debt as an asset, since they have the right to collect $1000 from you
3) AT THE SAME TIME the bank deposits $1000 in your account and records a liability. You not have the right to collect $1000 from that account.
4) Since the account is highly liquid you can and do treat it like cash so the money you have in this account is effectively newly created money.

With the redundant steps removed the bank doesn’t actually touch it’s cash reserves but simultaneously creates the asset (your loan) and the liability (your deposit). Naturally this new liability must conform to their reserve requirements and asset ratio or they can’t issue the loan at all.

drkitten

21st September 2010, 12:28 PM

They're not - at least initially. But ultimately - which is what matters - they are different. If someone defaults on a bank loan, the bank is eventually obliged to remove that loan from their books, thus decreasing their assets by the current value of that loan, thus causing a loss. If someone fails to repay a counterfeiter, though, the counterfeiter hasn't really lost anything.

Or to put it perhaps more clearly,.... why can a bank go bankrupt, but a counterfeiter can't?

psionl0

7th October 2010, 05:04 AM

There's also nothing especially magical about banks or the Fed in this regard. Stock brokers do this all the time with regard to short sales. If I sell a stock "short," then that means that I'm selling a stock that I don't own, with the intent of buying it back later (to "cover my short"), hopefully at a lower price.

How do I do this? Simple. I just borrow the stock from someone else and sell it, knowing that I will return the stock when I re-buy it. In actual fact, I don't do any of that -- my broker does. I don't know who I borrowed the stock from, and the owner of the stock may not even know that it's been borrowed. As far as he's concerned, the stock is still sitting there in his portfolio happily earning him dividends. The effect is that there's one more "imaginary" share of that stock out there in the world, a share that my stockbroker and I have jointly conspired to create and will destroy later.
I find this very interesting drkitten. Is this what is referred to as "Naked" short selling? In order to sell stocks, I would have thought that I would have to actually have stocks to sell and if I borrowed them, the lender would not have access to them at the same time.

The process you are describing effectively means that there could be more stocks in a company being traded in the stock market than were issued by the company itself. A sort of "Fractional Reserve Stockbroking" if you like. That's SCARY! :eye-poppi

ideogram

7th October 2010, 07:14 AM

Or to put it perhaps more clearly,.... why can a bank go bankrupt, but a counterfeiter can't?

Because a bank must maintain some fractional reserve but a counterfeiter need not?

drkitten

7th October 2010, 10:53 AM

I find this very interesting drkitten. Is this what is referred to as "Naked" short selling? In order to sell stocks, I would have thought that I would have to actually have stocks to sell and if I borrowed them, the lender would not have access to them at the same time.

No, "naked" short selling means that you skip the whole pesky borrowing phase and instead sell shares that you didn't even borrow. It's perilously close to counterfeiting shares, which is why it's illegal in the States.

But even "naked" short selling doesn't create money. You are creating phantom shares, but you're also creating a real obligation upon yourself to buy the phantom shares back.

Which is why this answer:

Because a bank must maintain some fractional reserve but a counterfeiter need not?

is wrong.

it's not the reserve requirement that keeps banks solvent, but the fact that they're creating both assets and liabilities (in balance).

If a counterfeiter is $10,000 in debt, he simply runs up the printing press and makes $20,000 in currency. This gives him $20,000 in new assets, putting him $10k in the black.

If a banker is $10,000 in the red, though, he can't just make $20,000 of loans to pay it off. Because he can "create" $20,000 in new assets, but those assets also come with new liabilities of $20,000. So the effect is that he's now up $20,000 but down ($30,000), or still ten grand in the red.

ideogram

7th October 2010, 12:29 PM

it's not the reserve requirement that keeps banks solvent, but the fact that they're creating both assets and liabilities (in balance).

If a counterfeiter is $10,000 in debt, he simply runs up the printing press and makes $20,000 in currency. This gives him $20,000 in new assets, putting him $10k in the black.

If a banker is $10,000 in the red, though, he can't just make $20,000 of loans to pay it off. Because he can "create" $20,000 in new assets, but those assets also come with new liabilities of $20,000. So the effect is that he's now up $20,000 but down ($30,000), or still ten grand in the red.

But if a banker didn't have a reserve requirement, why would it matter whether he is in the red or the black?

drkitten

7th October 2010, 04:30 PM

But if a banker didn't have a reserve requirement, why would it matter whether he is in the red or the black?

Because if he's in the red, he can't pay off his creditors even by liquidating the banks.

If he's in the black, he can in theory liquidate the bank and the creditors get paid in full.

If he's in the black and meets the reserve requirements then in practice his creditors can get as much money as they want without him having to liquidate.

ideogram

8th October 2010, 01:11 AM

Because if he's in the red, he can't pay off his creditors even by liquidating the banks.

If he's in the black, he can in theory liquidate the bank and the creditors get paid in full.

If he's in the black and meets the reserve requirements then in practice his creditors can get as much money as they want without him having to liquidate.

Okay, I think I got it now. Basically I didn't understand the legal term "liability", which apparently means a legal obligation to pay someone money. You said that every new asset must be matched by a new liability. Therefore the money "created" by loans doesn't really come from nothing, it comes from the creation of new liabilities, which is the promise to pay exactly that amount back.

I find this counterintuitive, because liabilities to me are just abstract numbers in a ledger, but an asset can be a physical object like a car.

If I have you right, liabilities are a sort of legal fiction but in our society they are (almost) as good as cash. Liabilities are cash-with-the-opposite-sign, like antiprotons?

drkitten

8th October 2010, 03:48 AM

Okay, I think I got it now. Basically I didn't understand the legal term "liability", which apparently means a legal obligation to pay someone money.

Yup.

You said that every new asset must be matched by a new liability. Therefore the money "created" by loans doesn't really come from nothing, it comes from the creation of new liabilities, which is the promise to pay exactly that amount back.

Yup.

I find this counterintuitive, because liabilities to me are just abstract numbers in a ledger, but an asset can be a physical object like a car.

Well, liabilities are legally enforceable and often attached to those physical objects. When you take out a car loan, you have a new asset (the car) and a new liability (the promise to pay for it). The bank has a new liability (the money they have to give you to pay for the car) and a new asset (your promise to pay for the car), and if necessary, they can enforce that promise by repossessing your car.

