Tuesday, October 25, 2016

Fractional reserve banking demystified: how money is multiplied today

This article is part of the Money Series
Note: if you click on the link above, you will be redirected to all the article on the Money Series available both in English (hosted at Exiteconomics.blogspot.nl) and in Italian (hosted at Rischiocalcolato.it). 

In the last article, we discovered what Bank Reserves are: in essence, they are the deposits, held at the Central Bank, that commercial banks use to make payments with each other.

Understanding the Central Reserves is fundamental if we want to understand one of the ways money is increased today inside the commercial bank system.

We have already seen how a commercial bank can expand the money in circulation by making loans and mortgages. We still lack an understanding of how this works on a systemic basis, ie taking the bank circuit as a whole.

The classic theory involves the fractional reserve banking mechanism.
The explanation sounds like this.

Mr. Adam White goes to bank A and deposit 10000€ in his bank account. If the law imposes that bank A keeps, let's say, 10% of the deposited sum in the form of bank reserves, then bank A will put 1000 € (that is 10% of the original 10000 €) in its account by the Central Bank.
There are 9000 € left for the bank to give out for a loan to another guy, let's call him Mr. Black.
So, Mr Black takes 9000 euros and pays Mr Smith, who has an account in bank B. Mr Smith deposits 9000 euros. Then, Bank B puts 900 € (10% of 9000 euros) in bank reserves, and is free to give the remaining 8100 away in the forms of loans. And the process starts over again.

So, in brief, the original 10000 have become in the overall customers' deposits, after many transactions:

10000 + 9000 + 8100 + 7290 + ... = 10000 * (1 + 0.9 + 0.9*0.9 + 0.9*09*0.9 + ..) = 10000*1/(1-0.9) = 100000

So, according to this theory, after many transactions, we have a geometric series converging to ten times the original capital, ie 10K have become 100K.
And the reserves?
Well, the principle is the same: the first bank puts 1K in reserves, the second bank puts 10% of 9K in reserves, so 100 euros, and so on.
In other terms, the total amount of reserves will be the reserve ratio times the total credit.
In this case: 10%*100000 = 100000

So, bank reserves have increased 10 times.
Total credit created: 100000 in commercial bank accounts plus 10000 bank reserves

What happens if the reserve ratio, set by the Central Bank authorities, is increased to 15%? in this case, only 85% of the deposit is available to the bank for extra loans, since 15% must be kept in the form of bank reserves.
The original 10K now becomes:

10000 + 8500 + 7225 + 6141.25 + .. = 10000 * (1 + 0.85 + 0.85*0.85 + 0.85*085*0.85 + ..) = 10000 /(1-0.85) = 66667
So, credit has increased 6.67 times.
And, for the bank reserves:

15%*66667 = 10000

the total bank reserves have not changed!
Let's make a simple table: we start with a capital of 10000 euros.

Original deposit
Reserve Ratio
Total credit in bank accounts
Total Bank reserves

Note: I ran some mathematics, here, simple geometric series expansion, and to me the formulas are the following (feel free to correct me if I am wrong):
C is initial capital
r is reserve ratio
Total credit becomes: C*1/(1-(1-r)) = C/r
Total reserve becomes: rC*1/(1-(1-r)) = C

That's the power of mathematics.
With the same initial deposit, even if the reserve ratio decreases, the total bank reserves are the same, equal to the first deposit, while credit can explode (up to 1Million from an initial deposit of 10K).
I remind you that it's up to the Central Bank to decide the reserve ratio, that is the ratio between the loans and mortgages a commercial bank can create and the quantity of reserves the commercial bank needs to keep for customers to do bank transfers to other banks and to withdraw money from the ATMs.

Some observations:
1. This model does not explain where Mr White, the original depositor, our "Adam", the first man,  got his money from. Somebody gave him the money.
2. This model assumes that the Central Bank fixes the reserves and so the Commercial Banks fixes the maximum amount of money they can give out to people and firms in the form of mortgages and loans. In other terms, the Central Banks can decide the amount of money in the Country according to this model. The Commercial Banks can only obey. You see? you fix the reserves, column in the right-end, and by modifying the reserve ratio, you have control over the credit.
3. Due to the control of the Central Bank, each moment the amount of credit in a Country is known and can be scaled up or down, according to specific needs.

