Saturday, Mar 13, 2010
Money machine
Greg Pytel: Money creation and circulation in the economy
A bit longish and technical but worth reading if you want to understand how money is created and circulated in the economy, what is the role of the banks, etc. The graph there is particularly neat showing how the “money machine” works.
Posted by ant @ 10:54 AM (1246 views) Add Comment
34 Comments
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1. icarus said...
Pytel seems to believe that you start with deposits and lend them on. There are those who think that loans create deposits (money loaned out creates economic activity and money comes back to the bank as deposits) and not vice versa.
This is from a discussion of QE at http://bilbo.economicoutlook.net/blog/?p=661
The aim (of QE) is to increase liquidity in the credit markets and encourage banks to increase lending to companies.
Does quantitative easing work? The mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment.
It is based on the erroneous belief that the banks need reserves before they can lend and that quantititative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.
But this is a completely incorrect depiction of how banks operate. Bank lending is not “reserve constrained”. Banks lend to any creditworthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).
The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.
2. ant said...
@icerus: you wrote:
"Pytel seems to believe that you start with deposits and lend them on. There are those who think that loans create deposits (money loaned out creates economic activity and money comes back to the bank as deposits) and not vice versa."
My take is that Pytel's explanation is compatible with both views. In his explanation it does not matter at all: sort of "chicken and egg" question. So depending what your views are on that you can apply Pytel's model accordingly.
3. Jim Green said...
Banks don't lend money deposited by savers. They create it out of thin air with accounting book entries when they make a loan.
4. icarus said...
This isn't a 'chicken-and-egg' question. If you have a chicken you'll get an egg and vice versa. The author I quoted says that if you have creditworthy customers you'll get banks making loans irrespective of reserves/deposits but if you have reserves or deposits in those banks you won't necessarily see loans being made. He claims that QE is ineffective for this reason.
Quotes from this article by Pytel and his 'Largest heist in history' article on the site make it clear that he sees loans as resulting from deposits and thinks that too high a loan-to-deposit ratio is a scam and a danger. Quotes from the posted article: "by accepting Deposits and Lending them out, money is circulated in the economy" Or "Credit Creation....is a result of lending deposits out". Or "Banks provide Deposits back to the market (to depositors: Deposits paid out) or give loans (to creditors: Loans given), which is Credit Creation".
I
Quotes from 'Largest heist in history' - "In the deposit creation process a bank accepts deposits and lends them out. But almost every lending returns soon to the bank as a deposit and is lent again." "Fundamental to this deposit creation principle is the percentage of deposits that a bank lends out."
The financial crisis had little to do with deposits. Wall Street found that the recycling of deposits (which were pretty small) or credit creation by commercial banks were both inadequate for its proprietary trading purposes and it turned to the wholesale markets - the inter-bank and commercial paper markets - which over the previous decade or two had been transformed from having little but simple short-term lending and clearing functions to being fund providers (from pension and other institutional money) for large speculative trading activity. The problem started here, not in the loan-deposit ratio of commercial banks.
5. taffee said...
lets go back to why banks existed in the first place.......they got deposits and lent money at a higher rate than they paid out...the rest is the bulls**t casino banking we have now
building societies used to lend most mortgages with banks only a handfull,so they should be doing great business..apart from the fact they've been seduced by the money market to go against tried and tested plan of lend what you have
6. ant said...
@icarus: none of the quotes you cited shows that "Pytel seems to believe that you START with deposits and lend them on." You may well start vice versa. Makes no difference to my understanding of Pytel's analysis
7. ant said...
@icarus: please note that the wholesale markets - the inter-bank and commercial paper markets is a part of Credit Creation process (affected by loan to deposit ratio). So your conclusion is absolutely compatible with Pytel's analysis. You just seem to understand it too narrow.
8. icarus said...
@ ant - I think the quotes do show that. And what IS his analysis? That the loan-deposit ratio is the key to banking and economic progress? Where would he stand, for example, on the idea that banks create most of our money in the process of making loans, or, additionally, on the following:
"Banks create only the principal but not the interest necessary to pay back their loans. Since virtually the entire money supply is created by banks themselves, new money must continually be borrowed into existence just to pay the interest owed to the bankers. A dollar lent at 5 percent interest becomes 2 dollars in 14 years. That means the money supply has to double every 14 years just to cover the interest owed on the money existing at the beginning of this 14 year cycle. The Federal Reserve's own figures confirm that M3 has doubled or more every 14 years since 1959, when the Fed began reporting it. That means that every 14 years, banks siphon off as much money in interest as there was in the entire economy 14 years earlier. This tribute is paid for lending something the banks never actually had to lend, making it perhaps the greatest scam ever perpetrated, since it now affects the entire global economy. The privatization of money is the underlying cause of poverty, economic slavery, underfunded government, and an oligarchical ruling class that thwarts every attempt to shake it loose from the reins of power"
9. ant said...
