Banks create money, but it's less impressive than it sounds

https://www.attejuvonen.fi/money-out-of-thin-air/

by baobabKoodaa • 6 years ago

221 222 6 years ago

hinkley3• 6 years ago

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.

AmericanChopper5• 6 years ago

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.

wisty• 6 years ago

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.

pdonis• 6 years ago

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.

whyhow2• 6 years ago

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?

vmception4• 6 years ago

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.

838hhh• 6 years ago

Do you have a blog?

sethjgore• 6 years ago

Would love to know more about your unpopular opinions. Too many people think the same way about money.

vmception4• 6 years ago

Some of my currently unpopular opinions:

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 shaken, so the credit markets remain resilient. Countries outside of the economic union who have freely adopted the currency have much bigger issues to reconcile.

Market signals are missing in the real estate market. A few hundred thousand playing with historically low interest debt (due to central bank activity) is a distraction, real estate agents and mortgage underwriters getting "so much business" should not be trusted, indeed this is all they see. Several million people defaulting is a bigger and looming issue.

zimablue7• 6 years ago

https://xkcd.com/1570/

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.

vmception4• 6 years ago

There is luck, I throw darts at the wall and see what sticks

I also make the darts and choose the walls

marcell• 6 years ago

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.

mgraczyk• 6 years ago

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.

https://www.federalreserve.gov/monetarypolicy/reservereq.htm

jkhdigital5• 6 years ago

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.

zimablue7• 6 years ago

Can you please explain this in further detail or provide a link?

baobabKoodaa27• 6 years ago

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.

eru9• 6 years ago

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.

stormbrew2• 6 years ago

These facts support the main argument of this article: that banks do not have any special powers in relation to money creation.

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.

baobabKoodaa27• 6 years ago

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.

eru9• 6 years ago

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.

stormbrew2• 6 years ago

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.

mehrdadn• 6 years ago

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).

baobabKoodaa27• 6 years ago

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).

thinkloop• 6 years ago

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?

cryptica3• 6 years ago

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.

roenxi2• 6 years ago

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.

I'm thinking of things like https://en.wikipedia.org/wiki/Liberty_dollar_(private_curren... which ended in FBI raids.

zajio1am3• 6 years ago

Deposit insurance is a fundamental difference between bank IOUs and non-bank IOUs.

Yes, but that is relatively recent development. Bank money (and IOU-based money creation) is much older than deposit insurance.

baobabKoodaa27• 6 years ago

I have now updated the article substantially. Deposit insurance is now covered in more depth. Diffs: https://github.com/baobabKoodaa/blog/commit/c2f7fef53d621acc...

jkhdigital5• 6 years ago

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.

jmtulloss• 6 years ago

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.

dragandj• 6 years ago

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.

irln2• 6 years ago

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.

baobabKoodaa27• 6 years ago

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.

anticristi5• 6 years ago

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.

yxhuvud2• 6 years ago

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.

brandmeyer• 6 years ago

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.

alasdair_3• 6 years ago

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.

sunshinerag• 6 years ago

I think it would not be shocking anymore to know that you discovered the operating model of the bank. Business as Usual.

omazurov2• 6 years ago

Suppose you have $100 in cash...

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...

baobabKoodaa27• 6 years ago

A hundred dollar bill has not represented an IOU since giving up the gold standard.

magicsmoke• 6 years ago

It represents not going to jail for failing to pay taxes.

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.

mcv2• 6 years ago

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.

patrickthebold• 6 years ago

IOU for what?

omazurov2• 6 years ago

For your goods, services... The U.S. of A. is a debt hub. Banks are also debt hubs but on a smaller scale and dependent on their sovereign.

rags2riches5• 6 years ago

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.

zajio1am3• 6 years ago

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.

andrewaylett2• 6 years ago

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.

gumby2• 6 years ago

Every time you use your credit card you create money as instead of pulling $20 out of your pocket you still have it to spend.

