Understanding creation of money and credit.

[Mandy Mac]

Nope, a mere economics graduate. My real passion is development economics - being the good bleeding heart humanitarian that I am.

I do think you are right to be concerned that our "wealth" is coming about because our properties are worth more, rather than because we are becoming more efficient.

So then you need to think about what ought to make us wealthy? What should we be doing to increase our GDP?

Bob Katter will argue that we ought to restrict banana imports and grow more bananas.

Adam Bandt will argue that we ought to invest in technology so we can sell green tech to the rest of the world.

And then there is a myriad of other opinions.

Personally I am of the opinion that we ought to go down the tech road. So who ought to pay for the NBN? Business or govt? Being a good neo-liberal I should be arguing that business should do it, but the other side of me believes that business will only do what it has to do, govt will do a more thorough job of it, but why should govt be interfering in that? Maybe they could build it and sell it off? And so the argument goes (in my head).

PS Tom, I like your analogy.

 

[tom32]

Though in my view, cip inflation is not as damaging as rip inflation. At least cips are used in the production process.

The Australian governments at each level actually consider commercial property far more important than residential in terms of supply. Look at undeveloped land on the outskirts of our cities and seee what value commercial or industrial zoned land has in comparison to residential. It would be like winning lotto buying industrial land on the fringe and getting it rezoned resi for most of our cities.

You will find the government does a better job of supply of commercial and industrial land. The law of wages which I do subscribe too tells us if the land itself used for production is expensive then the wages paid to those people who use it to produce will be lower in real terms than a place with abundant high quality / productive land.

these days of course land productivity is a mixture of location, infrastructure not agricultural production so much.

In Australia rather than being naturally short on land we have a contrived shortage created by government through inneficient regulation and lack of infrastructure investment.

I do think that it is fair to say they do a better job in commercial and industrial than in residential. The latter being taken into account in peoples wellbeing after real wages the former actually feeding into real wages. i.e. we think we have high real wages in Australia now but if you did not buy a house early than you don't individually.

I do not agree CIP inflation is not as damaging as RIP inflation CIP inflation having a direct effect on wages and business productivity competitiveness, but what I would say is RIP inflation is slower to affect peoples wellbeing in a negative fashion so easier for governments to get very wrong. 'RIP inflations first affect is positive; more consumers through wealth effect growing M3 etc growing deposits. It is only after several years (we are getting there now I believe) do we see slowing consumer growth due to a build up of debt to support asset prices and a debt effect overtakes the early wealth effect.

rather than make a call on whether we have a bubble or not I would say this:

early in housing bubble you have:

growing prices, very little stock changes hand but peoples "wealth" is high people consume more due to the wealth effect.

during bubble prices continue to climb some stock has changed hands while you have some virtual non consumers who have got in late most people go on consuming.

Several years into the bubble; by now large numbers of people have joined the ranks of the virtual non consumer. Working to pay off debt.

You know where this is heading? You know why I think government regulation or at least overregulation in residetial housing is stupid short sighted policy.

Worst part is to unpick this mess things get a lot worse before they get better!

 

[redwing]

Hi Bruce, thought of you when I saw this

Is the Australian economy the world’s largest Ponzi scheme?

Australia needs more than one billion dollars every day – that’s one thousand million dollars each and every day - to avoid default on its foreign debt, yet we seem to be basking in the illusion that we are not a future Greece.

Australia is now in a worse foreign debt position than Hungary and ranks as the 11th most indebted nation on earth. With gross external debts (equity and debt) of over 2 trillion and a debt to GNP ratio exceeding 100%, Australia sits well within the field of European countries facing a bleak future.

Australians should be able to hear clearly the “tick..tick..tick” of our own debt bomb. But government and business refuse to talk about it. Why?

Could it be that successive Australian Governments and businesses have been running a Ponzi scheme with our future?

At a recent Government Magazine roundtable, Senator Barnaby Joyce flagged our debt problem in clear language (language that ordinary people understand but spin doctors in Canberra hate) when he said:

“I looked at where our debt is this morning. It's grown to 131.66 billions dollars. And the last time I looked a week ago it was 130 billion dollars. We’ve become so blasé about this, and this is absurd. You can’t just go, week after week, borrowing a billion dollars. I don’t care who you are.”

