If you have understood the way banks create money, it’s all quite spectacular. But there are problems with this invention of ours we call banking. In some sense it is all rather arbitrary. Some guys back in Florence figured out that if they loaned out more money than they had in their vault, and everybody used letters of credit and accounting, that nobody would know. And after a century it just became accepted. Today this money created by loans is virtually the only money that exists.
That isn’t actually so strange really. Money is an agreement we have that we will accept it as a placeholder for real value. We can use this symbolic thing to buy stuff with. In the old world, money was physical, real gold and silver. Monarchs took things by force using armies. People mined this stuff from the ground to use as money. Banking changed all that. No longer was money just physical. We had a gold and silver “standard” that supposedly backed money. But in reality, there was more money than there was gold or silver. The gold or silver (or jewels, or copper, whatever it was) that backed money became less than the reserve money banks had retained. Only the original money (that $100 in our spreadsheet) was “real”. All the rest of it was something else.
We already know that when we only have physical money that investing is a losers game. Let’s revisit why. If no new money is created, then all financial transactions are what game theorists call “Zero sum“. So if you look at investing as a sector, there is no way for all the investors to get paid off. That means that for every winning investor there has to be at least one losing investor. But if you look at the sector as a whole, even at usurious rates of interest, money tends to flow from the investor to the borrowers. That means that investment, and with it, economic growth doesn’t happen.
Think about that. Think again about how banking creates money. It’s a fantastic thing, right? It has made everything you look at, from the computer and your iPad to cell phones, roads, schools and windows possible.
But, if you look at the graph for money creation you should see a problem.
The problem is that money creation flattens out. In the best case, we end up with 21 times the amount we had if our reserve fraction is 5%. (That’s maximum new creation of money of 20 times the original + the original amount.)
So with the invention of banking, things are peachy when we are in the early part of the curve. They are pretty good in the middle part of the curve. But then the curve flattens out. And the system hits its limit. What happens then?
One of two things happens. Either the banking system finds a new source of original money (gold or silver) or else the economy stalls. Loans don’t happen. Back during the 16th and 17th centuries the solution was to go find gold. Go to the “New World” or send out your armies to take it from other nations.
When the banking system is near its limit, sooner or later somebody can’t pay off a loan. This always happens. The Medici Family in Florence used to do horrible things to men who didn’t pay back their loans. They would capture them, strip them naked in the market square, tie their hands to their feet, throw a rope over a bar 30 feet above (about 10 meters) haul them up on the rope, then let them drop to the pavement. Depending on how much the man owed them, he would be dropped more times. It was often fatal. It was always crippling.
When the system is near its limit, one person not paying off a loan tends to have a cascading effect. Because remember that with physical money the money supply is fixed. That creates a zero-sum situation so the only way to pay interest back is if someone else can’t pay their principal on a loan. But now we have created all this money on credit.
When one person defaults on a loan, that means that suddenly that money is gone from the system. So in a banking system when people start to default, the money supply starts contracting. As it contracts, it makes the game worse than zero-sum. It’s a game in which the total amount is dropping. When credit collapses, it can happen fast.
The worst credit collapse is a bubble. Money is loaned for things that are of less value than the loan. (Think of tulip bulbs selling for $50,000.) Money is loaned to people that cannot possibly pay off the loan. (Think of Citibank pushing liar’s loans that they knew would go bad.) Money is loaned based on “notional valuation” of things like stocks or derivatives. (Think of the 1929 stock market crash when people could get loans to buy stocks and have little money of their own in it.) In a bubble, the prices of fixed assets that don’t change in utility value rise beyond any reasonable pricing. When a bubble collapses, it starts another cascade impacting people who would have been just fine in normal circumstances.
History shows us the boom and bust cycle of banking finance. In the 19th century some smart guys decided to put a stop to it by creating the Federal Reserve. The job of the Federal Reserve is to be able to shore up reserves at banks so that we don’t get into the boom and bust cycle. It has worked better than anything else so far. It isn’t perfect. The boom and bust cycle of banking finance takes a long time – either a lifetime or a big fraction of a human lifetime. So people forget.
That’s why we tossed out Glass Steagall. The younger generation forgot. But I digress.
Anyway, the bottom line here is that the central banks of the world and our fiat currency system was created because the world population and world economy got to the point where trying to pretend that we could every have enough gold to meet banking reserve needs was laughable. When people can only laugh at an idea, its time is over.
