The Long Run Blog

Critical Thinking on Money, Finance, and Economics

What is Money?

I had an exchange with a commenter in the thread after my post about the Fed.  Seems he saw a video (the link is in the thread, I don’t really recommend that anyone waste 47 minutes of their valuable time watching the thing) called ‘Money as Debt’ by Paul Grignon, a Canadian gentleman who is all up in arms about the concept of fiat money, especially of the type known as credit money.

You see, banks are given the right to create money, apparently out of thin air.  From an initial deposit of capital with the Fed, the bank can issue loans in an amount ten times as much.  So let’s say they deposit $1000 dollars with the Fed – they can then lend out $10,000, effectively creating new money just by putting it into somebody’s account.  The borrower can then take that money and buy something with it – a car for example.  The seller now has $10,000, and in thought-experiment world, where there’s only one bank, that seller could then deposit the money back in the same bank.  Now the bank has $10,000 in depositor money, and they can make new loans with it.  Not by multiplying by 10 again, fortunately, but they can lend $9,000 against the $10,000 deposit.  That new $9,000 might come back into the bank again and be turned into a loan of $8,100, and so on and so forth until the bank has created about $100,000.  This money wasn’t there before, and now it is. Hocus Pocus?  No, fractional banking.  This is how money is created – well, sorta kinda, but it’s good enough for illustrative purposes.

What Mr. Grignon is worried about is that this money appears to be backed by nothing more than the loans that were made – that it’s nothing more than debt.  Which gives me an opportunity to do one of my favorite things in blogging, and that’s to quote Terry Pratchett.  This is from his most recent book, ‘Making Money,‘ in which the Hero, Moist Von Lipwig (really), having recently rescued the post office, is given the task of updating the banking system of the Discworld’s most famous city, Ankh Morpork.  He’s trying to figure out what gives money its value:

…on a desert island a bag of vegatables is worth more than gold, in the city gold is more valuable than vegetables.
This is a sort of equation, yes?  Where’s the value?
He stared.
It’s in the city itself.  The city says: In exchange for that gold, you will have all these things.  The city is the magician, the alchemist in reverse.  It turns worthless gold into… everything.
How much is Ankh-Morpork worth?  Add it all up!  The buildings, the streets, the people, the skills, the art in the galleries, the guilds, the laws, the libraries… billions? No.  No money would be enough.
The city was one big gold bar.  What did you need to back the currency?  You just needed the city.  The city says a dollar is worth a dollar.

And that, my friends, is exactly the point.  All those loans that the bank makes to create that money are accompanied by either collateral or a plain old promise to repay.  Those things have real value – even an uncollateralized promise to repay.  The borrower is pledging labor, creativity, future income – again, real value – against that loan.

Combine all that with a country that is serious about the rule of law, that has good banking regulators, and has a central monetary authority making sure that the banks don’t overdo – or underdo – the money creation, and you have the basis for money that has real value, even if it isn’t backed by gold like currencies used to be.  Of course, a country that runs huge budget and trade deficits may find the value of their curreny dropping, but that’s for another day.

Now, if you want more formal education on money, like its role as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment, try wikipedia.  It’s pretty good, and has further links to some textbooks.  I just wanted to quote Terry Pratchett – whose books you should buy and read.  Now.

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August 23, 2008 - Posted by | Education, Theory | ,

29 Comments »

  1. Good article.

    Comment by jgirvine | August 24, 2008 | Reply

  2. Great article. Money can’t buy everything. Heh.

    Comment by zzeed | August 24, 2008 | Reply

  3. Great article. I know you understand and I hope you continue digging.

    Comment by arbiep | August 24, 2008 | Reply

  4. Instead of “money” backed by gold or silver: It is backed by souls of Men. Souls which are then bought and sold, foreclosed and disclosed, used and abused.

    “Now, if you want more formal education on money, like its role as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment, try” Scripture!

    Money (today) is nothing but paper with a value via ink.