Now, we have seen that Commercial banks can increase the quantity of money in circulation by making loans basind on internal decisions (ie, is the customer able to repay the principal plus the interest?). So, the first point is easily answered if we think that the banks create "endogenously", that is from the inside, the money. They give money to our Adam, the first man, by creating for him 10000 euros out of thin air. Of this, the bank puts 10% in the form of reserves, by the Central Bank.
Then, the show can get started.
But, and this is fundamental, every bank of the chain can EXTEND credit by creating loans and mortgages. This is not considered in the fractional reserve model. So, yes, banks keep reserves in the Central Bank registers, but it is UP to the Commercial banks to decide how much money they will put there: they will put there 5%, 10% or 15% of the money they create!

So, it is not the Central Bank who can determine the amount of credit in the country. The Central Bank can fix the ratio of the reserves, but the quantity is eventually decided by the commercial banks.

That's why the fractional reserve model is inherently incorrect: it does not take account that Commercial Banks can extend credit on their own, and assumes that Central Bank has total control over the credit in a country.

Of course, if reserve ratio decreases, banks have even more stimulus to lend money, but the real driver of credit creation by commercial bank is the confidence that the depositor will be able to repay his debt.

Friday, October 14, 2016

Guest post: The gold manipulation silliness continues

I love ZeroHedge. Really. They provide information that typically you cannot find elsewhere, and they give much importance to the Austrian School. Many valuable bloggers can publish their posts there and you can learn a lot.
Nevertheless, they have been shouting at the end of the financial world for years, and sometimes, in order to produce counterinformation (or contra-information), they go a bit too far with the "contra"part.

In this post, originally posted here, Steve Seville simply shows that sometimes there is no gold "manipulation"in the way many commentators propose, and the explanations for the recent downward movement of gold futures and gold mining stocks are simply related to US bond markets and expectations on the American bond yields in the future.
Let's be clear: every market is rigged. Just think about the recent Libor scandal. Nevertheless, this does not mean that since gold is the ultimate money, as many repeat like a mantra, every time that the price of gold drops there must be manipulation, while if the price goes up, then there is no manipulation.
Of course, we are moving into a world of negative interest rates, so it is my opinion that, on the long run,  the gold is a kind of protection against the loss of money you get into if you keep your money in a bank, or if the faith in the central banks start to deteriorate or if we enter into hyperinflation. In any case, these changes do not come all of a sudden (wars or alien invasions excluded) so it is a waste of time to think about hyperinflation risks right now, or the imminent collapse of the modern State as we know it.


Not surprisingly, one of the silliest explanations for last week’s sharp decline in the gold price appeared in an article posted at the Zero Hedge web site. According to this article, the only plausible explanation for the decline is rampant manipulation while China’s markets were closed for the “Golden Week” public holidays*.
In an effort to prove that manipulators in the West routinely take advantage of China’s markets being closed to suppress the gold price, the article includes charts covering the 2015 and 2014 “Golden Week” holiday periods. These charts suggest that, as was the case this year, the gold price tanked during each of the preceding two years when China was closed for business. However, the charts are very misleading. Deliberately so, in my opinion.
For example, the following chart from the article suggests that the gold price plunged from the $1140s to around $1105 during the 2015 “Golden Week” holidays and then quickly recouped its losses after China’s markets re-opened, but that’s not the case. The “Golden Week” is from 1st to 7th October every year, so what actually happened was that the gold price fell from the $1140′s down to around $1115 during the days leading up to the 2015 “Golden Week” (while China was open for business) and then rebounded to the $1140s while China was on holiday.

During the 2014 “Golden Week” holiday period there was no net change in the gold price.
The belief that manipulation is the be-all-and-end-all of the gold market is based on two false premises. The first is that the fundamentals are always gold-bullish. The second is that when financial markets are free from manipulation they always move in concert with the fundamentals. If you hold these two totally-wrong beliefs then every time there is a significant decline in the gold price you will naturally conclude that manipulation was the cause.
The reality is that gold’s true fundamentals have been deteriorating since July and that the pace of deterioration picked up over the past three weeks. At the same time, speculators in gold futures were adding to the risk of a steep downward price adjustment by stubbornly maintaining an extremely high net-long position.
The following chart compares the gold price with the bond/dollar ratio. The fundamental deterioration and the delayed response of the gold market can clearly be seen on this chart.

