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Comment by jljljl | Hacker News Reader

People do have this confusion all the time though: they think the bank lends out the money they put in, when really what’s happening is money creation as described in the article.

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Interestingly, money creation is done by making loans. But nobody mentions the converse: money destruction is done by paying off the loans!

Fractional reserve banking is an amazing invention.

What? Isn’t the money supply irreversibly expanded when a loan is created?

How does paying of the loan decrease the amount of money there exists?

When I loan 1000 the bank basically just writes a check for 1000 that is not attached to any money what so ever. When I’ve payed off my debt, the bank will have received 1100 and my understanding is not that they will simply delete the original 1000 and keep the change.

Paying off a loan contracts the bank’s balance sheet and the liability side thereof is what most private persons use as money.

They do just delete the original 1000. Otherwise they wouldn't be able to loan it out again, due to the reserve requirement.

I like to use the analogy of malloc() and free() to communicate the concept to programmers. Commercial banks malloc() and free() deposits and the Treasury/Fed tag team malloc() and free() reserves.

To elaborate, it's interesting to observe that a non-zero interest rate effectively creates a resource leak. Since the deposits created are equal to the loan's face value and don't include interest payments, in aggregate there are not enough deposits available for every borrower to pay off their loans with interest. In other words, interest makes a non-zero bankruptcy rate a mathematical certainty.

But the two are independent ideas. You don't need lending or money creation for a bank to work, though even there the analogy is sound. The bank does lend money out and if a lot of people try to withdraw it at the same time, you get bank runs and collapses.

That being said, in principle, it is possible to have a bank that literally takes the cash you give it and puts it in a giant vault, and when you come to ask for withdraw it, retrieves it and hands it back over. It is literally the idea that the author seems to be railing against. You come with your money (water) and deposit (pour) it into the bank's vault (glass).

What exactly is the confusion?

The confusion is that this isn't how banks work. But most people believe that this is how banks work.

More than that, most people have no idea how lending really works. They believe the bank is literally lending their savings out. So if no one saves, there's no lending.

Even some economists believe a more complex version of this.

https://larspsyll.wordpress.com/2014/09/21/the-loanable-fund...

Well at a micro level, it is still what happens, the bank doesn't make money appear by magic.

The multiplier effect just happens because the original amount of cash has been deposited, then lent, then deposited again. So you have the same amount of cash in the system but two deposits, one backed by a loan, the other by cash, and the deposits are treated as "like cash" whereas they are mere IOUs backed by a financial asset.

A reserve (or government cash deposit) is not technically required for a bank to issue a loan.

Its _risky_, since it could lead to a situation where someone tries to cash out and you have nothing to give them, which would destroy your business and reputation as a banker.

But if you could make perfect loan decisions and no one comes to redeem their deposit, you wouldn’t need to have any reserves at all. Most regulators require a minimum amount of reserves to prevent instability or bank runs (and to control money supply)

That’s the difference, you’re not lending out the original amount of cash, you’re using it as a reserve in case someone asks for their money.

The confusion is that modern commercial banks don’t work like a giant vault. So applying the analogy you described to, say, Wells Fargo, would mislead you about how Wells Fargo works.

You could have a bank that does what you say, but it wouldn’t be able to survive as a commercial institution.

Well said.

Most regular folks don't think like to think about banking, just like how they don't like to think about how their car engine works.

But if you ask them to describe how banking works, they'll inevitably resort to the some version of the "giant vault" analogy. Of course, that's the wrong way to think about banking. Which the article rightly attempts to dispel.

> in principle, it is possible to have a bank that literally takes the cash you give it and puts it in a giant vault, and when you come to ask for withdraw it, retrieves it and hands it back over.

That is indeed how banks originally worked (except gold, not cash). Then banks discovered they could hand out receipts instead of the gold, and people traded the receipts (how "banknotes" came about). Then banks realized they could issue more receipts than they had gold on deposit, and fractional reserve banking was invented.

That's not a confusion but rather an incomplete (but, for most purposes, good enough) understanding of how banks work.

The money is lent out, though, in the specific sense that a bank run during a crash of the economy can† result in the bank not having the cash-on-hand to give back to its depositors.

† Or, at least, this was true in the US until 2007, after which savings banks were legally limited in their ability to leverage their deposits.

This is a problem of not having enough reserves, and not quite of lending deposits. Banks encourage people to put their money in the bank in exchange for deposits so that they have these reserves.

It’s like the article says: banks give out deposits in exchange for Government Cash, or for Valuable Long Term Promises. A run can kill a bank if they read the market wrong and can’t generate enough government cash to redeem the deposits.

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