Personal finance podcast clued me into this at some point.
Every time a loan is used to pay for goods or services, some fraction of that goes back to “the bank” where 90% of it can be loaned out again. Best case, where all money is moved electronically and instantly, I keep seeing that 100 dollars go out and come back a little smaller over and over and over again. The tenth time I see it I can write a loan for about $30.
The language used to describe fractional reserve is pretty misleading. Banks don't increase the total supply of money, all fraction reserve does is keep more of it in circulation. If a bank takes a $1,000,000 deposit one customer, and lends $850,000 of it to other customers, there isn't $1,850,000 worth of money all of a sudden. There is $850,000 worth of debt held by customers, and another customer with a $1,000,000 balance, which on the banks books will be represented by $150,000 or cash reserves and that $850,000 of debt.
The thing that seems to confuse people is the abstraction mechanism by which the $1,000,000 depositor doesn't see any of the $850,000 debt, and the by which they can withdraw the $1,000,000 without being involved in any debt transactions themselves. Fractional reserve banking doesn't create money out of thin air, it's just a system that allows for deposits to be put to productive use. The alternative is that deposits are entirely withdraw from the economy completely until the depositor wants to use them, which would be the economic equivalent of hoarding all your money under the mattress.
The rest of it also doesn't really "go to the bank", it's money that they must have on hand to service withdrawals, and absorb defaults and other losses.
> Banks don't increase the total supply of money, all fraction reserve does is keep more of it in circulation.
It doesn't increase currency (M0).
But is there 'money' in your bank account? They increase money by a slightly broader definition (accounts + currency).
Even if you've got a narrower definition (and just want the physical paper to be defined as money, not entries in a database) then they don't increase the amount, but they greatly amplify its effect by increasing the velocity of circulation (which you did mention). One little bit of money is being thrown around between owners much faster, which effectively magnifies its impact.
No, there is no single, accepted definition of money. Money is not "literally defined as..." anything. For example, if you look at Wikipedia definitions for money, you will find multiple different definitions. The commonly used definitions seem to vary a lot by economic area.
No, there is a definition: Money is a commonly accepted medium of exchange. The problem is not that there is no accepted definition of money, but rather that this definition actually encompasses a very broad class of assets, each of which has some interesting and unique characteristics that can be defined independently of the definition of money. Talking about "money" by itself is often not specific or helpful enough for the subject at hand. Mises does an excellent job of defining a taxonomy for money and money substitutes in his book The Theory of Money and Credit.
I think it's better to say that the boundary of "money" is a bit vague, and things vary in their "moneyness". So sometimes a broad definition is more appropriate, and sometimes a narrow one is more appropriate.
What's _actually_ in my bank account is a mixture of cash, other peoples debt, and other assets, that all adds up to the value listed when I log in to check the balance. Part of the service the bank is offering me is that at any time I request, they will exchange all of that for its' cash value if I want to make a withdrawal. This is the bit that people contrive when they make silly claims like "banks can make money out of thin air". You bank balance of $x does not translate to $x of cash (physical money or not, is irrelevant) on the banks ledger, waiting for you to withdraw it. It translates to $x worth of cash + assets held by the bank.
They do it by keeping enough money laying around doing nothing, to service those withdrawals. If all of a sudden huge amount of customers started making huge withdrawals, they wouldn't be able to service them, because they wouldn't be able to liquidate those assets immediately. If banks were actually creating money out of thin air, this wouldn't be possible, because they'd just be able to create some money out of thin air to service them.
If you go and read the article you will find that it agrees with everything you posted here, with the exception of your weird conclusion that "banks do not create money out of thin air". The article uses a simple example to illustrate that, using Eurozone M1 definition for money, loaning factually increases the amount of money which exists. Perhaps you are thinking of a different definition of money?
Because Eurozone M1 doesn't account for the debt that backs some of those balances. That's like suggesting you can increase your net worth by taking out a loan. You can increase the amount of money you have to spend right now by taking a loan, but you're not "creating net worth out of thin air".
If you go and read the article, you will find that I use terms like "due to accounting conventions" or "economists decided to count these IOUs as money [but not some other IOUs]". Is there something in the article that you disagree with?
But debt isn't "negative" money. In fractional reserve banking, money and debt are like matter and anti-matter: money is created along with debt, and when the debt is repaid the money is actually destroyed. The money is purchasing power now; the debt is a claim on future purchasing power.
The interest portion is never destroyed though. If you loan 50k you might pay back 60k and only 50k is destroyed. Another wrong assumption is that loan gets paid back.
Unpaid loans and interest are not accounted for and create a need for even more loans to create more money out of thin air but of course those additional loans also have interest and are also unpaid so it spirals out of control.
Interest is just a fee. Your bank may charge you extra to compensate defaults which "destroys" part of the interest, it may charge a processing fee, a profit margin and then finally the actual interest rate the central bank sets.
Both the processing fee and profit margin circulate within the economy. They are not part of the loan, they are fees the bank is charging and using to pay its employees and shareholders who then spend that money. It is entirely possible that you are working for a bank and receiving that money as a paycheck, or your bank is purchasing services directly or indirectly from a company that you are working at.
When you think about it, central banks are not any different. They charge a fee and then send the profit to the government which then can spend it on services that eventually employ you.
You own a farm and borrow 50k from a bank that has $10k in its reserves. The loan has a duration of 10 years at 2% interest so you have to pay back 60k in total. You pay back $6k every year. The bank purchases $1k worth of food every year. The end result is that you have paid $60k to the bank and the bank has paid you $10k.
An advantage of that system was that banks did not lose reserves when customers withdrew money, ie converted deposits to cash.
(The banks lost reserves when those notes were eventually deposited with rival banks who demanded settlement in underlying reserves.)
Of course, even that system did not multiply the amount of reserves; you might call them M(-1), if you are so inclined.
Historically the underlying base money was gold, but you could imagine a system with private bank notes built on top of the federal reserve dollar just fine. You can even leave physical Fed cash in circulation, too.
> If a bank takes a $1,000,000 deposit one customer, and lends $850,000 of it to other customers, there isn't $1,850,000 worth of money all of a sudden.
Not all of a sudden, as in instantly, no, but there will be. See below.
> There is $850,000 worth of debt held by customers, and another customer with a $1,000,000 balance
Yes, but what do those other customers do with that $850,000 of debt? They either deposit it in another bank, or they use it to pay someone for something, and that someone deposits it in another bank, or...
In short, virtually all of that $850,000 of "debt" ends up as $850,000 of additional bank deposits in other banks. And to those other banks, those deposits are simple deposits--there are no debts (yet) against them on the other banks' books. So there is nothing to stop the other banks from lending out as much of that $850,000 as they can again. Which means the other banks have just turned what was $850,000 of "debt" into $850,000 of new money.
> Fractional reserve banking doesn't create money out of thin air
Yes, it does. I just explained how.
> it's just a system that allows for deposits to be put to productive use
More precisely, it's a bad system for putting deposits to productive use, because it mismatches maturities and therefore leaves the entire financial system open to bank runs, which then have to be prevented by additional "protective" measures. Which will sooner or later fail, and fail all the more catastrophically because the protective measures enable financial institutions to hide the fact that bad investments are being made.
The correct way to put deposits to productive use is to make them time deposits, not demand deposits. In other words, if you have a spare $1,000,000 that you have no good use for, you deposit it in some financial institution for a period of time, say a year, or 5 years, or 10 years, and that financial institution promises you some particular rate of return over that time in exchange for the use of your money to finance productive endeavors. Of course this is just another way of describing a bond, or a certificate of deposit, or a money market certificate, or whatever your financial institution chooses to call it.
But suppose you buy, say, a 5 year bond with your $1,000,000, and then, a year later, you find you need the money? Well, that's what a bond market is for--so you can sell your bond, at a fair market rate, and get cash in exchange, while someone else has now invested their money for the remaining term of the bond. There is no need for the financial institution to treat your $1,000,000 deposit as a demand deposit, withdrawable at any time, while it is transforming maturities by investing that money in other productive endeavors that take time to mature, just to shield you from unavoidable uncertainty about the future. There is certainly no need to expose the entire financial system to possible collapse to do this. The only reason this wacky system persists is that people in power benefit from it, and ordinary people have gotten so used to it, since it has been around for so long, that they don't connect it with the occasional meltdowns that it causes.
The person that received the $850k loan spent it, so their balance is then $0 and the bank also has a corresponding entry for -$850k of debt that they are owed and can collect interest on.
The debt is an asset held by the bank until it is paid off, is sold, or is defaulted on.
Person A deposits $1M
Person A $1M, total deposits on hand = $1M
Person B takes $850k loan
Person A $1M, Person B $850k, Person B -$850k debt
Total deposits on hand is STILL only $1M. The combined balances are 1.85M but these are just entries that have no impact on what is actually in the bank's vault/account.
If A and B both ask for their entire balance at that moment the bank will have to go to the overnight window or some other facility to take a short-term loan that it will owe interest on and may need to provide collateral to receive.
In that case the bank's overall balance sheet would be $-850k of debt it owes someone. Because that debt isn't collateralized their rate will probably be higher. This is what led to things like the credit market freeze up that the Fed needed to step in to provide liquidity for. Banks usually borrow from each other not just the Fed, but when shit hits the fan banks might not be willing or able to loan to each other except at extremely high rates.
When the bank repays its loan (perhaps when Person C is paid by B and deposits the money into their account) the situation will unwind and we'll be back to the previous situation.
In real life it's much more complicated because the bank probably has many other types of assets like CLOs, CDOs, etc.
Sometimes the Fed will take assets as collateral for a loan and the bank is expected to repurchase it later at a slightly higher price a/k/a the Repo market
>The correct way to put deposits to productive use is to make them time deposits, not demand deposits. In other words, if you have a spare $1,000,000 that you have no good use for, you deposit it in some financial institution for a period of time, say a year, or 5 years, or 10 years
That will not work for normal accounts where peoples salary are deposited in, they need to use that money over the month.
Also my savings account, I dont know when I will need the money. There might be emergency expensive repairs needed to my house or car that I need to take from that account.
> There is no need for the financial institution to treat your $1,000,000 deposit as a demand deposit
yes there is - because consumer's behaviour is irrational, and they cannot easily calculate the required interest for such a bond. A demand deposit is easy for a consumer to understand, and the bank can pay less than the equivalent bond interest, and pocket the difference.
There are termed deposits that banks offer. But consumers have overwhelmingly not chosen to use them imho, because it doesn't offer high enough interest rates, and the hassle of illiquidity isn't suitable for a consumer context.
So the depositor put $1,000,000 in the bank and the bank loans $850,000 to a small business so it can buy more inventory. The small business goes to the widget manufacturer and writes a check which the manufacturer deposits into the bank. So now the bank has 1,850,000 in deposits and 850,000 in loans.
The bank takes the new deposits and loans out 85% of it ($723k) to another small business. This small business goes and uses it to pay its employees and they all deposit the money in the bank. Now the bank has $2.573m in deposits.
The employees and the manufacturer can all withdraw the money at any time. So I struggle to see how this isn't creating money.
The fractional reserve system lets the bank loan the same dollar out multiple times. How isn't this creating dollars? If the bank takes one dollar and loans 85 cents to you and 73 cents to me, isn't there more money?
Because doing it one time, or 10 times, or 1,000 times doesn't change anything about how it works. If everybody pays all their debts, it all adds back up to $1,000,000 in cash (plus interest for the bank(s)).