If I have you right, liabilities are a sort of legal fiction but in our society they are (almost) as good as cash.

Basically, yeah. People can buy and sell liabilities just like any other financial instrument.

Liabilities are cash-with-the-opposite-sign, like antiprotons?

Roughly. They're not quite cash-with-the-opposite-sign because they're risky; an IOU for $10,000 isn't just the same as $10,000 because cash is always good, but an IOU might not be honored. (That's why you pay more than the face value of the car to pay off the car loan.)

But if you want metaphors, the particle-antiparticle metaphor isn't a bad one. Banks make money and anti-money at the same time in equal quantities. The money circulates while the anti-money typically doesn't.

psionl0

8th October 2010, 04:22 AM

But even "naked" short selling doesn't create money. You are creating phantom shares, but you're also creating a real obligation upon yourself to buy the phantom shares back.
I understand that the stock market analogy is about "creating" shares, not money just as your lawnmower example was about creating "virtual" lawnmowers.

No, "naked" short selling means that you skip the whole pesky borrowing phase and instead sell shares that you didn't even borrow. It's perilously close to counterfeiting shares, which is why it's illegal in the States.I don't know who I borrowed the stock from, and the owner of the stock may not even know that it's been borrowed. As far as he's concerned, the stock is still sitting there in his portfolio happily earning him dividends.
Amazing, add a couple of steps that don't change the end result and suddenly an illegal scheme that is "perilously close to counterfeiting shares" is suddenly a legitimate investment strategy.

I gather that under this scenario, the short seller/stockbroker would have to pay dividends on the stocks they "created" out of their own pocket or they would let the cat out of the bag.

timhau

8th October 2010, 04:38 AM

Amazing, add a couple of steps that don't change the end result and suddenly an illegal scheme that is "perilously close to counterfeiting shares" is suddenly a legitimate investment strategy.

They do change the end result. The number of shares being traded cannot exceed the number of shares issued by the company.

I gather that under this scenario, the short seller/stockbroker would have to pay dividends on the stocks they "created" out of their own pocket or they would let the cat out of the bag.

Yes, if you're short on ex-dividend date, the dividends come out of your pocket.

psionl0

8th October 2010, 07:37 AM

They do change the end result. The number of shares being traded cannot exceed the number of shares issued by the company.
Not true. If only a small fraction of the shares held by the broker's clients are actually traded at any one time then the broker could lend several times the number of actual shares held.

timhau

8th October 2010, 07:46 AM

Definitely. If they want to get sued and have their licence revoked, that is.

psionl0

9th October 2010, 08:56 PM

OK, so if everybody on this thread understands how fractional reserve banking leads to the "creation" of money in some sense then the next question to ask is, "is fractional reserve banking a good thing"? Do we really need to have many families hocked up to the eyeballs in order for the money supply to be maintained? Is is desirable to be paying banks what is effectively a tax (interest on our debts) for the privilege of having banks be the main suppliers of money?

Some might argue that under FRB, the money supply can grow with a nation's GDP and large sums of money can be made available for investment. However, FRB is not necessary for either of these benefits. It is also a fact that under FRB, the money supply can shrink causing recessions. (Remember, it was the "sub prime crisis" that caused the most recent global financial crisis and lead to the term "toxic debt").

Any financial advisor will tell you that there is "good debt" and "bad debt". Borrowing to buy a home is an example of good debt. Having large credit card debts due to a lack of financial discipline is an example of bad debt. It is the latter that is increasing and causing hardships in families as banks increasingly search for more debtors.

Under a FULL reserve system, banks would not be able to lend out depositors' money. Other financial institutions would still be able to lend out money but only money deposited into their bank accounts by investors (given the usurious interest rates charged for credit cards, investing in a credit card company would promise good returns for an investor). The total supply of money would be entirely in the control of the government (or, if you prefer, as semi-autonomous government appointed board) who would be able to issue new fiat money as required without the inflationary effect that would otherwise occur as FRB multiplied the amount of money created by the government.

Tippit

9th October 2010, 11:54 PM

And that's how money is "created"; there's an extra $1000 in the money supply (where "money supply" is basically defined as the entire amount of money that anyone can claim to have) that didn't exist before, and that wasn't taken from anyone's pocket. In this sense, it was created from thin air,... except in a stricter sense, it was created by the bank lending out deposits while still allowing depositors access to their money.

There's also nothing especially magical about banks or the Fed in this regard. Stock brokers do this all the time with regard to short sales. If I sell a stock "short," then that means that I'm selling a stock that I don't own, with the intent of buying it back later (to "cover my short"), hopefully at a lower price.

Stock brokers who sell shares they don't own and don't borrow within the three day settlement period are naked short sellers, a practice which is illegal in the US. This is different from a legitimate short sale, which itself is entirely different from how the money multiplier works in fractional reserve banking.

How do I do this? Simple. I just borrow the stock from someone else and sell it, knowing that I will return the stock when I re-buy it. In actual fact, I don't do any of that -- my broker does. I don't know who I borrowed the stock from, and the owner of the stock may not even know that it's been borrowed. As far as he's concerned, the stock is still sitting there in his portfolio happily earning him dividends. The effect is that there's one more "imaginary" share of that stock out there in the world, a share that my stockbroker and I have jointly conspired to create and will destroy later.

Loaning shares without the owner's consent constitutes securities fraud, and is tantamount to manipulating the security to the downside. That's why naked short selling is illegal, as per regulation SHO. Of course, the fact that it's illegal doesn't mean this form of stock counterfeiting doesn't exist, and wasn't a huge problem in recent years. Naked shorts have been used to bankrupt lots of small firms that aren't well capitalized, and it is used by JP Morgan and Goldman Sachs, among others, to artificially suppress the gold price (gold is encumbered from anywhere between 45 and 100 ounces per physical ounce).

Tippit

10th October 2010, 12:00 AM

I understand that the stock market analogy is about "creating" shares, not money just as your lawnmower example was about creating "virtual" lawnmowers.

