Economic Crisis

Money and the “missing link” – Part I

What is “money”? Do you know where it comes from? Not even one in a thousand finance professionals could answer those questions, let alone people in the broader populace. We take money for granted, which is surprising given how essential it is. With physical cash under siege, and savings threatened by negative interest rates, it’s time for some answers.

The big guns of the establishment are swivelling round and taking aim at our money. Some want to obliterate physical cash. Others want to impose negative interest rates on bank deposits, which amounts to a slow pounding into confiscation. Either way, if you want to survive the bombardment it pays to have a better understanding of money.

Cold, hard cash. Filthy lucre. Bucks. Bread. Wherewithal. Dough. Loot. Wad. Dosh. Gravy. Readies. Greenbacks. Money has a lot of popular names, which in itself tells us how important it is to human society.

The standard definition of money is pretty straightforward. A unit of account, a medium of exchange and a store of wealth. You can use it to measure the value of things. You can use it to buy things. You can use it as a place to park value for future purchases.

Those traits aren’t unique to money, although money does make things more convenient when it comes to keeping track and transacting. On the other hand, when it comes to storing wealth there are plenty of alternative assets – from financial securities like stocks and bonds to physical assets like gold bullion and buildings.

What money is used for is fairly simple to comprehend. What money really is, and where it comes from, are less easily understood. Or at least far less widely appreciated.

Most of what you count as your money will take one of two forms. These are physical notes, like dollar bills, and bank deposits.

Physical notes are issued by a central bank, such as the US Federal Reserve in the case of US dollars, and reach wider circulation by passing through commercial banks, which distribute them.

On the other hand, bank deposits are loans made by customers to a commercial bank in exchange for convenient payment services and modest interest income.

Deposit balances are transferred to other bank customers – at the same or another bank – every time you use a payment card or make a bank transfer. The claim against the bank is transferred to another bank depositor.

Alternatively your claim can be converted into physical notes when you make a “withdrawal” from the bank. In this case the customer claim against the commercial bank has been converted into a claim against the central bank.

Money has no intrinsic value. It’s only worth what someone else will exchange it for. The entire basis for a functioning money system is a social basis. Money needs trust for it to survive…

That said, it’s not clear what that claim is worth. Money has no intrinsic value. It’s only worth what someone else will exchange it for. The entire basis for a functioning money system is a social basis. Money needs trust for it to survive, but even so it loses value over time – at least now that we no longer use precious metals like gold and silver. (For more see: “Money, money, money, must be funny”.)

Most of the time there’s not much to worry about. Banks are supposed to be solid, and deposits are supposed to be insured. Deposit balances are supposed to pay some kind of interest to the customers, in return for the loans to the banks. But there are now real reasons for you to be concerned.

Money is now under threat from two directions. But first, the good news: due to stricter regulations, big banks are now far less likely to go bust than before the global financial crisis, which started in 2007. But ironically this has created new threats to money.

Put simply, the strict new bank regulations mean there’s less new money being created. That means the economy is weaker. That means low or even negative interest rates, supposedly to “stimulate” the economy by encouraging borrowing and spending.

In turn that means depositors potentially having to pay to lend to the bank. That means higher demand for zero interest physical notes (nothing is better than less than nothing). That means physical cash has to be restricted for the negative interest rate policy to work – even assuming it will in the first place.

I’ll explain these links some more in part II. First let’s get back to the central question about how money is created. Without getting to grips with it we can’t join the dots on the threats to our savings.

Apart from those physical notes that people keep in their wallets or stashed under their proverbial mattresses, the vast majority of money exists in electronic form.

Your bank account balance is just a liability entry in your bank’s computerised accounting system. The same goes for everyone else’s “money”, from your neighbours, to businesses, to government departments – spread across lots of banks, of course.

These balances are transferred between bank customers every time one of us makes an electronic transaction. If you buy clothes at a store using a payment card, your deposit balance is reduced and the store’s balance is increased.

