Money As Debt, Fractional Reserve Banking Etc

[Dr Doom]

No the BoE doesnt determine what money is worth- the MARKET does that-....

A market which the BoE has a monopoly over.

If the BoE had any control, all assets would rise and fall in unison subject to supply and demand

This isn't right, can anyone explain?

Edited October 2, 2007 by Dr Doom

[GDS]

Can we therefore conclude that banks do NOT create money out of debt and that the western banking system is sound (-ish)?

Or am I missing something?

The figures below prove conclusively that we now rely almost entirely on people going into debt to the banks for our money supply:-

According to Bank of England statistics, total UK bank deposits at the end of the Second Quarter of 2007 were £1,610.6 billion. Since total lending for the same quarter was £1,971.5 billion, we owed £360.9 billion more than we held in deposits. http://www.bankofengland.co.uk/statistics/...7/jun/index.pdf

For the same period, total Treasury-issued notes and coins in general circulation amounted to £47.4 billion, and total reserve balances to £17.9 billion: all together £65,311 million. http://www.bankofengland.co.uk/statistics/.../final%20nc.pdf

So the Treasury have actually issued us with no more than £65.3 billion, of which only £47.4 billion is in circulation as cash in your pocket.

Total Treasury-issued cash in circulation plus total bank deposits equals £1,658 billion, which is £313.5 billion too little to cover the growing gap between the UK money stock and debts outstanding. So every penny of the UK’s money supply is owed by somebody, somewhere, to the banking system - ie, our national currency consists entirely of debt.

Compare this with previous years, and you will see how bank lending systematically creates more and more money over a period of time:

1963:

Notes and coins, £3 billion; total lending, £9 billion; total money stock, £14.1 billion.

(Percentage of money issued by the Treasury as a debt-free input to the economy, 21%)

1983:

Notes and coins, £12.8 billion, total lending, £151 billion, total money stock, £161 billion. (Treasury debt-free input, 7.9%)

1985:

Notes and coins, 14.1 billion, total lending, £209 billion, total money stock, £205 billion. (Treasury debt-free input 6.8%)

1997:

Notes and coins, £25 billion, total lending, £780 billion, total money stock, £680 billion.

(Treasury debt-free input, 3.6%)

[source: the Bank of England Statistical Releases, 1995, 1997]

June, 2007:

Notes and coins, £47.4 billion; total lending, £1,971.5 billion; total money stock, £1,658 billion.

Since we now effectively use debt, and only debt, as our means of exchange, if people don’t keep borrowing enough to cover what is continuously disappearing out of circulation as loans are repaid, the money supply shrinks, and we have a recession. This is probably why the Government made no attempt to control the loose lending which led to massive house-price inflation.

As you can see from the figures above, the situation was less serious (though still bad enough) when we could at least rely on debt-free Treasury currency for around a fifth of the money the country needed.

Just after World War II, it was a lot more, closer to half - and inflation was far less of a problem. In fact, the danger of inflation - either price inflation or, as recently, asset inflation - has increased, as bank lending has taken over from publicly-created money.

http://www.freewebs.com/whosemoney

[Bloo Loo]

The other reason banks and the Gordon brown Government likes all this debt is becasue it makes controlling the money so much easier- if there was little debt, the interest rate changes they slip in would have little effect.

[Jason]

Ok, I've tried to fully understand this FRB and it is very confusing, as they are different people saying different things. Even the BoE can't answer my questions without confusing themselves, as I'm sure they don't (the person replying to my email) doesn't understand it.

If you only ever could lend out say 90% of your deposits, where does inflation come from?

Ok. This is how I think money is created in the economy:

1. The government decide to borrow, so create bonds and swap them for cash by selling them to the market (they do this is much as they want, or should I say need).

2. The people who buy these bonds can swap them for [digital] cash with the Bank of England. The Bank of England creates money out of thin air to pay for it. The BoE accounts do balance, because they have an asset in one hand, the Government Bond, and a liability in the other, the money they created out of thin air.

3. This cash, which is given in exchange for the bond, is high powered money and forms the reserve to the commercial bank, so they can lend several times that amount.

