Crash Course - Section on Creation of Money

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retnap's picture
retnap
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Crash Course - Section on Creation of Money

My comment point is that fractional reserve banking (FRB) is not the cycle where money is created. FRB simply enables the same quantum of money to be recycled, as the attached simple model demonstrates (I think that this model is implied by that Chapter of the Crash Course). FRB is a process which enables the recycling of money on an ever-decreasing scale. At some points, when loans are repaid and deposits cleared, there is a de-cycling of money, i.e. the money put into circulation is effectively taken out of circulation. 

In reality the borrower does not simply deposit the full amount of the loan he/she has taken (as is assumed in the attached model). For example company A borrows to invest in a cycle of capital accumulation which will involve the purchase of labour power and materials for the production process. More than half of Company A's expenditure (typically) is on payroll and the bank plays a purely financial intermediation role for the payment of salaries and wages, which are not savings deposits and therefore are not available to lend out on the basis of FRB. This fact further limits the amounts of money available for recycling. So FRB is limited even as a mechanisms for recycling the same quantum of finance, because it requires that a relatively high proportion of disposable income is deposited as short and medium term savings. In South Africa we have dissavings and I  understand that the savings rate in the US is also relatively low.

The point of the above is threefold: firstly, FRB does not per se result in the creation of new money; central banks as  banks of last resort create new money. Secondly, if we can control and manage the creation of new money on an ever decreasing scale, FRB can still play the legitimate role of simplifying/speeding up trade. Thirdly, we should be focusing our policy interventions not on commercial/retail banks through an assault on FRB (why throw the baby out with the bathwater?) but on the functioning of the central banks in devising mechanisms for slowing down the growth in money supply.

JAG's picture
JAG
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Re: Crash Course - Section on Creation of Money

retnap,

you might like this thread by Farmer Brown.

But you might also want to know that there is empirical evidence that shows that banks endogenously create money, and that bank deposits/reserves are a function of this endogenous money creation rather than the other way around. Dr. Steve Keen discusses this in this interview:

Predictions For 2010: Steve Keen

 

DrKrbyLuv's picture
DrKrbyLuv
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Re: Crash Course - Section on Creation of Money

retnap wrote:

The point of the above is threefold: firstly, FRB does not per se result in the creation of new money; central banks as banks of last resort create new money. Secondly, if we can control and manage the creation of new money on an ever decreasing scale, FRB can still play the legitimate role of simplifying/speeding up trade. Thirdly, we should be focusing our policy interventions not on commercial/retail banks through an assault on FRB (why throw the baby out with the bathwater?) but on the functioning of the central banks in devising mechanisms for slowing down the growth in money supply.

Hello retnap,

Your spreadsheet is very interesting and consistent with the "money multiplier" effect that is often cited as "fractional lending."  However, this is not really the way the banking system works which invalidates your conclusion. 

Fractional lending is probably the most misunderstood and confusing term in money mechanics. Even pundits and those assumed to be knowledgeable misapply and misunderstand the concept.  This is not by accident as the system is purposely designed to be hard to understand.  Let me try to explain how things really work.

First, banks DO NOT lend their or their depositors money. They create new money on the spot by monetizing a promissory note and suitable collateral.  Almost all (around 97% I think) of our money is created by commercial and investment banks - for virtually free. 

Almost all "reserves" in the system are a liability to the Federal Reserve. The Federal Reserve builds "reserves" by creating money to buy things like government securities. This is how the Federal Reserve controls the money supply through the FOMC (open markets committee) - if they want to increase the money supply, they buy securities to build reserves.  If they want to decrease the money supply, they sell securities to reduce the reserves.

Many people think that fractional reserve lending works like a "money multiplier," that is that if a bank receives a "demand deposit" (checkbook money) then they are free to lend a ratio or multiplier of that amount.

In actuality, banks have no such limits to lending.  For example, savings accounts that are time dated for removal require no reserves. A bank can theoretically lend as much as they want if they have savings accounts.  And, a bank will usually lend money even if they have inadequate reserves by simply borrowing or buying additional reserves later.

So, you might wonder what limits a bank from infinite lending?

The key is that they must maintain a minimum of two important ratios. First, the "capital ratio" is the ratio of a banks equity to a risk-weighted sum of of the banks assets. Second, the banks "leverage ratio" is the ratio of the banks equity to the unweighted sum of its total assets.

Banks are money making machines - the only thing that supposedly stops their lending ability is their solvency as measured through the two ratios that I just described. I say "supposedly" because as we know, there have been many banks that have gone insolvent this year.

If the bank regulators were really doing their job we would have far fewer bank defaults. The problem is that many are technically insolvent and the regulators are permitting them to continue via "creative bookkeeping."  The fraudulent theory is that the FDIC, Fannie and Freddie are the backstop to protect depositors.

Recently, Mish wrote an article that touched on this misconception (H/T to JAG) entitled "Fictional Reserve Lending And The Myth Of Excess Reserves"  He is correct though I disagree with the part of Mish's article that contends that there are no excess reserves but that's another story.

As a solution, I would suggest that banks should never be allowed to create new money.  Constitutionally that is a function of government and it would provide a huge opportunity to eliminate taxes while stabilizing our money supply against booms and busts, and as an added bonus, there would be no national debt.

Larry

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