Understanding creation of money and credit.

[WinstonWolfe]

EDIT: Apologies I just realised you meant who other than the gov can make more AUD, not how other than through OCR can the government get AUD out there... And for this I agree, no one other than the gov and counterfeiters can create AUD.

If Australian banks were banned from borrowing foreign funds as bank bonds, then they would have around 25% less funding...which would contract funds available to lend to Aussies for housing.

Please clarify how borrowing foreign funds doesn't expand our money supply and allow us to pay more AUDs for houses.

 

[tom32]

If Australian banks were banned from borrowing foreign funds as bank bonds, then they would have around 25% less funding...which would contract funds available to lend to Aussies for housing.

Please clarify how borrowing foreign funds doesn't expand our money supply and allow us to pay more AUDs for houses.

It creates M3 not AUD there is a short term demand for AUD in the thick of the transaction but in the end like all credit transactions the result is AUD used for settlement but at the end of the transaction the same AUD existed as before with more credit and debts through the system. In this case the credit is to foreign creditor.

i.e. someone ends up with a deposit account with AUD in it usually but in this case it will be $US and be in an overseas account. No AUD was created only used to settle the transaction.

Anyway an example:

Customer A wants to borrow 1 million dollars AUD to buy a house, assuming the bank has no spare funds but sufficient capital adequacy to make the loan.

The bank borrows US900,000.

It now has on its books

US900,000.00 liability

US900,000.00 in cash asset

The bank now needs to convert this to AUD so they buy futures of $US to allow them to pay this debt out a fixed rate as it comes due and carry the $US debt along with the hedge result on the balance sheet but convert the physical $US into AUD.

They take the US900,000.00 and convert them to AUD1,000,000.00. Their is a short term demand for AUD here, but this is only required for the transaction, later the AUD gets back out into the system to be used again to create more M3.

They then "deposit" this AUD1,000,000.00 into the seller of the houses nominated account assuming this is with another bank it is likely their will be a demand for this AUD soon enough, i.e. they will pay this AUD to the other bank. Most of these transfers will be electronic rather than physical but nonetheless by this time the requirement for physical AUD has passed. The bank has no AUD, no one has any AUD but the creditor has US900k in his account and the borrower has a 1million AUD debt in his account.

The AUD have travelled off to create more M# elsewhere. The $US are likely to find their way back to the US as well, or not, but typically if a country prints more of their currency even only to spend offshore it finds its way back.

So while AUD is used for the transaction none is created. It does create more Australian M3 however broad money but in the same way as it is created (M3) it can be undone. The US creditor can ask for their funds back for example. This means the Australian lender has to find alternate funds to fill the breech. This is what Keen is concerned about is our level of M3 v base money sustainable? Is our debt per person sustainable?

So yes it allows us to pay more AUD to buy houses but it does not create more AUD. It creates more M3, and yes M3 effects inflation generally not just in houses, but in Australia it appears certain asset classes are where our credit is concentrated residential housing being the primary one.

To be clear about M3 measures the increase in Australian M3 is only on the sellers account, the US creditor is not in our M3 but will count toward their own M2. However the punter who has just sold his house for 1 million AUD when before he only had a house is contributing to our M3. This is the feedback loop I mentioned in my earlier posts. The more the asset rises the more funds available to fuel further price increases.

 

[WinstonWolfe]

To be clear about M3 measures the increase in Australian M3 is only on the sellers account, the US creditor is not in our M3 but will count toward their own M2. However the punter who has just sold his house for 1 million AUD when before he only had a house is contributing to our M3. This is the feedback loop I mentioned in my earlier posts. The more the asset rises the more funds available to fuel further price increases.

Tom, you seem to be using M3 as if it includes credit money. AFAIK, it doesn't. See ABS. But I am still trying to understand and crystallize money and credit creation, their relationship.

Once foreign credit borrowed by a bank and lent to a house buyer is passed to the house vendor who deposits it with his bank, they are are able to use that deposit as reserve funds to expand their lending.

