Help a Drywallhanger understand money

February 19, 2009 9:29 AM

First let me say I'am ignorant when it comes to economics, but I'd like to have a better understand of it. With that in mind this clip makes sense to me but I also understand it flys in the face of everything held to be sensible about modern economics. Help me understand. Thanks.
posted by nola to work & money (8 comments total)

http://en.wikipedia.org/wiki/Fractional_reserve_banking
posted by monju_bosatsu at 9:52 AM on February 19

Fractional reserve banking is a bizarre conception. I came across the following re-interpretation recently and thought it was helpful (via):

...But banks do not take deposits and loan them out. In fact, banks make loans first and then those loans become deposits. Remember — loans create deposits, deposits do not "enable" loans.

Banks, by way of their Federal charter, can expand both sides of their balance sheet at will, subject to capital requirements. This money is created ex-nihilo, but always nets out to zero in the private sector, as each (private) asset that a bank creates must be matched by a (private) liability. Government can create money outside of the system, but banks always need to net out and balance the balance sheet.

People believe that fractional reserve banking, in some weird way, has banks taking deposits, multiplying it (through what seems like a strange and fraudulent process), and then making a larger quantity of loans. In fact, banks make whatever loans they think make sense from a credit perspective, and then borrow the money they need from the interbank market to meet their reserve requirements. If the banking sector as a whole is net short of deposits, it can borrow the extra money it needs from the Fed. If you think this is a weird and pointless regulation you are correct. Canada, for example, has no reserve requirements and yet seems to have a banking sector. The quantity banks can loan out is constrained by capital requirements and credit assessments.

posted by mullacc at 10:18 AM on February 19 [1 favorite has favorites]

These two This American Life episodes go a long way towards explaining the mechanics behind the current economic meltdown. Good listening for non-economists
posted by dydecker at 10:21 AM on February 19

The Guardian recently did a nice slide piece on this:

Financial Pyramid Scheme Explained
posted by occidental at 2:02 PM on February 19

The reason you don't understand it is because they're framing it in a way to promote abolishing fractional reserve banking. Fractional reserve banking is the process of borrowing money at a low rate in the form of savings accounts and certificates of deposits, and investing most of it in mortgages and other high interest loans. This is sensible on it's face, but for the big scary word "inflation".

I've had discussions with internet crazies who've been certain that fractional reserve was destroying the dollar, but they'd be okay with some alternative where the banks only lent out a percentage of deposits (which is exactly what they do).

A similar thing happens in simple spending. If I spend twenty dollars in exchange for a DVD, a lot of people have more money to spend in the economy. These people will invest in more inventory, hire more workers, etc, leading to a spiral that raises nominal GDP. The velocity of money is as important as the money supply itself, and fractional reserve crazies ignore this.
posted by pwnguin at 3:17 PM on February 19

If you have 47 minutes, this will illustrate the process banks go through to create money.

Money as Debt

The video is well put together. Every high-schooler should learn this
posted by iurodivii at 2:31 PM on February 20

I'm no expert, but I think iurodivii's video link is wrong (and your original video, OP, alludes to the same thing), in at least one key point. About 15 minutes or so in, it makes the claim that a 1/10 reserve requirement can multiply $1,111.12 into about $100,000 of new money by multiplying deposits, loaning out, getting new deposits from the loans, multiplying, loaning out, etc. But the more I work it out in my head and on paper the less it seems possible. And if it messes up a key thing like that, I don't know how much to trust the rest of the video.

Anyway, here's my thinking. Let's consider an example bank which, as in the video, gets a $1,111.12 deposit and see what happens. We'll say people have already deposited $10,000 into it. (The video uses a brand new bank in its example, but that doesn't work as we'll see shortly).

The bank has $10,000 in deposits, which it has put in its reserves. This means, since the reserve requirement is 1/10, it can have outstanding loans of up to $90,000. But remember what exactly a loan is: it gives that person full access to money. He can write a check based on it, withdraw it from an ATM, whatever. That means the bank is responsible for having access to $100,000.

