Fractional reserve banking

[Aught3]

I'm hoping to start a discussion on fractional reserve banking and the economic effect of increasing money supply through debt creation. This is a topic that has recently become of interest to me and I was hoping to find some people with a bit more knowledge on the subject than I have. Website, video, documentary, book, and article recommendations would be much appreciated.

I believe I understand the basics of modern fractional reserve banking in which banks create money by extending loans to people for houses, business, investments, etc. In New Zealand 98% of the money supply is created in this way. The loans that the banks make have interest attached which means over time more money must be paid back than was initially borrowed. In order to pay back the extra money you have to get someone else's debt-money which they also need to pay back, plus interest. What I'm having trouble understanding is how this system is supposed to work in theory.

If person B needs to go into debt so that person A can pay back their debt, does the system ever become stable? I just don't get it.

 

[WarK]

I know almost nothing about economy and money and stuff like that, but isn't the person taking the loan investing the money to earn more money and return the loan with interest?

There is 5(?) episode series on BBC - The Ascent of Money.
I found it on YT in one, 4 hour long vid:

​

 

[Aught3]

Thanks for the video WarK, I will watch it later.

I know almost nothing about economy and money and stuff like that, but isn't the person taking the loan investing the money to earn more money and return the loan with interest?

The problem I'm having is where the investment return money comes from. Every extra dollar that a person earns on their investment has to come from someone else and since 98% of the money supply in our economy comes from loans, the extra investment money that person A uses to pay back their loan is actually already owed by person B to pay back another loan.

I've been reading a bit more about this and one potential solution to the problem I'm having with debt-money appears to be flow. As long as the person with the loan can continually re-earn the money that they borrowed then a loan can be paid back with interest. This seems to mean that everyone is working, directly or indirectly, for the banks in order to pay back the debts they owe to the bank.

Alternatively, as long as the economy keeps growing people can continually take out more and more debt so people with the earlier debts can pay it back using money from people with the latter debts. Like a pyramid scheme eventually the people/resources/investments run out and the economy collapses into recession with the people at the bottom of the pyramid being wiped-out financially and the people at the top getting bailed out by our governments.

A video I watched last night:

 

[ArthurWilborn]

I'm missing the bit where it's necessary for person B to go into debt to pay person A back. In many cases, person B is using the loan to create wealth, a portion of which is used to pay back person A. They start a business, find new resources, create efficiency, or fulfill a need; this creates wealth, which they reap as money and use to pay back their loan.

The 2% figure they use is for physical money; this is mostly a reflection that most money is stored on account since most people don't do business by carrying around large amounts of cash. This is a good thing for most people.

There's also inflation, where the same number of money buys less and less wealth over time. This tends to favor people who have debts, since the debts are worth less wealth over time.

 

[Aught3]

I'm missing the bit where it's necessary for person B to go into debt to pay person A back. In many cases, person B is using the loan to create wealth, a portion of which is used to pay back person A. They start a business, find new resources, create efficiency, or fulfill a need; this creates wealth, which they reap as money and use to pay back their loan.

Yeah I'm not surprised that I'm being unclear as I'm still trying to understand the problem myself. Mainstream economics doesn't really consider the source of money to be particularly important so it is a new way of thinking for me.

Person B uses the loaned money to create wealth but then needs to turn that wealth into money to repay the initial loan. So he has to sell his wealth to person C, and person C ultimately got their money from a loan (since 97% of all money originates from debt). So it's not person B who has to go into debt to pay person A back but rather that someone else had to go into debt for person B's loan to be paid back. On a macro scale this means a growing economy requires debt to constantly increase, if debt does not increase the money supply contracts and we get a recession.

The 2% figure they use is for physical money; this is mostly a reflection that most money is stored on account...

The 2-3% is indeed the physical money (notes and coins) that exist, that money exists because treasury creates it and then sells it to banks at face value. The rest of the money in the economy is created by the banks themselves when they create loans. 97% of the money in the economy is matched by a loan to an individual or business, which they have to pay back at some point.