Of course you sterilize (cancel out) that creation when you pay the credit card bill.

count• 6 years ago

When you use your credit card, the bank fronts your spending out of their cash reserves - no new money is created.

gumby2• 6 years ago

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.

jkhdigital5• 6 years ago

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.

ipython• 6 years ago

I found this video very informative - an effective eli5 about how the economy works with an emphasis on debt: https://m.youtube.com/watch?v=PHe0bXAIuk0

7373737373• 6 years ago

'Richard Dawkins said in an offhand comment in The Selfish Gene that “Money is a formal token of delayed reciprocal altruism.”'

(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).

Zamicol• 6 years ago

Ethereum and Defi products are now creating money as well through lending.

Lock some amount of ETH up, get some amount of stable dollars out, which inflates the total amount of money in the system.

pan69• 6 years ago

This is a video of Richard Werner (an economist the article refers to) in action:

https://www.youtube.com/watch?v=EC0G7pY4wRE

sandGorgon2• 6 years ago

Is this the US way of defining assets & liabilities?

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)

bobthepanda• 6 years ago

TFA says the same. Rather what's considered assets are the book value of the loan and the cash the bank actually has on hand.

sandGorgon2• 6 years ago

Cash at hand is generally also not considered an asset. Because you're paying interest on it.

It's usually raised using deposits. Unless I'm missing something

riffraff• 6 years ago

Welcome to fractional reserve banking!

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

jbverschoor• 6 years ago

Doesn’t really matter, as the requirements were set to 0% recently

kgwgk2• 6 years ago

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?

dwd2• 6 years ago

According to Steve Keen[1] based on research by Kydland & Prescott[2] it's up to a year before the fractional reserve catches up.

[1] https://www.deflation.com/Articles/The-Roving-Cavaliers-of-C...

[2] https://researchdatabase.minneapolisfed.org/concern/parent/b...

csomar2• 6 years ago

It's still fractional reserve banking. zero fraction reserve banking. /s

marcosdumay• 6 years ago

It's called fractional because that X% is smaller than 1.

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.

zimablue7• 6 years ago

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

asgard1024• 6 years ago

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.

chii3• 6 years ago

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.

justinzollars2• 6 years ago

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.

FinanceAnon2• 6 years ago

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.

bproven• 6 years ago

I agree. And the book does off into crazy land about the 1/2 through to the end of the book.

BUT I think the first part is actually a pretty good approachable explanation of the Federal Reserve and how our money works.

justinzollars2• 6 years ago

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.

athrun• 6 years ago

I found this paper from the Bank of England very enlightening when it comes to the actual mechanisms of money creation and their limits.

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-...

anticristi5• 6 years ago

Thanks for sharing!

Would be cool to make it even more accessible. Something that can be shared virally via WhatsApp by my aunt. :D

nly• 6 years ago

Fun fact: Bank of England bank notes, denominated in £ sterling, still have printed on them:

"I promise to pay the bearer on demand the sum of <value> pounds"

Signed by the Chief Cashier of the BoE

jacobush3• 6 years ago

The UK is like that, banks have their own notes, still.

pjc504• 6 years ago

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

The current legal basis is the Banknotes (Scotland) Act 1845: https://www.scotbanks.org.uk/history/banknote-history.html

csomar2• 6 years ago

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]

You can see the M0, M1 and M2 money supplies at Trading Economics: https://tradingeconomics.com/united-states/money-supply-m2

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.

axegon_• 6 years ago

What... An... Awesome... BLOG! We need more of those!!!!!

gridlockd4• 6 years ago

"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.

baobabKoodaa27• 6 years ago

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.

gridlockd4• 6 years ago

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?

cryptica3• 6 years ago

> A bank loan is merely an exchange of 2 IOUs

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.

baobabKoodaa27• 6 years ago

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.

H8crilA2• 6 years ago

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.

baobabKoodaa27• 6 years ago

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...

H8crilA2• 6 years ago

Sure!

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

synnejye• 6 years ago

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.

baobabKoodaa27• 6 years ago

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.

nstj2• 6 years ago

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.

FinanceAnon2• 6 years ago

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?

andrewaylett2• 6 years ago

The customers started with $100 and the bank started with $0. By the end, the customers have between them paid the bank $1 for their services.

habosa• 6 years ago

There is a fantastic book that covers this topic called "The End of Alchemy" by Mervyn King who was Governor of the Bank of England during the 2007 crisis: https://www.goodreads.com/book/show/30231791-the-end-of-alch...