(for a full transcript, click here).

I was so surprised by these figures that I began to look more closely at the data myself. What I found was that even the Senator’s speech writers didn’t fully grasp the enormity of the problem – Australia’s gross foreign debt is actually over $1,300 billion - ten time worse than Senator Joyce indicated.

As a former banker who has dealt a lot with debt, the following numbers were enough to scare me.

Cont....

 

[Piston Broke]

Why?
A central bank trying to control credit in a deregulated market is as absurd as the government trying to control imports after abolishing tariffs.

And where did you learn that?
Check your loan statement and see how much your interest is.
Once again I think you net to re-asses your thinking of central banks.

 

[Intrinsic_Value]

Hi WW,

Cannot comment on all that high level stuff - way over my head, and I haven't seen a way of making a $ out of it, so I don't apply myself in that area.

I understand where you are comming from.
If the deal stack up the deal stacks up.

However having a basic overview of this stuff is still good (however one has to be selective of the source, otherwise there is the risk investment paralysis).

If you have time, get a 'feel' for things before/after the asian economic crisis.
Many individual investors where happy going about their micro world before this hit, and when it did it was like a sledge hammer.

 

[Mandy Mac]

And where did you learn that?
Check your loan statement and see how much your interest is.
Once again I think you net to re-asses your thinking of central banks.

Talk to me.

WW is trying to understand how it works, I freely admit I don't know. If you do, I'd love to hear it.

 

[WinstonWolfe]

However having a basic overview of this stuff is still good (however one has to be selective of the source, otherwise there is the risk investment paralysis).

My view is it is wise to understand the risk associated with any decision, and my wish is that the financial system be more reasonably and accurately understood.

Currently, it is not well explained by any one source. Something as profound as the preservation of the purchasing power of money and the role of credit should not be cloaked like some dirty secret. The concepts and mechanics should be transparent and explained so that a year 10 student understands them clearly.

In a deregulated banking world, when we take on debt we are taking on a business partner, the bank. If we do not understand a change in the risks they take then we are running in the dark.

If more of us understood the creation of money and credit, and associated risk, we might emulate Dazz more by focusing on +CF CIP. We might actually come to the belief -CF RIP is a poor reward for risk investment today.

 

[Piston Broke]

Talk to me.
WW is trying to understand how it works, I freely admit I don't know. If you do, I'd love to hear it.

I never said I 'm an expert, just that I have a diverging opinion:
The people with big wages 7 nice suits go on the tele and tell us that deregulation means that there is a competitive market and that is good for consumers. That banks can source cheap funding and pass it on, blah blah blah.
So where is it?
JAP = 0.1%
USA = .25%
GB = 0.5%
UE = 1%
CAD = 1%
NZD = 2.5%
RBA = 4.5%
As every other central bank in the world reduces rates, when the RBA increased or decreased rates, all the banks immediately followed, but only the RBA.
The gov guaranteed the deposits & borrowings of the RBA "4 pillars" bank cartel.
You can call the market whateva you want, but it seems obvious to me who controls the monetary system and credit.
And they have now increased their market share to >90%.

If more of us understood the creation of money and credit, and associated risk, we might emulate Dazz more by focusing on +CF CIP. We might actually come to the belief -CF RIP is a poor reward for risk investment today.

It's not that simple, though in theory i agree.
An investment makes money, a liability loses money.
But CIP can be very volatile and much more sensitive to credit availability.
And banks are a lot less sympathetic to defaults.

 

[jaycee]

I never said I 'm an expert, just that I have a diverging opinion:
The people with big wages 7 nice suits go on the tele and tell us that deregulation means that there is a competitive market and that is good for consumers. That banks can source cheap funding and pass it on, blah blah blah.
So where is it?
JAP = 0.1%
USA = .25%
GB = 0.5%
UE = 1%
CAD = 1%
NZD = 2.5%
RBA = 4.5%
As every other central bank in the world reduces rates, when the RBA increased or decreased rates, all the banks immediately followed, but only the RBA.
The gov guaranteed the deposits & borrowings of the RBA "4 pillars" bank cartel.
You can call the market whateva you want, but it seems obvious to me who controls the monetary system and credit.
And they have now increased their market share to >90%.


