A Corrective on The Nature of Money

[peristaltor.livejournal.com]

I just got through reading a very insightful reply from montecristo, one free of bombast and flourish, but focusing rather on the meat of his philosophy, a kind of exegesis. I thank him for his candor.

I cannot, though, overlook his errors. Now, before everyone rushes to the mods and reports this as a trolling post, bear in mind that he makes some very common mistakes on a subject that very few command well at all, myself especially. These mistakes are, in my opinion, directly responsible for a majority of the economic problems we are facing as a planet. Therefore, be your philosophical bent to the center, to the left, to the right; be it up to the totalitarian or down toward the anarchists; be it with Xenu or Gaia or whomever; all of us can benefit from a basic primer into the basic manner in which money today is created.

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First of all, the commonly held idea. I get this from Yves Smith, an excellent money and finance blogger at Naked Capitalism. Ms. Smith spent 25 years as a banker. Let's see what she has to say about money.

Banks hold deposits and pay interest on them. Depositors have the right to demand their funds at any time, but through experience, banks know that only a small percent of the funds they hold in trust will be withdrawn on any given day, and even that might be matched or exceeded by a new inflows. Thus banks, to earn additional profit, lend out a portion of their deposits, typically $9 for every $10, at a higher interest rate than they pay to their depositors. . . .

(Yves Smith, Econned: How Unenlightened Self Interest Undermined Democracy and Corrupted Captialism, St. Martin's Press, 2010, pp. 204.)

Does that sound right? It does to most. The problem lies in some basic systemic realities. If banks hold deposits and lend at interest, where does the money to pay the interest come from? In other words, what mechanism creates the interest money added to the principal due at the close of the loan, or for that matter the depositor's interest on their savings and the bank's profits? Let's cut right to this chase. (From hereon, all emboldened words in those quoted will be my emphasis.) The Chicago Federal Reserve came out with a handy explanatory pamphlet once, which contained:

"Of course, [banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) both rise [by the same amount]."

Chicago Federal Reserve, Modern Money Mechanics (1961, revised 1992).

"Credits to the borrowers' transaction account" is what most of us would call "money." Ellen Hodgson Brown maintains the banker-esque vocabulary to clarify:

When you lend someone your own money, your assets go down by the amount that the borrower's assets go up. But when a bank lends you money, its assets go up. Its liabilities also go up, since its deposits are counted as liabilities; but the money isn't really there. It is simply a liability -- something that is owed back to the depositor. The bank turns your promise to pay into an asset and a liability at the same time, balancing its books without actually transferring any pre-existing money to you.

(Ellen Hodgson Brown, Web of Debt, Third Millennium Press, 2008, p. 280, emphasis by the author.)

What Ms. Brown is trying to say is more clearly said by other authors, thankfully.

The amount of debt held by government, business and households is closely linked to the supply of money in the economy. Most of the "new" money in national economies is now created by commercial banks in the form of loans to customers.

(Tim Jackson, Prosperity Without Growth, Earthscan, 2009, pp. 25-26.)

But what of those deposits Yves Smith mentioned earlier?

Commercial banks play a dual role. They act both as "depositories" and as "banks of issue." In their role of depository, banks lend out depositors' funds (your savings and mine) to those who have need of them. That may be for either consumption or the creation of new productive capacity (capital formation). As banks of issue, they create new deposits (money) on the basis of short-term commercial bills that accompany the delivery of goods to market. That's the way it is supposed to work.

(Thomas H. Greco, Jr., The End of Money and the Future of Civilization, Chelsea Green Publishing Company, 2009, pp. 63.)

The dual role to which Mr. Greco refers is regulated by the "fractional reserve." Back to Mr. Jackson:

Governments through their central banks attempt to control how much money is created in the form of debt through two related instruments. One is the base rate -- the rate at which the central bank loans money to commercial banks. The other is the reserve requirement -- the percentage of deposits that banks are required to hold in reserve and which cannot therefore be used to make loans. The lower the base rate, the more likely commercial banks are to make loans. Over the last decade, the US Federal Reserve (and many other central banks) used an expansionary monetary policy to boost consumer spending. This worked to protect growth for a while but ultimately led to unsustainable levels of debt and destabilized the money markets. This is one of the reasons for calls to increase the reserve requirement.

(Tim Jackson, ibid., pp. 26.)

