Saturday, 25 December 2021

Money from nothing: how banks can loan money they don't have any access to

Fractional reserve banking, and leverage based paper loans where the cash doesn't have to exist.


The money you've taken on loan - from the bank - doesn't actually exist. The bank - when it loans out money to you - simply does some accounting entries recording: the amount which was paid over to you, perhaps in your account, and the amounts which it would need to have in case it ever needed to actually pay that money.

A sort of deposit is entered, of sorts, within their books, but banks don't actually need deposits in order to loan. They, in fact, very rarely actually need any actual money.

Let's put it this way. Let's say that you have an account at a bank and someone you want to pay has an account at the bank. The bank doesn't actually have to have any money on them in order to transfer money from your account into theirs, or vice versa. And banks, to transfer money from one another, they they don't like to have to physically transfer cash around and it would be quite cumbersome to transfer it every single day, back and forth, whatever is owed, between the banks ... And so, banks generally will either have an account with other local banks in the area, or with their local reserve bank, or some third-party bank.

And so, when money is transferred from one bank to another, all that really happens is an accounting equation where the account of the other bank is credited or debited and both banks do this sort of thing, saying that this or that bank therefore owes this-that-bank this much, and as transfers go back and forth between the banks, the amounts are probably not going to get too large between them unless there's some great inequality between the different banks.

And banks very seldom will actually want to call upon the money which is loaned, for the simple reason that keeping money is expensive. Storing it. Making it safe. This is why certain banks can get away with negative interest rates, where other banks will keep the money in them, and they know that the money is actually safe, and so they'd rather pay the negative interest rate, for the money to be safe, than have to store the money themselves, and keep it safe.

Now, this whole process simply shows you that a bank is able to do most of the business it does without actual money ever needing to be seen. The money which a bank will keep in an ATM, or the like, would be much like stock, and inventory, that a store keeps. Just as a store might restock milk or cheese within their store, or erasers, or whatever it would be - the bank stores money in its ATMs, for people to be able to use, and that money is there for if it ever needs to be drawn, and a bank will also have processes where it can transfer money - real money, or cheques, to other banks, or other institutions.

Now, this is where we get beyond the fact that a bank is not merely an intermediary. Now, an example which might help in understanding this goes back to the idea of the goldsmith, or even to temples which were keeping money - the sort of money changers at a temple. Now, in the ancient world you might want to keep your gold in the vault of the goldsmith, and so you put the gold in and he'd give you a sort of certificate saying this is the amount of gold which you have, and you can take that certificate to go and withdraw the gold at any stage you want.

The chances are you don't really want to withdraw that gold, and you might also have that certificate for a lesser amount, and use that certificate as though it were the gold - handing it over to someone else as a sort of bearer bond where they can then go and take the gold.

But they might not actually want to take the gold. Gold's heavy. It's cumbersome. People might steal it. So, they, in turn, might use that money as a sort of bearer bond. And, what you're starting to see is the equivalent of bank issued currency. This sort of currency, which would have existed in the earliest times of banks, where the paper currency which is issued is issued by the bank itself, and backed up by the gold in its vaults.

But banks, or goldsmiths, or whatever else it would be, got quite clever. They realized that they could actually loan money out of the money which they have in their stores, and people would pay interest for that.

Now, the earliest type of bank interest was in fact late fees for money being loaned, because banks had to get around the equivalent of usury laws, and so you'd be paying the fees. If you didn't, if you paid the money back immediately, without ever paying the fees, then you probably wouldn't be loaned money again.

So, you have this sort of banking system, but should they actually loan out the actual gold in the vaults, or should they instead simply write this, sort of, same sort of cheques of sorts, the sort of certificate saying: this amount of money is due you from the vaults - when they loan the money ... And, that person, in turn, could pay that money over to someone else, and so forth.

The banks realized they only had to keep a certain amount of money in their actual vaults at any given time. They could in fact loan a lot more money than was in the vaults. They could get away with not actually having the money there. And, you automatically assume, if you actually have money in your bank account: that's not money that's yours. The money becomes the bank's. But then .. you ... the bank has a liability to pay back that money, on demand, usually, but sometimes at different rates, and times. And you assume that's because the bank is going to be loaning that money out to other people, so you already have that sort of awareness.

Now, bank runs were a big problem before reserve banks - and that's the idea that all the customers of a bank might come through and demand their money, and the bank simply doesn't have enough money to pay them back.

And the solution to this might be that the bank, on that day, loans money from another bank, who loans at a relatively low rate to them, and they're able to pay the money out. And eventually you have a specialist bank called a reserve bank, which specializes in loaning money to banks when they need it, in a pinch. Which is why, if you have an especially large amount you need to withdraw, the bank actually needs a certain amount of time to do it. Because, chances are, they're ordering that money from a reserve bank, or another bank, or else their vaults somewhere else in the world.

Now, the SWIFT banking system is quite interesting. That's the international banking system. All it does is - it has certain codes: a code for the bank , a code for the country of the bank, a code for the city of the bank, the sort of bank identifier code ... identification code ... and then you have the IBAN, the international bank account number, or the equivalent of that, for the customer ... And you have the address of the bank, and so forth, which gets entered into the system. And what really happens is that the system finds a bank which has an account for both of the banks involved, and the one account gets credited, the other debited. The money doesn't actually transfer.