Some economists argue base money is quite meaningless, as we are a credit fueled economy with inflation and asset prices being set by it.

You might be interested in the writings of Australian economist, Leigh Harkness. Like Richard Werner, he recognizes the danger of expanding credit beyond the rate of production.

Appreciate your efforts in discussing this.

 

[tom32]

Tom, you seem to be using M3 as if it includes credit money. AFAIK, it doesn't.

M3 is deposits not loans. But more loans make more deposits.

i.e. if houses were suddenly worth 10million dollars and banks would loan this sum of money to people sellers are suddenly getting 10 million dollar deposit accounts and buyers 10million dollar loans. The deposits are M3 not the loans. But loans and asset rises also create deposits.

Actually your graph seems to indicate below where we started to rely on external credit. i.e. loans made increasing credit but the funds from a foreign non M3 source. The credit graph does appear to disconnect from M3 by 1993, but you would have to look back further to know for sure.

So the creation of M3 is coming about via expansion in credit. It is not measuring directly the expansion in credit but it is a pretty strong correlation.

See ABS. But I am still trying to understand and crystallize money and credit creation, their relationship.

Once foreign credit borrowed by a bank and lent to a house buyer is passed to the house vendor who deposits it with his bank, they are are able to use that deposit as reserve funds to expand their lending.

Some economists argue base money is quite meaningless, as we are a credit fueled economy with inflation and asset prices being set by it.

You might be interested in the writings of Australian economist, Leigh Harkness. Like Richard Werner, he recognizes the danger of expanding credit beyond the rate of production.

Appreciate your efforts in discussing this.

If they were to have the seller deposit the money or leave it with that bank they could extend credit to someone else as now they have the initial overseas funds and now more local funds. The local funds came about as a result of the house being monetised. i.e. someone prepared to sell their house and accept a deposit with that institution. The house itself was the funds to allow the bank to create a loan asset.

On Base money and its importance to inflation I have heard this too. Inflation usually comes about due to changes in M3 not changes in M0. This makes sense I suppose as if everyone had a million dollars but put it in the mattress and never spent it then what difference would it make to costs of production or indeed anything. It would really be a moot point. People however take out loans to buy stuff, the deposits created are likely going to be used to buy other stuff eventually.

However in Australia our burgeoning M3 seems to be used primarily on a few asset classes not throughout the economy. I wonder if inflation has been contained because of appreciating house prices and collectively us putting more into housing allowing other consumer goods to not inflate as would be expected with broad money growth as we experienced earlier this decade? i.e. is it possible house price appreciation has controlled inflation in this country?

Thanks for the references above I will have a look.

 

[WinstonWolfe]

sorry.... Leigh Harkness writings are here.

 

[Token Funder]

meant to add the following link, it is modern money mechanics printed (now out of print because it caused a furore) by Chigaco Federal reserve in the good old USA

www.rayservers.com/images/ModernMoneyMechanics.pdf

Not so much.

It's out of print becuase it is of no relevance to modern financial mechanics.

Other than, of course, that particular cohort of conspiracy theorists and generalist nutcases in the US who don't think bank loans are enforceable, income tax is Constitutional or that Barack Obama is an American citizen.

Worth noting that the day after a document with the word modern in the title is written, it was, not is.

 

[Piston Broke]

As far as the RBA liquidity operations, you are simply either selling outright or under a repurchase arrangment assets you already have. In other words, you can't borrow an infinite amount from the RBA. What you can do is sell certain asset classes to them, thereby limiting what you can get from them to a figure that is very finite indeed.

Unless there is a GFC.
And of course the other issue is what price the RBA pays for the assets.
And given that Krudd was saying that 200Bil is not much debt to hold, "very finite" does'nt seem very small.

 

[Ridin-High]

Well Winston i'll have a crack and feel free to correct me if im wrong

But i believe diversity is an old old wooden ship used during the civil war era

 

[Deltaberry]

Ah yes Tom... that reminds me of a book I read about red money, blue money, green money, yellow and black money or something. The same dollar goes around the economy around 6-7x. So what's the implication? Is it when there are bank runs there's only one piece of money in the first place but now you got to pay for all the colours?

