Beyond “Money as debt”2

January 31, 2009

Here’s the second part.As before:

I would like to have feedback and proposals on how to improve it The voice in the video is made by a “text to speech” engine and should be replaced by a more pleasant voice (is there anyone that wants to do it voluntarily? When the text is finally edited?)

Most of this is based on a blogg written by “Sunda pengar” and in particular his excellent blogg dealing with Basel 2:

Here’s the “text to speech” text and I should very much appreciate corrections in grammar and other issues concerning the language – since English is not my native language. Feel free to come with pedagogical remarks as well – where I’ve been to vague and so on. This is meant as an outline so I’m opened for suggestions.

Please refer to the number you think should be altered. It will be an easy thing to correct and replace it in the “text to speech” engine and put it back into the video.

1)

Another misconception is that banks transfer money directly between themselves. It’s commonly believed and perhaps according to the publics intuition that one bank send over the money directly to another bank in transactions between the banks. But the only time this occur is when a customer of his or her bank take physical cash out from his or hers deposit and walks over to the other bank and hand it over to another bank. But even then central banks money also known as bank reserves , in the form of cash, is used.

In all other instances the process is as follows:

2)

Lets say that a customers transfer 1000 dollar from one bank to the other through Internet. The 1000 dollar is then taken from the banks reserves and transfered to the other banks reserves through the central banks clearing system. The bank sending the money will decrease their reserves by 1000 dollar and the receiving bank increase their reserves with 1000 dollar. Note that nothing is changed in the banks balance sheets.

3)

But the first banks reserves have now shrank below the reserve requirement for the bank so it will have yo lend some central bank money back from, for instance, the bank that received the 1000 dollar, since this bank now have a surplus of central bank money. The second bank can then lend back the money to the first bank at an interest, the so called LIBOR rate, and restore the first banks reserves. So banks coordinate their transactions between them selfs through their reserves via the central banks clearing function. The process is called interbank lending.

Again: note that the balance sheets of neither banks are touched.

4)

But what if the second bank don’t want or can’t lend back the money to the first bank?

5) The central bank can then step in an lend money to the bank with a deficit in their bank reserves. This is done by something call repurchase agreement, also known as repo. This repo also has an interest an is an instrument for the central bank to control the banks reserves and hence the banks interest and credit expansion.

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Beyond “Money as debt”1

January 30, 2009

I made this video as a starting point in explaining the how banks creates money (or more accurately credit) and correct some misconceptions in the video “Money as debt”. I would like to have feedback and proposals on how to improve it The voice in the video is made by a “text to speech” engine and should be replaced by a more pleasant voice (is there anyone that wants to do it voluntarily? When the text is finally edited?)

Most of this is based on a blogg written by “Sunda pengar” and in particular his excellent blogg dealing with Basel 2:

Here’s the “text to speech” text and I should very much appreciate corrections in grammar and other issues concerning the language – since English is not my native language. Feel free to come with pedagogical remarks as well – where I’ve been to vague and so on. This is meant as an outline so I’m opened for suggestions.

Please refer to the number you think should be altered. It will be an easy thing to correct and replace it in the “text to speech” engine and put it back into the video.

1)
This an attempt to describe a banks balance sheet and the underlying reserves.

On the assets side are loans taken out by people, companies, municipal and states. On the liability side are deposits made by costumers. Deposits are seem as liabilities since the bank owes this money to the customers.

The bank also have reserves at the central bank. Cash in the banks vault are also included in the banks reserves at the central bank. Even though they physically at the bank, the cash is seen as central bank money.

2)
From Wikipedia,
Bank reserves are banks’ holdings of deposits in accounts with their central bank (for instance the European Central Bank or the Federal Reserve, in the latter case called federal funds), plus currency that is physically held in bank vaults (vault cash). The central bank sets minimum reserve requirements.

4)
The most common misconception is that banks make loans out of their customers deposits.
The story goes something like this;

5)
Lets say Peter takes a 1000 dollar loan from the bank. This will increase the assets on the banks balance sheet with 1000 dollar.

6)
He then buy a computer from Paul. Paul will get the money and put it on his deposit at the bank.. The banks liabilities will the increase with 1000 dollar.

7)
The 100 dollar are split and 1/10, that will say 100 dollar, will go to the banks reserve. And the bank will lend out 9/10 to, say John.

8)
John then buy a bicycle from William . William will get the money and put it on his deposit at the bank.. The banks liabilities will the increase with 900 dollar.
8a)
The process i then said to continue, forming a geometrical series, creating about ten times the initial deposit.

9a)
But that is not the way new credit are created.
This gives the impression that the bank makes new loans out of customers deposits. It’s probably close to the intuitive feeling people generally hold that banks lend existing money that customers put on their deposits. So this view is probably close to the way banks want you to percieve the process.

9b)
But the way banks create money, or more accurately credit, from thin air is far more simple.

9)
The bank expand their asset side simultaneously as they expand the liability side and it’s all based on how large their bank reserves are. We will go into more details about this later but the important thing to know is that the credit expansion always occur simultaneously at both side of the balance sheet and are always equal.
A loan is never based on a depositors money, the credit is instead created when you request it.
This means that when you take a loan for your house, you receive a new credit that instantly is balanced by corresponding amounts of new savings.
This means that all savings = loans.
The notion that savings are low is completely impossible. Savings are always the same size as loans within the laws of accounting. The distribution is however not evenly spread out.
A bank note is a proof of debt, not money in the traditional term.
A deposit you have on your bank is not an asset, it is a claim on your bank. The bank never in short term has possibility of paying more than a fraction of its depositors back. This is why bank runs are so feared.
The only way for a depositor to receive full payment on your claim on the bank is to withdraw physical cash.
The fact that money is created when it is borrowed also means that it disappears when it is repayed. This explains the fluctuations in money supply and why the money supply always seems to decrease in a credit crunch and increase in expansionary economy.