There's also inflation, where the same number of money buys less and less wealth over time. This tends to favor people who have debts, since the debts are worth less wealth over time.

This is true. Although, unless you have a very low interest rate, inflation won't compensate for the interest charged on most loans. But you're right, inflation is a factor.

 

[Dragan Glas]

Greetings,

The major part of the current financial crisis is the fact that, although banks (in America, for example) are allowed to lend up to ten times their actual value - the "real" money they have in their vaults - they've gone way over this limit (by moving loans off their balance-sheet through renaming them, so that it appears they never reach the limit - "shadow banking") with the result that "debt" has been increasing over the past several decades.

Kindest regards,

James

 

[ArthurWilborn]

I'm missing the bit where it's necessary for person B to go into debt to pay person A back. In many cases, person B is using the loan to create wealth, a portion of which is used to pay back person A. They start a business, find new resources, create efficiency, or fulfill a need; this creates wealth, which they reap as money and use to pay back their loan.

Yeah I'm not surprised that I'm being unclear as I'm still trying to understand the problem myself. Mainstream economics doesn't really consider the source of money to be particularly important so it is a new way of thinking for me.

Person B uses the loaned money to create wealth but then needs to turn that wealth into money to repay the initial loan. So he has to sell his wealth to person C, and person C ultimately got their money from a loan (since 97% of all money originates from debt). So it's not person B who has to go into debt to pay person A back but rather that someone else had to go into debt for person B's loan to be paid back. On a macro scale this means a growing economy requires debt to constantly increase, if debt does not increase the money supply contracts and we get a recession.

There is a bit of a "first cause" problem with money. This is why basic economic systems are based on commodities, which have some use other then as a means of exchange. However, commodities exchange as money gets annoying and hazardous at a point which our society is well past. So we have money representing commodities representing wealth - and we're quickly moving on to stored numbers representing money. As technology improves and wealth increases no doubt we'll layer the symbolism a few more times. However, once this symbol has been established it's just as reasonable to use as any of the previous methods. Money's like a big pool - once it's filled up everyone can swim in it.

Also, it's possible to have an economic system without debt - there's been a few - but they're nowhere near as efficient, so everyone is worse off.

The 2% figure they use is for physical money; this is mostly a reflection that most money is stored on account...

The 2-3% is indeed the physical money (notes and coins) that exist, that money exists because treasury creates it and then sells it to banks at face value. The rest of the money in the economy is created by the banks themselves when they create loans. 97% of the money in the economy is matched by a loan to an individual or business, which they have to pay back at some point.

It does not necessarily follow. Money doesn't have any value on it's own - it's a symbol of a symbol. Having a large amount of physical cash created wouldn't change the economics; the extra physical cash would just sit unused in a vault somewhere. It doesn't make sense to have more physical cash then people actually hold and use. There's no necessary dichotomy that cash that isn't physical must be created by debt.

 

[Aught3]

The major part of the current financial crisis is the fact that, although banks (in America, for example) are allowed to lend up to ten times their actual value - the "real" money they have in their vaults - they've gone way over this limit (by moving loans off their balance-sheet through renaming them, so that it appears they never reach the limit - "shadow banking") with the result that "debt" has been increasing over the past several decades.

I completely agree James. Ignoring the previous reserve requirements has made the debt-money supply increase to huge proportions. I don't think a return to an actual reserve requirement would actually help the situation as debt has to constantly increase to fund the previous round of debt.

 

[Aught3]

There is a bit of a "first cause" problem with money. This is why basic economic systems are based on commodities, which have some use other then as a means of exchange. However, commodities exchange as money gets annoying and hazardous at a point which our society is well past. So we have money representing commodities representing wealth - and we're quickly moving on to stored numbers representing money. As technology improves and wealth increases no doubt we'll layer the symbolism a few more times. However, once this symbol has been established it's just as reasonable to use as any of the previous methods. Money's like a big pool - once it's filled up everyone can swim in it.

