Credit Prestidigitation: A Vicious Circle?
A Naybob of numbers, Captain Numerica asked about money creation. Not so simple answer, as this is where SO MANY get lost and cannot see the forest for the trees, forget the physical coin and specie concept.
In order to do so, we followed the evolution of payment methods and transaction volumes in A Cashless Society? Our findings? At any rate, pun intended, despite cash still being King in under $25 transactions, it only accounted for a 8% share of value. Meanwhile, digital means and on line banking now account for a 68% value share of all transactions.
So, for our purposes, again let go of the old school physical, and what is money (convertible) or moneyness (liquidity of various asset classes), all Natterings for another day, and for now just think in CREDIT terms. And now this...
We have evolved into a ELECTRONIC CREDIT BASED payment and equally important, LENDING and ARBITRAGE system. A commercial bank (CB) customer wants to borrow money. The loan officer makes a loan, digitally clicking into existence an asset (debt to be repaid) and liability (deposit).
The asset debt (debit) and deposit liability (credit) balances did not exist previously. The source of those funds? Already existing assets, capital, deposits, or reserves? Gold bullion? I said forget the physical, bad dog.
For some financial entities, depending on the circumstances, existing capital, deposits or by borrowing from another bank or the Fed. However, in the unique case of a CB quite often NONE of the above.
As for reserves, reserves "typically" (with QE it was possible to lend without reserves increasing) increase when banks lend, and the required level of reserves will increase when deposits increase.
So is the source of those loan funds ex nihilo or "out of thin air"? are there any costs? and through what process are those funds "obtained" by the CB?
There is a reason which will become readily apparent as to why we select the CB. All the CB need do is promise to to clear and settle any payment requests that many be generated by the loan.
Those promises will be kept by shifting account balances (credit/debit) on the balance sheet and/or leveraging the ability to clear and settle interbank payments. The central bank (Fed) desk and window stands by to ensure sufficient interbank clearing capabilities (systemic liquidity).
The deposit balances were expanded by the act of lending or credit creation with the click of a button. This is done without obtaining any additional assets to keep those promises; to clear or settle payments or withdrawal claims on the newly created deposit liability.
The deposit account created with the loan (asset), is a bank liability which is backed by a promise to pay or IOU. Thus the product of credit creation is a negotiable liability of the bank, which is ultimately real with other banks, the CB's bank, the Fed's 12 regional banks, (which incidentally, the CB's own), and the government (Treasury).
This negotiable liability in the form of bank debt is a payment asset, and that deposit liability which the CB creates "out of thin air", serves as a form of widely accepted MONEY, which can and often is used in exchange for other assets.
The above process explains the CB's DISTINCT ability in a certain sense to CREATE its own "Manna from heaven", through the ex nihilo or "out of thin air" prestidigitation of credit.
As opposed to NON Banks, who must utilize already existing resources, the only limitation on the CB is liquidity preference, balance sheet capacity (both constrained by Basel and LCR capital ratios) and the "cost" of the "loan" funds.
Indeed a license to "print money", if not literally, then figuratively at least for the profit of the CB's engaging in said UNIQUE and PRIVILEGED activity. Money multipliers, stocks and especially flows are all key. For our purposes, without venturing further into the world of fractional reserve banking, collateral and moneyness, we shall stop at credit creation.
At the end of the day, the rate at which banks create credit; coupled with the motive (purpose of the loan) and manner (disposition) in which those funds or that credit are circulated (transaction turnover); will determine velocity, the rate of inflation, beneficial or deleterious economic consequence, and resulting economic "health" or conditions.
As we are witnessing, it can be a vicious circle.
Suggested reading: Do Banks Create Money From Thin Air? and Bank Lending and Reserves
Continuing our thematic duality, more to come in The Cash Balances Paradox? Stay tuned, no flippin
In order to do so, we followed the evolution of payment methods and transaction volumes in A Cashless Society? Our findings? At any rate, pun intended, despite cash still being King in under $25 transactions, it only accounted for a 8% share of value. Meanwhile, digital means and on line banking now account for a 68% value share of all transactions.
So, for our purposes, again let go of the old school physical, and what is money (convertible) or moneyness (liquidity of various asset classes), all Natterings for another day, and for now just think in CREDIT terms. And now this...