4. The money that is then lent out (to you or me) is not high powered money, and can not be multiplied as such. BUT the money that is lent out forms a deposit somewhere else, and so the flow goes on. I believe they have to keep a small reserve of this that is lent out to full fill their capital adequacy requirements.

Now I may be wrong, but I thought I would put down what I think.

[Sinking Feeling]

I've posted this before, but I think its worth posting again. This is a couple of quotes taken from the 1934 book in my signature below. It clearly states that banks create credit, they do not lend customer deposits. This was written after the Macmillan Commission - one of the first government inquiries into the workings of the banking system.

I think the money multiplier is only a text book demonstration it isn't really how the system works in practice. What is certain is that banks have to have a certain level of capital adequacy to remain solvent.

banking.doc

banking.doc

Edited October 2, 2007 by Sinking Feeling

[benj]

Your description is pretty accurate.

If you only ever could lend out say 90% of your deposits, where does inflation come from?

Inflation is the increase in the average price of goods and services in the economy. I'm not sure why you think that it should be related to the reserve ratios of commercial banks?

You can't analyse inflation in purely monetary terms without also considering GDP. Monetarists believe that if the money supply grows faster than GDP there will be inflation. For the most part, they are right. Is that what you were driving at?

[GDS]

1. The government decide to borrow, so create bonds and swap them for cash by selling them to the market (they do this is much as they want, or should I say need).

2. The people who buy these bonds can swap them for [digital] cash with the Bank of England. The Bank of England creates money out of thin air to pay for it. The BoE accounts do balance, because they have an asset in one hand, the Government Bond, and a liability in the other, the money they created out of thin air.

When the government needs money, the Bank of England draws up bonds, and sells them in the market. These bonds are usually bought by pension funds, insurance companies, banks, etc.

If the bonds are bought by, eg, pension funds, insurance companies or private individuals, money that already exists and has been saved is transferred to the government, and recirculated when the government spends it. However, because our entire money supply now consists of debt (see my entry above), this means that the money in question is owed twice over: once to the bank that created it in the first place, and once to whoever bought the bond. This is one of the reasons why the nation is now in a state of negative equity.

If the bonds are bought by a bank, however (and it doesn't have to be the Bank of England), the purchasing bank will pay for them with new money, which it creates using the money deposited with it at that time as collateral. When the government receives this new money, it spends it in the public sector, where it quickly finds its way into bank accounts, increasing total deposits, and, therefore, the amount which the banking sector is able to "lend" into existence (the multiplier effect).

SJ Bailey calculated that every increase of £1 in the public sector borrowing requirement during the 1980s added 40p to the money supply: new money created when banks bought government bonds. ("Public Sector Economics", 1995).

The Treasury does create some money out of thin air: but not in payment of bonds. The only money the Treasury creates comes in the form of notes and coins.

[DabHand]

If banks only lend out what they have on deposit where has the money come from to lend and thus fuel the massive global boom in house prices? Also if banks can only lend what has been deposited where does the money come from to pay the interest on loans and why do we have inflation?

Daddy what's wrong with that man's face?

[GDS]

3. This cash, which is given in exchange for the bond, is high powered money and forms the reserve to the commercial bank, so they can lend several times that amount.

4. The money that is then lent out (to you or me) is not high powered money, and can not be multiplied as such. BUT the money that is lent out forms a deposit somewhere else, and so the flow goes on. I believe they have to keep a small reserve of this that is lent out to full fill their capital adequacy requirements.

Now I may be wrong, but I thought I would put down what I think.

Notes and coins are the only money which the Bank of England creates itself, and which the country gets without having to "borrow" it. Notes and coins plus bank reserves are high-powered money, and the seed of all subsequent money creation.

As you say, once bank loans land in somebody's account as deposits, more money can be "lent" into existence using them as backing.

You're probably wondering why, if the Treasury can authorise the creation of notes and coins out of thin air, can't it also create, eg, cheque book or electronic money without plunging the country into unrepayable debt?

There is no good reason.

