Patterico's Pontifications

5/8/2014

How Commercial Banks Create Money

Filed under: General — Patterico @ 7:35 am

In the comments to one of the gold standard threads, a controversy is brewing that I think it might be helpful to bring to the fore in a post. Namely, I think I am blowing some commenters’ minds by noting that commercial banks create money when they make loans. Indeed, it’s the main way that money is created!

The Bank of England put out a couple of papers that describes the mechanism involved. Here is one (.pdf), and here are a couple of key passages supporting my contention that commercial banks create money when they lend money and create deposits:

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

. . . .

The vast majority of money held by the public takes the form of bank deposits. But where the stock of bank deposits comes from is often misunderstood. One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.

Watch these videos for some elaboration. First a short video from two bankers telling you, very clearly, that bankers do not simply lend out the deposits they have. They create money when they make the loan and create the deposit:

Here is a slightly longer, but still short, video featuring one of the authors of the Bank of England paper. One of his main points is that, while people think deposits enable loans, the truth is actually the reverse: loans enable (create) deposits.

When banks lend money, they create deposits, which are IOUs. Typically, no currency changes hands; a credit is simply posted to a bank account. As long as the bank stays within regulatory requirements, it need not have 100% of the cash on hand to fund these IOUs. It just creates the deposit.

The difference between these IOUs and IOUs from any other institution is that bank IOUs function as a medium of exchange and can be easily converted into currency.

Now, when banks lend this money, they have the loan, which is an asset, and they create a deposit, which is a liability. This balances out — but there is still new money in the system . . . until the loan is repaid, at which point the money is destroyed.

But the key point to recognize is that the bank does not need to have the cash on hand to make the loan. They simply create a deposit, by pushing a button on a computer keyboard, and voila! new money is created.

Commenters in the other thread note that banks cannot simply create this money “willy-nilly.” Well, of course. Banks are constrained by the need to have the loan repaid, and that means they need a supply of creditworthy borrowers. The bank’s ability to make a profit is affected by the interest rates set by the central bank.

So, if bankers can affect the money supply, thank God for the Fed, right? After all, bankers don’t have society’s interests in mind., so we need to rely on the steady hand and immense wisdom of our central bankers to prevent runaway inflation . . . right?

Yeah, not so much. Under the gold standard, there was a natural brake on bankers’ natural tendency to overinflate the supply of money . . .

. . . but that’s another post.

CAVEAT: As always, this comes with the caveat that I am not an economics expert, and I assure you that several commenters here could talk rings around me when it comes to balance sheets and the like. However, I have done enough reading on the topic to feel comfortable with my position, and am happy to have it challenged with facts, logical arguments, and links. As always, please keep dismissiveness and ad hominems out of the discussion. We’re all learning here.

77 Responses to “How Commercial Banks Create Money”

  1. Ding.

    Patterico (9c670f)

  2. The core issue here is that money is an absolutely abstract concept, designed to make commerce more convenient. It is a storage unit for value, not the value itself. And on some level it is a shared delusion that keeps working more because we want it to keep working than because it makes sense. Look at it too closely and it recedes towards the horizon, which I think is the basis of a lot of paranoia about banks, money, and governments.

    At least, I find that if I think about the details of how money is created too long I start to feel that I should be stuffing it in the mattress, which I know doesn’t work….

    C. S. P. Schofield (e8b801)

  3. thank God for the Fed, right?

    As a mere college student back in the 80′s it occurred to me to thank God the name of the Federal Reserve Chairman was unknown even to most educated and financially knowledgeable people. It occurred to me that once that position became politicized at the everyday common man level, where the person appointed would be influenced by the same factors that affect the appointments of labor secretaries or defense secretaries, etc. we were screwed. I knew this day was coming. We now have a fed chairperson who was chosen more by what exists (or doesn’t exist) between that person’s legs than by what exists between said person’s ears.

    Of course those where the days when the Fed Chief was Paul Volker who know wtf he was doing. I’m not familiar with Fed chairmen before him except slightly with what went on in the 20′s and 30′s.

    WTP (fd3093)

  4. This kind of discussion always reminds me of the a great exchange in the television show “The Beverly Hillbillies” in the 1960s.

    Jed Clamppett had become very rich off oil he found on his land. He deposited it with the banker, Mr. Drysdale.

    Jed went to Mr. Drysdale and asked to remove his money.

    Drysdale explained he couldn’t do that; he had lent it to other people.

    Jed stared at him. “You gave my money to other people?”

    Classic moment.

