# Want to know how money is created?



## dhukka (27 September 2007)

What is money and how is it created? I'm sure many will find the answers interesting and possibly unnerving.

Money as Debt


----------



## brilliantmichael (27 September 2007)

I watched this doco on youtube too. Now I know how nutty some of the conspiracy theorists in the U.S. can be, and it's easy to dismiss this as another one on the face of it. But the really scary thing is: this is something you'll actually find historical evidence for, and has in less-than common knowledge existed for hundredsof years, but somehow has not been taught in the schools of the west.

The thing is: Because the *supply of money is virtually uncontrollable in the absolute sense*. Nobody can stop people from burying their money in the backyard, which is the equivalent of "burning" money and _taking it out of the system_. Similarly nobody can stop people from "digging up" their money and effectively "printing money" back into the system. This is analogous to our spending and investment habits. If we're content to leave money sitting in the bank, it is essentially just sitting as a float for the bank to derive more fractional reserves to create more debt. Similarly as has been seen witht he debt-crisis of 2007, nobody can completely regulate how much debt is lent out to a required reserve ratio. In this way, there are microeconomic losers, but overall macroeconomically, the effect is less discernable.

The central banks around the world know this, and really it is just another evolution in the institutional change going on in our economic system. Whether it's coming crashing towards a cataclysm is another debate (which I think is certainly deserving of more publicity, but also a little more restraint in its foretelings to attract more serious public attention).


----------



## cuttlefish (27 September 2007)

I'd be interested to hear where the inaccuracies are in this - I don't understand how money supply works that well but haven't they misrepresented the way the fractional reserve system works?

At one stage it seems to imply that banks can lend more then they hold in deposits.  Banks can lend a proportion of what they hold in deposits.  e.g. if a bank holds 100,000 in deposits it can lend 90,000.  This process is implied to be 'creation' of money but I don't believe this is true - money isn't created - depositors money is lent.  The fractional reserve system is there to ensure that there is liquidity for depositors to obtain funds.  Really its a conversion of overnight debt to term debt.  i.e. depositors are effectively lending banks on a rolling overnight basis, and the banks then lend this money out on a different basis.  The bank makes margin on the difference between the interest it pays out vs the interest it receives.  

In modern times banks requiring more capital above the amount available via the deposits raise it by selling the mortgages - but they do this by writing mortgage securities first and then utlising the capital from the sale of those securities (CDO's?) for funding mortgages.  This is still not creation of money, the money has to come from somewhere (the purchasers of the securities)

Ultimately the US fed doesn't necessarily create money either but sells govt debt (bonds) to provide capital which it can then lend to the banks or use for govt spending. (actually maybe this is where money is effectivley created because the govt can create a govt bond without having a corresponding asset or cash to back it?)

And at the moment the fed is loaning against poor quality assets on 30 day terms via its discount window.  (the poor quality assets being mortgage backed securities of unknown quality).   The funding for the capital it is providing for these loans has come from govt issued debt.  In my view this dramatically lowers the quality of US govt debt.  (effectively lowering the value/confidence in the USD, since the USD is what needs to be bought to be able to then buy US govt debt).

The whole debt as an asset gets pretty confusing.

The goldsmith history stuff seemed like pure drivel to me. I always thought the history of bank notes was due to holders of gold (typically royalty) issuing notes to save people carting gold about. Theoretically no more notes than available gold could be written. This extended to the early incarnation of modern banking and the gold standard.

Then the US convinced the world to use the USD as the reserve yardstick, promising to always back it with gold, until Nixon abolished the gold standard, meaning the US could effectively issue more money than backed by gold - this seems to be where things have potentially come unstuck because that means they can create as much money as they want - but if they create more money, because its all relative, it just lowers the relative value of their dollar.   At the moment the scarier thing is if the fed reserve is holding bad assets to back debt that its written because it lowers the quality of US govt debt (and thus the USD).

This is a bit of a ramble and probably demonstrates how uncertain my understanding of this stuff is but I'd still be interested in comments and opinions on it.

What are others views - where and how is money created - I don't accept that a bank writing a loan is creating money (it might be creating liquidity but its not creating money).  The govt is the only one that can create money by issuing govt debt?


