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Banks and creation of money

See EconomicRiddles

A bank's balance statement list deposits as liabilities, and loans as assets. The reason is that deposits are money that the bank may have to give away in the future (if the customer withdraws it), and loans are expected income for the future (presuming that the default rate is predictable). Understanding this helped me understand basic economics.

This is slightly related to the riddles above because money is really created by banks making loans, with only a fractional reserve requirement (less than 100%). Banks don't store all the money given in deposits--they are allowed to loan out a certain percentage of it.

For instance, suppose that the banking rules for a country say the bank has to keep 10% of deposits in reserve (not available for loans), and the bank has $1,000,000 in deposits. This bank can then lend out $900,000. Suppose all of this was lent to Sam. Sam deposits the $900,000 in a second bank. That second bank can now make $810,000 in new loans ($900,000 - 10% reserve). The process continues and eventually up to $10,000,000 of new money (ten times the original amount) could be created (if all the possible loans are made and all recipients deposit the money in a bank).

Some external links:

In the case of the cascade loan, new money isn't created. The debt cancels the money in a very real way. This is why when you sum your assets you subtract your debt for your real value. I suppose you could say for every particle of money there is a particle of antimoney. --ss

Money is very much created. Let's not confuse money with value.

Interesting. It seems to be a way to stretch the money supply to cover all that new worth that is being created from people's time. --srs

That's exaclty right: stretching the money supply is exaclty what loans do. The money supply is perfectly plastic and has no natural length. If no corresponding increase in value comes along to take up the slack, inflation is the result. Sadly, people's time has little do do with worth (aka value). A thing is worth what you can get for it. The punchline is that this is just as true of money as it is of anything else. Worth is created from people's opinions (and may be destroyed by them, too).

In a sense, the "antimoney" idea could work, but with one addition: the governments/central banks can hold a huge supply of antimoney. (Indeed, the Federal Reserve (NOT the US Treasury) can and does create money simply by writing a check.) In the system described above, money is destroyed when loans are repaid. This destruction is only temporary, however, as the bank will loan the money back out as fast as possible. After yet more Google reading (GoogleIsAmazing??), I found a couple explanations of the process:

The first link, "How Banks Create Money" [2] is a very clear explanation of how more money was created once goldsmiths became bankers. These pages also explain how the modern bank policies work to regulate the money supply, with balance sheets to illustrate the process.

The other link [3] states the current US reserve policy straight from the Federal Reserve Bank of New York. Some of the most interesting points were:

"As of September 1996, the reserve requirement was 10% on transaction deposits,, and there were zero reserves required for time deposits." This means the bank can have as little as 10% of your checking (transaction) accounts in reserve ("vault cash or on deposit at a Federal Reserve Bank"), and your savings (time deposit) accounts do not require *any* reserve. To help small banks, for the first $52 million of a bank's transaction accounts, the reserve requirement is only 3%. "Current reserve requirements are low by historical standards. From 1937 to 1958, for example, the rate on demand deposits was always at least 20% for banks in New York and Chicago [...]."

When I first wrote the 30% reserve example, I was a bit worried that it would be too low to be realistic. Now I know better. --CliffordAdams (suddenly not feeling so good about his checking account...)

In the old days, banks were required to hold due collateral (e.g. silver in most cases) for every billing note issued. However, as the banks realized that at any one time the demand to cash in their collateral--mostly from other banks during interbank transfers, most of which came from cheques--was far lower than 100% of their supplies. They only had to have on hand more than the demand.

Eventually, I suppose they figured you could further reduce demand by balancing the amount owed to another bank with the amount that bank owes you. The cancelled value is much lower.

By the way, the opening chapter in CryptonomiconBook? has a nice description about this in Shang Hai.

Anyway, if you recall, when Russia melted down, the demand to withdraw funds broke the banks (literally in some cases; and the walls come tumblin' down.). There just wasn't enough cash or collateral on hand to distribute to the populace. This is where the system breaks down. -- SunirShah

I have in front of me a 20 UKP note. This means I have loaned the bank 20 pounds - the note is an IOU for the loan. We can tell this because it has "I promise to pay the bearer" written on it. Normally when we lend money, we expect interest payments. What happens to the interest on the 20 UKP?

0 risk loan = 0 interest rate? That is my guess. --StanSilver

Do UKP notes still have those kinds of "pay the bearer" text? I have an old (1950s) US $10 bill which says that it may be "redeemed for lawful money" at a Federal Reserve bank. The dollar was defined as equivalent to a certain amount of gold. (You can't redeem these notes for gold any more--the note is just a plain $10 bill now.) Nowadays the notes just say that they are legal tender. Also, even if you considered your withdrawal as a loan, how much interest would you expect on a loan with no fixed time to repay? (You could return the banknote at any time.)

I'm sure you'll get the interest rate that you negotiated when you withdrew the banknote. What? You didn't negotiate? Be glad you aren't paying the bank then. :-) Actually, when paper notes were introduced, they were essentially receipts for gold storage. One would pay a goldsmith to keep your gold in his safe. When loans were introduced, some smart goldsmiths figured they could drop the storage fees and make even more money by lending at interest (and thus became bankers). Indeed, if a depositor was willing to commit their gold for a certain length of time, the bank could even share some of the loan-interest with the depositor. --CliffordAdams

Yes, UK notes still have the text. It is not clear what you will be given if you turn up and demand your 10 UKP. Even in England you probably won't get gold. You might be given another 20 pound note.

