Money - Created from Thin Air?

[PoliticalNightmare]

This is such an abstract concept but I feel that I really need to understand it to be able to get any sort of grasp on economics but its just completely doing my head in.

So centralised banks such as the Bank of England and the Federal Reserve print and then loan money to the government who they buy an equivalent amount from in bonds (essentially loan contracts which the government promise to pay back the money with). The government then deposits said money into bank accounts which then becomes part of the bank's reserves. The bank must maintain legally required reserves equal to a presecribed percentage (10%) of its products (the required reserve) with the remaining 90% being considered an excessive reserve which can be used as the basis for new loans. This 90% is actually created on top of the existing loan and is loaned out to borrowers in exchange for credits. With this money deposited it goes back into the reserve and an additional 90% can be "created" by the bank, etc.

This is what I have "gathered" from the following video http://www.youtube.com/watch?v=1gKX9TWRyfs&feature=related

It hardly makes any sense to me (I'm stupid :) ) - the above paragraph was probably way off the mark. Even if its right, I'm still having trouble getting my head around something so abstract as the creation of money by a third body through no actual productive labour. Anyone care to explain?

Also, I thought a bank had to have a certain amount of gold before it could create money. Or is that just my imagination running wild?

[MarxSchmarx]

This is such an abstract concept but I feel that I really need to understand it to be able to get any sort of grasp on economics but its just completely doing my head in.

So centralised banks such as the Bank of England and the Federal Reserve print and then loan money to the government who they buy an equivalent amount from in bonds (essentially loan contracts which the government promise to pay back the money with). The government then deposits said money into bank accounts which then becomes part of the bank's reserves. The bank must maintain legally required reserves equal to a presecribed percentage (10%) of its products (the required reserve) with the remaining 90% being considered an excessive reserve which can be used as the basis for new loans. This 90% is actually created on top of the existing loan and is loaned out to borrowers in exchange for credits. With this money deposited it goes back into the reserve and an additional 90% can be "created" by the bank, etc.

This is what I have "gathered" from the following video http://www.youtube.com/watch?v=1gKX9TWRyfs&feature=related

It hardly makes any sense to me (I'm stupid :) ) - the above paragraph was probably way off the mark. Even if its right, I'm still having trouble getting my head around something so abstract as the creation of money by a third body through no actual productive labour. Anyone care to explain?

Also, I thought a bank had to have a certain amount of gold before it could create money. Or is that just my imagination running wild?

You're not stupid, it's just two different processes viz. what the central banks do and what we normally think of as "making money".

Start with the basics. Money is just a means of exchange. It in and of itself has no value. The value of the monetary unit (one dollar, one bottle cap etc...) is reflected by the perceived purchasing power of that unit (i.e., what you can exchange it for - e.g., with one dollar you can buy a loaf of bread) That is determined (at least under capitalism and arguably under socialism) by some sort of market mechanism.

So when one says that "a dollar went further back in 1842" or "Z dollars are worth X yuan" what one is saying is that the monetary unit's perceived purchasing power, and value as a means of exchange, has changed. The "creation of money" is therefore just changing the value of the monetary unit. You can't really think of it like you do "earning money" or making a profit, which is really just the exchange of a good or service via the means of money. The two could just as easily be done with bartering. When the central banks "create money" they're not engaging in bartering. It's just a different process but our use of everyday language just happens to obscure this subtlety and conflates money with value.

As far as gold goes, once upon a time it was tied to gold so that we could speak of, e.g., "X dollars are worth (exchangeable) for Z ounces of gold" one day but "2*X dollars are worth (exchangeable for) Z ounces of gold" the next. That system was abolished in the 60s/70s.

[scarletghoul]

money, yes. wealth, no.

[Amphictyonis]

Fractional reserve banking.

http://en.wikipedia.org/wiki/Fractional-reserve_banking

[ZeroNowhere]

Essentially, banks can only loan out what they have, and they obtain this through borrowing and deposits. Hence, if they receive $1,000 and must keep a reserve of 10%, then they must keep $100 of it, and may loan out $900. Nonetheless, they cannot create money out of nothing. There is a good discussion of this on libcom here (http://libcom.org/forums/news/economic-crisis-18122007?page=13) by the users Capricorn and Mikus, including this post:


The banks can't and don't "create credit". As is now manifestly evident, they can only lend out what has been lent to them, ie other people's purchasing power. So, bank credit only re-arranges, not increases purchasing power.

