< link rel="DCTERMS.isreplacedby" href="http://sirhumphreys.com" > Sir Humphrey's: Money from thin air


SITE MOVED:Sir Humphrey's has moved

Please join us at our new site: www.sirhumphreys.com.

The RSS feed for sirhumphreys.com is now here.

Friday, April 15, 2005

Money from thin air

In examining the advantages and disadvantages of smaller government, less tax and more personal freedom I've had to first step back and take stock of how the monetary system works. And it is becoming patently clear that it doesn't.

The world is capable of producing enough food for all of us, and it can produce more goods than we can possibly buy. To keep the delicate balance of solvency, companies are forced to act agressivley to stay in business, and in a time of plenty, EVERY country in the world owes more than it can possibly repay.

Think about it for a moment. Where does money come from? The answer is scary.

The financial system is founded on money made from thin air. The institutions with the power to create money are not governments, but banks. It seems that very few people have stopped to wonder why banks, and not the state, should have this power.

Lets see how this works. Say you want to buy a house. The house costs $300,000. You go to the bank and they offer to buy the house for you, providing you pay them $1500 per month for a very long time. They technically own the house (or the lions share of the house) until you can pay them for it.

They then create the money out of thin air, and give it to you. That's right. They created the money out of thin air. They are not required to have the same proportion of cash on hand as money they loan out. Once they create the loan, it goes in their books as an asset. They essentially get to own your house by creating money from nothing. What a great deal. You can't do that. The government can't do that. But a bank can.

This concept has been summed up in great depth in Michael Rowbotham's book "The Grip of Death." Forget every-thing you thought you knew about the money system. If you read this book, you will understand why the system doesn't work.

You can also visit the Prosperity UK site for some summary stories.

This book creates extreme responses in many readers. They seem to be 100% for, or 100% against. Reviewing the critics of his theories, I can't find many that want to go into any detail. The closest I got was some-one saying that banks can only loan what they have. However, that is not the case:

A review by Joseph Glynn sums this point up:
Traditionally, the amount of money banks could create and lend into circulation was controlled by governments setting liquidity and reserve/asset ratios for the institutions to meet. By the 1980s, however, the liquidity ratio had become functionally meaningless because, as Rowbotham explains, the banking system had found ways around it by investing in short-term government securities.

The reserve/asset ratio governed the amount of their own money banks were required to set aside as a standby in case large numbers of depositors wanted to withdrawal their money simultaneously. A reserve/asset ratio of 10% meant that if a bank made a loan of £10,000,000 it must have £1,000,000 of its own capital in cash or on deposit in the central bank to back it. This ratio has since been replaced by the capital adequacy ratio, which also links a bank's lending to the amount of its own capital it has. It is set at 8% by international agreement. However, instead of being an effective restriction on banking and money creation, Rowbotham shows in practice it helps perpetuate the problem of escalating debt and forced growth.
UPDATE: Here is a very good summary of the concept, from a link provided from a comment by Reid (Thanks).

Posted by ZenTiger | 4/15/2005 07:37:00 pm


Anonymous Anonymous said...

Y'know Zentiger when I say stuff like this I get shot down by people who DON'T UNDERSTAND, for being a conspiracy nut. Frankly, I can't believe how NAIVE even intelligent people are and how quaint is their trust in things like the media, which of course would let them know that if things like this go on, they'd let them know, wouldn't they. Duh. Glad you've finally started addressing the truth. And on another note, I LOVE your blog's bias-o-meter. Get those lefty scum. Yay.

Your readers may find some interest in this article, there are hundreds on this monetary topic. BTW, the geopolitics is where the real action is happening, this money stuff is just background noise.

However, for any serious readers, I have 1,000's of pages which I'm happy to refer them to.

I also recommend a book called the Creature from Jeckell Island which backgrounds the foundations of the US Federal Reserve System, and would you like to know where the Bank of England came from too? Anyway this article on monetary systems is very readable and necessary to know. People, get out of debt if you can. It's important, especially at this moment in time.


Now you may object that Rowbotham is not a "conspiracy nut", he is simply conversing factually on how the banking and monetary systems really actually in fact work. That's exactly what the articles I've just referred you to do too. I recommend an open mind, because you're going to get surprised.


4/15/2005 09:38:00 pm  
Anonymous Anonymous said...