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I hate to pick on otherwise excellent thinkers like Yves Smith, if only because her book EConned was (other than that quote above and a few minor quibbles) so enlightening. How could she not know of the loan creation of money? Yes, she spent 25 years as a banker; but it was as an investment banker. Investment banks are not allowed to create money through lending; only commercial or depository banks are. This is, in fact, the "firewall" in our financial system erected in the US by the Banking Act of 1933, aka the Glass–Steagall Act. Senators Glass and Steagall based this legislation on revelations into banking practice largely brought to light during the congressional hearings following the market crashes between 1929 and 1932, hearings conducted largely by Ferdinand Pecora. I've read half of the Stock Exchange Practices. Hearings before the Committee on Banking and Currency Pursuant to S.Res. 84 and S.Res. 56 and S.Res. 97, aka the Pecora Commission Report. Once one has a background into the loaning of money into existence, it's relatively easy to pick through the banker banter and decipher the actual meaning of some of the more dangerous practices the Glass-Steagall Act prevented.

That Act, though, was largely repealed in 1999 by the Gramm–Leach–Bliley Act of 1999. It took a non-investment banker to predict what might — did — happen afterward.

[Hyman] Minsky's knowledge of banking wasn't confined to what he had read in books. For years he served as a consultant to and director of the Mark Twain Bank in St. Louis, taking a keen interest in all aspects of its business. In the traditional banking model, which dates back centuries, banks take in money from their customers and lend most of it out to businesses and other borrowers, keeping a small amount in reserve to meet depositors' demands for cash. The source of banks' profits is the "spread" between the interest rate they pay depositors and the rate they charge borrowers. In this version of banking, the banking sector's role is essentially passive: it acts as an intermediary between savers and borrowers, and its activities don't have much impact on the overall level of economic activity.

Minsky pointed out a number of deficiencies in this analysis, beginning with the fact that when a bank extends a loan it creates a very special commodity: money. When banks lend more together, the total supply of money in the economy grows, which means total spending power increases. Similarly, when banks call in loans and refuse to make new ones, the money supply contracts and overall spending power falls. Apart from the government, banks are the only institutions in the economy with the ability to create money, and that is what makes them so important.

Unfortunately, there is nothing in a banker's employment contract that says he should take into account the impact of his actions on the economy as a whole. . . . As an employee of a public company, his only obligation is to maximize profits, which involves expanding lending when he things the outlook is good and refusing to lend when he is worried about the future. But the level of bank lending that makes sense for individual banks doesn't necessarily make sense for the country.

(John Cassidy, How Markets Fail: The Logic of Economic Calamaties, Princeton University Press, 2009, pp. 210-211.)

"The level of bank lending that makes sense for individual banks" is simply the level of lending that banks can issue at interest with the most likely chance either of return . . . or of possibility to seize valuable assets obtained after default. That last is what many enamored of the gold standard don't realize, that the same system of money creation through lending was in place at that time. When the availability of gold got low, bankers simply called in their loans to be payable only in gold and waited for the defaults to lower the credit money supply. This correction hardly cost them much, since the farms and factories they repossessed more than made up for the paper losses. But I digress.

I'll return to Greco to outline the fallout of improper lending.

As pointed out earlier, the vast majority of money is created by commercial banks by the process of lending it into circulation. They have the power to make loans (issue money) on either a proper basis or an improper basis. It is not the amount of money per se that causes inflation, but the basis upon which it is created. Loans made on an improper basis have the effect of inflating the money supply. What would be an improper basis?

An improper basis is any loan that does not put goods or services into the market either immediately or in the very near term. [Here he refers to the "dual role" of banks referred above.]

In practice, however, banks these days make little distinction between these two roles and they commonly create deposits (money) by making loans to finance both the flow of goods and services into the market as well as making loans that take them out of the market. When a bank makes a loan for the purpose of financing consumer purchases [credit card debt, for example] or for investment in long-term productive assets [stocks and bonds, for example], those newly created deposits are inflationary — because they deliver goods and services to the marketplace only in the distant future, or not at all. Improper bases of issue, then, include the purchase by banks of government bonds in excess of time deposits held by savers, as well as loans that finance market speculation.

(Thomas H. Greco, Jr., ibid., pp. 63-64.)

"Finance market speculation" was exactly the lending the Glass-Steagall Act outlawed . . . until its slow erosion starting in about 1983 and eventual repeal.

