Money. Doing it Right this Time.

Monsterzuma said:

How do you interpret the line "loans create deposits" if not as a form of private sector money creation?

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It's more a shorthand of nomenclature than anything else. Recall the money multiplier: A bank makes a loan, that loan is going to be deposited someplace. Hence a new deposit. But the money for the original loan came from someplace. Now the article you quoted earlier is a debate about where the original money, the Monetary Base, comes from. But they don't dispute the fact that the Monetary Base has an origin that is not thin air. The rest is leverage.

And accounting.

But it's not magic. The money supply as a whole is stagnant until there is a change in the monetary base. (With a few quibbles that are generally left out simply because the size of them don't often matter).

Now one of these debates concerns whether all new Monetary Base comes from the government, or whether a lot of it comes from cross border capital flows. Personally I think that international flows can be a major part of it. But there were some years where the standard Monetarist theories simply wrote that off as non-existent. Why? Because if one or the other is true, then you have very different outcomes and policy prescriptions.

Now the Austrians would say that financial crises come from having too much money in the system and the government is responsible, so have some "market money" instead of government fiat money. But if it is true that money flows across borders, what the book linked in my sig calls a Capital Inflow Bonanza, then the Austrians could be right that too much money causes financial crises, but wrong that the government is responsible for the money. That is market money.

The way it was explained to me when I asked about this on Steve Keen's blog, where transactions between clients of the same bank are concerned, transfers between deposit accounts can be made to settle goods exchanges without any involvement of reserves. The reserves only become a factor when settlements between banks have to be made. So those deposits can serve as money already just fine at the point of their creation, i.e. when no reserves are drawn in to "back" them.

It was hard to get clear answers on this, though, and the answers I got were at times contradictory.

Here's the most informative response I got:

“What are the reserves needed for? When are they needed? Are they not initially and immediately needed?”
Bank ‘reserves’ are deposits by banks at the central bank. They are used for clearing net inter bank payments (ie payments from Bank A to Bank B, less payments from Bank B to Bank A).
The way you get reserves is the way you get any sort of money. You either have it, or you borrow it.
Now banks have a capital buffer. That capital buffer is based on long term investments at the bank. Let’s say £100.
That represents reserves at the central bank. So the balance sheet looks like this.
DR Central Bank Reserves £100 CR Equity £100.
That immediately means that the bank can clear £100 of net inter bank payments without any problem.
So the loans and deposit can be created, paid, payments made and so on, and as long as the net inter bank payment with other banks (bearing in mind that their loans and deposits will be coming in the other direction) doesn’t ever exceed £100 everything rumbles along happily.
Once you get to the point that the variation in inter bank payments exceeds £100, the first thing you do is borrow the excess overnight from the other banks.
If a bank A is short reserves, and bank B is up reserves, then Bank A just borrows the extra reserves from bank B overnight to clear their account at the central bank and Bank B charges Bank A a fee for that.
The payment system clears about a 10 to 30% of the annual GDP flow of transactions daily using a very small stock of central bank reserves.

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http://www.debtdeflation.com/blogs/2012/03/29/krugman-on-or-maybe-off-keen/comment-page-5/#comments

From "NeilW", who I think is one of the more respectable commenters there with proper economic credentials.

Link to video.

Steve Keen was interviewed about the "blog war" by RT's Lauren Lyster for Capital Account.

Unfortunately he makes some poorly considered statements about Paul Krugman "ignoring private debt", which he doesn't.

Here's another explanation of how to interpret "loans create deposits" that was given to me by a post-keynesian economist:

Merijn Knibbe said:

Suppose you’re standing before an ATP machine. Your bank account has a zero balance, you do however the right to overdraw it to the extent of 1.000,–. You draw 100,– from the ATP machine, which means that you get a debt of 100,– while the amount of money in circulation (the money you just took from the machine) increases with 100,– (notes inside the machine are considered to be ‘base money’ and not ‘money in cirulation’ which is of course right: doubling (or quantupling) the amount of notes inside the machine does not alter spending power of people).
In this case, a 100,– loan created a 100,– deposit (in your wallet). The point: the bank does not create the money – the bank and the lender together create the money.
In the ATP case there still needs to be ‘base money’ in the machine. However – when you lend 10.000,– from a bank and it’s directly put on your electronic account, even that’s not necessary. The bank and you proclaim: “Let there be money”, somebody types “10.000,–” on your account – and then there is money. And debt, as the 10.000,– is also entered the “You Owe the Bank” account. And you will have to pay interest. And there is nobody who can stop the bank and you from doing this, the bank does at the moment of the transaction as a matter of fact not to have reserves to be able to do this.