Amazing, add a couple of steps that don't change the end result and suddenly an illegal scheme that is "perilously close to counterfeiting shares" is suddenly a legitimate investment strategy.

I gather that under this scenario, the short seller/stockbroker would have to pay dividends on the stocks they "created" out of their own pocket or they would let the cat out of the bag.

Short sellers are obligated to pay dividends to the owner of the stock. It follows that naked short sellers must pay dividends on phantom shares if they don't want to be caught.

Sceptic-PK

10th October 2010, 12:06 AM

OK, so if everybody on this thread understands how fractional reserve banking leads to the "creation" of money in some sense then the next question to ask is, "is fractional reserve banking a good thing"?

Yes, it is what enables people like you and me to borrow money at affordable interest rates.

Do we really need to have many families hocked up to the eyeballs in order for the money supply to be maintained?

Who are you to decide what a family may choose to do with their finances?

Is is desirable to be paying banks what is effectively a tax (interest on our debts) for the privilege of having banks be the main suppliers of money?

Lol, interest isn't a tax. Interest is what you pay the bank for the privilege of borrowing its money.

Under a FULL reserve system, banks would not be able to lend out depositors' money.

Yes, which would destroy economic growth.

Other financial institutions would still be able to lend out money but only money deposited into their bank accounts by investors (given the usurious interest rates charged for credit cards, investing in a credit card company would promise good returns for an investor). The total supply of money would be entirely in the control of the government (or, if you prefer, as semi-autonomous government appointed board) who would be able to issue new fiat money as required without the inflationary effect that would otherwise occur as FRB multiplied the amount of money created by the government.

I have no idea what you're trying to say here, but I suspect it's nonsense.

psionl0

10th October 2010, 12:23 AM

I have no idea what you're trying to say here, but I suspect it's nonsense.
I suspect you have no idea about ANY of this thread and are just trying to appear intelligent by labeling my post "nonsense".

Sceptic-PK

10th October 2010, 12:37 AM

I suspect you have no idea about ANY of this thread and are just trying to appear intelligent by labeling my post "nonsense".

Well, I was more than capable of pointing out how your earlier comments were horribly misguided, and my last comment was merely a terse request for you to explain yourself better, but given the erroneous logic displayed earlier, I suspected what you were saying was nonsense.

psionl0

10th October 2010, 12:41 AM

Well, I was more than capable of pointing out how your earlier comments were horribly misguided
No you weren't, all you did was contradict me. If you don't understand what I am saying then either educate yourself or leave the responses to people who know what I am saying.

Sceptic-PK

10th October 2010, 12:53 AM

No you weren't, all you did was contradict me. If you don't understand what I am saying then either educate yourself or leave the responses to people who know what I am saying.

Don't confuse your inability to explain yourself properly with me not being capable of understanding. But I will give it a second go.

Other financial institutions would still be able to lend out money but only money deposited into their bank accounts by investors (given the usurious interest rates charged for credit cards, investing in a credit card company would promise good returns for an investor).

How would lending institutions manage to raise enough funds to meet market demand? And how would you keep interest rates at an affordable level, since there would be much less credit available?

The total supply of money would be entirely in the control of the government (or, if you prefer, as semi-autonomous government appointed board) who would be able to issue new fiat money as required without the inflationary effect that would otherwise occur as FRB multiplied the amount of money created by the government.

Economic data often lags by approximately 3 months, how would a government be able to make appropriate decisions re the money supply when they're months behind the present? It is much more appropriate for the private sector to allocate capital at the behest of its customers, who know when they need the money, how much they need and what they need it for.

Additionally, the money supply is but one factor that effects the rate of inflation, and the only reason your system might have lower rates of inflation is because there would be lower growth because only the few would be able to access credit.

edit: Additionally, what happens to all the customers who wish to earn interest on their deposits, now that you've effectively stopped banks paying interest to its depositors? ie Banks won't pay interest to customers for nothing, and you've just banned them from lending customer money.

psionl0

10th October 2010, 02:44 AM

Don't confuse your inability to explain yourself properly with me not being capable of understanding. But I will give it a second go.

How would lending institutions manage to raise enough funds to meet market demand? And how would you keep interest rates at an affordable level, since there would be much less credit available?

I will assume that you are genuinely interested. You need to understand that under the current system, the supply of money is in a "steady state" meaning that as debts are repaid, new loans are created. The point is that you don't need to have a big pile of IOUs to make this happen. The money for making loans would come from investors who have cash to spare. At present, most people leave their surplus money in a bank account where the bank can lend it out. Under a full reserve system, they would be less interested in leaving their temporary surplus in a zero interest bank account and more interested in putting it in some form of managed investment fund where they can earn interest. It is this money that would be available for loans. The point is that while an investor's money is being lent out, the investor does not have simultaneous access to it.

Consider this from another perspective. Suppose that the government decided to phase out fractional reserve banking. It couldn't just allow the money supply to dwindle as people repaid their loans because that would lead to economic disaster. Instead, as principal repayments were made, the government would have to issue new fiat money to replace the money that was destroyed by loan repayments. In the transition phase, I suspect that the government would need to make grants to the newly created lending institutions in order to keep interest rates reasonable. Afterwards, more imaginative ways of releasing new money into the economy would be found (not to mention the odd "pork barreling" project).

Managing the supply of money is difficult to do instantaneously under any circumstances. As drkitten has already pointed out, the main objective is to have a small amount of inflation so that we don't accidentally go into deflation mode. One of the principle ways of managing the supply of money in a FRB system is to manipulate interest rates (the Federal Reserve manipulates the cash rate depending on its objective). Under full reserve banking, the opposite would probably take place. Rising interest rates would signal a tight money supply and trigger extra fiat creation while lower interest rates would trigger smaller fiat creation (and divert money from loans to more profitable investments).

One of the most unfair aspects of FRB is that it against a nation's interests for the average family to budget responsibly. If everybody were to pay off the credit card debts that they allowed to simply grow then this would prove disastrous for an economy. On the other hand, repaying debts under a full reserve system would not destroy any money. It would see extra money being made available for investment which is a good thing.

