Jump to content
House Price Crash Forum
DoctorJ

Money Created From Nowhere Disappears Again Upon Default

Recommended Posts

From what I understand, if money is created by a bank for a loan/mortgage and the borrower defaults then the money disappears from the system. Is this right?

If so, what do the banks care is there is a default or a repo? I always thought that they were concerned about getting their money back but they created the money from nothing in the first place.

Edited by DoctorJ

Share this post


Link to post
Share on other sites
From what I understand, if money is created by a bank for a loan/mortgage and the borrower defaults then the money disappears from the system. Is this right?

If so, what do the banks care is there is a default or a repo? I always thought that they were concerned about getting their money back but they created the money from nothing in the first place.

I have the same question regarding the central banks - why does it matter if the commercial banks default on these short tem loans? If the central banks control the printing press then what do they 'lose' here? They can just create more money at will.

In the same vein with the Fed buying up 'toxic waste' what does it matter if the money is never recovered? Apologies if these are simple questions.

Share this post


Link to post
Share on other sites
I have the same question regarding the central banks - why does it matter if the commercial banks default on these short tem loans? If the central banks control the printing press then what do they 'lose' here? They can just create more money at will.

In the same vein with the Fed buying up 'toxic waste' what does it matter if the money is never recovered? Apologies if these are simple questions.

exactly. Although I just read in an article about Northern Rock etc that they have to borrow money to loan out

http://www.ft.com/cms/s/3b440332-4ccb-11dc...00779fd2ac.html

Banks are finding it more difficult to borrow money to fund mortgage business, particularly at the more risky end of the market where subprime mortgages are often packaged up and sold on to investors.

Glad I've got some takers on this thread because this has been troubling me since I learned how banks create money for loans

Edited by DoctorJ

Share this post


Link to post
Share on other sites
From what I understand, if money is created by a bank for a loan/mortgage and the borrower defaults then the money disappears from the system. Is this right?

If so, what do the banks care is there is a default or a repo? I always thought that they were concerned about getting their money back but they created the money from nothing in the first place.

Goods price deflation?

Share this post


Link to post
Share on other sites
Goods price deflation?

Perhaps.

Also if you watch the 'money as debt' vid it says that the Fractional reserve system requires defaulters to continue - not sure how that works or how it fits into the grand scheme of things

money as debt

Share this post


Link to post
Share on other sites
From what I understand, if money is created by a bank for a loan/mortgage and the borrower defaults then the money disappears from the system. Is this right?

If so, what do the banks care is there is a default or a repo? I always thought that they were concerned about getting their money back but they created the money from nothing in the first place.

I think that when the bank lends someone money for a house then the money goes into circulation. So if Mr. A borrows £100,000 for a house they then give that money to Mr. B (who previously owned the house), who then puts the money into his account, where it is available for him to use - so it is not destroyed. The bank, however gets payments for the money it lent to Mr. A. When the bank gets each payment it destroys the money it created from nothing and keeps the interest. So if Mr. A. defaults then the money is never destroyed as the bank never get their payents but Mr. B still has his £100,000 in his bank. Therefore the bank still has an outstanding debt of £100,000 (essentially to Mr. B ) and needs to repay it somehow. Please correct me if I am wrong.

Edited by Death on a hobby horse

Share this post


Link to post
Share on other sites
Glad I've got some takers on this thread because this has been troubling me since I learned how banks create money for loans

Default is the very worst thing that can happen to a lender.

When the bank "creates" the money, they balance the books by setting the loan out against the debt which has been created. This debt is the promise by the borrower to repay. When the loan is repayed, the money (the debt and the loan) vanishes, except for the interest that has been paid. In the event of default, the debt vanishes, but the loan is still outstanding on the lenders books. This money then has to be found. A small level of default is planned for by the lender, and paid out of profits. A large number of defaults would result in sales of assets, attempts to hide the extent of defaults, a suspicion that others were doing the same, an unwillingness to loan to other institutions, a credit crunch, a temporary bail out by central banks and possible eventual collapse of the institution. Ring any bells?

A very large number of defaults would result in systemic failure. It is the fact that the number of defaults is not known that is leading to all the panic and rumour mongering.

Edited by Timm

Share this post


Link to post
Share on other sites
I have the same question regarding the central banks - why does it matter if the commercial banks default on these short tem loans? If the central banks control the printing press then what do they 'lose' here? They can just create more money at will.

In the same vein with the Fed buying up 'toxic waste' what does it matter if the money is never recovered? Apologies if these are simple questions.

As I understand it most of the central banks "target inflation".

