Sunday, February 1, 2009

Fractional Reserve Banking - More Explanation....

This post is a follow on from many comments on my last post on fractional reserve banking. If this is your first visit to the blog, you may want to look at some of the posts linked to on the left before this post, as this post is a little narrow and more than a little abstract, and attempts to clarify the previous post. If you do want to read on, in order to understand this post, you will need to read my previous post, which is here and may find the comments made by readers helpful in understanding the questions I am trying to address.

Before going on, I will re-emphasise something that some people missed. I am very clear that the central banks do indeed create money (but more of that in a future post). However, this should not be mixed up with the principle of whether Fractional Reserve Banking FRB creates money. My post on FRB seems to very contentious, with one commentator on a forum being very complimentary about the blog overall, but also suggesting that I do not understand FRB. I think the problem prompting such comments is very basic, and is the subject of argument amongst the different schools of economics - the question of what money is.

Returning to the definition of money, in my original post I went to some effort to make clear my definition of money. The argument about whether FRB creates money depends on how you might define money. Perhaps I never made the relationship between FRB and money clear as one person asked why I added this discussion of what money is.

I specifically gave the case of the IOU to make the point of my definition. The IOU is only money in the narrowest sense because it has a limited use in exchange, as it is only meaningful to a very limited number of people who are able to assess the value of the IOU. I would quote the section of the original post here but it is quite long. As such you may wish to return to the post, and you will find it about a third of the way down (using the scrollbar).

As another aside, it might be noted that a fiat currency can be viewed as an IOU, as in a fiat system we just collectively (most of the time) believe in the value of the fiat money. There is no underlying contract that gives value to the money, but simply a belief that is has vale. This is a difficult point to summarise, so you may wish to read my post here as this discusses money in some depth.

The question at the heart of the debate is whether FRB allows the creation of money from nothing. If we go back to how the money creation argument let us look at another example which is as follows:

Depositor A deposits 100 gold coins into Bank A.
Bank A loans 80 gold coins to borrower A for the purchase of a house.
Borrower A writes an IOU for 80 gold coins made out to Bank A.
At this stage we still have a total of 100 gold coins.
The house Seller A accepts the 80 gold coins in exchange for the house.
Seller A then deposits the 80 gold coins into Bank A.
At this point in time, we still have only 100 gold coins in total.
Bank A again has in hand the 80 gold coins.
Bank A lends out 64 of the gold coins to borrower B to purchase a house.
Borrower B writes an IOU for the 64 gold coins.
And so the process might continue....

....But you will notice that on each occasion, the total number of gold coins never changes, and the amount that the bank can lend diminishes on each occasion. Furthermore, there is never an increase in the number of gold coins, just an increase in the IOUs. I have left out interest on this occasion for simplicity and also because (at some point) I would like to deal with this on a post about inflation and deflation. In the end, in the above scenario, the bank will only ever be able to lend a total of 80 gold coins.

The key question in all of this is how money is defined, and this is why I went to some effort to make clear what my definition of money actually is. Under my definition, money only exists in the collective minds of all of us. Whilst some might imagine that the IOUs are money, they are not money, they are IOUs whose value requires specialist knowledge, is highly speculative and they are therefore of limited use as money.

The whole point of a bank run is that, when push comes to shove, these IOUs can not be used as money, because the depositors will not accept a note from the bank that says 'at some point in the future, subject to all kinds of circumstances, we will be able to give you x number of gold coins' - the simple reality is that in a case where gold coins are the universally accepted currency, that is all that counts as money in real terms.

As the situation stands, when people lined up outside Northern Rock, they wanted and accepted £5, £10, £20 and £50 notes, not IOUs. By their definition this is the only money there is, and they collectively are the only people that matter, as they finally determine what money actually is. In other words, the banking system creates what they believe is money on their balance sheets, but the people that really matter (all of us) do not accept the 'money' on their balance sheets as 'money'. It is an entry in a book, and can not be used as a unit of exchange that is accepted by us all.

In the example I have given above, lots of IOUs are created but there are never more than 100 gold coins, and therefore no money has been created. When someone wants their money back, they will not accept the IOUs, but they will accept the gold coins.

I used gold coins on the basis that in everyone's minds eye, it could be seen that no more money is created in the system. In my discussion of the subject I make very clear that the 100 pieces of gold creates a total of 80 pieces of gold lending in a 20% reserve system. Even Ben Bernanke's discussion of FRB agrees with this saying the following regarding a 20% reserve system:

'At this final stage the ratio of reserves to deposits equals the ratio desired by the banks (20%). No further expnasion of loans and deposits can occur after this point because the ratio of reserves to deposits is at its minimum acceptable level.' - Macroeconomics, 4th Edition, Ben Bernanke and Andrew Abel, p525.

In other words, at the end of the system, no more than 80% of the reserves can be lent. However the money shuffles around, the total money 'out in the world' will never be more than 80% of the total deposits. In the case of inter-bank lending, as I pointed out, the amount of those reserves 'out in the world' actually diminishes each time a bank lends to another bank.