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Several have warned through history of this conflict of interest banks represent. Sadly, not enough do. Worse, few realize that commodity banks are legally allowed to create money almost by fiat, money that can be used to further gather more money. As the money supply inflates, those in control of money's creation more and more concentrate their power in the society in which they issue their money, even as actual physical wealth might remain stagnant. Thus the financial sector has grown from about 5% of the economy to almost 40%, even as the living standards of average Americans and Britons has remained stagnant or fallen. We can neither fight nor hope to reform what we simply do not understand.

I'll let some former presidents close.

This money trust, or, as it should be more properly called, this credit trust, of which Congress has begun an investigation, is no myth; it is no imaginary thing.

(Woodrow Wilson from his book The New Freedom.)

"All the perplexities, confusions and distresses in America arise not from defects in the Constitution or Confederation, not from want of honor or virtue, as much as from downright ignorance of the nature of coin, credit and circulation."

(John Adams, in a letter to Thomas Jefferson.)

Comments

[ford-prefect42.livejournal.com]

Everything you said there is correct. But it does not address what Monte said.

Here's the thing. "Money" isn't "wealth". Money is an abstraction. Creation or destruction of money does not create or destroy "wealth", because "wealth" is goods and services.

The amount of money in circulation generally changes fairly slowly. so on a short timescale, the 2 are generally interchangeable, but looking at the *longer* timescale, the US$ is *constantly* losing value in real terms.


Monte's comment was about *wealth*, not money. so the mechanism by which *money* is created is relevant only insofar as it concerns the accumulation of *wealth*. For that, goods and services, must, as monte says, be created. They will be then paid for in money, and to the extent taht those that recieve that money convert it to durable assets, wealth accumulates.

While money can be freely created by the banking system, if a corresponding amount of increase in goods and services is not also created, then the additional *money* is merely inflation.

[soliloquy76.livejournal.com]

I'll admit that economics is not my forte, but isn't long-term annual inflation trending down?

(http://inflationdata.com/inflation/images/charts/Annual_Inflation/Annual_Inflation_chart.jpg)
^{click to enlarge}

[a-new-machine.livejournal.com]

This is the thing that's always struck me as odd about this whole model. I understand it all, but wouldn't it imply massive inflation as the money is loaned, spent, deposited, and re-loaned ad nauseum (with smaller amounts each time, but still). Or do the loans get paid off/called in in sufficient quantities to avoid that?

[politikitty.livejournal.com]

So long as the interest rate on the loan covers the risk of the loan, the amount of money should track pretty closely wealth created. Get an auto loan, buy a car. Get a business loan, start a business.

So long as the bank is covering their losses and has sufficient capital on hand, the simple lending process shouldn't create inflation. Instead inflation happens when there's a disconnect between goods and the money supply.

[ford-prefect42.livejournal.com]

Yes, and then again, no.

*optimally*, the money that gets created *exactly* offsets economic growth. That keeps everything costing the same.

If you were to use, say, gold, then there's only a set amount of it, so for every person you add, the price of every item would go down.

The reason that there isn't *massive* inflation at any given time is generally that yes, loans get paid down and the economy grows in rough proportion to money creation. The system is (roughly) at equilibrium.

[peristaltor.livejournal.com]

No, there is inflation inherent in the system. Some systems have used something called demurrage (http://en.wikipedia.org/wiki/Demurrage_%28currency%29), where the long-term value of stored or hoarded currency, ie. kept out of circulation, is reduced, giving the holder the incentive to spend it. Our system has no such demurrage.

Therefore, money accumulates. As long as the accumulation of goods and services tracks this money accumulation, inflation is negligible in its effects.

[peristaltor.livejournal.com]

There is one mechanism that can remove money from the system (other than Fed action, which isn't important here). If a loan defaults before the principal is paid in full, the unpaid money created by that loan disappears.

This is why the banks were in such dire straits when the subprime market collapsed. No one seems to have taken seriously warnings that not only would the loans collapse, but that the value in the houses they helped purchase would also collapse, leaving the bank no collateral of sufficient value to cover their losses.

It's also why the banks are today resisting resetting the principal of house loans underwater. Doing so would necessarily force them to restate downward the value of the loan, and thus expose them to reduced assets. If enough assets get revalued, they go underwater and into bankruptcy.

[peristaltor.livejournal.com]

I should note that the word "inflation" is a bit abused. Technically, when the money supply grows, that is "inflation." (In fact, when the money supply fails to inflate, we find ourselves in a "recession;" too many months of recession gives us a depression.)

