I have seen the idea addressed in the previous post promulgated by a couple of commenters on Russ Winters' "Winterwatch", and on Mike Shedlock's "Global Economic Analysis". I have been trying to understand how these commenters have come to their erroneous conclusion - I believe it is to do with the notion that banks create money "out of thin air".
Here are some examples of the posts:
CCG on Winterwatch: "As I now understand it, banks “lend” money simply by creating it in the borrower’s account. If the borrower pays it back, it disappears. If not - has the bank really taken a loss when it didn’t have the money to begin with?"
OilShock on Mish's Global Economic Analysis: "Banker is loaning money he doesn't have. He creates it out of thin air. He couldn't care less if he will get this "money" back or not. All he cares about is a perpetual interest rate on phantom money."
BuzzKill on same blog: "HAHAHAHA!!! Do you even understand how the banking system works? New Bank loans out $1 million they don't have. Borrower doesn't repay, bank goes BK. $1 million that didn't exist before now does exist. Later, the FDIC pumps new money into New Bank and they loan out $1 million they don't have again. Again the borrower doesn't repay, again they go BK. Now there is $2 million out there that didn't exist before. Not inflationary??"
As you can see, some individuals hold these ideas quite strongly.
This idea in turn comes from a misunderstanding of fractional reserve banking. There seems to be an idea growing out there that since reserve requirements have been shrinking (and in fact are zero for some time deposits) that any given bank can create unlimited loans. A bank can loan all the money it has under the right circumstances, but it cannot loan more than it has. That is to say, it cannot loan money out unless someother party has deposited the money, or lent money to it, first.
So, wherever you see the notion of the bank loaning "money it didn't have to begin with", you also see the root of this misunderstanding - they did have the money to begin with, it was deposited or lent to the bank in some way.
"So how does the multiplier effect work then?". The Fed creates new money by purchasing government securities on the open market, depositing cash in the account of the seller. Banks get to loan a "fraction" of their deposits. In some cases that fraction is 100%. This works through the chain of deposits that is created when one entity receives the proceeds of a loan that was spent by a borrower, and deposits it in their bank allowing that bank to make additional loans. Note that in no case is the fraction of deposits that is lendable greater than 100%.
A variation on this idea is that the bank credits a borrower's account creating an increase in deposits so now the bank can make even more loans "out of thin air". But this ignores the fact that the bank's loan book increased by exactly the same amount as the deposits. There is no net increase in deposits minus loans to enable a new loan to be written. The Fed has yet to go so far as to permit negative reserves. Note in addition that no bank in its right mind would lend 100% of its capital as it has to meet day-to-day operating expenses and it has to have money on hand to clear transactions.
In conclusion, banks don't really create money "out of thin air" they create it by making loans against deposits. It is the multiplier effect that causes this activity to inflate the money supply based on the money the Fed creates "out of thin air".
5 comments:
Your statements in this post seem to contradict those in the 40-minute video "Money as Debt" by Paul Grignon. The way that video explains it, banks do create money. I would really appreciate it if you took a look at the video and commented on it. I would like to understand this point.
http://video.google.com/googleplayer.swf?docId=-9050474362583451279
here's another try at the link:
ttp://video.google.com/
googleplayer.swf?
docId=-9050474362583451279
the video discusses fractional reserve lending.
Anon.,
Thanks for your comment and the link - it was a very nice presentation and I wish more people would watch it.
On the factual issues the only place I disagree with the presentation is where the presenter goes through the idea of capitalizing the bank with $1,111.12 put on deposit with the Fed and then going ahead and issuing a $10k loan.
The bank would need to acquire at least $10k in deposits before making that loan (either depositors open checking accounts, or purchase CD's, or some other lender makes loans to the bank).
To see this just consider the bank's balance sheet. Let's say the bank is capitalized by shareholders with $1,000. The balance sheet would show assets: $1000 reserve deposit (RD) and liabilities / equity: $1000 shareholders' Equity (SE).
If the bank were now to make a loan of $10k by the mechanism described in the presentation (i.e. simply credit the customer's account by the amount of the loan), the balance sheet would show assets: $1k RD, $10k loan receivable from customer A (LR-A) and liabilities / equity: $10k checking account customer A (DA-A) and $1k SE.
Let's say the borrower now buys the car for $10k. That reduces liabilities by $10k, but where does it come from on the asset side of the balance sheet? The money is drawn down out of reserves, but they are only $1k. So, the bank's balance sheet would now show ($10k) RD, $10k LR-A and $0k SE. The bank is insolvent and would be closed.
How do we solve this situation? The bank has to acquire deposits first. That is the step the producers of the video skipped over. A bank cannot simply capitalize itself make a deposit at the Fed and start loaning money into existence - if it did, the bank would be insolvent as soon as the borrowers tried to draw on their borrowed funds an amount greater than reserves.
They also skipped over until later in the video, the genesis of the whole process which is that the Fed purchases government securities to bring new money into ciculation, the government spends the money which is deposited at banks which can now make loans against the new deposits creating still more money. That borrowed money is used to purchase stuff which results in more deposits, more loans, and on and on it goes.
So to reiterate my main point: It is the Fed that creates money out of thin air, the banks then loan that money multiple times over to the limit of reserve requirements (or prudence) against deposits newly created by the loans themselves.
Looking at it another way, once every bank has loaned out as much as they can within the reserve requirement rules, and limits of good business sense, they cannot create any more money by themselves unless and until the Fed injects more money.
To me, the fact that a bank has to have deposits before it can make loans means they cannot create money out of thin air, they are limited by their deposits.
thanks for looking at that video and responding. I thought it was a good presentation, but if it is wrong on that point it is sort of misleading.
You write very well.
Post a Comment
Note: Only a member of this blog may post a comment.