No it doesn't. In my example the bank loaned out $850k to the first small business and $723k to the second. That's $1,573,000. The bank started with $1million.
It absolutely matters how many times the dollars come back to the bank because that is the pathway that lets the bank loan the same original dollar out multiple times.
I think you’re forgetting the bit where the business that took the $850,000 loan is left with $850,000 debt and $0 balance after they spend all of it. Every time it passes through the system the amount recirculated simply decreases by the reserve %. It all still adds up to the original amount (plus interest).
In your example though, the bank has a different problem of offering unsecured loans, which could lead to some losses for them.
> The employees and the manufacturer can all withdraw the money at any time
This isn't quite correct. If all parties go to withdraw their money at the same time, the bank will not be able to give it, because they only actually have $1M in reserve.
In practice, if there are more withdrawals than than the bank has in reserve, it is usually able to get short term loans from the central bank which than ACTUALLY creates the money and loans it to the bank.
However, over the long-term if too many of the bank's loans default, they won't have enough assets to cover the deposits, which is how banks usually fail.
And you might think, "Well, there are so many banks, that money probably won't end up back at mine," but yes, there are so many banks, all of them giving out loans. My million ends up all over town and the world, but so does yours.
I've done extremely well obtaining goods and services by operating under my unpopular perceptions of the world, including how banks make money and the purpose of money and currency. My unpopular perceptions have consensus with the people that matter (banks, lawyers, accountants, regulators, courts) but they just won't get very far on web forums if you try to tell people something that doesn't match their understanding.
The primary cognitive dissonance with other people comes from tying morality to prosperity. Or put simply "some people deserve money and when that criteria is not satisfied it is controversial", but what they really mean is that "someone should have the ability to have goods and services more than others", with the money itself only being a reductive surrogate to make that happen.
The further you abstract yourself away from that, the easier it becomes to operate and see opportunities, or how to exchange time for more food and shelter in a more efficient way. How to have enough resources that the money itself looses additional utility, no different than how an abundance of oxygen looses its utility while a known upcoming absence of oxygen will redirect all of your thoughts and resources into making sure that doesn't happen.
Yes, it should not be a mystery how banks can create money.
The universe of investible assets available for the central banks are small, they need your help in providing a service to them in the primary market (credit markets, corporate bonds). Direct issuances were always going to happen, if it wasn't the pandemic it would have been something else. Anything that slowed down China's growth would have resulted in the same outcome. There is no transparency in direct issuances, you just need to appear or structure your offering as credit worthy. There are no consequences. Some people are ready for this specific outcome, if you think you can steward money better (or just want a lot of it for whatever reason), you should structure an offering for this.
Central Bank direct and primary market operations are going to continue as their universe of investible assets is small, their monetary policy is not able to achieve the behaviors of market participants that they want as it requires associated fiscal policy changes from legislature and results. Central bank's stated goals for their monetary policy is disingenuous as they do not care about inflation targets or GDP numbers, but they do factor them in. They are just tools to alter and manage the yield curve as they just buy bonds from their friends at a profit.
Yield curve based monetary policy doesn't work to its stated goals due to a fundamental misunderstanding of what people want. Dropping yield curves don't cause as much growth in the real economy because people just don't want to give random entrepreneurs their money. People are willing to pay to not do that. Negative interest rates are therefore not controversial and can go much steeper than any central bank has experimented with. People would be willing to pay to keep their money.
Fed and Central Bank balance sheets should not be seen as a threat or overhang to the markets, as it doesn't need to sell credit assets, it just holds them to maturity. It and other sovereign wealth funds have an infinite time horizon.
Conspiracies about central banks and their ownership structure are irrelevant. Orphaned entities like trusts are common structures. There is a lack of transparency in some areas either way.
Don't just pay attention to the Fed, ECB and BOJ. There are plenty of Central Banks on the periphery of the EU who must react and expand their universe of investible assets before or after the ECB/Fed.
In smaller markets you can have a lot of influence as an individual. As in, you can get the ear of a regulator or the upper echelon, or even the stewards of a central bank, just by having a good idea and understanding their needs, interests and psychology. Compared to attempting to earn a pedigree you weren't born into.
The Swiss National Bank is amazing for Swiss people, but it should probably be considered a national security threat to the US markets. Since it is not, it is more likely that the SNB is part of a coordinated stock market growth arrangement with the US, as their stock purchases of individual companies with newly created CHF is not something the Fed is authorized to do, yet.
I wish more central banks were publicly traded like the SNB.
Liquidity of the currency shows the tolerance of distribution. Think of inflation like corporate stock dilution, if the market is liquid then you can create more without undermining confidence in that market. Think of government currency like shares of a country/economic union. People are uncomfortable with the idea of analogies that show the similarities between private organizations and states formed to serve the people.
Hyperinflation is not as big of a threat when all major currencies are doing it at the same time. Coordinated inflation masks hyperinflation of any individual currency as their value relative to each other stays similar while the supply of all of them is increasing. The price of individual consumptive goods can still increase dramatically, but the price of the currency and confidence in the currency is not ...
> Negative interest rates are therefore not controversial and can go much steeper than any central bank has experimented with. People would be willing to pay to keep their money.
A bank can store money in the central bank, but it can also put cash in a vault. If the central bank has steep negative rates, why would they use it for much?
Cash vaulting is fairly expensive. And once everybody starts to do it, you see a different problem - it becomes hard to get hold of the physical cash in order to store it!
This used to manifest as "hoarding specie", but economies have also hit deflationary problems of hoarding physical cash. Not sure what that would look like in a world of widespread electronic payments. You'd probably have to pay a premium to get cash from an ATM. Banks would start making it easier to deposit small business cash and harder to obtain rolls of change. Eventually at high enough negative rates people would be paying an (electronic) premium on the face value - you give me a $10 bill and I paypal you $10.50?
This is good stuff. I see negative rates as the "stability tax", which is why the leader is Switzerland. As you say, the real work has to be done in fiscal policy.
Denmark and Poland and Sweden also have a Central Bank and unique distortions in the credit markets. Very few people pay attention to them, getting information is tricky. The nordic credit market is its own animal centered in Norway, but all the countries want business. They are trapped because the Eurozone is a behemoth and the yield curve distortions there are like a gravity well, and the cultural sentiment of speculators or general people is the same or has the same inputs, so they must go steeper in negative yields faster or expand their universe of investible assets faster.
Pay attention to the corporate credit market. The steeper the yield curve goes, the more it drags down the cost of credit for corporate issuers. Getting aggregate corporate credit information in these markets is hard but rewarding, you can predict what to expect - investment grade corporations bonds yielding 0% possibly issued at 0% - but it is hard to confirm the market appetite. This is where we are right now in market efficiency.
I think you haved to be careful about attributing your success or ability in one field to a generalized philosophy that you have.
Just looking around empirically, "successful" and "unsuccessful" people seem to vary wildly in ideology. Stallman, Thiel and Bill Gates have pretty wildly varying ideologies and are all successful, I'm sure you could find 3 unsuccessful people with similar ideologies.
I'm moderately OK because society currently values ability to solve quite formally defined logic puzzles and I was in a sociological place to get a couple of pieces of paper that statistically indicated some combination of privilege and ability to do the former when I was 18-21.
That might not even last, never mind demonstrating philosophical superiority. If I make a few million or achieve inner peace in the next decades it still won't prove too much, since there's so many other people of all philosophies going in all directions.
> The main argument presented here is that banks do not have central bank-like special powers in relation to money creation; the process in which banks create money is entirely pedestrian.
I think this is wrong in a subtle way. Regular banks have a reserve requirement that limits their ability to create money. They must hold a certain number of federal reserve notes to meet the reserve requirement. The Federal Reserve can create federal reserve notes.
Reserve requirements haven't mattered in US banks for a long time. One way to think about it is that reserve requirements constrain bank behavior, but the optimal strategy for banks would be the same regardless of whether that requirement were removed.
The requirement was removed in the US in March 2020 but has been a formality for most banks for a long time.
Right; the hard limitation on money creation is that banks exist in order to earn profits for shareholders, and there is only a finite pool of profitable lending opportunities at any given time. With no reserve requirement a bank could theoretically create unlimited amounts of money but it would eventually go bankrupt as it would take massive losses on bad loans.
Even without laws requiring reserves, banks still want to hold some precautionary reserves to eg settle interbank transfers or to serve cash withdrawal requests.
But those precautionary reserves can be very small without causing much trouble. In Scotland in the 19th century they had about 2% gold reserves and where doing fine.
What's more important are equity cushions to take the blow of losses before the depositors do.
Scottish banks typically had about 30% equity cushions because that's what depositors demanded. (These days laws require about 8%. Depositors don't care much anymore, because government deposit insurance numbs them.)
Even if there was no reserve requirements, or other regulation to limit money creation by banks, a regular bank still would not have powers similar to the central bank.
Imagine a fraudulent banker who keeps adding billions to his own account. Suppose no-one notices. The banker starts to buy mansions and islands with this made-up money. Every time his bank transfers money to other banks (to buy those mansions), the bank loses some reserves. At some point the bank has no reserves left. Even if the reserve requirement was 0, having no reserves would mean that you could no longer transfer money to other banks.
Not all countries have minimum reserve requirements. Eg if memory serves right, Canada didn't have them.
And Scotland also didn't have them during their free banking episode.
What the Scottish banks had instead where crazy high equity cushions (like 1/3 of assets, instead of the about 8% common these days). But not because of any law, but because customers insisted.
Equity cushions are much more important in protecting depositors than reserves.
We could quibble about the definition of "special power" all day. Sure, a bank is in a better position to create money than a poker site. And a poker site is in a better position than an individual person. But these are not fundamental differences, these are differences of degree. Fundamental difference is having a literal money printer, versus not having one (central bank's ability vs regular bank). When you issue IOUs with the backing of a literal money printer (as a central bank), those IOUs are fundamentally different from the IOUs issued by me/poker site/bank.
Well, legal barriers aside, Amazon could print their own currency and be in the same position as the Fed.
Though to make it absolutely the same position, Amazon's currency should not be tied to the dollar but freely floating.
Then there can be no run on Amazon's currency, just like there can be no run on the dollar. However, of course, both Amazon's currency and the dollar can lose in value compared to goods and services or other currencies.
The question isn't so much whether I would accept, but at what price I would accept.
If Amazon is selling their own stuff for Amazon bucks (and people still want to buy stuff from Amazon so that Amazon bucks have a non-zero market price), there's a minimum finite amount of Amazon bucks that I would gladly accept.
If Amazon bucks weren't very commonly used (think like bitcoin today), I would probably ask for a premium over USD just to make up for the inconvenience of having to exchange them.
If Amazon bucks were more commonly used in daily life than USD, I might even accept a slight discount.
> If you worked for amazon, would you accept amazon bucks as salary?
That's actually an even easier question. Amazon already pays their employees partially in Amazon stock. At a big enough stock offering (and frequent enough vesting), I'd happily accept an all shares compensation.
Now, Amazon bucks would be different from Amazon shares. But the only thing that matters to me when accepting compensation in shares is how easy it is for me to convert the shares (or bucks!) into something I actually want later.
"legal barriers aside" is insane, legal barriers aside I'm off to rob a bank. There's only really two or three things that could possibly make banks different: the law, de facto capital requirements to enter the market and hidden knowledge, and you can normally buy hidden knowledge so the thing distinguishing banks from anyone else is either the law or money, and it's mostly the law.
