Say you have a bank that creates money on demand, if you borrow $1000 into existence and pay 10% interest,
only $1000 exists, therefore more people must borrow for you to be able to pay back, but then won't other
people be in your position? So it becomes a game of musical chairs.
Even if money goes back to the banks, it can only come into circulation through debt.
Only 3% of our money is in coins and notes, and this is not enough to cover the interest.
is this how it works? I'm not too sure.
Charging interest only makes sense if you don't issue the money,because if you are the sole issuer that creates an impossible situation.
meambobbo:You switched up my hypothetical. But even in yours, there's a big flaw in the logic. The federal government did not create the original money supply by issuing debt. Specie was already being used as money. Federal Reserve notes/accounts were titles to specie. Then, the government exempted all banks from fulfilling these titles. This money was a debt to no one.
Granted, a certain portion of the money supply was not originally debt. But is that still true today? Imagine a scenario where the total money supply is 10 cents, none of which is debt. Then, the country goes off the gold standard and begins "printing" new money under the current system (i.e. all new issuances of money are debt). Let's say that the Fed "prints" $10 so that the total money supply is now $10.10. And, further, let's say that the $10 of printed money accrues 2% interest per year, or 20 cents. It seems clear that under this hypothetical scenario, the 10 cents of non-debt currency would quickly get swallowed up by the interest, and, going forward, all dollars in the system would be accruing interest. If no new money were "printed," there would not be enough money in the system to pay off the $10.
Now, I don't know what the total money supply was in the 30s when we went off the gold standard, but it seems to me that that would be the point in time from which all new "printed" money would have been accruing interest. I haven't investigated this, but given the huge increase in the money supply since then, isn't there a significant chance that the non-interest bearing portion of our money supply was long ago overtaken by the amount of money owed in interest? I read that last year alone the federal government had to pay well over $400 billion in interest payments. If the link below is accurate, the $400 billion in interest paid last year alone dwarfs the total money supply in the system during the 30s.
http://www.sjsu.edu/faculty/watkins/depmon.htm
I'm sure I'm off base on this, but I'm just trying to learn. Thanks for your patience.
Perhaps my last post was confusing. Indeed, you are correct that the current amount of debt and annual interest owed dwarfs the latter-day interest-free money. My main point is that this does not represent an insurmountable paradox, where new credit is required to pay down old debt.
The best example I can give of this example is simply that interest payments earned by banks re-enters the economy as debt free money, rather than new loans. If the bank creates $100 in the form of a new loan, and $5 gets paid back in the first year (obviously possible), most of that is not going to be re-lent. Bank employees and owners will likely spend the money. This allows it to be earned by debt-holders in the economy and used to pay down more of the debt. Over time the debt is eliminated, without the need for any new credit to be issued...or money be created.
As said before, there are only two cases the paradox actually exists. One, all debts (including interest) must be repaid in one giant payment. Or, two, the bank refuses to allow money used to repay loans to re-enter the economy in any form other than new loans. Loaning it to others means they are not spending it. If done to a logical extreme, this means that no one in the banking industry eats food. Do you really believe bankers don't eat? It essentially means that bankers and bank employees work for free, in terms of real goods. This is obviously false as well.
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If money is lent into existence at interest, then yes, it is obviously unrepayable in the long run.
The fact of the matter is that no money is "lent into existence" in the United States. The Federal Reserve creates money by buying government and private debt with interest free money or by paying interest on bank reserves with newly created money. Private banks do not loan money into existence, instead, they take money from short-term lenders and lend it to long-term borrowers, which presents its own problems.
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krazy kaju: If money is lent into existence at interest, then yes, it is obviously unrepayable in the long run. The fact of the matter is that no money is "lent into existence" in the United States. The Federal Reserve creates money by buying government and private debt with interest free money or by paying interest on bank reserves with newly created money. Private banks do not loan money into existence, instead, they take money from short-term lenders and lend it to long-term borrowers, which presents its own problems.
Private banks do loan money into existence. That's why they are only holding fractional reserves. The Fed also creates money as you say.
Rooster:Private banks do loan money into existence. That's why they are only holding fractional reserves. The Fed also creates money as you say.
No, they lend out deposits. And buy banknotes from the local Fed.
scineram: Rooster:Private banks do loan money into existence. That's why they are only holding fractional reserves. The Fed also creates money as you say. No, they lend out deposits. And buy banknotes from the local Fed.
If they only lent out deposits, it wouldn't be fractional reserves.
Rooster:If they only lent out deposits, it wouldn't be fractional reserves.
No, it WOULD be. Fractional reserves means only holding a fraction of whatever banks promise to redeem their notes for on hand during any period. Their total assets (including the non-liquid assets that they must sell to meet redemption demand) would be equal to or greater than their liabilities, but they are still holding fractional reserves.
