Sunday, September 28, 2008

How money is created

If you are like me, trying to understand how the world's financial system works, you need to know about Fractional Reserve Banking. Don't get intimidated by politicians and others who tell you the economy is too hard for you to understand, so just keep your head down, glued to your PC and churn out whatever it is you churn out in order to make money for your company.

What you should remember is that everything in our world evolved. There is an explanation for the way corporations are the way they are now (you can read "The Corporation" by Joel Bakan for that), and there is an explanation for the way banks are the way they are now.

So, how did our banking system come to be?

Long ago, people would deposit their gold or silver with goldsmiths for safekeeping. The goldsmith would then give their clients promissory notes that guarantee their gold. If you'd like your gold back, just show the notes. These notes came to become currency as people traded them instead of their heavy gold. These goldsmiths realised that people did not usually redeem their notes at the same time, which gave them the idea that they could invest that gold, which remember, belongs to other people, to make money. So, while you are out spending your notes for chickens and cows, the goldsmith was spending your gold to buy more gold, or loan your gold for an interest. He would be ok, as long as you do not redeem your note at the same time as all his other clients (he could be spending a fraction of his reserves, say 50% of all the gold on hand, so he'd have backup in case some customers did come back for their gold).

From becoming passive keepers of gold, these goldsmiths now became essentially banks - earning money from investing (depositors' money) and charging interest for loans (again, depositors' money). Banks make money, as we all know, by charging a higher interest for loans than the interest it pays its depositors. Indeed, banks consider deposits to be a liability and loans and reserves to be assets. And so long as not all depositors withdraw their money at the same time, the bank would be safe. However, it has happened, such as in the UK's Northern Rock crisis of 2007, when depositors' took out their money at the same time in what is called a Bank Run, or a Run on a Bank.

"For the economy and the banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to "create" money." - US Federal Reserve.

Ok, so now we need to understand the cumulative effect and the way this allows the banking system to "create" money.

This is how it works:
Say you deposit $100 with a bank, which has a fractional reserve rate of 20%. This means the bank keeps 20% of its deposits as reserves. So, it lends $80 and keeps $20. Say the person who borrowed the $80 then spends the whole amount at my shop and I then deposit the $80 into the same bank. The bank keeps 20% of this $80 which is $16, so it now has $16+$20=$36 in its reserves. It then loans out the remaining 80% ($80-$16=$64). You can see already that the bank has been able to lend more money than the original $100 deposit. It has loaned $80+$64=$144. In this way, the bank "creates" money even though no extra money was physically created beyond the $100 that was the first deposit. We call this money created by banks "Commercial Bank Money" or "Chequebook Money". This contrasts with Central Bank Money, which is actual, physical money (coins and notes) that government mints print. And the bulk of the money 'in circulation" in the market is this commercial bank money

Wikipedia has a great chart that shows clearly what happens as the lending process continues and more money is created. Most of what I say here can also be found on the wiki site.

I'll post this first and continue with the problems of this system in another post.

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