> "legal barriers aside" is insane, legal barriers aside I'm off to rob a bank.
Well, that's not just a legal barrier there, but also that the people on the other side of that transaction don't like to be robbed.
People deal in currency blackmarkets all the time, and all participants are willing. Obviously, being able to do business out in the open is much more efficient and productive. And especially eg Amazon as an above board organisation could not engage in blackmarket operations without endangering their legal activities.
This is silly. Yes, there is a difference of degree and nature between A and B here. Are you saying that there is no similar gap between the banks and regular people in terms of their power to create money? Because that's patently nonsense.
And I mean, the vast majority of money in circulation does not come from the money printer or even the central bank's own ability to duplicate money, it comes from the multiplicative recirculation by banks.
The banks have been both legally empowered and de facto relied on to do this money creation on behalf of the government in ways that other people and organizations are not allowed to do.
Just witness the largely successful regulatory crackdown on cryptocurrency services, or the fact that "point exchange systems" like Xbox live points to to great lengths to insist that their points are not recoverable into dollars to avoid regulations as actual evidence that banks are not accidental money creators but an empowered subsystem of the process of making money exist.
This is a fantastic page. I just have an issue with one of his points though:
> That banks do not have any special powers in relation to money creation
They most definitely do though: FDIC insured accounts have legal government backing—a random IOU from me can't achieve that, no matter how much anyone trusts me. Put another way, a bank deposit seems less like an "IOU" and more like a "WeOU"—"we (the bank or the government) owe you". That seems like quite a fundamental difference, no? It seems to distinguish "fake" and "real" money (or banks).
Hey, author here. Your criticism is correct. Deposit insurance is a fundamental difference between bank IOUs and non-bank IOUs. So it's incorrect for me to say that banks have _no_ special powers (still not even close to central bank's power though).
Hi author, excellent article. But I'm just not seeing the central premise that Werner is wrong in saying that banks are unique in their ability to create money. What Full Tilt Poker did was illegal, simply because they were not licensed as a bank. We do have a special class of institution in our society that is blessed with the ability to create money through fractional reserve that we call "banks". Do you mean regardless of law?
Yes, I suppose I mean regardless of law. Although I wasn't looking at it like that, I was just looking at it from a practical perspective: "he is claiming that only banks create money - well here is a counterexample where a non bank made money".
The reason I attacked Werner's article is that he mystifies money creation and perpetuates the misconception that banks' ability to create money is similar to central banks' ability to create money (he does not directly say so, but a non expert reader is likely to gain this misunderstanding when he uses terms like "fairy dust" etc.).
In the article I attacked 2 specific claims of Werner. One was patently false. The other was correct due to a technicality only.
Hi author. Excellent write-up and nice food for my brain!
Although "technically" I agree with your article, banks have a legal definition, legal power and legal responsibility. That makes them special and gives them the legal power to create money -- not without limits, though. Banks can -- subject to some rules -- borrow money from the central bank, which will create said money for them. With repo rates hovering zero and all processing happening electronically, "out of thin air" is not really that far from reality. :)
I would argue that if I issue you an IOU, that is not real money: I do not hold a banking license, I do not keep track of all IOUs, I have no audit to pass once-a-year. In fact, I might drink away your deposited cash next day. :) The Full Tilt Poker example is relevant, but I would argue that that is illegal banking: It happens, but it really shouldn't. Wirecard is the other extreme: They were a bank (legally) and created money against the rules (I'm a bit oversimplifying).
I guess the common person needs to be educated about legal powers: For example, what makes this house special that I own it? A large enough hammer can open the door, as easily as my keys. In fact, if I sublet it, I might not even have the keys! Ownership, as money, are legal constructs that only hold value if they are properly enforced. Of course, enforcement is easier the more society accepts the construct.
This article is misleading. Banks do ultimately create money. Even if you ignore the details and complexity of how this works, the empirical evidence is clear:
- How do you explain that the M2 money supply is always going up? Where is all that new money entering into the system? Government contracts funded by government bonds? If that was the case, government contractors would be getting very wealthy and everyone would be working for them (directly or indirectly)...
- How do you explain the recent, significant, almost instantaneous jump in stock prices of major tech companies after the Fed printed and injected trillions of new dollars into the economy? Did these corporations all suddenly score huge government contracts from the bonds which the government created? Seems more like investors and company insiders used loan money from banks to do stock buybacks or increase their positions.
- Under the model suggested by the article, how does one explain why there are so many millionaires are in the real estate industry? If you assume the opposite argument that banks are able to print money (directly or indirectly), the number of millionaires makes perfect sense since everyone buys houses using 'loans' from banks; so it's natural that all this free money from banks would constantly inflate real estate prices; each new generation of citizens would inflate the prices of the properties which were bought by the previous generation with increasingly larger loans from newly printed credit from their banks.
What is claimed by the article does not match the evidence, even the people have wised up to this scheme which is why Bitcoin and cryptocurrencies have been able to hold their value.
People and other non-bank entities do not create money, they create and attempt to sell contracts to the bank which are supposedly backed by the value of future goods and/or services. The bank is the one which decides if a contract is worth what the seller is claiming. The seller could claim that they own a lot of user data and that this data is a valuable intangible asset and if the bank agrees with this valuation, then that person can get access to a lot of credit.
Nonetheless, this is all irrelevant, people cannot legally create money (that would be counterfeiting), they can only create assets; only banks can create money and they can cherry-pick who is allowed to get credit and who isn't using whatever rules or metrics they see fit. All the new money enters the economy through loans and government bonds. Companies and individuals who are close to the money printers get most value out of the new money since they get it first (Cantillon effect). By the time inflation kicks in, these people who are close to the money printer will be able to take another bigger loan in the future using their existing collateral which will undoubtedly be worth more due to inflation in the nominal monetary 'value' of that collateral.
How confident are you on that point? I don't have a reference on me right at this moment but I expect it is illegal for a non-bank entity to hand out IOUs at scale. People would be arrested.
So I suppose I put it to you that there is something special about the IOUs created by banks - they are legally allowed to used.
Even if everyone agreed to use your IOU from the article the tax office is going to have quite a bit to say on the subject and probably start launching audits. And if the IOU start getting traction they are likely to trigger police raids and maybe a legislative response (look at how Facebook dropped their Libra for example). That seems substantially different from the IOUs the banks can create.
I wouldn't use bank-issued IOUs if I thought I had a choice. I'm pretty sure I'm forced to by government policy.
> So I suppose I put it to you that there is something special about the IOUs created by banks - they are legally allowed to used.
IANAL, but the IOUs created by Full Tilt Poker were also legal to use. When the government eventually pressed charges in the debacle, no charges were pressed against regular players of the poker site, including those who used these IOUs for small economic activity. If using these IOUs would have been illegal, then surely the government would have pressed at least some charges after spending years investigating the case?
But anyway, even if _using_ the IOUs was not illegal, creating them like a fractional reserve bank surely was illegal. So you definitely have a point that the regulatory environment creates a special status for the legal tender of the country.
That's what corporate bonds are. In the extreme, every as-yet-unpaid invoice on 30 or 90 terms creates a debt and "creates money".
Full Tilt Poker created a small closed e-money system which was seemingly legally fine; it was the gambling that got them raided, because only mob bosses in politically connected US states are allowed to profit from gambling and the US will go after gambling providers in other countries.
Liberty reserve were facilitating money laundering. This is the difficult bit - if you provide an electronic facility for easy transference of ownership of debts or e-money, the authorities want access to the paper trail.
>That's what corporate bonds are. In the extreme, every as-yet-unpaid invoice on 30 or 90 terms creates a debt and "creates money".
No, there's a big difference, in that you don't have the right to redeem ("put") the corporate bond any time at face value.[1] You do have that right for the IOU that is your bank account. This allows two people to carry on as if they both are full owners of the dollar in the bank account (both the depositor and the business it was lent to), and that mechanism is what allows the money supply to increase.
When you don't have that right, you, as the corporate bond holder, know that you can only get the money out early by selling the bond at its current market rate, whatever that is, which may force you to take a discount. This expectation -- and the necessity to redeem it for someone else's dollars on the market -- prevents it from being money creation.
Exactly... not all IOUs are created equal. Any bank that is part of the Federal Reserve System can create US Dollars, the most liquid and trusted form of money in the world presently.
It comes with the downside of being highly regulated. I have no idea if the weights and balances are correct, but it makes sense at the surface level that if you are risking the government’s money, you have to do it on their terms.
So heavilly regulates you can hand out mortgages to people who can't afferd them, then turn around and package those loans intonCDOs, and mislead investors as to their liquidity. Then suffer no consequences when global economy crashes.
I agree with you, but as a non-expert in the matter, I have to add that banks are heavily regulated in that regard and have to deposits certain reserves to central banks (depending on the country) for that privilege. It's not that they operate differently than LLCs while having the privilege of insurance. They pay a price for that privilege, and we can argue whether that price is too low or not.
> Deposit insurance is a fundamental difference between bank IOUs and non-bank IOUs.
Deposit insurance is a fundamental difference but it's not the main difference. Individuals and most non-banks don't have access to Federal Reserve accounts and therefore access to reserves. The main distinction between a bank and a non-bank is the ability to create IOUs ultimately backed by reserves (whether they have sufficient amounts or not) which can only be created by the FR (and in this context) to back a bad IOU. Whether the new reserves go directly to backing up the IOU or indirectly via added liquidity is irrelevant. A bank can create a misguided IOU that defaults, which if too big to fail, is a liability that the FR and thus all holders of the IOUs, cash, and reserves must bear.
This is not entirely accurate. Suppose a fraudulent bank decided to credit my account with a trillion dollars. The federal reserve would not honor this IOU with actual dollars. This is in stark contrast to federal reserve's ability to create a trillion dollars. They could create an actual trillion dollars and give it to a corrupt politician. A regular bank does not possess this ability.
What does a fraudulent bank have to do with the fact that the FR is the ultimate backstop to loans (IOUs) created by a bank...a "power" you claim is the same as a non-bank created IOU or a an individual IOU? Further not sure how your example refutes my previous reply's accuracy, regardless, if a bank makes a bunch of fraudulent loans adding up to a Trillion dollars and it isn't discovered until those loans are cross-collateralized sufficiently to cause systemic risk, you can bet the FR will back those loans. Finally, given a bit of time a single Trillion dollar loan may not seem as large as it does now. :)
> What does a fraudulent bank have to do with the fact that the FR is the ultimate backstop to loans (IOUs) created by a bank...a "power" you claim is the same as a non-bank created IOU or a an individual IOU?
I'm not claiming it's the same. I'm saying these are differences of degree (my IOU vs bank's IOU), whereas the difference between central bank IOU and bank IOU is fundamental. We have several historic examples of central banks ruining entire economies by printing excessive amounts of money causing hyperinflation. Do you have a single example of a regular bank printing so much money that it causes hyperinflation? No. Why is that, if it's so easy for a regular bank to print a trillion dollars of fraudulent money without anyone noticing?
I love the IOU vs WeOU differentiation. Banks need to have licenses and adhere to strict regulations, which are checked at least yearly by auditors. (Joke: Unless you are a German bank, in which case you get checked only once-a-decade.) That is what makes banks special: They have legal backing, but also legal responsibility.