The claim against the bank has been transferred from you to the store. Ditto if you use your online banking system to transfer money to a friend or family member.

In this way, electronic money is washing around the banking system all day long. It’s constantly being moved from one home, or deposit account, to another. All it takes is a bit of technology and some keystrokes.

But the total amount of this computerised money isn’t static. New money is coming into existence all the time. In fact, every time a bank makes a new loan it creates new money out of nothing.

Let’s say you take out a $10,000 bank loan to buy a car. The bank creates a loan asset of $10,000, which is money owed by you to the bank. At the same instant it credits your deposit account with $10,000. That’s a bank liability, and money the bank owes to you.

The bank’s balance sheet just got bigger on both sides, adding $10,000 to both its assets (loans) and its liabilities (deposits). So did yours. You have a $10,000 deposit balance to draw on, but you also owe the bank $10,000 which you have to pay back in future (with interest).

You then pay the $10,000 to the car dealer and receive your new wheels. You now have a shiny new car today and a loan to pay back in future. The car dealer has $10,000 credited to his bank deposit account.

If his account is at the same bank as you then the bank just has to switch the $10,000 between customers. It now owes the dealer instead of you (and you still owe the bank $10,000). If the dealer’s account is at another bank then your bank has to transfer the funds to that new bank. (Your bank then has to find new funding, but that’s a whole other topic.)

From this you can see that commercial banks create money out of nothing each time they make a new loan. This is known as the “credit creation theory” of banking.

Unfortunately not everyone agrees, including most mainstream economists. There are two competing theories. One is “fractional reserve banking” and the other is the “financial intermediaries theory of banking”. I won’t go into full detail on those theories but here are the key points.

Fractional reserve banking says that a minimum reserve balance – which is an asset made up of physical cash notes and deposits at the central bank – must be held by commercial banks. Any excess of customer deposit liabilities over that reserve asset is known as excess reserves and can be lent out. According to this theory, if there are no excess reserves then banks can’t lend.

Financial intermediaries theory says that banks just act as a pass through, taking in deposit money from customers and lending it on to other customers. According to this theory, banks can’t lend unless they’ve got un-lent deposits sitting around.

Economists don’t agree on which of these theories is correct. But I’ve just read a paper from 2014 by Richard A. Werner, a professor at the University of Southampton in the UK. He set out to find out whether banks do indeed create money out of nothing, which would back up the credit creation theory.

Werner did this by taking out a loan with a small German bank under controlled conditions. He then examined the accounting records of that bank before, during and after the loan was made.

The bank at no point checked its reserve or customer deposit balances before it made the new loan, nor did it transfer money from one account to another. It just created a new customer loan and a new customer deposit out of thin air, as new entries in its computerised accounts.

The finding clearly points to the fractional reserve and financial intermediary theories of banking being incorrect. This is because there was no need for excess reserves or “spare” deposits before the new loan was made. The lending officer just went ahead and created a new loan and a new deposit.

Commercial banks create most money out of nothing. There’s no real magic. You now know more about where money comes from than “one in a thousand” finance professionals – and probably most economists.

So there you have it. Commercial banks create most money out of nothing. There’s no real magic. You now know more about where money comes from than “one in a thousand” finance professionals – and probably most economists.

This is a crucial “missing link” in understanding of the economy, and may go a long way towards explaining the mess we’re in. If economic policymakers don’t understand something as fundamental as money, then how are they supposed to come up with decent policies?

You might think this means the supply of money and credit are unlimited, which of course would be dangerous. Any money in infinite supply would become worthless pretty quickly (just ask the people of Zimbabwe). Actually, even if it’s counterintuitive, there are now major constraints on credit creation.

In the next article I’ll examine why, and how that could be a huge problem for the economy. Most importantly I’ll explain why the attempted or proposed solutions are a big threat to your savings. Have you understood the risks? Or what you can do to protect yourself from them?

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.