At its most basic, an IOU on a bank balance sheet does not constitute money. It does not constitute money because it is not accepted as a unit of exchange. This is why we have bank runs.

I can quite understand why people become so confused about this, as many people would like to imagine that the IOUs do constitute money, in particular many economists. However, the reality is that, when push comes to shove, this does not constitute money, which is why banks hold reserves. However everyone might try to pretend that an IOU is money, the truth that it is not money is revealed when a depositor asks for their money back.

The problem that we have here is made even greater by the fact that fiat money is of itself a form of money based upon nothing more than belief that it is money. However, it is the only medium of exchange that is universally accepted. The idea that IOUs on a bank balance sheet are money is occasionally tested, and whenever the test happens, it is found that it is NOT money. Once again, we can see this in the case of Northern Rock.

As before, comments are welcome. I hope that I can leave this subject and start to look at central banks, but will come back to the subject if anyone can do the following:

1. Show me how the IOUs held by Northern Rock, the numbers in their books, constituted money.
2. How, using gold coins, with no central bank input, a fractional reserve banking system might create more gold coins than depositors have put in (excluding interest payments). For the sake of ease, please try to use 20% reserves.
3. How a bank lending to another bank does not lead to diminishing credit outside of the banking system (again in a flat 20% reserve system)

As I have said, comments welcomed and I hope that I have clarified my point. Like many commentators on my last post, I am occasionally seduced by the idea that money is 'created' when I have read the clever arguments, but keep pulling myself back to the reality of what a depositor accepts as money, and also what I would accept as money. What would you accept as money if you went to get your money from the bank, and they refused to return your £10 as a bank note when you ask for it to be returned as such?


  1. I have just hit the 'publish' button, and thought of something I should have added. A central theme of this blog is to try to shatter some of the delusions that seem to exist in economics. In this case there is a delusion that an IOU is money.

    You may note that I also see fiat money as highly suspect concept, but I also see gold standard money as problematic. Again, my post on banking regulation details this, so I will not repeat it. All money is problematic, but some money is less problematic than other money.

    In the case of the IOUs, or notations on balance sheets, they fail as money whenever they are tested as such by depositors. As such, in the 'real' world of us all, they do not count as money.

    I know this is very abstract, but it is important to how we understand the economic system, and (as I hope I will show in the future) is important in understanding the roots of this crisis.

  2. I had a request for an email address for the site and have created the following:


    I have ommitted the @ symbol to avoid spam....

  3. Mark,

    Thanks for a stimulating series of posts. You make many interesting observations in your lengthy comments, but I'm afraid I have to disagree with your central premise that "IOUs are not money". I think that many of the tensions between your various statements can be traced back to this particular article of faith (I sense in it a certain sympathy with Austrian thinking on this point). For example, you concede that in some cases IOUs **can** function as money, but then go on to talk about "gold coins" and "ten pound notes" to show that IOUs are not "really" money, since the quantity of gold or notes is not affected by borrowing in FRB.

    If we assume that "money is debt" it is possible address some of the questions you raised at the end of the post, in a consistent manner. I don't like to use the phrase "money is debt" since there is a totally lunatic, conspiracy-minded web site of the same name out there, with which I disagree completely, but can't think of a better term.

    A few points about debt in general:

    1. Debt is a legal category, its "quality" depends on the debtors ability to pay and the legal/enforcement framework under which it functions.

    2. Debt (or its flip side credit) is inherently risky, and different "debts" carry different degrees of risk.

    Now, "money" is simply transferable debt. The "quality" of this money depends on the quality of the debt and its transferability. So the "quality" of Joe's IOU is much lower than the "quality" of a UK government bond, but they are fundamentally one and the same thing, and it is a matter of historical record that government bonds have also been known to default.

    Another element in monetary systems is the concept of "legal tender". By law, legal tender must **always** be accepted when settling debts (in a particular juristiction). It is the highest "quality" of transferable debt, and its universal acceptability is guaranteed by the state (that's why they say that cash is the poor man's credit card). In the past gold was legal tender in the UK, but has been replaced by fiat currency.

    It's amazing how many people don't seem to understand the concept of bank deposits. Most think that depositing money in a bank is analogous to leaving their bags in a storage locker at a railway station. Nothing could be further from the truth.

    When you deposit cash in your bank account, you are actually entering an exchange transaction with the bank. You exchange your high-quality transferable debt (legal tender) for a bank IOU (your account balance). In other words, you buy a bank IOU in exchange for your cash. Your cash becomes the property of the bank. It is not "deposited" in your name anywhere. The bank simply "created" a new kind of money. For most practical purposes in normal conditions, the quality of the bank IOU is as good as cash, and you get the convenience of banking, a chance to earn interest etc. for the (usually marginally) riskier bank IOU. When you use your debit card to pay for purchases, transfer money to somebody else's account, write cheques etc. you are actually using the bank "money", not legal tender (i.e one kind of debt instead of another). I hope that answers your question as to how IOUs issued by Northern Rock constitute "money".