Yes agreed with all that.

Also, it's possible to have an economic system without debt - there's been a few - but they're nowhere near as efficient, so everyone is worse off.

I don't think an economic system without debt is a good idea but I'm starting to think that a monetary system without (or with a vastly smaller proportion of) debt would be beneficial. The inherent lack of purchasing power and constant trade wars lead to some serious distortions in the world's economies.

There's no necessary dichotomy that cash that isn't physical must be created by debt.

There's no necessary dichotomy but it is the way money is currently created. Either the government makes physical cash or the financial institutions create loans. There is no major third mechanism that I'm aware of.

 

[ArthurWilborn]

Also, it's possible to have an economic system without debt - there's been a few - but they're nowhere near as efficient, so everyone is worse off.

I don't think an economic system without debt is a good idea but I'm starting to think that a monetary system without (or with a vastly smaller proportion of) debt would be beneficial. The inherent lack of purchasing power and constant trade wars lead to some serious distortions in the world's economies.

I'm not quite sure how you would separate economic debt from monetary debt (indentured servitude?), but yeah, the economy isn't perfect by any means and having too much debt is certainly a bad thing. This is why you hear me complaining about excessive national debts now and again.

There's no necessary dichotomy that cash that isn't physical must be created by debt.

There's no necessary dichotomy but it is the way money is currently created. Either the government makes physical cash or the financial institutions create loans. There is no major third mechanism that I'm aware of.

I can think of at least two -

The psychological/confidence component, which "creates" money by making existing money worth more due to people having a positive view of it. I've been told this mainly benefits the US dollar.

Efficiency, which is where capitalism shines. If you can do something more efficiently, you use less resources and hence less money, "creating" money that would have otherwise been used for some other purpose.

 

[Aught3]

I'm not quite sure how you would separate economic debt from monetary debt (indentured servitude?)

For a simple example you could have a monetary system composed entirely of government-issued debt-free notes and coins and employ a system of full reserve banking where the banks had to have 100% of the loans they give out as deposits from their customers. Now I'm not saying this is the ideal situation but it is one was to have economic debt with a debt-free monetary system. I think the idea system may be a mix between the two where government issues ~50% of the money debt-free and the rest is made up by loans from banks. The exact proportions could change depending on economic circumstances.

This is why you hear me complaining about excessive national debts now and again.

I've argued in the past that national debts are necessary to keep national economies functioning and I still think this is true under the current system. But that is because the current system requires borrowing in order to keep growing. It doesn't matter is the borrowing is done on the personal, industrial, or national level but it has to be done otherwise the economy sinks into recession. This is not a good system.

The psychological/confidence component, which "creates" money by making existing money worth more due to people having a positive view of it. I've been told this mainly benefits the US dollar.

There could be some impact here, I wonder what percentage of the total money supply it would be? Anyway I doesn't seem to impact the money supply of the GB Pound or the NZ dollar etc.

Efficiency, which is where capitalism shines. If you can do something more efficiently, you use less resources and hence less money, "creating" money that would have otherwise been used for some other purpose.

Efficiency doesn't create money it just allows you to use the same money for other purchases. Perhaps on an individual level it feels like you have more money but doesn't actually add anything to the national money supply.

 

[ArthurWilborn]

I'm not quite sure how you would separate economic debt from monetary debt (indentured servitude?)

For a simple example you could have a monetary system composed entirely of government-issued debt-free notes and coins and employ a system of full reserve banking where the banks had to have 100% of the loans they give out as deposits from their customers. Now I'm not saying this is the ideal situation but it is one was to have economic debt with a debt-free monetary system. I think the idea system may be a mix between the two where government issues ~50% of the money debt-free and the rest is made up by loans from banks. The exact proportions could change depending on economic circumstances.

