Showing posts with label after the music stopped. Show all posts
Showing posts with label after the music stopped. Show all posts

Tuesday, 19 December 2017

How Is Money Created?

Money isn't just pixel dust! 

In an earlier post I described money as “pixel dust.” I was being cute—way too cute! Sometimes an analogy can hide much more than it reveals. Money is not created by Tinker Bell, though I did feel a bit smug upon realizing that the writers of the Zeitgeist film series repeated my observation that when you take out a bank loan you create that debt out of nothing.

Banks have the right to create money, but they need your help

The bank does not have the money it is lending you. Stop and think about that for a moment, because it is the answer to the question “how is money created?” As more and more people struggle to understand bitcoin, the fact that money is just a way of recording debt is starting to sink in. When I googled the question “how is money created?” I was surprised by the number of sites covering the question—the number of people who knew the answer. I found myself asking, as I often do, how could I not know this? Shouldn’t every ten-year-old know the answer to this question?  Every time you take out a loan for a house or a car or an education, or buy a cheeseburger with a credit card, you create money--those pixels on a computer screen somewhere that are the reason you work and save and struggle.

The Federal Reserve gives banks the right to create money

In the USA the Treasury prints the money, but the amount of printed money is less than three percent of the total money supply in the system. Actually no-one really knows how much digital debt (i.e. money) there is floating around on the internet and in the intranet systems of all the banks and financial institutions in the world. We know, as I pointed out in my earlier post, there are 1.35 trillion US dollars in circulation (i.e., paper money), but the US debt is 18 trillion dollars. The unregulated derivatives market (the one that caused the crash of 2008) is believed to be worth between 710 trillion and 1.2 quadrillion dollars. To answer the question how much US money exists in the world today (remember money is just a measurement of debt), you need to add up all these numbers: 1.35 trillion plus 18 trillion plus (to be conservative) 710 trillion.  In total, a conservative estimate is that there are  729.35 trillion US dollars in circulation right now. How was all this money created?

The rules for creating money

There is an exchange of paper but, basically, the US Treasury gives it to the Federal Reserve. The Federal Reserve then distributes the money to 12 Reserve Banks across the country which in turn pass the money onto private banks. So how does so much money get produced?  We've been here before: leverage.  It's all about the leverage ratio.  

This graphic (above), which I found online, does a nice job of showing how the money flows in what is known as the "fractal reserve banking" system.  "Fractal" (aka "fractional") means that the banks get a fraction of the amount that they are allowed to lend out, so it really boils down to leverage. Descriptions of the "fractal system" make it sound as if the amount of leverage in the system is quite modest, but as Blinder (who you might remember was a VP in the Federal Reserve) points out, in After the Music Stopped, financial institutions figured out ways to create synthetic leverage ratios of up to 40%.  Let me remind you of what a 40% leverage ratio means.  A 4% leverage ratio means a bank with $1 can lend out $25,  a 40% leverage ratio means that a bank with $1 can lend out $250--250 times more than it actually has.

What is the US Federal Reserve? 

The Federal Reserve is the moolah machine, the institution that creates money and runs the monetary system.  It is the model for and has tentacles into just about every central bank in every country in the world.  The cynical, conspiratorial answer to the question is that the Fed is a bunch of bankers, a cabal of the CEOs from the biggest banks and financial institutions in the world. According to the Zeitgeist movement, all the ways that we might imagine the world is being run--politics, religion, economics--are distractions, cover-ups, window dressing.  The only real power is the monetary system which remains hidden behind the activities of governments, religions, and all movement of goods and services.  If you ask why the USA is constantly at war with someone or something, the Zeitgeist answer is that nothing feeds the monetary system better, profiting and empowering those closest to the system, than warfare. Even conservatives acknowledge that money is the life-blood of the economic system, and nothing pumps more spending, borrowing and debt (i.e., money) into the system than a war.

graphic of Federal Reserve System

Who owns the Federal Reserve?

This may seem like a strange, dumb, childlike question, but as I have attempted to get a handle on how the system works, I understand perfectly how we end up at this question.  The pervasive suspicion that the Fed is owned and run by self-serving financial titans is hard to dismiss.  In her book Plutocrats, Chrystia Freeland notes a study on the incomes of Harvard University graduates showing a "split between bankers and everyone else, with financiers earning 195 percent more than their classmates." Harvard grads aspiring to become part of the 1% of the 1% have figured out that being connected to the monetary system is the way to do it. Certainly Jamie Dimon, a card-carrying member of the .1%, CEO of Morgan Chase, the largest bank in the USA, being a member of the board of the New York Federal Reserve has got to have the average wage-earner wondering "what the fuck! how is that possible?"

