Yes, I know that Jefferson said that, and in practical and historical terms he has largely been proven right. Karl Marx said a similar thing, though far more colourfully–if I can find the time, I’ll post it here one day.

But that doesn’t change what I see as the fact that there are just two types of monetary systems: debt money, and nothing.

I realise that there is an enormous literature on alternatives to debt-money, and an equally enormous literature portraying previous financial systems as being based on gold, or in some other way anchored to real production so that banks cannot “debase the currency”, etc. Even Milton Friedman’s monetarism was an attempt to control private credit creation.

The developing Post Keynesian - Circuitist - Schumpeterian school of thought to which I am a contributor sees these views as misguided: though debt-money has enormous problems, you can’t have a functional capitalist economic system without it.

An analogy here comes to mind from a comment in James Lovelock’s latest book, where as the non-orthodox contrarian he is, he takes a swipe at people who believe we should aspire to live a life without artificial food additives, etc., and who cite the carcinogenic properties of various man-made substances as evidence.

He points out that the number one cause of cancer on Planet Earth is … oxygen.

Cheers, Steve

“if the american people ever allow private banks to control the issue of their money, first by inflation and then by deflation, the banks and corporations that will grow up around them (around the banks), will deprive the people of their property until their children will wake up homless on the continent their fathers conquered.” -thomas jefferson

much of this trouble can be traced to our present “debt-money” system

Contrarian, have you read Fooled by Randomness? I’m currently reading The Black Swan, but frankly I don’t feel it has expanded the concept much. Where the original was a captivating, engaging read, full of meaty, real world examples and anecdotes that grabbed my attention and left me feeling like I’d some kind of revelation, the new book seems to be more meandering, less specific. At times even vague. I guess it’s not fair to judge a half-read book, and even half-read I rate it highly (just not THAT highly!).
If you haven’t read Fooled by Randomness, do yourself a favour. Cheers, F.

You may be surprised, but I do not necessarily disagree with you on that. With the proliferation of derivatives and CDOs, it is hardly surprising that money and credit creation is now largely out of the hands of the central bank. Nevertheless, the “deposit create loans” is useful for illustrating how the banking system works originally and thus, serve as a base of understanding the more complicated financial contraptions of today.

For me, for the purpose of investment, it isn’t really that crucial to delve deeply into the technical aspects of what drives credit creation first- deposits or loans. For one, we may not really know for sure which is the case (or in fact there is a mixture of cases). Philosophically, attempts to go to the bottom of this mystery may be what Nassim Nicholas Taleb said in his book, The Black Swan: The Impact of the Highly Improbable the human tendency to ‘platonify’ knowledge. I know I’m being abstract here, but there’s not enough space to give a deeper explanation on what I mean by this.

In today’s global financial system, money and credit expands when the central bank is willing to increase the supply of base money and people (and businesses) are willing *AND* able to borrow money. That ties in with my article, What makes monetary policy ‘loose’ or ‘tight?’. In today’s financial system, the “willing and able” part is mired deeply into the murky world of derivatives, CDOs and other dodgy financial engineering that not even central bankers fully understand (see How dangerous are credit derivatives?.

In short, I don’t necessarily disagree with Steve- I’m just agnostic about the “desposit create loans” or the “loans create deposits” views. My usage of the former is just for illustration purpose.

The money multiplier analysis effectively argues that the government has to firstly create “base money” before the fractional banking system can leverage that into credit money. Once this base money is deposited in a bank account, the money multiplier process begins. Basically, “deposits create loans, which creates money”.

That is the conventional case, accepted by most economists–but it is very hard to reconcile with both the data, and the abject failure of Monetarist policies to control the rate of growth of the money supply in the Thatcher/Reagan days.

There is an alternative analysis which says that credit is created “out of nothing”–an endogenous process. This says “loans create deposits and money”: the causation is reversed.

The analysis is rather technical in the first instance, but I’ve found a way to explain it using double entry book-keeping; I’ll aim to post that in August.

a) Is it true that under our current system, bank lending has no theoretical limit? Providing borrowers are keen to borrow at current rates

and banks keen to lend to borrowers, credit can go on expanding?