@icarus: in response I suggest reading:
http://gregpytel.blogspot.com/2010/02/comment-to-largest-heist-in-history.html
http://gregpytel.blogspot.com/2009/09/loan-to-deposit-ratio-and-banks_02.html
http://gregpytel.blogspot.com/2009/08/liquidity-risk.html
In my view you narrow Pytel's analysis to strictly consumers' deposits. He makes it clear that it relates to entire money circulation process. In view of the quote you put I suggest you distinguish between money supply growth related to growth of GDP and inflation AND money multiplier. The difference is significant and that quote puts them both into one bag.
10. icarus said...
ant - So, in your own words, what's the story?
11. estrader said...
I highly recommend this video:
http://video.google.com/videoplay?docid=5352106773770802849&ei=S-CbS_zyKpXL-QaB0-meDQ&q=debt+is+money#
12. tenyearstogetmymoneyback said...
taffee said "building societies used to lend most mortgages with banks only a handful"
The trouble is that model was destroyed by the banks (e.g. Northern Rock) using the wholesale money markets
to provide more freely available and larger mortgages.
Back in the days when all the money leaving a building society had to come in from depositors the chances of getting
more than a 3 x salary mortgage, a second mortgage or a buy to let mortgage were non existant.
Now that the wholesale money markets are closed we might have to go back to that model.
13. ant said...
@icarus: the story is simple: according to Pytel (and I agree with him) if banks keep on lending with loan to deposit ratio above 100% the liquidity shortage is assured in a finite time regardless of other circumstances (unless they cancel exponential growth of the money multiplier, but that would mean that effective loan to deposit ratio is below 100%). This is because a money multiplier cannot grow (especially at exponential pace) without causing a liquidity shortage. If that were possible, it would be possible for one dollar cash to provide liquidity to ever growing (and ultimately infinite at the limit) number of dollars of banks liabilities on their balance sheets.
14. ant said...
@estrader:
it is a nice video. But as much as it is informative it misses the point on the real cause of the current crisis. The banking they talk about is based on fractional reserve banking: a kind of statistical machine that is risky and may fail. The current crisis was caused as the banks started practicing something sinister (and criminal) called depleting reserve banking (which in legal sense it is a pyramid). I recommend reading:
http://gregpytel.blogspot.com/2009/04/largest-heist-in-history.html
http://gregpytel.blogspot.com/2009/10/economic-world-remains-confused.html
Generally the author of this video confuses growth of GDP and inflation with money multiplier. Apart from that quite good.
But please do not take this video as the explanation of the causes and mechanics of the crisis. This is much, much, simpler: “it is a pyramid, stupid”.
15. icarus said...
ant - As I pointed out @3 the financial crisis had little to do with the loan-deposit ratio of commercial banks. The investment banks at the centre of the storm used pension and other institutional funding via the wholesale money markets in order to make their bets in the rigged casino where they dealt themselves aces, The other big source was the 'shadow lending' market (investors buying securitised products, thereby freeing up banks to loan or invest yet more), which was huge. Depositors' funds were small beer by comparison and were of only moderate significance to the Wall Street spivs. Basing any explanation on the loan-deposit ratio is wide of the mark unless you recast everything in the loan-deposit mold, i.e. explain where securitisation and wholesale money-market funds, as well as OTC derivatives, fit into the loan-deposit ratio paradigm. Otherwise the Mr Micawber type idea "loan-to deposit ratio <100% = happiness, loan-to-deposit ratio >100% = disaster" is too simplistic.
16. ant said...
@icarus: you clearly do not understand how lending with loan to deposit ratio above 100% works (as what you wrote implies that money multiplier can be as arbitrary high as you can think of and the system would not suffer from liquidity shortage. Securatisation, wholesale, OTC's products, shadow banking clearly and obviously fit into Pytel's loan to deposit model of depleting reserve banking. You do not have to recast anything: it is all there. Basically you only provided justification of Pytel's model correctness.