It's not that simple, though in theory i agree.
An investment makes money, a liability loses money.
But CIP can be very volatile and much more sensitive to credit availability.
And banks are a lot less sympathetic to defaults.

I took CIP & Dazz as good examples only of CF+ invetments / investment strategies

 

[Sunfish]

I have spent many hours trying to get up to speed on this but find comfort in knowing greater brains than I haven't grasped it fully either. Fractional reserve banking as explained using goldsmiths is just TOOO simple for me to grasp.

Does it mean that the bank only needs 10c on deposit and may then borrow another 90c to lend out $1 or do they simply pretend they have it all? The presenters are saying the latter but I can't grasp how they can pull that off.

PB seems to be saying that it is wrong to have interest rates @ 4.5% and that is what Bob Katter is saying also. Surely interest rates are a bit like blood pressure: Don't want it too high but 60 over 30 must be too low, surely? Remember the RBA governors aren't investment speculators and must consider the broad picture.

 

[Sunfish]

So then you need to think about what ought to make us wealthy? What should we be doing to increase our GDP?

Bob Katter will argue that we ought to restrict banana imports and grow more bananas.

Adam Bandt will argue that we ought to invest in technology so we can sell green tech to the rest of the world.

And then there is a myriad of other opinions.

Personally I am of the opinion that we ought to go down the tech road.

I have no education in economics, but that doesn't mean I can't have an opinion. I can see the problems with a two speed economy while we are reliant on mining, but it does have it's virtues. The bulk materials in particular require little labour but the guys/gals are well paid and can support service industries for those who choose not to get dirty (and there are many valid reasons for this, I'm not calling them bludgers). I see this as mitigation for the demographic bombshell they like to scare us with.

Mining can keep the country moving even with an aging population. I understand that the tax regime will need to change, but so do the miners.

 

[Bill.L]

Hi all,

Always an interesting topic of where money comes from and how it exists.

Firstly to a few misconceptions. The RBA was set up by an act of Parliament, it has the following on it's website....

The role and functions of the Reserve Bank are underpinned by various pieces of legislation. The Bank is a statutory authority, established by an Act of Parliament, the Reserve Bank Act 1959, which gives it specific powers and obligations. In terms of the Act, there are two Boards: the Reserve Bank Board and the Payments System Board.

The Reserve Bank Board’s obligations with respect to monetary policy are laid out in Sections 10(2) and 11(1) of the Act. Section 10(2) of the Act, which is often referred to as the Bank’s ‘charter’, says:

‘It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank ... are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to:

1. the stability of the currency of Australia;
2. the maintenance of full employment in Australia; and
3. the economic prosperity and welfare of the people of Australia.’

The misconception is that it is independent of Government, yet by an act of parliament the government can change everything the RBA does. For the RBA to be truely independent, it would have to be written into the constitution, it isn't.

Sunfish,

Does it mean that the bank only needs 10c on deposit and may then borrow another 90c to lend out $1 or do they simply pretend they have it all? The presenters are saying the latter but I can't grasp how they can pull that off.

Yes, that's the game. The money is created out of thin air, just an added entry in the books. I couldn't believe it myself until I found out a little more about it a few years ago. I looked carefully through the annual statements of ANZ about 5 years ago and sure enough there it was. Assets had gone up $38b in half a year, yet total liabilities (all deposits,bonds,borrowings etc) had only gone up $8b. Repayments of loans could not account for it either. It was like the money just appeared on their books. Creating money out of thin air is the only thing that could explain it.
I've spent a fair bit of time this afternoon going through the latest financial statements of the ANZ to see if I could find it again. I woke up (because I had fallen asleep ), and couldn't find anything in the latest one, yet they (banks) seem to report totally differently to other companies. Very difficult to read their financial statements for me anyway. However I still have questions about the whole process..