In 1833 Robert Peel's government attempted to take control of the money supply back under government control when it passed an act saying that only notes issued by the Bank of England could be accepted, along with coin of the realm, as legal tender - ie, the assumption was that only a democratically accountable authority had the right to issue the nation's money. But with other forms of money taking over, it's now private, profit-making businesses called banks which create our means of exchange, mainly as electronic entries in bank accounts, and who decide who they will lend it to, and for what purposes.

Recently the most popular purpose has been speculation in the property market.

http://www.freewebs.com/whosemoney

[othello]

No the BoE doesnt determine what money is worth- the MARKET does that- thats why there is going to be a house price crash- the market is saying a shoebox with inside loo is no longer worth 200,000GBP, but its worth a lot less. And yet, at the same time, the market says a loaf is no loger worth £1.00, but £1.30- If the BoE had any control, all assets would rise and fall in unison subject to supply and demand

"the market is saying a shoebox with inside loo is no longer worth 200,000GBP, but its worth a lot less."

You are confused methinks. You are talking about what property is worth - not money!

[othello]

The figures below prove conclusively that we now rely almost entirely on people going into debt to the banks for our money supply:-

According to Bank of England statistics, total UK bank deposits at the end of the Second Quarter of 2007 were £1,610.6 billion. Since total lending for the same quarter was £1,971.5 billion, we owed £360.9 billion more than we held in deposits. http://www.bankofengland.co.uk/statistics/...7/jun/index.pdf

For the same period, total Treasury-issued notes and coins in general circulation amounted to £47.4 billion, and total reserve balances to £17.9 billion: all together £65,311 million. http://www.bankofengland.co.uk/statistics/.../final%20nc.pdf

So the Treasury have actually issued us with no more than £65.3 billion, of which only £47.4 billion is in circulation as cash in your pocket.

Total Treasury-issued cash in circulation plus total bank deposits equals £1,658 billion, which is £313.5 billion too little to cover the growing gap between the UK money stock and debts outstanding. So every penny of the UK’s money supply is owed by somebody, somewhere, to the banking system - ie, our national currency consists entirely of debt.

Compare this with previous years, and you will see how bank lending systematically creates more and more money over a period of time:

1963:

Notes and coins, £3 billion; total lending, £9 billion; total money stock, £14.1 billion.

(Percentage of money issued by the Treasury as a debt-free input to the economy, 21%)

1983:

Notes and coins, £12.8 billion, total lending, £151 billion, total money stock, £161 billion. (Treasury debt-free input, 7.9%)

1985:

Notes and coins, 14.1 billion, total lending, £209 billion, total money stock, £205 billion. (Treasury debt-free input 6.8%)

1997:

Notes and coins, £25 billion, total lending, £780 billion, total money stock, £680 billion.

(Treasury debt-free input, 3.6%)

[source: the Bank of England Statistical Releases, 1995, 1997]

June, 2007:

Notes and coins, £47.4 billion; total lending, £1,971.5 billion; total money stock, £1,658 billion.

Since we now effectively use debt, and only debt, as our means of exchange, if people don’t keep borrowing enough to cover what is continuously disappearing out of circulation as loans are repaid, the money supply shrinks, and we have a recession. This is probably why the Government made no attempt to control the loose lending which led to massive house-price inflation.

As you can see from the figures above, the situation was less serious (though still bad enough) when we could at least rely on debt-free Treasury currency for around a fifth of the money the country needed.

Just after World War II, it was a lot more, closer to half - and inflation was far less of a problem. In fact, the danger of inflation - either price inflation or, as recently, asset inflation - has increased, as bank lending has taken over from publicly-created money.

http://www.freewebs.com/whosemoney

I think you are confusing cash and notes with other forms of money 'issued' by the bank (not the Treasury). The figures you quote support the view that lending and borrowing are broadly in balance.

Anyway, it is the Central Banks that control money creation, not the commercial banks. the idea that the high street banks can create money is absurd and wrong - erm, I am 99% sure of this.

Edited October 2, 2007 by othello

[bdon]

Can someone recommend a good book, extensively peer-reviewed, that explains all this!?

I am fascinated and confused in equal measure.

[Injin]

I think you are confusing cash and notes with other forms of money 'issued' by the bank (not the Treasury). The figures you quote support the view that lending and borrowing are broadly in balance.