Side note regarding non-bank IOU: I found the idea of having a payment card from my grocery store very appealing. If they run out-of-cash, they can repay me in food, which I'm pretty happy to take at any time. However, that is not how it works in 2020. The grocery entity and the banking entity need to be separated, and have different licenses.
> The grocery entity and the banking entity need to be separated
Quite a few of the grocery chain cards here in Sweden have accounts backed by chain-owned banks. So at least here, the separation is not all that great.
They share branding and sometimes ownership, but the entities are separated. ICA Gruppen has ICA Banken as a bank subsidiary. COOP outsourced banking to EnterCard, etc.
Quite true. Its also why we should find it deeply concerning when a tech company starts taking on some of the powers of a bank without any of the responsibilities of a bank.
Facebook's digital currency system is one recent example. Paypal's behavior is a much longer-running example.
Seems like a great scam. Create a bank, go through the many many steps to obtain FDIC backing, pay out enormous loans to insiders, have a run on the bank, then everyone is made whole again while the fraudster skips town.
I understand that this is basically insurance fraud, but the money is gone long before the fraud occurs and the government must pay out, unlike a single insurer.
I was just thinking about this exact issue. Before abandoning the gold standard, money was basically an IOU for gold. Since abandoning the gold standard, it's clearly not an IOU anymore. It's just the value in itself. Why does it have that value? Only because we trust it.
And honestly, that's really not so different than gold. Why would the gold standard work? What intrinsic value does gold have? Again it only has that value because we trust it. If we stopped caring about gold, maybe if asteroid mining were to quickly result in 10 times the amount of gold that's currently available, gold would quickly lose that trust; same as when a government started printing money with wild abandon. As long as governments are responsible about the money supply, money is just as good as gold. But only as long as they are.
It's an IOU for 100 dollars. You can exchange it for other cash IOUs from the central bank. A bank can also exchange it for electronic central bank reserve IOUs.
Base money (both cash and central bank reserves) is often emitted through short-term repo operations. If a bank wants some base money (e.g. to put some banknotes in ATMs), it sells central bank some (usually government) bonds with promise to repurchase it after a fixed time limit (e.g. 14 days, done in periodic rounds). That is essentially a lease agreement with different legal detais.
So it is essentially an IOU for bonds, just not redeemable in retail (by individuals) but in bulk (by commercial banks). If commercial bank wants 'redeem' some cash (for bonds), then it just acquire less cash in the next round of repo operations.
UK notes are still an IOU. The note I have in front of me says "Clydesdale Bank PLC promises to pay to the Bearer on demand Ten Pounds Sterling at their office here By order of the Board of Directors". This is one of the few cases where "legal tender" actually has meaning: if I present a wodge of bank notes to Clydesdale (or for Bank of England notes, the Bank of England) saying I want repaid in coppers, I'm obliged to accept legal tender for repayment of the debt represented by my notes. Which in Scotland means pound coins, but in England it probably means I'm getting more (although possibly different) notes back.
Interestingly, Clydesdale's office address isn't shown on the note.
Though they were obtained at the discount window, as they are not circulating they have no impact on the functional money supply until you use them...at which point you still have that $20.
But I am engaging in some hair splitting, I admit.
Money is defined as a commonly accepted medium of exchange. Yes, anyone can create IOUs which satisfy the abstract idealization of money as a "numeraire", but if these IOUs are not commonly accepted for commercial transactions then they aren't money. This is an empirical definition, which is perhaps less useful for theoretical arguments.
Banks which participate in a central banking scheme (such as the Federal Reserve System) have a license to create IOUs which are authenticated by the government which sponsors that central bank. In other words, such banks can create IOUs that are backed by the full trust and credit of the government, not merely their own trust and credit as a business enterprise. I'm not sure I would characterize this as "impressive", but it is most certainly a privileged and unique position over the rest of us.
I was just thinking about the immutability debate in the Ethereum blockchain world, where the community split due to a difference of opinion/interests on whether their system of money should allow a transaction reversal due to unintended effects of a certain contracts code on the state of the system (https://en.wikipedia.org/wiki/The_DAO_(organization)).
Those who were in the "code is law"/"immutability despite errors/malicious behavior" faction insisted that no change should take place, resulting in the loss of money/decreased action (state change) potential for the original holders affected by the unintended state change.
The more popular/valuable (by market cap) system of money (ETH) was the one where this change took place, though this was a one-time event. The state of the system was since not adjusted to reverse effects of hacks, accidental transfers/state changes of smaller impact (still millions of dollars equivalent).
Reversible systems need adjudicators which determine if a reversal should take place, and since this is a complex, subjective consensus issue, they pretty much must be humans, resulting in unpredictable and possibly unstable sociopolitical processes.
Fiat money derives its value through its utility (widespread acceptance in the exchange for goods) and its contractual enforcement ability provided by a states monopoly on violence (resulting in working contract law) and as the primary means of paying taxes.
An (unbacked) IOU has less value than central bank (digital or cash) money, because whether it results in delayed reciprocity is more uncertain (credit default risk, bank runs). In the same way, more irreversible money/settlement systems (like cash https://en.wikipedia.org/wiki/Real-time_gross_settlement) carry less of this type of uncertainty and risk but more of others (legal, last resort to violence to enforce state/or even consenus change, large losses due to mistakes).
FRB is the system where a bank is required to have a reserve of X% before it can issue money, while in the current system the banks first emits money and then (in the US) it attempts to get a reserve[0] for that (and in the EU, it doesn't either, tho there are liquidity requirements).
So you think this is not fractional reserve banking because instead of having the fractional reserve of X% beforehand they get the fractional reserve of X% right afterwards?
Edit: I've just briefly skimmed it [1], but "The creation of credit money should happen after the creation of government money." would be true if the system was working at capacity. The fractional reserve requirements are not really a limiting factor, the banking system in aggregate is operating well below that limit if I remember correctly.
[1] The 2012 article, for a few seconds; I didn't look at the 30-year-old paper beyond noticing the date in the cover
He first published that article in 2009 right after the markets imploded with the GFC. He's also generally acknowledged as one of the few who predicted the crash which he predicated on the buildup of private debt.
His articles make for interesting reading even now given his general rejection of mainstream models being inadequate.
I think there's a mixup between what most people who have no idea what they're talking about (almost everyone including self) mean when they say fractional reserve banking and the technical meaning.
People mean:
Bank has less "hard cash/assets" than deposit liabilities
Technical meaning:
The bank is legally/practically constrained to a fixed minimum reserve fraction of liabilities to harder assets
So banks DO have a "fractional reserve" even when not practising technical "fractional reserve banking"...
I think
The way I like to explain this is to start from an intensional definition of money as "something that has no value by itself but can be potentially exchanged for something of that value". And total amount of money in economy is the total amount of these things at a given point in time.
So when somebody creates an IOU trusted enough so it could be resold, they have effectively created "money" according to the above definition, because now that IOU can be traded _independently_ of the thing it was originally exchanged for.
I think what confuses lot of people about this is that creation of money is a 3-sided transaction, and we are conditioned to think of a market economy as a sequences of 2-sided transactions.
Also, what I find very funny, some libertarians want to impose government to only create money backed by a commodity, like a gold standard. Yet their fundamental axiom is to allow any two parties to enter (almost) any contract, in particular, allow them to create and resell IOUs. However, if the government has to enforce any contract that two parties can come up with, this is already giving too much freedom for the money to be created regardless of the actual commodities in existence, and regardless what the government does.
To me, commodity money (gold/silver) is only required when the trust in the gov't enforcement of money creation doesn't exist.
and this isn't the case (yet) with the USA - despite the rampant increase in money supply. Unlike other hyper-inflating economies such as Venezuela, the USA gov't isn't printing money to meet it's obligations, but instead turning illiquid assets (such as bonds and treasuries) into liquid assets (cash), that can then be used to grease more commerce and transactions. I don't believe this can cause hyper-inflation that many fear (and thus turn to buy gold/commodities), because the money is backed by debt, which has to still be paid pack.
I recommend reading "The creature from Jekyll Island". This book opened my eyes up to the question "what is money?" and it's especially relevant today, given we are living through the largest wealth transfer in human history. But it also talks about how smaller banks work, and this notion of IOUs, credit and loans.
From wikipedia, about the author: 'He is an HIV/AIDS denialist, supports the 9/11 Truth movement, and supports a specific John F. Kennedy assassination conspiracy theory.[2] He also believes that the Biblical Noah's Ark is located at the Durupınar site in Turkey.[6]'.
I would recommend learning from different sources.
That's an Ad hominem attack by Media Matters and doesn't effect my strong recommendation that this book explains the banking system and how the federal reserve functions.
The BoE ones are the "real" government-issued ones. The interesting ones are the genuinely private ones by the Scottish and Northern Irish banks. Including my favourite ever, the Northern Bank portrait-format space shuttle: http://www.polymernotes.com/northireland.html
Of course, in 2004 Northern Bank was acquired by Denmark-based Danske Group. So now, you have Northern Irish banknotes, which are UK pounds (GBP), with Dankse Bank written on them!
It's not the wild west, though. The Central Bank do know how much these banks are issuing; and also differentiate between the different kinds of money. And not only banks issue money, other financial institutions do also issue some kind of money. From Wikipedia (https://en.wikipedia.org/wiki/Money_supply)
- M0: In some countries, such as the United Kingdom, M0 includes bank reserves, so M0 is referred to as the monetary base, or narrow money.[20]
- MB: is referred to as the monetary base or total currency.[17] This is the base from which other forms of money (like checking deposits, listed below) are created and is traditionally the most liquid measure of the money supply.[21]
- M1: Bank reserves are not included in M1.
- M2: Represents M1 and "close substitutes" for M1.[22] M2 is a broader classification of money than M1. M2 is a key economic indicator used to forecast inflation.[23]
- M3: M2 plus large and long-term deposits. Since 2006, M3 is no longer published by the US central bank.[24] However, there are still estimates produced by various private institutions.
- MZM: Money with zero maturity. It measures the supply of financial assets redeemable at par on demand. Velocity of MZM is historically a relatively accurate predictor of inflation.[25][26][27]
By the way, you can issue money too. Let's say you buy a computer for $1.000 and promise the seller that you are going to pay him $1.050 by next year. You just issued $1.050 of M2.
Counter-intuitively, this money supply system is helping developed countries control inflation. In some developing countries, inflation is harder to control because people are issuing money on their own.
"There’s a lot to unpack here. First, Werner claims that banks are special due to their ability to create money out of thin air. Second, Werner claims that the first claim is proven conclusively with empirical evidence.
Werner’s second claim is patently false, because the ”evidence” he presents in his paper only describes banks’ ability to create money out of thin air — he presents no evidence for non-bank entities’ inability to create money out of thin air. Thus, he presents no evidence that banks possess an ability non-banks do not possess. And yet, he claims to have done the opposite."
This is awful semantic gaming to "prove" that a false claim was made. If the definition of "money" is fuzzy and there are different kinds of money, if "bank IOUs" and "private IOUs" are materially and legally different from one another, then the strongest interpretation of Werner's words must be taken: He is talking about the sets of money that do not include IOUs from random private entities.
Clearly, banks are special in this regard and the amount of bank-created money on the money supply is enormous, whereas the impact of private IOUs is so minor that we can disregard it.
It sounds like you are referring to "claim one", not "claim two". I noted in the article that Werner is (only) technically correct on claim 1, essentially due to the reasons you described. Claim two is about presenting empirical evidence for claim one. You might think that empirical evidence is not needed. That's fine. It still was not presented, so claiming to have presented it was a false statement.