 

[tom32]

Ah yes Tom... that reminds me of a book I read about red money, blue money, green money, yellow and black money or something. The same dollar goes around the economy around 6-7x. So what's the implication? Is it when there are bank runs there's only one piece of money in the first place but now you got to pay for all the colours?

Thats where the potential for deflation starts from.

All these people with deposits in the bank count as M3 but they cannot all spend their money at once.

It can start because people are fearful of their deposits and so take cash out which causes a rapid deterioration in funding availability and worse liquidity hence banks must find ways to shrink their loan books.

Alternately it can start because people demand less money in loans. When people are not demanding loans less deposits are created. Either side can drive the money creation process in the same way either side can cause it to shrink, i.e. demand for loans or demand for deposits.

To be clear however where I say loans create deposits, funds are still required to create a specific loan. They can and often are created as a by product of a loan creation but this is not automatic for the bank. The bank must attract and maintain the deposit to grow their loan assets.

This is why I do not like the description that banks create money. It is the demand for credit and demand for deposits which create money, there is no unilateral ability on the part of the banks to create money. They must have either their own capital or a depositor to create a loan asset. That said the extension of credit to people often comes back to the bank as deposits. As per the description above of the houses suddenly worth 10million dollars, guess what happens to our deposit rates in this country if this happened? Initially they would grow quite significantly as well as credit. Each seller of a house suddenly has a 10million dollar kitty. This is not necessarily a good thing for the resilience of the economy however because for each of these deposits their is a loan.

 

[sash]

So true....it is only a matter of time before this (Cloud Computing) becomes the norm.

Data privacy issues will be circumvented by organisations setting up Clouds in country!

I work for a company that is at the forefront on Cloud Computing...

As for IT, I can host servers & support with Amazon or Engineyard for 1/3 of the price it costs here with no need for to rent buildings & hire people. It will soon be cheaper to throw out at least half those servers (and staff) imo.
The only consideration may be that some storage of data may have to be held locally.

 

[aaarghhh]

I work for a company that is at the forefront on Cloud Computing...

Conficker by any chance?

 

[WinstonWolfe]

Thanks Chaz. I picked up the link to Richard Werner's Basel 3 recommendations. Excellent reading.

 

[Token Funder]

Unless there is a GFC.
And of course the other issue is what price the RBA pays for the assets.
And given that Krudd was saying that 200Bil is not much debt to hold, "very finite" does'nt seem very small.

The second point is the key lever. The RBA can inject funds into banks in a relatively subtlee way by simply paying well above the odds for those assets.

 

[Piston Broke]

The second point is the key lever. The RBA can inject funds into banks in a relatively subtlee way by simply paying well above the odds for those assets.

And when the banks have nothing left to sell, the RBA can convince the gov that a stimulus is urgently needed, 200Bil is not much to borrow, and throw $$ from helicopters, build infrastructure at 3 times the price, knowing full well that most of the money borrowed from the gov will end up in the banks in addition to those injected funds.
Nice honey pot if your on the receiving end...

----

But there is also the issue of legal tender.
Legal tender made it compulsory to accept banknotes & coins as payment.
But now with transactions done via computer, what will be the future of cash as legal tender?
And will an online payment become the new legal tender?
Without a legal tender there will be a lot of confusion.

 

[Deltaberry]

Thats where the potential for deflation starts from.

All these people with deposits in the bank count as M3 but they cannot all spend their money at once.

Ah yes, I've thought about this, only on a very high level basis.

So I guess the key would be identifying a bank run before it comes. A bank run will occur because of lack of confidence... in the US and UK we saw that happen to some extent as liquidity freezed up. So again liquidity seems to be the key, and it'd seem serviceability which is in turn driven by cost of debt will drive liquidity and credit risk. Cost of credit in turn seems to stem from all sorts of economic fluctuations.

