40 thoughts on “Weekend reflections

  1. Just to keep it clear, I have done up a spreadsheet, using your example above. It is here.
    It clearly shows what actually happens. You deposit $100 in the bank, earned from some productive activity. It lends out $90 (keeping $10 as its reserve), which then gets used for something productive and then re-deposited. The bank then lends out $81 (keeping $9 this time). This is then also used for something productive and re-deposited.
    In the end, the bank has a total amount lent out (I stopped at 5 cents on the spreadsheet) of about $899.44, liabilities to pay depositors of $999.37 and a total amount of reserves of $99.94.
    There is still only the original $100 in the system, Kevin – it has just been used (in my example) 70 times for productive purposes.
    If you claim (as I presume you do) that this means there is now (approximately) $1100 in the system I say that is balderdash. This is exactly the same as saying that if there is only one hammer on a building site, being used by the 6 tradies there in turn that we really have 6 hammers. Sorry, Kevin – there is only one hammer.

  2. Andrew,

    If the loans are all paid back then there is only $100 left on deposit. However at some point in time there is $1000 in deposits in the bank. Freeze frame the system. Observing all this from the outside and “forgetting” about the loans we can see with our own eyes $1000 in deposits. To you the banks may not have created $900 but most people will see $900 and they will act as though the money was “real”.

    Let us now imagine for some reason or another all the loans default and no money is repaid. How much money is on deposit in the system? It is still $1000. The lenders may have acquired other assets in return for their loans but there is $900 in extra money and there are no extra assets in the total system.

    This is why it is so dangerous to create money (even temporarily) this way. The most common way that things go wrong is that the loans are given for assets that are not worth as much the money loaned – the classic asset bubble.

    To make the hammer analogy match what happens with money then when a hammer is used on a different trade then a copy of the hammer is created and two hammers now work on different trades at the same time. When the hammer stops being used on a trade then the hammer “disappears”. At some point there will be six hammers all working at the same time. Freeze frame the system and we can see 6 hammers. The fact that five of them disappear after being used does not alter the fact that at some point in time we can see 6 hammers being used. Now let the mechanism that causes the hammers to disappear malfunctions and we have a surfeit of hammers:)

    I am not denying that there is only $100 of “real” money but I am saying that allowing banks to create extra money even for a short time is dangerous and leads inevitably to trouble. Calling it something else like fiat money does not make it less real.

    I haven’t even got onto the bit where I think the islamic approach has it right when they decry the payment of interest on the money created as loans. Interest on fiat money adds to the problem because until the money has turned into a productive asset there is nothing to pay the interest and we have to create more money from loans to pay the interest.

    I also haven’t got onto the creation of the first $100 of real money. It is also created through a loan mechanism so the question now becomes where is the real money?

    The proposal I am making is that we will have a better system if we get rid of fiat money and find another way of creating enough money that does not involve loans.

    In practice I do not think it necessary to get rid of fiat money if we have other ways of creating money especially if we can use those mechanisms to deflate asset bubbles before they get too large.

    That is, when we have a variety of ways of creating money then we will not get the lemming like rush of money to the latest financial fad with its inevitable inflation of asset values and the panic rush of money out of deposits when asset values are shown to be wrong and loans are liable to default.

    I think you would agree that fiat money is “dangerous” and that our money system would work better if it did not exist – provided we had some other way of creating money.

    The discussion over whether we call fiat money real money or not is irrelevant to the issue. What is relevant is whether the mechanism I propose to increase the money supply will work and not have unfortunate side effects.

    I would urge you to look more closely at what is proposed because if it is a sensible way of increasing the money supply then the likely properties of a financial system with this mechanism inside it are pretty amazing.

    It should appeal to those with libertarian tendencies because it puts the government spending in the hands of the individuals not the government and it should appeal to the social democrats because it distributes new wealth through society and not mainly to the already rich. Fiscal conservatives should also like it because governments no longer have to go into debt to get public infrastructure built.