It is quite likely that I have oversimplified things and there are problems with a full reserve banking system that I haven't foreseen. If that is the case then by all means, point it out. I relish an intelligent debate on this with people who aren't just looking to get something for nothing. On the other hand, if all you want to say is that this post is just a bunch of hooey then tell it to some other skeptic.

my_wan

10th October 2010, 05:17 AM

I found drkitten's description well informed. The system has issues I don't like, but don't know how to do it better without putting a hell of a lot of abuse power in someones hands. Also note that, in the same sense as money is created, money gets destroyed when the borrowing volume drops. Thus the more money being borrowed, the more money that is available to borrow. This helps to induce the so called business cycle.

Personally, I'd live in a tent before I signed a 30 year note. In fact, generally if I made house payments to myself for 7 years while living in that tent, I could pay cash for that house the bank wanted me to make payments to them for 30 years to own. Used to be a lot worse.

The notion that a 30 year note is a good investment, because it's a house, is absurd. People are then lulled by the notion, after a few years, that they finally have a little equity in the house. When in fact they payed many times that equity in cash to own the non-liquid equity. It get much better with very low interest rates, but nowhere near 30 years worth of better.

Consider a 30 year 150k not at 6.5% interest. After 10 years, assuming house has the same value, you have nearly 23k equity. Yet you payed the bank nearly 91k in interest alone. Think the house will increase value that much? In fact, you've payed a total of nearly 114k total for your 'good' investment now worth 23k to you. Never seen the 'good' part of it myself. At least at 6.5% interest you only bought about 1.27 houses for someone else (2.27 houses total), if you are still there after 30 years. If people sell after 10 years on average, that's 4 houses bought for someone per house payed for but not owned. It only gets progressively silly at higher interest.

At 10% interest that's 3 houses+ bought per house purchased if owned in 30 years, and 11 houses to 1 if sold after 10 years on average.

Sceptic-PK

10th October 2010, 05:48 AM

The notion that a 30 year note is a good investment, because it's a house, is absurd. People are then lulled by the notion, after a few years, that they finally have a little equity in the house. When in fact they payed many times that equity in cash to own the non-liquid equity. It get much better with very low interest rates, but nowhere near 30 years worth of better.

Consider a 30 year 150k not at 6.5% interest. After 10 years, assuming house has the same value, you have nearly 23k equity. Yet you payed the bank nearly 91k in interest alone. Think the house will increase value that much? In fact, you've payed a total of nearly 114k total for your 'good' investment now worth 23k to you. Never seen the 'good' part of it myself. At least at 6.5% interest you only bought about 1.27 houses for someone else (2.27 houses total), if you are still there after 30 years. If people sell after 10 years on average, that's 4 houses bought for someone per house payed for but not owned. It only gets progressively silly at higher interest.

At 10% interest that's 3 houses+ bought per house purchased if owned in 30 years, and 11 houses to 1 if sold after 10 years on average.

Houses in my city have doubled in price every 9 years since 1972. So, in your example, my house would be worth $300K after 10 years, and my mortgage is $127K. So that's $173K of equity for which I've paid $114K, and if it's a rental investment I'm more likely to have paid $84K in that time.

Now, obviously markets are different in various countries, and certainly recent events have showcased what happens when markets crash; I just wanted to point out why people view property as a good (long term) investment and certainly more sensible than living in a tent! A bank won't lend me $400K to play the stockmarket, but I had little problem getting them to do so for me to buy bricks and mortar. I'm about $130K ahead, and its cost me approx $50K over the last 5 years. A good friend of mine has built about $2M equity over the last 12, far more than he could have achieved by saving his pennies.

drkitten

10th October 2010, 06:35 AM

OK, so if everybody on this thread understands how fractional reserve banking leads to the "creation" of money in some sense then the next question to ask is, "is fractional reserve banking a good thing"?

Yes.

Do we really need to have many families hocked up to the eyeballs in order for the money supply to be maintained?

No, we don't. But we also don't need for families to be hocked up to the eyeballs in order for fractional reserve banking to work. Under FRB, money is only created as needed.... well, money is only created as desired, which is slightly different. If you need money in order to expand your business, the bank can make that money available to you without withdrawing it from other people who also need/want it. The more business expansion and whatnot, the more money is needed in the economy,... and FRB provides it.

Of course, if you just "want" money but don't really need it, the banks can create money to that purpose, too. If you choose to get yourself in debt over your head, it's not the bank's fault, any more any more than it's the liquor store's fault that you're a drunkard.

Is is desirable to be paying banks what is effectively a tax (interest on our debts) for the privilege of having banks be the main suppliers of money?

It's hardly a tax. It's a fee. You're paying the bank a fee for making money available to you that you wouldn't otherwise have, and for taking a substantial risk on your behalf. If you want a nicer car now than you could afford with cash on hand, you can have it,... but you'll pay something like double the value of the car, all told.

If you don't like that, don't finance a nice car and pay cash for an old wreck.

But it's ridiculous to call it a "tax", unless you're also willing to call the interest the banks pays on your CD a "tax" you charge them.

Some might argue that under FRB, the money supply can grow with a nation's GDP and large sums of money can be made available for investment.

There's a reason for that. They're both true.

However, FRB is not necessary for either of these benefits.

No, but FRB is one of the simplest and safest methods to get those benefits.

It is also a fact that under FRB, the money supply can shrink causing recessions. (Remember, it was the "sub prime crisis" that caused the most recent global financial crisis and lead to the term "toxic debt").

And, oddly enough, it wasn't the shrinking money supply that caused the crisis. It was falling demand.

drkitten

10th October 2010, 06:45 AM

Skeptic-PK called this quite rightly. It's nonsense.

Under a FULL reserve system, banks would not be able to lend out depositors' money. Other financial institutions would still be able to lend out money but only money deposited into their bank accounts by investors (given the usurious interest rates charged for credit cards, investing in a credit card company would promise good returns for an investor).

Okay, so what can banks do with depositors money?

If they have to keep it in reserve, how do they make enough money to cover the simple costs of opening a bank (e.g., paying tellers, keeping the lights on in the building, insuring themselves)? How can they pay depositors interest? And if they can't pay interest, what rational person would deposit money into a bank?

You've just moved the entire banking industry into "other financial institutions," but not actually changed a thing.