    Simon Jester (cf5a93)

  5. Simon, exactly. Except in this scenario, where Uncle Jed appears to be one of the largest depositors in Drysdale’s bank, if UJ insisted on getting his money out, and putting aside the whole Fed complication, Drysdale could sell those loans off to other banks, provided the loans are good and other banks would want to buy them, and give UJ his money. Of course this lessens Drysdale’s ability to make money off those loans, creates a big headache and has the potential to cause other depositors or even other banks to lose at least some faith in Drysdale’s bank…and in Drysdale’s ability to manage such.

    WTP (60406d)

  6. O … k. So banks have created a medium of exchange between themselves — promissory notes. And those promissory notes are worth the same as my greenbacks outside the banking world, like the grocery store and gas station, because of checks and ATM cards. And this devalues my greenbacks. And bankers try to hide this by making us dizzy with loans being deposits and deposits being liabilities. I get that, too. So …, why do we need more than “Thou shalt not lend out anything with the $ in front of it if the U.S. Treasury has not already printed a corresponding legal tender for it”, if that’s bothersome? Why do we need gold?

    nk (dbc370)

  7. And if bulk of paper is a problem, there are $100,000 bills negotiable only between banks.

    nk (dbc370)

  8. So …, why do we need more than “Thou shalt not lend out anything with the $ in front of it if the U.S. Treasury has not already printed a corresponding legal tender for it

    such would just be a formality. kinda like the “what if there’s no gold in fort knox” question. There is no need for the Treasury to print money that isn’t needed because there just isn’t enough demand for credit to justify it. Actually, the only reason to physically print money is for the petty transactions twixt individuals. IIRC that $100,000 note (with Ma-Ma-Where’s-My-Pa’s picture on it) is no longer being passed around.

    WTP (fd3093)

  9. Also meant to add. The more physical paper in circulation, the more expense with maintaining it. Dollar bills cost money to make, you know.

    WTP (fd3093)

  10. We don’t need a gold standard. We need this law:

    Any banker who engages in a money transfer of any kind, whether paper or electronic, without being in a position to deliver cold, hard cash to the payee within three business days, shall be imprisoned for three years and one additional year for each day of delay past three days to a maximum of _____.

    Now this is a daydream, Omega Palladin. When I was prepping for the bar exam I was given this advice on doing well on Negotiable Instruments questions: The bank wins.

    nk (dbc370)

  11. Dollar bills cost money to make, you know.

    I know. That’s the concept of seigneurage when currency was precious metals — the face value of the coin was a percentage above its cost. I thought that’s what the Fed rate is supposed to do, too. Pay for itself and make a little profit for the general revenue.

    nk (dbc370)

  12. And, FWIW. Well into the ’80s, even after the cash transaction reporting law, you could buy a house with a paper bag full of cash for your down payment on top of your mortgage. Even if it was not done at the lender bank. The title commpanies had cash registers and they’d counnt your money and give you a chit to take to your closer. I’ve done it to clear liens and taxes due.

    nk (dbc370)

  13. such would just be a formality. kinda like the “what if there’s no gold in fort knox” question.

    I think it would be total control of the money supply, as good as gold, or even better — as good as America.

    nk (dbc370)

  14. @nk

    We wouldn’t even need that law.

    All the Fed would have to do is make the Fractional Reserve Rate 100%.

    Of course, by doing so our economy would immediately crash.

    Ty (ef09b3)

  15. “But the key point to recognize is that the bank does not need to have the cash on hand to make the loan. They simply create a deposit, by pushing a button on a computer keyboard, and voila! new money is created.”

    Patterico – Still not quite getting the point. Who want to take out a loan that they don’t have the ability to draw on or spend for its intended purposes? Nobody. That’s a fraudulent loan if the buyer can’t draw on it. See my last comment on last night’s thread. The 14 page article you linked from the BOE deals with that scenario in Figure 2.

    The bank has to have on hand cash or electronic equivalents (which are assets) for the borrower to spend when he wants to use the proceeds of his loan. Using the proceeds of his loan reduces the deposit account these bankers say is created on the borrower’s behalf when the loan is created and reduces what they also call reserves on the asset side of the bank’s balance sheet. Debit the deposit, Credit an asset. With respect to that one bank money blipped up then back down.

    daleyrocks (bf33e9)

  16. the problem is not one solitary loan, but the structure of finance, under QE Omega,

    narciso (3fec35)

  17. Here is my last post from there which directly addresses this.

    I won’t challenge any of those assertions from the article, I will just look at the consequences.

    Banks should not be able to “create” “money” through debt, and everything should be based on actual, real, hard, currency.
    What does that mean?