It explains how banks work today in a patient and and accessible way that helps you really "get" it.

dalbasal4• 6 years ago

I think "fundamental" is a treacherous concept for explaining money creation.

Both this article and the stuff Atte is responding to end up with "X is merely Y" explanations. The (arguable, but widely accepted) reality of macroeconomic and monetary dynamics is that it is not merely microeconomics. A layer of emergence separates the two.

It's true that what banks do is not fundamentally different to what full tilt poker did. Even the "bank run" parallels the many bank runs in history, and associated monetary collapse.

You can find other parallels too. My favourite is employees. Say you have no money. You hire 10 people clean pools, with salaries due at the end of the month. They work. You get paid. If you get paid enough, you can pay salaries on time and make profit.

This is the same principle as monetary stimulus, where a government makes loans to stimulate economic activity. We do call that money creation, but it's not fundamentally different to what every employee does.

IRL, a poker site or pool cleaning business will (almost) always hit a point of reversal. Expansion becomes deflationary rather than inflationary. Further growth requires capital, rather than generating it. The business models that don't do reach levels where their money creation starts to have macro-scale effects. These tend to join the financial sector (eg, the stock market), where they are regulated in some fashion to curb monetary inflations and deflations.

What makes banks qualitatively different is stability. They can do this long term, continuously increasing scale, without bank runs. Quantity is a quality of its own. If banks expand mortgage lending, real estate will inflate... either with higher prices or with more building. This isn't money that was redirected from one sector to another. It's new money.

This is why monetary policy isn't just central banking. It's regulators. The regulator controls this sort of activity (eg mortgage lending) in order to regulate the supply of money.

italicbold• 6 years ago

The modern banking system does not use fractional reserve lending.

Highly recommend this video to understand and this channel in general: https://youtu.be/K3lP3BhvnSo

Skip to 1:14.

UmbraeImperator• 6 years ago

Would the same principle work for non national currency ? I am thinking specifically of Bitcoin.

Say a bank would accept deposit and issue loan in Bitcoin. We apply the same example as in the article. Someone deposit 100BTC. Another person takes a loan of 10BTC and owns the bank 11BTC. (that would be much bigger value than $100, but the principle is the same)

Would the total number of Bitcoin be higher than before those transactions ? That would break the hard limit on the total number of Bitcoin. My understanding was that hard limit was a key feature of Bitcoin.

icebraining• 6 years ago

As the article said, deposits are just IOUs. You can definitively have IOUs denominated in BTC.

The number of Bitcoins in the ledger/blockchain would not increase, but if you asked everyone how many Bitcoins they owned and summed it all, it would have increased.

To use the standard terms, the hard limit on the number of BTC in the ledger/blockchain is M1. You can have an increase in M2/M3 without an increase in M1.

II2II• 6 years ago

After starting to read this article, I had several random thoughts:

* What makes this author's explanation credible?

* Does anyone actually understand how money works, or are people trying to rationalize what we already have?

* All that really matters (to me) is the value is relatively stable and it doesn't create a crazy imbalance of power.

* Money does an okay job maintaining a stable value for some stuff (e.g. food), but an incredibly lousy job for other stuff (e.g. land).

That got me to thinking about a game I was recently playing and frustration with it's two in-game currencies, neither of which have anything to do with external transactions (such as obtaining DLC). One of those currencies could fluctuate in value based upon supply and demand (actually, how much you were trying to sell). Now that leaves me wondering if the game developers discovered that it was impossible to balance the game with a single currency (i.e. avoid an imbalance of power through the fluctuating value of currency).

In other words, did art avoid emulating reality because the premise of reality is fundamentally flawed?

dalbasal4• 6 years ago

* Does anyone actually understand how money works, or are people trying to rationalize what we already have?

I would say, no.. considering the divergence of expert opinions. Limited consensus have formed around high profile economists (eg Keynes, Friedman) but generally erodes as history throws up new examples that don't fit neatly into popular theories.

Monetarism is still the working understanding behind most central banking, but japanese staglation and later events (arguably including the current covid economy) have demoted it from "a theory of the truth about money" to "a method of doing central banking."