The total supply of money would be entirely in the control of the government (or, if you prefer, as semi-autonomous government appointed board) who would be able to issue new fiat money as required without the inflationary effect that would otherwise occur as FRB multiplied the amount of money created by the government.

No, we'd just get the inflationary effect as the government board deliberately overshot the necessary amount of money created by creating approximately ten times as much as the amount they could create under FRB with a 10% reserve requirement.

Why all this fear about inflation in the first place? Inflation is not a bugbear.

lomiller

10th October 2010, 08:17 AM

Consider a 30 year 150k not at 6.5% interest. After 10 years, assuming house has the same value, you have nearly 23k equity. Yet you payed the bank nearly 91k in interest alone. Think the house will increase value that much? In fact, you've payed a total of nearly 114k total for your 'good' investment now worth 23k to you. Never seen the 'good' part of it myself.

At 3.5% per year, which is about in line with the historic average the house is worth $60k more after 10 years. You also have to account for the $80k in rent you would have paid over that time.

what you have = $23k + $60k appreciation = $83k
What it cost = $91k - $80k = $11k

You also need to throw in taxes for a real comparison, either way it's a good return on your investment

lomiller

10th October 2010, 08:25 AM

Under a FULL reserve system, banks would not be able to lend out depositors' money.

And would therefor not accept deposits unless you paid them a large flat fee. you'd be better off keeping it as cash in a tin can burred in your yard, something you can already do.

Other financial institutions would still be able to lend out money but only money deposited into their bank accounts by investors (given the usurious interest rates charged for credit cards, investing in a credit card company would promise good returns for an investor).

So you plan on replacing bank deposits with a system where people get paid interest by a company that holds their money for them, and uses that money to loan out to other people...

psionl0

10th October 2010, 09:36 AM

And would therefor not accept deposits unless you paid them a large flat fee. you'd be better off keeping it as cash in a tin can burred in your yard, something you can already do.
My mistake. I was unaware that you had fee free banking in the US. In most other countries, banks charge account keeping fees and transaction fees and they pay bugger-all interest on these trading accounts. We have little choice but to make use of their services because carrying large sums of cash around is risky and there is little practical alternative when it comes to paying bills to distant creditors. (You don't want to do away with cheques and internet banking do you?)

So you plan on replacing bank deposits with a system where people get paid interest by a company that holds their money for them, and uses that money to loan out to other people...
You might have missed a key point in my post: "The point is that while an investor's money is being lent out, the investor does not have simultaneous access to it." Giving both the bank AND the depositor access to the SAME money at the same time is fractionalism and it is NOT the banks who lose under this arrangement.

As for drkitten, I'm surprised that a man who has researched the concept of FRB and explained it so well has not given more thought to this matter. If the same concept is so bad in the stock market ("perilously close to counterfeiting shares") that it has to be banned then how could it be good when applied to money? We are not talking about a self-regulating system or a benevolent set of corporations here. We are talking about institutions that create money and CHARGE for the use of it.

Borrowing money is fine if you want to invest in a property or if you just want to get something a little sooner and are willing to pay extra for that convenience. However, credit is being thrust on people who don't know that credit is a risky thing. People are not being taught how to manage money and as a result, many families are struggling to service their debts. It is not good enough to "blame the victim" here.

lomiller

10th October 2010, 02:07 PM

My mistake. I was unaware that you had fee free banking in the US. In most other countries, banks charge account keeping fees and transaction fees and they pay bugger-all interest on these trading accounts.

They do not, however, charge a fee simply to have your money in an account. Under your system they would have to require you to make frequent for-fee transactions, you couldn't just have an account.

You might have missed a key point in my post: "The point is that while an investor's money is being lent out, the investor does not have simultaneous access to it."

No I saw that. It amounts to taking what is currently a savings account and locking it in so you can't touch the money. Such accounts do exist, but are not a great option for savings because you can't touch the money if you have an emergency. Your idea is all lose, with nothing to show for the downside.

Nobbit

10th October 2010, 02:50 PM

As for drkitten, I'm surprised that a man who has researched the concept of FRB and explained it so well has not given more thought to this matter. If the same concept is so bad in the stock market ("perilously close to counterfeiting shares") that it has to be banned then how could it be good when applied to money? We are not talking about a self-regulating system or a benevolent set of corporations here. We are talking about institutions that create money and CHARGE for the use of it.
Some money theorists have proposed ideas in which FRB is abolished. An interesting one I read a while ago is described here:

Creating New Money (http://www.neweconomics.org/publications/creating-new-money)

In this idea, FRB is gradually phased out by declaring bank deposits to be "legal tender", whereupon creating new deposits (as banks do now) would be regarded as counterfeiting (and would therefore be illegal).

drkitten

10th October 2010, 03:49 PM

My mistake. I was unaware that you had fee free banking in the US.

Yes, it's actually rather rare to pay fees for banking in the USA. Even the accounts that charge transaction fees rarely charge fees just to store your money for you.

As for drkitten, I'm surprised that a man who has researched the concept of FRB and explained it so well has not given more thought to this matter. If the same concept is so bad in the stock market ("perilously close to counterfeiting shares") that it has to be banned then how could it be good when applied to money?

For several reasons. Less importantly, because there's no actual documented harm from naked short sales, and so the idea of making it illegal is actually quite controversial. Tippit vastly overstates the significance of the problem, in the same way that someone claiming that Bigfoot is a major threat to wildlife and cattle is overstating it.

More importantly, because even "naked" short selling creates both assets and liabilities, which means that it's very difficult even in theory to manipulate stock prices in the long term. You can create a short-term drop in price, but you then have to buy every share you sold back at market rates, and there typically aren't enough shares out there. The end result is usually that you pay more money to unwind your short position than you made off of it, because the people to whom you sold your short position on the way down were bottom fishing, got the stock at bargain basement prices, and see no reason to take a loss on a stock whose fundamentals are actually quite good.

Most importantly, though, it's because the needs of an economy are considerably different from the needs of a company. Stocks represent partial ownership of a company; money represents nothing but a medium of exchange for goods and services. When a company grows, the ownership doesn't change, but as the economy grows, we need more money to prevent deflation from stalling the economy out. Since no one "owns" the economy, no one's hurt by the increased money supply -- and people would be seriously hurt indeed if the money supply didn't at least keep up with productivity increases.