  3. Kevin,
    The point is that there is no extra money at all. Ever. The only money available to actually transact is the original $100 – now minus what the bank is holding in reserve.
    If people are ‘act[ing] as though the money was “real”’, what does this actually mean? They are not spending it. It is sitting in their bank deposit account. For them it is the same as if it were sitting under their bed. The difference with a banking system like ours is that, instead of it gathering dust under their bed it is out there actually being used for productive purposes – it is earning them interest. Borrowers are using it to either buy consumption goods or for investment.
    How is this a bad thing?
    As for “those with libertarian tendencies” I would completely and utterly disagree. I covered this a while back. To achieve such a ban the extent of the regulations and the force needed to achieve such a ban I see as being out of all proportion to any possible (if there are any) benefits.

  4. Expectations that the economy may have avoided a contraction in the March quarter have been raised by data showing a narrowing of the current account deficit and improvement in net exports, economists say.

    “The seasonally adjusted current account deficit was $4.614 billion in the March quarter, the Australian Bureau of Statistics (ABS) said on Tuesday, equivalent to about 1.5 per cent of gross domestic product (GDP).

    The ABS said net exports – the difference between import volumes and export volumes – would add 2.2 percentage points to GDP in the March quarter, after exports held up reasonably well in the quarter while imports declined sharply.

    ANZ Banking Group economist Alex Joiner said the large contribution of net exports would offset sharply lower business investment and residential construction.

    “It now appears that Australia may have avoided two consecutive quarters of negative growth and hence a ‘technical recession’,” Dr Joiner said.

    “ANZ is now forecasting GDP to expand by 0.4 per cent in the March quarter, reversing the 0.5 per cent fall in the December quarter and highlighting Australia’s relative economic resilience.”

    ANZ had forecast last Friday a decline of 0.2 per cent in the March quarter.

    ICAP senior economist Adam Carr also revised upwards his GDP forecasts from an 0.3 per cent contraction to a flat result.

    Mr Carr said there was a strong probability that GDP would be positive.”


    wow, who could have predicted that.

    It’s almost as though Chinese demand for Australian commodities rebounded strongly after the decline in the December/January period was exacerbated by the timing of Chinese New Year for 2009.

    I look froward to the Marxists and Austrians alike explaining how this result is ENTIRELY consistent with their respective ideologies.

  5. http://www.bloomberg.com/apps/news?pid=20601081&sid=avfqhRWZVKOs&refer=australia

    May 27 (Bloomberg) — The Baltic Dry Index, a measure of shipping costs for commodities, surpassed 3,000 points for the first time since October, buoyed by Chinese demand for iron ore.

    The index tracking transport costs on international trade routes rose 222 points, or 7.6 percent, to 3,164 points, according to the Baltic Exchange today. The measure posted an 18th straight gain, its longest advance in two years.

    “Such is demand that shippers “are almost pleading” to hire vessels, Stuart Rae, co-managing director of M2M Management Ltd., a hedge fund group that trades freight derivatives and operates carriers, said by phone today. The rally “is being driven by iron ore, by congestion in China, and by a lack” of ships available for hire in the Atlantic.

    The Baltic Dry Index advanced fourfold since the start of the year, recovering some of last year’s record 92 percent collapse. China’s iron ore imports ran at a record pace in February, March and April, according to customs data.

    The line of capesize vessels at Chinese ports has climbed to 70 from 33 two months ago, according to data from Simpson, Spence & Young Ltd., the world’s second-largest shipbroker. The carriers are waiting nine days to unload, compared with five on March 25.

    Contracts indicating future freight costs surged. July-to- September forward freight agreements, bets on the exchange’s future price assessments, rose 21 percent to $47,000 a day for rentals on capesizes. Panamaxes gained 16 percent to $21,250. ”

    Oh wait, I forgot we’re only interested in indicators supporting apocalyptic visions of economic collapse.

    Never mind then.

  6. Andrew,

    I am struggling to understand your view of the world. You ask

    “If people are ‘act[ing] as though the money was “real”’, what does this actually mean? ”

    It means people use the money to trade. They do not leave it sitting in their bank account. They spend it and it goes into someone else’s bank account. That is what makes money real. It is real if others will accept it in exchange for goods and services.