    Comment by bobdabalina | August 24, 2008 | Reply

  5. More from Bob –

    I utterly disagree. Nobody is buying or selling souls, whatever you may think, and money is more than paper and ink – I’ve already devoted a couple of thousand words to the topic.

    Comment by Jon Blumenfeld | August 25, 2008 | Reply

  6. Have you heard of “prisoner bonds”?

    Comment by bobdabalina | August 26, 2008 | Reply

  7. I think you may be missing the point of the film, maybe getting too distracted by Gold Bugs. Whether money is based on anything or has some fundamental underlying value is beside the point. Much more important is who creates the money and why.

    Who holds the debt of national governments and who gets the interest? The federal government pays billions of dollars to the banks in interest every year to borrow money that the banks create. Both the federal government (via the Fed) and the banks create money, so why should we the people pay billions every year to the banks?

    There are other important issues in “Money as Debt”, namely the question of whether it’s even possible to pay off debts given our current system and whether it’s possible to create a sustainable economy when its financial system relies upon growth. I don’t think that the underlying value of a dollar was a big issue.

    Comment by Adrian | August 26, 2008 | Reply

  8. BTW: I see a feed for all comments. Is there any way to subscribe to the comments for just a single post?

    Comment by Adrian | August 26, 2008 | Reply

  9. Adrian- let me add a few things which maybe you are misundertanding or misconstruing:
    “Who holds the debt and who get the interest”?
    Actually, the banks hold very little of the governments debt. They prefer to hold loans like mortgages, lines of credit to people and companies and other loans. Why? Because government debt is so safe from default, it pays very little interest compared to other debt. A bank generally can not borrow as cheap as the governemnt and would be underwater if it had to pay out more interest than it earned. Thus they hold higher yielding assets- loans- rather than government debt.
    The public holds the debt. This includes mutual funds and trading houses that trade it. It included foreign governments, foreign individuals and foreign companies too.

    Another way to view it is that we [taxpayers] are NOT “paying billions in interest to the banks”. Interest is being paid to whoever lends the governemnt money by buying the bonds. Paying interest to the lender is fair isn’t it?

    Comment by Brett | August 26, 2008 | Reply

  10. I will look into feeds for an individual post.

    Comment by Brett | August 26, 2008 | Reply

  11. Brett,

    I wasn’t trying to argue that banks hold all of the government debt. Banks do hold a lot of government debt because it counts towards their reserves, so to that extent even a small amount of interest is still pure profit since they would otherwise be holding cash.

    Regardless, the issue I was trying to raise isn’t whether banks hold most or little of the government debt but that the Federal bank (or the national banks for other countries, such as the Bank of Canada) do not hold all of the government debt. I was also trying to raise the question of why banks should be creating the vast majority of the money supply for countries and so collecting the interest on this. Last I checked, the money multiplier was over 150 and at times over 300. That means for every dollar that the Fed puts into circulation, banks put in $150 to $300 and collect the interest on this, all of which is a gift from the government.

    When the government wants to borrow money, virtually all of it comes from the banks directly or indirectly. If a private individual uses their own money to buy $10,000 in bonds, it’s little exaggeration to say that the money she used was credit created by a bank since actual currency makes up a single-digit percentage of M3. A private bond-holder may collect the interest but it’s rarely more than a step or two removed from a bank-created debt.

    So no, I think it does not accurate to say that the public holds the government debt.

    Another way to view it is that we [taxpayers] are NOT “paying billions in interest to the banks”. Interest is being paid to whoever lends the governemnt money by buying the bonds.

    We citizens are paying billions to banks, that’s the nature of credit money. If you mean that we aren’t paying billions to banks via national debt, I think you’re not looking closely enough.

    Paying interest to the lender is fair isn’t it?

    Depends. If there’s no opportunity cost to the lender, then no, it doesn’t seem fair to me. Borrower risks real-world assets, banks risk nothing.