Borrowing money is fine if you want to invest in a property or if you just want to get something a little sooner and are willing to pay extra for that convenience. However, credit is being thrust on people who don't know that credit is a risky thing. People are not being taught how to manage money and as a result, many families are struggling to service their debts. It is not good enough to "blame the victim" here.

Oh, yeah, right. It's the banks fault that people don't know how to use credit properly. And did I mention how much trouble BowFlex is in because I'm still fat?

psionl0

10th October 2010, 09:15 PM

Some money theorists have proposed ideas in which FRB is abolished. An interesting one I read a while ago is described here:

Creating New Money (http://www.neweconomics.org/publications/creating-new-money)

In this idea, FRB is gradually phased out by declaring bank deposits to be "legal tender", whereupon creating new deposits (as banks do now) would be regarded as counterfeiting (and would therefore be illegal).
Thanks for that Nobbit. It is good to see that not everybody thinks it is a good idea for us to pay for our money. It is not just the debtors that pay. There is a flow on effect through lost sales and the subsequent loss of investment and employment opportunities. All of this is because money is being siphoned off the economy for the benefit of privately owned banks.

The problem seems to be that nobody thinks that debt is a serious thing (how many digits does the national debt clock have?) You can have a great party while your charge account is active. The problem is that sooner or later, the repo-man will come along and cut off your line of credit, take away all the things you bought on credit and hound you for the "balance due".

Sceptic-PK

10th October 2010, 10:02 PM

It is good to see that not everybody thinks it is a good idea for us to pay for our money.

It would be a rare day indeed for a stupid idea to have only one believer.

It is not just the debtors that pay. There is a flow on effect through lost sales and the subsequent loss of investment and employment opportunities.

What?

All of this is because money is being siphoned off the economy for the benefit of privately owned banks.

How is money being “siphoned” off the economy? I’ll ignore the fact that banks are part of the economy for the purposes of my question.

The problem seems to be that nobody thinks that debt is a serious thing (how many digits does the national debt clock have?) You can have a great party while your charge account is active. The problem is that sooner or later, the repo-man will come along and cut off your line of credit, take away all the things you bought on credit and hound you for the "balance due".

Debt isn’t a serious thing. Debt is a tool that, when used responsibly, can act as a force for social mobility. I have 4 or 5 credit cards, collective limit almost $30K. I owe approx $370K in 2 home loans. My bank just sent me an offer to increase my credit limit again. I am richer now than I ever would have been had it not been for my debt burden. If we banned everything due to irresponsible people, we’d be banning an awful lot of things. I for one don’t wish my choices to be restricted because other people can’t manage their finances.

Tippit

10th October 2010, 10:10 PM

Consider this from another perspective. Suppose that the government decided to phase out fractional reserve banking. It couldn't just allow the money supply to dwindle as people repaid their loans because that would lead to economic disaster. Instead, as principal repayments were made, the government would have to issue new fiat money to replace the money that was destroyed by loan repayments. In the transition phase, I suspect that the government would need to make grants to the newly created lending institutions in order to keep interest rates reasonable. Afterwards, more imaginative ways of releasing new money into the economy would be found (not to mention the odd "pork barreling" project).

What you just described is the essence of the Monetary Reform Act, endorsed by Milton Friedman. As the bank reserve requirement is slowly raised to 100%, the bank would monetize massive amounts of debt and lower interest rates to offset.

Managing the supply of money is difficult to do instantaneously under any circumstances. As drkitten has already pointed out, the main objective is to have a small amount of inflation so that we don't accidentally go into deflation mode.

Only if you accept the false premise that small amouts of inflation are good (they're not), and that small amounts of deflation result in deflationary spirals (they don't).

One of the principle ways of managing the supply of money in a FRB system is to manipulate interest rates (the Federal Reserve manipulates the cash rate depending on its objective). Under full reserve banking, the opposite would probably take place. Rising interest rates would signal a tight money supply and trigger extra fiat creation while lower interest rates would trigger smaller fiat creation (and divert money from loans to more profitable investments).

The false goal of "price stability" is convienient in that it requires if not a central bank to administer monetary policy, at least policy driven by statute. The reality is that the pro-inflation meme is an excuse to administer the arbitrary and practically unlimited tax of money inflation. Most people don't understand that without it, the price of everything would be cheaper. It's easy for people to understand money taken out of their paycheck, harder for them to understand what an opportunity cost is.

One of the most unfair aspects of FRB is that it against a nation's interests for the average family to budget responsibly. If everybody were to pay off the credit card debts that they allowed to simply grow then this would prove disastrous for an economy. On the other hand, repaying debts under a full reserve system would not destroy any money. It would see extra money being made available for investment which is a good thing.

Congressman Wright Patman, who was Chairman of the House Committee on Banking and Currency, asked Fed Chairman Mariner Eccles,
“How did you get the money to buy those $2 Billion worth of government securities in 1933?”
Eccles answered, “We created it.”
Patman, “Out of what?”
Answer (Eccles), “Out of the right to issue credit money.
Question, “And there is nothing behind it is there except our government’s credit?”
Answer, “That’s what our money system is. If there were no debts in our money system there wouldn’t be any money.”

Sceptic-PK

10th October 2010, 10:15 PM

If you wish to learn about economics psionl0, I would strongly suggest ignoring JREF’s resident econ loony, Tippit.

Amazer

10th October 2010, 10:19 PM

If you wish to learn about economics psionl0, I would strongly suggest ignoring JREF’s resident econ loony, Tippit.

I actually think that Tippit is pretty useful. It gives people like DrKitten an opportunity to really explain things.

Sceptic-PK

10th October 2010, 10:19 PM

Hmmmm, I hadn’t thought of that!

Tippit

10th October 2010, 10:40 PM

For several reasons. Less importantly, because there's no actual documented harm from naked short sales, and so the idea of making it illegal is actually quite controversial. Tippit vastly overstates the significance of the problem, in the same way that someone claiming that Bigfoot is a major threat to wildlife and cattle is overstating it.