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Would this be an appropriate place to ask for advice on building a credit rating? I've always been very prudent with my money, never spending funds I didn't have. Both of the cars I've owned were purchased outright with cash, from my savings. (They were 'used', naturally.) Although this has helped me avoid getting into debt trouble, I can't imagine I have much a credit rating, either, since I've never used credit cards or taken out a loan, the notable exception being my student loans which I'm faithfully paying for. My bank (PNC) offers credit cards, and I've been thinking about taking one out and then using it for minor internet purchases, then paying off the balance immediately. Would this be an effective approach to building my credit rating? I'd like a strong one for when I apply for an apartment of my own, or -- in the far future -- start looking for a small home.

Monsterzuma said:

The way it was explained to me when I asked about this on Steve Keen's blog, where transactions between clients of the same bank are concerned, transfers between deposit accounts can be made to settle goods exchanges without any involvement of reserves. The reserves only become a factor when settlements between banks have to be made. So those deposits can serve as money already just fine at the point of their creation, i.e. when no reserves are drawn in to "back" them.

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If it's within the same bank, then it's just entries in that bank's database. Nothing else is involved. It's all handled electronically. It makes no difference at all to the bank's overall balance sheet.

Monsterzuma said:

Here's another explanation of how to interpret "loans create deposits" that was given to me by a post-keynesian economist:

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I don't think that's right. One thing we haven't said much about is cash on hand. If the money is in the ATM, it is cash on hand for the bank against day to day transactions. If the money is in your pocket, then it is cash on hand against day to day transactions. Nothing has changed as far as the money supply is concerned. The banks have the same deposits, the same reserves, and the system has the same cash on hand. What has changed is that you will have to pay some fee for the money you have borrowed from the bank.

The monetary base has not changed.

The following day the bank has to refill the machine from some other account and the transactions balance.

Now what if you borrow money and then deposit it?

One thing that we haven't talked about, because I'm fairly sure that over time it has little real impact on the rest of the equation, is the propensity for holding cash. Now assume every American, on average, holds $100 in cash on any given day. Some will be holding nothing, others will be holding thousands. But we'll call the average $100 for discussion. Does that hold true every day? No. The day after payday people will have more cash than the day before payday. People will have more cash in December than in February. But those variations don't matter. What matters is the average and the long term trends. One thing the FDIC does in guaranteeing deposits is prevent bank runs. By doing that, it essentially eliminates the hysterical actions of stripping clean bank accounts and holding all the money in cash. So the propensity for holding cash does change, seasonally, on a schedule, and over time with changes in the economy. But the seasonal and scheduled changes are knowable and predictable. And any changes over time can be tracked and the CB can factor them in to their equations.

It's not talked about much, because frankly, it rarely does anything to really talk about.

Now assume a situation happened where the average cash on hand for Americans suddenly went from $100 to $150. That would make an impact. And the Fed would have to take actions to offset that impact. Banks and many large companies now in the wake of the financial crisis are holding a lot more cash. And so the Fed has had to act to change the money supply to compensate for that.

Smellincoffee said:

Would this be an appropriate place to ask for advice on building a credit rating? I've always been very prudent with my money, never spending funds I didn't have. Both of the cars I've owned were purchased outright with cash, from my savings. (They were 'used', naturally.) Although this has helped me avoid getting into debt trouble, I can't imagine I have much a credit rating, either, since I've never used credit cards or taken out a loan, the notable exception being my student loans which I'm faithfully paying for. My bank (PNC) offers credit cards, and I've been thinking about taking one out and then using it for minor internet purchases, then paying off the balance immediately. Would this be an effective approach to building my credit rating? I'd like a strong one for when I apply for an apartment of my own, or -- in the far future -- start looking for a small home.