Now, when a bank needs reserves it goes to the Federal Reserve Bank. Now, any time a bank can make a loan and support the economy by doing that, there is always money to loan.
The Federal Reserve isn’t perfect. That system is being gamed (as you read this) by a crew of shysters who are abusing the banking/finance system. They create dirty deals composed of notional value instruments. They run up the prices of those instruments and play games that do nothing to serve the real economy. This is always going to happen. It’s like bribery. You can never kill it. You can only keep it down to a supportable level that doesn’t damage society.
These days, finance-finance, (otherwise known as flim-flam) where no traceable benefit to the real economy exists is somewhere around 40% of all financial transactions.
So there are two basic problems with banking.
- When it is tied to a gold standard, the world is condemned to boom and bust.
- When central banks allow society to escape the gold standard, shysters can game the central bank (and the taxpayers) to trick the system into making them fabulously rich – but provide no benefit to society.
We accepted banking back in the Medici era because it benefited societies so much. We need to keep that part. What we cannot allow is for society to be wrecked by those who game the system.
quantiger - A sometimes snarky blog 
Both basic problems you list with banking are due to the centralized nature of it. Theres an easy centralized target to milk for whatever it’s worth, so unscrupulous people do it.
Any centralized system based on fixed rules, like banking, will be gamed for all it’s worth. So, what follows is that if the best way to game the system is to play by the rules, it just might work.
I believe the fix to this issue is to transform the bank to have the role of facilitator rather than a central participant in the process. That is, a bank would help people needing loans meet with people who have money to loan.
This will, of course, shift the risk to individual people. But it’s worth realizing that it’s the very act of shielding their customers from risk that puts the bank itself at an even greater risk than the customers combined would be in. This is the source of the instability.
When you add the central bank pumping more money to banks that are close to going under, you’re effectively distributing the realized amplified risk of banks to be paid by everyone equally (except for those who benefited from the bank’s losses, they effectively gained).
What I’m trying to say is that the central bank pumping money at failing banks is what allows the finance-finance transaction percentage to stay and keep growing. The banking system is what allows it to happen. It’d be way too risky to do without the banks.
What you are suggesting is that banks turn into brokers for money-lending transactions. So you need to understand the severe limitations of money-lending. Take a look at Money-Lending. Money lending without banking’s ability to increase the amount of money so everyone can win means that the investment sector as a whole will lose. This is because the best that the investment sector can do in that case is break even.
So your idea won’t work unless you turn those transactions into banking transactions. Now, this latter idea is powerful, and it is something I would like to see. The way it would work is that any investor would be able to act as a banker if they loan money or invest in a legitimate value producing enterprise. They would be able to borrow funds at the Fed Discount window, they would establish a track record of performance, and they could take deposits and pay interest on those deposits.
In the modern world, this could happen. It could be implemented through banking service bureau companies that specialized in a new type of regulated banking entity. I would call it the “Venture Bank”. We used to have a banking entity like this. It was called “Investment Banking” and it used to be a powerful method for generating wealth and backing new ventures. But Investment Banking got itself deregulated to the point that what we now call Investment Banking is now arguably the primary problem we have in finance.
The Fed exists to provide money when the expansion of the money supply through credit inevitably stops. If you have a little bit of math it will be obvious that every banking system will hit a limit.
When you get over to the right on this curve, less money is available. I already covered this. The Fed was created so that when that limit is hit, there is still money to loan.
I dealt with Ripple. Ripple is ridiculous. Anybody who has lent money to friends knows this is an idiotic idea.
What would you say to this kind of conclusion derived from statistics and macro economic data-
http://etfdailynews.com/2012/07/27/u-s-economy-17-reasons-why-a-recession-in-2012-is-underway-indexsp-inx-spy-tza-faz-gld/
I thought it was just one thought out article in the above link but this guy seems to be a doomsday prophet and has nothing but gloom to predict as below-
http://etfdailynews.com/2012/10/14/21-signs-the-global-economic-crisis-is-headed-to-a-whole-new-level/
Oh, it’s true enough to say, I think, although he’s got a political bit in there. “viz. Obama kool-aid” That tends to imply that the anti-Obama folks are helping the economy, which they are most definitely not.