Gold market participants and observers who were looking at the right indicators (bold is mine) will not have been surprised by last week’s price decline.
*China is apparently the bastion of honest price discovery in the gold market and corrupt Western bankers apparently wait for the Chinese to go on vacation before launching their bear raids.

Tuesday, October 11, 2016

What are the bank reserves? why are they so important?

This article is part of the Money Series.

Last time, we saw how a single commercial bank can create money by creating loans, so expanding its  balance sheet, and how it destroys money when the loan is repaid, so contracting its balance sheet. In a fiat money system, the trend of credit is always increasing, otherwise the system collapses, since to repay the interests and to have growth, new money must be created. Before reading this post, I strongly encourage you to have a look at that post.

Today, we want to focus on bank reserves: what they are, what is their purpose.
It is essential to understand the bank reserves if we want to understand:

1. how money is transferred from one bank to another.
Example: you pay the car dealer by means of a bank transfer from the account that you have at your bank, and the account that the dealer has at his bank.
2. where the cash comes from
Example: you go to an ATM and withdraw some money. Is this money following a different bank circuit than the money that you pay through a bank transfer?
3. How the famous Quantitative Easing works
Example: the ECB is said to be injecting 80 billion euros in the economy each month
4. What is an Open Market operation
5. What happens if there is a bank run
6. How money is "multiplied" when money is moved from one bank account to another (or "fractional reserve"mechanism, which is non correct, as we will see in the future).
7. Why banks want to become bigger and bigger.
8. Why the recent war on cash.

I remind you that currently there are three types of money:

1. Cash, issues by the Treasury
2. Bank deposits, that is Money created by the commercial banks
3. Bank Reserves, created by the central banks

Cash accounts only for less than 3% of the money in circulation, which is measured by the indicator M2. The rest, that is 97%, is created by commercial banks, and this is the money we use for settling payments on a daily basis.
Bank reserves are "digital cash"that banks use to settle money transfers between them, so they are not considered in M2 Money supply, because they can be used only by banks and not by ordinary people. You cannot go to the grocery shop and pay with bank reserves.

I also remind you that nowadays there exist the following identities:

Money = Credit = Debt

Money is credit since it is always created by banks and it comes with an interest: you pay back in the future more money than what you got from the bank. Since credit is somebody else's debt, the second equality is straightforward.

We can argue that real money is such when it does not bring an interest: therefore gold is real money, bitcoin is real money and cash is real money since they do not bring an interest, or a yield. This is going to become an academic discussion, that I leave to others since, at least to me, the added value of this kind of discussion tends to zero after the first 5 minutes. I already discussed this point here.
In its essence, since money today is digital, money is information, it is a collection of ones and zeroes in the bank ledgers. And as any ordinary information, it undergoes through a complex process that modifies it, spreads it, compress or expand it, and destroys it eventually. How this process is standardized is at the very basis of our civilization.

Now, you can view bank reserves as cash that banks keep at the central bank. These deposits at the central bank are typically a percentage of the loans that commercial banks have in their balance sheets. Why? let's make an example.

Bill has an account at bank B. Charlie has an account at bank C. Charlie is a car dealer.
Both bank B and bank C have an account at the central bank, and each of them has a certain amout of reserves on its own account.
Bill goes to Charlie, buys a car and sets the payment by a bank transfer.
Bill's account at bank B decreases by 10K, the reserves of bank B at the central Bank decreases by 10K, while the reserves of Bank C at the central Bank increases by 10K, and these 10K are also an increase of Charlie's account.

So, the net transfer of money from Bill's account to Charlie's account is actually a transfer from Bank B to Bank C, and this is done via a exchange of bank reserves. There is no van with cash going from Bank B to Bank C. Only a net transfer of "cash-like"reserves, completely digital...and cyphered.

Indeed, reserves are like cash for banks. Extremely liquid, they can be moved by typing figures on a keyboard.

In a day, there are millions of bank transactions, and most of them will clear up with the others: in other terms, many bank transfers may go from bank B to bank C, but many others, in the same day, may go the way aroung, from bank C to bank B. So, in reality, the NET settlement is just a tiny fraction of the overall payments. That's the main reason why the bank reserves are only a fraction of the assets of a bank.

