And does it really matter?
Steve Saville has a nice piece on this topic, check it out.
http://www.321gold.com/editorials/saville/saville041007.html
I'm not sure why Steve does not make these articles available in the archive of his website ( http://www.speculative-investor.com/new/index.html )
Out of Thin Air?
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".
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".
Subscribe to:
Posts (Atom)