    Well first off, no more credit cards. That’s right, cut them all up because they only function by letting the issuer lend you money then transfer that money to someone else’s banker, all on a theory that you, your credit card company, and the business taking the credit card will all make actual hard currency transactions at a later date.

    With no credit cards you can throw away all internet business.

    You can also forget about checks, which are of course IOUs, and are predicated on the person accepting it being able to go to his bank and exchange it for cash on the theory that your bank will send money to his bank, which of course operates on the theory that you aren’t engaging in check fraud. Well, we might be able to keep checks, but the time to cash them will go from days to weeks, and I really doubt anyone will turn over any goods or perform any service until your check has first cleared.

    You can also say goodbye to multi-location banking. If you insist on a bank having enough money on hand to satisfy all depositors no matter what, then the bank will only be able to give you your money back at the precise location you deposited it. To do otherwise they would need personal reserves of their own money they can store at multiple locations to cover the entire amount of deposits they have for everyone at each location at any time.

    Since loans will only be made with hard currency, and since iterative lending of IOUs will be pretty much impossible, you can expect collateral requirements to be severely tightened up. In fact loans may disappear entirely and all you will be able to do is pawn stuff – hand over the collateral directly in exchange for hard currency. And even that may require the lender be able to actively profit from the collateral during the term of the loan or require collateral greater than the value of the loan thus ensuring the interest will be paid. If actual lending does continue expect the interest rates will soar to levels that will make loan sharks and payday lenders redundant.

    Now consider all of your daily, monthly, and yearly transactions.
    What percentage do you make based on the spot lending and ledger shifting that would be done away with and what percentage do you make with direct, physical, transferences?
    How far would you have to travel, how long would it take, and how much would it cost to make all of your payments in person with hard currency?
    Granted, that is merely anecdotal, but to what extent would you expect that to apply to everyone else?
    To what extent do you expect that would affect the ability of all the merchants you do business with to profit at their current prices?

    Again, I am not challenging anything in that article.
    All I am doing is pointing out the consequences of not “creating money” in the way described in that article, and asking what you think about them, what effect you think they will have on your way of life, and what effect you think they will have on your standard of living.

    Sam (e8f1ad)

  18. Re. the Jed Clampett scene above, the issue isn’t that Jed wants to withdraw the money, it’s the timing. The bank can borrow the money from the fed, via computer, and make it available to Jed the next day (and technology being what it is, the one day waiting time is more about float than actual need).

    I’m speculating, not expressing an informed opinion here.

    East Bay Jay (a5dac7)

  19. I know, Ty. These series of posts has only served to illustrate the Libertarian/Anarcho-Capitalist fallacy for me. If we want our standard of living we need complex organizations with hierarchies of authority to make them function in an orderly, predictable, and above all trustworthy manner.

    nk (dbc370)

  20. As a consequence of the new loan from the Fed, the bank might have to call in loans. This is how Jed’s decision can turn into a bank run.

    East Bay Jay (a5dac7)

  21. “In the modern economy, most money takes the form of bank deposits.”

    A definition of how the U.S. defines money can be found here:

    http://federalreserve.gov/releases/h6/current/default.htm

    Just scroll to the bottom of Table 1. The breakdown of supply by category is further down the page. Readers will immediately note that the definitions exclude what I believe are trillions of dollars of assets held in money market accounts at non-bank financial institutions such as Fidelity, which are not members of the Federal Reserve. Such accounts are used by most people as the equivalent of cash.

    daleyrocks (bf33e9)

  22. “the problem is not one solitary loan, but the structure of finance, under QE Omega,”

    narciso – My issue is that if people do not understand how one loan works its way through the system they are not in a position to attack or defend the system. I believe we have people here who fundamentally misunderstand how banking works.

    daleyrocks (bf33e9)

  23. The Hidden Secrets of Money

    Nice, simple multimedia presentation on the basics of the corruption inherent in monetary system and the need for a gold (or other objective) standard as money. It’s a handful of easy-to-understand episodes that are well worth your time.

    Just sayin…

    J.P. (bd0246)

  24. You neglect several things, Patterico. Among them is that the is a limit to the ability of banks to reloan, namely a liquidity requirement. The system has built-in friction.

    But lets look at what you suggest for a moment:

    A bank loans $100K. The borrower intends to use it for an addition to his house.

    To start off, all the money is in a bank account, and the bank treats this as a deposit and loans out on it. You suggest this deposit is fanciful and simply double counting of the same dollars.

    As he builds, he pays contractors and they put the money in (to make it easier) the same bank, but in their accounts. If you ask the contractors, they will assert their deposits are real.