    And since governments can literally print money and lend it to itself, no, it doesn’t seem fair to pay someone else for the privilege. (And before you mention ‘inflation’, the government can also control the reserve ratio directly and so can directly control the money supply so printing money is only as inflationary as it chooses. The Fed chooses not to do this for its own ideological reasons, but it is not an immutable fact.)

    Comment by Adrian | August 26, 2008 | Reply

  12. Adrian,

    First, it doesn’t look like there is feed just for comments in wordpress. If they add it, so will I.

    Second, let’s back up and start at square one since I’m having a little trouble understanding your grievance with the banking system. How about you make one point and I will address that? Then we can continue from there.

    Comment by Brett | August 26, 2008 | Reply

  13. I am shocked this discourse about money is happening. Years ago I ran into some folks that I thought were nuts. They explained to me that what we are calling money is far from it. It is a federal reserve note, a debt instrument. If a note can be money then our personal debt is therefore money that we can use to pay people or buy goods and services. I am not sure any of you would do any work for me for my debt.

    In the accounting systems which I am acquainted, liabilities are negatives in terms of net worth. Would some one explain to me why we keep reporting these debt instruments as an asset?

    Keep digging, I like at lest the open discussion.

    Comment by arbiep | August 27, 2008 | Reply

  14. I am shocked this discourse about money is happening. Years ago I ran into some folks that I thought were nuts. They explained to me that what we are calling money is far from it. It is a federal reserve note, a debt instrument. If a note can be money then our personal debt is therefore money that we can use to pay people or buy goods and services. I am not sure any of you would do any work for me for my debt.

    In the accounting systems which I am acquainted, liabilities are negatives in terms of net worth. Would some one explain to me why we keep reporting these debt instruments as an asset?

    Keep digging, I like at least the open discussion.

    Comment by arbiep | August 27, 2008 | Reply

  15. Brett,

    The way I understand it, the federal government has the right to create money. This is done at no direct cost to citizens. The government also allows banks to create money (credit) with some restrictions (the reserve ratio). Any form of money creation may have inflationary effects and since both government-based money creation and bank-based money creation has the same problem, I’ll ignore it for the moment.

    I think we both agree that the money supply currently needs to grow at a controlled rate and that there’s nothing inherently wrong with money that doesn’t have some fixed underlying value (a la Bretton Woods). Indeed, being fixed to some underlying assets makes it much more difficult to expand or contract the money supply.

    I have a few problems with the current system.

    * Governments can print money on demand which carries an effectively zero percent interest rate (the Bank of Canada, for example, can lend to the Canadian Government with a fixed interest rate but all interest is payable to the Federal Government as profit so zero net interest). Instead of availing themselves of this, governments borrow money which is created by banks and pay real interest

    * To control the money supply, the Fed buys and sells different securities and adjusts interest rates in order to grow or shrink the money supply. To contract the money supply (control inflation), they increase interest rates which also increases the amount of interest the government pays in debt-servicing payments. They have the ability to just adjust the reserve ratio which can directly grow or shrink the money supply without increasing their own costs, yet they refuse to do this.

    * As a small point: because virtually all of M3 is bank-created debt/credit, the participants in the economy must seek ever expanding growth in order to meet our debt obligations. Any plateau or levelling-off means economic death to many businesses and individuals because there is simply not enough money available to pay their creditors. This directly opposes a sustainable economy.

    * Most importantly, I see no reason why the reserve ratio should be tolerated at all, let alone be 150:1 or more. We the citizens should reap the benefits of money creation and not the banks. We (as individuals, as businesses, as governments) are charged interest for a service which costs nothing but the flipping of bits in a computer, there is no risk and no opportunity cost. In exchange for creating a new bank account with $500,000 in it (which costs the bank essentially nothing), a bank can seize my real-world house. In exchange for the zero-cost purchase of federal debt (which, because federal debt has no default risk, acts as reserve currency and so really doesn’t cost anything), we citizens must make real debt payments and possibly give up real-world benefits which the taxes may otherwise fund.