    I read your bit on regulating fractional reserve banking and you have missed the point on what fractional banking is about. We do not have to regulate loans to stop fractional reserve banking.

    To stop fractional reserve banking we stop banks being able to call loan IOUs Australian dollars. We require banks who make a loan to have a positive value for the total amount of deposits minus loans on issue.

    To stop fractional reserve banking we make the system simpler and we turn banks into institutions with the same rules as building societies or credit unions.

    Banks are more than welcome to create their own money from IOUs. I don’t mind them calling them bonds but I object to them calling IOUs Australian dollars.

    You haven’t answered my question. Will my proposal increase the amount of money in the system or not?

    You haven’t commented on the revised analogy of hammers.

    You haven’t commented on what happens to the money deposited in a bank account when a loan was made, subsequently transferred to another persons bank account and then original loan is not repaid.

  7. Kevin,
    1. If you create more money and use it then of course it means there is more money in the system – leading (if this money is more than is needed) to inflation.
    2. The revised analogy is obviously wrong – as there is only one hammer on the building site. A building site does not have hammers appear and disappear just because someone else is using it.
    3. If the funds are transferred within the bank then, obviously, nothing happens. If the funds are transferred to another bank than the cash reserves of one bank drop and the cash reserves of the other bank increase. Productive activity happens in the mean time This would happen with or without fractional reserve, so I do not see your point.
    As for the regulation – to stop FRB you would need to regulate banks into the ground. It is, as I presume you can see, a profitable activity for the bank and for the depositors – as well as facilitating the flow of funds to borrowers, reducing th ecost of borrowing. It is good for all involved.
    If you want to stop it the regulations to require this would have to be massive and intrusive to stop an activity that everyone actually makes a return out of. If you think this is good from a libertarian standpoint then I believe you really do not understand either what would be required or you do not understnad banking – or probably both.

  8. Andrew,

    At least we agree on one thing.

    “1. If you create more money and use it then of course it means there is more money in the system – leading (if this money is more than is needed) to inflation.”

    Where we disagree is with whether money that a bank puts into someone’s account when the bank makes a loan (and the bank does not have matching deposits BEFORE making the loan) is or is not creating money.

    If the bank issued its own currency and put that into the borrowers account then I would agree with you – but the bank does not do that. It is allowed to put in the common currency and that is different.

    I am not saying we stop lending. I simply say if you do not have matching uncommitted funds on deposit then you should not lend it. That is banks should have the same rules as credit unions and building societies.

    On 2 when you are using analogies to support an argument the analogy must be correct and your analogy requires hammers to appear and disappear because that is what happens with loan money.

    On 3 I agree it is irrelevant where the bank account resides.

    We do not have stop lending to get rid of FRB. All we have to do is to say if a bank has $x on deposit and it has $x in outstanding loans then the bank is not allowed to lend any more money.

    You seem to think that banks already do this. I keep saying building societies do but banks do not. Banks are allowed to lend more money than they have on deposit.

    You seem to think that because the bank is able to increase $x to $y then that is not creating money because $y-$x = the loan liability. I am sorry you are wrong. Going from $x to $y where you already have a loan book of $x increases the money in circulation while-ever the loan remains outstanding.

    Here is another question for you.

    What is the difference between a bank like the CBA and a credit union in terms of their ability to make loans?