So a quick summary of the state of the bank before we consider the $1,111.12 deposit:
Reserves: $10,000
Responsible For: $100,000

(The bank has $10,000 in its reserves from deposits or investors or whatever. Based on this, it has approved loans to people of $90,000. The bank is responsible for paying back its depositors if they walk up to an ATM or write a check, as well as for honoring the loans it has set up. So altogether, with $10,000 worth of deposits and $90,000 worth of loans to honor, the bank has set up a system where people feel like they can retrieve $100,000 from it. This is more than is actually in the bank, but the reserve requirement is just 10%, which this bank meets: Reserves / Responsible For = 10,000/100,000 = 10%.)

Let's begin. Someone deposits $1111.12 into the bank, which gets added to the reserves. Now, the bank can loan out MORE than that, since the reserve requirement is 10%, so it approves a new $10,000 loan to someone wanting to buy a used car (as in the video), which it is now obligated to pay should the man want it. Also, should the original depositor of $1,111.12 want his money back, the bank is responsible for that, too. So:
Reserves: $10,000 + $1,111.12 = $11,111.12
Responsible For: $100,000 + $1,111.12 + $10,000 = $111,111.12

If we check the bank's reserve ratio, we see 11,111.12 / 111,111.12 = 10%, so the bank is all set. The bank has just created out of thin air, about $9000! So far the video is right, but here's where it goes wrong.

Notice that the $10,000 loan for the new car was created right into an account for the person taking out the loan. So he has access to the money, but he doesn't have the money yet. Now let's say it's time for him to actually buy the used car, so he withdraws his $10,000 from an ATM (or gets a money order, or writes a personal check, or whatever), to pay the person with the car. When he does this, the bank has to take the money from the reserves since that's where the bank's real money is. So see what happens:
Reserves: $11,111.12 - $10,000 = $1,111.12
Responsible For: $111,111.12 - $10,000 = $101,111.12

(The bank's responsibilities decrease by $10,000 as well, since it has now given the money to the guy who took out the loan for the car. The bank doesn't have to honor any more requests for money from him. Also notice this is why we couldn't use a brand new bank, like in the video. A brand new bank started with $1,111.12 in reserves, wouldn't be able to give the $10,000 to the person!)

But, uh oh, something shocking has happened. Let's check the bank's reserve ratio of Reserves / Responsible For, which is $1,111.12 / $101,111.12 = 1.1%! The reserve ratio has plummeted from the required 10%, and the government will now swoop in and close the bank.

Now, if the person who sold the car, happened to be a customer of this same bank, then the bank might still be okay. The person who sold the car now has $10,000 so he heads over to his bank (this one) and deposits it. And lo and behold, see what happens, the banks reserves go right back up, and the bank is now responsible for this new depositor's money should he want it back:
Reserves: $1,111.12 + $10,000 = $11,111.12
Responsible For: $101,111.12 + $10,000 = $111,111.12

Ta-da! The reserve ratio is back to $11,111.12 / 111,111.12 = 10%. The bank squeaks by. However, it certainly is not able to take this person's deposit and loan out a ton of new money based on it, like the video says.

So, in conclusion: I think the video is wrong about a $1,111.12 deposit being able to get multiplied, loaned out, have those loans come in as deposits, multiplied, loaned out, etc, on and on creating more than $100,000 of new money. With the reserve requirement at 1/10, the banking system can turn each $1 into $10, but that's it. Similarly, if the reserve requirement were 1/5, then it could turn each $1 into $5, and so on. The video neglects to consider the effect of actually withdrawing the money from the loans the bank makes.

By the way, it could help to know the technical terms for what I just went over, in case you wanted to learn more. The proper term for "Responsible For" is "liabilities". And we just went over the bank's very simplified "balance sheet". For much more detail, look into something like Wikipedia's article on Double Entry Bookkeeping. However, I'm not an accountant or banker or anything, and this is just what I've gathered from the internet, so take what I say with a grain of salt...
posted by losvedir at 3:51 PM on February 22

I have found that there is a blue page on this video here

losvedir, this comment is similar to yours.

Which is clarified by this. The big thing here is that it is not a single bank creating that much money, but that much money being created in the banking system.

Then here, Malor seems to split our differences, losvedir, pointing out how a single bank wouldn't make a single loan to bankrupt it, but this doesn't stop the bank from making lots of little loans which continue increasing the money supply.

I must admit you have me doubting some of the efficacy of the video, but that's been debated quite a bit in the link I started with, so i'll leave it at that. I appreciate you calling me on this and getting me to look at both sides of it. I certainly didn't post it to push a conspiracy theory.
posted by iurodivii at 5:57 PM on February 22