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Friday, October 16, 2009

Creating Money & Credit

As a follow up to "What is Money?", it was established that having a central authority to issue new money is required, to minimize fraud. Notice, I didn't say eliminate fraud, since, the power is in the money printer.

In a closed system, how does money get back into the system? It is unfortunately complex system. I'll explain it in simple terms, then layer on the added complexity. Like most things in life, the detail is where the danger lies.

It is important to understand that almost all of this only applies to FIAT Currencies. Fiat currencies backed by nothing, just a promise "it has value". A Non-Fiat currency is backed by a hard asset, such as gold. Almost all currencies after the 30's is FIAT currencies.

Bonds - Step 1 (IDEAL MODEL)
Simply put, the US government issues bonds, which are debt notes with interest, with term duration, that are sold to generate money. When I say sold, there is really two different ways of selling bonds.

Primarily, bonds are sold on the open market, just like a stock. The amount of demand for bonds dictate interest rate levels. High demand for bonds equals low interest rates. When people dont want a bond (like junk bonds), they demand high interest rate to be compensated for the "undesirable" investment.

Alternately, the government may sell bonds .... to itself. A great example is "social security". A division of the government collects social security money, and "invests" it to eventually pay for everyone's retirement. In my opinion, Social Security should have been diversified into natural resources, other countries bonds, etc. But instead, the US government primarily sold to the Social Security administration US Bonds for the cash.

Printing Cash - Step 2 (IDEAL MODEL)
Basically, when the government gives an IOU (a bond), the proceeds is money that can be spent by the government.

In reality, (from Wikipedia) New dollars are issued when the Federal Reserve elects to fund the purchase of debt, primarily U.S. Treasury Bonds, by creating new reserves rather than financing the purchase with existing reserves. When the bond issuer spends the money, new dollars enter circulation.

Which is basically saying that new dollars are created when the Federal Reserve Bank purchases bonds from the US Government. So, in a nutshell, new money has interest that gets paid to a private institution. The banking system sits above all the taxpayers.
This is very complex as to why and who benefits. You can find tons of tin foil hat information. Lets just go with ideal model, and ignore the details of reality for this blog post. Who owns what and who profits is politics. The point of this isn't to go into tin foil hat land, but to explore "money & credit".

Expanding Money Supply - Step 3 - Fractional Reserve Lending (IDEAL MODEL)

Step 1 and 2, without fractional reserve lending would not lead to an increase in money supply. US dollars would circulate, but the number of dollars in existence would be finite. A crucial role in monetary expansion is fractional reserve lending.

Basic Lending (no fractional reserve policy)
Without fractional reserve rules, if I wanted to lend someone money, I would need to physically have 100% of the cash that I can lend out. It doesn't have to be hard cash, could be bonds, could be bank account wiring. The amount of money I could led out is at maximum, the amount of money I own.

Fractional Reserve Lending
A bank may own 100 million dollars, but with Fractional reserve lending (wikipedia) , the bank could give credit to someone, say for 100 million dollars to a corporation. But instead of giving the asset (bond, cash etc), the bank issues a "Credit" for 100 million dollars, and EARMARKS part of the 100 million dollars to be held as collateral for the loan, say 20%. It now has 80 million more dollars to lend out. The process repeats, lends out 80 million, keeping 16 million on hand, etc. By the time your done the bank turns 100 million into 357 million + the original 100 million (reserve) for a total of 457 million!

Assuming all the loans is at 5%, the bank pays the depositor 5 million a year, but pulls in 17.85 million. Not so bad!

Feed back loop- Step 4
Some of the extra money generated by Fractional Reserve lending is goes back to step 1. Therefore we have a net increase in new dollars with issuance of debt notes. This therefore requires new physical cash to be printed for the "extra money" created.


Is Fractional Reserve Lending bad?
If we go back to the definition of money, the idea is to capture work done with an IOU. Money maintains value if all work done is paid back with the debt note taken in compensation. So if responsible lending is done, and money paid for services is paid back, the system is reasonably sound.

Significant problems arise when money is lent "overpaying" for work, or the money lent cannot be paid back.

So if the bank lending is sound, and conservative, Fractional Reserve Lending isn't evil. Unfortunately, such power is abused and therefore FIAT currencies that can be printed to pay debts, combined with loose terms for making loans, that can never be paid back, break the system. Therefore in my opinion, fiat currency systems should have tighter reserves, say 50%. If the Federal Reserve required say, 0.01% to be held, you could see how credit would explode.

This is why people afraid of central authorities prefer gold backed currencies. The money creator can't over-create credit/money since the currency can always be paid back. In my opinion, gold backed currencies are severely flawed also. However their only advantage is it prevents loose printing presses. Main problem with gold backed money is you cant capture "work done" without digging a hole, pulling a shiny rock out, put it in a vault, (or make coins) then print a piece of paper to use for capturing value of work. Digging shiny rocks out the ground have no relation at all to capturing work. But it does ensure the piece of paper always has value and cannot be abused into hyper inflation. (devaluation of paper money)

Summary
  1. Fractional Reserve lending allows credit (money) to be created out of thin air. Responsible lending and reserves for lending are required to prevent problems with the currency.
  2. All new money is created through bonds, which are IOU's with interest. The Federal Reserve Bank purchases US Treasuries to create new physical cash.
  3. Credit and money are the same thing. Its an IOU for work done.
Next up, Ideal form of money - Power to the People


*** PLEASE add comments below for any corrections to my view ***









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