I do think that since pure fiat currency became the norm in the 70s, our understanding of money has improved. We are forced to conclude that "the truth about money" can only be found in financial systems, because there is nothing else anymore.

It's not really a question academics are trying to answer, atm. One reason is that trying to answer "what is money" is associated with all sorts of ideological quackery with a bad reputation. Another reason is that high prestige economics deals with a more pertinent question: "what should central banks and regulator do."

The economist who answers this question becomes the next JM Keynes or M Friedman. At the least, he becomes a central bank governor. This limits the field of search to stuff a central bank can do. Economic understandings are also generally curbed by what can be measured, and this also limits the field of search.

* All that really matters (to me) is the value is relatively stable and it doesn't create a crazy imbalance of power.
* Money does an okay job maintaining a stable value for some stuff (e.g. food), but an incredibly lousy job for other stuff (e.g. land).

These are not universally agreed to be products of monetary systems. Stability is, under the current theories used by central banks (mostly monetarism) but the others are explicitly "out of theory."

zajio1am3• 6 years ago

I would say, no.. considering the divergence of expert opinions.

I would disagree and think it needs more details. There is difference between just 'how money works' and 'how economy works'. The first question 'how money works' is mostly just insitutional and legal knowledge of existing processes of central and commercial banks.

OTOH, 'how economy works' is empirical field of knowledge about complex emergent phenomenon - the economy, and contains questions like how would economy reacts on specific monetary policies. That is what macroeconomic theories like keyensianism and monetarism are about.

kangnkodos• 6 years ago

I agree that no one really knows. My reasons are a little different. Look at what happens when there is a run on a bank. If the bank is insured, then some other bigger entity says they will pay all the IOU's. Either they actually pay the IOU's off, or the panic stops, or some combination.

But what happens when there is a run on the central bank of a country? If another bigger country (example Germany) bails out a smaller country (example Greece), then the panic stops. If no other country steps in, the currency becomes worthless (example Zimbabwe).

But what happens when there is a run on the largest central bank in the world (United States)? A bank so big that no other country can possibly bail them out, even if they wanted to? What happens when there is a run on the reserve currency of the world?

No one knows. It never happened before.

Also, what set of conditions will cause this run on the reserve currency? People have a lot of educated guesses, but because it has never happened in the past, there is no scientific data available on what does and what doesn't cause it.

No one knows.

danybittel• 6 years ago

But the bank hasn't made any money?! It just wants back "more" than it "gave". Am I missing something? The one who is forced to "create" the money is the one who has to pay back the 1$ extra in interests (which previously did not exist). But he is not allowed to create any! So he has to create anything of value and sell that for money, so he can pay back the money and the interest. But that just moves it to the next poor fellow.

Doesn't this create a feedback loop?

stanleydrew• 6 years ago

Yes, I think. The feedback loop is the economy.

baobabKoodaa27• 6 years ago

But the bank hasn't made any money?! It just wants back "more" than it "gave". Am I missing something?

Let's take the example where the bank loans out $10 and wants back $11. The money created in this example is not $1 (when the loan is eventually paid back and the bank makes $1 profit), it's $10 (when the loan is initially given out).

Let's imagine that the bank does not want to make a profit and only wants back $10. Even in this example the bank is creating $10. If you sum up how much money everybody has, people have $10 more money the moment the loan is given out.

x87678r4• 6 years ago

It wants the extra dollar, just like any other company in the economy, its working to earn it.

It also doesn't always get the dollar, or even the principle. Lots of people borrow the $10 and only repay $5.

axilmar2• 6 years ago

Yes, it's a feedback loop.

If the value created from the loan covers the interest, then the whole thing is a net positive for the economy,

otherwise it's a net negative.

yxhuvud2• 6 years ago

It is also a feedback loop where many of the steps are used to invest in the economy and create more value. So as long as the investments pay off it is a virtuous feedback loop.

aronpye3• 6 years ago

The article doesn’t adequately cover the role of central banks in fractional reserve banking.