Interesting, so as there is no special "tricks" required, anyone can do it, anyone perhaps with the confidence to get away with it ? And when banks borrow money, like offer you interest on deposits, that money then just disappears I suppose. Neat trick.

Think about this, I borrow $1,000 from 100 people, then lend $100,000 to a friend to buy a house. He pays me interest, and I pay a little bit less to the people I borrowed off originally. Look, by your lights, I just cretated some money ! I have no cash on hand at all, and yet I just loaned out $100K.

And since banks just create money, they must be making absolutely enormous profits, no ? I mean, A typical bank might have $30 billion out in mortgages, at, say, 5% per year, $1.5 trillion profit, where do they hide the stuff ! Their expenses couldn't even make a dent in that.

Perhaps you have a closer look at the book, OK ?

4/15/2005 10:33:00 pm  
Blogger ZenTiger said...

Thanks for the link Reid. It is a good summary.

Anonymous: Thanks for your comments. However, I don't understand your points:

1. There are obviously "tricks" to it, in that not any-one can get to be a bank.

2. When the banks offer you interest on deposits...yes, say 5% on deposits whilst charging 19% on credit cards, plus a 2-4% fee on the merchant. So what was you point exactly?

3. Your example is talking about loaning out the entire 100,000. The theory articulated is that around 90% is loaned back out, and 10% is kept on hand to satisfy normal cash withdrawals. The rest of the "money" circulating is virtual.

And to look at that example: I get $100,000 cash. I keep $10,000 on hand and loan out $180,000, secured by assets I don't actually have. My interest charges are at 8% on 180,000 whilst I am paying 5% on 100,000.

4. 30 billion profit does not create 1.5 trillion in interest at 5%, it would be $1.5 billion profit. That was Westpac Australia's profit last year I believe, with CBA and National over 2 billion and 4 billion respectively (I vaguely remember). Did I miss the point?

I am interested in any counter articles you may be able to point to (to save you time in typing) because it is a huge topic and I am not an economist. Although, that may actually be an advantage in starting this from a fresh perspective :-)

4/15/2005 10:59:00 pm  
Blogger Antarctic Lemur said...

Banks are required to maintain substantial liquid assets within New Zealand aren't they? E.g. gold bars sitting in the Reserve Bank or whatever they use these days.

4/15/2005 11:05:00 pm  
Blogger ZenTiger said...

Nope. The reserve/asset ratio is 8%. The Gold Standard was dropped years ago.

The amount of cash (printed money) circulating in the economy is around 3% of the total debt in the UK, and similar in the States.

You've hit on the key point that is really the start of this entire debate.

To all of the doubters out there: Banks are NOT required to have the same ratio of deposits as lendings, true or false? I am saying TRUE, they do not have the same ratio. They may have security over the asset (your house) for the money they transferred to another bank account, but that doesn't mean they actually had the same amount of deposits as mortgages.

The fact the bank gets to list your property as an asset against the loan of money it did not have (when compared to total deposits) is key to understanding why it is considered a DEBT BASED economy, and why growth is vital to maintain the economic balance.

Once we agree on this

4/15/2005 11:32:00 pm  
Blogger Antarctic Lemur said...

I realise the gold standard was dropped a long time ago, but aren't banks required to have other financial assets in NZ which are easily converted into cash?

I think you may have missed off part of your comment...

4/15/2005 11:43:00 pm  
Anonymous Mike Readman said...

I think it's true about banks, but is it so bad? The alternative is not to have banks, you'd have to save for a LOOOOOOOOONG time to afford a house (especially at today's prices) and you couldn't make big bucks in property investment, speculation and develeopment (unless you already had piles of money sitting around).

4/16/2005 12:51:00 am  
Anonymous Anonymous said...

Have a look at this site too for some very good info.



4/16/2005 01:16:00 am  
Blogger ZenTiger said...

Mike Readman: I think Banks are good, and the ability to go into debt is a vital element of a capitalist society, and I am for this. Banks have a key role to play in this area, and they certainly wouldn't disappear with any of the solutions I've read about.

What I am questioning is the ability (right?) for Banks to lend money into existence, in that they can lend out more money than deposits.

There may be better mechanisms for the creation of money than by generating it as a debt. This of course leads into in inflationary theories, and becomes an even longer discussion.

