My grandpa can’t comprehend how bitcoin has “created value out of nothing” but really the finiancial world has been doing it for ages.
Well, not really.
Financial instruments like stocks and bonds are real legal claims on the real assets of an entity. They are not creating value out of nothing, they are transferring ownership rights.
Derivatives are a zero-sum game. There is no value out of nothing, the money you make is your counterparty's loss.
Seignorage is what the government does when it creates dollars (or when bitcoin is created). That truly is creating money for nothing.
>Financial instruments like stocks and bonds are real legal claims on the real assets of an entity. They are not creating value out of nothing, they are transferring ownership rights.
While an instrument making a claim to a real asset can't create value from nothing, it can create value from almost nothing. For example if the going price for a particular beanie baby is $100,000 a huge amount of speculative value has been created from a very small (basically nothing) real world value. In general it's poor speculation that causes problems, not necessarily the nature of the asset itself
If I pay $1 for a beanie baby the manufacturer presumably captures the value of the difference between where they value labor and materials (< $1) and $1. I capture the value of the utility a beanie baby gives me (>=$1) less $1.
If I then mark the beanie baby on my books as worth $1 million, because that's where I have seen other similar beanie babies trade, on my balance sheet I have captured $9,999,999 because I was able to get real property the market values at $1 million for $1. That is ludicrous, but it is real (though unrealized).
Now I could sell it for the $1 million, and my gain would realized, and it would equal the difference between my cost and the (possibly irrational) utility the buyer placed on that beanie baby. That the buyer irrationally believes that a beanie baby has value beyond that of a toy, as a store of value, or a possible rising speculative asset is not prudent or wise, but it is real.
If I issue some kind of "IOU" certificate, redeemable for a rare Charizard card, and people trade those IOUs instead of redeeming them (good thing because I don't have those Charizard cards in my possession at the moment), then I'm basically expanding the supply "things that people trade and commonly use to pay for goods" (i.e. money/currency).
I didn't create any new Charizard card, but as long as people don't ask me to redeem them, it's roughly as though the market had 10 more copies of that card circulating.
There isn't more "value/wealth" created, but there is now more "money/currency" circulating. You can imagine how something similar is happening with derivatives.
- A deposits $300k
Total deposits: $300k, total lendings: $0k, total lendable: $270k
- Bank lends B $270k to buy C's house
- C deposits $270k from the sale of his house.
Total deposits: $570k, total lending: $270k, total lendable: ($570k * 0.9 = $513k, $513k-$270k = $243k)
- Bank lends D $240k to by E's house
- E deposits $240k from the sale of his house
Total deposits: $810k, total lending: $510k, total lendable: ($810k * 0.9 = $729k, $729k - $510k = $219k)
- Bank lends F $210k to by G's house
- G deposits $210k from the sale of his house
Total deposits: $1,020k, total lending: $720k, total lendable: ($1020k*0.9 = $918k, $918k - $720k = $198k)
In this process, the bank has turned $300k into $1,020k, and has loaned out $720k, while never loaning out more than they have deposited. That's the magic of fractional reserve banking.
So I don't think it makes any sense to say they turned $300K into $1,020K. C, E, and G already had existing houses, and the series of events isn't going to change the amount of deposits or loans in the world as a whole. It doesn't give the bank a profit of $720K. They get interest on $720K, but they have to pay interest on $1020K so obviously they need a spread in rates to do it.
As far as I can tell, you're just describing the bank getting a larger balance sheet and they've got to raise more capital to do it which limits profits.
The total money supply has grown though. From an initial $300k, they now have 4 people who all, looking at their bank statements, have deposits totaling $1M. If they all tried to withdraw that at the same time, there'd be trouble, but fractional reserve banking rests on the assumption that they won't.
And yeah, there's a pretty significant spread on interest rates between deposits and loans.
The GP post was talking about "creating a dollar". This is precisely how banks "create dollars". As those loans are repaid and the deposits are withdrawn, they're subsequently "destroying" those dollars from a money supply perspective.
And yes, the banks are controlling the money supply. See https://en.wikipedia.org/wiki/Fractional-reserve_banking for more detail.
Edit: why do you say withdrawing money destroys it? It removes it from a bank's balance sheet, but not from the economy...