Finally: "loan-to deposit ratio <100% = risky way to not guaranteed happiness with possible disasters on the way, loan-to-deposit ratio >100% = disaster" (and the latter is the key to explaining on the causes of the current crisis).
17. icarus said...
I'm implying that "money multiplier can be as arbitrary (arbitrarily?) high as you can think of and the system would not suffer". Where did I imply that? Pytel did not fit securitisation, wholesale money markets, derivatives etc. into his system. Why did he refer only to the loan-deposit ratio without explaining how these other quantities fitted in to his schema? These are, after all, very big numbers. Do they all count simply as "deposits"? I'm saying it's too simplistic to explain everything in terms of a single ratio. Why didn't he take into account, e.g., banks' capital requirements, risk weighting of different kinds of loans, maturity of loans or the spread between IRs on loans and those on deposits? And why does he give the example of loaned money coming back to the bank as a deposit "twice a week" - where did that figure come from?
18. ant said...
@icarus: it seems that you have not read his blog in detail. All your questions are answered there you do not bring anything new that was not discussed in his articles. I will sit down and prepare a reference list to relevant articles that address it all. In essence all the monies coming into a bank, apart from disbursements, are treated as deposits. A bank investing its own cash into any financial instrument has to account for its cash spent for this purpose as a loan to itself (with an appropriate loan to deposit ratio). Really, it is all on Pytel's blog but it is so intuitive that it goes without saying. I.e. whenever cash is passed (circulated) with an element of the risk of not being called back immediately, the prevision has to be made for a risk of losing it and for probability of a demand for repayment. As to risk weighing just refer to:
http://gregpytel.blogspot.com/2009/04/exampleexercise-how-does-it-work.html
PS. Your disagreement with Pytel implies that money multiplier can be as arbitrary high as you can think of and the system would not suffer from liquidity shortage. Pytel's explanation of the current financial crisis is that the money multiplier cannot be as arbitrary high as you can think of as the system would suffer from liquidity shortage. (It is trivial to prove mathematically that if loan to deposit ratio is above 100% then money multiplier grows exponentially to infinity, i.e. it can be arbitrary high in a finite time.) The rest is a side discussion to Pytel's model.
19. ant said...
@icarus: Pytel's explanation how deposit - loan cycle relates to wholesale money market is here:
http://gregpytel.blogspot.com/2009/08/liquidity-risk.html
20. ant said...
@icarus: Pytel's explanation how deposit - loan cycle relates to CDS market is here:
http://gregpytel.blogspot.com/2009/06/credit-default-swaps-cds-financial.html
21. ant said...
@icarus: please read also this:
http://gregpytel.blogspot.com/2009/05/pyramid-model-and-risk-management.html
22. techieman said...
poor icarus... how much does he have to read ant? Its like you suggesting reading the bible to explain why people should be nice to each other.
In effect, the loaning money into existence is all very well as a mechanism of creating money in the system. The point is though very simple 1. that you have to have someone on the other side who wants to borrow the money. 2. that there has to be confidence that that person will pay back the money lent.
However exotic you want to get with derivatives, otc goodies etc, is - at the end of the day - irrelevant (in terms of the fact they exist although clearly the size just focuses the issue more). At some point in that cycle someone has to buy the obligations under CDO / CDS etc, so it just demonstrates confidence in the ability of the other side to honour their obligations. Therefore everyone was assuming risk, on the assumption there was none... i.e. that [virtually] everyone would pay back.
In insurance and reinsurance companies track accumulations of risk, and those that dont do so at their peril. Because of the compexities of the CDOs / CDS etc people were unable to track their stratered accumulations.
It was always going to be the case that this would EVENTUALLY blow up in people's face... but the question was always when? Had this happened when the market was less mature then of course the reaction wouldnt have been so bad.
Of course when it happened then the reaction is to contract the loan book and not make loans to anything that appears marginally "risky", the determination of what is "risky" changes, since its even more important that people pay back their loans. Not only that but the margins have to increase to support the risks involed.
So credit becomes harder to come by and the relative cost of it increases. Clearly thats a spiral as less people either want or can afford tom borrow. In other words thats a deflationary credit liquidation spiral.
All of this stuff has happened before, what i find amusing is that this "macro environment" is never considered by the old BTL gang. Yes some of them get involved at the early stages, and they will do ok. [unless they have geared up - like the Wilsons and Grant]. But they dont even realise this... they look at local conditions and assess the current demand.