----------



## nioka (27 September 2007)

cuttlefish said:


> I'd be interested to hear where the inaccuracies are in this - I don't understand how money supply works that well but haven't they misrepresented the way the fractional reserve system works?
> 
> At one stage it seems to imply that banks can lend more then they hold in deposits.  Banks can lend a proportion of what they hold in deposits.  e.g. if a bank holds 100,000 in deposits it can lend 90,000.  This process is implied to be 'creation' of money but I don't believe this is true - money isn't created - depositors money is lent. :




I think you will find that the banks lend up to 10 times the amount of the cash deposits they hold. That is creating money. Years ago paper money was a promisary note backed by gold, Not any more.


----------



## cuttlefish (27 September 2007)

We have to be careful with definition here, because this is where I think there's a big flaw in that video.

My understanding is that the banks must maintain 10% cash as a capital adequacy/reserve requirement in order to provide liquidity for withdrawals by depositors.  The other 90% of depositor money can be lent out.   They still can't lend more than is deposited with the bank unless they write securities and use the cash raised to fund the mortgages.  (i.e. mortgage backed securities sold in the market).

The video implies that a bank that has $1000 of deposits can lend $10,000, I don't believe this to be true.  A bank with $1000 of deposits can lend $900 and must keep $100 in cash.  If there is a run on the bank then they won't have the cash at hand to pay back all depositors (because they've lent it out). But if the $900 the bank has lent is fairly safe then a central bank might step in and lend money to the bank to fund the depositors that run on the bank. In the meantime the banks can onsell the debt and use that onsold debt to repay the central bank loan. Unfortunately banks have lent far more than depositor funds because they've also been writing mortgage backed securities.  And as I understand it the fed is accepting these mortaged backed securities as collateral for loans its giving via its discount window (and is funding the discount window loans by issuing govt debt - selling bad debt as good debt).

I'll try and find some more info.


----------



## cuttlefish (27 September 2007)

There's a PDF here that talks about it on the us fed site, I'm pretty sure the way I've described it above is how its meant to work conceptually though what I've presented is a simplified form. (i.e. there's all sorts of detail about how it can fluctuate from day to day and what timeframes they need to use to determine the total capital base upon which to base the reserve requirement - e.g. average over 2 weeks etc.).


http://www.federalreserve.gov/monetarypolicy/0693lead.pdf

Interestingly it says that the reserve requirement for transaction accounts is 10% (so banks can lend 90% of transactional money) but for non personal term deposit accounts the reserve requirement was lowered in 1992 from 3% to zero.  (the transaction account reserve was lowered from 12% to 10% in 1992 as well).

So currently its 10% for transactional account deposits and 0% for term deposits.  But basically they can't lend out more than is deposited, only whats held in deposits.  So once the deposit source of capital has dried up they have to source funds by securitising the mortgages.


----------



## dhukka (27 September 2007)

Cuttlefish you are right up to a point. However you have to go one step further. You are right that fractional reserves mean that a bank must keep a fraction e.g 10% of deposits on hand to satisfy withdrawals by depositors. Thus a bank with $100 of deposits loans out $90 and keeps $10 on hand. 

Let's say that $90 was lent to an individual for a car loan.  The loan is made out as a cheque to the individual who pays for the car and that cheque is then deposited back into the same bank. The bank now has another deposit of $90, of which it has to keep $9 and can lend out the remaining $81, this can go ad infinitum. Thus the initial deposit is multiplied several times.


----------



## So_Cynical (27 September 2007)

Interesting video...i want to be a banker

seriously any1 got $1111 they can lend me.:


----------



## fleathedog (27 September 2007)

It's not the original bank that 'creates' the money. By way of 
example:

Bank A receives $1000 in deposits. Its reserve requirement is 10%, so it can loan out $900. 

It loans the money to person A, who buys a $900 computer.

The computer shop deposits the $900 into Bank B.

Bank B, having a 10% reserve requirement, can now loan 90% of the $900 dollars ($810).

If it does so (and it will), $1710 of loans will have been created from a $1000. This process continues to the point where loans amounting to many times the original deposit are written. 

Hope that clears things up!


----------



## aaronphetamine (27 September 2007)

Wow very interesting documentary, thanks for posting this, and thanks to all the people who are replying in this thread its helping me learn alot, I work at Suncorp so im finding this interesting !

I remember when i was a little kid i thought that when you deposted money into the bank they actually had a small drawer with your name on it and had a draw for everyone, and i used to think how banks actually made profits at all. hahaha


----------



## cuttlefish (28 September 2007)

fleathedog said:


> It's not the original bank that 'creates' the money. By way of
> example:
> 
> Bank A receives $1000 in deposits. Its reserve requirement is 10%, so it can loan out $900.
> ...




