Beyond “Money as debt”7-The need for bubbles

February 15, 2009

Part 7


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.

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.

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.

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

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

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.

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.

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.
The process i then said to continue, forming a geometrical series, creating about ten times the initial deposit.

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.

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

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.