Thats a bit like buying individual shares. Aside from , you having to assume the EMH stands (and the price reflects everything known anyway), its very difficult (although not impossible) to make money on going long a share if the market is falling. Of course if push comes to shove you can liquidated your shares with a few clicks of the mouse or a phone call. With property that cant be done.
23. dbc reed said...
You are all missing the point viz.Why are we paying interest on new money which is not loaned off anybody but created
by the banks?
Also why does n't the Gov create the money instead of paying the banks to do it for them ?.Quantitative easing shows it can be done without the sky falling in)The Gov could spend the money into circulation (as was originally done by Lincoln to pay for Civil War) and could pay for the public sector without the rigmarole of getting the private sector to use the money supply first then taxing them so the public sector can get money second-hand?
24. ant said...
So maybe I summarise in one sentence how I understand Pytel's pyramid model of the current crisis: Pytel proved mathematically on his blog that if loan to deposit ratio is greater than 100% in deposit-loan cycles then the risk of liquidity shortage is 100% in finite time (i.e. it is practically certain). At the same time Pytel proved that if loan to deposit ratio is greater than 100% in deposit-loan cycles it is technically a financial pyramid mechanism exactly the same as used by Albanian gangesters back 1996 - 1997.
This is it. The rest is a side discussion which, of course, may be important and providing a lot of insights to the working of individual instruments. It is a bit like moving from Newton's laws (which are general) to engineering.
25. techieman said...
dbc read - the answer to your question is:
History :-).
26. techieman said...
ant "in finite time (i.e. it is practically certain)"... yes, i have not read this but common sense tells you this anyway, as i said EVENTUALLY.
EVENTUALLY i will die, but there is no certainty as to when [suicide excepting]. So unless the model confirmed WHEN finite time was, then its not very useful. I would be surprised if anyone could do that because of the complexities involved. Someone could guess my age but it would be a range of guesses. If he did this can you give me the link, because that would be worth reading!
So how you determine the when can be based on some interpretations of cycle theory (which may or may not prove to be successful), or other indications - but does the timing of that allow you to profit from it, or is it too loose to enable you to do that? By profit i actually mean by mitigating loss too.
27. ant said...
@icarus: techieman, I agree with you. In Pytel's model "finite time" is a very short time (if it helps :-) as the process has exponential pace. And incidentally as much as you are correct in your comment, it has been accepted for some time that pyramids are illegal. Pytel basically shows a scientific basis for making financial pyramids illegal and also shows that the current financial system was turned into a financial pyramid. (Your parallel is quite good: we do not know when a pyramid scheme is going to collapse, but the experience teaches us that it is a matter of a very short time. They are unsustianable: that's why they are illegal.)
28. icarus said...
The root of the financial crisis was in the push by investment banks to increase leverage and balance-sheet expansion. This push was driven by the banks' aims of attaining a critical level of market/pricing power in their trading activities. This aim was achieved by a series of mechanisms. e.g. driving up asset prices enabled balance sheet expansion with no increase in leverage (Assets:100-worth of securities. Liabilities:10-worth of equity, 90-worth of debt). If the securities become worth 101 (and equity thereby becomes 11) the bank can, with no leverage increase, take on 9 worth more debt and buy 9 worth more securities, resulting in 110 worth of securities, 11 equity and 99 debt. (Of course if the value of the securities then fell by 1 you'd have, respectively, 109, 10, 99 and leverage would go up (109/10 = 10.9 instead of the previous 10). Let's get back to an increase in the value of securities; the bank borrows the 9 worth of debt typically in the repo market, a form of borrowing that works fine as long as security prices keep rising - self-reinforcing incentives to create bubbles with the previously-mentioned pricing power.
Increased leverage was achieved largely through the shadow banking system, consisting of institutional agents ("banks without regulation or capital") and practices and instruments (e.g. otc CDSs expanded leverage through obviating the requirement for banks to insure their credit operations with appropriate collateral - the shadowy CDSs didn't require the commitment of appropriate tranches of collateral). In short banks expanded their balance sheets without corresponding equty expansion.
It's this kind of analysis - investment banks deliberately blowing asset bubbles with other people's money and profiting hugely by doing so, knowing that the whole thing is a bubble and therefore unsustainable - that gets us much closer to the action than a simple "loan-deposit ratio over 100% = eventual disaster" (mechanisms and time-frame unspecified). Even if all of the above were reducible to "loan-deposit ratio over 100%" what would be the point of doing so? We can trace what went on without this. BTW - If £1 real money ends up servicing £ X trillions of potential demands within a year why didn't the thing explode after a month? What determines the timing, what triggers the explosion?