Anyway, it is the Central Banks that control money creation, not the commercial banks. the idea that the high street banks can create money is absurd and wrong - erm, I am 99% sure of this.

Money creation is not difficult, tricky or limited to the banks. Anyone can do it. You, me anyone.

Have a pound - £1.

Wasn't hard, was it?

So, why don't you me or the banks just create all this cash all the time?

Here's why -

No one has to accept your money or my money or the banks money. What they, you and me do have to accept is legal tender, which is the bank of englands money because there is a law backing it. Banks money is designed to closely resemble bank of england money but isn't the same at all. This is why they call it pounds and give it the little £ sign and will exchange it for paper currency if you ask and they have enough on them at the time.

Northern rock got into trouble because people stopped accepting the cash they create and wanted legal tender instead.

[CHD]

Hmm, seems to be a lot of heat in this thread, questioning of credentials etc.

The quotation below is from an authoritative source.

[FreeTrader]

Can someone recommend a good book, extensively peer-reviewed, that explains all this!?

I am fascinated and confused in equal measure.

bdon,

I've lost count of how many times on HPC this subject has been argued about, and each time I've recommended the same book. It was written some time ago, but it gives a very clear explanation of the mechanics of fractional reserve banking. Even better, it's freely available as an eBook on the Web:

The Mystery of Banking by Murray N. Rothbard (pdf warning)

Gene Epstein, Barron's economics editor (and formerly chief economist for the NYSE), has recommended The Mystery of Banking as the best book to read for anyone interested in understanding how the central banking model works. Rothbard is vehemently opposed to the fractional reserve model as implemented today, but it's up to the reader to make his or her own judgement on the merits of the current system.

You can also Google something like: Federal Reserve speeches open market desk. Many Fed governors have made public speeches in which they explain in layman's terms the day-to-day operations of the Fed and how it conducts monetary policy (most central banks run along very similar lines).

Cheers.

[davidhpc]

Ok, I've tried to fully understand this FRB and it is very confusing, as they are different people saying different things. Even the BoE can't answer my questions without confusing themselves, as I'm sure they don't (the person replying to my email) doesn't understand it.

< snip>

3. This cash, which is given in exchange for the bond, is high powered money and forms the reserve to the commercial bank, so they can lend several times that amount.

<snip>

Agree with everything else you say, except, why would they be able to lend several times the amount they borrowed from the BofE? I don't understand that part.

[bdon]

bdon,

I've lost count of how many times on HPC this subject has been argued about, and each time I've recommended the same book. It was written some time ago, but it gives a very clear explanation of the mechanics of fractional reserve banking. Even better, it's freely available as an eBook on the Web:

The Mystery of Banking by Murray N. Rothbard (pdf warning)

Gene Epstein, Barron's economics editor (and formerly chief economist for the NYSE), has recommended The Mystery of Banking as the best book to read for anyone interested in understanding how the central banking model works. Rothbard is vehemently opposed to the fractional reserve model as implemented today, but it's up to the reader to make his or her own judgement on the merits of the current system.

You can also Google something like: Federal Reserve speeches open market desk. Many Fed governors have made public speeches in which they explain in layman's terms the day-to-day operations of the Fed and how it conducts monetary policy (most central banks run along very similar lines).

Cheers.

thanks dude

[DabHand]

If banks can only lend money according to how much they have on deposit

Why do they securitise debt and sell it to pension companies?

Where has all the money come from to pay for all these houses that are getting more and more expensive?

Why has the personal indebtedness of the UK rocketed but at the same time saving ratios have dropped.

Surely the two are inextricably linked either debts increase in line with savings ratios or more money is created than is on deposit.

Has anyone, particularly the "banks only lend what they have on deposit, go back to sleep citizen" crowd actually managed to answer any of Grav's questions?

Unless l missed it, l am betting that none of you feckin' know do you!

My first instinct is its foreign savers, but the overall global change in asset prices is UP, the value of every fiat monetary unit is DOWN. How can this happen if new money ISN'T being created or leveraged into existence at some rate by every country, everywhere.