Back in the days of the gold standard you used to be able to redeem a set weight of physical gold from the central bank for a dollar / pound of paper cash or minted coin. This conversion ratio was set by the central bank and acted as a final brake on inflation. When the gold standard was abolished and the dollar and pound became free floating fiat currency, it only became worth something because the government says it is. The “I promise to pay the bearer x pounds/ dollars” is just a hangover from the gold standard days when you could redeem money for gold directly from the central bank rather than through a private gold dealer. Now you can only redeem an equivalent amount of fiat currency at the central bank if day your dollar / pound note becomes damaged.

Banks can create deposits / reserves at the central bank out of nothing, they just have to promise to pay the central bank back at a later date, plus an equivalent amount of interest equal to the central bank set interest rate. This is how the central bank regulates the interest rate in the economy. If a bank charges another bank a higher level of interest for lending than the central bank, that bank can just go to the central bank instead and get charged the lower central bank interest rate. This acts as a brake on maximum inter-bank interest rates and ultimately what interest rates are charged by end consumers. The same is true for cash deposits, the central bank acts a floor / minimum interest rate for deposits as the central bank will pay interest at the central bank interest rate for deposits held at the central bank.

TheBobinator• 6 years ago

Loaning money drives inflation; when a loan check is created, it spends just like cash, except the banks, behind the scene's, trade the loan checks so everyone has enough cash on hand to appear solvent.

Inflation drives interest rates; interest consists of the rate of inflation plus risk and margin, no bank is going to make a loan at less the rate of inflation. This self-regultes the rate of loans; the first people to take out loans gets them cheaper than late comers and have more favorable pricing.

Business loans drive companies to leverage capital by taking out loans using their business as collaterol in order to capture market share (and rarely, creating new markets or shrinking existing ones through technological change). If they do not do this, they will be driven out of business.

Net on net, because the markets are not expanding at pace with interest, prices rise. I like to think of this as the accumulation of cumulative interest; effectively when every business in a supply chain has to pass its labor and material through a bank loan, the end product becomes much more expensive than production cost.

Cumulative interest acts as a tax on the velocity of capital, and when that stagnates, business revenues drop and companies\people begin to play a game of musical chairs of solvency.

What this is supposed to do, in theory, is kill off rotten businesses and ownership, and provide a capital market to ensure the economy can continue expanding and when you have commonwealth companies; companies that pay majority profits to employee's and put employee welfare and interests first; this works because employee's invest in the company during downturns to reap profits in upturns.

In practice, in every downturn, wages stagnate because businesses shed labor and do not have to compete for labor during the upturn. Governments are motivated to assure labor shortages are solved because paying staff more because they demand it never improves profitability of a business and is always a serious detriment. Because wages stagnate and do not recover, the profits from upturns are captured by ownership and investorship.

This cycle, historically, is not new, and tends to repeat until the people become so impoverished they lose their concept of self repect and dignity and actually think burning things and killing people are effective means to solving their problems which tends to break down systems of government and force governemnts to devolve to basal forms such as tyrranies, dictatorships or autocracies out of necessity.

E.G. Many western countries have negative fertility rates despite being the most technologically advanced societies in recorded history, and the way governments are assuring labor shortages do not occur is through replacement-level immigration which further radicalizes politics (it provides people making arguments about genocide with a lot of convincing empricial evidence in favor of their argument).

jacobush3• 6 years ago

What empirical evidence is supposed to sway me in favour of genocide?

golergka3• 6 years ago

it only became worth something because the government says it is

That's the only nitpick I have against your otherwise excellent comment: it's not that government says it is, it's the societal consensus that it's worth it.

Of course, government is usually a pretty big entity it the country's economy, and since it uses the currency for all of it's transactions, currency acquires some value at least from these transactions alone; however, if the society as a whole loses trust in the currency, government will not be able to define it's worth. And when it tries, it just leads to black market, barter-based economy and even deeper economical collapse.

guerrilla• 6 years ago

it's not that government says it is, it's the societal consensus that it's worth it.