When you withdraw money from an ATM, the cash reserves of the bank decrease by the same amount. So, theoretically, if many people go to the ATMs or to the bank counters to withdraw their money or send their money to other banks, the bank reserves of the "victim"bank may go rapidly to zero. In that case, either the bank can get extra reserves (by paying an interest, of course) from other banks or from the central bank, or the bank becomes illiquid, ie it cannot pay its debts on the short term: if you want to repay a debt, and you are without cash, you can sell your car, but it requires time. In the meantime, you are formally bankrupt.

Of course, the bigger the bank, the less money in reserves it needs to have in percentage with its assets. In fact, the net settlements on a day by day basis will be minuscule with respect to the size of the bank. Ideally, if there was only one super bank, its  bank reserves held at the central bank would go to zero since all the payments and bank transfers would be internal. So, bigger is better for banks since they can keep less reserves with respect to their size.

You can imagine that, if a bank is supposed to have 10% of his assets in bank reserves (in reality it is much less), this is money that cannot be reinvested in assets with a higher yield. Especially now that Central Banks are giving zero or negative interest rates. So, the less it is, the better it is for the bank.

In this context, a war on cash, that is the banning of cash, for a bank is extremely helpful: it decreases the risk of going illiquid if too many people withdraw their money at the same time. Simply, they cannot.
So, a "no cash policy"is definitely good for banks, which also get total control over your deposits: just remember, when you put money in your bank account, that money belongs to the bank, which has a liability towards you. That's why you have to communicate your bank in advance if you want to close your account with them.

We have answered some of the questions listed above. In a future post, we will have a thorough view on the fractional reserve, or money multiplier, model.

This graph is taken from here. It shows the vertical increase of credit in UK up to 2010, when the crisis hit violently UK. You can see by yourself that the increase of credit was much sharper than the increase of the central bank reserves up to the burst of the financial bubble. The UK reacted by lowering the interest rates, devaluing violently the Pound Sterling against the euro and the dollar and pumping reserves through Quantitative Easing.

Wednesday, October 5, 2016

Guest post: wearing blinders when analysing China

This post was originally written by Steve Saville and is available at the following address.


I really appreciate Steve Seville's commentaries, so it is a pleasure for me to join his views on economics with you all.