The only body which can create additional purchasing power is the government via its Central Bank. It can in effect print more money. But this can only have a temporary effect, certainly not one lasting decades. As what it leads to its inflation, ie a depreciation of the currency so that, in the end, everybody's purchasing power is reduced proportionately. Insofar as it doesn't just lead to a general increase in prices leaving everything else unchanged, inflation benefits borrowers as the expense of lenders because it means they can repay their debts in depreciated money, i.e, once again, a transfer of purchasing power from one group to another without increasing total purchasing power.

As regards fractional reserve banking and the 'creation of money', this is a pretty comprehensive analogy from here (http://libcom.org/forums/news/economic-crisis-18122007?page=15):



The issue of the fractional reserve money and the money supply seems to be generating a huge amount of confusion when the issue is really quite simple.

Let's look at a very simple, analogous example that should clarify the issue.

Let's say that we have a holding facility for backpacks. People drop off (aka deposit) their backpacks at this holding facility, and the holder of the backpacks loans out backpacks to those who need them. If you deposit a backpack with him, you can withdraw it at any time with no advance notice. There is no money paid for the service. No backpack-interest is paid (i.e. if he loans you a backpack, he expects to receive it back after a certain period of time, let's say 1 month -- he does not expect 2 backpacks in return for his loan). All of the backpacks in this society are identical. Anyone who deposits his backpack receives a receipt saying "1 backpack" on it. The holder of these backpacks (let's call him the "banker") keeps account of all the backpacks deposited with him, all of the backpacks on reserve, all of the backpacks loaned to others, and all of the backpacks owed. When you leave a backpack with him, this goes down in his ledger both as a liability (since he owes you a backpack) and as an asset (since he has a backpack). When he loans out a backpack, he records this as an asset.
The banker starts with a reserve of 1 backpack, which was his initial capital that he started with. This is an asset. He expects to keep a total of 1 backpack as an asset at all times (after canceling out liabilities and assets) since that is what he has started out with, and he is not in this business in order to accumulate backpacks but just to increase the distribution of existing backpacks. He already knows, from previous conversations with famous bankers, that during the month in question, the total number of customer withdrawals is never greater than 1 backpack.

Let's say you, Mr. X, deposit 1 backpack with this banker. He credits your account for 1 backpack, and gives you a receipt letting you know that you have 1 backpack in your account. He goes to his own ledger, and notes that he now has 2 backpacks as assets (the backpack on reserve and the backpack you have loaned him), and 1 backpack as a liability (the backpack in your account).

He doesn't want to keep unnecessary reserves of backpacks in his holding center, so he takes your backpack and loans it to Mr. Y. Mr. Y agrees to give it back to the banker at the end of the month. The banker still has 2 backpacks as his assets (but now 1 is a reserve and 1 is a loan to Mr. Y) and 1 backpack as his liability.

As it so happens, Mr. Y does not need the backpack until next week. So he gives it to the banker to hold for him. The banker gives Mr. Y a receipt saying "1 Backpack", credits Mr. Y's account for 1 backpack, and then goes to his own ledger and counts this backpack as both an asset in his reserve of backpacks, and as a liability. He now has assets of 3 backpacks (2 in his reserve and 1 out on loan to Mr. Y) and liabilities of two backpacks (1 backpack in Mr. X's account and 1 backpack in Mr. Y's account).

Since he still has more than enough backpacks in his reserve to cover the usual number of withdrawals during this month of the year, he loans out a backpack once again, now to Mr. Z. Mr. Z agrees to repay the backpack within 1 month. Unlike Mr. Y, Mr. Z actually needs to use the backpack as his school starts the next day. So he does not deposit this backpack, but just uses it. The banker still has assets of 3 backpacks (but now 1 is in his reserve, 1 has been loaned to Mr. Y, and one has been loaned to Mr. Z) and liabilities of 2 backpacks (still one backpack each in the accounts of Mr. X and Mr. Y).

Looking at it from the perspective of the deposits, Mr. X has 1 backpack in his account, Mr. Y has 1 backpack in his account and one which he owes to the bank within 1 month, and Mr. Z has -1 backpacks.