    The entire system of bank-created money is the biggest boondoggle in history and gets worse every decade. I say we should cut the reserve ratio from 150:1 to 10:1 then 5:1 then 1:1 and end the whole thing. Let banks make their money like other companies do – by providing a real service.

    I’ve got a general understanding of the Fed and US banking system, so please correct me if I’m off base. I think I’m pretty close to the mark in general, even if I may be off on a couple details.

    Comment by Adrian | August 27, 2008 | Reply

  16. Adrian You have a lot of it. Our for fathers tried to prevent central banking because they knew the thievery that would ensue. Money is not only of value on its own, it has the ability to buy, pay and earn. However debt has none of these capabilities. It can not buy, pay or earn. These debt notes only have the ability to discharge debt.

    The search and seizure laws I am sure take this into account.

    Comment by arbiep | August 27, 2008 | Reply

  17. arbiep,

    I’m not sure I understand you.

    The Fed already manages the money supply, it just manages it crudely so I don’t follow your reference to central banking. I specifically referenced the Bank of Canada which is a nationalized central bank so if you would like to make accusations of thievery you can provide concrete examples. To my knowledge, the closest examples to thievery flow towards the banks in the form of massive bailouts and the shrinking of the reserve ratio is just one of many.

    I don’t know what you’re getting at when you try to draw distinctions between ‘money’ and ‘debt’ – debt is one part of our money supply, and a very large part of it. Look up the differences between M0, M1, and M3. If you re-read the initial blog post, you’ll see that debt _is_ money.

    For more information, Wikipedia has an overview of Money Supply which covers M0 (currency) from M1, M2, and M3: http://en.wikipedia.org/wiki/Money_supply

    Perhaps you can elaborate a bit so I can understand where our differences lie.

    Comment by Adrian | August 27, 2008 | Reply

  18. Adrian,
    I think I found the source of your discontent. You wrote “It is a federal reserve note, a debt instrument” by which you mean that the paper $20 bill is representative of $20 in debt by the government. Let’s start there. A Federal Reserve Note is a unit of currency ONLY. It is important to understand a unit of currency does NOT represent an equal amount of debt and is NOT issued in exchange for debt or any promise to repay. It is merely an official store of value, declared by government fiat to be “legal tender”. In other words, if in the U.S., one is bound to accept payment in U.S. currency. Your bank cannot demand payment on your mortgage in gold or diamonds- they must accept U.S. dollars. Now, if you start to view the amount of money units in the system as separate from the amount of debt, a very different system becomes apparent.

    Comment by Brett | August 27, 2008 | Reply

  19. Brett,

    That was arbiep who made that comment, not me.

    Comment by Adrian | August 27, 2008 | Reply

  20. You are right, sorry. My printout got cut off and mismatched “a” posters.

    But, when you say “the federal government has the right to create money” and “governments can print money on demand” what do you mean by “print” and “create”. If you mean actually create the paper currency, then comment #18 still applies.

    Comment by Brett | August 27, 2008 | Reply

  21. Adrian, you make some interesting points, for example in the second * in your comment #15, but there are very long explanations for why “they have the ability to adjust the reserve ratio…yet they refuse to do this” which I’m afraid you are ideologically opposed to. Adjusting the reserve requirement instead of using interest rates when trying to tighten the money supply would force all banks to liquidate assets nearly overnight in order to build reserves and lower the ratio- which can’t possibly happen (who would buy them?).

    But let’s start with what you said: “because virtually all of M3 is bank-created debt/credit, the participants in the economy must seek ever expanding growth in order to meet our debt obligations.”

    Mathematically, of course an economy must grow to pay for debt, but you don’t need debt to grow. Are you saying an economy shouldn’t grow or an economy shouldn’t use debt?

    I want to address the other points, but let’s stick to the basics and then move forward. We might catch an error or disconnect sooner that way.