But it doesn't mean they lend out deposits either. If depositors put $100 in the bank, and the reserve requirement is 10%, the bank can create $1000 in loans that day. It usually chooses not to do this so suddenly, because a noticeable price inflation could raise redemption demand and wipe them out. It usually chooses instead to issue loans that are less than the size of its deposits, then wait for those to create new deposits before making additional loans.
In general, the process shouldn't be thought of as loaning out deposits as creating money. It can operate as though it were loaning out deposits, but this technically isn't an actual restraint, especially today with fiat currency and central banking...and gov't bailouts.
meambobbo: But it doesn't mean they lend out deposits either. If depositors put $100 in the bank, and the reserve requirement is 10%, the bank can create $1000 in loans that day. It usually chooses not to do this so suddenly, because a noticeable price inflation could raise redemption demand and wipe them out. It usually chooses instead to issue loans that are less than the size of its deposits, then wait for those to create new deposits before making additional loans.
You are correct I think, my statement was wrong. What I meant to say is that fractional reserve banks lend more than their deposits, and therefore are creating money, so I agree with you.
Edit
Meambobbo,
Please see the article below. If the depositor puts $100 in the bank and the reserve requirement is 10%, then the bank can loan out $90, not $1,000. And the $90 does come from the $100 deposit. That's the essence of the fractional reserve system.
"To limit this multiplier effect of new money entering the system, banks are required to place a fraction of their new deposits with the country's CB and it is only the remainder that may be loaned out. Typically the fraction of new deposits required to be placed with the CB is of the order of 10%. Thus in the example above, Bank A receiving a new deposit of $10m would have to place $1m on deposit with the CB and would be free to loan $9m. The bank receiving deposits from the $9m loaned by Bank A would have to place $900,000 with the CB and would be free to lend $8.1m. Banks receiving the $8.1m would have to put $810,000 with the CB and could lend $7.29m, and so on. Eventually the original injection of $10m is multiplied to $100m in loans, a ten-fold increase of the original $10m deposit."
http://www.321gold.com/editorials/field/field041008.html
Rooster: krazy kaju: If money is lent into existence at interest, then yes, it is obviously unrepayable in the long run. The fact of the matter is that no money is "lent into existence" in the United States. The Federal Reserve creates money by buying government and private debt with interest free money or by paying interest on bank reserves with newly created money. Private banks do not loan money into existence, instead, they take money from short-term lenders and lend it to long-term borrowers, which presents its own problems. Private banks do loan money into existence. That's why they are only holding fractional reserves. The Fed also creates money as you say.
You are incorrect. It is illegal for banks to loan more money than they have. Banks do not loan money into existence, they simply take short term deposits and lend them to long term borrowers. This creates money on a balance sheet, but it doesn't create actual money.
Take this example: 100 savers put $100 each into a one month CD in a bank for a 5% interest rate. The bank loans the $10,000 as a 30 year fixed-rate mortgage at 7%. The bank can only remain solvent if, after a month, it sells the mortgage to another bank and is able to pay back investors or if it can find more savers to deposit money into the bank after the one month CDs expire. However, no money is lent into experience. If you believe that it is, prove it.
Likewise, as I've stated before, the Fed no longer uses the discount window, except for extremely rare occasions. Most of the time, the Fed buys government bonds from private investors with newly printed money in order to expand the money supply. Recently, under the regime of quantitative easing, the Fed has been buying private asset-backed bonds in order to expand the money supply. Either way, the Fed's main tool - the purchase of bonds - creates so-called "interest free" money.
krazy kaju: You are incorrect. It is illegal for banks to loan more money than they have. Banks do not loan money into existence, they simply take short term deposits and lend them to long term borrowers. This creates money on a balance sheet, but it doesn't create actual money. Take this example: 100 savers put $100 each into a one month CD in a bank for a 5% interest rate. The bank loans the $10,000 as a 30 year fixed-rate mortgage at 7%. The bank can only remain solvent if, after a month, it sells the mortgage to another bank and is able to pay back investors or if it can find more savers to deposit money into the bank after the one month CDs expire. However, no money is lent into experience. If you believe that it is, prove it. Likewise, as I've stated before, the Fed no longer uses the discount window, except for extremely rare occasions. Most of the time, the Fed buys government bonds from private investors with newly printed money in order to expand the money supply. Recently, under the regime of quantitative easing, the Fed has been buying private asset-backed bonds in order to expand the money supply. Either way, the Fed's main tool - the purchase of bonds - creates so-called "interest free" money.
Let me clarify, you are right that individual banks don't loan more than their deposits, but they are still creating money. The banking system as a whole does create more money than is in deposits. When a bank makes a loan, the depositor still has a claim on his funds, while the borrower also has new money in the form of the loan. This is the standard money creation mechanism. The Fed also uses open market operations to create or destroy money.