Some analysts who are usually astute and show a good understanding of economics seem to put on blinders before looking at China. It’s as if, when considering China’s prospects, they forget everything they know about economics and refuse to see beyond the superficial. A recent example is Doug Casey’s article titled “Chung Kuo“.
Here’s an excerpt from the Casey article:
I can give you a dozen credible scenarios describing what might happen in China over the next couple of decades. But the trend that seems certain to continue is the rapid rate of wealth increase there. I don’t credit official figures with any great accuracy, but if we take them as being approximately right, then the U.S. economy is growing at 2%, and China’s at about 7% — but with a base of about four times the population. What this means is that the largest economy on the planet will soon no longer be America’s — but China’s.
There are two big problems with the above paragraph. First, after saying that he doesn’t credit official figures with any great accuracy he takes these figures as being approximately right. The reality, however, is that China’s reported growth figures are completed fabricated. It’s not that China’s government reports growth of 7.0% when the actual rate of growth is 6.5%; it’s that China’s government reports growth in the 6.5%-7.5% range every year regardless of what’s happening. If the economy were shrinking rapidly the government would still report growth in the 6.5%-7.5% range. Based on other measures of economic activity there have almost certainly been 12-month periods over the past 10 years when China’s economy shrank in real terms, but during these periods China’s government still reported growth of around 7%.
The second problem is that the monetary size of an economy is irrelevant to the people living in it. What matters is per-capita wealth, not aggregate wealth and certainly not aggregate spending (which is what GDP attempts to measure). For example, it’s quite possible that in size terms Nigeria’s economy will overtake Switzerland’s economy within the next few years, but so what? Nobody in their right mind is saying that if this happens then the average Swiss will be worse off than the average Nigerian, because it obviously must be taken into account that there are 175M people in Nigeria and only 8M in Switzerland.
The Casey article then goes on to list some of the things that China has going for it, but most of these things were just as applicable 100 years ago as they are today. Therefore, they aren’t critical ingredients for strong, broad-based economic progress.
Surprisingly, given that Doug Casey’s big-picture analysis is usually on the mark, the Casey article fails to address any of the most important issues. There’s no mention, for example, that China has a command economy with only token gestures towards free markets.
The true colours of China’s economic commanders were shown in 2015 following the bursting of the stock market bubble that they had purposefully created. I’m referring to how they became increasingly draconian in their efforts to stop the price decline. When words of support didn’t work, they made short-selling illegal and began to aggressively buy stocks. When that didn’t work, they forbade corporations and investment funds from selling at all and made it clear that bearish public comments about the stock market would not be tolerated. And when the market still didn’t cooperate, they started apprehending or ‘disappearing’ people suspected of placing bearish bets.
Related to the “command economy” issue is the fact that China has always had an emperor. This means that there is no history of freedom or a culture of individual-rights to fall back on. Furthermore, Xi Jinping, the current emperor (who doesn’t call himself an emperor), has shown admiration for Mao Tse Tung, the most brutal emperor (who also didn’t call himself an emperor) in China’s history.
There’s also no mention in the Casey article that over the past 10 years China has experienced the greatest mal-investment in centuries. You would have to go back to the pyramids of ancient Egypt (Note  by Exiteconomics.nl: this example is the same as the one mentioned by Richard Duncan here) or the building of the Terracotta Army by China’s first emperor more than 2000 years ago to find comparable examples of resource wastage on such a grand scale.
All the ghost cities, spectacular-but-mostly-vacant shopping malls, barely-used airports and bridges to nowhere have boosted the Keynesian measures of growth — such as GDP — that don’t distinguish between productive and unproductive spending. Consequently, even if the GDP growth figures reported by China’s government bore some resemblance to reality (they don’t), the reported growth wouldn’t be a reason to be optimistic because so much of it is associated with wasteful spending. Moreover, the bulk of the spending is debt-funded by State-controlled banks that would make Deutsche Bank look financially ‘rock solid’ if given a proper accounting treatment.
Next, there’s the legacy of the “one-child policy” to consider. Thanks to decades of the national birth rate being restricted by the giant boot of government, China is now facing a major demographic problem. Specifically, for at least the next couple of decades the number of prime-age workers is going to shrink relative to the elderly.
Finally, it is worth mentioning China’s mind-boggling wealth disparity. A few hundred million people are doing OK and a few million have become extremely wealthy while at least a billion people are living in abject poverty.
As to why some people who produce well-reasoned analysis of what’s happening in the Western world seem incapable of applying the same principles and logic when analysing China, I can only guess. My guess is that they are too focused on trying to show the US in a negative light to see what’s going on in China. It is, however, possible to be concerned about the direction in which the US is heading without being bullish on China.

Saturday, October 1, 2016

Money series: how commercial banks create money (part 3) - money creation and destruction

In our last post, we have examined on a very high level the four misconceptions that surrounds the process by which money is created by commercial banks.
Now it is time to dive into more details and provide an example of the way money is created when Mr. Smith goes to a bank and apply for a loan of, let's say, 20 k€.

Money creation
Let's imagine that the initial balance sheet of the bank looks like this.

Shareholder equity: 1000000

For the sake of simplicity, we are assuming that the liabilities are only made by the shareholder equity, that sum up to 1M€. This money has been invested into assets for an equivalent value of 1 M€.

Now Mr. Smith steps into the bank and ask to borrow 20K€ for whatever reasons he may have. Let's suppose he needs to buy a new car for his business. The bank checks the financial situation of Mr Smith and grants him the loan.
Here is how the new balance sheet of the bank looks like:

New loan to Mr. Smith: + 20000
New account for Mr. Smith: +20000
Previous assets: 1000000
Shareholder equity: 1000000

Total Assets: 1020000
Total Liabilities: 1020000

We can see some important things, here:

1. In the immediate term, the bank does not need to find the money from anywhere, therefore...
2  ..there is no "lending" here. There is money creation.
3. The only thing that counts is that the bank considers Mr. Smith trustworthy to pay back the debt.
4. Most important: by increasing both sides of the balance sheets simultaneously, by 20K, the bank has created new money and this money is available to Mr. Smith that can spend it in the real economy, improving the GDP (he asked the money to buy a car for his business).

Let's suppose that the loan is for a duration of 2 years and the payment the interest to be paid is 5% year. Let's suppose that the bank is paying Mr. Smith 1% of interest on the deposit.
The margin for the bank is 5-1 = 4%. This spread is the origin of the profit for the bank. So, this is why banks makes money by creating money and applying a spread between the cost of money for the borrower and the cost of money that the bank has to pay for the depositors.