And, if you try to take physical money out of a country, often, you're limited to something like 10 000 dollars or 10 000 euros that you're allowed to take in - or it might be seized by customs on your arrival. So, money - physical money - is quite restricted. And in certain countries they even have moved to ban withdrawals for more than 10 000 dollars, or euros, or whatever it would be, being withdrawn physically from the bank.

And so most of the time that money is not actually needed by the bank - physically - and when it is needed, they can simply loan it from a reserve bank. And so, when a bank writes a loan to you, they're literally writing it down in their books. They don't actually have to have the money. And, if at any time they do need to have the money to satisfy some or other demand, they can loan the money at a relatively low rate from other banks, or from a reserve bank, and if you have deposits with them, they loan the money from you at an even lower rate, which gives them a beneficial sort of deal - that they don't have to pay as much.

And this is also why a country will determine the rate of inflation by determining the rate at which the reserve bank will loan to other banks. Because, the higher the rate of interest that is demanded by the reserve bank, the higher the rate which will be demanded by the banks of their customers, and so that fewer people will loan money.

Now, there's an example - you can have - of Jack and John. Jack and John each have one dollar, but they each need a hundred dollars' worth of services from the other one. So, Jack pays John and John pays Jack, and so forth, until they've actually spent a hundred dollars with that one dollar. That's sort of the frequency of money, and that sort of makes each of those one dollars actually worth a hundred dollars in the impact of what they do.

But let's say that you are paid a hundred dollars for a day's work. Would you do another hour's work on top of that for another dollar, or would you demand a larger amount? The more money you have, the more you demand. And, let's say that you're able to loan money from a bank - money which doesn't actually exist - in order to buy a house. Now, if you have that - more money - you're able to spend more on buying that house, and so the price of the house will go up, because people will be competing. So, inflation goes up.

In the case of Jack and John, if they were to actually have to pay 10% tax for each transaction, the amount they'd be able to spend would probably not be a hundred dollars, for the simple reason that: the second transaction, they'd only have 90 cents, and then 81 cents, and so forth, as they'd have to give the rest to the tax. So, taxation slows down the growth of an economy, and the use of money, and it also slows down inflation. While, things such as loaning by banks will increase growth in the economy, because there's more opportunity to use money and therefore more of what could be used.

For instance, Jack and John - if they just have one dollar and they're not doing any work - they're not producing anything. But, more of what can be produced, can be put to work, so banks are good in that sense. At the same time, the amounts that are used to put things to work can be in excess of what would be required for the money to keep its same value, and so the value of the money changes as a result of that.

And - fractional reserve banking - people have this idea that it's: oh, you keep 10 euros of what's in your accounts, gets kept by the bank, and the other 90 gets loaned out. But really what's happening is, their loans aren't dependent on your deposits. Their loans are dependent on all sorts of algorithms of how much they can loan out, and your deposits, and the reserve bank play a role in that. And, so, the money that the bank's loaning out isn't money that the bank actually owns. It's out of thin air, so to speak, and that's a very beneficial thing for an economy, though it's borrowing from the future, because that money doesn't actually exist. And, if you look at all of the money in existence and then you look at the actual GDP of countries you might find that the amount which exists and the amount which is owed and the amount which is actually spent are quite different and this is money which often doesn't actually exist but which can be put at a greater frequency to work.

And, this is also why - in the old days - things - partially why - in the old days - things like usury were seen as something bad, as something which could even be criminal, because if a bank is loaning money that doesn't actually exist, they reduce the worth of any money actually in circulation.

The euros in your pockets become worth less because a bank is able to loan say 100 million euros, which don't actually exist, and if you try to actually borrow money from a ... federal ... bank ... a federal reserve bank, or the like, you wouldn't actually be able to do it. Only banks can have accounts with that. And, for a bank to actually exist and to enter into the sort of system of writing up loans of money which doesn't exist, it actually generally has to have a certain amount of assets to its name, and often countries will restrict the amount that a bank can loan based on - it has to have this amount in its accounts, whether borrowed from a reserve bank, or from depositors - or a country will have restrictions on the amount a bank can loan based on its actual assets that the bank has, so its actual degree of leverage gets reined in a little bit.

And, the benefits obviously are huge. I mean, if you can take out a loan to buy a car, you have a car. You don't have to wait the amount of time to buy the car. The converse is that property prices and the prices of things like cars have gone up by massive amounts as a result of inflation and fractional reserve banking.

Ayn Rand famously said that inflation is theft by remote control ... uh sorry it's theft ... uh ... it's remote theft or something along those lines. The exact phrase I can't remember ... but essentially, by printing money ... In the Soviet Union, the government was taking away the value of the money that people had, and so it was seen as a sort of theft, and this is where the sort of extreme anger which people on the left might feel towards banking might come from, because they are loaning money which doesn't exist ...

But there's a great benefit at the same time - of banking in our economy - which is that it makes the economy more efficient. It means that people who would qualify for a loan can get that loan even though that money doesn't exist, and that frees up the economy, and it brings more prosperity, even though the price of that prosperity is - well, a rather strange one ...

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