Money creation through bank lending

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CharlesHarris's picture
CharlesHarris
Status: Member (Offline)
Joined: Oct 15 2008
Posts: 6
Money creation through bank lending

As Martenson says, this is a very difficult concept for us economic ludites. He suggests I may have to watch a few times, but it's just not going to help me:

You know, the example where Bob gives his $1000
to Bank A who loans $900 to Judy who gives it to Mary who puts it in
bank B, who loans $810 to Frank.... etc, until you have $10,000.

I've
seen this over and over and I just don't get it. I simply don't get
this. As far as I can tell, it's still $1000. If you replace "banks"
with "people", then it is still just $1000.

If I loan $1000 to my dad, who then loans $900 to my uncle.... that doesn't mean there is suddenly $1900!

I mean, it seems to me the dollar amounts below each person or bank are misleading. For example, the first bank has $1000 under it. As far as I can tell, this is the not the amount it has in its coffers, or the amount it has given out. It is therefore the amount it owes. Now the first guy has $900 underneath him. That makes sense, because he owes $900. But wait! The next guy has $900 underneath him, but he was simply paid the money by the other guy. He doesn't owe anything! See what I'm saying?

I know I'm wrong, and I just don't understand, but can someone please explain to my why I'm wrong...

Reuben Bailey's picture
Reuben Bailey
Status: Silver Member (Offline)
Joined: Mar 17 2008
Posts: 138
Re: Money creation through bank lending

I think that your confusion may lie in what banks are allowed to do with money.  When certain kinds of deposits are made, the bank is allowed to lend out a certain percentage of that - 90% is the current figure, I believe.  So the scenario, just one layer deep, goes like this:

Let's say the first $1000 dollars is hard currency that I earn.  I take that to a bank and deposit it.  That is a $1000 asset to me and a $1000 liability to the bank.  In a sense, I have just loaned the bank $1000.  The bank turns around and loans out $900 of the money that I just deposited.  They now have a $1000 liability and a $900 dollar asset.  If I go in and withdraw my money the next day, I now have my $1000 in my hands, and the person who borrowed the $900 still has their money in hand (they are a little slow in spending it).  Therefore, there is now $1900 in money in circulation.  There is still a place where $900 of that will eventually disappear, in the form of the $900 liability of the borrower, but until that is paid off, $1000 just became $1900.

It works with people, too, when this form of "fractional reserve" is used.  My understanding of the way some banks do it is to keep the entire $1000 on deposit and lend out 900% ($9000) of it.  They get the money to do this "out of thin air", since the asset and liability cancel each other out when it comes to their books.  If they need cash to pay out the $9000, then they borrow it from other institutions or the Fed itself.  

 

This is just my understanding of how it works.  If anyone see any flaws, please feel free to correct me.

All the best.

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