So, for example, fair to say an oil shock will drive up cost of credit which could crunch serviceability which smashes liquidity and lowers credit rating, resulting in loss of confidence followed by widespread recall of loans and forced bankruptcies, eventually leading to widespread panic on the retail side and mass public bank runs and the collapse of the United States...? Just wondering...

 

[WinstonWolfe]

This afternoon, I've been reading Bill Mitchell's BillyBlog.

Bill Mitchell is the Research Professor in Economics and Director of the Centre of Full Employment and Equity (CofFEE), at the University of Newcastle, NSW Australia.

He addresses many of the money/credit creation issues I am fuzzy on, but I'll have to read it a few times because it isn't dumbed down terribly.

Like Steve Keen, he argues banks expand money via acceptable lending risk first, and reserves follow after.

Here, he debunks that the money multiplier effect due to fractional reserves drives money creation in Australia.

 

[tom32]

Here, he debunks that the money multiplier effect due to fractional reserves drives money creation in Australia.

It is only a stylised model of M3 in relation to M0, it was never presented to me as the precise way base money turning into broad money. Of course the 100 in 90 out 90 in 81 out etc does not translate exactly in the economy.

Anyway it works on our system as a model it is just that the inputs are not as per the examples that one might study at university or high school.

1) We do not have a 10% reserve of deposits required in Australia and certainly not required as cash sitting in the bank. Banks must manage liquidity but the important APRA requirement is on capital not on deposit retention.
2) Also importantly whatever reserve we do have (capital not liquidity like in usual multiplier effect examples) can be deposited in other banks. So our inverse m is really infinite, i.e. it can be multiplied depending on the demand and access to credit the multiplier effect when the banks can just deposit there reserve with another bank is infinite leverage of each base dollar.

In short it is not that it is wrong, its that when the deposit reserve is 0 the multiplier is infinite.

That he says banks lend and rely on the sourced funds coming about from the transaction is something that I have heard before.

It really comes back to what you consider funds. Take a seemingly fundless transaction:

Person A sells a house to person B and says pay me in 10 years $600,000.00. Ask yourself what has funded this loan. It is the house! The $600,000.00 has not been created out of nothing the loan asset is created through the sale of his home.

The authors of such things would it seems like you to think that through conspiracies the banks can create money out of thin air. Like the person above who gives his house up in the case of bank funds it might be someone trading their house for a deposit, but make no mistake the borrower is not signing up to a life of debt servitude for nothing he wants something for his loan.

Something funds each transaction it could be cash, it could be a boat it is quite likely to be a house and if the seller of this item is happy to keep a deposit with the lending institution in return for his asset then hey presto this asset has been turned into M3 where none existed before.

A bank however must hold onto these deposits. If the previous owner of the house wants his deposit out like any other funds the bank must replace them with new funding. So this funding is far from automatically generated out of writing up a loan.

Anyway all that said I do agree that lending growth does generate deposit growth over time. As above M3 is created where none existed before on sale of assets. It is not a unilateral power of the bank however to create money. There must be both a willingness on the part of a depositor and a willingness on the part of a borrower for the bank to make this transaction and create a loan asset / deposit liability. Of course they can source funds in other ways but they are sourcing funds nonetheless. Sell RMBS, sell bonds, use their own capital but this is all still funding.

 

[Piston Broke]

Person A sells a house to person B and says pay me in 10 years $600,000.00. Ask yourself what has funded this loan. It is the house! The $600,000.00 has not been created out of nothing the loan asset is created through the sale of his home.

Money is created out of thin air when the bank lends out money not having any assets.
The bank lends money it does not own (or even have), Person A owns a house.

 

[tom32]

Money is created out of thin air when the bank lends out money not having any assets.
The bank lends money it does not own (or even have), Person A owns a house.

OK so the seller of the house has funded the transaction in this case. Take the house away how does the bank create money then. Sure someone can sell an asset and say bank I'll take a deposit in favour of my asset this is precisely how asset sales turn into M3 deposits but the bank cannot do this without the depositor. i.e. no unilateral money creation.