Rooster is correct: Banks do loan money into existence. See, for example, the blurb below from Wikipedia:
"The process begins when an initial $100 deposit of central bank money is made into Bank A. Bank A then takes 20 percent of it, or $20, and sets it aside as reserves and then loans out the remaining 80 percent, or $80. At this point there is actually a total of $180 in the system, not $100; because the bank has loaned out $80 of the central bank money, kept $20 of central bank money in reserve, and substituted a newly created $80 IOU claim for the depositor that acts equivalent to and can be implicitly redeemed for central bank money (the depositor can transfer it to another account, write a check on it, etc.). These checkbook IOUs are termed commercial bank money and are simply recorded in a bank's register as an asset (specifically, an IOU from the loan recipient) next to the reserves. From a depositor's perspective, commercial money is central bank money--it's impossible to tell the two forms of money apart until a bank run happens (at which time everyone wants central bank money). At this point Bank A still holds $100 of central bank money reserves on its books, but $80 of those reserves are soon going to be needed to satisfy the loan recipient. The loan recipient soon spends the $80. The receiver of that $80 then deposits it into Bank B. Bank B demands $80 of central bank money be delivered from Bank A to Bank B in satisfaction of the loan recipient's check. Bank A now only has $20 of central bank money on its books.
Bank B is now in the same situation as Bank A started with, except it has a deposit of $80 of central bank money instead of $100. Similar to Bank A, Bank B sets aside 20 percent of that $80, or $16, as reserves and lends out the remaining $64, creating $64 of IOUs to its depositors. As the process continues, more commercial bank money is created. To simplify the table, a different bank is used for each deposit. In the real world, the money a bank lends may end up in the same bank so it then has more money to lend out."
http://en.wikipedia.org/wiki/Fractional-reserve_banking
I think yall are arguing semantics, not substance. Money cannot be created by the bank, but money substitutes (titles to money) can. This is what the bank loans. Thus, there is no requirement that deposits are greater than loans. In fact, the very nature of fractional reserve banking is that the bank creates and issues more titles to money than it presently owns.
If a bank has $190 worth of obligations, and $100 of liquid reserves in the vault, it's reserve ratio is clearly not 10%. A bank can create TITLES to money, not money. It can lend actual deposits (specie), or it can make its loans as titles to specie. If it receives $100 in specie and the legal reserve ratio is 10%, it can legally create $1,000 of bank notes or demand account credit in the form of a loan. The reason it doesn't do this is practical - creating that much money substitutes so swiftly will likely raise redemption demand above what the bank can cover, or what its legal reserve ratio is. It goes from 100% reserve to 10% over night. If customers then withdraw any amount of reserves, the bank will be in trouble with the FED, having to borrow from other banks, go to the discount window, or sell its assets on the market.
Banks usually operate as Kaju specifies, but this is not because they are limited to restrict loans to a fraction of deposits. They aren't lending out what is actually deposited, be it gold, silver, or Federal Reserve Notes. They are lending out account credit, which they create when the loan is initiated. The result of the loan will usually mean its gold, silver, or FRN reserves are additionally drawn down; but in general, the loan will not result in the drawing down their reserves by the size of the loan.
meambobbo: I think yall are arguing semantics, not substance. Money cannot be created by the bank, but money substitutes (titles to money) can. This is what the bank loans. Thus, there is no requirement that deposits are greater than loans. In fact, the very nature of fractional reserve banking is that the bank creates and issues more titles to money than it presently owns.
We're not on a commodity standard, "money substitutes" are money.
Rooster:We're not on a commodity standard, "money substitutes" are money.
Maybe. Does the Federal Reserve hold gold on the asset side of its balance sheet?
In any case, it works the same way. The base money is Federal Reserve account credit and Federal Reserve Notes, held by banks. The money substitutes are checking accounts, savings accounts, and clever variations. Just as the amount of above-ground commodity can expand, the fiat base money can expand. This doesn't change the way the fractional reserve system works.
The bottom line is this - when the bank grants a loan, does it give the recipient cash or account credit? If it is account credit, does anyone else have their account credit diminished by the size of this loan? If no, does the bank receive any additional deposits of base money to cover these additional claims upon it?
Think about this. I deposit $100 fiat dollar notes into the bank. They create a $90 loan to my friend in account credit. My friend writes McDonald's a $90 check for food, which they use to open an account. Has McDonald's deposited $90, or claims for $90? When the bank makes a new $81 loan based on the $90 they just received, are they loaning deposits, or claims to deposits, or are they simply making more claims?
So, it should be obvious they are making money substitutes. If they make too much, without increasing their reserves, they'll have to borrow fiat money to cover withdrawals. Withdrawals are generally the true limitation on expansion.
Thus, when the fiat base money is created at such a swift pace that obtaining it is cheap and swift, then banks will swiftly expand credit, independent of whether people are depositing reserves or other banks have huge reserves to lend.