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Sorry, I don't really want to get into personal finance. I'm not expert in the field and I don't want want to lead you the wrong way. By the same token, I'm trying to keep this thread fairly narrow and just discuss money itself, because I want to dispel some myths that have been floating around about it.

cutlass said:

If it's within the same bank, then it's just entries in that bank's database. Nothing else is involved. It's all handled electronically. It makes no difference at all to the bank's overall balance sheet.

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How is that relevant to anything? The deposits are a store of value, a medium of exchange and a unit of account to the clients of the bank. They are for all intents and purposes money.

What I've been somewhat confused about is why these deposits, which are no more than "accounting entries", are accepted as a store of value by the clients. I'd imagine you'd need to be able to pay taxes in terms of them for a demand for these deposits to exist. I haven't gotten any clear answers yet on how taxation works with regard to these bank deposits, though. I'll try asking Keen directly.

Monsterzuma said:

How is that relevant to anything? The deposits are a store of value, a medium of exchange and a unit of account to the clients of the bank. They are for all intents and purposes money.

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Yes. But it doesn't actually matter who's account it is in. Not to the bank reserves, and not to the money supply. All the rest of it is just keeping track of which account it belongs in.

What I've been somewhat confused about is why these deposits, which are no more than "accounting entries", are accepted as a store of value by the clients. I'd imagine you'd need to be able to pay taxes in terms of them for a demand for these deposits to exist. I haven't gotten any clear answers yet on how taxation works with regard to these bank deposits, though.

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There's a lot of faith involved. But, essentially, if something has always worked, then why wouldn't it not work now?

The thing to keep in mind is that all those accounts and all those loans are backed by something. What is true in a bank run or a bank insolvency is not that the bank does not have assets sufficient to cover liabilities, but that the assets are not liquid, and the liabilities are. Which is to say that the bank is required to refund deposits on demand, but cannot call in loans on demand. If you're half way in to a 30 year mortgage, the bank cannot call you one day and tell you to be paid up by the end of the business day. But a depositor can empty their account at any time.

So because those deposits are all backed by some real asset, and because in the normal run of things (with the help of FDIC) no one is unable to get at their money on demand, there's no reason to lack confidence in the system.

As far as taxes are concerned, you owe a certain tax on the interest income of your deposit above a certain level. You do not owe taxes (in the US) on the value of the deposit.

say1988 said:

Because the initial money has to come from somewhere. It may go through the system a large number of times and geat heavily multiplied, but there must be a starting point.

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I am always kinda baffled by this.

Quackers deposits £100, the bank keeps £10 in reserve and lends out £90 left over.
Another guy borrows that £90 and buys a new car, the guy who reciees the £90 puts it all in the bank. The bank keeps £9 and lends the remainder £81. Cutlass borrows the £81 and buys new materials for an extension on his house, the home supply seller deposits the £81 in the bank. The bank keeps £8.10 and lends out £73.20. This proccess continues on and on and on. How can we say this isn't private money creation? I'm not against this process, it just seems quite a dangerous way of doing things.

Quackers said:

I am always kinda baffled by this.

Quackers deposits £100, the bank keeps £10 in reserve and lends out £90 left over.
Another guy borrows that £90 and buys a new car, the guy who reciees the £90 puts it all in the bank. The bank keeps £9 and lends the remainder £81. Cutlass borrows the £81 and buys new materials for an extension on his house, the home supply seller deposits the £81 in the bank. The bank keeps £8.10 and lends out £73.20. This proccess continues on and on and on. How can we say this isn't private money creation? I'm not against this process, it just seems quite a dangerous way of doing things.

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Well first, you have to keep in mind that this has been going on a long, long time. Kings in England legalized this at least 500 years ago, and it was certainly going on centuries before that. So while it may superficially provoke a visceral negative reaction in a lot of people, it's not like it's this new thing in the world that we do not have vast experience with. This has been going on for the entire modern era. Not problem free, I grant you. But with sufficiently few problems that people who understand it don't really think twice about it.

In other words, so what if it is private money creation? How does that change anything? Why does it matter? What is it about that that is so disturbing to people? Particularly, with a world of weirdness, why does it bother free market conservatives, libertarians, and anarchists? They should love the fact.

Quackers said:

I am always kinda baffled by this.