You ask for empirical evidence that "private entities have the inability to create money out of thin air", but this rests on a definition of "money". You brought up the example of a private IOU (the Poker Site).
If we remove the distinction between private IOUs and bank IOUs, indeed you would have an example of a private entity creating money out of thin air, for a more loose definition of money. However, as we established, removing this distinction is unwarranted, bank IOUs are treated quite differently both legally and materially.
If we maintain the distinction between private IOUs and bank IOUs, then your example becomes simply irrelevant. Any IOUs that may be issued by private entities that are materially and legally different from bank IOUs have no bearing on Werner's claims.
I believe the empirical evidence for private non-bank entities not being able to create bank IOUs is that they're not banks. Am I missing something?
> I believe the empirical evidence for private non-bank entities not being able to create bank IOUs is that they're not banks. Am I missing something?
That's not what "empirical evidence" means. Empirical evidence is something we observe in the world. If we set a definition "all murder is illegal" and then we conclude "legal murders do not exist", do we have "empirical evidence" that legal murders can not exist? Of course not. We can conclude the claim is true by definition. That's not empirical evidence.
> You ask for empirical evidence ...
I never asked for empirical evidence for non-banks' inability to create money out of thin air. Werner claimed to have empirical evidence for this, and I merely pointed out that he does not have empirical evidence for this, contrary to his claim. If Werner had instead said "due to accounting conventions, we declare banks' IOUs to be money and non banks' IOUs to not be money", I wouldn't have any problem with that.
> That's not what "empirical evidence" means. Empirical evidence is something we observe in the world. If we set a definition "all murder is illegal" and then we conclude "legal murders do not exist", do we have "empirical evidence" that legal murders can not exist? Of course not.
Hmm, you're right...
> We can conclude the claim is true by definition.
...which means we don't even need any empirical evidence to say that banks are different and unique from non-bank entities!
> I never asked for empirical evidence for non-banks' inability to create money out of thin air. Werner claimed to have empirical evidence for this.
No, he doesn't. He claims that he has empirical evidence for banks creating money out of thin air, nothing more.
> If Werner had instead said "due to accounting conventions, we declare banks' IOUs to be money and non banks' IOUs to not be money", I wouldn't have any problem with that.
Doesn't that go without saying, considering that non-bank IOUs, such as poker website deposits, aren't considered part of the money supply under pretty much any definition?
> ...which means we don't even need any empirical evidence to say that banks are different and unique from non-bank entities!
That's correct, and I said so in the article. I said that (although there is no empirical evidence) the underlying claim is true on a technicality.
>> Werner claimed to have empirical evidence for this.
> No, he doesn't. He claims that he has empirical evidence for banks creating money out of thin air, nothing more.
Here is a direct quote from Werner's paper: "We now know, based on empirical evidence, why banks are different, indeed unique … and different from both non-bank financial institutions and corporations: it is because they can individually create money out of nothing."
When Werner claims to have empirical evidence that banks possess a unique ability to create money out of nothing, he is technically making 4 claims:
1. Banks possess said ability
2. Non-banks do not possess said ability
3. Empirical evidence shown for claim 1
4. Empirical evidence shown for claim 2
Claim 4 ("empirical evidence shown for claim 2") is patently false.
Again, this is an uncharitable misreading of one sentence of the paper.
This is a more reasonable reading:
Banks are different because they create money out of thin air. That has been generally accepted so far, but where is the empirical evidence for banks creating money out of thin air? It's in the paper. That's the contribution of the paper, to show empirically how new money is created.
We don't need evidence (empirical or otherwise) for non-banks not creating money, because that would be proving a negative.
If you want to attack the strong interpretation of the claim, you would have to show how non-banks do create money, which you didn't, because as we already agreed, deposits at non-bank institutions are not considered money.
I implore you to apply the principle of charity (steelmanning) instead of wasting your time on semantic disputes.
Hmmh, I can see how you might take a more charitable interpretation of that claim, and maybe this does fall in the category of semantic disputes.
> we already agreed, deposits at non-bank institutions are not considered money.
...due to a technicality / accounting conventions. Yes, I conceeded that already in the original revision of the article. Nonetheless, I made a pretty good case why the IOUs created by Full Tilt Poker could be considered money, even though they were created by a non bank institution. Yes, the IOUs created by banks are "more like money", but in my view, the difference is not that large.
Wow. This is a flat out lie. Banks operate on a fractional reserve system and they are allowed to loan out more money than they have. It's not just about swapping an IOU between a depositor and a borrower. With the recent COVID-19 regulations, banks don't need any reserves at all anymore. The Fed had been constantly lowering the reserve requirement over the years, effectively causing an infinite but controlled supply of money to enter the economy with financial firms being the biggest beneficiaries.
The "money" created by the bank in the process of loaning money _is_ an IOU, so all this stuff that you talked about does not invalidate the description that "taking a loan is an exchange of 2 IOUs". If you disagree with something in the article, please be more specific what you disagree with.
> For example, when you make a bank transfer to another bank, the bank can not simply send over money created by itself.
Uhh, yes it can. That's what LIBOR is (supposed) to represent - short term unsecured lending between major banks. I.e. they can agree that the sending bank is now slightly more indebted to the receiving bank. It depends on what the involved banks agree on.
And because such things are based on trust they do blow up sometimes. For example during the panic in March there was a pretty wide gap between FRA rates (unsecured lending) and OIS rates (secured lending). FRA was quite a bit higher.
Edit: let me just add that this does not invalidate the rest of the article.
Thanks for this feedback. I have now updated the article substantially. The new version covers the possibility of banks lending money to each other as opposed to settling a transaction with cash/reserve deposits. Diffs: https://github.com/baobabKoodaa/blog/commit/c2f7fef53d621acc...
The various types of money usually have interest rates associated with them, and those rates tell you about the relationships between the types of money. For example there is an interest rate differential between the central bank money and the US treasuries (which are equivalent to USD money for most people most of the time), captured by the repo rate minus IOER. This differential blew up quite recently (in 2019), showing a temporary divergence between tbills and "real money".
In the past, before central banks, each region of the US had their own money, and merchants had conversion tables. They would literally tell you that, for example, Boston money is worth for me only 80 cents on the dollar. Much like today we quote prices on bonds.
Robert Shiller has some really good finance lectures on YouTube. The one about central banking:
This article makes no sense?
There is a fundamental difference between issuing a random "IOU" (like anyone can do) and an "IOU" which is universally accepted as payment (ie money - which banks do).
I'm sure I could issue a OMGPWNIOU, but difference is, that no one will accept it as payment.
It's not black and white like some IOUs are accepted everywhere and some IOUs are accepted nowhere. For example, USD is not accepted as payment in Finland, where I live. In the article I gave a concrete example of non-bank IOUs which were effectively money. If you have an argument why the Full Tilt Poker IOUs should not be considered money, let me hear it.
Full Tilt Poker didn't operate like a bank from what you described as they "had slowly siphoned off almost all player funds over the course of multiple years, leaving only a small fraction in reserve".
In this case they were like a _Ponzi Scheme_ and not like a fractional reserve bank as they had _no assets_ to redeem the claims of their depositors with.
Pokerstars (from what you've described) was operating in a manner similar to a fractional reserve bank.
Pokerstars was not operating like a fractional reserve bank, because it had segregated player funds to separate bank accounts. As in, it didn't have a "fraction" of reserves for the money players saw in their accounts, it had "full" reserves. It didn't have to go out and sell illiquid assets in order to pay players. It already had the money at hand.
If you want to characterize Full Tilt Poker's operation as a ponzi scheme, I have no problem with that. Full Tilt Poker was operating as a fractional reserve bank, and in addition to this it was siphoning assets of the bank to its owners.
In the first example, is it possible to repay all the debt?
The bank has $100 cash and $11 promised. Customers have $10 cash and $100 promised. Assuming the person with $100 withdraws the money and wants to share it with the other person to pay off his loan, they end up with $99, but they started with $100. If they started at $0 they would be at -$1.
How is this resolved in a real banking system?
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[ 2.8 ms ] story [ 253 ms ] threadEvery time a loan is used to pay for goods or services, some fraction of that goes back to “the bank” where 90% of it can be loaned out again. Best case, where all money is moved electronically and instantly, I keep seeing that 100 dollars go out and come back a little smaller over and over and over again. The tenth time I see it I can write a loan for about $30.
The thing that seems to confuse people is the abstraction mechanism by which the $1,000,000 depositor doesn't see any of the $850,000 debt, and the by which they can withdraw the $1,000,000 without being involved in any debt transactions themselves. Fractional reserve banking doesn't create money out of thin air, it's just a system that allows for deposits to be put to productive use. The alternative is that deposits are entirely withdraw from the economy completely until the depositor wants to use them, which would be the economic equivalent of hoarding all your money under the mattress.
The rest of it also doesn't really "go to the bank", it's money that they must have on hand to service withdrawals, and absorb defaults and other losses.
It doesn't increase currency (M0).
But is there 'money' in your bank account? They increase money by a slightly broader definition (accounts + currency).
Even if you've got a narrower definition (and just want the physical paper to be defined as money, not entries in a database) then they don't increase the amount, but they greatly amplify its effect by increasing the velocity of circulation (which you did mention). One little bit of money is being thrown around between owners much faster, which effectively magnifies its impact.
Money is literally defined simply as "currency plus bank accounts" so obviously funding a bank account creates "money".
Your post gets into the velocity and momentum of money, which is yet another concept.
They do it by keeping enough money laying around doing nothing, to service those withdrawals. If all of a sudden huge amount of customers started making huge withdrawals, they wouldn't be able to service them, because they wouldn't be able to liquidate those assets immediately. If banks were actually creating money out of thin air, this wouldn't be possible, because they'd just be able to create some money out of thin air to service them.
Unpaid loans and interest are not accounted for and create a need for even more loans to create more money out of thin air but of course those additional loans also have interest and are also unpaid so it spirals out of control.
Both the processing fee and profit margin circulate within the economy. They are not part of the loan, they are fees the bank is charging and using to pay its employees and shareholders who then spend that money. It is entirely possible that you are working for a bank and receiving that money as a paycheck, or your bank is purchasing services directly or indirectly from a company that you are working at.
When you think about it, central banks are not any different. They charge a fee and then send the profit to the government which then can spend it on services that eventually employ you.
You own a farm and borrow 50k from a bank that has $10k in its reserves. The loan has a duration of 10 years at 2% interest so you have to pay back 60k in total. You pay back $6k every year. The bank purchases $1k worth of food every year. The end result is that you have paid $60k to the bank and the bank has paid you $10k.
That bank debt is backed by all the kinds of bank assets that you mention. Plus perhaps some government deposit insurance.
An advantage of that system was that banks did not lose reserves when customers withdrew money, ie converted deposits to cash.
(The banks lost reserves when those notes were eventually deposited with rival banks who demanded settlement in underlying reserves.)
Of course, even that system did not multiply the amount of reserves; you might call them M(-1), if you are so inclined.
Historically the underlying base money was gold, but you could imagine a system with private bank notes built on top of the federal reserve dollar just fine. You can even leave physical Fed cash in circulation, too.
Not all of a sudden, as in instantly, no, but there will be. See below.