    Comment by Brett | August 27, 2008 | Reply

  22. Since I’m thinking about this, I’ll continue as food for future thought:

    “I see no reason why the reserve ratio should be tolerated at all, let alone be 150:1 or more.” A correction here, the reserve ratio is about 9:1, not 150:1. Perhaps you meant the money multiplier, but that is ‘only’ about 11x.

    Now, you claim that “We the citizens should reap the benefits of money creation and not the banks. We (as individuals, as businesses, as governments) are charged interest for a service which costs nothing but the flipping of bits in a computer, there is no risk and no opportunity cost.”

    You claim that the citizens should benefit directly because the banks are essentially getting a freebie. It’s a freebie because “there is no risk or opportunity cost” right? Here we have a huge disconnect. The banks have huge risk and opportunity cost. It works like this: I decide to start a bank and deposit capital reserves at the Fed. The Fed grants me a license to ‘multiply money’ as banks do. Here is the opportunity cost: I could have done anything with that money. Stocks, real estate, spent it, bought gold- anything. Whatever else I might have done with it instead is an opportunity cost.

    Here is where the risk is: as a condition of my license as a bank, I promise to pay back my depositors. A bank’s balance sheet might look like this: Assets of $100 million in reserves at the Fed and $900 million in loans. If some of my loans go bad, say just 10% or $90 million of the loans I made can’t be repaid because the borrowers went bankrupt. What happens is I still owe $900m to my depositors, which means that $90 million loss comes from my reserves (that’s why they are ‘reserves’). My net worth of $100m fell to just $10m, a 90% loss. That is the risk assumed with the leverage that comes with being a bank.

    Comment by Brett | August 27, 2008 | Reply

  23. Brett,

    print/create is sort of a shorthand. What is the right term to use? I understand that currency is not a debt or an obligation to pay though the issue gets fuzzier when we expand our discussion from M0 to M1 and up.

    Adjusting the reserve requirement instead of using interest rates when trying to tighten the money supply would force all banks to liquidate assets nearly overnight in order to build reserves and lower the ratio- which can’t possibly happen (who would buy them?).

    I’m not saying any of this has to happen overnight. I said “I say we should cut the reserve ratio from 150:1 to 10:1 then 5:1 then 1:1″ to illustrate that it would be a gradual process with plenty of fore-warning. Selling Treasuries back to the Fed would increase the reserves without requiring dramatic short-term impacts.

    Over the longer term, the Fed could continue to buy back its debts and issue new currency to pay salaries and for government projects while balancing the reserves to compensate. I’m open to suggestions for accomplishing this. Is your concern purely practical or do you have any objections with the goal itself?

    Mathematically, of course an economy must grow to pay for debt, but you don’t need debt to grow. Are you saying an economy shouldn’t grow or an economy shouldn’t use debt?

    I’m saying that goals such as sustainability, reuse, and reduction of human impact are at odds with the need to growth. I don’t have any problem with growth per se but argue that it is not always in our interest and our ability to make long-term plans are shut down by our financial system.

    This is admittedly my weakest concern and mentioned it only for completeness.

    A correction here, the reserve ratio is about 9:1, not 150:1. Perhaps you meant the money multiplier, but that is ‘only’ about 11x.

    I may be used to dealing with Canada’s system which abolished the reserve requirement in a bank bailout (ugh). Let me check the Fed data.

    You are right that all but the smallest banks need to have 10% of assets in reserve, but the reality is fuzzier. In Feb 2006 which is the last time M3 was published, M3 stood at 10298.7B and M0 was 733B, (http://www.federalreserve.gov/releases/h6/hist/h6hist2.htm and http://www.federalreserve.gov/releases/h6/hist/h6hista.htm), a ratio of 14:1.

    Anyway, I was clearly off by an order of magnitude with my numbers when dealing with the US system. I’m sorry, that was sloppy on my part and thank you for the correction.

    My net worth of $100m fell to just $10m, a 90% loss. That is the risk assumed with the leverage that comes with being a bank.