Dazz,

and I haven't seen a way of making a $ out of it,

...neither have I, except that it helps in the understanding that all of the debt in the world that many think is going to swamp us, in all likelyhood wont. The money to pay for that debt comes out of thin air, providing TPTB want to let it happen.

My real questions on the whole money issue revolve around things I don't understand like...

1. If banks create money out of thin air when lending, why do they need to borrow from overseas??
2. What happens when a borrower repays a loan that was created out of thin air?? Does the bank make an entry against the loan effectively destroying the money, or does the bank just keep it, or does something else happen??
3. If banks are creating money out of thin air, then how can they ever go broke?? If 50% of loans defaulted why should it matter if 90% of the money in all loans was created out of thin air??
4. If banks don't create money when a new loan is made, then where did all the existing money come from and how is it growing??

bye

 

[HiEquity]

Hi Bill

Not quite. Fractional reserve banking only explains the (very high) leverage a bank can use to undertake its business. If it could only make loans on a 70% LVR it would soon run out of cash - fractional reserve allows their tiered capital ratios to go a lot further. It does not allow a bank to create money "out of thin air".

That power belongs to the RBA, if they ever chose to use "quantitative easing" a la the Fed. Provided banks stay within their capital ratio limits, as regulated by APRA (not the RBA), then they can borrow funds from the RBA at the overnight (cash) rate (which the RBA sets) and other sources at will.

Sometimes they can source the same funds in other places than the RBA (either internationally or domestically by, for example, depositor's funds (domestic) or bond placements (international and domestic)) at a cheaper price / greater margin. This explains the 25% international base (to me that's a pretty small ratio - I'm not quite sure what the fuss is about TBH). So while they try to make some money on the margins with other sources of funding (that's what banking is all about - taking a margin on the way through for the risk of default), the price they charge the borrower has to reflect the marginal price they end up paying for funds, which is predominantly set by the overnight cash rate set by the RBA, as the greatest source of cash ultimately available to them. Plus a margin of course...


If all overseas funding dried up then the Banks would be forced to use domestic sources like deposits and ultimately the RBA overnight source more heavily. If the RBA runs out of money to lend to the banks at the interest rate they wish to set across the economy then they can always print more. They use a number of different levers to set interest rates and creating money is just one of them. Gold reserves are another, along with foreign exchange positions etc.

Hope this helps!

 

[Crabnet]

Hi all,
1. If banks create money out of thin air when lending, why do they need to borrow from overseas??
2. What happens when a borrower repays a loan that was created out of thin air?? Does the bank make an entry against the loan effectively destroying the money, or does the bank just keep it, or does something else happen??
3. If banks are creating money out of thin air, then how can they ever go broke?? If 50% of loans defaulted why should it matter if 90% of the money in all loans was created out of thin air??
4. If banks don't create money when a new loan is made, then where did all the existing money come from and how is it growing??

bye

I'm a CBA shareholder so am using their recent results as an example but rounded off.
CBA has deposit liabilities of $600billion, that is their depositors account balances total $600billion.
Around 60% of that is depositors funds the rest is borrowed mostly from overseas but are reserved at the same rate.

A 10% fractional reserve means that of the $600billion it has agreed to repay depositors $60billion is held as cash or equivalent to satisfy the requirements of those depositors who want their money back.
The other $540 billion has been lent out with a promise from the borrowers that they will pay it back. Of course those loans are mostly backed by the borrowers assets.
One result of the above situation is that you could say the value of the assets used as security by the borrowers is being inflated by the overseas borrowings as Australians don't save enough to fund our own lending.

 

[Mandy Mac]

I never said I 'm an expert, just that I have a diverging opinion:
As every other central bank in the world reduces rates, when the RBA increased or decreased rates, all the banks immediately followed, but only the RBA.
The gov guaranteed the deposits & borrowings of the RBA "4 pillars" bank cartel.
You can call the market whateva you want, but it seems obvious to me who controls the monetary system and credit.
And they have now increased their market share to >90%.