Stakeholders in Bear, Lehman, and Overstock.com might disagree with you, just to name a few.

Wall Street's Naked Swindle - A scheme to flood the market with counterfeit stocks helped kill Bear Stearns and Lehman Brothers — and the feds have yet to bust the culprits (http://www.rollingstone.com/politics/news/12697/64824)

More importantly, because even "naked" short selling creates both assets and liabilities, which means that it's very difficult even in theory to manipulate stock prices in the long term. You can create a short-term drop in price, but you then have to buy every share you sold back at market rates, and there typically aren't enough shares out there. The end result is usually that you pay more money to unwind your short position than you made off of it, because the people to whom you sold your short position on the way down were bottom fishing, got the stock at bargain basement prices, and see no reason to take a loss on a stock whose fundamentals are actually quite good.

If you use counterfeit shares to drive down the market price such that all debt and equity financing dries up, you can effectively cover at zero as the firm is destroyed. Even if you are able to scare down the price a little by causing the sale of some legitimate shares, you can still cover at a profit as a direct result. How you can claim that naked shorting is inconsequential is beyond me, as are a lot of your purported beliefs.

Most importantly, though, it's because the needs of an economy are considerably different from the needs of a company. Stocks represent partial ownership of a company; money represents nothing but a medium of exchange for goods and services. When a company grows, the ownership doesn't change, but as the economy grows, we need more money to prevent deflation from stalling the economy out. Since no one "owns" the economy, no one's hurt by the increased money supply -- and people would be seriously hurt indeed if the money supply didn't at least keep up with productivity increases.

It's the old deflation scaremongering ruse to justify the inflation tax, again. Money represents the ownership of claims on wealth - the aggregate of the goods and services people are willing to exchange for money. Just as in a secondary stock offering, when the money supply is increased, money (share)holders get diluted. Why do you expect anyone other than your loyal idiot following to believe that it isn't harmful?

psionl0

10th October 2010, 10:48 PM

I have 4 or 5 credit cards, collective limit almost $30K. I owe approx $370K in 2 home loans. My bank just sent me an offer to increase my credit limit again. I am richer now than I ever would have been had it not been for my debt burden.
I own my house free and clear, I have no credit card (or other) debts, I have money on hand for when my bills come around and I also have some money put away for a rainy day.

My car may not be as new as yours and my TV screen not as big but I am not forced to work like a slave every day just to keep the debt collectors at bay :p

Sceptic-PK

10th October 2010, 11:11 PM

I own my house free and clear, I have no credit card (or other) debts, I have money on hand for when my bills come around and I also have some money put away for a rainy day.

Yeah, so you're either fairly old, have a huge income or had stuff given to you. Given that not everyone falls into any of those categories, borrowing money is the only option if home ownership is one of their goals.

My point though, which you seemed to miss, is that my debt is working for me and making me money in the long term. So no, debt isn't all that spooky.

psionl0

10th October 2010, 11:32 PM

Yeah, so you're either fairly old, have a huge income or had stuff given to you.
Wrong, wrong and wrong. I just happen to know the difference between good debt and bad debt. :D

Oh I did the working day and night at two jobs routine in the past and the benefit is that I paid my mortgage off within 7 years. I now have the luxury of a wife who can stay at home and look after the kids full time. Will your master let you do the same?

Sceptic-PK

10th October 2010, 11:38 PM

Wrong, wrong and wrong. I just happen to know the difference between good debt and bad debt. :D

Right, so what are you complaining about debt for when you used debt to buy your house? Your opinions are not internally consistent.

Oh I did the working day and night at two jobs routine in the past and the benefit is that I paid my mortgage off within 7 years. I now have the luxury of a wife who can stay at home and look after the kids full time. Will your master let you do the same?

Why would my "master" care if my non-existent wife stayed home to look after our non-existent kids?

psionl0

10th October 2010, 11:56 PM

Right, so what are you complaining about debt for when you used debt to buy your house? Your opinions are not internally consistent.

Any financial advisor will tell you that there is "good debt" and "bad debt". Borrowing to buy a home is an example of good debt. Having large credit card debts due to a lack of financial discipline is an example of bad debt.

Borrowing money is fine if you want to invest in a property or if you just want to get something a little sooner and are willing to pay extra for that convenience.

I don't see anything inconsistent there. Just to clarify something, your debt is making you rich in the SHORT term not long term. Just don't go chucking in your job now.

Sceptic-PK

10th October 2010, 11:59 PM

Yeah, but you've made several other posts lambasting debt as well, hence my confusion. And no, property is a long-term investment. I mean sure, it can be a short term one as well depending on several factors, but if you're after capital growth generally its a long-term arrangement.

psionl0

11th October 2010, 02:19 AM

Nobbit

11th October 2010, 05:30 AM

Thanks for that Nobbit. It is good to see that not everybody thinks it is a good idea for us to pay for our money.
Having to pay for money (through interest on debt) does have the curious effect of making poor people pay more than rich people for exactly the same things, but that's not what most monetary reformers object to, as far as I can tell. Usually the objection to FRB is that the profit from creating money is private profit, and monetary reformers think it should be public profit instead (for reasons of justice, democracy, etc.).

The problem seems to be that nobody thinks that debt is a serious thing (how many digits does the national debt clock have?)
Actually, referring to the national debt as "debt" is a pet peeve of mine, because it's not really analogous to a personal debt. Personal debts typically do have to be paid off eventually, or else there are serious consequences (for the debtor); but the national debt can be rolled over continuously with no serious consequences. Indeed, I believe some economists have argued that trying to pay down the national debt would serve no useful purpose, and might actually be harmful to the economy.

drkitten

11th October 2010, 05:56 AM

Having to pay for money (through interest on debt) does have the curious effect of making poor people pay more than rich people for exactly the same things, but that's not what most monetary reformers object to, as far as I can tell.

Well, that's not an effect that's caused by banking. Terry Pratchett described it quite well in Men at Arms. The rich are rich because, by and large, they spend less money. He used boots as an example

A really good pair of leather boots, the sort that would last years and years, cost fifty dollars. This was beyond his pocket and the most he, Vimes, could hope for was an affordable pair of boots costing ten dollars, which might with luck last a year or so before he, Vimes, would need to resort to makeshift cardboard insoles so as to prolong the moment of shelling out another ten dollars.