As Reid said earlier: "get out of debt if you can" is a very good point. In Australia, they implemented mandatory savings to ensure people had some kind of pension fund. It effectively means another 10% of your disposable income is taken off you and invested for your long term benefit. If you had the ability to put that money in an offset account against your mortgage, the ROI would be far greater.

The problem is many people have been sucked into consumerism (myself included, but I'm woprking hard to resist this now)

Its almost silly to be saving and aerning 5% net, when many are paying 19% on their credit cards.

Every loan is a loan against future earnings, and the interest payments can end up consuming a big chunk of your income. Combine it with high taxes, and the middle class are under a lot of pressure.

But before I say too much :-), I'm off to read a few more links. I sense a discussion of religious proportions is in the wind.

And to borrow from the wise words of TheProphet:

Allah Protect Us.

4/16/2005 10:45:00 am  
Blogger David said...

I'd need to think about this in a structured fashion (meaning cold drinks and a hammock), but I do not think that banks lend out more than they have in deposits. What we're talking about here is that the money they lend eventually comes back, via a different path, as a deposit. So, 100 people deposit $1k with a bank. The bank keeps 8% to cover operations and contingencies, and lends $92k for a house. The borrower/buyer pays that to the seller, who deposits the money back in a bank. The bank then has assets of $8k in original cash, $92k in mortgage, and $92k in new cash. It has liabilities of $100k to original depositors and $92k to new depositor. Assets = liabilities.

But, and I think this is the confusion that leads to the assertion that banks are creating money, they can then lend out the new $92k. They keep $7.5k for operations and contingencies, and lend $84.5k for another house, which is redeposited a short time later. The banks assets are now $8k in original cash, $92k in original mortgage, $7.5k in the second lot of cash, $84.5k in the second mortgage, and $84.5k in the recently deposited house sale money. Liabilities are $100k to original depositors, $92k to the first new depositor, and $84.5k to the second new depositor. Assets still = liabilities (at $276.5k), even tho there is only $100k in cash in the system.

None of which is a problem, provided that the percentage kept as contingencies is enough to cover minor runs on the bank. And that the value of the mortgage assets is realistic, so that the interest charge covers the risk (and the occasional default).

4/16/2005 12:06:00 pm  
Blogger ZenTiger said...

"but I do not think that banks lend out more than they have in deposits"

This is indeed a good starting point. Whilst you are in your hammock I'll see what evidence I can dig up. Well, as soon as I've mown the lawns adn maybe recovered with a few cold ones myself.

4/16/2005 12:33:00 pm  
Blogger ZenTiger said...

Here is an interesting discussion on the two ways money is created. The writer spends his time explaining why the second method is currently under-pinning the massive increase in the US deficit - it is over 7.8 trillion dollars now.

"Money is created in two ways: First, money creation comes from borrowing it and spending it. (Money is literally borrowed and spent into existence.)

Second, it can simply be printed up “out of thin air” by a central bank. The U.S. economy and other modern economies have central banks and fiat currencies. Central banks have two major powers. They can 1) “peg” the nominal level of short-term interest rates, and 2) purchase assets such as government debt, with newly printed money. When the central bank pegs short-term interest rates at a low level, it greatly encourages corporate and individual borrowing and spending.

You can read more by Richard Benson here It is a good read.

What is salient is that Richard does not explicitly mention that the two ways of creating money (borrowing it into existance, or the central bank creating it) both involve creating it as debt. The Central Bank issues Treasury Bonds as a promise to pay, that is a debt, plus an interest rate on the amount. These are then purchased by Banks and Investment houses as being "as good as gold."

I think the article mentions over 1 trillion dollars of US T-Bills have now been purchased by China.

The original point of my post was eventually going to lead to the concept of creating DEBT FREE money, rather than as a debt. What's wrong with the debt system? Well, its going to crash eventually, and spectacularly. The above article explains why. Debt free creation of money is a post for another day.

4/16/2005 01:13:00 pm  
Blogger ZenTiger said...

I orginally set out to discuss how money is "borrowed into existence". Here is an article that goes through the process step by step.

The effect of this is shown on any graphs tracking consumer spending, rising mortgages etc. The rapid growth, in billions of dollars far exceeds the amount of money being minted by the government.