The bank's assets and liabilities balance out. The new deposit is a liability and the loan is an asset. The bank's total deposits rise by $1000. Because normal deposits count towards M2 money, and this new deposit appeared out of thin air, the M2 rises by $1000. New money has been created.
Banks do have to make sure that they meet their capital and reserve requirements, e.g. if they find themselves short they can increase their reserve by taking out a loan from the central bank.
Institutions such as banks and credit unions are also able to create money 'from nothing', via lending.
When they make a loan, it's not as though they deduct the amount loaned (or any part of it) from someone else's account, and typically they're allowed to make loans totaling many times (9x? 11x? I forget) the amount of deposits they possess.
I think I must have been assuming a situation along the lines of "bank loans out 90% of its deposits, and then all those debts are moved to other institutions", in which case I expect the bank would be left with 10% of its original deposits plus the loan agreements, the total value of the latter being equal to ~9x the value of the remaining deposits.
> Because banks hold reserves in amounts that are less than the amounts of their deposit liabilities, and because the deposit liabilities are considered money in their own right, fractional-reserve banking permits the money supply to grow beyond the amount of the underlying base money originally created by the central bank.
https://en.wikipedia.org/wiki/Fractional-reserve_banking
It is literally just paperwork.
Fractional-reserve banking is the greatest scam ever, or a pillar of our economic system, depending on whom you ask.
In any event...
> hyperinflation is often associated with some stress to the government budget, such as wars or their aftermath, sociopolitical upheavals, a collapse in export prices, or other crises that make it difficult for the government to collect tax revenue.
~ https://en.wikipedia.org/wiki/Hyperinflation
Banks generally give loans to people who they believe are very likely to repay them. Typically this means that you get a loan if you have a good plan for repaying it and a history of doing so. (Leading to the old complaint, "The only people who can get loans don't need them.")
These are two different kinds of "money creation".
IANAEconomist
Reserves are not the amount of assets the bank has on its balance sheet - if they had less assets than their liabilities (aka deposits), they would be insolvent.
Capital ratios and reserve ratios are different concepts - just as solvency and liquidity are different.
I am open to the idea that fractional-reserve banking is a scam, because of my experience of human nature, especially when money is involved.
Certainly the history described in the wikipedia article makes it sound like a clever trick the old goldsmiths came up with, and no one the wiser until time and custom had rendered it respectable.
> the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills.
The trick works fine until it doesn't.
> If creditors (note holders of gold originally deposited) lost faith in the ability of a bank to pay their notes, however, many would try to redeem their notes at the same time. If, in response, a bank could not raise enough funds by calling in loans or selling bills, the bank would either go into insolvency or default on its notes.
This activity is different from mining, or farming, or manufacturing, or shipping, or goldsmithing. It's a kind of consensus hallucination (or a hoodwink) that worked and kept working.
Now we could argue all day whether the bankers né goldsmiths deserve to make money this way, but I'm not interested. If it really bothered me, I would start a bank. ;-)
I'm not financially sophisticated. To me, if there's more cash than gold, something's fishy. :-)
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edit: (Apparently I have nothing better to do this morning.)
Let me see if I can clarify my position:
Long ago my friends got into playing Magic the Gathering. They tried to get me to play and I said I would but I was going to make my own cards. (Make photocopies of the real cards and laminate them and play with those.) To me it seemed totally obvious and reasonable. After all, in D&D no one tries to make you only use the official dungeon modules, eh? But my friends wouldn't hear of it. I got kind of mad at them and told them, "You know there are no real wizards at Wizards of the Coast, right?" But they were baka as the Japanese say. Fools.
For what it's worth, this is my attitude to banking: Neat trick, I can't believe people go for it, but whatever.
As long as anyone can open a bank and get in on the "scam" I can't really condem it. Consenting adults and all that.