    Things become interesting when the bank collapses. Its IOUs (your account) instantly become worthless. By depositing cash in the bank account of a subsequently failed bank, you have exchanged high-quality debt into virtually worthless debt. The value of NR's IOUs depended on the bank's perceived ability to meet its obligations. When that came into question, there was a stampede of 'depositors' wishing to convert the bank's IOUs into legal tender.

    Now let's look at how banks 'create' money by lending. Actually, like 'bank deposits' the term is a misnomer. Banks do not create money by lending - it is borrowers who create money (i.e. debt) by borrowing (since money is debt, new money can only be created when a new debt is created). When Sam takes a 100k mortgage to buy a house, what actually happens is that he sells his newly created, highly illiquid, long term, personal debt to the bank in exchange for the bank's much more liquid IOUs. The IOUs are simply created as an accounting entry in the bank's books as new "money", which can then be spent in the economy. That's all there is to it...

    Now where does FRB enter into all this? I think all the excitement about FRB "creating money out of thin air", especially on some conspiracy-minded websites, is a bit of a red herring. In an ideal world, where people trust their banks and are content on using bank IOUs instead of legal tender, banking reserves would not be necessary. Of course in the real world this is not the case. People withdraw cash all the time, so the banks need to hold liquid reserves to meet these claims on their IOUs. The purpose of FRB rules seems to be threefold:

    1. To ensure that a bank has sufficient liquidity to meet everyday withdrawal needs.

    2. To create a natural limit to the amount of debt that a bank can buy (i.e. the amount of money in the form of its IOUs it can create).

    3. To allow central banks macroeconomic control of the amount of credit (money) in an economy by varying reserve ratios

    To answer question two, you seem to assume that only the gold coins in the bank vault are "money". In fact both the gold coins and the bank-issued IOUs are "money" (can be used to purchase goods and services). The gold coins are money because they are legal tender (assuming a gold standard), The IOUs are also money, since they are backed by gold coins (via deposits), and legal claims on borrowers' future income streams and assets (in the case of mortgages). The IOUs are simply slightly lower quality than legal tender, but it does not stop them from functioning as money in normal circumstances. Of course, every bank will collapse when all the depositors try to convert their IOUs into legal tender at the same time. But this instability is inherent to every "real" banking system, since banks by their very nature "borrow short and lend long". So a bank run can cause a bank collapse, even though the bank is technically solvent, but does not have sufficient liquidity to meet its immediate demands. Hence various "lender of last resort" systems put in place since the XIXc . Bank insolvency is another matter altogether.

    Hope this helps.

  4. All right, you convinced me. After all, when IOUs are sold, that just transfers the credit – and the risk – to somebody else. Only central banks create (print) money.

    A temporary creation of money can occur - say - when I issue a check to pay my rent to the landlord and he, instead of cashing it, endorse it to somebody else who does the same and so on.
    So my check is used as a negotiable instrument (category that includes banknotes too) by several people and until the check is presented to my bank to be cashed, the bank can use my money. Which means a temporary doubling of that amount.

    Considering the global number of similar transactions it’s not peanuts, but it’s way less important of the supposed “money creation by FRB”.
    Phil in Cyprus
    P.S. If this post appears twice, as I fear, please delete the second copy

  5. Great post MArk, and very coherent and almost concincing, but I'm with MattInShanghai on this one (at the moment)... debit cards and bank transfers are surely a way of using the bank's IOU as money. Plenty of people spend huge amounts buying goods without ever converting their money into cash - its all bank balance sheet adjustments.

    However perhaps we have run up against 'semantic limit' - does this question have any real implications for the economy and financial system?

  6. A quick question

    In your explanation you pretend that bank reserves are gold coins - easy to understand and very tangible. What are the bank reserves made of in real life? Are they safes full of £10 notes, or are they account books full of numbers? This would make a big difference.

  7. CE, that article was insightful... however, the same example is being used by the "economists" (incl. economics professors and in business-schools (BS, see I make joke hahaha) to show how the fractional reserve system generates "wealth"!! Jokes apart, i was appalled when i hear professors use such examples to "twist it" their way.. among many other things. in my class, a majority of them wanted to take finance classes so they can go into i-banking, one of the accelerators of the current crisis.. I wonder how many of my classmates were involved in this ponzi scheme..

    p.s.: You could've edited your post to include the details in the comments...

  8. MattinShanghai:

    As I would expect from you, an interesting reply. However, you still ignore the central point of my clarification. I accepted in my post on reform of banking, and in the first post on FRB that money is a difficult concept to pin down.

    Going back a long time, in a post called synthetic economics, I even pointed out that the $Linden has the same basic legitimacy as the $US, in that both are rooted in belief. The $Linden is a currency developed in a virtual world (Second Life)- and I even accept the gold coins (not real gold but virtual gold) that are used as a currency in World of Warcraft as a form of money in principle.

    However, you are missing the point that our collective belief is what finally determines what makes money = 'money'. The $Linden are money to those that use them, but not to you or I. The IOUs on the bank balance sheet do not constitute money, in that they finally fail the test of belief, when people are faced with the choice of accepting them as money.