Disagree. The government only accepts their preferred currency for payment of taxes. This is, in my opinion, its initial source of value. Secondly, they may literally stop you from using an alternative currency if they can't figure out how to tax it.

aronpye3• 6 years ago

That’s where the term legal tender comes from. Society is legally mandated to accept whatever is determined by the government as legal tender for the settlement of debts. However, this does not include everyday transactions, only the settlement of debt. A trader can accept or deny any currency or form of barter as long as it is not for the settlement of debt.

This is why the Scots are wrong to get in a fuss about shops not accepting Scottish bank notes, as shops are not legally obligated to accept them as legal tender does not apply in this case. Also, Scottish bank notes are not actually legal tender anyway.

baobabKoodaa27• 6 years ago

Excellent comments. I have now made substantial changes to the article. If you would like to review the diffs, they are here: https://github.com/baobabKoodaa/blog/commit/c2f7fef53d621acc...

jariel• 6 years ago

"something because the government says it is."

This is misleading. Gold was replaced by other assets, notably 'T-Bills'.

Basically, USD are backed by Government debt, instead of Gold.

To imply the Fed just 'says it is' is misleading.

Since 2008 a lot of the assets on Fed balance sheets are mortgages = notably, underwater mortgages bought by the Fed at face value from banks that were going bankrupt.

But I think the point about Gold->Other Assets is important.

Euros are backed by assets as well.

RMB is the major currency based on the magic will of one man, Xi, who can effectively control currency with the press of a button. We think that is 'bad' because money should be separate from governance, but they look at it differently apparently.

So imagine if Johnson, Macron, Trudeau, Trump etc. could literally decide how much money to 'print', to which banks it goes, and to whom the loans would be made, and under what terms.

This is they key limitation on RMB becoming a truly 'global currency'.

The article is a very worthwhile read though, so as to dispel a lot of conspiracy theories about banking.

Funny enough, there is a lot of shady activity in banking, but it takes a good understanding I think to make sense of it.

raducu• 6 years ago

Two things:

1) Politicians around the world are circumventing central banks with special laws, guaranteed loans programs.

2) Central banks can just "temporarily" buy treasury bills with fictional money -- the only thing keeping us from Weimar inflation is the fact the money hasn't trickled down enough, the population is on the decline, and most of the money goes into propping up asset prices.

thescriptkiddie• 6 years ago

Gold itself only became worth something because the government says it is. Or rather, it became worth far more once governments started demanding that taxes be paid in gold. Before that it probably wasn't worth all that much, because despite its rarity it wasn't useful for much in the ancient world. Gold isn't some magic substance with intrinsic value.

See Debt: The First 5,000 Years by David Graeber.

kakwa_• 6 years ago

Also, a key idea of Graeber's book is that money is in fact debt (the example with English soldiers checks being used as bills in Hong Kong bars is quite striking in my opinion).

Money is basically a small abstraction over explicit debt bonds linked to material goods, making it more easily exchangeable.

This comes from the fact most economic chains are far from synchronous (example: a farmer needing tools to prepare his field, but being able to pay for said tools only after the harvest, the blacksmith needing coal and iron ore to produce said tools, but not being able to pay until the farmer has paid him, etc).

In this context, the banker (or any other lender) acts as an intermediary, evaluating if the debt can be repaid and bearing the risk instead of the creditor for a fee.

vagab0nd• 6 years ago

Question: Why isn't a one dollar bank note worth more than one dollar in my bank account, since the bank note can be used to pay back the central bank?

rags2riches5• 6 years ago

Because the dollar in your bank account is an obligation of the bank to pay you a one dollar bank note or another bank a central bank electronic reserve dollar.

x87678r4• 6 years ago

These descriptions are way too complicated.

If I have a check account with $0 balance and you have the same we have no money. If I write a check for $100 and you deposit it suddenly you have money - created from thin air.

axilmar2• 6 years ago

In my humble opinion, the article is too complex and the topic at hand could be explained in an easier way:

-banks can create money when they issue a loan, because, if all things go well, the created money will create wealth.

-banks cannot create money when they return money to depositors, if they don't have that money, because if they did the created money would not correspond to created wealth.

