Wednesday, January 6, 2010

Creating money

An article on the peculiarities of the ways we create money.

Our present system is hyper-capitalist (don’t get me wrong I do like many aspects of capitalism, particularly when competition results in lower prices for the basic necessities of life). However in our capitalist system money is created in three ways:

1) The logical way: the central bank (Bank of Canada, Federal Reserve, etc.) literally prints extra paper money (through the mint).
2) The normal (but weird) way: A commercial bank creates a loan and thus gives money to the loan recipient. It is normal for a bank to have many more loans than assets (due to the widely used fractional reserve banking system). The sum of all the bank’s loans less its assets is money that has been created (effectively printed!) in our ridiculous system. (the money did not exist before the loan existed but when the bank approves the loan, the money is created – the bank doesn’t need to physically print this money, just to account for it on a computerized ledger sheet somewhere). It is government law that allows banks to create money in this manner.
3) The super weird way (quantitative easing). This method combines the first two methods in a spectacularly ridiculous way.
 The government creates new money (through a loan) and hands it over to a commercial bank. The commercial bank then counts this money as an asset and loans out much much more money to home owners and businesses then charges interest on ALL of the outgoing loans they made. (quantitative easing is pretty weird - if anyone wants to help clarify this please send me an e-mail or post a comment)

Interestingly enough, most commercial banks’ loans heavily outweigh their assets. So if we wanted to know exactly how much money has been created in any given currency then we would add up the total amount of money printed by the central bank plus the total of all of the loans (less assets) of all of the commercial banks.

The great irony here is that the private self-serving commercial banks decide who gets newly printed money and get to charge interest on the money they created! The further irony is that the money created by the commercial banks through this loaning process is typically much greater than the amount created by the central banks through standard money printing etc. (in the U.S. there are about 5.4 trillion dollars of mortgage based loans which to my understanding is the bulk of the 8.3 trillion dollars in existence according to the M2 estimate available here)

Changing this system could easily improve government revenues which are flailing all over the world.

Interestingly according to this wiki article on money creation it is estimated that in 1959 the U.S. had 286.6 billion dollars in existence and that by May 2009 the U.S. had 8,327 billion dollars in existence (M2 estimate again). This yields a money growth rate of about 6 or 7 percent per year on average. Now assuming this trend were to continue then in 2010 there would be another 6 percent of the total money supply created. This represents a creation of about 500 billion U.S. dollars in one year! The bulk of this money is going to loan recipients (businesses that convince a bank to loan to them or individuals who get a mortgage based loan from the bank for their house). Those loan recipients have to pay the money back of course but a huge amount of what they pay back is handed to the commercial banks not to the government who is both responsible for our currency and badly needs the funds!

The banks mostly decide whether or not to provide a mortgage/loan based on some actuarial mathematics that are largely automated by computers these days. It would be trivial for the government to implement a loan/mortgage policy directly to its citizens using actuarial mathematics similar to those used by the banks. This has the potential to generate oodles of money for the government and I bet sticking it to the banks would be great electoral politics as long as you don’t cause an economic meltdown. Otherwise the government could cut the citizen a break by simply banning the charging of a markup on the interest rate charged on loan money that comes from the central bank.

I find it ironic that in Canada we call our 1 dollar coin the 'loonie'. Albeit because of the loon on the coin, but it sure seems appropriate when we look at how the money is created in general.

Jacob Levman