GDP and Inflation

Money Matters, Monumentally

Monday January 29, 2018 Konrad Hurren

Part three: Funny munny or foney money?

 

In our previous articles part 1 and part 2 we’ve briefly covered monetary history in NZ and how money obtains its value. Now, we get rather serious and identify the machinations of “fractional reserve banking”.

 

What is a bank?

 

A bank is actually really similar to a warehouse. Viz, you may pay a warehouse owner to store your commodities (maybe, although few of us really do this now), you can also pay a bank to store your commodities (your money, the most marketable commodity). In return the warehouse gives you a note that entitles the bearer to the goods upon redemption, banks do the same and we can call these notes “notes of promise”.

 

Further, you might say to someone with whom you wish to trade that you’d like to settle the trade using the warehouse note instead of writing a cheque or shipping gold/silver/salt to her. In this way warehouse receipts can become money substitutes.

 

In the same way, you may write someone a cheque that states essentially “pay the bearer some amount of gold/silver/salt.” We’re going to refer to money in terms of $ from now on for expediency.

 

Or, you may just use the “notes of promise” the bank creates for you to settle any liabilities. Just as you might with a “normal” warehouse note.

 

As a concrete example consider a new bank opening. Some people get together and pool their money and make a bank (let’s ignore capital and equipment). Then, luckily, they get some customers who want to deposit $3,000. In return the bank issues “notes of promise” to the money owners that entitle the owner to withdraw his money at any time (these equal $3,000).

 

So, in accounting terms the bank has:

 

Debit (asset) side: $3,000 cash

 

Credit (liability) side: $3,000 “notes of promise”

 

Nothing nefarious to see here. You might be wondering how this bank might make money. There will be fees associated with storage of the cash, additionally the bank can contract with people to borrow their money (so they cannot withdraw until a specified date) and then lend this out. Thus earning a differential interest amount.

 

In the real world of hampered markets and central banking

 

Same story as above, except this time the bank knows it can create money “from thin air”. Customers deposit $3,000 to this bank and receive “notes of promise” in return. The bank then is approached by some other customer who wants to borrow $500. The bank issues “notes of promise” to the customer for $500. Note that these go on the credit side as in the last example, so the accounts now read:

 

Debit (asset): $3,000 cash

 

Credit (liability): $3,500 “notes of promise”

 

How to make this balance? The bankers think for a second, then with a twinkle in their eye they say to the borrower “just give us an IOU”. And it is so. The bank’s accounts now have $3,500 on the debit side ($3,000 cash and $500 IOU) and $3,500 worth of “notes of promise” on the credit side.

 

The banks here have created $500 “out of thin air” there is no reserves of cash to back this up, just an IOU.

 

In the real world these “notes of promise” are issued by Treasury and have pictures of famous New Zealanders (and birds) on them.

 

We emphasise that anyone trading with the bank’s customers only sees the “notes of promise”. There is no way to tell if these are from the stock of “real” money or are “out of thin air”.

 

How does a bank work?

 

Well, in our world there exists a Reserve bank – backed by the power and the will of The State and legislation. The Reserve bank is there as a “lender of last resort”. When time comes for banks to clear the cheques of depositors they may will need to sell assets or borrow from other banks, this will put pressure on money market interest rates.

 

Without the existence of a Reserve bank lending money at the Official Cash Rate. Banks would need to borrow at ever higher rates from each other (or sell ever more of their assets) if they were to engage in large scale Fractional Reserve Banking. This implies potentially large losses. In the unhampered market (no central bank) this is enough to make the practise pretty much non-existent.

 

However, in our world, the Reserve bank has an interest rate target (the tool it uses to “target inflation”) and so is obligated to pump money to relieve the pressure on the money market rates. That the reserve bank’s role is to target inflation using… inflation is an irony lost to the misuse of the word “inflation”.

 

In effect the reserve bank acts to cartelize all the banks in the market and force them to act as one in the expansion of the money supply.

 

We’ve so far shown some neat data on the deterioration of purchasing power in New Zealand; identifying that it is increases in the money supply (inflation) which cause this deterioration. This inflation is brought about through fractional reserve banking, made possible only by the existence of a reserve bank.

 

Next, we describe how this inflation acts as a transfer of wealth from the rest of us to those who receive the “new money” first. This series serves as a primer for the penultimate article about what is over the horizon.