The official answer is that the Federal Reserve is “a blend of public and private characteristics.” Historically the network of "reserve banks" was created in 1910 at a meeting of private bankers on Jekyll Island (yes, it's a real place; I played golf there once in the 60s).  The idea that the entire monetary system would be run by unsupervised private bankers was unacceptable to Democrats; consequently, it was eventually agreed that the Chair of the Federal Reserve and the seven members of the Board would be chosen by the President of the USA and ratified by Congress. They all inevitably have strong connections to the world of banking and finance. As you work your way through the layers of administration, through the lip service and platitudes, the Federal Reserve does seem to be more and more a system run by banks for banks—despite repeated claims that the objective of the system is “to promote the effective operation of the U.S. economy and, more generally, the public interest.”

There are three kinds of answer to the question "Who owns the Federal Reserve?"

  1. The historical, conspiracy-inclined answer is that the Federal Reserve is owned by eight families:

  1. The official answer is “The Federal Reserve System is not 'owned' by anyone. Although parts of the Federal Reserve System share some characteristics with private-sector entities, the Federal Reserve was established to serve the public interest.”

  1. The third answer, on the other hand, is “The Fed is privately owned. Its shareholders are private banks.”

Whatever answer you accept, it seems clear that the much mocked concept of "trickle-down economics" is beside the point. We live, without much question, in a trickle-down monetary system.

Tuesday, 8 August 2017

What Is Money?

The system runs on borrowed money

The cliché that “The system runs on borrowed money” is well known.  You might imagine that you are somehow removed from that “system.”  Whether you are aware or not, your country, state or province, your school, your job, your church, your city, and your household are all run on borrowed money.  Nonetheless, “borrowed money” is a funny/peculiar expression because it is redundant.  There is no other kind of money.

What is money?  Experts aren't sure.

Reading Graeber’s Debt:  The First 5000 Years I was bemused to discover that there is no consensus among the experts on what exactly money is.  (See   When Should You Repay Your Student Loan? ) Of course, we all know what money is, but it is one of those obvious, everyday concepts that makes perfect common sense until you start to think about it.

IOU or Commodity?

Historically, the debate has been between seeing money as a commodity like gold or silver (something that has a value) or viewing it as an IOU, a promise to pay issued by the government of a particular country.  These days money is either paper or, more likely, pixels on someone’s computer screen—nothing of value in itself.

Money:  Without the gold standard, a debt that can never be paid.

However, if money is an IOU, it is a very strange kind of debt because no-one ever expects it to be paid.  (In the old days, countries were expected to have a supply of gold in storage—the “gold standard”—to back up their currency and, in theory, you could request an exchange of paper money for gold.  Those days are long gone.  (See   When Should You Repay Your Student Loan? .)

Money is simply a system of measurement

If money isn’t a commodity and it isn’t an IOU, what is it?  Graeber points out that the dominant theory in major economies like those of the USA and Germany—and I must confess it has taken me a long time to get my head around this idea—is that money is just a measurement system like feet and inches or litres and cubic centimetres. 

“Credit Theorists insisted that money is not a commodity but an accounting tool.  In other words, it is not a ‘thing’ at all. You can no more touch a dollar or a Deutschmark than you can touch an hour or a cubic centimetre.”

Money is a measurement of debt.

This is where the idea of “borrowing money” starts to get strange.  If money is just a measuring tool, imagine that you owe your buddy Georges 100 yards or you borrowed 300 miles from the bank to buy a house.  A hundred yards of what? Three hundred miles of what?  

Graeber writes:

"The obvious next question is:  If money is just a yardstick, what then does it measure?  The answer was simple:  debt."

The leverage ratio:  Why money doesn't really exist

“Borrowed money,” then, is just a way of saying “borrowed debt” or, more precisely, "a borrowed quantity of borrowing."  Once you’ve grasped this concept everything else in the financial and banking system begins to make sense—sort of.  As I’ve pointed out a couple of times, the mainstream, conservative banking system uses a leverage ratio of 4%; that is, 1 to 25,  meaning if the bank has 1 million dollars, it can lend out 25 million or 25 times more than it actually has.  “Actually has” (in the previous sentence) doesn’t mean to possess in a physical sense because as we have just learned money is “not a thing at all” so “has” does not apply in a physical sense.

When you borrow, you create money, which is the measurement of your debt

To trace the chain of “borrowed money” backward:  if you get a mortgage from the bank for $300,000, you will never get to see or touch or smell that money, but it is understood that you now have 300,000 dollars (i.e., money = debt).  You don’t have the money in an ontological sense (that is, in the sense that it actually exists), but you and the banks have an understanding.  