    Meanwhile the house, the collateral for the building loan is becoming more valuable; wealth has been created. Eventually he is done and all the money is in the contractors’ accounts.

    At what point in this process does the bank have “real” deposits instead of fanciful ones? How does the bank know the difference? No money has actually left the bank, and it has exchanged $100K for (presumably) at least $100K in additional collateral. At no point was the loan at risk.

    Kevin M (b357ee)

  25. The American Enterprise Institute had a good short history of losing the gold standard.

    http://www.american.com/archive/2014/may/coins-that-go-clunk

    Key point, in 1964, it was the first change to American money since 1792. It effectively made our money backed by nothing more than a politicians pledge. (Which we all know how much that is worth)

    So the reason to back money with gold is because it forces credibility into the system.

    DejectedHead (a094a6)

  26. Texas banks don’t show me sh*t…

    http://dfw.cbslocal.com/2014/05/08/houston-authorities-searching-for-serial-defecator/

    Teh Serial Defecator (7ce80a)

  27. Looking back over the other comments, Sam again nails it. I note that he is the first person to mention “collateral” which the post entirely ignores, but is the basis of all loans. You cannot have a discussion of loans and deposits without talking about collateral.

    Even credit card loans have the collateral of the borrower’s credit worthiness (or should; banks have a tendency to jack up interest rates to cover statistical losses, but competition limits this).

    The real question that you need to consider, Patterico is “What is money?” The idea that it is physical paper, bullion or seashells is to money as “Old Man with a Beard” is to God.

    Kevin M (b357ee)

  28. Taking my example of #24 is a world where no money (a housing loan) can be created pretty much leads to a world where no wealth (a room addition) can be created because of a lack of ready capital.

    One would have to save up one’s shekels over years and years to build that room addition, and their means of earning those shekels would be severely limited because everyone else would have to save up theirs before they could have the money to hire you.

    Kevin M (b357ee)

  29. The other problem with not leveraging deposits is that a single failure of a loan at an unleveraged bank can cause a bank failure if the collateral has fallen in value. Since the bank cannot sell the collateral and recoup its loan, it is no longer 100% liquid. Since that is the requirement, it must fail.

    Kevin M (b357ee)

  30. “The core issue here is that money is an absolutely abstract concept, designed to make commerce more convenient. It is a storage unit for value, not the value itself.”

    C. S. P. Schofield – And then there is the issue that most countries don’t control their money as much as they think they do because it is traded on futures and options exchanges, often offshore where the home country cannot regulate the activity, lending occurs in various currencies in international markets and a variety of other developments over the past 75 years. This Luddite anarcho-capitalist fascination with the gold standard and getting rid of central banks is the stuff of pure conspiracy theories in MHO.

    daleyrocks (bf33e9)

  31. I tried to answer the question “What is Money”…personally I think money can most closely be associated with trust. Money is trust that someone will accept your money. A promisory note. No one really cares what “it” is, just as long as it is accepted.

    The problem arises when that trust is eroded and the claimed value of the note is subject to distrust.

    With regard to the lending/creating money vs collateral. Kevin M, you are right that people would have to save up shekels to build a house or whatever. That is roughly called “Living within your means”. The new system works great for building that house more than normal…unfortunately it creates other problems also. Debt. Lots and lots of debt.

    Now the debt is a problem in the sense that it makes everything else more expensive. Taking out a loan on a house worth $150,000 does not cost you $150,000…it costs you $260,000 at 4% interest for a 30 year fixed. That means your purchase is not at face value. It has the purpose of raising your cost of living. It is a hidden inflationary effect on the borrower.

    DejectedHead (a094a6)

  32. “But the key point to recognize is that the bank does not need to have the cash on hand to make the loan.”

    Kevin M. – Modifying your #24 to fit Patterico’s concept in the post, if the builder did not bank at the same institution as the borrower how would the conversation go?

    Borrower – I want to pay my builder now, please wire him funds under my construction loan.

    Bank – I’m sorry but we don’t have funds on hand to do that.

    Borrower – But I signed documents for the full amount of the construction loan and you credited my account with a deposit for the full amount of the loan. I’m paying interest on the full amount of the loan. Are you saying there’s not really a deposit there?

    Bank – Weeeelllll……

    Borrower – Are you saying I can’t really spend the money you claimed you lent me and are charging me interest on?

    Bank – Weeellll…….

    Borrower – Are you saying this was all a scam because you never had assets on hand to fund my loan?