In England, in 1960, the total mortgage debt was 3.3 billion pounds, and the number of mortgaged properties was around 3,355,000.

By 1996, the total mortgage debt was 409 billion pounds, with only a threefold increase in morgaged properties.

The extra 4.6 billion dollars was loaned into existence by the banks. If they hadn't, they never would have received an extra 4 billion on deposits to match it, becuase there was that much money in circulation.

By creating a loan on the books, and then effectively having the money credited back into some-one elses account as an asset, and showing it as an asset over security, the money to buy the house came into existence and started circulating as a payment to the seller.

4/16/2005 02:02:00 pm  
Blogger David said...

I'll check the references later. But...

Increasing the size of the money supply ("printing" money) is OK as long as it increases in line with the size of the economy. In fact it is necessary to increase the money supply with economic growth, otherwise people wouldn't be able to buy stuff. That would be deflationary. Too fast an increase is obviously inflationary.

Sale of government debt has no effect here. T-Bills sold to China are in exchange for US bucks that China has earned by selling things to the US. Government debt is no different to other borrowing in terms of money supply. But may have effects on interest rates, due to the potential size of the borrowing (supply and demand, etc).

4/16/2005 02:05:00 pm  
Blogger ZenTiger said...

"Increasing the size of the money supply is OK as long as it increases in line with the size of the economy."

Yes, I agree it is necessary or you'll get a painful collapse. If you continue increasing it by issuing debt, there will come a point where you get a collapse anyway, because your interest payments will overwhelm you. This applies to the country as it does to an individual.

And who is increasing the money supply in response to "growth"? Not just the government, but banks. We need to establish that this is true or false before looking any further at the consequences.

I'm still convinced Banks are creating the debt, as I haven't found evidence to the contrary yet.

4/16/2005 03:12:00 pm  
Anonymous Anonymous said...

I thought it was common knowledge that the banks had the ability to lend out $100 for every $10 held on deposit. The essence of this being that they only lend to credit worthy people, on relatively low risk ventures, and for most punters out there this only extends to purchasing a house within 3-5 times their early income. Banks won't lend on risky stuff like mutual funds, and only rarely lend on stocks.
The banks cannot simply create the money by themselves, they need entrepeneurs to be able to offer the commodity for the punter to be willing to go into debt for.
I don't see how any of this is a big problem, because without the desire to create new things to better people's lives (of which wealth is the spin-off) people would soon lose their desire to work, achieve more and improve their lot in life- and Keynes would be rightand his argument about progressive taxation is true- and we all know that it is one of the biggeest lies ever perpetrated onto the general public.

4/16/2005 04:27:00 pm  
Blogger ZenTiger said...

Thanks for the comment Pundito. We are making progress! It's looking like we may get past the loan-to-deposit ratio issue.

The next issue is that "The banks cannot simply create the money by themselves, they need entrepreneurs to be able to offer the commodity for the punter to be willing to go into debt for."

The loaning of money by banks is not a problem per se, and I am NOT advocating stopping our capitalist system - I think its good. The point about this is WHY should the banks get the power of creating money out of nothing?

Are there other ways of creating money out of nothing and spending it into the economy, which the banks receive as deposits, and then loan out according to a closer ratio (say 1 to 1 instead of 1 to 100)

The other issue is the effect of a debt based economy creates inevitable boom and bust cycles, and now on a world stage, we can completely decimate a country's economy by share market movements withdrawing funds from one country to invest in another.

I'll do another blog post about this stage when I get a moment!

But keep 'em coming! It's forcing me to think harder and read more. It's just difficult summarising several different articles into one snappy reply.

4/16/2005 04:51:00 pm  
Blogger Antarctic Lemur said...

The 'why' is probably because they are large capitalist institutions with strong regulative controls. I guess the the regulation grew at the same time as their ability to create money.

They are effectively quasi-state bodies in some respects, as credit card companies will come to be soon.

4/16/2005 05:06:00 pm  
Blogger David said...

But banks do not create money out of nothing. They can only lend out what they have on deposit, so it appears that Pundito's common knowledge is wrong. I still haven't figured out what banks "issuing debt" is supposed to mean, but for every liability there is a corresponding asset... banks are only acting as the middle men between people who have spare cash and would like to earn interest on it and people who need cash to finance an asset of some sort and are happy to pay interest. Moving this spare cash from lender to borrower is issuing nothing and is neutral in respect to the size of the money supply.