Quackers deposits £100, the bank keeps £10 in reserve and lends out £90 left over.
Another guy borrows that £90 and buys a new car, the guy who reciees the £90 puts it all in the bank. The bank keeps £9 and lends the remainder £81. Cutlass borrows the £81 and buys new materials for an extension on his house, the home supply seller deposits the £81 in the bank. The bank keeps £8.10 and lends out £73.20. This proccess continues on and on and on. How can we say this isn't private money creation? I'm not against this process, it just seems quite a dangerous way of doing things.

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I would make the distinction from private money creation in that it is just leveraging the initial $100 that was presumably from a central bank. A central bank putting $100 into the economy knows that (assuming a 10% ratio for simplicity and because of your example) this will add about $1000 to the money supply and intentionally does so (if $100 was wanted, then only $10 would be added).

Private money creation would be when the initial $100 is created by a private source.

There isn't really any ambiguity about whether the textbook version of fractional reserve banking involves banks creating money or not if you choose your terminology correctly. Banks expand the broad money supply (M1, M2, total credit market) by lending, but keep the narrow money supply (M0) the same.

The last few pages in this discussion have gone a step beyond fractional reserve banking, though. The question is whether banks can expand broad money before the government expands the monetary base, and whether such monetary expansion on the initiative of the private sector can induce an accommodatory expansion of base money by (more or less) necessity.

Look at what the situation would have to be to make that happen. With a conventional bank operating under conventional regulations, the only way would be to import money from abroad. They still have to get a monetary base from somewhere.

But this is an area which actually blurs the distinction between conventional banking and the rest of finance. Because other parts of finance can actually do more or less the same thing, only without the regulations and restrictions. So people are upset that banks might do this, but banks are constrained in how they do it. Other parts of finance have little to no regulation. It's the unregulated free market that provides the dangers, not the regulated banks.

Banks can only "create money" within the rules that the government creates and enforces. If the government is neither creating or enforcing rules, then the banks, or more particularly the non bank parts of the financial services industries, can pretty much do any damned thing they please.

The main danger area with banks is that they've found that with creative bookkeeping they can evade the government's reserve requirements. And the non bank financial firms don't face that reserve requirement at all. So you get firms leveraged far beyond sanity.

So there is a lot more danger outside of the regulated parts of the industry than there is inside of it. Which is ironic in that the enemies of banks mostly want the regulated part gone and the unregulated part left to its own devices.

Someone a few months ago was talking about killing conventional banking and replacing it with something not called a bank that serves the same role, but is unregulated. Partly a Ron Paul plan. And that would actually make the "money creation" situation far worse than it is now. But there are non bank financial institutions now that fill some of that role and act in that manner. And it's growing.

So your problem is not the regulated banks, but rather everyone else. This is why the focus of monetary policy is moving from M0, MB, M1 to M2 and M3. Those broader measures are above and beyond what conventional banking is doing.

The world is changing. The regulatory environment is not keeping up with it. This is why the financial crisis happened.

Cutlass said:

Not problem free, I grant you. But with sufficiently few problems that people who understand it don't really think twice about it.

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Indeed. They don't need to think twice: they immediately set themselves up as bankers if they possibly can!

Cutlass said:

In other words, so what if it is private money creation? How does that change anything? Why does it matter? What is it about that that is so disturbing to people? Particularly, with a world of weirdness, why does it bother free market conservatives, libertarians, and anarchists? They should love the fact.

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Because it becomes one huge advantage to those doing it and profiting from the interest charged on this money, over the vast majority who doesn't get to do it?
Because those who already set up shop do their best to keep it a privilege only accessible to themselves: by having governments regulate the business and place barriers to entry (licensing, minimum capital requirements, old boy's networking for interbank business, etc) by keeping the way such business works as obscure as possible (letting people believe that banks first have to get deposits and only then can lend money, for example)?

innonimatu said:

Indeed. They don't need to think twice: they immediately set themselves up as bankers if they possibly can!

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Or just anyone who's bothered to study a bit of economics.

Because it becomes one huge advantage to those doing it and profiting from the interest charged on this money, over the vast majority who doesn't get to do it?
Because those who already set up shop do their best to keep it a privilege only accessible to themselves: by having governments regulate the business and place barriers to entry (licensing, minimum capital requirements, old boy's networking for interbank business, etc) by keeping the way such business works as obscure as possible (letting people believe that banks first have to get deposits and only then can lend money, for example)?