Also, when the prices of basic commodities grows, that is also called "inflation."

One, money inflation, can lead to the other simply because there are more dollars or euros or whatever chasing the same number same goods. If it gets too out of hand, you get hyper-inflation (Weimar Republic, Zimbabwe, etc.).

If the price of commodities falls, though, as happened as more and more factories overseas have reduced manufacturing costs (at the expense of overseas humans, but that's another story), one may not even notice that the money supply has grown because one pays less over time for lots of stuff. More stuff equals less demand for each thing equals less market price per thing. That doesn't mean the money supply hasn't inflated.

Hope that helps.

[ford-prefect42.livejournal.com]

That's the *annual* inflation rate. Meaning that next year, a dollar will be worth 3% less than today. That little jag into the blue was a brief period when, for 8 months, the $ *gained* value. Deflation (according to most current economic theories) is harmful to economic growth, so we had 2 rounds of "quantitative easing", dropped the fed interest rate to nearly zero, and a federal stimulus package to get the dollar *losing* value again.

If you brought $60 in a "basket of goods" (gold, oil, corn, rice, etcetera), from 1990 to 2010, and sold it, it would be worth $100 (assuming you are able to buy and sell at the same pricing tier, and that you didn't select cell-phones) :)

[soliloquy76.livejournal.com]

This all seems more complicated than it needs to be. We need to go back to swapping chickens or somesuch.

[politikitty.livejournal.com]

The money created by the banking system was funneled into a lot of houses that can't move and bond prices that evaporated. The houses were real, so it included a bubble rather than inflation that just evaporated when the housing market fell out.

In this market there aren't more dollars chasing less goods. In fact, after the crisis, lending has been waaaaaay down. So low inflation is exactly what you'd expect to the point that some economists worry about deflation.

[montecristo.livejournal.com]

The money created by the banking system was funneled into a lot of houses that can't move and bond prices that evaporated.

It is not so much that housing "can't move" but rather, the market is being prevented from clearing on the theory that the "wrong people" will be forced to take losses.

[montecristo.livejournal.com]

Inflation as charted presumes a definition rooted in price changes. The Austrians point out that inflation is better understood to be an increase in the money and credit supply. (http://wiki.mises.org/wiki/Inflation)

[kylinrouge.livejournal.com]

The increase in money and credit supply causes inflation. Price changes are evidence of it.

I'm fully aware I'm just arguing semantics here, but there's nothing wrong with the definition as-is.

[the-s3ntinel.livejournal.com]

What I take away from that chart is that inflation is trending sdevug which is a new word I've coined, referring to the exact shape of the black line.

[peristaltor.livejournal.com]

"Money" isn't "wealth". Money is an abstraction.

While technically correct, nothing in our society prevents improperly created money from buying actual wealth. The distinction is therefore moot.

Money that can be exchanged with wealth becomes wealth. Therefore those that control the creation of money divert the wealth of the nation toward their clutches.

I used the phrase "wealth of the nation" deliberately. Consider the following:

To prevent a recurrence of credit busts, [Adam] Smith advocated preventing banks from issuing notes to speculative lenders. "Such regulations may, no doubt, be considered as in some respects a violation of natural liberty," he wrote. "But these exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments, of the most free, as well as the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed."

Alan Greenspan and other self-proclaimed descendants of Smith rarely mention his skeptical views on the banking system, which were shared by many nineteenth-century economists who otherwise maintained a favorable view of the free market. J.S. Mill traced most economic downturns to disturbances that emerged from the financial system, as did Alfred Marshall, the late-Victorian economist whose Principles of Economics replaced Mill's textbook as the standard work. Marshall said, "reckless inflations of credit" were "the chief cause of all economic malaise," and he called for vigorous action on the part of the monetary authorities to prevent them.

The notion of financial markets as rational self-correcting mechanisms is an invention of the last forty years. Before that, most economists sympathized with Charles Mackay, the journalist and sometime colleague of Charles Dickens whose 1841 book, Extraordinary Popular Delusions and the Madness of Crowds, compared speculative manias, such as the "tulipomania" that gripped Holland in the 1630s and the South Sea bubble of 1720s London, to witch trials, millenialism, and other examples of collective insanity. The transition from Mackay's jaundiced opinion of finance to Greenspan's sunny view took a long time, and it was based, at least partially, on a misreading of the theory of the invisible hand, which Smith had never intended to be applied to finance.