    I am jumping ahead of where I want to be in saying this, as you may note that my arguments are progressive. However, I will jump in here with what deserves a proper explanation. Our belief in the £5 notes is about to be tested too, which is the purpose of the points that I have made in my post about banking regulation and the meaning of money, as well as these posts on FRB.

    As I have said, all money is imperfect, all money is a contract, and our belief in the money is based on our belief that it will fulfill the contract.

    The IOUs from the banks are very flawed as a measure of money. Fiat money is flawed. Gold backed money is flawed. In the end money is invested with meaning by **us**. That is the flaw.

    FRB shows that a number on a bank balance sheet holds less belief than a government backed bank note, and that a gold coin holds more belief than a fiat bank note. To a starving person, a pound of rice has more meaning as a currency than a gold coin if the rice keeps him alive.

    This is why I offered the IOU explanation. It was to try to make everyone think about how money is an idea with meaning invested in our minds.

    You are right in your argument, as is everyone on this. We can all make an **intellectual** argument that x, y or z is money. This makes for interesting debate, but does not 'make' the reality of money where it matters - in the minds of people who are not playing a part in the debate.

    My argument is rooted in the pragmatism that the value of money is rooted in the belief that the implicit contract can be met. In such a scenario, an entry on a bank balance sheet is very fragile, such that it really is a very poor form of money.

    It is for the reason of the fragility that I deny it the status of money in our consideration of the amount of money that actually exists.

    The essential nature of money is a contract to provide the equivalent of x value of labour at some point in the future (even commodity extraction only creates value in the extraction process and the provision to a place where it is used and this is created by labour).

    In the end it comes down to this. You say:

    'In fact both the gold coins and the bank-issued IOUs are "money" (can be used to purchase goods and services).'

    My answer remains - tell that to the people who waited in line to withdraw their deposits in Northern Rock, and I think you would have found that they disagree. As I have done in the IOU scenario, I made the argument that this is money in principle, but rejected the IOU as money in reality - on the basis that we need to know the employment status of the person writing the IOU, the state of his industry and so forth....We can make a similar argument for fiat money, but that is the matter of a future post.

    When I look at this crisis, one of the problems appears to me to be that the bankers insist that the IOUs are money, as do the politicians, and many economists. In doing so, they forgot that the value of money is rooted in the belief of us all, not in the belief of those who have studied and/or think about the economics of money....

    I will (in a future post) explain why this led to the crisis, and that is why I have taken the trouble to make clear the variable understanding of money, and why a bank IOU is not money as understood in the world **outside of economic theory**.

    I am finding that I am repeating myself on this subject. I can put it no clearer than this:

    If money in the mind of an economist/banker/politician diverges from money in the mind of the rest of people who use it daily, then there is potential for problems - very serious problems.

    I hope that you can bear with me, as I hope that all will become ever clearer as I explain the financial side of the economic crisis.

    As a further note, I take your point about the length. However, I am arguing against some considerable weight of views....

    Phil in Cyprus: An interesting point on the time lag, thanks. I has not considered that, and you are quite right.

    General: This does seem to be a painful process....which is not a criticism of the comments, but rather it is taking far more time than I expected. I also note that the number of visitors to the site is dropping, so ask for patience from those who might think this is abstract. It does and will relate to the problems we are seeing...and will pull together...

  9. First off, as this is my first post on this blog I'd like to say Hi and a big thanks to CE for what is a brilliant blog.

    Now, into the deep end.

    To MattinShanghai,

    I've re-written my reply to you so many time's I've almost lost the thread of my disagreement.

    This whole discussion has boiled down to the semantics of "money", I understand and agree with your assessment/definition of money in the context of our current economic framework.

    However I really can't accept this system as being a useful or sustainable model, you will need eternal growth to maintain it and there is almost nothing tangible in the system, just transitory debt.

    How can circulatory debt be an accurate scale of a system or entity's wealth? Surely all of what we're seeing now was an inevitable conclusion somewhere down the line when we abandoned the gold standard.

    I realise everything I've put is a gross over simplification, and there's probably a million and one text books arguing why this system can work, but every instinct in my body screams against it.

    Anyhow, keep up the lively debate! :D.

    Tony R.

  10. Cynicus,

    Don't be discouraged - your efforts are greatly appreciated.


  11. Mark,

    I have just started reading your blog, and have to admit that you have articulated (far better than I ever could) a lot of the "fears" that I currently have and opened my eyes to a lot more. Thanks for this.

    I have no idea what is the right or wrong answer on whether FRB creates money. However, it seems to me that the original deposit causes an an increase in the supply of money over a period of time.

    For example:

    Person A deposits 100 gold coins (GCs) in a bank. Person A now has an IOU from the bank for 100GCs. The bank now lends person B 80GCs. The bank now how has 20GCs + IOU for 80GCs. Person B buys something from Trader X for 80GCs, who then deposits this in a bank (the same one or a different one). The trader now has an IOU for 80GCs and the bank. The bank now lens person C 64GCs, who purchases something from trader Y, who deposits this in the bank, and so on.

