Monday, July 28, 2014

Money and Banking Basics

In this post, I'm gonna talk about the basics of understanding money and banks. When I took intermediate macroeconomics, we spoke about the market for "loanable funds" where the supply of savings in a bank and the demand for loans determined a whole host of factors. As the supply of savings or demand for loans shifted, we were told that this is what determined the rate of interest. In other words, economics assumes the interest rate is the equilibrium rate at which the supply of loans meets the demand for them. This is a load of horseshit! The interest rate is no such thing. Before we talk about what determines the dynamic that determine interest rates and effective macroeconomic models, we will first need to ground ourselves in the basics of money and banking.

There's a lot of technical aspects to money, but I'm gonna skip over a lot of that and just discuss the basics. First of all, what we consider money is primarily credit. Credit and money are two sides of the same coin. All money is some kind of a claim on real resources. What we (by we, I mean regular people) use as money are usually bank deposits (in today's world). In other words, money is a typical banking asset which means that it must be a liability on the other side. For example, my bank deposit is a liability of a bank but it is my asset. All money is both a liability and an asset. If I hold a Federal Reserve note, the note is a liability of the Federal Reserve and it is my asset. Today, almost all payments are cleared in bank deposits and it's all done electronically. However, banks clear their payments in bank reserves held at the Federal Reserve (if there's no central bank, banks clear payments at private clearinghouses). Historically, the international money was gold where there'd be a convertibility to turn bank reserves into gold at par; this is the gold standard. However, even having a gold standard really doesn't change the monetary basics all that much.

I'm gonna now talk about this idea of savings and how money gets created. There are two ways money can be created, but remember that the bank creating money is issuing a liability. Since the firm is issuing a liability, it must either be creating a new asset or swapping the newly created liability for an existing asset (for the net worth to not change). In other words, when banks issue loans, deposits get created simultaneously. This brings me to the myth about banking and money: SAVINGS DO NOT GET LENT OUT!!!!!

THERE IS NO SUCH THING AS LOANABLE FUNDS! There isn't some pool of savings that gets lent out. BANKS ARE NOT LIMITED BY THE AMOUNT OF SAVINGS! If banks want to create loans, they simply create new deposits. Also note one more thing: LOANS ALWAYS CREATE DEPOSITS. This is not a new phenomenon either. It's been there for a very long time and will continue to do so. If I want a loan, a bank expands its balance sheet on its asset and liability side simultaneously. My assets and liabilities expand simultaneously as well. My asset side now adds bank deposits and my liability side now contains a loan. The transaction is shown below. Note that the net worth of everyone involved in the transaction does not change.
      Bank                           Me
+Loan|+Deposit     +Deposit|+Loan

It's also important to notice money starts bottom up. Money isn't something that starts off with governments setting up a monopoly and working off that. Money developed in the exact opposite direction. Money starts from the bottom up. Money co-developed with developments in credit along with shifts in trade. Anyone that says there's a one way development of money that started off on a linear path beginning with some sort of a centralized structure is false. Money was something that co-developed with many other things and cannot be separated by those shifts. Remember that economic systems co-develop with geopolitical systems and money co-developed with a whole host of other factors.

Central banks (and clearinghouses) create liabilities by swapping them for assets, unlike normal banks that just issue liabilities in order to create new assets. I'll talk more about central banks and monetary policy in detail on a later post.


  1. Not to be too technical or picky, but not sure I understand "All money is some kind of a claim on real resources". In case of US dollar today, what would these "real resources" be?

    1. By real resources, I mean some claim on the productive value of the country. The dollar is backed by the productive capacity of the US, if that makes any sense. It's worth something because of the country's current and future production value.