    Bank – Let me get my manager.

    daleyrocks (bf33e9)

  33. And debt is not capital but that’s like so retro, 1970s even.

    nk (dbc370)

  34. “And debt is not capital but that’s like so retro, 1970s even.”

    nk – Some people treat 100 year debt as capital for regulatory purposes.

    daleyrocks (bf33e9)

  35. With no credit cards you can throw away all internet business.

    You failed to account for debit cards. Those cards allow you to spend money that is in your account instead of operating as a revolving line of credit. When a purchase takes place, the money is instantly deducted from the buyers account and deposited in the sellers account.

    Anon Y. Mous (8ec442)

  36. Out until tomorrow night. Have fun. Play nice.

    daleyrocks (bf33e9)

  37. Of all the comments I’d guess that maybe 10% are by people who really understand our banking/monetary system. A riddle inside a mystery wrapped in an enigma.

    Mark Johnson (ea2309)

  38. Comment by WTP (fd3093) — 5/8/2014 @ 8:10 am

    As a mere college student back in the 80′s it occurred to me to thank God the name of the Federal Reserve Chairman was unknown even to most educated and financially knowledgeable people.

    I knew who he was: Paul Volcker.

    I also knew that Jimmy Carter had appointed him specifically to do what he had done in the beginning of the year 1980 – and that that had caused the recession, so the public was quite right in blaming Jimmy Carter and electing Ronald Reagan. (although Reagan didn’t understand this too well either, but Volcker had corrected himself by then)

    Jimmy Carter had appointed two Fed Chairmen. The first one, to replace Arthur Burns (who caused the recessions of 1969-70 and 1973-75 – to fight inflation, which of course only made it worse and slowed down the economy as well) was G. William Miller. He had a permanent appointment.

    But Jimmy Carter persuaded him to resign by offering to make him Secretary of the Treasury in 1979. (Miller was kind of stupid)

    This created the vacancy which allowed him to appoint Paul Volcker who proceeded to raise interest rates to 20% to “fight inflation” until even he had to admit defeat.

    This was one of Jimmy Carter’s flaws – besides lying. He trusted the experts. And he did exactly what the experts said he should do (Jimmy Carter had contempt for the intelligence of the average person) on both energy and the economy and that was responsible for his worst policy failures.

    Jimmy Carter’s energy policy was to beat a shortage to the punch. He also (although Congress had to pass this stupid law) supported preventing thermostats in the summer in major buildings from going below 80 degrees when used for air-conditioning – I think Congress changed that to 78 degrees, and above 65 degrees in the winter.

    There was leeway for the president to waive that and just about the first thing President Reagan did when he came into office in January, 1981, was to get rid of that restriction, which in the third of a century since has never reared its head again.

    We haven’t had such luck with toilet bowl restrictions and incandescent lights, and they are working on plastic bags, albeit only at the state and local level..

    Jimmy Carter was also listening to them about the Middle East to some degree, but Begin and Sadat took the whole thing out of his hands anyway.

    Sammy Finkelman (d22d64)

  39. It occurred to me that once that position became politicized at the everyday common man level, where the person appointed would be influenced by the same factors that affect the appointments of labor secretaries or defense secretaries, etc. we were screwed.

    No we are not. And if it not politicized you blame the president, sometimes unfairly. It was however 100% fair in the case of Jimmy carter in the year 1980.

    By the way, in the FDR and Truman Adminstration until March 4, 1951, the Fed accomodated the Treasury. FDR agreed to the change in policies that created the recession of 1937.

    I knew this day was coming. We now have a fed chairperson who was chosen more by what exists (or doesn’t exist) between that person’s legs than by what exists between said person’s ears.

    Half and half. Obama knew she was for lower interest rates. And if any Fed Chairman in the near future is not: the deluge.

    >i> Of course those where the days when the Fed Chief was Paul Volker who know wtf he was doing.

    So well that he cost Jimmy Carter the election.

    Sammy Finkelman (d22d64)

  40. 37. Yeah, if I understood finance I ought to have made a fortune at some point in my life.

    Hanging onto it is something else again.

    gary gulrud (e2cef3)

  41. Kevin: if the builder did not bank at the same institution as the borrower

    Then, when the money leaves the bank, he bank has to replace it. It’s not really holding on to it, anyway. It holds on to money by getting people to hold their deposits there either with branches, some other conveniences, or interest rates.

    But when it makes a loan it is new money. It may need to get other new money from other banks.

    Banks lend money to each other “overnight” when they don’t have enough. (The shortest unit of time in banking is the day, although Friday to Monday = 3 days)

    Sammy Finkelman (d22d64)

  42. Comment by daleyrocks (bf33e9) — 5/8/2014 @ 9:56 am

    Such accounts are used by most people as the equivalent of cash.

