Blame the Banks, Too

Thu, Jan 23, 2014 - 8:19am

Everyone loves a scapegoat, and when it comes to money creation, the Fed is the target of choice. OK, maybe the Fed's not really a scapegoat since it actually does create money, but let's broaden our horizons a bit. Today I want to focus on the creation of money through commercial banks and lending institutions, not the central bank.

But first, let's revisit the Fed for a moment to get warmed up.

When the Fed creates money, it does so through the act of purchasing securities from its constituent banks. Newly created reserves are exchanged for Treasuries and Mortgage-Backed Securities. If we pretend for a moment that the Fed's balance sheet sits outside the economy (which it does from many perspectives), then we can get a better feel for how the Fed's creation of money is impacting the economy. Recall that each time the Fed creates money, it is not the amount of money in the economy that changes, rather it is the size of the Fed's balance sheet that increases. For every $75 billion that is created and provided to the banks, $75 billion of securities (Treasuries and MBS) are removed from the balance sheets of those same banks. The end result is that the banks do not have any more, or less, assets. The only thing that changed was the composition, or more precisely the liquidity, of those assets.

So if the Fed doesn't increase the amount of money floating around in the economy when it creates money, how does the amount of money in the economy change? Answer — through the creation of credit by lending institutions, and through the destruction of debt via payoff and default.

[Related: Former Fed President Admits Central Banking, Paper Money a "Confidence Game"]

In reality, the amount of money in our economy is completely a function of debt.

This makes sense when you understand that all new money is loaned into existence— Yes you read that right. Where did you think money came from? It all comes into existence through borrowing. That's why you commonly hear the phrase that all money (not talking about gold here) is simultaneously someone else's liability.

Here it is in simplified equation form: DEBT = MONEY

An example is warranted here. Let's say I borrow $25,000 to do home-improvements. Forgetting for a moment about where that $25,000 comes from, when I pay the $25,000 to my contractor, it becomes money to him and everyone else down the road. My contractor's new $25,000 is simultaneously my liability, but to him and everyone he pays those funds to, it's money.

Now let's attack the question of where the $25,000 that I borrowed came from. Was it the bank's money that was loaned to me? Was it someone else's savings that I borrowed? Was it money that the Fed created that I borrowed? No, no, and no.

The $25,000 that I borrowed was created out of thin air, not by the Fed, but by the bank that loaned it to me. We're going to take an oversimplified look at a bank's balance sheet and the accounting entries to show that this is the case.

Below we have a very basic example of a bank's balance sheet. For those non-accounting types, the key to a balance sheet is that it must, well, balance. The most fundamental equation in accounting is: Assets = Liabilities + Equity.

When a bank creates a loan, two items on their balance sheet change: Deposits and Loans. Banks extend credit through the simultaneous creation of a loan asset and a deposit liability.

In the case of my ,000 loan, this is what the accounting looks like:

Notice that the balance sheet still balances. The ,000 that was created on the deposit side was not pulled from another account, it was not pulled from excess reserves, it was simply created from thin air with a few keystrokes — and you thought there was no such thing as magic.

Commercial banks and lending institutions are licensed money creators, and this is money that will increase the total amount of money in the economy.

I mentioned that the new ,000 deposit did not come from bank reserves or excess reserves. But there is something important regarding reserves that happens when deposits are created from thin air. If we assume that this bank must maintain a 10% reserve requirement, then until the new deposit is removed from the bank (I pay my contractor), the bank has ,000 extra in deposits, and thus must maintain an extra ,500 in reserves. If the bank had excess reserves at the time (as most do now) then ,500 of those "excess" reserves just became "required" reserves. If the bank did not have excess reserves, it would have to borrow ,500 worth of reserves from another bank or directly from the Fed. This requirement to hold an extra ,500 in reserves disappears when the deposit leaves the bank (I pay my contractor). Unless of course my contractor banks with the same bank in which case the bank will need to maintain those reserves as the new deposit funds move from my account to my contractor's.

Next episode we'll take a look at a simplified central bank balance sheet, but for now, I want to talk about the paradoxical implications stemming from the fact that banks create deposits whenever a loan is made, and that all new money is loaned into existence.

If all new money is loaned into existence, then how much money would exist in our economy if everyone paid back all their debts? As strange as this may seem, the answer is none. OK that's not entirely correct. Things get a little tricky and philosophical here, and beyond the scope of this article, so let's go with "very little."

If everyone paid off all their debts, the amount of money destruction or money "de-printing" would be tremendous. It would greatly shrink the amount of money in our economy available to represent goods and services. Guess what we call a shrinking of the money supply in relation to the amount of goods and services represented by that money? You got it, deflation. I'll get into why deflation poses such a threat in another article. For now let's keep it simple.

When the amount of money in the economy decreases, it means less spending. When there is less spending, there are fewer jobs. And fewer jobs come with many negatives, from less innovation to a greater likelihood of social chaos.

So where does that leave us? Ultimately, it means that as an economy we can have more money and more debt, or less money and less debt. Of course we could drastically change the way the system works, but we'll leave that hypothesizing for another time.

For now we need to understand that the value of the money we hold and the value of the assets denominated in that money are heavily dependent on how much money creation (lending) and money destruction (payoff and default) is occurring.

When money creation is outpacing money destruction, the total amount of money in our economy is expanding. When money destruction outpaces creation, the amount of money in our economy is contracting. Be careful not to interpret this relationship as indicative of inflation/deflation, as that is a function of the relationship between the amount of goods and services in the economy and the amount of money available to represent those goods and services.

The main idea here (oddly enough) is that we all have an aversion to debt, but our modern economy is built on debt and couldn't function without it. Erase too much debt (money) at one time and you end up in a financial crisis with plummeting asset prices. At the same time, we can't allow for runaway credit creation because that poses a whole other set of concerns. In between we hopefully find a balance where money creation paces the growth in goods and services and price levels remain stable.

The above content was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.

About the Author

Chief Investment Strategist
matt [at] modelinvesting [dot] com ()