29. ant said...
@icarus: to be honest, I do not think you disagree with Pytel. It seems to that your understanding of the crisis is very descriptive and non-technical. Pytel simply puts this into technical form. (This debate looks similar to a historian discussing with an engineer why a bridge collapsed: Both may be right but they speak in different "languages".)
Your question: "What determines the timing, what triggers the explosion?" is a really good one. The answer is by example: if you start riding a motorbike with high acceleration and unlimited possible speed (which is parallel to unlimited growth of money multiplier when you lend with loan to deposit ratio is greater than 100%), I cannot tell you whether you will end up in accident at 100mph, 200mph, 500mph, 1000mph and so on. But I am really certain you will not reach 1000mph (i.e. you will not be able to handle a bike at such a speed). But whether it would be 568mph or 945mph (or anything else) I do not know. And I cannot even tell you what the direct cause of your accident would be: an oil patch on the tarmac, uneven surface, a tiny stone that hits your glasses, or a tiny stone on the tarmac (or whatever else). For very similar reasons we cannot say when exactly a financial pyramid is going to collapse and what would directly triggers its collapse. But we have known for years that it will soon and spectacularly. This is why financial pyramids are illegal.
30. ant said...
@icarus: the significant of Pytel's analysis is not limited to conclusion "loan-deposit ratio over 100% = eventual disaster" as his conclusions have serious implications. He actually proved, on a forensic level, that the financial system was turned into a giant pyramid scheme, therefore a serious crimes were committed. It follows that all those responsible for the financial system should face long jail sentences and confiscation of their possessions.
This is the main reason why Pytel's analysis is important as it shows clear grounds for the justice system to get actively involved.
31. icarus said...
The account I gave @27 is potentially very technical but I tried to keep it at blog level (e.g. didn't go into how repo borrowing works). Pytel's account misses the mechanisms (mine would e.g go into the bursting of bubbles and how the leverage unwound). For reasons @27 I think that if Pytel doesn't give an historical account in which he shows how his ratio works out at these levels and thro' these actors and institutions then it's not much use. I never had much time for the idea of a simple equation at the centre of history slowly ticking away and leading to an end game.
@28 - my kind of account, fully worked out, would be more likely to land people in the nick than Pytel's.
32. ant said...
@icarus: Pytel's model is not primarily historical (you are right on that) but technical (and legal). It shows that lending with loan to deposit ratio greater than 100% is bound to blow up the financial system and, above all, is illegal. I can clearly see your arguments as a part of Pytel's model. If you study this graph, it should be clear: http://2.bp.blogspot.com/_LqJ8roNddzQ/S5taPsLeYpI/AAAAAAAAADY/aZi7VfgjysY/s1600-h/Circulation_graph.jpg
Could you please indicate what legal basis your account of the financial crisis implies that would land people in the nick? (In Pytel's case it is a pyramid scheme argument.)
33. icarus said...
What will land people in the nick is getting away from the core argument, but I'll just say that Pytel's account is too divorced from a 'history' of who did what, where, when and how. For a problem to occur it has to be at a global level - one or two commercial banks overlending won't cause a huge ripple (and he's end up just nicking the CEOs of those banks), and if you're applying his ratio to global lending, global wholesale money markets and global securities investors, with ratings agencies and others deeply involved, then there's a problem of coming down to earth and fingering and pinching individuals.
And I'd go easy on calling his stuff 'technical' (or on distinguishing between 'historical' and 'technical' - a proper account requires both). He starts with a simple commercial bank lending model, identifies an exponential function and then says 'it's just got to blow up somewhere, somehow but I know not where or how'. The institutions, practices and financial inventions that led to the blow-ups and the bubbles in property etc. have real effects i.e. are more than just resultants of a simple ratio inexorably ticking away. And governments can keep bubbles alive for longer than people think. Then you're into different territory (sovereign default etc.). A simple thing - like looking at the regulations and feedback mechanisms which might limit the overlending and the exponential, absurd rise in which £1 real money theoretically ends up servicing £ trillions of potential demands - is missing in his account.
34. ant said...
@icarus: you still did not make any legal argument why your explanation of the current crisis will land anyone in the nick. Moreover could you explain why pyramid schemes are illegal? (Your questioning of validity of Pytel's model seems to suggest that there is nothing wrong with pyramid schemes.)