The size of the money supply is decided by RBNZ. They grow it in line with growth in the economy according to legislation, which mandates that they keep inflation under a couple of percent or so.

4/16/2005 08:10:00 pm  
Blogger ZenTiger said...

David, why do you think Banks do not create money out of nothing? Have you read my links?

Banks are limited in the process of money creation by the need to hold some assets in the form of reserves.

The amount of reserves and the form that they take are determined by government regulation. The amount of reserves that banks must hold is calculated as a percentage of the deposits they hold. This percentage is called the required reserve ratio.

I've found a great article by Robert Schenk that lays this out clearly.

Where did you learn about the 1-1 ratio? Can you point me to any documents?

4/16/2005 08:54:00 pm  
Blogger gazzadelsud said...

man some of your readers need to get out more.

banking is not a mystery business and its not a conspiracy - people lend money based on risk - the expectation they will get the dosh back including the cost they are prepared to bear for the risk they might.

banks lend out many multiples of what they may have on deposit - this works because they can manage risk, they can take assurances from other banks and spread the risk, and because they have (some)reserves. The bank works on the premise that not everyone will want to withdraw at once, and this is how it works.

There have been examples - 1929 crash where this failed - and banks do fail from time to time -they all have a credit rating check it out.

not sure why everyone is so excited about this - its been probably 600 years since anyone really expected the money lender to have a 1-1 ratio.

finance is one of the reasons we have civilisation - its not a conspiracy, its how we organised an industrial revolution.

4/17/2005 06:17:00 am  
Blogger ZenTiger said...

Nice summary gazzadelsud. Thanks.

My point is not that this system is a conspiracy. It is not to imply that investment is wrong.

To turn the conversation into a "conspiracy theory" discussion is like living in a "first past the post" electoral system, and then saying any alternate electoral system, such as MMP, is a conspiracy theory nut job discussion.

We've had "first past the post" for a few hundred years, why look for any-thing different? And if we decide MMP is not quite living up to its promise, will we be able to talk about a variation?

I think it is a very worthwhile point learning that banks can lend out more money than they have. Some people don't realise, and dont stop to think about it. I didn't.

Now that we are on the conversation on how banks can loan out money they don't have (and would obviously want to manage the risk) it might be worth while understanding what effect this has on an economy. I'll build a post for it.

Maybe, once the next step is discussed, a few more people will join me and say "oh, I never saw it that way". And the step after that, and after that...

1929 did happen. From what I've been reading, it can happen again. Quite possibly in the year 2006.

This is not to announce conspiracy and doom and gloom, after all, the world recovered and moved on. However, if people understand the reason for a collapse it may cause a re-think about the entire banking system.

I think being part of such a discussion is vital, as it underpins the way our economy functions.

4/17/2005 10:53:00 am  
Blogger Antarctic Lemur said...

1. I don't see how this discussion is a conspiracy, considering about 99.99% of NZers have no clue as to how money is created (as opposed to wealth).

2. I'm still sure the entire process is controlled by the Reserve Bank, and ultimately the Government.

4/17/2005 01:23:00 pm  
Blogger David said...

I've checked out the references. They show only that as economic activity takes place, money changes hands. And that in the process of changing hands it moves in to and out of the banking system, thereby showing up simultaneously as an asset and a liability for the bank.

I don't have any references for this. It is all 6th form economics. You just have to realise that banks are normal businesses, and one of their businesses is matching borrowers with lenders. They can't create money out of nothing. Their assets must equal or exceed their liabilities, or they are bankrupt. And debt isn't a bad thing... in fact it is essential for allowing people to move from a feudal economy based around centralised ownership of land to one based on capital and capitalism.

4/17/2005 05:46:00 pm  
Anonymous Anonymous said...