Money destruction
The very first day after he got 20 K€ from the bank in his account, Mr. Smith goes to a car dealer and buy a 20K€ car. Let's suppose that he makes a bank transfer from his bank to the dealer's bank, which is different from Mr Smith's bank. An intermediate balance sheet would look like this.

Existing loan to Mr. Smith: + 20000
Existing account for Mr. Smith: +20000 – 20000 = 0
New assets: 1020000 - 20000 = 980000
Shareholder equity: 1000000

Total Assets: 1000000
Total Liabilities: 1000000

Since there is no money in Mr Smith's account, the liabilities entry for Mr. Smith goes to zero.
Nevertheless, he has still to pay his debt, so there is no change in the existing loan to Mr Smith row. The new assets lowers by 20000, because Mr. Smith took away his money from the bank, in the form of bank reserves. We will cover better this point in the next post. Since Shareholder equity is the algebraic difference Assets - Liabilities, this means that the shareholder equity goes back to 1M€.

Now, after one year, Jack can pay his debt to the bank, which is 20K, plus the interest: after one year, the bank got 5% of 20K, which makes 1K, and has reinvested this extra 1K in other assets.

Exist. loan to Mr. Smith: + 20000 - 20000 = 0
Exist. account for Mr. Smith:  0
Previous assets: 1000000
Shareholder equity: 1000000 -> 1001000
New assets: +1000 //interest paid by Mr. Smith

Total Assets: 1001000
Total Liabilities: 1001000

After one year, there are 19000 euros less. This money has been destroyed.
The extra shareholder equity, 1K€, is the profit of the bank, coming from the interest on the loan, that can be used to pay staff, taxes and the shareholders in the form of dividends.

So, let's recap: 20 K were created, 20K were destroyed, extra 1 K, the interest over the loan, became the profit for the bank, created elsewhere. During this loop of  creation and destruction, money has been used by Mr. Smith to buy a new car, the new car has been bought from a car dealer that has put the money of the sell in his bank account, in order to buy other goods and services on his turn. The process of how money flows from one bank to another is explained by the principle of endogenous money theory, that we will cover with detail in a future post, dealing also with the study of what bank reserves are and what their use is for.
NOTE: The endogenous money model is a much more accurate description of the process according to which money is increased across the banking system as a whole, than the obsolete and inaccurate fractional reserve model. Don't be scared. Money creation is a complex phenomenon and that's why bankers have so much power. People are ignorant in these topics. We only need patience and time to understand the basics.

The bank has made profits by creating money and giving it to a customer who was believed reliable to pay back his debt. The shareholders of the bank got money thanks to dividends on the interest upon the loan of Mr. Smith.
And the government got money from a percentage of the profits of the bank, that is, again, as a percentage of the interest of the loan paid by Mr. Smith, who works hard in the real economy to pay back the principal and the interest on the principal.

So, in a nut shell, the initial creation of money is, in its essence, a risk management evaluation: is the guy asking for a loan able to repay his debt (principal + interests)?
This risk assessment is done by the commercial bank

Now we can start figuring out one important point: if bankers are skeptical about "lending"money to people and enterprises, you can imagine that on a long run, as long as  interests and capitals are paid back, the overall amount of credit in the economy drops.  This leads to recession. Because of this mechanism of credit creation and destruction, if the rate of credit destruction is higher than credit creation, the bridge between the present and the future (such as credit) is wearing out and we dive into a disaster, since the economy suffocates by the lack of credit. Credit, in the present monetary system for economy, is like what water is for a fish: if there is not enough water for the fish to swim and breathe, the fish slowly dies.

This is the precise reason why Central Banks have started injecting huge amount of easy credit in the economy. Since private banks did not lend, then the Central Banks had to intervene starting from 2008 not to end up into another Great Depression like the one in the Thirties. But this important topic is out of scope of the present post. We will talk about Quantitative Easing and negative interest rate policy in the future.

We conclude this post by saying that lending for productive activities to businesses, like the one of Mr Smith, is only a small fraction of the total lending by banks: on average, they account only for 7% of total lending by banks.

Tuesday, September 27, 2016

Money series: how commercial banks create money (part 2) - common misconsceptions

This article is part of the Money series in this blog.