    If some of my loans go bad, say just 10% or $90 million of the loans I made can’t be repaid because the borrowers went bankrupt.

    I think you’re ignoring the point that I’ve been raising all along, that governments are different than individuals. They can print money so don’t need to borrow from banks and if they do borrow, they can borrow from banks which they own so effectively pay no interest. When they do borrow, there is virtually no risk of default.

    So turning to banks lending to individuals, it seems that the biggest problem you raise deals with leverage which is exactly what I would like to see restricted. If a bank was only using 2:1 leverage instead of 10:1, then a 10% loss over some period would only represent 20% of reserves and not the disaster you describe.

    In general, loans don’t go bad or get defaulted in isolation. A debit and credit are created in tandem and when a loan is used to pay for goods/services, the money is usually deposited in another bank (a small amount gets lost from the banking system into cash collections, “mattress banks” or actually lost. Some goes overseas which is another issue.). For even a 10% overall loss, a bank would have to withstand a string of serious losses combined with patrons withdrawing funds. And to make this unlikely scenario even more unlikely, the FDIC insures deposits to prevent runs on the bank. It’s not easy to lose at this game.

    When disaster does strike, it’s rarely something as simple as individual loans defaulting. When individuals do go bankrupt, the banks losses are minimal and if the initial loan may get re-deposited in the same bank, loan defaults may leave no net loss. When we factor in the interest paid out over the life of the loan (which may be very high if there’s a real risk of default) minus the pittance in interest paid to depositors, the situation looks even better.

    Comment by Adrian | August 28, 2008 | Reply

  24. Forgive me for taking these somewhat out of order. “print/create is sort of a shorthand” No problem, just checking to make sure we’re on the same page.

    “You are right that all but the smallest banks need to have 10% of assets in reserve, but the reality is fuzzier.” Yes, it is a little fuzzier because at least in the U.S., not all deposits are equal. Demand deposits require a different reserve ratio than say CD’s. Banks also have other more complicated instruments on their books, all regulated differently (you will see terms like Tier I or II capital). If you look at the big guys- BoA, Citi, etc, you will find them levered about 8.2:1 when looking at the debt:equity ratio. This is the best measure of leverage. As for comparing to some of the Fed’s monetary aggregates, it doesn’t quite line up due mostly to Fannie and Freddie, who comprise an enormous amount of the banking assets but at levered 40:1 or more- this is a separate subject entirely, so let’s do that later in the year (and I probably agree with you on that one). Anyway, I think for our purposes we are pretty much in agreement that leverage is around 10:1.

    “Over the longer term, the Fed could continue to buy back its debts and issue new currency to pay salaries and for government projects while balancing the reserves to compensate. I’m open to suggestions for accomplishing this. Is your concern purely practical or do you have any objections with the goal itself?”

    Yes, I have a objections with the goal itself. What it seems you are proposing is that instead of the government issuing debt to pay for, say the war, it would instead issue currency/create money (paper or credit). Then the Fed would buy back the currency to prevent inflation via too much money creation. Is that a correct understanding of your position? I’d like to be sure before I continue.

    Comment by Brett | August 28, 2008 | Reply

  25. Brett,

    Then the Fed would buy back the currency to prevent inflation via too much money creation. Is that a correct understanding of your position? I’d like to be sure before I continue.

    I would like to see the reserve ratio increased (as a Canadian this is especially relevant as the BoC has abolished all reserve requirements! Our M3 is 1,123B and M0 appears to be about 50B using the BoC’s annual report on currency, a ratio of 22:1). Can you think of any reason why the ratio of M3 to M0 (the multiplier? Not sure about the right term) shouldn’t be, say, 2:1?

    As a consequence or a goal on its own, I’d like to see federal and provincial/state government borrowing coming more from the Fed/BoC than from private sources.

    As for issuing & buying currency back, I suppose so. With staggered and announced rollbacks on the reserve ratio the Fed would issue new currency to keep the money supply stable. Since the Fed isn’t a lending institution, to shrink the money supply it could “buy” it back or use the current system of open market activities.