Fair enough.

This is why you hear me complaining about excessive national debts now and again.

I've argued in the past that national debts are necessary to keep national economies functioning and I still think this is true under the current system. But that is because the current system requires borrowing in order to keep growing. It doesn't matter is the borrowing is done on the personal, industrial, or national level but it has to be done otherwise the economy sinks into recession. This is not a good system.

Uh... no, it doesn't. Growth is based on an increase in wealth, which can mean an increase in efficiency or an increase in resources. Growth based only on borrowing is a "bubble" which inevitably collapses in short order. The Dutch Tulip bubble is the easiest example of this, fake growth based on speculation and rampant borrowing. This doesn't change that the addition of a new resource, tulips, caused some actual economic growth.

Efficiency, which is where capitalism shines. If you can do something more efficiently, you use less resources and hence less money, "creating" money that would have otherwise been used for some other purpose.

Efficiency doesn't create money it just allows you to use the same money for other purchases. Perhaps on an individual level it feels like you have more money but doesn't actually add anything to the national money supply.

... What? Yes, efficiency does create money. If you don't have to spend money on something, you've created that much money. Perhaps thinking of it as "not lost" will make the concept easier to understand. Money that's not lost enters the economy just the same as money that was printed.

 

[Aught3]

Uh... no, it doesn't. Growth is based on an increase in wealth, which can mean an increase in efficiency or an increase in resources. Growth based only on borrowing is a "bubble" which inevitably collapses in short order. The Dutch Tulip bubble is the easiest example of this, fake growth based on speculation and rampant borrowing. This doesn't change that the addition of a new resource, tulips, caused some actual economic growth

Yet the US debt has been growing for decades and is getting even bigger under Obama. The only president in recent memory who did anything about the US national debt was Bill Clinton, which led to an escalation in private borrowing to keep up the rate of growth. Of course when the private debt collapsed the Bush/Obama response was a federal bail-out. This shifted the debt creation back to the government and keeping the economy growing, at least compared to countries like Britain which adopted austerity in the face of a similar fiscal crisis.

My basic argument here is:
Economies need money to function. As the economy expands the money supply must grow to match the new level of economic activity. Conversely, if the money supply is too tight then the economy will contract as commerce is slowed. Since the majority of money is created in the form of debt, in order for the money supply to grow debts need to increase. Therefore, if an economy is to expand then debt must increase.

... What? Yes, efficiency does create money. If you don't have to spend money on something, you've created that much money. Perhaps thinking of it as "not lost" will make the concept easier to understand. Money that's not lost enters the economy just the same as money that was printed.

I think we just mean different things by 'create'. I'm talking about a process that brings money into existence that was not already there before. It would be like claiming a baker 'creates' flour if he gets more efficient at making muffins. I can kind of see what mean as that flour is now available to do other things, but the baker did not create that flour in the sense that I am talking about.

 

[ArthurWilborn]

Uh... no, it doesn't. Growth is based on an increase in wealth, which can mean an increase in efficiency or an increase in resources. Growth based only on borrowing is a "bubble" which inevitably collapses in short order. The Dutch Tulip bubble is the easiest example of this, fake growth based on speculation and rampant borrowing. This doesn't change that the addition of a new resource, tulips, caused some actual economic growth

Yet the US debt has been growing for decades and is getting even bigger under Obama. The only president in recent memory who did anything about the US national debt was Bill Clinton, which led to an escalation in private borrowing to keep up the rate of growth. Of course when the private debt collapsed the Bush/Obama response was a federal bail-out. This shifted the debt creation back to the government and keeping the economy growing, at least compared to countries like Britain which adopted austerity in the face of a similar fiscal crisis.

My basic argument here is:
Economies need money to function. As the economy expands the money supply must grow to match the new level of economic activity. Conversely, if the money supply is too tight then the economy will contract as commerce is slowed. Since the majority of money is created in the form of debt, in order for the money supply to grow debts need to increase. Therefore, if an economy is to expand then debt must increase.