    Which leads to a discussion of “shadow banking” – other kinds of promissary notes that are treated as cash equivalents.

    Anything can become a cash equivalent.

    In 1929, stocks were basically cash equivalents. A very dangerous situation to be in.

    Sammy Finkelman (d22d64)

  43. The ‘first to mention “collateral”‘.

    The low information voters are ubiquitous, more numerous than Sciuridae.

    gary gulrud (e2cef3)

  44. Daley,

    The only difference in #24 if the money is in several banks is that it is harder to talk about. But that is the only difference.

    Kevin M (b357ee)

  45. And, daley, I don’t put those restrictions on banks, Patterico does. That you find a reducio ad absurdum in that is not MY problem.

    Kevin M (b357ee)

  46. The horrible demographics of the blogosphere strike again. Sigh.

    Private banks don’t create money. Never have they created money. That would be like saying casinos create money by issuing chips or markers. Um, no. Duh. The colloquialisms used in dog & pony show videos don’t change reality.

    Treasuries create money by printing it. Central banks create money with bank reserves. The Fed in recent years has created a helluva lot of money in connection with its QE programs. But that’s all the gummint, Chief, not private commercial bankers.

    A commercial bank loan is the conversion of a short term asset of the bank’s (existing deposits, cash or cash equivalents) into a long-term asset of the bank’s (note receivable) and a long-term liability for the borrower. The money comes from the bank’s existing cash and deposits, or from commercial paper, or from overnight loans from other banks. Or preferred shares. Or swaps. Whatever. The money already belongs to the bank is the key point. When the loan funds the bank debits the cash line on its balance sheet and credits the notes receivable line. The borrower gets the cash or the cash credited to him or her. This is not necessarily a deposit in the bank. It could be a direct payment to a construction contractor. A wire to an account in Japan. Whatever. No money is “created.” Again, that’s the gummint. A private commercial loan involves existing money in hand that gets moved around.

    Lawrence Westlake (4fc30a)

  47. Gary, are you really comparing the gold standard and specie money to sophisticated economics? It really just shows a lack of ability to deal with abstraction (and there’s a word for that).

    Kevin M (b357ee)

  48. Money is a sequence of 64 zeroes and ones. It’s existence, non-existence, presence, absence and travel all measured in milliseconds.

    gary gulrud (e2cef3)

  49. OK now see in the previous posts on this topic, Patterico’s detractors were arguing based on the bank’s reserves being 10% of deposits.

    This Scenario: Customer opens account and deposits $100 cash. Bank puts $10 cash in the safe and loans out $90 to other borrowers. This is the Fractional Reserve Banking discussion as it occurred in the earlier posts criticizing Patterico’s position.

    Then someone said something about Customer’s entire deposit representing the bank’s 10% reserve, while the bank loaned out 9 to 12 times as much as what the customer deposited.

    This Scenario: Customer opens account and deposits $100 cash. Bank puts $100 cash in the safe and loans out $900 to other borrowers.

    Patterico’s detractors now magically not only accept this second scenario as the norm, but criticize the original scenario as the death of our economy.

    WTF.

    Chris (0ba377)

  50. Paul Volcker who proceeded to raise interest rates to 20% to “fight inflation” until even he had to admit defeat.

    Driving up interest rates did kill inflation. Inflation was rediculous throughout the 70s. According to what was reported in the media it was like some sort of mystery. Richard “We’re all Keynesians now” Nixon tried wage & price controls. Ford printed up a bunch of WIN buttons. Ford’s effort probably had as much impact. Volker pushing up rates effectively stopped the Fed/Treasury from printing money. Cheap money bad, stable money good in all but extreme circumstances.

    WTP (60406d)

  51. 47. No, I’m saying you don’t read and consider the words mouthed.

    gary gulrud (e2cef3)

  52. I’ve made a pact with my unmarried, unusually beautiful 28 yr old daughter. I insist on having all potential suitors tested for “banker’s blood”. Those who have that detestable concoction running thru their veins have their asses kicked out the door.

    Colonel Haiku (e576fc)

  53. folks who don’t understand fractional reserve banking say “banks create money out of thin air when they make a loan”. But a bank alone can’t create money. It’s the borrower and bank, working together, that create money.

    The borrower creates something of value by signing a promise to repay. That promise to repay goes by any number of names including “note” and “bond”, and that promise can itself be traded (often at a discount) from bank to bank to bank. Even defaulted promises have some residual value to debt collectors – they’ll buy them at pennies on the dollar on the hope that some of the borrowers can be shamed or harassed into paying what they owe.