Edited by Ash4781

Share this post


Link to post
Share on other sites
From what I understand, if money is created by a bank for a loan/mortgage and the borrower defaults then the money disappears from the system. Is this right?

No, if the customer defaults, the money is still out there in the economy. The bank is not able to cancel the "demand deposits" which it issued. The bank still has theoretically an obligation to the central bank from whom it "borrowed" (created out of thin air) the money. The thing is, this obligation doesn't mean very much to the bank because it will never have to pay the money to the central bank...

If so, what do the banks care is there is a default or a repo? I always thought that they were concerned about getting their money back but they created the money from nothing in the first place.

The banks don't care. Most banks would not be able to pay back anything close to what the have "borrowed" from the central banks. Occasionally some banks get a conscience about it and declare themselves bankrupt (see here)

I have the same question regarding the central banks - why does it matter if the commercial banks default on these short tem loans? If the central banks control the printing press then what do they 'lose' here? They can just create more money at will.

In the same vein with the Fed buying up 'toxic waste' what does it matter if the money is never recovered? Apologies if these are simple questions.

http://en.wikipedia.org/wiki/Moral_hazard

"A moral hazard arises if lending institutions believe that they can make risky loans that will pay handsomely if the investment turns out well but they will not have to fully pay for losses if the investment turns out badly. Taxpayers, depositors, other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions"

I think that when the bank lends someone money for a house then the money goes into circulation. So if Mr. A borrows £100,000 for a house they then give that money to Mr. B (who previously owned the house), who then puts the money into his account, where it is available for him to use - so it is not destroyed. The bank, however gets payments for the money it lent to Mr. A. When the bank gets each payment it destroys the money it created from nothing and keeps the interest. So if Mr. A. defaults then the money is never destroyed as the bank never get their payents but Mr. B still has his £100,000 in his bank.

yes

Therefore the bank still has an outstanding debt of £100,000 (essentially to Mr. B ) and needs to repay it somehow. Please correct me if I am wrong.

Why do you say to Mr. B? The loan is ostensibly to the Bank of England. But these loans never need to get paid back! They just sit on the books forever.

Default is the very worst thing that can happen to a lender.

unless the bank uses fractional reserve banking

When the bank "creates" the money, they balance the books by setting the loan out against the debt which has been created. This debt is the promise by the borrower to repay. When the loan is repayed, the money (the debt and the loan) vanishes, except for the interest that has been paid. In the event of default, the debt vanishes, but the loan is still outstanding on the lenders books. This money then has to be found. A small level of default is planned for by the lender, and paid out of profits. A large number of defaults would result in sales of assets, attempts to hide the extent of defaults, a suspicion that others were doing the same, an unwillingness to loan to other institutions, a credit crunch, a temporary bail out by central banks and possible eventual collapse of the institution. Ring any bells?

A very large number of defaults would result in systemic failure. It is the fact that the number of defaults is not known that is leading to all the panic and rumour mongering.

"This money then has to be found" the money doesn't have to be found because the bank can simply leave the loan on the books and do nothing about it. It does not restrict further lending because the reserve requirements are voluntary "The reserves scheme is voluntary...". The bank just keeps on lending and the reserve ratio is reduced. Today the reserve ratio across the UK banking system is just 3%.

Share this post


Link to post
Share on other sites

I'm glad someone has brought this up!

I would have done but I didn't want to appear stupid. (I know - it's never stopped me before!)

Thing is, I've never quite got to grips with this 'money created as debt' business. Can't get my head around it.

Why does Northern Rock borrow money on the wholesale market if it could just pluck it out of thin air?

Answers on a postcard please.

Share this post


Link to post
Share on other sites
From what I understand, if money is created by a bank for a loan/mortgage and the borrower defaults then the money disappears from the system. Is this right?

If so, what do the banks care is there is a default or a repo? I always thought that they were concerned about getting their money back but they created the money from nothing in the first place.

Well, while that "money" exists before disappearing back into the quantum financial vacumn, the person who borrowed that money is essentially spending some of their time working for the bank.

If the person defaults and declares bankruptcy, then the bank has lost a slave ^H^H^H^H^H borrower...

Share this post


Link to post
Share on other sites
From what I understand, if money is created by a bank for a loan/mortgage and the borrower defaults then the money disappears from the system. Is this right?

If so, what do the banks care is there is a default or a repo? I always thought that they were concerned about getting their money back but they created the money from nothing in the first place.

Defaulted loans are inflationary, if the money borrowed is spent into the economy and never repaid. If debts don't get repaid the books don't balance but banks expect defaults. Pricing risk etc.