    I think you’ve convinced me that trying to have M3=M0 would get messy and over-complicated, but why not get the ratio down to 2:1?

    Comment by Adrian | August 28, 2008 | Reply

  26. Adrian, I don’t know much about the Canadian system, so I will have to do a little research before commenting on that. Even so, I can make one suggestion in your thinking here. The ratio of M3 to M0 doesn’t mean anything in terms of the health or leverage in the system. Again, you need to examine debt to equity as the measure of leverage. M3 and M0 are only forms of money and do not represent debt. Kind of like comparing $20 bills to the amount of money in checking accounts.

    “I’d like to see federal and provincial/state government borrowing coming more from the Fed/BoC than from private sources.” Would you explain to me *why* you prefer this?

    Comment by Brett | August 28, 2008 | Reply

  27. Brett,

    First, thanks for setting me straight on a few points.

    “M3 and M0 are only forms of money and do not represent debt.”

    Really? M0 is all of the currency that the Fed creates, and I thought M3-M0 measures the money which was created by banks as loans. If I’m wrong, where did this amount come from?

    “Would you explain to me *why* you prefer this?”

    So that the interest payments required to service the debt returns to Federal government – essentially an interest-free loan.

    Comment by Adrian | August 28, 2008 | Reply

  28. Adrian,

    Ahh. I see. Yes, M3 (and MZM and other measures too) measure things besides currency in circulation- BUT just because some money is not currency, does not mean it is debt either. For example, banks have reserves which are not currency and not debt.

    “So that the interest payments required to service the debt returns to Federal government – essentially an interest-free loan.” Here you are suggesting a nationalization of the banking system. Even communist China does not have a fully nationalized banking system. Now, if it is your political/economic philosophy to suggest such a thing- that’s fine. I’m not going to debate political theory here except to say it is highly unlikely a nationalized banking system would work efficiently, but even if it did, it would be subject to political will more than economic law- a situation I would argue heavily against.

    Comment by Brett | August 28, 2008 | Reply

  29. Re-addressing your assertion that banks face little risk, I think you are underestimating a few things. First, let’s take this “In general, loans don’t go bad or get defaulted in isolation.” I need to disagree here. Loans do default in isolation every day. Even in good times, individual loans go bad. We can even buy bad loans from banks for pennies on the dollar and try to collect more than the bank expected. Happens all the time.

    “A debit and credit are created in tandem and when a loan is used to pay for goods/services, the money is usually deposited in another bank”
    You are confusing money in the system with the assets/liabilities of a single bank. If a borrower defaults, but had bought cars/boats/tv/whatever with the money, that money got deposited in *another* bank. But that had NO bearing on the bank that made the loan. What you are seeing is the effect of velocity where $1 gets spend over and over. Remember that the leverage works in reverse too- when a bank writes off $1 as a default, $9 of other loans must be reduced to keep the leverage in line. *Thus, when a loan defaults, money is destroyed reversing the multiplier effect.* If you can’t accept this, then I will have to point you to some textbooks, for this is indeed how it works.

    “For even a 10% overall loss, a bank would have to withstand a string of serious losses combined with patrons withdrawing funds. And to make this unlikely scenario even more unlikely, the FDIC insures deposits to prevent runs on the bank. It’s not easy to lose at this game.”
    Yes, writing off 10% of loans is a serious string of losses, yet this is exactly whats going on right now. It is not 10% yet, but you can see the pure pain the banks are in from 1-3% losses of assets turning into 20-30% destruction of equity. This is risky stuff and the banks’ shareholders are suffering for it enormously. The FDIC insures the *depositors*, not the banks. The banks don’t see a dime of that. When a bank goes bust, the FDIC takes over completely and gives that cash to the depositors- it has nothing to do with the bank that formerly was.

    Comment by Brett | August 28, 2008 | Reply


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