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

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

#41

Post by jkhdigital »

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.

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

#42

Post by amurthy1 »

whyhow wrote: post #20
AmericanChopper wrote: post #9

Earlier quoted context omitted.

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…

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 a…

> The employees and the manufacturer can all withdraw the money at any time

This isn't quite correct. If all parties go to withdraw their money at the same time, the bank will not be able to give it, because they only actually have $1M in reserve.

In practice, if there are more withdrawals than than the bank has in reserve, it is usually able to get short term loans from the central bank which than ACTUALLY creates the money and loans it to the bank.

However, over the long-term if too many of the bank's loans default, they won't have enough assets to cover the deposits, which is how banks usually fail.

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

#44

Post by [deleted] »

baobabKoodaa wrote: post #39
magicsmoke wrote: post #35

Earlier quoted context omitted.

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.

That doesn't make it an IOU, though.

[deleted]

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

#45

Post by omazurov »

patrickthebold wrote: post #34
omazurov wrote: post #27

>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...

IOU for what?

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.

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

#46

Post by eru »

marcell wrote: post #5

> 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 Reserv…

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.

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

#47

Post by 7373737373 »

'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).

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

#48

Post by baobabKoodaa »

omazurov wrote: post #45
patrickthebold wrote: post #34

Earlier quoted context omitted.

IOU for what?

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.

This sounds more like am argument for USD's utility/value. That doesn't make it an IOU.

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

#49

Post by eru »

jkhdigital wrote: post #24
mgraczyk wrote: post #6

Earlier quoted context omitted.

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.h…

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.

It's more complicated than that.

Even without laws requiring reserves, banks still want to hold some precautionary reserves to eg settle interbank transfers or to serve cash withdrawal requests.

But those precautionary reserves can be very small without causing much trouble. In Scotland in the 19th century they had about 2% gold reserves and where doing fine.

What's more important are equity cushions to take the blow of losses before the depositors do.

Scottish banks typically had about 30% equity cushions because that's what depositors demanded. (These days laws require about 8%. Depositors don't care much anymore, because government deposit insurance numbs them.)

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

#50

Post by thinkloop »

baobabKoodaa wrote: post #21
mehrdadn wrote: post #18

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 gover…

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).

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?
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