  9. Kevin,
    There is no difference. None at all. In Australian law at least (similar to elsewhere) the difference between a “bank” and a “credit union” is simply that a “bank” has been inspected to a higher degree by APRA and holds at least $50 million in shareholder’s funds, a building society has at least $10m in shareholders funds and there is no lower limit for the credit unions. There is no other difference. They are all regulated under the same rules. People in the industry normally refer to them all as “ADIs” (Authorised Deposit-taking Institutions) just to make this point. Using the word “bank” is unusual and pointless.
    Just have a look at their balance sheets, as I invited you to do. If you can find one bank, anywhere on the planet, that has more in assets (loans etc.) than the total they have on deposit (their liabilities) plus equity then I will show you a bank that is not doing its accounting correctly – and has an auditor that should be sacked.
    It is simply not possible. Loans are funded by deposits and equity. There is no magical source of money for a bank. None.
    As for the process of granting a loan – you seem to be reading some very old textbooks. It is now very rare for the funds to be disbursed into a bank account. Typically the bank will simply mark a limit on an existing account or disburse the funds straight away.
    For example – I go in to the bank for a car loan. They grant the loan. What happens (normally, not always) is not that the bank will deposit the funds into a deposit account, but that they will either mark a new account (or an existing account) with a borrowing limit or that they will hand me a cheque to hand to the car dealer. From the bank’s point of view withdrawing the funds just to put them back on deposit makes no sense at all, as the regulatory capital and liquidity positions would be harmed by this sort of action. It does not (normally) happen.
    It happened up to the 1970s, but computerisation eliminated the need to account for it in this way.

  10. Andrew,

    You are correct in that banks and credit unions are both ADIs. Presumably the difference between a credit union and a bank is in the amount of credit they are allowed to generate. I have been unable to find the limits on credit creation allowed by any ADI. In other words I cannot find for Australia where the fraction of fractional reserve is defined for any institution.

    If there is no fraction and if banks and credit unions are allowed to create as much credit as they feel appropriate then the situation is even worse than I thought. You may be able to enlighten me if there is a limit and where it can be found.

    The discussion on whether money created through credit is or is not money is a sterile argument. I say it is, you say it isn’t. A more useful discussion and the one that I was hoping you and others would address was the proposal to increase the money supply through the mechanism I have described and have called an amasset to distinguish it from creating money through loans. http://stableproductivemoney.wordpress.com/2009/05/18/amasset-an-economic-tool-for-managing-economies/

    The current system is to create commercial money through the issuing of debt. However, according to Steve Keen the money system does not operate as expected. http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/
    He says that the empirical evidence is that the fractional reserve system does not work as described in text books. That is, the central bank loans some money which now permits the banks to lend more money up to the fractional limit. That is, the money from the Central bank comes first then commercial money. The empirical evidence is that credit expands first then the Central bank issues more money – not the way of the text books.

    If this is the case then it makes it even more urgent to find ways other than debt of increasing the money supply because Minsky’s Financial Instability Hypothesis appears to hold with the current approach to increasing the money supply. http://en.wikipedia.org/wiki/Hyman_Minsky

  11. Kevin,
    The system is a lot more complicated than you seem to think it is – and there are many ratios that are monitored on a day, weekly and monthly basis. Two of them, however, may fit with your question on how much “credit” a bank is able to “create”.
    The main regulated liquidity ratio is fairly simple and relates to how much a bank has to hold in “HQLA” (High quality liquid assets) compared to parts of their liability base – let’s say call deposits as a shorthand (but this is not strictly correct). Not wanting to get too deeply into it, but the smaller ADIs this has to be 9% – i.e. holdings of cash and other high quality liquid securities (like government bolds) has to be at least 9% of the call deposit base – in practice this is normally kept around 12% for safety. If you want to get deeper into it have a look on the APRA website and in particular here. The larger ADIs that have approved risk model have to keep the ratio above whatever ratio the model says is appropriate.
    The other main ratios are the tiered capital ratios. Again, a very complex area. Essentially, though, the risk of all of the assets you have on your books (loans, shares, buildings, bonds) etc. is assessed and an appropriate amount of capital (ordinary shares, reserves, certain types of long term secure liabilities) have to be held against those assets. Again, there are two major approaches – if you can model the risk then you are able to use those models (subject to regulatory approval) and if you cannot then you use a simplified approach.
    Both of these ratios to some extent restrict your ability to lend, but neither of them allow you to lend more than your deposit base. That, as I said before, cannot happen.
    I am not surprised that the system does not work the way that Steve Keen seems to expect, Kevin, he has the system wrong.
    Sorry, but on Amasset – if you want to directly subsidise something there is no need to print new money to do so, all the government has to do is what they normally do – tax the productive part of the economy to subsidise the less productive. Printing money to do it would be directly inflationary and harm everyone.