In this figure, the money created by commercial banks in UK from 1969 to 2014.

The preliminary considerations I exposed last time were just an explanation of the methodology the I follow when I study economics. This led me to demolish some common misconceptions I had..

NOTE: an excellent book that explains how money is created nowadays is "Where does money come from?", by Positive Money think tank. It is not a super-easy book, nevertheless it is a mandatory read for everybody interested in the topic. The theories it carries on are very well documented. 

First misconception: the money that you deposit in a bank is yours. 
We have already covered this misconception in a previous post, extensively.

Second misconception: A bank lends you money when you apply for a mortgage or a loan.
The act of lending implies that you renounce to the possession of something for some time. For example, you may lend 20000 € to a friend of yours, who will give it back to you the next year.
In this case, for one year, you have 20000 € LESS at you disposal.
In the case of a bank, this is not true. Simply, the bank creates money from thin air when you ask for a mortgage. The bank does not take any money from anybody when it puts 20000 in your bank account. When a bank gives you money, it expands the money in circulation, by the same amount of your loan. That is why currently 97% of money in circulation, called M2 money, that is the money that everybody uses, is made of money created by commercial banks. Only 3% of the money in circulation is made by coins and notes, that are printed by the Treasury.

NOTE: this is extremely difficult for an average person to accept. I have done technical studies, and to me the first law of Thermodynamics,  that is , broadly speaking, nothing can be created or destroyed but only transformed, is a kind of basement in my brain. In finance, under current monetary system, it is not like that: Money is created and destroyed by banks.

So, a bank does not lend you any money, it creates money from nothing and gives it to you in exchange for the original principal plus the payment of interests. You and the bank are binded by a contract, for example the mortgage contract, that is an asset for the bank. More on this in a future post.
Remember, in today's world, there is no difference between money and credit, as I explained here.
You may wonder where the money for paying interests is coming from. Of course, on average, if we consider million people and transactions with the pertaining interest rates, it is money created in the future by other banks.

Third misconception: money is created by means of fractional reserve mechanism.
For an explanation of how fractional reserve works, please visit this page.

This assumption is not completely wrong, but it is strongly misleading.
First, it does not explain who creates money first. If you go to a bank and deposit, say, 10000 euros in your account, and this 10000 euros are turned into 100000 euros in the system thanks to a reserve ratio of 10%, you are missing one piece of the puzzle: who gave you originally the first 10000 euros?
Second, banks nowadays have many many ways to bypass the reserve ratio control, so actually it is up to the bank to decide how much money through loans and mortgages they want to inject into economy, and according to this figure the bank sets apart amount of reserves it needs to keep in liquidity to obey the law. It is not the way around, that is it is not the basic reserve that determines how much credit a bank can produce. Theoretically, there is no limit, no ceiling, to the amount of credit that a bank can create.
Third, this model assumes that Central Banks can control the amount of money in the economy, by changing the monetary base. More on this in future posts. This implies that there is no possibility that money supply can get out of control. Of course this is false, as the crisis of 2007 reminds us.

Fourth misconception: banks takes money from savers (families) and lend it to borrowers, like firms (that can invest this money).
This is the story that everybody is told since their childhood. It is false. As we have already seen, banks create money from nothing. They do not take money from one party to give it to another party. Of course, banks make money by charging borrowers more for a loan than it is paid to depositors. But that is a complete different matter. Banks make money when they create money, by applying a delta between the cost of money for the borrower and the cost of money for the bank.

Since credit is the bridge between the present and the future for the population, you can imagine that if you leave the control of the credit erogation to a private company (a bank IS a private company), then it is only up to the mood of bankers if we are in excess of credit or in shortage of credit. If the banker feels insecure about giving me credit, then it does not issue mortgages. If he feels we are in a boom, he will give me the money. It is not that he does not give me the money because there are not enough deposits from savers in his bank to take the money from, for my needs!

So, after this introduction, two question may arise:
1. If banks can create money "ad libitum", at least theoretically, why can they go bust? Why cannot they create all the money they need to avoid bankrupcy?
2. If banks can crete money "ad libitum", at least theoretically, why are they so scared of a bank run, ie when a large number of depositors decide to withdraw their money?

I will answer these two questions in another post.