I'm sorry david but you are wrong. Banks can and do lend out multiples of their on deposit funds. If you don't believe us, ring the reserve bank tomorrow, and ask. Alternatively ringthe banking academic guy from Massey University that we see on TV every now and then.
The argument can be made a conspiracy theopry, and indeed I have seen articles written based on such theorem, but they are mainly anti semitic in nature, as inevitablythey state that it is a jewish conspiracy, because Jews own all the big banks in the US (too bad that the big Asian and English banks aren't woned by Zionist zealots trying to hold back the rest of us to keep us subserviant and poor).
I don't ascribe to that theory at all, and I marvel at the magnificence of the debt system, because without it I would not own the income producing assets I own today. The problem with bedt is that most people don't know that there is good debt and bad debt; Bad debt being the stuff punters go in for when they want to go on a holiday, or buy a TV, a car, or their own house, rather than good debt being used to purchase income producing assets to spin off more cash for the owner.
Other essential reading in order to understand this stuff a little better is the Paul Zane Pilzer books, especially the book on the US Savings and Loan debacle and Unlimited Wealth, along with stuff by Kiyosaki to name 2 authors. There are hunderds more out there, but those 2 alone will keep you busy for the next few months

4/17/2005 08:48:00 pm  
Anonymous Anonymous said...

Pundito, you are not getting it. Banks lend far more than their mandatory retained deposits, but that is only 8% of their assets. They do not lend out more than their total assets. Try asking the reserve bank that question. David is, sadly for this nice little conspiracy thread, correct.

I like the idea earlier, of borrowing 100K, and then lending out 180K. Of course, it works if the loan is in Galleons and sickles.

BTW, you can restart the Social Credit party if you want, they had very similar ideas. Big on the conspiracies, too...

4/17/2005 09:57:00 pm  
Blogger ZenTiger said...

Anonymous, why are you so quick to label things a conspiracy theory?

Before I have even mentioned the plans of the illuminati to take over the world, you seek to expose them, thus dooming yourself to be known to the new world order.

Meanwhile, if I could just confirm reality: That banks increase the money supply in the economy by using asset ratios.

Somewhere, it is all backed by a promise to pay, not on an ability to pay, other than the "assets" the money has purchased.

Where do you think my logic is failing here:

ANZ has $10,000 in deposits. That enables ANZ to loan $90,000. ANZ loans it to John who is buying a house.

ANZ secures the $90,000 by taking a mortgage over Johns house.

ANZ balance sheet shows $90,000 tied up in the house and $10,000 for deposits on hand. That adds up to $100,000. Every-one seems happy about that.

However, the $90,000 was borrowed into existence.

The ANZ Bank never had $90,000. It had the capacity to guarantee payment of the $90,000, and that was all that was required to make the loan.

Meanwhile, the $90,000 gets deposited into a BNZ account. $90,000 more is now circulating in the economy. More significantly, BNZ can buy up additional assets to nearly $900,000 (10 times the $90,000 deposit). Providing it can loan this money to people with assets, its books will balance and so the money supply grows.

Is that not the case?

4/17/2005 11:01:00 pm  
Blogger Antarctic Lemur said...

But the total equity of the bank is surely still the original, ie $10,000, plus whatever the difference is in interest charged to interest paid.

Therefore money 'creation' must occur elsewhere, probably from the Government printing more money and selling bonds secured by taxes to banks and larger capitalist enterprises.

[Warning: I did High School economics many years ago, and won't revisit it until i've finished my science]

4/17/2005 11:18:00 pm  
Blogger ZenTiger said...

"Therefore money 'creation' must occur elsewhere, probably from the Government printing more money and selling bonds secured by taxes to banks and larger capitalist enterprises."

From what I know, the amount of cash printed by the bank represents a small percentage of the total amount of "money" in existence.

If the Bank has $10,000 in deposits, and the RBNZ issues some bonds for sale, the bank can't buy them, because it needs the $10,000 to cover deposits. As it is, it does buy the coins and notes at face value, and it does buy the bonds the government prints, but where does the money come from to buy it? Excess circulation? I don't think so, becuase the amount of money in circulation (including virtual money) is increasing significantly every year. It increases far quicker than the amount of money printed.

That's why I'm sticking with the above theory, but I am curious to see if Anonymous can explain it a different way....

4/17/2005 11:28:00 pm  
Blogger ZenTiger said...

(Chuckle) Just found a few of the conspiracy theory + social credit party links with a google search.

Some of them are a real hoot! I'd say more but they are watching

4/17/2005 11:30:00 pm  
Blogger Antarctic Lemur said...