> There is $850,000 worth of debt held by customers, and another customer with a $1,000,000 balance
Yes, but what do those other customers do with that $850,000 of debt? They either deposit it in another bank, or they use it to pay someone for something, and that someone deposits it in another bank, or...
In short, virtually all of that $850,000 of "debt" ends up as $850,000 of additional bank deposits in other banks. And to those other banks, those deposits are simple deposits--there are no debts (yet) against them on the other banks' books. So there is nothing to stop the other banks from lending out as much of that $850,000 as they can again. Which means the other banks have just turned what was $850,000 of "debt" into $850,000 of new money.
> Fractional reserve banking doesn't create money out of thin air
Yes, it does. I just explained how.
> it's just a system that allows for deposits to be put to productive use
More precisely, it's a bad system for putting deposits to productive use, because it mismatches maturities and therefore leaves the entire financial system open to bank runs, which then have to be prevented by additional "protective" measures. Which will sooner or later fail, and fail all the more catastrophically because the protective measures enable financial institutions to hide the fact that bad investments are being made.
The correct way to put deposits to productive use is to make them time deposits, not demand deposits. In other words, if you have a spare $1,000,000 that you have no good use for, you deposit it in some financial institution for a period of time, say a year, or 5 years, or 10 years, and that financial institution promises you some particular rate of return over that time in exchange for the use of your money to finance productive endeavors. Of course this is just another way of describing a bond, or a certificate of deposit, or a money market certificate, or whatever your financial institution chooses to call it.
But suppose you buy, say, a 5 year bond with your $1,000,000, and then, a year later, you find you need the money? Well, that's what a bond market is for--so you can sell your bond, at a fair market rate, and get cash in exchange, while someone else has now invested their money for the remaining term of the bond. There is no need for the financial institution to treat your $1,000,000 deposit as a demand deposit, withdrawable at any time, while it is transforming maturities by investing that money in other productive endeavors that take time to mature, just to shield you from unavoidable uncertainty about the future. There is certainly no need to expose the entire financial system to possible collapse to do this. The only reason this wacky system persists is that people in power benefit from it, and ordinary people have gotten so used to it, since it has been around for so long, that they don't connect it with the occasional meltdowns that it causes.
The debt is an asset held by the bank until it is paid off, is sold, or is defaulted on.
Person A deposits $1M
Person A $1M, total deposits on hand = $1M
Person B takes $850k loan
Person A $1M, Person B $850k, Person B -$850k debt
Total deposits on hand is STILL only $1M. The combined balances are 1.85M but these are just entries that have no impact on what is actually in the bank's vault/account.
If A and B both ask for their entire balance at that moment the bank will have to go to the overnight window or some other facility to take a short-term loan that it will owe interest on and may need to provide collateral to receive.
In that case the bank's overall balance sheet would be $-850k of debt it owes someone. Because that debt isn't collateralized their rate will probably be higher. This is what led to things like the credit market freeze up that the Fed needed to step in to provide liquidity for. Banks usually borrow from each other not just the Fed, but when shit hits the fan banks might not be willing or able to loan to each other except at extremely high rates.
When the bank repays its loan (perhaps when Person C is paid by B and deposits the money into their account) the situation will unwind and we'll be back to the previous situation.
In real life it's much more complicated because the bank probably has many other types of assets like CLOs, CDOs, etc.
https://www.investopedia.com/ask/answers/040715/what-differe...
Sometimes the Fed will take assets as collateral for a loan and the bank is expected to repurchase it later at a slightly higher price a/k/a the Repo market
https://www.bankrate.com/banking/federal-reserve/why-the-fed...
That will not work for normal accounts where peoples salary are deposited in, they need to use that money over the month.
Also my savings account, I dont know when I will need the money. There might be emergency expensive repairs needed to my house or car that I need to take from that account.
yes there is - because consumer's behaviour is irrational, and they cannot easily calculate the required interest for such a bond. A demand deposit is easy for a consumer to understand, and the bank can pay less than the equivalent bond interest, and pocket the difference.
There are termed deposits that banks offer. But consumers have overwhelmingly not chosen to use them imho, because it doesn't offer high enough interest rates, and the hassle of illiquidity isn't suitable for a consumer context.
The bank takes the new deposits and loans out 85% of it ($723k) to another small business. This small business goes and uses it to pay its employees and they all deposit the money in the bank. Now the bank has $2.573m in deposits.
The employees and the manufacturer can all withdraw the money at any time. So I struggle to see how this isn't creating money.
The fractional reserve system lets the bank loan the same dollar out multiple times. How isn't this creating dollars? If the bank takes one dollar and loans 85 cents to you and 73 cents to me, isn't there more money?
It absolutely matters how many times the dollars come back to the bank because that is the pathway that lets the bank loan the same original dollar out multiple times.
In your example though, the bank has a different problem of offering unsecured loans, which could lead to some losses for them.
This isn't quite correct. If all parties go to withdraw their money at the same time, the bank will not be able to give it, because they only actually have $1M in reserve.
In practice, if there are more withdrawals than than the bank has in reserve, it is usually able to get short term loans from the central bank which than ACTUALLY creates the money and loans it to the bank.
However, over the long-term if too many of the bank's loans default, they won't have enough assets to cover the deposits, which is how banks usually fail.
The primary cognitive dissonance with other people comes from tying morality to prosperity. Or put simply "some people deserve money and when that criteria is not satisfied it is controversial", but what they really mean is that "someone should have the ability to have goods and services more than others", with the money itself only being a reductive surrogate to make that happen.
The further you abstract yourself away from that, the easier it becomes to operate and see opportunities, or how to exchange time for more food and shelter in a more efficient way. How to have enough resources that the money itself looses additional utility, no different than how an abundance of oxygen looses its utility while a known upcoming absence of oxygen will redirect all of your thoughts and resources into making sure that doesn't happen.
Yes, it should not be a mystery how banks can create money.
The universe of investible assets available for the central banks are small, they need your help in providing a service to them in the primary market (credit markets, corporate bonds). Direct issuances were always going to happen, if it wasn't the pandemic it would have been something else. Anything that slowed down China's growth would have resulted in the same outcome. There is no transparency in direct issuances, you just need to appear or structure your offering as credit worthy. There are no consequences. Some people are ready for this specific outcome, if you think you can steward money better (or just want a lot of it for whatever reason), you should structure an offering for this.
Central Bank direct and primary market operations are going to continue as their universe of investible assets is small, their monetary policy is not able to achieve the behaviors of market participants that they want as it requires associated fiscal policy changes from legislature and results. Central bank's stated goals for their monetary policy is disingenuous as they do not care about inflation targets or GDP numbers, but they do factor them in. They are just tools to alter and manage the yield curve as they just buy bonds from their friends at a profit.
Yield curve based monetary policy doesn't work to its stated goals due to a fundamental misunderstanding of what people want. Dropping yield curves don't cause as much growth in the real economy because people just don't want to give random entrepreneurs their money. People are willing to pay to not do that. Negative interest rates are therefore not controversial and can go much steeper than any central bank has experimented with. People would be willing to pay to keep their money.
Fed and Central Bank balance sheets should not be seen as a threat or overhang to the markets, as it doesn't need to sell credit assets, it just holds them to maturity. It and other sovereign wealth funds have an infinite time horizon.
Conspiracies about central banks and their ownership structure are irrelevant. Orphaned entities like trusts are common structures. There is a lack of transparency in some areas either way.
Don't just pay attention to the Fed, ECB and BOJ. There are plenty of Central Banks on the periphery of the EU who must react and expand their universe of investible assets before or after the ECB/Fed.
In smaller markets you can have a lot of influence as an individual. As in, you can get the ear of a regulator or the upper echelon, or even the stewards of a central bank, just by having a good idea and understanding their needs, interests and psychology. Compared to attempting to earn a pedigree you weren't born into.
The Swiss National Bank is amazing for Swiss people, but it should probably be considered a national security threat to the US markets. Since it is not, it is more likely that the SNB is part of a coordinated stock market growth arrangement with the US, as their stock purchases of individual companies with newly created CHF is not something the Fed is authorized to do, yet.
I wish more central banks were publicly traded like the SNB.
Liquidity of the currency shows the tolerance of distribution. Think of inflation like corporate stock dilution, if the market is liquid then you can create more without undermining confidence in that market. Think of government currency like shares of a country/economic union. People are uncomfortable with the idea of analogies that show the similarities between private organizations and states formed to serve the people.
Hyperinflation is not as big of a threat when all major currencies are doing it at the same time. Coordinated inflation masks hyperinflation of any individual currency as their value relative to each other stays similar while the supply of all of them is increasing. The price of individual consumptive goods can still increase dramatically, but the price of the currency and confidence in the currency is not ...
A bank can store money in the central bank, but it can also put cash in a vault. If the central bank has steep negative rates, why would they use it for much?
This used to manifest as "hoarding specie", but economies have also hit deflationary problems of hoarding physical cash. Not sure what that would look like in a world of widespread electronic payments. You'd probably have to pay a premium to get cash from an ATM. Banks would start making it easier to deposit small business cash and harder to obtain rolls of change. Eventually at high enough negative rates people would be paying an (electronic) premium on the face value - you give me a $10 bill and I paypal you $10.50?
Pay attention to the corporate credit market. The steeper the yield curve goes, the more it drags down the cost of credit for corporate issuers. Getting aggregate corporate credit information in these markets is hard but rewarding, you can predict what to expect - investment grade corporations bonds yielding 0% possibly issued at 0% - but it is hard to confirm the market appetite. This is where we are right now in market efficiency.
I think you haved to be careful about attributing your success or ability in one field to a generalized philosophy that you have.
Just looking around empirically, "successful" and "unsuccessful" people seem to vary wildly in ideology. Stallman, Thiel and Bill Gates have pretty wildly varying ideologies and are all successful, I'm sure you could find 3 unsuccessful people with similar ideologies.
I'm moderately OK because society currently values ability to solve quite formally defined logic puzzles and I was in a sociological place to get a couple of pieces of paper that statistically indicated some combination of privilege and ability to do the former when I was 18-21.
That might not even last, never mind demonstrating philosophical superiority. If I make a few million or achieve inner peace in the next decades it still won't prove too much, since there's so many other people of all philosophies going in all directions.
I also make the darts and choose the walls
I think this is wrong in a subtle way. Regular banks have a reserve requirement that limits their ability to create money. They must hold a certain number of federal reserve notes to meet the reserve requirement. The Federal Reserve can create federal reserve notes.
The requirement was removed in the US in March 2020 but has been a formality for most banks for a long time.
https://www.federalreserve.gov/monetarypolicy/reservereq.htm
Even without laws requiring reserves, banks still want to hold some precautionary reserves to eg settle interbank transfers or to serve cash withdrawal requests.
But those precautionary reserves can be very small without causing much trouble. In Scotland in the 19th century they had about 2% gold reserves and where doing fine.
What's more important are equity cushions to take the blow of losses before the depositors do.
Scottish banks typically had about 30% equity cushions because that's what depositors demanded. (These days laws require about 8%. Depositors don't care much anymore, because government deposit insurance numbs them.)
Imagine a fraudulent banker who keeps adding billions to his own account. Suppose no-one notices. The banker starts to buy mansions and islands with this made-up money. Every time his bank transfers money to other banks (to buy those mansions), the bank loses some reserves. At some point the bank has no reserves left. Even if the reserve requirement was 0, having no reserves would mean that you could no longer transfer money to other banks.
And Scotland also didn't have them during their free banking episode.