    So whilst I agree that at any one time there are only ever 100GCs in existence + a series of IOUs, person A, person B etc. have actually spent 80GCs, 64GCs etc. in the economy. So over a period of time, there has been the creation of money.

    If I've completely missed the point, then I apologise, as I am new to thinking about this stuff.


  12. Is this book of any interest? It is, apparently, a book published by the Federal Reserve Bank of Chicago which explains the process of FRB in great detail. I haven't had time to plough through it yet, but I notice it does use the word "create" in relation to deposits and reserves quite a lot...

  13. I think this passage from Elliot Wave clearly explains why credit is not money:

    'The dynamics of value expansion and contraction explain why a bear market can bankrupt millions of people. At the peak of a credit expansion or a bull market, assets have been valued upward, and all participants are wealthy - both the people who sold the assets and the people who hold the assets. The latter group is far larger than the former, because the total supply of money has been relatively stable while the total value of financial assets has ballooned. When the market turns down, the dynamic goes into reverse. Only a very few owners of a collapsing financial asset trade it for money at 90 percent of peak value. Some others may get out at 80 percent, 50 percent or 30 percent of peak value. In each case, sellers are simply transforming the remaining future value losses to someone else. In a bear market, the vast, vast majority does nothing and gets stuck holding assets with low or non-existent valuations. The "million dollars" that a wealthy investor might have thought he had in his bond portfolio or at a stock's peak value can quite rapidly become $50,000 or $5000 or $50. The rest of it just disappears. You see, he never really had a million dollars; all he had was IOUs or stock certificates. The idea that it had a certain financial value was in his head and the heads of others who agreed. When the point of agreement changed, so did the value. Poof! Gone in a flash of aggregated neurons. This is exactly what happens to most investment assets in a period of deflation.'

    In a Crash money goes up in value.

    That is why the banks are insolvent, all the IOU's are deflating and they don't have enough money to cover the losses.

    I must admit I go round in circles on this subject.

    Thank you Cynicus. You get my brain cells rocking.

    All the best

    Death to Bubble Addicts

  14. Cynicus,

    been following your blog for some time.

    Perhaps you might consider think of cheques instead of IOUs? Then you will be able to pose the 'cash or cheque?' question to your readers. How many would prefer a cheque?

    Despite the efforts of the banks, cash is still king.

  15. Mark,

    Thanks for your quick reply to my comments. I think that we are in agreement as to many of the general principles. What I find puzzling is your distinction of "real" vs. "unreal" money.

    You make a statement (with part of which I totally agree) that:

    "... all money is a contract, and our belief in the money is based on our belief that it will fulfill the contract".

    This is another (better) way of saying that money is a legal category, rather than a "thing". Its viability depends entirely on trust, which in turn depends on a real ability to fulfill it on the part of the debtor (and enforce it on the part of the creditor) , as you've pointed out in your other posts. But you prefix this statement with the words:

    "All money is imperfect..."


    "The IOUs from the banks are very flawed as a measure of money. Fiat money is flawed. Gold backed money is flawed. In the end money is invested with meaning by **us**. That is the flaw"

    Money is certainly "flawed" in that respect, but this is a flaw that any kind of contractual obligation must share. I cannot see any way around it. Of course some obligations are more "flawed" than others, and I agree that debt guaranteed by the UK government is more "secure" than an IOU signed by Joe Bloggs.

    In a well run bank, behind the bank IOUs created out of "thin air" stands real value in the form of legally enforceable (by force if need be) claims against income streams and real, tangible, assets. That's what gives bank IOUs their credibility. If that credibility is shaken in any way, the IOUs lose their value, and become worthless (like any obligation in default).

    Your comment about the "unreality" of Northern Rock bank accounts vs. the "reality" of pound notes misses the point that I was making. It was precisely when NR was threatened with collapse that its debt (the bank accounts) was in real risk of becoming worthless. That's not to say that pound notes are in some way "inherently" more "real" than NR accounts, it is simply the case that NR was far more likely to go bankrupt in the given timescale than the BoE, hence the run on the bank.

    Is it possible to have a different monetary system than the current one? Possibly... Many have been tried in the past. But its worth noting, that at the height of the gold standard (around 1850-1914), most of the "money" in circulation consisted of private IOUs, discounted bills, private bank notes, endorsed cheques, warehouse receipts, bills of lading and the like. The current system, for all its imperfections, has at least the virtue of (relative) simplicity and transparency. It is only due to the "innovations" introduced over the last two decades that it has come unstuck, but that will hopefully be the subject of your next posts.

    All the best

  16. MattInShanghai,
    I can understand most of what you say. I don't get why you call money debt. Money is a form of exchanging labour. Debt is the promise of future labour. But I don't think it is important.

    You are saying that as long as there is confidence in the IOUs issued they can be passed as currency (just as cheques used to be written over to people until too many were found to be worthless when cashed).

    I completely understand the bank deposits and the IOU to the depositor. That has huge confidence because it is government backed. But surely it is only the banks that will take further IOUs as payment. Hence they can pass a mortgage debt on to each other as though it were money. This IOU cannot be counted toward their reserve and cannot then be used to push more money into the economy.