OK I get it. The amount of paper money doesn't have to equal the total equity of an economy - its just a paper agreement that someone else owes you something (the Reserve Bank if its kiwi dollars). So in that respect banks do 'create money'. But their equity only increases based on interest they receive which is greater than interest they pay out.

4/18/2005 12:03:00 am  
Anonymous Mike Readman said...


As I understand it, the problem with your example is that if the ANZ has $10,000 in deposits and the reserve rate for example is 10%, that means they have to keep 10% of their ACTUAL deposits is reserve. That is $1,000. The rest of their ACTUAL deposits is what they can loan out, $9,000. They need $100,000 in ACTUAL deposits to loan out (by way of mortgage) $90,000.

Still, I don't really understand money supply and all that stuff. Even printed money is only a promise to pay, the materials that make up the money don't have much value.

4/18/2005 11:50:00 am  
Anonymous dogsbody said...

Here's my take on all this.

Credit is money, and credit is created on demand.

So called fractional reserve banking, in which banks indeed lend out far more than they hold on deposit, is the key to the increase in the money supply, and hence inflation.
As has already been pointed out, the actual amount of hard cash ("M0") makes up just a small percentage of the amount of money in the economy. The rest is credit created *on demand* out of nothing by the banks: Together they make up so-called broad money - "M3" (actually I believe NZ uses a 'C' prefix rather than 'M').

So banks literally have the right to create money and make it work for them; and every dollar they create slightly devalues every dollar already in existence: Those under your and my mattresses, for example. Nice work if you can get it.

Fractional reserve banking is why interest-rate changes can lead to inflation: The lower the interest-rate the more money people will borrow - money which is conjured out of thin air *on demand* in the form of credit backed by just a small percentage of actual cash on deposit. This rapid increase in the money supply, way beyond any increase in the size of the underlying economy, is the very definition of inflation. House prices are particularly sensitive to interest-rates and shoot up in times of low interest simply because, being more affordable, more money is being created/borrowed to buy them.

Margaret Thatcher's famous experiment with Moneterism involved carefully scrutiny of the broad money supply, with the aim of not letting it increase faster than growth in the actual economy. The aim was to achieve zero inflation and economic stability. The mechanism to achieve this was interest-rates: When too much money was being created interest-rates were increased to throttle demand.
In the long term this may have been an admirable policy, but in the long term we're all dead and the pain at the time was politically unsustainable.
Nowadays central banks typically aim for price stability, managing the *effects* of changes in the money supply (inflation). The issue then is how you measure inflation. If house prices are not included in the calculation then arguably the 800lb gorilla in the room is being ignored.

4/18/2005 02:00:00 pm  
Blogger ZenTiger said...

Hi Mike

That was indeed the way it worked in the early days. It changed. It also changed not because Banks deliberately set out to create money, because the way they see it they do match assets with liabilities. The money creation happens as a side effect.

In an attempt to explain the concept, my example is a little simplistic, so I will build a new post and it might be easier to critique the idea when it is laid out in full.

This is not some conspiracy theory push here, it is an attempt to explain the reality of the system. The system brings many benefits, and it is not without serious controls.

Individual banks are limited in their ability to create money because actions which create money usually result in a loss of reserves to other banks. This has a balancing effect.

The Reserve Bank has a few ways of controlling (limiting) the amount of money this debt based system can generate.

The main way is for the Federal Reserve buying or selling U.S. government securities. When the Federal Reserve buys securities, it creates the funds with which it buys T-bills. It pays by a cheque drawn on itself. When a commercial bank "cashes this in", the bank gets reserves that did not previously exist.

If it didn't control the market in this way, you'd get the hyperinflation experienced in Germany in 1923.

However, there are signs that the debt-spending the US government is engaged in has similarities and is getting out of control.

Is there anyone out there that actually agrees with me that can explain it better? Or conclusively set me straight?

4/18/2005 02:03:00 pm  
Blogger ZenTiger said...

That's amazing. Just as I was writing "Is there anyone out there that actually agrees with me that can explain it better?" dogsbody was posting. Thanks.

Thanks too to Pundito for the tangental comment about "good debt and bad debt" and wealth creation -certainly another huge area. If kids were taught any-thing useful at school, then the true cost of bad debt would be a good start. I blame the school system for my credit card mess! Still I can probably calculate the area of the hole I'm in.

4/18/2005 02:37:00 pm  

Post a Comment

<< Home