Therefore over a period of ten years, he, Vimes, might have paid out a hundred dollars on boots, twice as much as the man who could afford fifty dollars up front ten years before. And he would still have wet feet.

The rich can afford to buy something when it's on sale, to buy in bulk and store, and generally to buy better-quality and longer-lasting goods.

drkitten

11th October 2010, 07:45 AM

I suppose I should congratulate you for investing in property Sceptic-PK. Property is not as safe an investment as it used to be thanks to speculation and silly lending decisions but if you have chosen wisely and the economy remains relatively stable then your equity should build up in time - even if you are making minimum repayments.

Even if he's chosen poorly and the economy tanks, his equity should still build up in time.

Debt, per se, is neither good nor bad. Like almost everything else in economics, it's a question of opportunity costs. What else would you do with the money that going in to debt frees up?

For example, if I need furniture, I can pay cash for it.

Or I can get one of those "no interest or payment until 2014" loans that every furniture store on Rte. 666 seems to be running. Which means that I can get my furniture now, leave the five grand in the bank for three years, and make whatever I can off the interest. (In the money market account, that's about 1%/year. In a three year CD, a few more percent. In the stock market, history suggests about 10%/year, but that's obviously more risky.)'

Similarly, I'm paying about 5%/year on my house, but I get half of that back in tax deductions, so I'm really paying about 2 1/2% in interest; if I can get 3% on my money in a CD, I'd be better off putting the money there and paying the minimum on the mortgage.

What I am opposed to is money based on debt. There are alternatives to this

There are indeed. Don't take out a loan. Voila -- none of your money is based on debt.

but it doesn't look like I will win any converts here.

Well, there's always Tippit. No idea is too wrong for him.

psionl0

11th October 2010, 07:50 AM

Actually, referring to the national debt as "debt" is a pet peeve of mine, because it's not really analogous to a personal debt. Personal debts typically do have to be paid off eventually, or else there are serious consequences (for the debtor); but the national debt can be rolled over continuously with no serious consequences. Indeed, I believe some economists have argued that trying to pay down the national debt would serve no useful purpose, and might actually be harmful to the economy.
There is a difference between personal debt and national debt but I would say not in the way you believe. Individuals can go bankrupt. They make an agreement with some bankruptcy trustee where they promise to be a good boy for a few years and afterwards they can reset their life back to zero (albeit with a permanent record).

Nations can't go bankrupt. However, they can't just roll over their debts over and over again because sooner or later their interest bill will become bigger than they can pay (or borrow to pay). When that happens, they have one of two options:
1) They can default. This will deal them out of most legitimate international trade and they risk retaliatory action from their creditors
2) They can go cap in hand to their creditors and try to make some "arrangement" (usually some austerity package where their citizens must work more and spend less)

In either case, their debt is never forgiven nor forgotten.

psionl0

11th October 2010, 08:08 AM

Hi drkitten,
Your analysis on using debt as a money saving strategy is pretty accurate but you have neglected one thing. Servicing a debt requires a person to maintain a certain income-generating capacity. If misfortune strikes (unemployment, injury, illness etc) then what might otherwise be one of your regular monthly payments can become a bankruptcy threatening burden.
What I am opposed to is money based on debt. There are alternatives to thisThere are indeed. Don't take out a loan. Voila -- none of your money is based on debt.
Fair go! If you have been reading my posts you know EXACTLY what I am on about here.
Well, there's always Tippit. No idea is too wrong for him.
Tippit seems well read but I don't know anything about him yet. In any case, I am siding with you on the inflation/deflation debate.

drkitten

11th October 2010, 09:31 AM

Your analysis on using debt as a money saving strategy is pretty accurate but you have neglected one thing. Servicing a debt requires a person to maintain a certain income-generating capacity. If misfortune strikes (unemployment, injury, illness etc) then what might otherwise be one of your regular monthly payments can become a bankruptcy threatening burden.

Except that you don't need to maintain an income-generating capacity if you use credit to pay for what you could get in cash (but have better/more valuable things to do with the cash). My furniture suite is an example. If misfortune were to strike, I could just spend the cash. For that matter, I could continue to pay it off over time (paying interest if necessary) to preserve my cash money for other things.

Essentially, it becomes a risk/reward tradeoff, one that adds options but that has, literally, no downside. If I don't want to risk taking out more debt, I don't have to. But I can use debt to preserve or extend the capital I already have, which allows me to do other things that I couldn't otherwise have done. Like live in a house I own at the age of thirty instead of sixty, or start a business.

Now, of course, just because I have options doesn't mean that they're all good options for me. But it's not the restaurant's fault that I'm allergic to shrimp; if I don't do enough homework to realize that camarones diablo contains shrimp, that's my fault for getting into a dish (or an investment, or a debt) that I didn't think all the way through.

drkitten

11th October 2010, 09:36 AM

There is a difference between personal debt and national debt but I would say not in the way you believe. Individuals can go bankrupt. They make an agreement with some bankruptcy trustee where they promise to be a good boy for a few years and afterwards they can reset their life back to zero (albeit with a permanent record).

Nations can't go bankrupt. However, they can't just roll over their debts over and over again because sooner or later their interest bill will become bigger than they can pay (or borrow to pay). When that happens, they have one of two options:
1) They can default. This will deal them out of most legitimate international trade and they risk retaliatory action from their creditors
2) They can go cap in hand to their creditors and try to make some "arrangement" (usually some austerity package where their citizens must work more and spend less)

Actually, the consequences of default for nations are usually a lot less severe than the consequences for individuals; the bond market has a notoriously short memory, and if traders think that you can pay off this round of bonds, they'll buy.

"Retaliatory action" is usually more threatened than carried out, for the simple reason that it's hard to make any sort of threat stick. There's no international court with the authority to do more than make "tut-tut" noises. The target economy is usually already in the trash, and if you're a heavy enough investor that you're hurt by a default, you're usually more anxious to get out with what you can than you are to throw good money after bad seeking retaliation.

In the immortal words of Don Corleone, "it's bad for business."