So, lets say I'm the only person in the world with $1000.  I deposit it in the only bank in the world 'Thebank'.  That bank lends $900 of it to Mr A who buys a computer from Mr B.  Mr A is now paying $5/annum to the bank which covers my $3/annum interest and they take a profit.

Mr B takes the $900 and puts it into Thebank.  Thebank then lends $810 to Mr C who buys a bicycle from Mr D.  Mr D puts his $810 into Thebank.

Thebank now has $2710 in deposits and $1710 in debts.  So its net position is $1000.   But yeah I can see that $1710 'new cash' appears to have been created.  In theory me, Mr B and Mr D should all be able to go and withdraw our money out if we want and the bank would have to front up $2710, but its only got $1000. So it would have to recall the loans in to fund the rest of it, or sell the debt at face value and, since its the only bank, the govt would be the only ones that could buy the debt, and they would issue govt bonds (non-asset backed just 'govt' backed) to buy the debt, thus creating the extra $1710 needed.  I'd argue that the money isn't actually 'created' until the fed reserve actually decides to bail out/support the bank (rather than have it go bankrupt owing its depositors) because that is the stage that the govt creates money out of thin air.  (not by physically printing it but by selling debt that is only govt backed).

So while the 10% reserve is adequate to fund general transaction banking in normal circumstances, much larger amounts of debt can be created.  Whilst this debt is all being comfortably paid back (with a minimal level of defaulting) there's no problem and there's unlikely to be a run on the bank.

Now as I understand it what could be happening now is that the loan default rate is getting ugly because a lot of the debt is subprime.  The fed reserve has the choice of bailing out a bank if it can't fund its transactional banking by buying its debt (even if temporarily for the 30 days allowed in the discount window) but that debt isn't good debt.  The fed can of course also allow ones that it thinks don't have a sound business model or too great a portion of bad debt to go under I guess.  I think another issue is that the banks have been providing capital to funds that then act as mortgage lenders.  There's also the separate issue of the securitised mortgages which compounds the problem as well.   At the end of the day the default rates a key part of the issue.  That can possibly be reduced by the rate reductions the fed has done (the prime rate as well as altering the discount window conditions).  However the downside of that is that the banks don't learn their lesson, money is now even cheaper and so the continue to loan more and the credit bubble continues to grow. All funded by US govt issued debt - that debt used to be backed by US productivity basically, but with the US govt willing to lend via the discount window against poor quality assets that debt isn't looking as good.

Its interesting to ponder on anyway - does seem like at some point the escalation of US foreign debt has to get it unstuck - particularly if its not backed by productivity.


----------



## dhukka (28 September 2007)

fleathedog said:


> It's not the original bank that 'creates' the money.




It practice it could just as easily be the same bank as another bank. There is nothing to prevent the money being deposited back into the same bank and then being lent out again.


----------



## dhukka (28 September 2007)

cuttlefish said:


> So, lets say I'm the only person in the world with $1000.  I deposit it in the only bank in the world 'Thebank'.  That bank lends $900 of it to Mr A who buys a computer from Mr B.  Mr A is now paying $5/annum to the bank which covers my $3/annum interest and they take a profit.
> 
> Mr B takes the $900 and puts it into Thebank.  Thebank then lends $810 to Mr C who buys a bicycle from Mr D.  Mr D puts his $810 into Thebank.
> 
> Thebank now has $2710 in deposits and $1710 in debts.  So its net position is $1000.   But yeah I can see that $1710 'new cash' appears to have been created.  In theory me, Mr B and Mr D should all be able to go and withdraw our money out if we want and the bank would have to front up $2710, but its only got $1000. So it would have to recall the loans in to fund the rest of it, or sell the debt at face value and,




Exactly, banks work on the assumption that not everybody is going to want their money at the same time and 99.9% of the time they don't. The exception of course is a good old bank run ala Northern Rock. 




> I'd argue that the money isn't actually 'created' until the fed reserve actually decides to bail out/support the bank (rather than have it go bankrupt owing its depositors) because that is the stage that the govt creates money out of thin air.  (not by physically printing it but by selling debt that is only govt backed).