What the Scottish banks had instead where crazy high equity cushions (like 1/3 of assets, instead of the about 8% common these days). But not because of any law, but because customers insisted.
Equity cushions are much more important in protecting depositors than reserves.
Nothing in this blog post comes even close to supporting the idea that banks have no special money creating power.
The hidden assumption is that this "iou power" is not regulated or enforced by government control over the money supply.
That you can write a cheque and then not cash it, and that a poker site can commit fraud, do not make banks unspecial.
This is just a libertarian is/aught fallacy dressed up in a lot of words.
Though to make it absolutely the same position, Amazon's currency should not be tied to the dollar but freely floating.
Then there can be no run on Amazon's currency, just like there can be no run on the dollar. However, of course, both Amazon's currency and the dollar can lose in value compared to goods and services or other currencies.
If Amazon is selling their own stuff for Amazon bucks (and people still want to buy stuff from Amazon so that Amazon bucks have a non-zero market price), there's a minimum finite amount of Amazon bucks that I would gladly accept.
If Amazon bucks weren't very commonly used (think like bitcoin today), I would probably ask for a premium over USD just to make up for the inconvenience of having to exchange them.
If Amazon bucks were more commonly used in daily life than USD, I might even accept a slight discount.
> If you worked for amazon, would you accept amazon bucks as salary?
That's actually an even easier question. Amazon already pays their employees partially in Amazon stock. At a big enough stock offering (and frequent enough vesting), I'd happily accept an all shares compensation.
Now, Amazon bucks would be different from Amazon shares. But the only thing that matters to me when accepting compensation in shares is how easy it is for me to convert the shares (or bucks!) into something I actually want later.
Well, that's not just a legal barrier there, but also that the people on the other side of that transaction don't like to be robbed.
People deal in currency blackmarkets all the time, and all participants are willing. Obviously, being able to do business out in the open is much more efficient and productive. And especially eg Amazon as an above board organisation could not engage in blackmarket operations without endangering their legal activities.
And I mean, the vast majority of money in circulation does not come from the money printer or even the central bank's own ability to duplicate money, it comes from the multiplicative recirculation by banks.
The banks have been both legally empowered and de facto relied on to do this money creation on behalf of the government in ways that other people and organizations are not allowed to do.
Just witness the largely successful regulatory crackdown on cryptocurrency services, or the fact that "point exchange systems" like Xbox live points to to great lengths to insist that their points are not recoverable into dollars to avoid regulations as actual evidence that banks are not accidental money creators but an empowered subsystem of the process of making money exist.
> That banks do not have any special powers in relation to money creation
They most definitely do though: FDIC insured accounts have legal government backing—a random IOU from me can't achieve that, no matter how much anyone trusts me. Put another way, a bank deposit seems less like an "IOU" and more like a "WeOU"—"we (the bank or the government) owe you". That seems like quite a fundamental difference, no? It seems to distinguish "fake" and "real" money (or banks).
The reason I attacked Werner's article is that he mystifies money creation and perpetuates the misconception that banks' ability to create money is similar to central banks' ability to create money (he does not directly say so, but a non expert reader is likely to gain this misunderstanding when he uses terms like "fairy dust" etc.).
In the article I attacked 2 specific claims of Werner. One was patently false. The other was correct due to a technicality only.
Although "technically" I agree with your article, banks have a legal definition, legal power and legal responsibility. That makes them special and gives them the legal power to create money -- not without limits, though. Banks can -- subject to some rules -- borrow money from the central bank, which will create said money for them. With repo rates hovering zero and all processing happening electronically, "out of thin air" is not really that far from reality. :)
I would argue that if I issue you an IOU, that is not real money: I do not hold a banking license, I do not keep track of all IOUs, I have no audit to pass once-a-year. In fact, I might drink away your deposited cash next day. :) The Full Tilt Poker example is relevant, but I would argue that that is illegal banking: It happens, but it really shouldn't. Wirecard is the other extreme: They were a bank (legally) and created money against the rules (I'm a bit oversimplifying).
I guess the common person needs to be educated about legal powers: For example, what makes this house special that I own it? A large enough hammer can open the door, as easily as my keys. In fact, if I sublet it, I might not even have the keys! Ownership, as money, are legal constructs that only hold value if they are properly enforced. Of course, enforcement is easier the more society accepts the construct.
- How do you explain that the M2 money supply is always going up? Where is all that new money entering into the system? Government contracts funded by government bonds? If that was the case, government contractors would be getting very wealthy and everyone would be working for them (directly or indirectly)...
- How do you explain the recent, significant, almost instantaneous jump in stock prices of major tech companies after the Fed printed and injected trillions of new dollars into the economy? Did these corporations all suddenly score huge government contracts from the bonds which the government created? Seems more like investors and company insiders used loan money from banks to do stock buybacks or increase their positions.
- Under the model suggested by the article, how does one explain why there are so many millionaires are in the real estate industry? If you assume the opposite argument that banks are able to print money (directly or indirectly), the number of millionaires makes perfect sense since everyone buys houses using 'loans' from banks; so it's natural that all this free money from banks would constantly inflate real estate prices; each new generation of citizens would inflate the prices of the properties which were bought by the previous generation with increasingly larger loans from newly printed credit from their banks.
What is claimed by the article does not match the evidence, even the people have wised up to this scheme which is why Bitcoin and cryptocurrencies have been able to hold their value.
"creating money" is ambiguous to be nearly meaningless, "creating money in a way that noone else is able to" is a lot less ambiguous
Nonetheless, this is all irrelevant, people cannot legally create money (that would be counterfeiting), they can only create assets; only banks can create money and they can cherry-pick who is allowed to get credit and who isn't using whatever rules or metrics they see fit. All the new money enters the economy through loans and government bonds. Companies and individuals who are close to the money printers get most value out of the new money since they get it first (Cantillon effect). By the time inflation kicks in, these people who are close to the money printer will be able to take another bigger loan in the future using their existing collateral which will undoubtedly be worth more due to inflation in the nominal monetary 'value' of that collateral.
I'm thinking of things like https://en.wikipedia.org/wiki/Liberty_dollar_(private_curren... which ended in FBI raids.
Even if everyone agreed to use your IOU from the article the tax office is going to have quite a bit to say on the subject and probably start launching audits. And if the IOU start getting traction they are likely to trigger police raids and maybe a legislative response (look at how Facebook dropped their Libra for example). That seems substantially different from the IOUs the banks can create.
I wouldn't use bank-issued IOUs if I thought I had a choice. I'm pretty sure I'm forced to by government policy.
IANAL, but the IOUs created by Full Tilt Poker were also legal to use. When the government eventually pressed charges in the debacle, no charges were pressed against regular players of the poker site, including those who used these IOUs for small economic activity. If using these IOUs would have been illegal, then surely the government would have pressed at least some charges after spending years investigating the case?
But anyway, even if _using_ the IOUs was not illegal, creating them like a fractional reserve bank surely was illegal. So you definitely have a point that the regulatory environment creates a special status for the legal tender of the country.
When I give a Amazon gift-card to someone, it is an IOU against Amazon, and most people will gladly accept it as money.
Full Tilt Poker created a small closed e-money system which was seemingly legally fine; it was the gambling that got them raided, because only mob bosses in politically connected US states are allowed to profit from gambling and the US will go after gambling providers in other countries.
Liberty reserve were facilitating money laundering. This is the difficult bit - if you provide an electronic facility for easy transference of ownership of debts or e-money, the authorities want access to the paper trail.
No, there's a big difference, in that you don't have the right to redeem ("put") the corporate bond any time at face value.[1] You do have that right for the IOU that is your bank account. This allows two people to carry on as if they both are full owners of the dollar in the bank account (both the depositor and the business it was lent to), and that mechanism is what allows the money supply to increase.
When you don't have that right, you, as the corporate bond holder, know that you can only get the money out early by selling the bond at its current market rate, whatever that is, which may force you to take a discount. This expectation -- and the necessity to redeem it for someone else's dollars on the market -- prevents it from being money creation.
[1] There are "puttable bonds" where you can do something like this, but it's over specific intervals and times, not immediate. https://en.wikipedia.org/wiki/Puttable_bond
Yes, but that is relatively recent development. Bank money (and IOU-based money creation) is much older than deposit insurance.
Deposit insurance is a fundamental difference but it's not the main difference. Individuals and most non-banks don't have access to Federal Reserve accounts and therefore access to reserves. The main distinction between a bank and a non-bank is the ability to create IOUs ultimately backed by reserves (whether they have sufficient amounts or not) which can only be created by the FR (and in this context) to back a bad IOU. Whether the new reserves go directly to backing up the IOU or indirectly via added liquidity is irrelevant. A bank can create a misguided IOU that defaults, which if too big to fail, is a liability that the FR and thus all holders of the IOUs, cash, and reserves must bear.
I'm not claiming it's the same. I'm saying these are differences of degree (my IOU vs bank's IOU), whereas the difference between central bank IOU and bank IOU is fundamental. We have several historic examples of central banks ruining entire economies by printing excessive amounts of money causing hyperinflation. Do you have a single example of a regular bank printing so much money that it causes hyperinflation? No. Why is that, if it's so easy for a regular bank to print a trillion dollars of fraudulent money without anyone noticing?
Side note regarding non-bank IOU: I found the idea of having a payment card from my grocery store very appealing. If they run out-of-cash, they can repay me in food, which I'm pretty happy to take at any time. However, that is not how it works in 2020. The grocery entity and the banking entity need to be separated, and have different licenses.
Quite a few of the grocery chain cards here in Sweden have accounts backed by chain-owned banks. So at least here, the separation is not all that great.
Facebook's digital currency system is one recent example. Paypal's behavior is a much longer-running example.
I understand that this is basically insurance fraud, but the money is gone long before the fraud occurs and the government must pay out, unlike a single insurer.
Now if you realize that that $100 is a mere IOU from the U.S. of A. you may get a feeling you are onto something...
As a example of how much the value of fiat currency depends on taxation: https://www.irs.gov/taxtopics/tc420
Even if you barter without using any currency, the IRS wants a cut.
And honestly, that's really not so different than gold. Why would the gold standard work? What intrinsic value does gold have? Again it only has that value because we trust it. If we stopped caring about gold, maybe if asteroid mining were to quickly result in 10 times the amount of gold that's currently available, gold would quickly lose that trust; same as when a government started printing money with wild abandon. As long as governments are responsible about the money supply, money is just as good as gold. But only as long as they are.
So it is essentially an IOU for bonds, just not redeemable in retail (by individuals) but in bulk (by commercial banks). If commercial bank wants 'redeem' some cash (for bonds), then it just acquire less cash in the next round of repo operations.
Interestingly, Clydesdale's office address isn't shown on the note.
Of course you sterilize (cancel out) that creation when you pay the credit card bill.
But I am engaging in some hair splitting, I admit.
Banks which participate in a central banking scheme (such as the Federal Reserve System) have a license to create IOUs which are authenticated by the government which sponsors that central bank. In other words, such banks can create IOUs that are backed by the full trust and credit of the government, not merely their own trust and credit as a business enterprise. I'm not sure I would characterize this as "impressive", but it is most certainly a privileged and unique position over the rest of us.
(from: https://nakamotoinstitute.org/reciprocal-altruism-in-the-the...)
I was just thinking about the immutability debate in the Ethereum blockchain world, where the community split due to a difference of opinion/interests on whether their system of money should allow a transaction reversal due to unintended effects of a certain contracts code on the state of the system (https://en.wikipedia.org/wiki/The_DAO_(organization)).
