Monday, March 4, 2013

Can a bank "create" money and how much?

When someone deposits money in a bank, the bank takes on a liability; it owes money to the depositor. It also takes on an asset, the cash deposited.

At the present time it, the bank, only needs to keep 10% of that asset in cash so it makes a loan and transfers the cash asset to a loan asset. As the loan is repaid the balance sheet will show a periodic transfer from the loan asset back to the cash asset. The bank should also show an increase in cash and equity from the interest.

The bank can keep cycling cash back into loans but the bank's holdings will never exceed its cash assets, loan assets, and reserve assets. The amount it loans can increase as its equity increases but the total assets must equal its liabilities, what it owes depositors, and its equity, what it earned in interest.

So is the bank creating money? Yes, but there is a limit on how much it can create. (We are not talking the Fed here. As to the Fed, it is essentially a branch of the Treasury for all the talk of it being independent.)

There is a problem with the money that banks create. When economic times are bad, just when an influx of money is needed, banks become reluctant to loan money so the supply dries up. The sovereign has no restraint on creating money and can (and should) put money into the economy when there is a slow down. The time to restrict government money is when unemployment comes down, demand and prices go up, and the supply is struggling to catch up.


Bill Gilliland said...

What about when a bank creates a derivative? It has created a salable product, really, out of nothing. It trades that product for cash, which it can then circulate with the multiplier effect you mentioned.

But what is your point?

Ron (AKA Albert) said...

Yay, a comment. At long last. :=))

Now I have to go back and re-read what I said.

It's a technical question, I guess. For every asset created there has to be a liability lurking somewhere.And, except for the government itself, that liability needs to be resolved at some point. That, of course, creates the question as to hos long before that bill comes due.

That reckoning will reveal that the Emperor has no clothes and the holder of the manufactured asset at the time gets stuck with the loss of equity.

Banking should be boring. Banks should not be allowed to do anything that can't be regulated. I hope that Senator Warren's new Glass-Steagle law goes through but, without reading it, I will observe, it doesn't go far enough.