“The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.” - F. Scott FitzgeraldAs noted previously, so many get lost because they lack the above. We might ask you to momentarily let go of old concepts, however the fundamentals still serve. At the same time you think CREDIT and modern ELECTRONIC TRANSACTION SYSTEMS, think old school accounting, and a double entry ledger with credits and debits.
We have evolved into a ELECTRONIC CREDIT BASED payment and equally important, LENDING and ARBITRAGE system. A commercial bank (CB) customer wants to borrow money. The loan officer makes a loan, digitally clicking into existence an asset (debt to be repaid) and liability (deposit).
The asset debt (debit) and deposit liability (credit) balances did not exist previously. The source of those funds? Already existing assets, capital, deposits, or reserves? Gold bullion? I said forget the physical, bad dog.
For some financial entities, depending on the circumstances, existing capital, deposits or by borrowing from another bank or the Fed. However, in the unique case of a CB quite often NONE of the above.
As for reserves, reserves "typically" (with QE it was possible to lend without reserves increasing) increase when banks lend, and the required level of reserves will increase when deposits increase.
So is the source of those loan funds ex nihilo or "out of thin air"? are there any costs? and through what process are those funds "obtained" by the CB?
There is a reason which will become readily apparent as to why we select the CB. All the CB need do is promise to to clear and settle any payment requests that many be generated by the loan.
Those promises will be kept by shifting account balances (credit/debit) on the balance sheet and/or leveraging the ability to clear and settle interbank payments. The central bank (Fed) desk and window stands by to ensure sufficient interbank clearing capabilities (systemic liquidity).
The deposit balances were expanded by the act of lending or credit creation with the click of a button. This is done without obtaining any additional assets to keep those promises; to clear or settle payments or withdrawal claims on the newly created deposit liability.
The deposit account created with the loan (asset), is a bank liability which is backed by a promise to pay or IOU. Thus the product of credit creation is a negotiable liability of the bank, which is ultimately real with other banks, the CB's bank, the Fed's 12 regional banks, (which incidentally, the CB's own), and the government (Treasury).
This negotiable liability in the form of bank debt is a payment asset, and that deposit liability which the CB creates "out of thin air", serves as a form of widely accepted MONEY, which can and often is used in exchange for other assets.
The above process explains the CB's DISTINCT ability in a certain sense to CREATE its own "Manna from heaven", through the ex nihilo or "out of thin air" prestidigitation of credit.
As opposed to NON Banks, who must utilize already existing resources, the only limitation on the CB is liquidity preference, balance sheet capacity (both constrained by Basel and LCR capital ratios) and the "cost" of the "loan" funds.
If the bank already possesses excess payment assets, it might not be able to expand its deposit liabilities without acquiring any more payment assets. [Balance sheet capacity constraints]Regarding "cost" of "loan" funds: the CB's create credit, and unlike the NON bank, in that process (outside of balance sheet capacity) no one has to forgo any purchasing power on already existing resources, to extend the credit. Voila!!!
It is also important to recognize that while banks obtain some reserve payment assets by borrowing them – either from other banks or directly from the Fed – some of those reserve assets are acquired for “free”: as interest on loans the banks make to the Treasury and as interest on reserve balances they already hold. [IOER - interest on excess reserves held at the Fed, and Manna from heaven]When one does not have to forgo any purchasing power, and the "cost" of the source of the funds is "free" and "zero risk" (T-bills), that "manna from heaven" can be considered to have come "out of thin air".
Indeed a license to "print money", if not literally, then figuratively at least for the profit of the CB's engaging in said UNIQUE and PRIVILEGED activity. Money multipliers, stocks and especially flows are all key. For our purposes, without venturing further into the world of fractional reserve banking, collateral and moneyness, we shall stop at credit creation.
At the end of the day, the rate at which banks create credit; coupled with the motive (purpose of the loan) and manner (disposition) in which those funds or that credit are circulated (transaction turnover); will determine velocity, the rate of inflation, beneficial or deleterious economic consequence, and resulting economic "health" or conditions.
As we are witnessing, it can be a vicious circle.
Suggested reading: Do Banks Create Money From Thin Air? and Bank Lending and Reserves
Continuing our thematic duality, more to come in The Cash Balances Paradox? Stay tuned, no flippin
Comments