    The note is more valuable if it’s based on more than just the promise of the borrower – Tack on “if I don’t repay, you can have my car”, and it’s better. Tack on “if I don’t repay, you can have my house and the land it sits on”, and it’s even better.

    BIll (cf98e2)

  54. Daleyrocks. Clearly I misread #33.

    The problem is more like when the specie-lending bank goes to send the messenger with the gold coins to my contractor’s bank, and they draw the coins out of the vault, some stick-in-the-mud pipes up with “But sir, we have loans out on those coins!”

    Kevin M (b357ee)

  55. No, I’m saying you don’t read and consider the words mouthed.

    Oh, I consider it alright. I just don’t believe a word of it. I read Rothbard back in the 70′s when he was actively propounding this stuff (For a New Liberty remains on my shelf). But specie money was a no-nothing idea back in the 1830′s when Jackson championed it and it hasn’t got better with time.

    Kevin M (b357ee)

  56. As I said earlier:

    The gold standard is to money as “Old Man with a Beard” is to God.

    Kevin M (b357ee)

  57. Comment by WTP (60406d) — 5/8/2014 @ 2:01 pm

    Driving up interest rates did kill inflation.

    No, it didn’t. That is dependent on a breakdown in inventory control, which hasn’t happened since the Great Depression.

    Sammy Finkelman (d22d64)

  58. gary (#55),

    Yes, this is absurd, but you the fact that people can cheat does not mean that you have to outlaw the game. Instead, outlaw cheating and shoot the bastards when they do.

    Kevin M (b357ee)

  59. * you

    Kevin M (b357ee)

  60. Inflation is “dependent on a breakdown in inventory control”? Please clarify.

    WTP (41d24a)

  61. I think it better to say “when a bank increases its balance sheet by taking on deposits/making loans — money is created.

    The reasoning presented above misses the double accounting entry principle.

    Rodney King's Spirit (ca9e04)

  62. Driving up interest rates did kill inflation. No, holding down the money supply did that.

    Kevin M (b357ee)

  63. No, holding down the money supply did that
    Well, yeah. Nobody was taking money from the Fed at 20%, so the money supply shrank. However it should be noted there were considerable advancements in the real world of the economy at the time due to technology, the personal computer, etc. which effectively brought the real GDP up to meet the previously inflated money supply.

    WTP (bb50a1)

  64. Also: Reagan.

    Kevin M (b357ee)

  65. You failed to account for debit cards. Those cards allow you to spend money that is in your account instead of operating as a revolving line of credit. When a purchase takes place, the money is instantly deducted from the buyers account and deposited in the sellers account

    I didn’t account for it because it isn’t a solution.

    First and foremost, unless the customer and the merchant both have accounts with the debit card company the money is not going to be instantly transferred. You still need to create a debt record and wait for the physical transfer.

    Second, even if they do both have accounts with the same debit card company unless they are in the same neighborhood, which is pretty much not going to be the case with internet business, that debit card company still has to have its own massive reserves to maintain multiple warehouse locations as I originally noted or again it must rely on a debt record and wait for a physical transfer.

    Third, it still has the problem of ease of physical access for the customer and merchant to the warehouses.

    Fourth, since we can pretty much inevitably expect the existence of multiple debit card warehousers it means that merchant and customer will have to maintain multiple accounts to ensure they can serve a wide range of customers or buy from a wide range of merchants respectively, much as people currently have a Visa, a MasterCard, and an American Express card today, except with the need to maintain reserves with all of them and more.

    Fifth, the costs associated with all of this are going to skyrocket. If you think the fees for using your debit card in the wrong bank are bad now wait until you start having to pay for this.

    Sixth, since these debit card warehousers are going to be dealing in truly massive amounts of warehoused specie, and since they are going to be essential to maintaining the economy of large areas, they are going to take “too big to fail” to astounding new heights.

    Ultimately, at best, debit cards merely remove one level of the debt creation bookkeeping that is being taken as fraudulent money creation, and as such is useless to actual resolve the problem, and so internet business is still doomed.

    Sam (e8f1ad)

  66. The difference between these IOUs and IOUs from any other institution is that bank IOUs function as a medium of exchange and can be easily converted into currency.

    Any transferable IOU is currency of a sort. So making such a loan is creating money. Banks basically guarantee the IOUs of people who have borrowed from them making these IOUs more liquid. Banks are restricted on how many IOUs they can guarantee (relative to the bank’s capital) in order to reduce the chance they will be unable to honor their guarantees.