Those who were in the "code is law"/"immutability despite errors/malicious behavior" faction insisted that no change should take place, resulting in the loss of money/decreased action (state change) potential for the original holders affected by the unintended state change.
The more popular/valuable (by market cap) system of money (ETH) was the one where this change took place, though this was a one-time event. The state of the system was since not adjusted to reverse effects of hacks, accidental transfers/state changes of smaller impact (still millions of dollars equivalent).
Reversible systems need adjudicators which determine if a reversal should take place, and since this is a complex, subjective consensus issue, they pretty much must be humans, resulting in unpredictable and possibly unstable sociopolitical processes.
Fiat money derives its value through its utility (widespread acceptance in the exchange for goods) and its contractual enforcement ability provided by a states monopoly on violence (resulting in working contract law) and as the primary means of paying taxes.
An (unbacked) IOU has less value than central bank (digital or cash) money, because whether it results in delayed reciprocity is more uncertain (credit default risk, bank runs). In the same way, more irreversible money/settlement systems (like cash https://en.wikipedia.org/wiki/Real-time_gross_settlement) carry less of this type of uncertainty and risk but more of others (legal, last resort to violence to enforce state/or even consenus change, large losses due to mistakes).
Lock some amount of ETH up, get some amount of stable dollars out, which inflates the total amount of money in the system.
https://www.youtube.com/watch?v=EC0G7pY4wRE
In india, all deposits are considered liabilities (since you need to pay the customer interest on it).
All loans are considered assets (since you make money on them)
It's usually raised using deposits. Unless I'm missing something
I don't think that is fractional reserve banking.
FRB is the system where a bank is required to have a reserve of X% before it can issue money, while in the current system the banks first emits money and then (in the US) it attempts to get a reserve[0] for that (and in the EU, it doesn't either, tho there are liquidity requirements).
[0] https://en.wikipedia.org/wiki/Reserve_requirement
[1] https://www.deflation.com/Articles/The-Roving-Cavaliers-of-C...
[2] https://researchdatabase.minneapolisfed.org/concern/parent/b...
Edit: I've just briefly skimmed it [1], but "The creation of credit money should happen after the creation of government money." would be true if the system was working at capacity. The fractional reserve requirements are not really a limiting factor, the banking system in aggregate is operating well below that limit if I remember correctly.
[1] The 2012 article, for a few seconds; I didn't look at the 30-year-old paper beyond noticing the date in the cover
His articles make for interesting reading even now given his general rejection of mainstream models being inadequate.
https://theconversation.com/i-predicted-the-last-financial-c...
I do agree that, 0 being an integral, that name lost its meaning, but it's still the same thing, so people keep using the same name.
People mean: Bank has less "hard cash/assets" than deposit liabilities Technical meaning: The bank is legally/practically constrained to a fixed minimum reserve fraction of liabilities to harder assets
So banks DO have a "fractional reserve" even when not practising technical "fractional reserve banking"... I think
So when somebody creates an IOU trusted enough so it could be resold, they have effectively created "money" according to the above definition, because now that IOU can be traded _independently_ of the thing it was originally exchanged for.
I think what confuses lot of people about this is that creation of money is a 3-sided transaction, and we are conditioned to think of a market economy as a sequences of 2-sided transactions.
Also, what I find very funny, some libertarians want to impose government to only create money backed by a commodity, like a gold standard. Yet their fundamental axiom is to allow any two parties to enter (almost) any contract, in particular, allow them to create and resell IOUs. However, if the government has to enforce any contract that two parties can come up with, this is already giving too much freedom for the money to be created regardless of the actual commodities in existence, and regardless what the government does.
and this isn't the case (yet) with the USA - despite the rampant increase in money supply. Unlike other hyper-inflating economies such as Venezuela, the USA gov't isn't printing money to meet it's obligations, but instead turning illiquid assets (such as bonds and treasuries) into liquid assets (cash), that can then be used to grease more commerce and transactions. I don't believe this can cause hyper-inflation that many fear (and thus turn to buy gold/commodities), because the money is backed by debt, which has to still be paid pack.
BUT I think the first part is actually a pretty good approachable explanation of the Federal Reserve and how our money works.
The paper is short and concise enough and the diagrams are very helpful to the uninitiated.
Money Creation in the Modern Economy: https://www.bankofengland.co.uk/-/media/boe/files/quarterly-...
Would be cool to make it even more accessible. Something that can be shared virally via WhatsApp by my aunt. :D
"I promise to pay the bearer on demand the sum of <value> pounds"
Signed by the Chief Cashier of the BoE
The current legal basis is the Banknotes (Scotland) Act 1845: https://www.scotbanks.org.uk/history/banknote-history.html
https://danskebank.co.uk/about-us/bank-notes/ten-pound-note
By the way, you can issue money too. Let's say you buy a computer for $1.000 and promise the seller that you are going to pay him $1.050 by next year. You just issued $1.050 of M2.
Counter-intuitively, this money supply system is helping developed countries control inflation. In some developing countries, inflation is harder to control because people are issuing money on their own.
Werner’s second claim is patently false, because the ”evidence” he presents in his paper only describes banks’ ability to create money out of thin air — he presents no evidence for non-bank entities’ inability to create money out of thin air. Thus, he presents no evidence that banks possess an ability non-banks do not possess. And yet, he claims to have done the opposite."
This is awful semantic gaming to "prove" that a false claim was made. If the definition of "money" is fuzzy and there are different kinds of money, if "bank IOUs" and "private IOUs" are materially and legally different from one another, then the strongest interpretation of Werner's words must be taken: He is talking about the sets of money that do not include IOUs from random private entities.
Clearly, banks are special in this regard and the amount of bank-created money on the money supply is enormous, whereas the impact of private IOUs is so minor that we can disregard it.
If we remove the distinction between private IOUs and bank IOUs, indeed you would have an example of a private entity creating money out of thin air, for a more loose definition of money. However, as we established, removing this distinction is unwarranted, bank IOUs are treated quite differently both legally and materially.
If we maintain the distinction between private IOUs and bank IOUs, then your example becomes simply irrelevant. Any IOUs that may be issued by private entities that are materially and legally different from bank IOUs have no bearing on Werner's claims.
I believe the empirical evidence for private non-bank entities not being able to create bank IOUs is that they're not banks. Am I missing something?
That's not what "empirical evidence" means. Empirical evidence is something we observe in the world. If we set a definition "all murder is illegal" and then we conclude "legal murders do not exist", do we have "empirical evidence" that legal murders can not exist? Of course not. We can conclude the claim is true by definition. That's not empirical evidence.
> You ask for empirical evidence ...
I never asked for empirical evidence for non-banks' inability to create money out of thin air. Werner claimed to have empirical evidence for this, and I merely pointed out that he does not have empirical evidence for this, contrary to his claim. If Werner had instead said "due to accounting conventions, we declare banks' IOUs to be money and non banks' IOUs to not be money", I wouldn't have any problem with that.
Hmm, you're right...
> We can conclude the claim is true by definition.
...which means we don't even need any empirical evidence to say that banks are different and unique from non-bank entities!
> I never asked for empirical evidence for non-banks' inability to create money out of thin air. Werner claimed to have empirical evidence for this.
No, he doesn't. He claims that he has empirical evidence for banks creating money out of thin air, nothing more.
> If Werner had instead said "due to accounting conventions, we declare banks' IOUs to be money and non banks' IOUs to not be money", I wouldn't have any problem with that.
Doesn't that go without saying, considering that non-bank IOUs, such as poker website deposits, aren't considered part of the money supply under pretty much any definition?
That's correct, and I said so in the article. I said that (although there is no empirical evidence) the underlying claim is true on a technicality.
>> Werner claimed to have empirical evidence for this.
> No, he doesn't. He claims that he has empirical evidence for banks creating money out of thin air, nothing more.
Here is a direct quote from Werner's paper: "We now know, based on empirical evidence, why banks are different, indeed unique … and different from both non-bank financial institutions and corporations: it is because they can individually create money out of nothing."
When Werner claims to have empirical evidence that banks possess a unique ability to create money out of nothing, he is technically making 4 claims:
1. Banks possess said ability
2. Non-banks do not possess said ability
3. Empirical evidence shown for claim 1
4. Empirical evidence shown for claim 2
Claim 4 ("empirical evidence shown for claim 2") is patently false.
This is a more reasonable reading:
Banks are different because they create money out of thin air. That has been generally accepted so far, but where is the empirical evidence for banks creating money out of thin air? It's in the paper. That's the contribution of the paper, to show empirically how new money is created.
We don't need evidence (empirical or otherwise) for non-banks not creating money, because that would be proving a negative.
If you want to attack the strong interpretation of the claim, you would have to show how non-banks do create money, which you didn't, because as we already agreed, deposits at non-bank institutions are not considered money.
I implore you to apply the principle of charity (steelmanning) instead of wasting your time on semantic disputes.
> we already agreed, deposits at non-bank institutions are not considered money.
...due to a technicality / accounting conventions. Yes, I conceeded that already in the original revision of the article. Nonetheless, I made a pretty good case why the IOUs created by Full Tilt Poker could be considered money, even though they were created by a non bank institution. Yes, the IOUs created by banks are "more like money", but in my view, the difference is not that large.
Wow. This is a flat out lie. Banks operate on a fractional reserve system and they are allowed to loan out more money than they have. It's not just about swapping an IOU between a depositor and a borrower. With the recent COVID-19 regulations, banks don't need any reserves at all anymore. The Fed had been constantly lowering the reserve requirement over the years, effectively causing an infinite but controlled supply of money to enter the economy with financial firms being the biggest beneficiaries.
Uhh, yes it can. That's what LIBOR is (supposed) to represent - short term unsecured lending between major banks. I.e. they can agree that the sending bank is now slightly more indebted to the receiving bank. It depends on what the involved banks agree on.
And because such things are based on trust they do blow up sometimes. For example during the panic in March there was a pretty wide gap between FRA rates (unsecured lending) and OIS rates (secured lending). FRA was quite a bit higher.
Edit: let me just add that this does not invalidate the rest of the article.
The various types of money usually have interest rates associated with them, and those rates tell you about the relationships between the types of money. For example there is an interest rate differential between the central bank money and the US treasuries (which are equivalent to USD money for most people most of the time), captured by the repo rate minus IOER. This differential blew up quite recently (in 2019), showing a temporary divergence between tbills and "real money".
In the past, before central banks, each region of the US had their own money, and merchants had conversion tables. They would literally tell you that, for example, Boston money is worth for me only 80 cents on the dollar. Much like today we quote prices on bonds.
Robert Shiller has some really good finance lectures on YouTube. The one about central banking:
https://m.youtube.com/watch?v=_SpIaGTq0u8
I'm sure I could issue a OMGPWNIOU, but difference is, that no one will accept it as payment.
In this case they were like a _Ponzi Scheme_ and not like a fractional reserve bank as they had _no assets_ to redeem the claims of their depositors with.
Pokerstars (from what you've described) was operating in a manner similar to a fractional reserve bank.
If you want to characterize Full Tilt Poker's operation as a ponzi scheme, I have no problem with that. Full Tilt Poker was operating as a fractional reserve bank, and in addition to this it was siphoning assets of the bank to its owners.
It explains how banks work today in a patient and and accessible way that helps you really "get" it.