Comment by nicobn | Hacker News Reader

Comment by nicobn | Hacker News Reader

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You do not understand central banking at all.

Banks do not create money out of thin air: central banks do. Through loans to charter banks and bond purchases, the Federal Reserve creates (or destroys) money whenever the internal one day inter-bank loan market interest rate is above (or below) a certain guideline (the "interest rate").

On the other hand, if I deposit $100.00, the bank is allowed to loan a certain percentage of it to someone else. That is fractional reserve banking. Let's say the bank operates with a 2% reserve. I deposit $100.00, they loan $98.00 to Johnny. A naive understanding of the system would lead you to think that the bank "created" $98.00 because the sum of the balances of yours and Johnny's bank account is $198.00; it did not. If Johnny doesn't pay his loan back, they're out $98.00. Your deposit is a liability for the bank. The loan is an asset. So in this situation, the bank has $100.00 in liabilities, $98.00 in assets and $100.00 in reserve.

When too many people don't pay their loans back, you have a bank run. Part of the reason the Federal Reserve system exists is to avoid this situation by allowing the banks to borrow from a lender of "last resort" if this were to happen.

Money is largely created by commercial banks. Let me quote from a 2014 report by Bank of England titled "Money creation in the modern economy."[0] Follows selection of excerpts from the report's Overview section.

"In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans."

"Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits."

"Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits."

"The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’."

I recommend reading the whole report. It is meant to be readable by the non-academic and is not dumbed down either. The report is part of Bank of England's Quarterly Bulletin from 2014[1], it contains other similar articles like "Money in the modern economy: an introduction."

[0](http://www.bankofengland.co.uk/publications/Documents/quarte...) [1](http://www.bankofengland.co.uk/publications/Pages/quarterlyb...)

Money != Wealth

Not to disagree with the point you're making, but relying on a bunch of references to Bank of England sources is not really an un-biased argument. They have a vested interest in you assuming they're doing "the right thing" but have also been implicated in the whole LIBOR scandal[1], so I now tend to take their press releases with a handful of salt.

[1]: http://www.theguardian.com/business/2015/may/27/bank-of-engl...

"Banks do not create money out of thin air: central banks do."

I think that's not exactly true. The reality is that banks make loans and then search for the reserves. So, in practice, are the credit departments in commercial bank who decide if new money is created. Central banks can influence this by making the creation of new money cheaper or expensive.

http://www.economonitor.com/lrwray/2013/08/15/banks-dont-len...

To anyone interested in these issues, I recommend Modern Money Theory ( http://neweconomicperspectives.org/modern-monetary-theory-pr... ).

When you say money, you mean M0. When GP says money, they mean M2.

Indeed. I think what I'm trying to clear up is that the "money" created by banks is not "free money". It is a carefully crafted game of musical chairs on the bank's balance sheet. Bottomline is, the loan is an asset and the deposit is a liability. Banks don't create M0.

No, but nobody cares about M0. It's M2 that creates demand in the marketplace. As soon as a bank fails, all that created M2 disappears from circulation and that's what crashes economies ("too big to fail"). In a full-reserve banking system (M0 = M2) nobody would care about crashing banks.

> Bottomline is, the loan is an asset and the deposit is a liability.

I used to be as skeptical as you about the full-reserve crowd but that point is actually what got me thinking: banks are the only players in the economy for whom giving out loans is a balance-sheet extension (what you're describing). They're worth more, the more loans they give out.

For everybody else, giving out a loan doesn't change their net worth! They're just exchanging one asset (money) against another asset (an IOU from someone). In other words: banks are special and are not allowed to fail, because we let them create money.

For anyone else not up to spec on the lingo:

Definition of M0, M1, M2, M3, M4 [1]

>Different measures of money supply. Not all of them are widely used and the exact classifications depend on the country. M0 and M1, also called narrow money, normally include coins and notes in circulation and other money equivalents that are easily convertible into cash. M2 includes M1 plus short-term time deposits in banks and 24-hour money market funds. M3 includes M2 plus longer-term time deposits and money market funds with more than 24-hour maturity. The exact definitions of the three measures depend on the country. M4 includes M3 plus other deposits. The term broad money is used to describe M2, M3 or M4, depending on the local practice.

[1]: http://lexicon.ft.com/Term?term=m0,-m1,-m2,-m3,-m4

My understanding of fractional reserve banking, if they operate with a 10% reserve, they can loan up to $900 of the $100.

So with 2% it's much more than that.

As well as the $98.00 loan to Johnny they can also loan $98.00 to Sue, $98.00 to Jane, $98.00 to Dave etc, all from the original $100 deposit.

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