    James B. Shearer (9233b4)

  67. daleyrocks (#30)

    Maybe it’s because I’m stupid, or ignorant, but every time I run into the assertion that money has to be based on something, my immediate thought is “and what is that based on other than a collective agreement to view the material that the money is based on as valuable?”

    It always comes back to Money is money because we collectively SAY it is money.

    On another topic; on sick days from school, in the early 1970′s, I remember watching a Public TV (I don’t think it was officially PBS yet) program about economics, with the action being marionettes meant to represent an isolated tribe of Pacific islanders. Does anybody else remember such a thing, or was it hallucinations brought on by exposure to LET’S MAKE A DEAL and THE DINAH SHORE SHOW?

    C. S. P. Schofield (e8b801)

  68. 46

    Private banks don’t create money. Never have they created money. That would be like saying casinos create money by issuing chips or markers. Um, no. Duh. …

    Actually casinos are creating money of a sort. Rumor has it casino chips can sometimes be used as money in casino towns.

    James B. Shearer (9233b4)

  69. If you think the fees for using your debit card in the wrong bank

    Not to mention the new fees on the merchants (cartage fee, assay fee, bonding fee, etc), the delay for specie payment, and the general bother of working through multiple systems, regions and clearinghouses and very quickly you find that no merchant will deal with it. Credit cards today are way bad enough.

    Kevin M (b357ee)

  70. Promissory notes, if they have the magic words, are negotiable like checks, and these days are mostly uniform to save the trouble of reading all the way through them for “the fine print”. Between bankers and investors they’re as good as Genghis Khan’s scrip or the Bank of England’s banknotes or your $5.00 at Starbucks. They’re money.

    nk (dbc370)

  71. Rumor has it casino chips can sometimes be used as money in casino towns.

    And sometimes not. And the sometimes not thing is what separates money from private IOUs.

    Kevin M (b357ee)

  72. On the upside, all this movement of gold coins suggests a boom for robbers.

    Kevin M (b357ee)

  73. 72

    And sometimes not. And the sometimes not thing is what separates money from private IOUs.

    It’s a matter of degree. Some forms of money are more widely accepted than others.

    James B. Shearer (9233b4)

  74. 68 C. S. P. Schofield — vague memories, but they could have been from my econ text, which did not use marionettes but had cartoons of very early econ as islanders (unspecified as to which island) who were initially trading coconuts and fish sticks(!) In the game that accompanied this, I tried to disrupt the economy by teaching people how to fish; a friend succeeded by selling shell necklaces (which became money a chapter before we were supposed to have money.)

    htom (412a17)

  75. 68. Comment by C. S. P. Schofield (e8b801) — 5/8/2014 @ 6:51 pm

    Maybe it’s because I’m stupid, or ignorant, but every time I run into the assertion that money has to be based on something, my immediate thought is “and what is that based on other than a collective agreement to view the material that the money is based on as valuable?”

    It always comes back to Money is money because we collectively SAY it is money.

    That’s absolutely right. There are some things that have intrinsic value, but gold, and silver and precious stones aren’t in that category. Not at their current prices.

    They are valuable because everybody else thinks it is valuable.

    What is money? Money is whatever it is nobody is afraid they’ll have to get rid of it at a loss. Everybody is willing to take it.

    These days that’s not gold or silver – that’s Dollars.

    Sammy Finkelman (bcd7c8)

  76. On another topic; on sick days from school, in the early 1970′s, I remember watching a Public TV (I don’t think it was officially PBS yet) program about economics, with the action being marionettes meant to represent an isolated tribe of Pacific islanders. Does anybody else remember such a thing, or was it hallucinations brought on by exposure to LET’S MAKE A DEAL and THE DINAH SHORE SHOW?

    Maybe this??

    http://en.wikipedia.org/wiki/Thunderbirds_(TV_series)

    It involved marionette, was made in Britain in the 1960s, and therefore is something that could have been picked by non-commercial “educational” TV channels in he 1970s, was set in the South Pacific, and while it wasn’t about economics, it did involve money…

    Maybe you saw only one episode?

    Wait. They made four different televisions shows using marionettes. No, more:

    http://en.wikipedia.org/wiki/Supermarionation

    Four Feather Falls (1960)
    Supercar (1961)
    Fireball XL5 (1962)
    Stingray (1964)
    Thunderbirds (1965)
    Captain Scarlet and the Mysterons (1967)
    Joe 90 (1968)
    The Secret Service (1969)

    That still doesn’t sound like it.

    Sammy Finkelman (bcd7c8)


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