    Also you say that Sam takes 100k from the bank against his future work and the bank creates an IOU. Surely the bank has given the money out and it is Sam that is issuing an IOU. The 100k does go into the economy, but it was provided by other depositors. It is not created, but moved from one place to another.

  17. Mark, sorry if this subject is turning out to be a bit too esoteric for many potential readers of your blog. By all means shunt it off to the sidebar somewhere and I'm sure we saddos will find it!

    But, back to FRB: one thing I find strange is that we are trying to analyse what FRB does as though it is a mysterious, but universal law, rather than simply stating what it is supposed to do and then verifying whether it does it or not. Why is this? Perhaps this is what gives the subject a 'conspiracy theory' mystique. If even economists can't agree what it does, yet all banks use it, there must be something fishy going on...

    What role does FRB play in maintaining inflation, money supply, exchange rate? Why is the required reserve ratio 10% and not 14.38%. Or 0%? Or 100%? (A fixed round number sounds a bit strange in a supposedly self-regulating mechanism). I'm not sure we have established yet what FRB is supposed to 'do', but if we could do that, what alternatives would there be, which could provide the same function?

  18. Well CE you've certianly been inundated with comments. You might have to quit your day job!

    It does make sense but it's tricky to get your head around. In essence banks do not create (or print money) as this is the job of central banks; rather banks take money via deposits and give/receive promises of money (IOU's). The money supply does not increase - it is merely an illusion. So the economy is largely premised not on money but on IOU's. Interesting.

    An Anonymous poster (February 1, 2009 12:26 PM) posed a similar question to a remark I made on a previous post (I get the feeling this would be more relevant to a future post on inflation/deflation or central banking):

    Whilst IOU’s vastly outnumber money, it is not a problem as the IOU’s will cancel each other out. However the IOU’s are issued with interest added and this remains after the IOU’s are cancelled. This interest is real money that is owed. So where does the money to pay for the interest come from? Such a system is clearly geared towards perpetual growth which in a finite world is unsustainable and as there is a shortage of money bankruptcies are inherent in the system.

  19. There is a man and he goes to the newly created, single bank in town. He deposit 100 gold coins and takes a nice piece of paper. The bank can keep 20 gold coins (gc) and lend out the other 80. But the banker thought he was smart, so he did something else. He went to the mint and borrowed 400 gold coins. He kept the original 100 in the bank and lent the extra 400 out. He still kept his 20% reserve ratio, which is the requirement for the mint to give him the loan..

    As long as the interest rate he had to pay to the mint, was less than the interest rate that his clients payed him, he was making a profit that he placed in his pocket. Lets assume that we have a really nice mint that has 0% interest rate (something like the Fed :) ). The bank was charging 1 gc per 50 it gave, so our banker had an 8 gc little bonus.

    One of the clients, took a 50 gc loan and bought a house. He had a very bad year though and he couldn't pay the bank. The bank then took possession of his house and threw him out. When the bank had to pay back the mint, it needed 400 gc. So, the bank took 50 gc out of the initial deposit.

    The bank's reserves now are 50 gc and a house worth 50 gc. As long as the bank could sell the house for 50 gc (or more), any time it wanted, everything was ok. The bank could still borrow 400s of gc from the mint and stay in business.

    One day, the plague came to town. Lots of people died. There where empty houses everywhere. Even if you tried to sell that 50 gc house for 40 gc, there was no one to buy it. That puts the bank in a tough position.

    First, the reserves are now in 90 gc (assuming that someone will buy the house for 40 gc). The bank had to do a 10 gc write off.

    If the original depositor comes to claim his gc, then we have a bank run and the banker is insolvent.

    As long as the house remains in the market, it looses value (more write offs).

    What should the banker do?

    PS. If you are wondering, “Why on earth, do I need the original deposit? Just borrow from the mint and do business” then welcome to the world of investment banking. You must be one of the Lehman Brothers.

  20. Jonny,
    The IOUs cancel out in that the debt is just being passed on, but it takes one person to default in a chain of debt and everyone is suddenly defaulting.
    I lend you £100. You lend £50 to Mark. He can't pay you back and suddenly you can't pay me back all of my money.
    Mark is screwed for whatever reason stopped him paying you.
    You are screwed because you can't pay me.
    I'm screwed because you can only pay me back half of the loan.
    So they cancel each other in that it was still only the original £100 that was lent.

  21. Surely the point with FRB is that it allows a series of people to 'spend' the gold coins (or £10 notes, or whatever constitutes the original deposit) many times over, while the original depositor does nothing?

    I deposit my 100 GC in the bank and then set off on a long voyage of discovery. While I am away 80 GC are lent to someone to buy a water mill. He works the mill to pay back the GC. The seller deposits the 80 back in the bank so then 64 GC are lent to someone to buy pigs, and fatten them for market. The sellers of the pigs deposit the GC back in the bank, and so on and so forth. From the original 100GC there are now a number of people who 'think' they have GC deposited in the bank, well in excess of the actual number of GC in existence (100).