... Huh? Government spending doesn't create wealth, quite the opposite in fact. It might increase the money supply, but more money without more wealth just creates inflation. Wealth generally increases as a rule, so continually putting out more money to match it is generally a good idea. This also creates the phenomena you may have noticed things have a higher money cost but a lower purchasing power cost as time goes on. A dollar will only buy a fraction of what it would a hundred years ago, but we have more then enough dollars in circulation to make up the difference.

I think you're confusing the actual, physical bills and coins with what they represent. The coins and bills themselves don't have any inherent value.

... What? Yes, efficiency does create money. If you don't have to spend money on something, you've created that much money. Perhaps thinking of it as "not lost" will make the concept easier to understand. Money that's not lost enters the economy just the same as money that was printed.

I think we just mean different things by 'create'. I'm talking about a process that brings money into existence that was not already there before. It would be like claiming a baker 'creates' flour if he gets more efficient at making muffins. I can kind of see what mean as that flour is now available to do other things, but the baker did not create that flour in the sense that I am talking about.

Then you're just arguing semantics. That extra money due to increased efficiency is the primary method how money (as in purchasing power) is added to an economy. If you print more bills you're not adding any purchasing power, you're causing all the numbers to go up.

 

[Aught3]

Government spending doesn't create wealth, quite the opposite in fact.

What about road infrastructure or public education? These are forms of wealth created by government spending. Or the government could just give the money straight to a company like GM. As long as they spend it manufacturing new cars you have government spending leading to wealth creation.

Wealth generally increases as a rule, so continually putting out more money to match it is generally a good idea.

Yes this is the key point from my last post. But if more money has to come in to an economy then it has to be created somewhere. The mechanism for the majority money creation is bank loans (this is what Obama meant when he talked about a 10x money multiplier for bank bail-outs). Therefore, more money for the economy inevitably means more debt in the economy.

This also creates the phenomena you may have noticed things have a higher money cost but a lower purchasing power cost as time goes on. A dollar will only buy a fraction of what it would a hundred years ago, but we have more then enough dollars in circulation to make up the difference.

I agree.

I think you're confusing the actual, physical bills and coins with what they represent. The coins and bills themselves don't have any inherent value.

No, I don't think I am confusing this point. Money is the medium of exchange, this can be notes, coins, electronic numbers, shells, or whatever. What I'm concerned with in this topic is the creation process of that money and what it means for the economy.

Then you're just arguing semantics. That extra money due to increased efficiency is the primary method how money (as in purchasing power) is added to an economy. If you print more bills you're not adding any purchasing power, you're causing all the numbers to go up.

I am definitely not talking about the purchasing power of a unit of currency and the fact that it tends to decrease over time. Since there is a lot of misunderstanding going on here I think semantics is actually pretty important.

 

[ArthurWilborn]

Government spending doesn't create wealth, quite the opposite in fact.

What about road infrastructure or public education? These are forms of wealth created by government spending. Or the government could just give the money straight to a company like GM. As long as they spend it manufacturing new cars you have government spending leading to wealth creation.

Well, infrastructure and education are legitimate government roles, so fine. However, the money given to GM didn't come from nowhere. That's wealth redistribution, not wealth creation. I refer you to Venezuela for an idea on how redistributing wealth by government fiat is a bad idea.

Wealth generally increases as a rule, so continually putting out more money to match it is generally a good idea.

Yes this is the key point from my last post. But if more money has to come in to an economy then it has to be created somewhere. The mechanism for the majority money creation is bank loans (this is what Obama meant when he talked about a 10x money multiplier for bank bail-outs). Therefore, more money for the economy inevitably means more debt in the economy.