Over time, economists come along and claim that backpacks are not actually the things you wear on your back, but just ledgers in the accounts of a banker. It is said that Mr. X, Mr. Y and Mr. Z, all have backpacks, except in different forms. The banker has apparently created 3 backpacks, if not out of nothing then out of 1 backpack deposit, and economists look upon this situation as a miracle which arises from the peculiar power of the backpack holding system. Demogorgon quotes the Dallas backpack reserve saying that they create backpacks, and is greatly impressed. Baboon says something incoherent about the decadence of of the backpack holding system, since a healthy, backpack-using society apparently has no need for the extension of backpack credits. Capricorn denies the possibility of creating backpacks out of nothing, pointing out that the banker has not loaned out any more backpacks than have been deposited with him. Red Hughes goes on with his usual pseudo-profundity and declares that while Capricorn may be correct that no backpack has been created, he doesn't particularly care about making true statements and would prefer to say that a backpack has been created since he wants to emphasize the "backpack-like" nature of the credit to a backpack account. A movement grows up in opposition to the fractional reserve backpack system, which gives bankers the unjust ability to loan out more backpacks than are deposited with them.
But let's say Mr. X decides he wants his backpack today. He withdraws one backpack from his account. To do honor this claim, the banker has to give Mr. X the 1 backpack that was in his reserve. The reserve is now down to zero, and Mr. X's account has zero backpacks in it. The banker's ledger now reads 2 backpacks as assets (the backpacks loaned to Mr. Y and Mr. Z) and 1 backpack as a liability (in Mr. Y's account). The banker thinks he is okay, since he already suspected that 1 backpack would be withdrawn this month, and he does not expect any more backpacks to be withdrawn until the beginning of the next month, at which point he will have been repaid his loan to Mr. Z and perhaps will have received additional deposits.
As it so happens, Mr. Z's dog eats his backpack and he is forced to default on his debt. The banker has to erase 1 backpack from his assets, so he now has 1 backpack as an asset (the backpack loaned to Mr. Y) and one backpack as a liability (the backpack in Mr. Y's account). But the backpack loaned to Mr. Y was already deposited at the bank and credited to his account. Mr. Y decides he wants the backpack the next week, because school is about to start. He tries to withdraw the backpack but his claim cannot be honored as there are no reserves at the bank. The bank is insolvent and is forced into bankruptcy.

So what has happened in in this hypothetical bank? Have new backpacks been created by loaning out backpacks? No. All that has happened is that the distribution of backpacks has changed. People who are not using their backpacks allow the bank to loan their backpacks out to others, with the expectation that their backpacks will return to them, just as if they held their money in a safe and withdrew their money from time to time, as necessary. The bank has economized on backpacks by reducing the need to form hoards. In the absence of a holding system for backpacks, each owner of a backpack would need to have his own backpack and hold it himself while he isn't using it. Instead, in the banking system, 1 backpack can supply the needs of 3 backpack users. Also note that deposits have not actually increased the bank's assets, since any backpack the bank acquires through a deposit is not only an asset, but also a liability, which cancels it out. It is neutral.

This all can be applied, with appropriate modification, to a bank that holds money and lends it out at interest. A bank does not create money whether we consider this from the point of view of an individual bank or the banking system. A bank receives money and credits it to your account, which is basically an IOU saying that the bank will pay you whenever you wish to withdraw your money. In normal circumstances it functions just as well as a piggy-bank would -- in fact even better, as it is simpler to use, there is no need to pay for security costs once the sums get large, and you earn interest on your money. When two customers of the same bank participate in some kind of purchase/sale of a commodity and one writes a check to the other, the bank simply credits the account of one client and debits the account of the other. (Just like if person A owed person B $20, and I owed both person A and B $20, and they agreed to have me pay person B $40 and pay no money to person A.) No money actually enters into the transaction. In Marx's terminology, money figures in here only as a measure of value, not as a means of circulation. The same thing holds in the case of two customers at different banks, where the checks go through a clearing house and cash is only used to settle the balance. The banking system greatly reduces the need for means of circulation, since physical money is only needed to settle remaining balances between parties.

But any time you are loaning money out, there is a chance that the money will not return to you and it will be lost. The fact that the bank doesn't create money becomes obvious during a commercial crisis, during which too many depositors try to redeem their IOUs (their deposits) than can be redeemed.

The printing of money is discussed in more detail here. (http://libcom.org/forums/news/economic-crisis-18122007?page=33)