If a bank has too many people demanding their deposits back at once, that's a liquidity crisis. It's not insolvent. A bank can be perfectly solvent, in that it has more assets than liabilities, and still not have enough reserves to satisfy people right now.
a) Imagine a coin tossing game. We both put in a dollar and flip a coin; heads you win both dollars, tails I win both dollars. Truly zero sum.
b) Consider a vendor selling me a $5 hamburger for $5. They lose $5 worth of goods and gain $5 worth of cash; I lose $5 worth of cash and gain $5 worth of goods. In an accounting and physics sense this is zero sum; no dollars or molecules were created or destroyed, the universe just slightly rearranged itself. But in economic terms, this isn't a zero-sum transaction; the purchase created value since at that exact moment I valued the hamburger more than the cash (due to hunger), and the vendor valued the cash more than the hamburger. We both improved our situation and created value "for nothing". After eating the hamburger, I satiate my hunger, and now value a second hamburger less than $5, which prevents a second trade from happening for a few hours.
c) Let's say I'm a wheat-producing farmer and you're a wheat-consuming baker, and there are thousands of others like us in the economy so neither of us really has any effect on wheat prices. When the wheat price is up, I benefit, and when the wheat price is down, you benefit. At this point we have a zero sum situation. Now let's say we're both reasonably content with the wheat price being what it is right now, so we sign a "futures" agreement for me to deliver wheat to your bakery for the next year, locked in at the current price. By signing the contract, I'm choosing to forgo extraordinary profits next year if the wheat price happens to go up, but also insuring myself against extraordinary losses if the wheat price happens to go down. Your end of the bargain is the same thing in reverse.
Like the hamburger example, in an accounting sense this is zero-sum. My potential profits are exactly equal to your potential losses, and vice versa. But in an economic sense, there was another quantity that was affected in this transaction: risk. Both of us reduced our wheat price risk to zero for the next year. Risk is something people intrinsically dislike, so it has disutility (i.e. negative value). Eliminating a negative therefore adds value.
As a concrete example, let's consider what would happen if you couldn't sign the futures contract above--let's assume no modern banking or finance at all for this example--and had to just accept wheat price fluctuations. Overall, on average, the highs and lows should more or less cancel out. But on a short-term basis it's not unlikely at all to have a run of 3-5 years of bad prices (too low for me, or too high for you). To survive this potentiality, we'd both have to set aside a considerable rainy day fund just in case I had to cover 3-5 straight years of depressed profits or outright losses. Most of the time this cash will be unused, but the mere threat of a prolonged unlucky spell means we can't use that cash to buy more land or tools. The net effect on all farmers and all bakers is that everyone has a large chunk of their wealth sitting around in a completely unproductive state, which ultimately means less loaves of bread are produced and society is relatively impoverished.
Likewise, other financial derivatives like options, swaps, etc., also create economic value. They might be zero sum in a cash sense, but they affect some more-abstract quantity like "risk" or "leverage" and therefore create value for both buyer and seller.
My original point was that the finance whizzes aren't creating money.
Your gain/loss from a derivative contract is paid by/to your counterparty.
As opposed to a stock, which is a legal claim on the assets of an enterprise. When an IPO happens there is no magic in which wealth is being created -- rights to the enterprise are being sold.
(This is distinction with a typical ICO, in which what is being sold is often unclear or simply worthless. That is seigniorage -- or simply a scam.)
At first they were just a safe place in which to store your valuables (basically they were goldsmiths renting out vault space)
Then someone (I think dutch) realised that most of the time people kept there cash in one place. Which meant that instead of raising money explicitly for lending, they could "double enter" the cash, which meant any deposits to the bank were lent out immediately.
If you've written an IOU, you've created a kind of currency. Same for arcades, carnivals, etc. Any time you acquire a service or good in exchange for a promise of a service or good in the future (and that promise could also be in a tangible thing like gold, seashells, or bottles of Tide, but often it's just word of mouth), you've created a kind of currency. The real ticket comes when you can convince third parties to accept your promise and trade goods in exchange for it.
But alternative currencies have a really long history, as old as society and maybe older. They tend to arise during depressions when fiat currency is hard to come by. I don't think it's by accident that Bitcoin was first published in 2008 and released in 2009, during the Great Recession. This is liquidity being popped out of the ether due to demand for more currency (in spite of pumping by the Fed). And this is why I never really bought the "infinite" deflationary story for Bitcoin: people can just start another cryptocurrency if there's actual demand for it. Of course, that doesn't take into account irrational speculation...
The current ramp-up in cryptocurrencies is occurring now, during a relative economic boom. This is pro-cyclical and probably bad. It'll eventually pop, but no one knows when.
Commodity futures give other FD's a bad name.