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There are 11,000 banks in the US. Almost anyone can start a bank.

But if you really think interest rates now, just try to wrap your head around what the interest rates would be with 1/10th the money in the system.

Cutlass said:

There are 11,000 banks in the US. Almost anyone can start a bank.

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Then I'll concede to you in this whole discussion if you start one!

Cutlass said:

Now the Austrians would say that financial crises come from having too much money in the system and the government is responsible, so have some "market money" instead of government fiat money. But if it is true that money flows across borders, what the book linked in my sig calls a Capital Inflow Bonanza, then the Austrians could be right that too much money causes financial crises, but wrong that the government is responsible for the money. That is market money.

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I recall there was a theory about the financial crisis being started in China because of some major financial event there somewhere in the mid-00s, that wasn't really bad or good for China, but would lead to massive capital inflows to the US where they would spark a crisis. Are the two related?

Cutlass said:

Well first, you have to keep in mind that this has been going on a long, long time. Kings in England legalized this at least 500 years ago, and it was certainly going on centuries before that. So while it may superficially provoke a visceral negative reaction in a lot of people, it's not like it's this new thing in the world that we do not have vast experience with. This has been going on for the entire modern era. Not problem free, I grant you. But with sufficiently few problems that people who understand it don't really think twice about it.

In other words, so what if it is private money creation? How does that change anything? Why does it matter? What is it about that that is so disturbing to people? Particularly, with a world of weirdness, why does it bother free market conservatives, libertarians, and anarchists? They should love the fact.

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I am surprised when you learnt about fractional reserve banking that you didn't think: "O-M-G, WTF?! Banks can just *make money*?!". Obviously from your post your associating me with some kidna Paulinista approach to money, but I am not. I just have a "WTF" emotive feeling toward firms creating money. It works and people with a capital surplus can earn money and provide funds to people with capital deficits, so it is a win-win situation. Carry on with it.

Kaiserguard said:

I recall there was a theory about the financial crisis being started in China because of some major financial event there somewhere in the mid-00s, that wasn't really bad or good for China, but would lead to massive capital inflows to the US where they would spark a crisis. Are the two related?

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It wasn't China. It was the Asian financial crisis as a whole, which included most of the Rising Tigers, but not China or Japan (Japan had a separate crisis with different causes and timing). There was also a series of financial crises in Latin America. One of the effects of all these crises was a flight to safety. And safety meant the US and EU. Another effect was to have governments put away a savings for the next crisis, rather than more deficits for the next crisis. Both those factors meant that for the first time in modern history the developed nations were net importers of money and the developing nations net exporters of money. It normally works in the opposite direction. A further factor is the sovereign wealth funds of the major exporting nations of the oil exporters and China. They have huge surpluses of money and nothing to do with it. Again, the US and EU are the safe places to send that money. And were dumb enough to run massive deficits.

So that really is a huge amount of money. A Capital Inflow Bonanza. Financial crises are almost a certainty after something like that happens.

Quackers said:

I am surprised when you learnt about fractional reserve banking that you didn't think: "O-M-G, WTF?! Banks can just *make money*?!". Obviously from your post your associating me with some kidna Paulinista approach to money, but I am not. I just have a "WTF" emotive feeling toward firms creating money. It works and people with a capital surplus can earn money and provide funds to people with capital deficits, so it is a win-win situation. Carry on with it.

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It's just what is. It's not a wtf moment for most people who understand it.

Quackers said:

I am surprised when you learnt about fractional reserve banking that you didn't think: "O-M-G, WTF?! Banks can just *make money*?!". Obviously from your post your associating me with some kidna Paulinista approach to money, but I am not. I just have a "WTF" emotive feeling toward firms creating money. It works and people with a capital surplus can earn money and provide funds to people with capital deficits, so it is a win-win situation. Carry on with it.

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Banks are no different than any other entity. A person is in the business of living, said person will take out a loan (liability) and buy a house with the money (asset). A corporation is for the purpose of carrying out business, it takes out a loan (liability) and manufactuing equipment (asset).

Neither of these parties just holds the cash they get from a loan, they use it for the purpose of carrying on their normal business.

A bank takes loans from individuals and companies (liabilities) and carries out its business of giving loans to other parties (assets). Nothing suprising or crazy.