No particular currency has crashed (forget Zimbabwe) so we can assume all currencies are being inflated away at roughly par by all govts. Is ALL of it coming from Govt bonds? I am not aware of massive deficit spending by any country l know that could create the deposits required to even fuel the Irish bubble, let alone the worlds.

Is there more being created than we know?

[othello]

OK, this is a really interesting thread and at one extreme we have views that all banking is fraud and banks can create money. On the other hand we are being told that everything is in order and that banks only lend what they have in terms of deposits.

The fact that this discussion has arisen so many times without a clear onclusion speaks volumes. It is a somewhat murky situation. Having said that I am now of the view that in very simplistic terms:

Banks can only lend what they have in terms of deposits PLUS what they have a security. A mortgage is a good example: they are lending against the security of an asset (a house) and while they do not have the cash in hand, so to speak, if the debtor fails to repay the loan the property is sold. This does NOT mean banks are 'creating money'. It is also a necessary mechanism to allow for economic prosperity. Take another example: if I dig up a diamond worth £1 billion I can sell it and the buyer may well need to bnorrow a billion to pay for it. It is an asset worth an amount of money that did not previously exisit in the 'economy'. So new money has to be found to pay for it but it is not created ouyt of nothing it is created from the increased wealth of the economy.

Not a great example perhaps but I think it summarises the situation in hand. The picture painted by the fractional reserve opponents is not without foundation but is a grossly distorted view of what is actually a raitional approach to money and wealth.

Does that make sense?

[GDS]

I think you are confusing cash and notes with other forms of money 'issued' by the bank (not the Treasury).

You're right, I should have said Bank of England. I was thinking in terms of it being publicly-created money. But I'm not confusing cash (notes and coins) with 'other forms of money' created by the Bank, because they don't create any other form of money.

The figures you quote support the view that lending and borrowing are broadly in balance.

Hmmmm ... yes, I suppose so - if you consider a few hundred billion shortfall between total debt and the money available to pay it as being 'broadly in line'. And if you look at the figures, you'll see that the gap has been increasing exponentially ever since debt first exceeded the money stock, back in 1985. Next year it will be even bigger.

Anyway, it is the Central Banks that control money creation, not the commercial banks. the idea that the high street banks can create money is absurd and wrong - erm, I am 99% sure of this.

You're right, the idea is absurd - but not wrong (except perhaps morally). Central banks 'control' money creation only indirectly, via interest rates. The commercial banks do the actual creation job for them ... at a high price. The Bank of England creates no money other than notes and coins. I am 100% sure of this. If you doubt it, write and ask them.

So the figures quoted in my previous post clearly show £1,610.6 billion in bank deposits which was not created by any public authority.

http://www.freewebs.com/whosemoney

[mfp123]

Has anyone, particularly the "banks only lend what they have on deposit, go back to sleep citizen" crowd actually managed to answer any of Grav's questions?

Unless l missed it, l am betting that none of you feckin' know do you!

My first instinct is its foreign savers, but the overall global change in asset prices is UP, the value of every fiat monetary unit is DOWN. How can this happen if new money ISN'T being created or leveraged into existence at some rate by every country, everywhere.

No particular currency has crashed (forget Zimbabwe) so we can assume all currencies are being inflated away at roughly par by all govts. Is ALL of it coming from Govt bonds? I am not aware of massive deficit spending by any country l know that could create the deposits required to even fuel the Irish bubble, let alone the worlds.

Is there more being created than we know?

its the central banks that create the extra money. during the credit crunch a few weeks ago the european central bank pumped in an extra $370 billion into the european economy.

also part of the reason of why loans are easier to get and have balooned is due to how they are financed. previously banks used to fund mortgages using their deposits. however companies realised that they could get their funding from the money markets instead.

e.g companies like northern rock dont have large deposits at their bank yet they are able to fund lots of mortgages. they do this by gettting the funding from the money markets i.e they borrow money from other banks/instututions rather than attracting business/high street deposits.

thats why when the money markets dried up last month i.e banks stopped lending money to each other, companies like northern rock which relied on this for funding seized up and ran out of funding, and hence they had to borrow emergency funding from the BOE as noone else would supply them with cash.