To conclude this post, I invite you to watch this excellent, yet professional, short video, by Positive Money, that shows the misconceptions I have written about so far. Subtitles are available in many languages.

Monday, September 26, 2016

Money series: how commercial banks create money (part 1) - preliminary considerations

This article is part of the "Money series" in this blog.

In our last post of the Money series, we learned that the money that you put in a bank is no longer yours. Legally, it belongs to the bank, which on its turn has a liability to you.
Nevertheless, after several posts about the origin of money, what money is, what it the deep meaning of an interest rate applied to credit, we still don't know who creates money.

This is one of the most important questions ever: where does the money come from?

It is odd that everybody uses money, yet they ignore who is in charge of creating it. I started questioning the origin of money in 2014, when I began studying investment strategies and macroeconomics. When the stock exchange collapses, and TV news claim that 3 billion euros were destroyed, where did they actually go? When there is a surge in New York Stock Exchange, where is this money coming from? When the FED claims they have printed 1 trillion dollars, how this money was created? where did it go?
And still: when you buy a house by means of a mortgage loan, and the bank gives you the money, how did get the money on the first instance? When you pay back the principal and the interests, on a monthly basis, to the bank, where is this money going?

Ok, let's get started.

There are two ways that money can be created:

1. By central banks
2. By commercial banks

In the following posts, we are going to cover the process of money creation by commercial banks. How money is created by central banks..well, I am still studying it. I have little time to dedicate to my studies in monetary economics, at work I am moving to other projects and I have to study also other engineering and product assurance documentation. In any case, maybe later than sooner, I will be able to explain also the exact way central banks create money.

Before moving on, it is important to get rid of some common misconception, which are unfortunately very popular by the people, also "supposed-to-be"economists and journalists. Bear in mind that economics is a very wide social science, therefore those who claim to be "experts" in economics are already lying: it is like asking a heart surgeon if he is also and expert in tumors only because he has studied medicine!
I consider economics as a social science because economy is a byproduct of human activity: to get and maintain a complex society, you need complex financial tools. Renaissance was born in Italy not because of the nice weather, but because the family of Medici invented extreme powerful financial tools to be able to survive for decades and fund artists and scholars. They turned from gangsters into banksters. One day I will cover this nice story in a dedicated post.
The financial tools are created by human beings so their behavior is not predictable like the motion of an electron in an electromagnetic field, which is easily described by Lorentz law.
As a consequence, those economists who claim they have found the perfect explanation of the law of economics make me laugh: how can you expect to have laws for humans in a world which is continuously changed by human beings? When demographic forces, technological innovation, information media, and many other factors altogether concur to change and influence each other?
That is why there are so many economic theories. Each theory has its flaws. You discover the flaws only after there is a change in history that cannot be explained by the former theories.

NOTE: The Nobel Prize for economy is a fake Nobel Prize. It is a marketing ploy.

I am not an academic. I do not embrace a particular theory like a Taliban. I only want to understand how things work "hic et nunc", here and now. And to understand how money is created and transferred across the population is mandatory if you hope just to scratch the surface of how the world works nowadays. From the crisis of pension funds, to how everlasting wars can occur, to the rising of inequality in the Western countries, to the importance of private debt over government debt, to the generation of the Japan and Chinese bubbles in the last thirty years, and so on.

This long introduction was just to make you aware that for me the key point for a good post is to find somebody destroying my theories. It makes no sense in looking for evidences to support my findings: I had already these evidences when I formulated and explanation to the events I had observed! If I read ZeroHedge (Austrian school, basically) and I am convinced that the Doomsday is coming, and the Doomsday has not arrived yet, it is mandatory for me to accept the idea that they have to be wrong somewhere. Or, if I read Krugman (Keynesian) and he is one of the promoters of the super Quantitative Easing by the Bank of Japan, and this policy is not producing the expected outcomes, it is important to understand, if I am a long-term investor or a simple saver, the reasons behind all this and the delta between the propaganda and the reality. I can end up making money or losing money.

It is not only for a pure research of the Truth, with the capital T. Nobody knows that, you can simply come closer to that. The Truth is like a mathematical asymptote. You get as close to it as you can (providing that your life is finite and your free time is even shorter!), but never touch it.

Since the way money is created is by far and foremost the most important topic in economics, we will cover this in detail, with an open minded approach, and will examine the social consequences of all this, that are of extreme importance.