(John Cassidy, How Markets Fail: The Logic of Economic Calamaties, Princeton University Press, 2009, pp. 35-36, emphasis mine.)

[ford-prefect42.livejournal.com]

AH! Well, in *that* case, I should mention that I am pretty much certain that Monte is in agreement with those statements. I do know that I am.

The banking system has to be *closely* watched to prevent corruption of the system. But it's not *intrinsic* that loans only be made to the corrupt.

[peristaltor.livejournal.com]

The banking system has to be *closely* watched to prevent corruption of the system.

That's all I'm sayin'.

I would also suggest going back and reinstating the laws that helped prevent quite a bit of that corruption.

[the-rukh.livejournal.com]

This is an interesting statement. How would you suggest the banking system is watched closely?

[montecristo.livejournal.com]

Ah, no, I do not agree. The banks must be watched, it is true, but only to prevent fraud, not to prevent loans to "the corrupt."

[montecristo.livejournal.com]

WHOA. You need to take a good hard look at what you're claiming there.

...nothing in our society prevents improperly created money from buying actual wealth. The distinction is therefore moot.

This is precisely the equivalent of claiming that, "Since nothing in our society prevents fraud from resulting in a transfer of property the distinction between theft and trade is moot."

I see that Cassidy is quick to cite Adam Smith to make the point that "reckless credit inflation is the chief cause of all economic malaise." The Austrians would agree with that point. Their own Austrian Business Cycle Theory (http://wiki.mises.org/wiki/Austrian_business_cycle_theory) explains the mechanism. The problem with Cassidy's criticism of finance is not that reckless credit creation does not cause booms and busts; it does. Rather it is his implied endorsement for credit regulation in leiu of what he considers the mistaken notion that financial markets are rational self-correcting mechanisms. His error stems from the logical contradiction of implying that where distributed entrepreneurs cannot find the "correct" rate of interest, "regulation" can somehow determine determine it. This is the fallacy of perfect equilibrium or efficent market hypothesis. (http://wiki.mises.org/wiki/Equilibrium) The Austrians point out that there is no perfect equilibrium to be found and there is no other "more efficient" correlation between differing time preferences among savers and investors, the rate of interest, to be found, outside of what the market does naturally in its very operation. It is the Federal Reserve Bank's ludicrous notion that it can guess, or worse set and determine the rate of interest which is at the root of the business cycles we experience.

[jonathankorman.livejournal.com]

It is the Federal Reserve Bank's ludicrous notion that it can guess, or worse set and determine the rate of interest which is at the root of the business cycles we experience.

That is such a strikingly odd assertion that I think I must be misunderstanding you somehow. We had business cycles before the creation of central banks, did we not?

[stewstewstewdio.livejournal.com]

Here's the thing. "Money" isn't "wealth". Money is an abstraction.

Money is an asset, just like goods and services. Wealth is assets minus liabilities. All you would need to do is look at a corporate balance sheet to see that. That is how money and wealth are tied together. It is not an abstraction.

[peristaltor.livejournal.com]

Nope. Money itself represents an asset, mostly a loan's principal. To conflate it with an asset is to fall into what John Michael Greer called Descarte's Fallacy:

In The Wealth of Nations Adam Smith criticizes the notion — as common in his time as in ours — that money is the same thing as wealth. The wealth of a country, he points out, consists of the product of its natural resources and collective labor: in the terms I've sketched out in the previous chapter, it's the sum total of the goods and services produced by a nation's primary and secondary economies. In another place, though, he defines wealth as anything that can be valued in money. These definitions do not conflict with one another; rather, they make the crucial point that money is not wealth but the yardstick by which modern cultures measure wealth. This ought to be the first thing we teach children about money, though, of course, it ain't.

It probably ought to be the first thing we teach economists about money, too, but the power of Descarte's fallacy stands in the way.

(John Michael Greer, The Wealth of Nature: Economics as if Survival Mattered, New Society Publishers, 2011, pp. 89-90, emphasis by the author.)

[the-rukh.livejournal.com]

http://www.thefreedictionary.com/wealth

in the definition used by economics, wealth is basically the abstraction of the value of goods and services. Money is a physical representation of the abstract value of "wealth" without the direct representation. When we converted from money being a deposit for gold, and then silver, it really did just become an abstract unit of "wealth". If you can get something you value for money, then it is wealth- as long as we continue to value money as a currency.