[Injin]

OK, this is a really interesting thread and at one extreme we have views that all banking is fraud and banks can create money. On the other hand we are being told that everything is in order and that banks only lend what they have in terms of deposits.

The fact that this discussion has arisen so many times without a clear onclusion speaks volumes. It is a somewhat murky situation. Having said that I am now of the view that in very simplistic terms:

Banks can only lend what they have in terms of deposits PLUS what they have a security. A mortgage is a good example: they are lending against the security of an asset (a house) and while they do not have the cash in hand, so to speak, if the debtor fails to repay the loan the property is sold. This does NOT mean banks are 'creating money'. It is also a necessary mechanism to allow for economic prosperity. Take another example: if I dig up a diamond worth £1 billion I can sell it and the buyer may well need to bnorrow a billion to pay for it. It is an asset worth an amount of money that did not previously exisit in the 'economy'. So new money has to be found to pay for it but it is not created ouyt of nothing it is created from the increased wealth of the economy.

Not a great example perhaps but I think it summarises the situation in hand. The picture painted by the fractional reserve opponents is not without foundation but is a grossly distorted view of what is actually a raitional approach to money and wealth.

Does that make sense?

Not in the slightest. To loan someone money requires that you have money in the first place to give them, otherwise it's just ********, lies and fraud.

The mortgage taker is told that existing cash has been given by the bank and handed to someone else. You've just said it never happened. That's fraud.

Banks collect interest on loans that never occur. How is this not fraud?

How could it be clearer?

Turn your example around. I go to a bank and tell them I have a great big diamond. They believe me because I am convincing and well known to have a jewellers shop. I go and spend the money, and then for some reason or the bank finds out I am lying and comes looking for the diamond. It's not there. I lied to acquire their money.

I'd go to prison for fraud.

Somehow when we reverse this procedure and the bank says it has money it doesn't have, all is fine, no fraud occurs, go back to sleep, nothing to see here....such ********.]

There is no alternative view of the banking system presented anywhere apart from the fractional reserve system. The BoE, the Fed etc all agree that the banking world operates this way.

[ockham]

I read this up to p 64-ish, up to which point it makes sense, but after which it completely loses the plot.

(Rothbard) "Where did the money come from? It came—and this is the most important single thing to know about

modem banking—it came out of thin air. Commercial banks—that is, fractional reserve banks—create

money out of thin air. Essentially they do it in the same way as counterfeiters."

He gets to this starting from the correct observation (p 64) that the time structure of bank's assets (which are typically long-dated and illiquid) are different from the time structure of its liabilities (which are typically short-dated and liquid). Everyone knows this.

But the idea that banks are counterfeiting is quite incorrect. A counterfeiter has no balance sheet, or credit rating. And his conclusion that this system produces inflation is false, so long as there is a rational pricing system for assets (i.e. such that the value of the assets are always equal to or close to the expected present value of the future income belonging to the assets). Indeed, it is false even when there isn't a rational pricing system for the assets (as I would argue, following economists such as Farlow and Shiller, has happened in the case of the housing market). In that case, what produces the inflation is the irrational pricing itself, not the banking system.

[DabHand]

Banks can only lend what they have in terms of deposits PLUS what they have a security. A mortgage is a good example: they are lending against the security of an asset (a house) and while they do not have the cash in hand, so to speak, if the debtor fails to repay the loan the property is sold.

Makes sense at a glance but the problem is, the willingness to lend is what creates that asset's value.

Catch 22: if a lender would lend a million for a studio flat, then studio flats would be "worth" a million and for each flat lent against in this way, another £9m gets telescoped out based on recursive lending on each deposit (at the oft used 10% reserve).

Holy crap, l guess that's the answer.

[Injin]

Makes sense at a glance but the problem is, the willingness to lend is what creates that asset's value.

Catch 22: if a lender would lend a million for a studio flat, then studio flats would be "worth" a million and for each flat lent against in this way, another £9m gets telescoped out based on recursive lending on each deposit (at the oft used 10% reserve).

Holy crap, l guess that's the answer.

Yes, it is.

The value comes from the borrower. The bank has nothing until he walks through the door.