Share this post


Link to post
Share on other sites
I'm glad someone has brought this up!

I would have done but I didn't want to appear stupid. (I know - it's never stopped me before!)

Thing is, I've never quite got to grips with this 'money created as debt' business. Can't get my head around it.

Why does Northern Rock borrow money on the wholesale market if it could just pluck it out of thin air?

Answers on a postcard please.

It is a riddle wrapped in a mystery inside an enigma

Share this post


Link to post
Share on other sites
"This money then has to be found" the money doesn't have to be found because the bank can simply leave the loan on the books and do nothing about it.

It's magic!

While they're at it bankers should put their salaries and bonuses in the magic bad debt book too.

Never has to be paid. I'm sure the shareholders won't mind.

Magic!

:rolleyes:

Share this post


Link to post
Share on other sites
I'm glad someone has brought this up!

I would have done but I didn't want to appear stupid. (I know - it's never stopped me before!)

Thing is, I've never quite got to grips with this 'money created as debt' business. Can't get my head around it.

Why does Northern Rock borrow money on the wholesale market if it could just pluck it out of thin air?

Answers on a postcard please.

Money is created out of thin air, although the banks have created a system to make it look more valid than it really is whilst adding a level of complexity that will stop the average Joe from asking any questions. :blink:

Share this post


Link to post
Share on other sites
Why does Northern Rock borrow money on the wholesale market if it could just pluck it out of thin air?

Answers on a postcard please.

I think, it can only create a certain amount of plucked out of air money, depending on the reserve ratio of how much deposits it has. If it also borrows wholesale money and lends that, then it doesn't affect the reserve, so it can offer a lot more loans, in effect just making a margin on them.

In terms of repossessions, in the case of lending out if thin air, after the house is sold and offset part of the debt, the bank has no liability to another party and would show the loss in it's accounts (or hide it). But, when it's borrowed off the money market it still has the liability to repay, plus it has to show the loss.

So borrowing money wholesale is riskier to the liquidity of the bank if it goes wrong (which it is).

Share this post


Link to post
Share on other sites

Quote from the Austrian which blows away my snug little world:

Therefore the bank still has an outstanding debt of £100,000 (essentially to Mr. B ) and needs to repay it somehow. Please correct me if I am wrong.

Why do you say to Mr. B? The loan is ostensibly to the Bank of England. But these loans never need to get paid back! They just sit on the books forever.

Default is the very worst thing that can happen to a lender.

unless the bank uses fractional reserve banking

When the bank "creates" the money, they balance the books by setting the loan out against the debt which has been created. This debt is the promise by the borrower to repay. When the loan is repayed, the money (the debt and the loan) vanishes, except for the interest that has been paid. In the event of default, the debt vanishes, but the loan is still outstanding on the lenders books. This money then has to be found. A small level of default is planned for by the lender, and paid out of profits. A large number of defaults would result in sales of assets, attempts to hide the extent of defaults, a suspicion that others were doing the same, an unwillingness to loan to other institutions, a credit crunch, a temporary bail out by central banks and possible eventual collapse of the institution. Ring any bells?

A very large number of defaults would result in systemic failure. It is the fact that the number of defaults is not known that is leading to all the panic and rumour mongering.

"This money then has to be found" the money doesn't have to be found because the bank can simply leave the loan on the books and do nothing about it. It does not restrict further lending because the reserve requirements are voluntary "The reserves scheme is voluntary...". The bank just keeps on lending and the reserve ratio is reduced. Today the reserve ratio across the UK banking system is just 3%.

You know, I really thought I understood fractional reserve banking. But I always thought its essential validity rested on the basis that the debt was balanced against the loan, thus meaning that the money, rather than being "plucked from the air", was in fact borrowed from the future earnings of the borrower. What the Austrian is saying - that in default the debt becomes a de facto voluntary obligation to the lender - would destroy this cosy assumption.

He seems to know what he is talking about, and I have no reason to disbelieve, but does anyone have any further evidence to back up these assertions?

Share this post


Link to post
Share on other sites
Why do you say to Mr. B? The loan is ostensibly to the Bank of England. But these loans never need to get paid back! They just sit on the books forever.

I said Mr. B because he has the £100,000 that was created by the bank from their fractional reserves.

Are you saying that the debt is between the bank and the BOE who 'created' the money from nothing and loaned it to the bank so they could lend it to Mr. A? I though the bank would use there reserves and the fractional reserve banking system to create the money and the BOE would never come into the picture unless the bank needed to borrow money as they had no reserves left.