The book LiarsPoker? talks about how US mortgages, which can be paid back at any time, were made desirable to lenders. The trick is to collect, say, 1000 of these little pieces of debt and then divide them into groups, say, A, B and C. The first 1/3rd of people who repay get allocated to group A respectively, etc. So you can sell group C to someone who wants to give a long term loan, knowing that 667 people will have to repay early before that loan is touched. There's still some risk, but it's much more managed.

Anyway... in effect the interest on the 20 UKP goes to the bank. That the right to issue money is an ability to borrow interest free, is one of the things which makes that right valuable and why banks don't like people inventing their own currencies. Something to bear in mind when we think about digital cash. -- DaveHarris

FYI: The text on UK notes related to silver, not to gold. But it's obsolete now anyway, and remains only as a throwback - the law no longer requires that the Bank of England backs your notes with equivalent reserves of precious metals, nor does it give you the right to demand them. In short: it's only written on the notes for tradition's sake. -- DanQ?

For the straight dope on where money comes from, check out http://www.straightdope.com/classics/a3_163.html
The 1995 essay "Governments and Money" at [4] has many interesting notes on the gold standard, fiat money (not backed by gold), the Bretton-Woods system (the last attempt at an international gold-based system which collapsed in 1973), and other related topics. In some ways the US Federal Reserve system sees itself as defending the money supply from the whims of the US government.

Should anyone realise how dicey paper money is and prefer gold, you should use Wiki:GoldBackedElectronicMoney, if you actually want some yellow shiny metal email me and we can negotiate a rate for posting some out to you. --AndrewMcMeikan

Money is a social invention. It is based on the trust that some symbolic token can be converted to a real value in the future. Without a community that creates trust and stability reaching out into the future, money can't represent value. This means that money and the community, economy and social justice are tightly coupled. It may be a shock, but: there is no way to separate monetary wealth and social responsibility. -- HelmutLeitner

Not to quibble or anything *8) but strictly speaking that argument only seem to show a link between monetary wealth (i.e. having lots of basically symbolic money) and social responsibility? Some other argument will be required to show a link between non-monetary wealth (i.e. having lots of actually intrinsically valuable stuff under your control) and social responsibility. -- DavidChess

Yes, exactly, monetary wealth (I inserted that into my statement). I've not thought about the other one, but I would expect that the answer to the second problem is the creation of role expectations. Perhaps a "rich person role" (independent from richness in gold or knowledge) must be re-designed to cover the necessary expectations, rights and obligations. At least that is the answer that might come from (my kind of) online community thinking. -- HelmutLeitner

Currencies that are hard-backed by some commodity (eg, coins made out of gold, that are worth their gold content) don't require anything in the way of stability. Currencies that are soft-backed by some commodity (eg, "promise to pay the bearer five pigs") require stability in whatever entity issued them. Currencies that are unbacked (eg modern currencies) require economic stability. You can have economic stability without social responsibility: Thatcher's "There is no such thing as society" had no impact on the markets. Also, the stability doesn't have to be local stability: a broken society can always fall back to the US dollar (Russia, etc). -- MartinHarper

To further that point, Britain happens to have a particular kind of liberalist system that properly separates the state from the majority of economic affairs. In other state systems like Communism or Feudalism, the economy and political systems are highly integrated, so social irresponsibility such as cutting off the heads of your major landowners leads to economic crashes.

The liberal view is that the economy be free, and the State only has to get involved in a regulatory manner to ensure the economy remains free. Since the economy requires people to work and people need to economy to do things for them, they aren't really separated. The direct social effect of the State on the economy though is limited to managing the people's well being (e.g. criminal negligence), regulating how people may be employed (e.g. labour laws), regulating how people may use the economy (e.g. the Bank Act), and regulating how the economy uses the people's property (e.g. mining rights). In a sense, you can consider the economy to be a separate thing from the State, and the two are in constant and continuous negotiation with each other. -- SunirShah

You can have economic stability without social responsibility. I would dispute that (although maybe we just mean different things by the words). If everyone broke the laws whenever they thought they could get away with it (or whenever the payoff was worth more to them than the penalty), we'd have chaos; the chaos would include the impossibility of enforcing (some/most) property rights, and that would mean no economic stability. So at least for the minimal value of social responsibility (not breaking the law without good reason), I think it is in fact a prereq for economic stability.

Thatcher's "There is no such thing as society" had no impact on the markets. That's because everyone knew what she meant. *8)

-- DavidChess

I think it's a complicated topic and I surely don't have the silver bullet to it. But there is some important relationship between (community, life, social processes), (future, stability) and (synergy, cultural inventions, money). If there is no future, a lot of things loose its value. If you die next month, you won't work to save money for yourself. If we wouldn't trust Meatball to exist next year, most of us wouldn't write anymore. The core of the community, the members or the founder, must grant this stability. It's all about the future.

Whatever MT has said, it didn't mean that community changed in stability. Money backed in gold didn't change it's value when gold went up for a factor of 10 and down again. The gold served the purpose to give a reason for trust at a certain point in history, but you don't really need it. That's the reason why a lot of countries reduce their gold reserves. Stock markets rise and fall according to assumptions about the future and the trust of the shareholders. It's all about trust.

The community has developed rules (laws), processes (tax) and institutions to guarantee the advantages of the community from the processes of the economy, to make economy socially compatible. But this is a dynamic process. If global economy isn't controlled by a global community, then the social compatibility is not guaranteed. Then the system will fail. The questions are the same as in the wiki: who is the community, who may participate in decisions, who grants stability, who has the advantages of stability, is the system fair? -- HelmutLeitner



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