  12. Andrew,

    Thanks for that. The system works the way I thought it worked but I did not know that the ratios are so low and for so many institutions. I thought credit unions had 100%. I can see now why when, a few years ago, we tried to become an ADI it was such an expensive operation even though we wanted to have a ratio of 100% and never give loans and never pay interest. We were trying to set up a system to transfer money for trading but we were only allowed to do it provided the total amount of money “residing” in the system stayed below $2Million – I think it has been increased to $10M but that is still not enough for a viable money transfer system. I could never understand why they had such a restriction. I now do because deposit taking institutions have the ability to turn $10M into $100M through issuing commercial money and they can charge interest on it all. In the system we built the income was going to come from transaction fees and not interest which is why we were able to live with a ratio of 100%. We were unable to commercialise because we could not become an ADI and existing ADIs had no incentive to change the system.

    I am now even more convinced that commercial money created the way it is done is dangerous and unnecessary. The reason is that it is in interest of an ADI to lend as much as they can simply from the point of view of lending and not from the point of view of lending for a purpose. Lenders in the current system do not care why the money is lent as long as they can get the money back and get paid interest. The system should favour lending for productive purposes which is why the Islamic approach of banning interest and getting your return when the borrower gets a return is better – but it suffers from the expense of the extra due diligence required.

    The use of money for the exchange of goods is not an issue – as long as there is enough of it around and it does not attract interest only transaction fees. For trading purposes we can use money that has zero interest and charge transaction fees to cover the costs and the system will work well.

    The amasset approach will be non inflationary if governments stop selling the equivalent amount of bonds (or go into debt). The reason amassets are a better way of increasing the money supply than governments selling bonds is that the money will be invested in productive goods and services. The investment will be done through a market place and so it will be invested to good purpose by individuals who will get the benefit from the investments because they will own the investments – not the government if it issues bonds and tries to build infrastructure.

    If you agree that increasing the money supply through amassets rather than governments issuing bonds is a good idea then why not extend it to the way we create commercial money for ADIs who then lend the money through the normal loans process. If we start to do this then we would have to increase the liquidity ratio of ADIs above 9%. If we get too much money created through amassets then the money can be destroyed through government taxes. It is not too hard to keep the money supply under control and stop inflation because we will now have many avenues of adjusting the money supply and not depend on the government setting the interest rate on its bonds and on governments creating enough bonds to seed the commercial money system.

  13. Andrew,

    Thinking about this a little more the ability of an ADI to lend $100 even though they only had originally $10 is much riskier than lending ten lots of $10. The problem arises because ADIs loan money for things that they see as being less risky but the fact is that they all tend to go for the same things be it bonds or houses. This in turn increases the risk of systematic failure through asset price increases (bubbles) followed by rapid decreases when things fall out of favour.

    If there are other ways of increasing the money supply for people to lend then we can get to the situation where $10 is backed by a deposit much closer to $10. This will change the psychology of the process. It will not stop bubbles but it will make them less likely – or at least that is my belief. We will only find out by trying it.

    What I am advocating is reducing our dependence on ADIs lending more than they have received in deposits to make loans. This can still go on but at a much reduced level.

    One of your concerns is that commerce will grind to a halt. Of course that would happen if it was done too quickly but a gradual introduction of amassets would allow the system to adjust and we could observe the outcomes and adjust accordingly. One of the nice things, from a control point of view, is that we will know in real time how much money has been released into the system and how much money is still sitting in zero interest accounts waiting to be spent. The other is the price of zero interest money. If the price of the zero interest money is close to its nominal value then we do not need to issue any more as the purpose for which the money is created can be satisfied by the money market. If it is very low then we have issued many more than the market can absorb or there has to be a good social reason to continue. For example, I believe that Energy Rewards will initially be priced quite low when first issued because the cost of Renewable infrastructure is very high. However, people will still build the renewable infrastructure and we know that we have a wonderful compounding effect that every time we double capacity of product or service it drops in price. For things like photo voltaics it has historically been 50% or more. For solar thermal and geothermal and windmills it is likely to be 10 to 20%. As we will not be doubling the capacity of fossil burning systems their costs will remain the same so we know that sooner or later Energy Rewards will be priced close to par – at which time we can stop issuing them.