Call it money or debt or whatever you like the fact is the bank in your example (or in the real world it may be a number of banks) are lending out much more than the initial $1,000. Debt is being created in excess of the original amount and people are carrying out transactions based on it so it does not require a central bank to step in to legitimize it's creation. 



> So while the 10% reserve is adequate to fund general transaction banking in normal circumstances, much larger amounts of debt can be created.  Whilst this debt is all being comfortably paid back (with a minimal level of defaulting) there's no problem and there's unlikely to be a run on the bank.




Exactly.


----------



## nomore4s (28 September 2007)

There is another thread on this issue, where Lakemac posted some very good posts on the banks and "creating money", very much worth reading. Lakemac has a wealth of knowledge on this issue as well as alot of research. Post 3 & 4 gives a good explaination.


----------



## >Apocalypto< (28 September 2007)

dhukka said:


> What is money and how is it created? I'm sure many will find the answers interesting and possibly unnerving.
> 
> Money as Debt




It printed in a mint, case closed!


----------



## cuttlefish (28 September 2007)

Thanks nomore4s I'll have a look at it.

In relation to this thread a light bulb just went on for me as I realise the sum of the mathematical sequence of the 1000*.9 + (1000*.9*.9) + (1000*.9*.9*.9) ... etc adds up to $9,000.  So this is why they're saying that banks can lend up to 9 times their deposits.


----------



## aaronphetamine (28 September 2007)

In the documentary they said that 111.12 could be used to make a 10grand loan and then u guys  were saying 1000bucks can only be used for a 900dollar loan ?

Sorry i watched this doco late last night ?

The doco is multiplying by 9 and you guys are multiplying by .9


----------



## dhukka (28 September 2007)

nomore4s said:


> There is another thread on this issue, where Lakemac posted some very good posts on the banks and "creating money", very much worth reading. Lakemac has a wealth of knowledge on this issue as well as alot of research. Post 3 & 4 gives a good explaination.




Thanks for the link nomore4s. Excellent posts. I think he has a very apt description of credit



> the "thin air" or "goodwill" if you like that a bank will give you to go and purchase something.


----------



## ROE (28 September 2007)

That why you buy stock and don't keep your cash in the bank 
your money is spread over many stocks in many banks in many countries 
you feel a little safer


----------



## fleathedog (28 September 2007)

> In the documentary they said that 111.12 could be used to make a 10grand loan and then u guys were saying 1000bucks can only be used for a 900dollar loan ?
> 
> Sorry i watched this doco late last night ?
> 
> The doco is multiplying by 9 and you guys are multiplying by .9




The example you are quoting is where a new infusion of capital by an INVESTOR is made to the bank.

To understand this example you need to distinguish between a DEPOSITOR and an INVESTOR. 

The depositor has the right to demand their money at any time. So, the bank must keep 10% (or whatever the reserve requirement is) of the deposit as a reserve as explained.

An investor has NO RIGHT to demand their money back. They are a shareholder, not a depositor. So in this example, $1000 of loans can be written over $111.12 because the bank only needs to keep 10% in reserve.

Hope that makes sense!!

Note* I realise 111.12 is not 10% of 1000. It's the reciprocal of the 9:1 ratio quoted in the film. Ie: 1000 x (1 / 9)
I don't have time right now to nut out the maths, but I believe the principal is correct.


----------



## dhukka (28 September 2007)

aaronphetamine said:


> In the documentary they said that 111.12 could be used to make a 10grand loan and then u guys  were saying 1000bucks can only be used for a 900dollar loan ?
> 
> Sorry i watched this doco late last night ?
> 
> The doco is multiplying by 9 and you guys are multiplying by .9




aaron,

The documentary said $1,111.12. Remember in the example on the video the $1,111.12 is the amount of reserves the bank has deposited at the central bank not customers deposits as we are talking about above. A reserve ratio of 9:1 exists on this money enabling the bank to legally lend out 9 times this amount or $10,000. 

In the video example the $10,000 is credited to a borrower's account who then draws on it to buy a car. The seller of the car then deposits the $10,000  into her bank. 

This is where you are probably getting a little confused. Unlike the reserves at the central bank. The customers deposit cannot be loaned out at 9:1 but rather at the inverse ie. 0.9. Thus $9,000 of the $10,000 can be loaned out. Then that $9,000 is deposited at another or the same bank and 0.9 of that can be loaned out - $8100. Thus each deposit can be lent at slightly smaller amounts in an infinitely decreasing series.


----------