    So FRB has allowed lots of activity to take place, which all falls apart unless more GC can be gained from elsewhere to pay back all the debts that have been incurred. If you can't introduce more GC into the system, it all falls apart when I return and demand my 100GC. Or indeed if everyone turns up at the bank to demand 'their' deposits. Because there isn't enough GC for everyone.

    FRB is very productive, but also very dangerous. It allows economic activity to flourish were it otherwise would not. But equally it can all come crashing down, as we are discovering, because the system is built on sand, (or 'confidence' as it is called).

    FRB may or may not create money. Its irrelevant really. What it creates is a system that is fundamentally unstable and is doomed to failure in the long run, especially when legal tender is not backed by anything physical, such as gold.

  22. Jonpaul,

    You are right. I should have said in an ideal situation all the IOU's could be canceled out. Thank you for pointing that out.

    But even if everyone is paid back and all the IOU's are canceled, where does the money come from to pay the interest as the broad money supply is simply not enough?

  23. I think the most important thing is that such things are being discussed at all. The more people who start thinking, the better.

  24. Firstly I think this is an excellent blog.

    However this FRB is the first time I have questioned your accuracy. I have been of the belief the FRB is a method of money creation, but not for reasons given by most replies. I can perhaps express it more succinctly than one of a few comments that share my view.

    It is how you apply the reserve requirement. You seem to discount one of the methods; from Wikipedia:

    “1) loaning $80 of the original $100 without creating any more money, or 2) creating an additional $400 out of thin air and loaning out that newly created $400”

    Option 2 does not seem to have been addressed and I can recall as others mentioned the Chicago Fed report being quoted by Austrian leaning authors.

  25. Dear Mark

    I am coming late to this post of yours but I feel really strongly that you are missing something important here. I appeal to you to listen to What MattinShanghai said. He is 100% correct.

    Your argument that FRB does not create money comes down to the fact the you do not believe that the IOU's that banks issue are money because no-one believes they are money. This would be a position that I would agree with, if it were true but is not and demonstrably so in a conclusive and unambiguos fashion:

    Where do you suppose the banks record these IOU's on their balance sheet? They would have to be under liabilities right? Because the banks are saying they owe someone something. Take a look at this balance sheet for HBOS (old but it does the job):

    What do you see under liabilities?

    Deposits by customers are one of the biggest items. These deposits are IOU's from the bank. The figures on your bank statements are IOU's. Do most people think of the figures on their bank statements as IOU's?

    Of course they do. Ergo these IOU's are money. Everyone believes and treats them as money because they are what make up their bank account balances!!

    They can be created by the banks, not at will, but with a co-operating borrower. The commercial banking sector inflates the money supply of the UK through it's own devices. The BoE only controls this indirectly through interest rates.

    If you look again at the HBOS balance sheet you will see in assets 'Cash and balances at central banks'. This is the moderna equivalent of the gold you keep mentioning. This is the stuff that the IOU's are claims on.

    Please, please can you incorporate this into your understanding. I am pretty sure it will not change any of your major conclusions, I believe it just further informs them.

    I only wish I could follow this blog more regularly as it is of an exceptional quality.

  26. correction to my post above:

    "The figures on your bank statements are IOU's. Do most people think of the figures on their bank statements as IOU's?"

    This should have been:

    "The figures on your bank statements are IOU's. Do most people think of the figures on their bank statements as money?"

  27. Since it is indisputable that commercial banks create bank deposits via lending, the argument that commercial banks don't create money rests on the argument that bank deposits are not considered to be money.

    In a fiat world, where commercial bank IOUs are (partially) backed by ethereal "reserves", which are nothing more than an electronically created IOU of the central bank, one has to ask the question: why consider the IOUs of a commercial bank to be any less a form of "money" than the IOUs of a central bank? Simply because a central bank is less liable to default on its obligations than a commercial bank?

    Bank "reserves", the fiat equivalent to old-fashioned gold-backing, although convertible into cash, are not used by the public to settle accounts, they are used by the commercial banks for this purpose. The general public settles accounts with one another with commercial bank credit, or cash. The vast majority of transactions among the general public occur using transfers of commercial bank IOUs, people are paid with these IOUs, and I can't help noticing that even those people standing in lines to withdraw their money from Northern Rock had happily accepted their income in this form for quite some time before their nerves got the better of them. And the reason they stood in line was not because they suddenly became enlightened about the fact that their deposits were only partially backed by central bank credit, but rather because they were concerned that the downfall of the bank would lead to an evaporation of all of the banks liabilities to them. In other words, they were concerned about bank solvency, not the inherent illiquidity extant under a fractional reserve system.

    Even cash is simply an IOU of the central bank, and if you hand it over for redemption at the central bank, you will obtain nothing more than a replacement note in return.

    There is no "hard money" in a fiat world. All is credit, whether created by the central bank, or by commercial banks.

  28. Mark,

    Sorry to flog a dead horse, but I noticed, after reading your latest post, that this thread seems to be still active, and wanted to answer some questions posed to me by jonpaul.

