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.






Wednesday, September 21, 2016

Lies, damned lies and statistics: emigration from Italy to UK





This article is part of the "Lies, damned lies and statistics" series.
In a past article, I wrote about the lies that information media produce each time they claim that a raise of the average wage in a Country is so important.
Now, let's talk about the figures of immigration/emigration. In time of crisis, these are key terms that are on everybody's mouth.

The newspapers and the TV news have hammered us with the story that the Brexit would be the end of Paradise for those Italians (and Spanish, and Rumanians. etc) living in the UK. There are articles claiming that half a million of Italians are resident in the UK!
Now, I have done some research.

To work in London you need a Nino (National Insurance Number). This is mandatory in order to have the possibility of going to the  family doctor or applying for a job or even studying.

So, an Italian that decides to live in the UK needs to be registered there,
If he has not communicated the AIRE (the official National bureo that tracks the Italians that are registered for living abroad) that he left his Country, the UK National Insurance Office does not care a thing. For the Italian Government, you are still in Italy, because you are not registered at the AIRE, even if you have been living for years in UK!

Now you start seeing something odd: UK National Insurance Office and Italian AIRE do not communicate with each other. This reflects dramatically in a huge error for the statistics of Italian emigration rate, that are based on the communication provided by AIRE.

Let's start digging into data.

According to the AIRE database, in 2012 (no info since then!!)  there were 210.000 Italians living in the UK.

According to the Dataset provided by the UK office for National Statistics (Table E of this file), in 2015 there were 192.000 Italians permanently resident in the UK.

Now we already see a problem. Apart for the three-years gap (AIRE data are available for 2012 only, UK data are updated to 2015), from 2012 to 2015 we know that many Italians left the Belpaese for UK. So, the numbers are biased: we would expect many more Italians in the UK dataset than in the AIRE dataset. Are they measuring the same thing?

Ok, things get complicated. Instead of looking at the residents, let's compare the country of birth: the reason is simple, maybe an Italian couple has had babies in the UK, the babies are Italian but they are registered in the UK.

So, there is this nice site, that takes data from the UK Office for National Statistics.

We can see from this graph:


that the Italian in the UK have been growing steadily since the crisis in 2008.
The difference between two consecutive years is therefore the net increase of Italians in the UK.

So, let's put some numbers:
2008: 105000
2009: 108000
2010: 118000
2011: 124000
2012: 133000
2013: 142000
2014: 150000
2015: 162000  //this is coming from Table A of this file

On average, in 7 years, the Italians that have left have increased by 60%!

NOTE: In Italy the Press is  crap, just have a glance at this article from a well-known newspaper, Il Fatto Quotidiano: they mention 550.000 Italians living in the UK in Jan 2014! THREE times as much as the real numbers! An error of 200%. I mean, if they cannot even read a table, just imagine the quality of their articles when it comes to economics and finance.

Now that we know how many Italians, born in Italy, are living in the UK year per year, we can compute a net saldo of migration for each year, with the data coming from UK statistics.

2009: +3000
2010: +10000
2011: +6000
2012: +9000
2013: +10000
2014: +8000
2015: +12000

Now, let's compare this data with the data provided by the Italian ISTAT (at this page), that stops at 2014 (indeed they are a bit lazy in updating the website! and also to personalize the graph is a bit cumbersome...)

NOTE: the website of AIRE is crap, we need something more professional. ISTAT is definitely better

Italians Leaving Italy for UK:
2009: 5042
2010: 5251
2011: 5378
2012: 7404
2013: 12962
2014: 13491

Italians Entering Italy from UK (maybe they were fed up of pudding and soups..):
2009: 2255
2010: 2208
2011: 2283
2012: 2202
2013: 2152
2014: 2398

We are almost there...
So, net saldo according to ISTAT, which is based on data coming from AIRE (sic!) is:

2009: 5042-2255 = +2787
2010: 5251-2208 = +3043
2011: 5378-2283 = +3095
2012: 7404-2202 = +5202
2013: 12962-2152 = +10810
2014:13491- 2398 = +11093

For example, in 2014 2398 Italians left UK for Italy, 2398 left Italy for UK, so anet of 11093 Italians left Italy for UK. Simple as that.


So, we can finally compare the data from the UK office for National Statistics and the data from the Italian office for National Statistics.

Total Italians that left Italy from 2009 to 2014 (UK Statistics): +46000
Total Italians that left Italy from 2009 to 2014 (IT Statistics): +35000

A graph explains things better than a thousand words.



On the Y axis, the net number of Italians that each year have left Italy.

There is a huge difference between the two data-sets: simply stated, many Italians did not registered by the AIRE the same year that they registered in the UK. The two plots are completely decorrelated, i.e. each of them follows its way regardless of the other's. We can see that in the middle of the crisis, in 2009, there was a boost of Italians leaving Italy (red line).
But in a period of 6 years this is not sufficient: simply, many Italians have NEVER registered at the AIRE, and I guess this is for a simple reason. When they go back to Italy, they can still go to the family doctor, to the hospital for free, have many rights that otherwise would be deleted in their home country. Just imagine if you are being paid by the government if you have lost your job: you do not declare that you are working abroad and you go on taking the monthly the unemployment benefit. Not a nice news for the ones who still live in Italy and who are paying taxes also for those who left.

NOTE: in case you are wondering, I have registered my family at the AIRE. I pay taxes and services both in the Netherlands AND in Italy. In the Netherlands the social security number is called BSN.

So, on average, we can say that, on a mid-long term, the statistics from AIRE are suffering from a  (35000-46000)/35000 = 31% of error, ie 31% of the Italians are not known to the Italian Government to be living abroad.

Since I do not think that the Italians that go to live in the UK are so different from the Italians that go to live in the Netherlands or Germany, I am pretty confident that ALL the statistics of the Italians living abroad are suffering from the same bias.

On average, the Italians living, eating, working, etc. abroad permanently are 30% more than what the official Italian statistics claim.
There are not 1 million Italians in the UK, or 500 thousand, but 192000, including children born in the UK from Italian families.
Now you have the right figures and you can have conversation and comment news about Italians living abroad with a bit of background knowledge.

Another point worth noting is the following: the difference of 30000 people in 2015 between the Italians living in UK (192000) and the Italians living in UK that were born in Italy (162000).
This means that roughly 30000 children were born in UK from Italian parents in recent years. This is going to be an interesting topic for a future post.