I.e. fractional reserve banking exists because what can be created with money, i.e. the actual wealth, can come after money is created, and not before: first money is created out of thin air, then that is used to pay people, which create wealth. The old system with the gold standard was limited because it depended on the amount of gold that existed.

adwn• 6 years ago

No. Money creation through fractional banking is neither directly related to, nor dependent on, wealth creation.

known3• 6 years ago

US dollar is the national currency of Ecuador https://en.wikipedia.org/wiki/Currency_of_Ecuador

OPEC sells Oil exclusively in US dollars https://en.wikipedia.org/wiki/Petrocurrency

globular-toast• 6 years ago

There's an organisation in the UK called Positive Money which has a lot of great information about this. See, for example: https://www.youtube.com/watch?v=Rd9Pf3Bqp20 They also have a series explaining how banking works: https://www.youtube.com/playlist?list=PLyl80QTKi0gPBcb32paMv... This is one of those things where learning it completely changed the way I saw the world.

jonplackett4• 6 years ago

I’d recommend ‘Money As Debt’ if you’re interested in this subject. It’s done as a cartoon but makes it really easy to understand why the world works like this and what the big problems are with it.

Namely that if money is created only when you lend it to people, but they have to pay back what you created + interest, there is never enough money to pay all debts back. So bankruptcy is built into the system. It’s like musical chairs. It has to happen.

zoul• 6 years ago

Does it? Can’t we just expand the amount of money available forever?

jonplackett4• 6 years ago

Well, the credit crunch would suggest not.

But, probably more importantly, that relies on an ever increasing economy, which relies on ever increasing use of natural resources, which = earth is screwed.

rags2riches5• 6 years ago

Paying back all debt would mean there was no more money! What would that even look like?

It was years since I saw 'Money as Debt' but I remember it as quite flawed in its arguments.

Let's say there's a silly town with a single evil bank. The good people borrow a hundred dollars in total. Horror! The evil bank is now owed one hundred and ten dollars. This can never be repayed, there is not enough money!

Except the good janitor at the bank has his wage of ten dollars credited to his account by the bank for the value created by his labour. He pays the grocer, the landlord and so on and now the silly town people can pay all their loans, should they ever want to.

And then the old grocer dies and his estate defaults on its debts. And it turns out the bank overvalued his house. The banks is now down ten dollars on its loan assets. But the bank still has its liabilities to the other good town people the grocer paid when he took out the loan. Suddenly the town can pay back all their debts and still have ten dollars left owed to them by the bank! The evil bankers are foiled.

'Money as Debt' goes to all this trouble to explain that money is debt. Then we are supposed to be shocked by the fact that debt can be created by no more than signing a paper! It's stupid.

jonplackett4• 6 years ago

Well I, like many people. was very surprised money is created that way. And your fictional town doesn’t seem to work much like anywhere else. All the banks seem to be doing fine just fine. Houses usually go up in value not down so when someone defaults on a loan the bank makes money rather than loses it. With the exception of the credit crunch (where we all just gave the banks our hard earned money instead)

daneel_w• 6 years ago

"There are two ways to conquer and enslave a nation. One is by the sword. The other is by debt."

Debt created by a bank through a loan can never truly be repaid. The debt is just passed on to another place in society, and the society as a whole remains forever indebted to the bank. Sinister in its very essence and a form of true evil.

nstj2• 6 years ago

In general this is a half decent way of explaining how fractional reserve banking is presented in econ 101 text books. This is very different to how commercial banks operate in the real world. Reading the piece however is a reasonable exercise for people to understand how a bank may not retain the same amount of liquidity as their deposits may demand.

x87678r4• 6 years ago

If you have an argument why these IOUs should not be considered money, I would love to hear it. Otherwise, let’s conclude that non-bank corporations can sometimes create money out of thin air.

It comes down to the definition of money. Yes non-financial intermediaries are very similar to banks and "create money" but money is defined as the amounts on bank's balance sheets so by definition non-financial intermediaries cannot create "money", but they are doing something very similar.

Also Nonintermediated debt is probably a better example. If you own a CD from a AAA corporate its effectively money but technically isn't.

anticristi5• 6 years ago

For my own clarification, are financial instruments "money"? I think common people, like me, have a hard time to distinguish money from cash and cash-equivalents.