    I think one of the problems that people have with the concept "money as debt" is that they think of debt as an interest bearing, money loan. Now, while money loans are a form of debt, and in some cases may lead to the "creation" of money (as in the example you gave of personal IOUs), they are just a special, and not very interesting case. Since a money loan is in essence "second-order" debt, i.e. debt on debt (with interest thrown in), it is not a good vehicle for understanding the basic idea of "money", it just muddies the waters...

    A debt is an obligation. If I promise to mow your lawn in return for fixing my computer, I have incurred a debt, which is outstanding until I actually get around to mowing your lawn. The debt has "value"; in this case the labour I have pledged to expend. I may default on this debt (by e.g. dying) or I may annul the debt by mowing your lawn. There is no interest and no cash or gold coins involved in any of this.

    How does this relate to a more realistic scenario, and how does debt (in the sense of "obligation") become money?

    Let's say Alice wants to buy a house and Bob who has just inherited one from his grandma, wants to sell it for 100k to buy himself a Ferrari (second hand). Unfortunately, Alice does not have 100k, but she has a job and is willing to give up half her earnings for the next 15 years to own the house. This is not good enough for Bob, because the Ferrari dealer will not exchange the car for Alice's 15-year labour. We have a deal-breaker.

    Enter the banker. He says to Alice, in effect, "I will give you your 15-year half-earnings, up front, in return for your commitment to pay us half your income for the next 30 years". This is a good deal for Alice, since she needs a place to live, and the monthly costs are similar to what she would have to pay for rent (courtesy of the way the system has been set up in the UK). It is a good deal for the bank, since it secures a long term income stream, guaranteed by the physical asset of the house itself. So the mortgage is signed. But the banker does not go down to the vault to fetch a palette of 50 pound notes, put there by "depositors", to give to Bob. No. He says to Bob: "Here's an IOU for 100k. Spend it as you like and put it on our tab!".

    Why would Bob accept such an arrangement? He doesn't have to. He can say "I want my palette of 50 pound notes", and in this (highly unusual case) the bank would be good for it, after all, 100k is small change to a bank. It **would** put him on terrorist watch lists (have you ever tried to rent a car or an apartment for cash?), and on arriving at his dealer's with a forklift-truck worth of notes, the latter would probably lock himself in a safe room to call the police. So of course he will accept the IOU. (I'm exaggerating with the fork lift truck - a suitcase would probably do)

    So, let's recap. The 100k IOU has been created by the bank for Bob to spend in his Ferrari. Where did the money come from? Has the bank just "printed" it out of thin air? Not really. Alice has pledged her income to the bank, and her "debt" is guaranteed by the property that Bob sold to her plus the legal/enforcement framework of the state. The bank has taken its cut for all its trouble from Alice (an extra 15 years of debt peonage). In the long term, the bank is good for its IOU (it will extract enough "value" from Alice's labour to cover the cost of the house, and then some..) But the "current" increase in the money supply is due entirely to Alice's debt. Debt has become money.

    To answer jonpaul's question - the 100k for the house was **not** taken out of the money paid in by the depositors, so the money has not just been "moved around". It was created when Alice signed the mortgage (mortgages are listed in the "asset" column in bank balance sheets). In fact, in theory, a bank does not need depositors to "create" money - it just needs borrowers (the depositors are just a distraction). Banks convert illiquid long-term debt into liquid short-term debt, and take their cut of the action. That is, if they are not too greedy...

    This is, of course, a highly simplified model, but it captures the essence of what is (or should be) going on in an ideal world. Reality is more complex. The model does not explore what happens if the bank "securitizes" Alice's debt into collateral for bonds issued by an off-the-books SPE then sold on to a hedge fund, which leverages it up 20 times and then uses it to speculate on the the yen etc. etc. But that's a different story.

  29. I am trying to create a web site that exposes money for what it is and keeps things as simple as possible and that *avoids* masking the truth by avoiding economics speak.

    I continue this quest whilst all the time reforming what I have written as I find *real* information.

    My latest opinion that all money should be regarded as a debt to be repaid with interest. But beware that the "interest" can be recovered by the banking system in a number of ways.

    What concerns me aslo recently is the the Federal Reserve is a collection of private banks and I am coming more and more to the conclusion that every time that money is created by the government that they must go to the banks and to do so and subsequently pay interest.

    Thus the debts are impossible to repay, debt upon debt, you see.

    The federal Reserve is against the American constitution. Look here

    In the UK (debt upon debt)

    My website refers to the banking systems generally and is not specific to the USA.

  30. I simply do not get what the issue is with fractional reserve banking. Is banking with no reserves somehow better? Its certainly more risky.

    And banking with 100% reserves is simply burying things in the ground, so that can't be a viable way to make your money work for you when you're not using it. The risk, of course, is non-existent unless someone digs up your hole (banks aren't going to store it for free).

    I don't see how FRB somehow creates money, when actually a percentage of it has to lay around to cover risk. The rest is loaned out but where is there anything created?

    The printing done by the Fed is the source of inflation, not this FRB red herring.


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