We have age demographics throughout the developed world moving things. Simply put, the real economy sustains value by constant work. The more people are not working, the more resources go to supporting them from those who are working. The boomers have driven up home prices and stock prices as they moved through time. The boomers are now moving out of those markets.
So the law of supply and demand is operating. Demand for housing will continue to drop. Demand for all those things that support families will continue to drop. The boomers have proven themselves to be the most selfish generation ever. They don’t want to pay taxes to support infrastructure. They want to send others to fight but stay home. I have called the boomers, “Selfish, greedy and easily conned.” This will take at leas 15 years to work out. The tide turned in 2008 from a period when the net flow of savings was going into financial markets to a period when net flow needs to come out. That time is accelerating.
These days, the stock market (in my opinion) has still outrageous PE ratios that are sustained by speculation fueled by cheap money from the Federal Reserve.
Yes, basically I agree. We are in trouble and barely treading water.
The cures are several:
1. Massive tax increases on the top tier. This should entail taxing at rates north of 70% for at least 10 years and slowly declining to the world’s top tier tax rate median of around 50%.
2. Closing tax loopholes on the top earners. Except for long term capital gains (10 years or more in an investment) there should be no tax breaks – period.
3. Get rid of almost all taxation of corporate perquisites, provided that those perquisites are reasonably related to the business.
4. Major spending on a huge national project, not just resurfacing roads. The top two government spending programs in the USA that created the highest amount of money for every dollar spent are:
A. The interstate highway system, estimated at 13X. (i.e. for ever $1 spent, $13 dollars returned)
B. The space program – Apollo, followed by the space shuttle at over 8X.
Most science research spending returns around 3X. Military spending returns around 1X.
5. Establish a new type of bank (with similarity to the old pre-deregulation investment bank) called a venture bank. This will allow any venture capitalist or angel investor to act as a bank and treat their investments as bank loans, and have access to the Fed discount window.
Do those three things, and define a goal of either establishing orbital solar power satellites or a self-sustaining colony on Mars. Run it like Apollo as a go-for broke set of projects and you will see:
– Employment, particularly tech employment skyrocket, and most importantly for the young.
– Deficits go away.
– With the incentive to rape corporations by maximizing payments to top executives mostly gone, the incentive becomes for those executives to develop the corporations to maximize their status and power. So corporations will grow and prosper. About half of jobs are with big corporations. As the ranks of big corporate jobs swell, small businesses also grow in number.
Sorry, Kiddo. No more from you until you demonstrate that you can actually study. I have spent plenty of time on you and you persistently fail to remember things, fail to read completely, etc. There is plenty on this site to occupy you. I expect you to study, not just casually read and wander through your mind flopping around. Go back through all the pages. Go back over discussion threads. Work examples. Think it over.
You have too high an opinion of yourself Mr. Kaartinen. I am deleting your recent comments because they have been answered before, they are answered by what is on this blog, they are tiresomely obvious, and you have displayed an studied unwillingness to learn.
Put yourself to school. I have spent a lot of time answering you, and as long as that is adding something somewhat useful I’m fine with it. But when it degenerates into twaddle, no. You can easily answer your own questions if you cared to bother.
Very interesting. You’re the only one I’ve read so far that explains where money comes from to pay for interest, on a society wide level. I always thought that eventually that just forces the masses to be in greater and greater debt, leading to slavery/rebellion/war.
But it seems like the answer is actually nowhere, once your banking system has run to the 20x multiplier limit. You don’t even get to slavery stage, because the banking system can’t generate enough loans to give to the masses before it crashes.
As you explain it, that seems like a real hard core limit. Is this what we’ve been operating under all these years (going back to Renaissance times when banking was first invented)?
If you read to the bottom, you will see the answer. That is what the invention of fiat money and the Federal Reserve was for. The Federal Reserve can always loan money to banks when the bank needs to make a loan. There is no longer a gold standard.
i appreciate your attention Jason. It is a bit disappointing that you broke off reading before getting to the point of the article. But clearly, for as far as you did read, you paid attention. So thanks for that.
I have some ideas I may submit to a journal this year for how to improve on the Fed. But not going to talk about those here – not yet. And I probably owe the Bitcoin people a paper ripping their ideas to shreds first. Of course, most of them will not care – they think they know everything. And those who would understand, like the exploiters creating new Bitcoin alternatives, will be completely aware and not care because their intent is to con the public out of it’s underwear.