The more we “follow the money” the more imaginary and less real money becomes.  Following the leverage rules, it is understood that the bank does not have (in any sense of the word "have") the money it is lending you.  It is even understood that the bank has no understanding with anyone about the $300,000 you are borrowing prior to you borrowing it. Your $300,000 mortgage debt is created out of nothing, out of pure imagination.  It is a debt which you now owe to the bank.  It only exists as a piece of paper which you signed, meaning you created it for the bank's benefit out of nothing and which, by the way, the bank can turn around and sell or keep and claim as an asset in its bookkeeping. 

Synthetic leverage: how $1 becomes $40

In After the Music Stopped:  The Financial Crisis, the Response and the Work Ahead, Alan S. Blinder, an economist and former vice-president at the Federal Reserve, is adamant that “We need a financial system with much less leverage” (his italics, page 55).  Banks may give the impression on their books that they are leveraged to a conservative ratio of 1 to 10 but, as Blinder points out, the largest investment banks in the USA were creating “synthetic leverage” (using leverage to invest in something that is also leveraged; therefore leverage on top of leverage) to create leverage ratios of up to 1 to 40. 

Leverage and bankruptcy

If you want to understand what people are saying when they claim that the financial system was near collapse in 2008, consider a couple of salient facts.  The five companies that Blinder is talking about above—Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs—were the five largest in the USA.  Goldman Sachs, according to a French documentary I watched recently, has greater assets than the country of France (Goldman Sachs had $1.12 trillion in assets in 2007 according to Blinder).  Lehman Brothers, with assets of $691 billion, was allowed to go bankrupt.  To avoid bankruptcy, Merrill Lynch, with assets of $1.02 trillion, was forced to merge into the Bank of America.  As bankruptcy approached, Bear Sterns, with assets of 395 billion, was bought up, under government pressure, by JP Morgan Chase.  With these kinds of assets, how is it possible that these companies faced bankruptcy and needed government bailouts? 

The simplest answer is that no matter how rich you are if you are lending 40 times more than you have on paper (or in pixels, if you prefer) then a 2.5% mishap can send you spiralling into bankruptcy.  Think about it.  You have a billion dollars on paper, so you lend 20 of your friends 2 billion each.  One of those friends screws up and comes to tell you that he can’t pay you the 2 billion.  He’s bankrupt.  Guess what, so are you now.  Remember you only had a billion dollars on paper (in pixels), so now you can’t claim that you have those pixels anymore.   But are you really bankrupt now?  Sure you can’t say you “have” a billion dollars anymore (whatever “have” means in this context), in fact, you are a billion dollars in the hole.  According to the banking rules, you can’t lend out any more money because you don’t “have” any money to leverage—which is a problem if you are a bank because lending money is what banks do.  However, since money is just a measurement of debt, you still “have” the other 38 billion that you lent to your other 19 friends—don’t you?

Zombie Banks [Updated Nov. 3, 2018]

Listening to Yanis Varoufakis, former Greek Finance Minister, I learned there is an expression for what I described [above] a year ago:  Zombie Banks.  When banks no longer have the cash, the liquidity, the seed money, the "pixel dust," or whatever you want to call the million dollars that allows them to lend out 25 million, they stop lending money.  "Lending money" is the only reason for a bank to exist.  The bank is dead, insolvent, bankrupt, a zombie, but it continues to exist by receiving money from the national treasury, from taxpayers, which it hoards to itself to preserve the illusion that it is still a functioning bank.

High finance is like musical chairs until the music stops

The money game is a game of pretend.  The game only works if everyone believes or, as we say in literary studies, “suspends disbelief.” The game starts to fall apart when too many people start to notice that a billion-dollar or a trillion-dollar company doesn’t seem to have any money. You win the game by pretending that you “have” the money, even when it becomes obvious that no-one “has” the money.  All we have is the understanding that we all owe each other and the debt is measured in dollars or pesos or euros, etc, which is fine as long as we all understand the game and follow the same rules.


In my previous post, I described money as “pixy dust”—the magic stuff that Tinker Bell spreads with her wand in Peter Pan.  It wasn’t a metaphor that I thought about very much, but on second thought I’m a bit shocked by how accurate, how close to reality, that metaphor is.  Realizing that money is a kind of strange fiction that we have been convinced is the ultimate reality answers some of the questions I have asked in the past.  How is it possible that the USA is 17 trillion dollars in debt?  That the USA owes more American dollars than actually exist in circulation?  That every country in the world is in debt?  That the unregulated “derivatives” market is said to be between 700 trillion and 1.2 quadrillion dollars?  Since all these numbers are measurements of something that doesn’t really exist, they have no limits.  Nonetheless, I shouldn’t have called money “pixy dust.”  I really wish I had called it “pixel dust” the first time.  "Money is pixel dust!"  Spread it around!

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