A bond from an AAA corporate might not be money, but it's so liquid that it's as good as cash to me. :D

x87678r4• 6 years ago

No one can agree exactly what money is so that's why you see a bunch of arguments like this. A stock market billionaire who has a small mortgage on one of their properties has no money - he owes money.

You can see different countries have different definitions. https://en.wikipedia.org/wiki/Money_supply#Definitions_of_%2...

SpicyLemonZest• 6 years ago

They're not. There are actually multiple different definitions of "money" in use, because it's complicated to define exactly what distinguishes money from a financial instrument, but corporate bonds aren't included in any definition I'm aware of.

known3• 6 years ago

As of August 5, 2020, there was $1.95 trillion worth of Federal Reserve notes in circulation https://www.federalreserve.gov/faqs/currency_12773.htm

known3• 6 years ago

The devil is in details https://en.wikipedia.org/wiki/Money_supply

scottmsul• 6 years ago

This article misrepresents just how much of the economy it's made up of these IOUs. If you deposit $100 and there's a 10% reserve requirement, that doesn't mean the bank can loan out $90. Rather, they can loan out $1000 since the $100 is 10% of that.

baobabKoodaa27• 6 years ago

The article did not make any claims about how much the money supply can expand within a specific regulatory environment (such as the 10% reserve requirement you mentioned). I felt like that was outside the scope and would not be possible to present with a simple example.

PeterStuer• 6 years ago

Alice is a customer of ABank Bob is a customer of BBank.

Alice asks ABank for a $100 loan at 10% interest to buy some fidgets from Bob Bob asks BBank a $100 at 10% interest to buy some doodads from Alice

ABank creates a $100 credit line for Alice, and creates an asset of $110 future revenue payments. BBank creates a $100 credit line for Bob, and creates an asset of $110 future revenue payments.

Bob and Alice make their deals each paying with their respective debit cards.

ABank and BBank settle their transactions with a net 0 transfer.

Alice and Bob both repay $100 to their outstanding loan.

Both ABank and BBank now own $10 in future revenue from Alice and Bob respectively. You can argue that 'technically' ABank and BBank didn't 'create' the money, they merely created the legally backed first row claim to that money that will be created.

zimablue7• 6 years ago

There's another paper by Richard W that I happened to read yesterday which seems to contradict this article and is not refuted or addressed in it, basically that a combination of accouting practices and "client money rules" distinguish bank loans from "random IOUs", basically anyone can issue an IOU but anyone other than a bank has to draw down their accounting assets when they disburse it, and undisbursed IOUs are not spendable.

https://www.sciencedirect.com/science/article/pii/S105752191...

amgreg• 6 years ago

I think what the author would take issue with is this notion of “has to.” His point is that non-bank corporations can empirically create money (ie people will treat the IOUs as money), even if they may not be legally permitted to do so.

zimablue7• 6 years ago

I think it's splitting a very meaningless hair in a way that's totally misleading to say that "anyone can create money", when you mean "anyone can theoretically create money, they'll just land in jail fairly quickly"

It's like saying that nation-states don't have a monopoly of force, because I can shoot my neighbour, or that I support abortion but I think you should be jailed afterwards.

Only banks can create money without getting locked up in jail.

That's the important point, and this article adds or takes nothing, other than a very weird dodge with the justification that somehow legality isn't a primary consideration.

It's as interesting as saying you don't have to pay your taxes, (small print: because you can choose to go to jail instead).

MrXOR• 6 years ago

Excellent article.

Yesterday, I read about the role of banks, I found two quotes:

“Banking was conceived in iniquity and was born in sin. The Bankers own the earth. Take it away from them, but leave them the power to create deposits, and with the flick of the pen they will create enough deposits to buy it back again. However, take it away from them, and all the great fortunes like mine will disappear and they ought to disappear, for this would be a happier and better world to live in. But, if you wish to remain the slaves of Bankers and pay the cost of your own slavery, let them continue to create deposits.” [1]

“Give me control of a nation's money and I care not who makes the laws.” [2]

[1] http://libertytree.ca/quotes/Josiah.Stamp.Quote.69BB [2] http://libertytree.ca/quotes/Mayer.Amschel.Rothschild.Quote....

Banks create money, but it's less impressive than it sounds

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