You are, again, conflating money and wealth. Governments can just print money out of hand without associating it with a debt if they want to - they usually don't since that's a terrible idea. People can create wealth without creating debt by increasing the efficiency of the economy - a dollar not wasted is the same as a dollar created. There's been a few economies (historically Russia) that were in bad shape because they had plenty of wealth but not enough money medium to exchange it efficiently. Muslim economies are hampered by religious strictures against creating money via debt.

Then you're just arguing semantics. That extra money due to increased efficiency is the primary method how money (as in purchasing power) is added to an economy. If you print more bills you're not adding any purchasing power, you're causing all the numbers to go up.

I am definitely not talking about the purchasing power of a unit of currency and the fact that it tends to decrease over time. Since there is a lot of misunderstanding going on here I think semantics is actually pretty important.

Ok, then. What you're doing is typical of someone with an incomplete understanding. You take one aspect of the system, the increased availability of money due to loans, and assuming that the entire system runs off that principle. It's the same as Scientology asserting all illnesses are forms of PTSD, or the conspiracy theorist who claims that since some bad things are the result of government manipulation, that therefore all bad things are.

 

[Aught3]

Welcome back Arthur.

Well, infrastructure and education are legitimate government roles, so fine. However, the money given to GM didn't come from nowhere. That's wealth redistribution, not wealth creation. I refer you to Venezuela for an idea on how redistributing wealth by government fiat is a bad idea.

Correct, the money didn't come from nowhere, it came from the government borrowing the money in the wake of the GFC. There was no massive wealth redistribution, no special tax or enforced wealth confiscation. Nor did the government dip in to a trillion dollar reserve it happened to have sitting around from previous years. They borrowed that money into existence then gave it out to keep the economy going and the wealth being created.

You are, again, conflating money and wealth. Governments can just print money out of hand without associating it with a debt if they want to - they usually don't since that's a terrible idea. People can create wealth without creating debt by increasing the efficiency of the economy - a dollar not wasted is the same as a dollar created. There's been a few economies (historically Russia) that were in bad shape because they had plenty of wealth but not enough money medium to exchange it efficiently. Muslim economies are hampered by religious strictures against creating money via debt.

I agree that wealth can be created without debt. I don't think I have denied that. I also agree that an economy with wealth but without money runs in to the difficulty of inefficient exchange. Further, I agree that creating debt is the main way money is created allowing wealth to be exchanged which takes us back to my OP, a discussion around the effect of money creation via debt. I think we pretty much agree on the discussion around wealth but you think that government-backed money is a bad idea, why? And if the only other option is debt-created money is the government-back option actually any worse, if so why?

Ok, then. What you're doing is typical of someone with an incomplete understanding. You take one aspect of the system, the increased availability of money due to loans, and assuming that the entire system runs off that principle. It's the same as Scientology asserting all illnesses are forms of PTSD, or the conspiracy theorist who claims that since some bad things are the result of government manipulation, that therefore all bad things are.

I think it is just a fact that 97-98% of the money in our economic systems is created by debt, it's even on Wikipedia. Where does the majority of the money supply come from if not loans and debt?

 

[Lukendog]

I think you will find the answers to your questions here: http://bilbo.economicoutlook.net/blog/

You may also be surprised by the answers you find.

 

[Aught3]

I think you will find the answers to your questions here: http://bilbo.economicoutlook.net/blog/

You may also be surprised by the answers you find.

Thanks for the link Lukendog and welcome to the forums. The blog at that link does seem to talk about the right sort of things but I'm having trouble finding a post specifically on the way money is created and any negative consequences that system might have. DId you have a specific post or two in mind?

 

[Lukendog]

Start with http://bilbo.economicoutlook.net/blog/?p=1623 as it specifically addresses your question.

Professor Mitchell's blog is not always easy to navigate but a search will usually return relevant information..

If you are interested, under the heading of "Categories" on the right-hand side of any of the the blog pages you will find the "Debriefing 101" link. Go back to the very first article from February 2009 and work your way forward in time.