Divergent opinions welcome!!!

I can't find a pretty graph to show, but the RBA did drop rates as soon as the GFC hit. Then along came the govt with big spending plans to keep us out of recession and be the heroes! Problem is that big govt spending leads to inflation, and thus RBA started to raise rates again (in an attempt to keep inflation under control).

When I say that the RBA can't control credit creation, they can't force banks to loan willy nilly or to tighten credit. Most of us here would know that it's a lot harder to get a loan now than a few years back. Why? Because banks got spooked due to USA sub prime mortgate meldown - something independent of the RBA.

 

[Mandy Mac]

Mining can keep the country moving even with an aging population.

Agreed. In fact I have no ethical problem with a super mining profits tax. It's not as though anyone manufactured them, so why shouldn't everyone benefit from what we find in the ground. However that is more a political opinion than an economic one.

A 10% fractional reserve means that of the $600billion it has agreed to repay depositors $60billion is held as cash or equivalent to satisfy the requirements of those depositors who want their money back.
The other $540 billion has been lent out with a promise from the borrowers that they will pay it back. Of course those loans are mostly backed by the borrowers assets.

OK but then the $540 billion is paid to some guy for his block of land. He then goes and deposits it at the CBA. So the bank can then loan out $486 B to some woman who then buys a different block of land, and the person she buys it off takes it to the bank and deposits it and then $347 b gets loaned out to the next person, and so on.

So it looks like it's coming out of thin air, but the only bank that can make money out of thin air (or bits of paper) is the RBA.

 

[Mandy Mac]

I should just add that although I have no objection to mining per se, I would like to think that we use the income it generates to do something.

Like WW I worry that our income from our incredible natural wealth is being used to pay higher prices for bits of land with buildings on it, when it could be diverted into developing something that we could sell once the stuff runs dry.

But I don't have the answers.

 

[Bill.L]

Hi all,

I understand all about fractional banking, it explains things nice and easily until you look deeper. A million dollars deposited works its way around the system that has a 10% reserve until it becomes 10 million, but that's it. New money must be created to become more than the $10m.

Foreign borrowings just don't cut it. If ANZ goes and borrows $US10b from the US banks they have $US10b, not $A11b. If this just sits on their books as $US, where do the $A100b that they lend out come from. If it is only $A11b lent out where does it come from?? If it is exchanged for $A from another source, then that is existing money and not newly created money.

There is a lot more to this money creation than is explained in economics 101.

bye

 

[Piston Broke]

PB seems to be saying that it is wrong to have interest rates @ 4.5% and that is what Bob Katter is saying also. Surely interest rates are a bit like blood pressure: Don't want it too high but 60 over 30 must be too low, surely? Remember the RBA governors aren't investment speculators and must consider the broad picture.

I was'nt saying it's right or wrong, just that the RBA controls credit availability & price, and deregulation has had no effect at all.
But the RBA (and most central banks) do not vary rates according to supply/demand, but charge what the market will bear lowering prices only when defaults are too many.

I haven't seen a way of making a $ out of it,

The bank lends money it does'nt have, and you spend money you don't have.
If the bank could'nt lend it, you could'nt spend it.

 

[Piston Broke]

1. If banks create money out of thin air when lending, why do they need to borrow from overseas??

OS interest is cheaper, though exchange rate risk come into play.
Their holdings of other currencies may also be due to trading activities.

2. What happens when a borrower repays a loan that was created out of thin air?? Does the bank make an entry against the loan effectively destroying the money, or does the bank just keep it, or does something else happen??

Yep. Money supply diminushes. If more people pay off loans than take them out, money supply contracts.

3. If banks are creating money out of thin air, then how can they ever go broke?? If 50% of loans defaulted why should it matter if 90% of the money in all loans was created out of thin air??

Actually they are broke. They are a Ponzi scheme, if depositors want their money, it's not there.
But your right is it more complex than that youtube video about the goldsmiths makes it out.
For even if loans = deposits, and withdrawals > net profit
loans would have to be called in to give depositors their money back.

where do the $A100b that they lend out come from.

The RBA