If I am wrong, can you explain why the loan never needs to be repaid? If a bank does borrow money from the BOE, I assume it is backed with some form of interest re-payment or asset and therefore it is in the best interests of the bank to pay off the debt to the BOE.

Edited by Death on a hobby horse

Share this post


Link to post
Share on other sites
I think, it can only create a certain amount of plucked out of air money, depending on the reserve ratio of how much deposits it has. If it also borrows wholesale money and lends that, then it doesn't affect the reserve, so it can offer a lot more loans, in effect just making a margin on them.

In terms of repossessions, in the case of lending out if thin air, after the house is sold and offset part of the debt, the bank has no liability to another party and would show the loss in it's accounts (or hide it). But, when it's borrowed off the money market it still has the liability to repay, plus it has to show the loss.

So borrowing money wholesale is riskier to the liquidity of the bank if it goes wrong (which it is).

this is incorrect. a bank cannot create any money out of thin air. banks must loan money from somewhere in order to loan it to you. banks are just an intermediary between the capital markets and the public, or between the public and the public. they just recirculate and match money from those who have excess cash to those that need to borrow it.

new money can only be injected/created by the BOE.

the reason why banks must pay back loans to the boe is that the books must always balance. losses must come out of the commercial banks profits and if they cant pay it back then the bank is bankrupt.

for those that say that if commercial banks default to the boe then the money is still in the system - yes it is, but this doesnt really matter. the boe can increase/cut money supply at will anyway so it makes no difference. money has no meaning to the boe, its purpose is to create an equilibrium between supply and demand of money,if it really wanted to, it could inject an extra £100billion tomorrow into the bank system.

Share this post


Link to post
Share on other sites
this is incorrect. a bank cannot create any money out of thin air. banks must loan money from somewhere in order to loan it to you. banks are just an intermediary between the capital markets and the public, or between the public and the public. they just recirculate and match money from those who have excess cash to those that need to borrow it.

new money can only be injected/created by the BOE.

the reason why banks must pay back loans to the boe is that the books must always balance. losses must come out of the commercial banks profits and if they cant pay it back then the bank is bankrupt.

for those that say that if commercial banks default to the boe then the money is still in the system - yes it is, but this doesnt really matter. the boe can increase/cut money supply at will anyway so it makes no difference. money has no meaning to the boe, its purpose is to create an equilibrium between supply and demand of money,if it really wanted to, it could inject an extra £100billion tomorrow into the bank system.

So how does fractional reserve banking fit in to this if only the Central Bank are allowed to create money?

Share this post


Link to post
Share on other sites
I though the bank would use there reserves and the fractional reserve banking system to create the money and the BOE would never come into the picture unless the bank needed to borrow money as they had no reserves left.

It is kind of complicated because the bank can borrow in the "fractional reserves" sense but it can also borrow more reserves if needed.

This is how (I think) it works:

The bank has reserves. Let's say the bank has £10 in reserves. It can now lend fractional money. To do this it "borrows" from the BofEng. This money is written into the balance sheet of the bank. The BofEng are involved because the money has been borrowed from them but in a sense they are not involved because it is automatic that the bank will be able to get these funds. The central bank are not informed or consulted, it just happens.

It has been created out of thin air in the sense that the money supply has just gone up. When this debt gets repaid the money supply will return to what it was before.

Let's say the bank lends £50 based on the £10 reserves. The reserve ratio is now 16.7%. If the bank wants to lend more money but does not want to reduce the reserve ratio, it can borrow more reserves. This is called a repo with the BofEng (repo because the reserves must eventually be repurchased by the central bank).

So imagine the bank borrows £10 extra reserves, it can now lend another £50 and the reserve ratio will not fall below 16.7%.

If a bank does borrow money from the BOE, I assume it is backed with some form of interest re-payment or asset and therefore it is in the best interests of the bank to pay off the debt to the BOE.

The loan (fractional money) is not secured by any asset of the bank and it is interest-free so there is no incentive for the bank to pay back the BofEng.

Share this post


Link to post
Share on other sites
From what I understand, if money is created by a bank for a loan/mortgage and the borrower defaults then the money disappears from the system. Is this right?

If so, what do the banks care is there is a default or a repo? I always thought that they were concerned about getting their money back but they created the money from nothing in the first place.

The confusion is when you assume the bank creates the money. Money may be printed by the central bank (ie cash) but is is not destroyed because is exists as a unit. Credit can be destroyed by default, today though most people call credit money or even cash. So when the bank recieves a depositors money it credits his account. The bank then lends out most of the money in return for credit from who they lend it to (mortgage, CC debt.). If that debt is defaulted on the bank looses out, if the value of defaults is larger than can be made up by charging interest on the debts then the bank and its depositors are in trouble.

