Wednesday, October 1, 2008

Money Destroyer

(Cross posted from bartoncii)

In 1970 I decided to fill in a gap in my education. I took some classes at the University of Tennessee on subjects I had not studied as an undergraduate. In particular I took freshmen courses on Economic and Geology. These classes made useful additions to my general stock of knowledge and I still look at the world differently because I studied them.

One of the most interesting things I learned, was the way banks create money. If I take $1000 and put it in my savings account, it will earn interest. But in order to pay my interest, the bank will have to do something with my money. The bank has to put my money to work, by loaning it out. Banks make money by loaning money at a higher ate than they pay their customers. Now the interesting thing about a bank loan is that the bank does not take money out of my account to loan it to a customer. The bank still carries my acount as an obligation, so in theory my money is still there, but the customer gets the loan. So he has money too. Banks, I learned in Freshman economics, create money by making loans.

Now this is really neat stuff, but there can be problems. If banks create too much money you can get inflation. In flation is a situation in which too much money is chasing too few goods. As a consequence the price of the goods goes up. In order to control inflation the Federal Government created a central banking system, the Federal reserve system. The Federal Reserve system can control the amount of money banks can loan, and thus it controls the creation of money in the economy.

Now Americans enjoy a good standard of living. We like nice cars, big houses, and the latest electronic gadgets. These things are expensive to make. A long time ago some retailers, discovered that it was cheaper to buy gadgets abroad where they are made by low wage foreign workers, and sell them to American customers, rather than buying them from American manufacturers. There were other things that Americans wanted too, like Gasoline. Most oil is no longer produced in the United States, so if Americans wanted gas, they had to buy the oil from foreigners. We did not actually make the money that we used to pay for the oil, we sort of put it on the credit card. In fact that has been the story of the American economy for some time. We as a country don't make many things any more, instead we buy things that are made in other countries. But how do we pay for the things we buy? The answer is we don't, we put everything on the credit card. Foreigners loan us money to keep the American Economy afloat.

If you stopped making money and financed your life with credit card debt, sooner or later you would go broke. Eventually you would go bankrupt. What happens to the money you owe when you go bankrupt? Now this is an interesting subject, one which my professor did not talk about in freshman economics. The money gets destroyed. Remember that banks create money when they make loans? When loans cannot be repayed, they get written off as bad debt. The money represented by the loan is thus destroyed.

Now when foreigners lend americans money, they expect to get repaid with interest. If you look at the American economy as a whole, you would have to say, that eventually the foreigners will not get repaid, because the American economy has for the last generation steadily borrowed more and more money from obliging foreigners than we were able to repay. Because so much money is being loaned to the United States now, foreighners are looking for investment opportunities in the United States. Mortgage backed securities was one way to soak up the money foreigners were loaning us. Of course, there are only so many high quality housing loans generated in the United States every year. But the loans kept coming, and we needed the money to keep the American Economy afloat, so the money industry started generating low quality loans to back mortgage securities. These loans went to buyers who did not have money. If a would be buyer did not have the income to pay interest, no problem. The loan featured a low teaser interest rate for the first few years, and then the interest rate ballooned to a rate the borrower could not pay. The borrower does not have money for a down payment? No problem, loan the down payment money. Of course the borrower cannot pay that either. The important point is that the foreigners got a place to put their money, and the foreign loans that kept the American economy going kept coming.

Alan Greenspan, who created the system was hailed by everyone as a great and wise man, because inflation was under control, and the country appeared to be flourishing. Politicians did not worry as long as the voters got their new houses, their new cars, and the credit cards worked. But one day a home purchaser got an interest bill from his bank, that he could not pay. He moved out, and the Bank repossed the house. The next door neighbor got a high interest bill too, and moved out. Soon half of the houses on the block were empty. The back had long since sold the loans to Fannie Mae and Freddy Mac, who had packaged them and sold them to foreigners. Pretty soon everyone in the home loan industry was over his or her in debt, and it looked lioke the foreigners were going to get stiffed, and the economy was going to collapse. President Bush's advisors thought a bailout would work, but a loan to a man who lives by running up credit card debt, is not going to solve the problem. The problem is that the contry is bankrupt, and the solution to for the bankrupt is to write off the debt and start over. Our creditors are just going to loose a great deal of money, we will suffer a great many privations and hardships, but eventually life will go on.