  14. Kevin,
    If a bank could lend $100 if they only had deposits of $10 then I would agree it would be, at best, dangerous – but they cannot. It really is that simple. For them to lend $100 they need to have a deposit (or equity, or some other source of fundss) of about $110 – not $10. I do not know that I can put it any simpler than that.
    Sure, not all of the deposit sits mouldering away in a bank vault somewhere, but this is a good thing. It means that people’s savings are mobilised to all for current investment and spending.

  15. Andrew,

    You are of course correct and I have never said that the banks do not have backing for the extra funds.

    I do appreciate your effort in trying to explain to me why I am misguided (that is a genuine statement and I am not being sarcastic) I have been trying to understand why people think what I say is wrong and you have been kind enough to take the time to tell me why you think I am wrong.

    Of course I do not think I am wrong but I have been having trouble understanding why others cannot see the world as I see it.

    I am not talking about changing bookkeeping. I am talking about a change to the rules we use when an ADI creates a loan.

    At present the system is that I go to an ADI, I say I have these assets that I can mortgage against a loan. The ADI says yes I will loan you some money, puts some money into my account and keeps my mortgage.

    Before we started the ADI had $100 of “real money” on deposit. Of this it was limited to lending me $90 so there was a limit on how much the ADI could lend. So the ADI starts off with $100 and lends $90. The books before said that there was $100 in cash and that the ADI owed this to the depositor. The books later says there is still $100 in cash, there is a $90 as a mortgage and the borrower owes the ADI $90. So $90 as been lent. You say there is no new money created because there is a loan and mortgage that balance each other out and the money was just used to allow the transaction. You say all we have done is reuse the money not create more money.

    I as a person building the system to do the book keeping observe that there is now $190 in deposits and so I say that there is now more money on deposit – hence there has been some money created. However, your view in saying that this is not new money but old money reused and the extra money can be considered a property of the way we do our bookkeeping is also a valid way of viewing the transaction.

    What I would like to do would be to change the way we limit how much an ADI can lend. I suggest we allow the ADI to lend $100 – but put a “mark” against the $100 on deposit with a little note saying this is no longer available to lend. That is get rid of the fractional reserve – but everytime we create a loan then mark the money as being committed. So when we give a loan of $100 the money is reused but the limit is now $100 not as in the current fractional reserve method $900. In my terms we will limit the limit on deposits to $200 when we started with $100.

    You will say, if you limit the amount that can be lent to $100 that will cause commerce to come to a halt because we will not have enough money when we need it and besides it is unnecessary because the ADIs making loans secured against assets is as safe as houses and they should be allowed to create as much as they like as long as there is a matching asset.

    I say commerce will not come to a halt if there is enough “real” money in the system to loan.

    You will say if we print this much real money then we will get inflation.

    I will say not if you print “real money” give it to a lot of people who must invest in market places that only sell new productive assets and long as the newly minted money does not collect interest until it is spent on a new productive asset – and if you limit the loans people can make with existing money.

    I will also say you can have both systems operating and you can see how the new approach works.

    I urge you to think through the way I am proposing we “print money”. It will not be inflationary and it will mean that we “stimulate” the economy in ways that we can predict the outcome – while at the same time allowing the normal lending and borrowing of money continue as it does at the moment – and with a whole lot less regulation.

    There will be many emergent properties of what I am saying. One will be that banks and ADIs will no longer require regulation. We can get rid of APRA and replace it with fair lending legislation administered by Attorney General.

    Another will be we will get rid of private/public infrastructure projects – they will all become private.

    Another will be a reduction in taxation because we will give people money that they must first spend in productive ways instead of giving social security payments.

    Another will be that we will be able to set an inflation target of zero and meet it but still grow our economy.


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