Share this post


Link to post
Share on other sites
So how does fractional reserve banking fit in to this if only the Central Bank are allowed to create money?

If £100 is deposited at a bank, the bank keeps £10 in reserve (in this example) and lends out the other £90.

Share this post


Link to post
Share on other sites

Alright guys, let me put an end to this mystery....

First of all forget fractional banking. Assume infinite multiplier i.e. a bank has zero reserves (e.g. inauguration of the newly formed bank was 9:00 AM today).

The bank has zero reserves. I have house which I inherited 20 years ago from my relative. I have neither any debts nor any outstanding mortgage. I go to the bank to borrow money (let's say 125,000 and my house is worth 250,000) at 11:00 AM. The bank creates the loan from thin air but asks me to secure it against my house. The bank has not made any money. It lent me 125000 but assumes right over half my house. You see the bank only creates money when someone agrees to put an equivalent asset in the bank deposit. If no one puts an asset in the bank, the bank can not create money. So on day one of the bank opening, they did not create £1m at 10:00AM. They can't except when someone comes with an asset to deposit. Deposit could be anything. Your house, cash earned from employment etc. So the bank has the right to create money but YOU are the one that asks the bank to switch on the printing press. In efect, the bank was given the right to create money only for the borrower but not for itself and since by creating and lending it to the borrower they went -125000, they kept half of the borrowers property to keep even. Theoretically speaking if everyone in UK went to the bank to borrow money AGAINST their house, the bank would create and lend 1Trillion but will assume it's rights over all houses in UK. Again the bank is not positive or negative in balance sheet, it is equal (balanced). The bank has not made any money for itself. What it created was for to give out and go negative. It has a zero net profit even after creating 1Trillion. It hopes to make money by charging interest on the loaned(created) amount. It also hopes that people won't default and the assest price (against which loans are made) does not fall in value otherwise it's balance sheet will look negative and it may be declared bankrupt.

Upsides and Downsides of this arrangement...

Consider an economy. New inventions have been made which promise great rise in standards of living. Consider also that in this economy has banks that do not create money (call it gold, as it was done historically). Only when someone deposited gold (i.e. savings) in a bank was it possible to lend that gold to an inventor. Since not many people saved, new loans could not be made. So investors sat seeing their prototypes rusting away. Somehow by creating gold and lending out, they could get the inventor started. But gold can't be produced from thin air. They needed a different system; PAPER MONEY with embedded confidence that it was worth it. Given the example in the previous paragraph, the new system worked fine. The inventor was successful and the whole nation enjoyed the fruits of creativity.

Downside....

In the new system (paper money), by creating money, this diluted other peoples purchasing power (especially when inventor ideas did not bear fruit). The new system, in effect, had the affect of forced savings on the rest of the population. In the new system consumption could be before saving. Eventually both will settle out but for a while consumption could be ahead of saving. If the extra consumption was not compensated by extra saving later, inflation was born.

So all in all, the new system was wonderful but had a downside of inflation.

Fix inflation then somehow....

So the instrument of IRs were used to dampen out the appetite of borrowers by increasing the cost of borrowing to hammer down on excess credit creation and keep faith in the paper money system.

Where did it all go wrong then ...

1. It was hard to work out what exactly inflation is and how to measure it and hence IRs.

2. The assets which the bank kept (houses, MBS etc.) could go down in price.

3. A speculative rise in assets could make borrowers ask for more money creation from banks and result in a disbalance between consumption and savings.

3. For a while politicians could lower IRs and disbalance consumption and saving for political gain.

Hope it helps. Any questions please ask.

Cheers,

Madman

Share this post


Link to post
Share on other sites

Join the conversation

You can post now and register later. If you have an account, sign in now to post with your account.

Guest
Reply to this topic...

×   Pasted as rich text.   Paste as plain text instead

  Only 75 emoji are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

×   You cannot paste images directly. Upload or insert images from URL.

Loading...

  • Recently Browsing   0 members

    No registered users viewing this page.

  • 355 The Prime Minister stated that there were three Brexit options available to the UK:

    1. 1. Which of the Prime Minister's options would you choose?


      • Leave with the negotiated deal
      • Remain
      • Leave with no deal



×
×
  • Create New...

Important Information

We have placed cookies on your device to help make this website better. You can adjust your cookie settings, otherwise we'll assume you're okay to continue.