Anonymous said...

I spent a lot of time working in the software development business. I always found it fascinating how the money part was handled. One started out small, and got a small contract which everyone worked on like crazy with all kinds of unpaid overtime. While it was taking place you signed another contract based on your obvious current success. Again everyone worked liked crazy, but there was no way to complete the contract on budget. No problem, another even bigger contract had been signed, again based on the obvious current success at delivering. This continued, moving from contract to contract in a really frantic growth mode. So good products got delivered, growth took place, money was lost all the way along, but as long as bigger and bigger contracts kept coming in everything was fine. Most of these adventures failed fairly early, so there was lots of job mobility. Some however, were managed very adroitly, and the companies grew quite large before they finally crashed in a spectacular style. I came to the conclusion that business success was driven by growth, not by profit.

Soylent said...

In some technical sense banks can be said to create money; but if you instead consider debt an asset(a very liquid asset in the case a deposit account, but an asset none the less) banks cannot be said to create money through fractional reserve banking.

Before you deposit your $1000 you have $1000 in money and no assets. After you make your deposit you have no money and an interest bearing asset worth $1000.

From your deposit the bank has gained $1000 in money and -$1000 in assets(they're in debt to you and obligated to pay out $1000 at a moments notice).

Under a fractional reserve banking system they're only required to keep as much money on hand as dictated by the reserve rate. If the reserve rate is 10% they're allowed to loan out up to 90% of the money you have deposited. In doing so they lose $900 in money and gain an interest bearing asset worth $900; the bank now has an obligation to pay out $1000 to you(worth -$1000), $900 debt and $100 in money. Sum them all up and it's still zero(but that will change over time as interest is payed).

Odds are the person borrowing these $900 will take them and spend them on something. The businesses, persons or entities that receive these $900 in money will either spend them in turn or stick them back into the bank.

With these $900 in money the bank can now loan out $810. And so it may go on until the entire $1000 must be kept as reserves and the bank has $10000 in obligations to savings accounts, $9000 in assets and $1000 money as reserve.

Even though they've lent out up to $9000, at no point in this process was money poofed into existance; they necessarily accepted $10000 in savings to do so. The money moved sequentially through the system. If person A pays person B $1000, and person B uses that $1000 to pay person C, no new money was created even though that $1000 led to $2000 exchanging hands.

If a bank is unable to keep above the reserve requirement it may borrow from the fed in the short term, but in the longer term it is obliged to sell off assets until the reserve requirement can be met.

Money is emphatically not created in the same sense of creation as the fed running the printing press.

Charles Barton said...

soylent, economic textbooks still say that banks create money by makes loans.

David Walters said...

Basic capitalist economics 101. Charles probably mistates his case here: banks don't create money, they are supposed to create 'wealth' which as they note in the same class above, is not the same as money.

Credit takes money and allows for what is called a 'multiplier factor' (discsussed in Samulson's text book as well as Marx in Volume II of Capital, I think). So, one dollar lent to a small business, allows for the creation of a product that is sold at a profit, say doubling the dollar, some or all of it paid in wages and then deposited back to the bank to be lent out.

The money supply is supposed to regulate the amount of credit available in the form of money, usually by a central bank, or, in the US, "The Fed".

The multiplier factors is the basis of all modern capitalist States, without which capitalism would collapse, as we are kind of/sort of seeing this very moment.


Charles Barton said...

Banks create money:

DV8 2XL said...

Charles is right. It boils down to the fact that both the deposit and the loan are considered spendable. So where there was one spendable dollar, now there are two. It's just that simple. This is known as the M2 value and the rate st which it is allowed to grow is the rate of inflation in a fiat currency economy with fractional reserve banking.

Warren Heath said...

Charles is totally right, almost all money is created by loans by banks, and the Federal Reserve is a privately owned corporation. For the history of the Federal Reserve and the story of the U.S. banking system see:

The U.S. Federal Reserve System – Money must be a DEBT!

Marcel F. Williams said...

"We did not actually make the money that we used to pay for the oil, we sort of put it on the credit card. In fact that has been the story of the American economy for some time. We as a country don't make many things any more, instead we buy things that are made in other countries. But how do we pay for the things we buy? The answer is we don't, we put everything on the credit card. Foreigners loan us money to keep the American Economy afloat."

And that's the core of the problem, IMO. We live for today and we don't worry about tomorrow. We save very little money in this country, but we borrow a lot. A smaller and smaller percentage of our kids are getting a good education. And we don't make many things anymore. If it weren't for the American computer hardware and software revolution of the last few decades, I don't think the US would still be the world's largest economy today. We seem to have evolved from a country that use to make a lot of things into a country full of lawyers and money managers.

Obviously, the federal, state, and local governments need to start seriously reforming and investing in the K-12 educational system in this country-- especially in regions of the country with large minority populations. There's no doubt in my mind that having huge numbers of undereducated teens and adults in this country is probably costing the American economy more than a trillion dollars annually due to crime, welfare, and community neglect.

But we also need to aggressively invest in the-- energy re-industrialization-- of this nation through nuclear and renewable energy technologies. Moving from a fossil fuel economy towards a nuclear and renewable energy economy should keep us from spending 700 billion dollars annually on foreign oil while also possibly enabling us to become a major exporter of carbon-neutral fuels and technologies.

The silver lining in our current economic crisis, IMO, may be that people will finally decide to shift their purchases from credit cards to debit cards: saving for what we want instead of borrowing for what they want. And saving more means more money and cheaper money for the banks to lend to small and large businesses in order to grow the economy and create more good paying jobs.

Marcel F. Williams

New Papyrus Magazine:

The Future of Humanity:

Soylent said...

"Charles is right. It boils down to the fact that both the deposit and the loan are considered spendable. So where there was one spendable dollar, now there are two. It's just that simple."

That's a convenient illusion.

If a significant fraction of depositors where ever to try to collect their money then you've got a run on the bank. The bank has to either go borrow money, sell off assets or file for bankruptcy.

The debt can act as money if you transfer debt, such that the bank was obligated to pay me $1000 and I transfer that to your account and the bank is now obligated to pay you $1000. But that's not a special privilege banks get; if your neighbour owes you $10 you could transfer that debt to someone else as a means of payment; what you're doing is not printing money, it's bartering with a rather liquid asset.

DV8 2XL said...

Illusion is how the system works, even new money issued by government is backed by nothing more than the words 'Legal Tender' written on the bill. This is why it is called a fiat currency - the money has value only because the government says so, there is no underlying specie for which it can be exchanged.

The amount of cash in circulation at any given time, the M1 value, is always a small fraction of the M2 value of deposits and loans which are both as spendable as cash. In your example, you cannot force me to accept your neighbor's debt to you to pay your debt to me - with legal tender, I must by law.

Charles Barton said...

When I was young, there were those who wanted to bring back the gold standard. Of course at that time, silver coins were still in circulation as part of the money system. Sigh! Those were the good old days when a nickel would get you a coke, gas cost thirty cents a gallon, and you could take a date to dinner and a movie for $5.00. Well $10.00 if you bought flowers.

Well was their in fact any intrinsic value to gold and silver? Not really. They are pretty easily worked, and people for some reason think them desirable. But gold and silver replaced older mediums of exchange. In much of the ancient world the first money was cowrie shells. The ancient Chinese used the cowrie pictograph as their written word for money 貝. Native Americans also traded shells for money.

Cowrie were the medium of exchange in West Africa into the 19th century, and the English would ship them to Africa by the boat load where they were exchanged for slaves.


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