No. If the reserve ratio is 0%, then the theoretical upper limit on the amount of credit that can be created by banks is infinity. If the

reserve ratio is 10%, then the theoretical upper limit is 10 times.

b) How (exactly) does this work? I can’t seem to find a clear explanation of why/when/how the commercial banks do what in the same market

(ES?) that the RBA tools around in.

The central bank inject/drains money into the financial system through the purchase/sale of government securities in the market. Say, the RBA decides to injects money. It would go about by ‘printing’ money and buying government securities in the market with those ‘printed’ money. Therefore, the price of government securities will go up, which means its yields (interest rates) will go down.

Therefore, the RBA will supply/drain money into the system such that interest rates will arrive at the level that it wants.

Contrarian, at that link you’ve written:

“Monetary policy is considered “tight” if it reduces the quantity of money and credit. Conversely, it is considered “loose” if it the

quantity is increased.”
Are you talking about quantity relative to, say, income? Or absolute quantity?

In the absolute sense.

Wouldn’t 100% reserve and gold-backed banking require a painful period of adjustment (to put it mildly)? If a free market for credit pricing

is the goal, why not implement that without the others?

Yes, it will be an extremely painful adjustment- that’s why it is called ‘radical.’ But consider that more than 200 years ago till before the disruption of the First World War, the world is running in such a system and it works great.

I think I understand fractional reserve banking, but I can’t see why its necessarily a problem. If interest rates were priced by the market,

wouldn’t that be enough to prevent the excessive buildup of credit and the excessive bidding up of prices for unproductive assets? Wouldn’t

it be easier to live with the current system and just fix its flaws than throw it out?

Yes, you are right (to a certain degree) on that if “interest rates were priced by the market, wouldn’t that be enough to prevent the excessive buildup of credit and the excessive bidding up of prices for unproductive assets”

However, some Austrian School economists see the issue of the fractional reserve banking system as theft. Back in the old days when paper ‘money’ was just a warehouse receipt for gold, it is theft if the warehouse took out, say 90%, of the gold that you had just deposited for safe-keeping and lent it out to another person. What happen if that person defaulted in that 90% of your gold? The bank will be in trouble and you will lose 90% of your gold.

But today, with fiat money, this is not a problem. In a nightmare scenario of widespread defaults, the bank can always borrow the lost money from the central bank (who is called the “lender of last resort”), who in turn will print the money to lend it to the bank. This is what happens when central banks ‘inject liquidity’ into the system to maintain ‘confidence’ in the banking system. In such a system, don’t you agree that this remove the incentive for banks to lend prudently because there’s always the central bank to prop up bad debts and loans?

Also, in a fractional reserve banking system, if it is easy for bank to create credit, then it is also for credit to contract when people start withdrawing cash from the financial system. The only way to stop credit contraction is for the central bank to ‘print’ money to keep the banks afloat.

Thanks, I did. It didn’t quite sort me out though

I’ll try to be clearer:
a) Is it true that under our current system, bank lending has no theoretical limit? Providing borrowers are keen to borrow at current rates and banks keen to lend to borrowers, credit can go on expanding?

b) How (exactly) does this work? I can’t seem to find a clear explanation of why/when/how the commercial banks do what in the same market (ES?) that the RBA tools around in.

Contrarian, at that link you’ve written:
“Monetary policy is considered “tight” if it reduces the quantity of money and credit. Conversely, it is considered “loose” if it the quantity is increased.”
Are you talking about quantity relative to, say, income? Or absolute quantity?

Wouldn’t 100% reserve and gold-backed banking require a painful period of adjustment (to put it mildly)? If a free market for credit pricing is the goal, why not implement that without the others?

I think I understand fractional reserve banking, but I can’t see why its necessarily a problem. If interest rates were priced by the market, wouldn’t that be enough to prevent the excessive buildup of credit and the excessive bidding up of prices for unproductive assets? Wouldn’t it be easier to live with the current system and just fix its flaws than throw it out?

On the ‘printing of money’ issue, is it fair to say that the Reserve Bank allows the commercial banks to create as much credit as borrowers demand at the price set by the RBA? I’ve been involved in arguments before with people who ‘prove’ by pointing out that bank liabilities match assets, that the commercial banks don’t ‘create’ money, they are restricted to lending from their deposits.

Banks don’t ‘create’ money if we have 100% deposit banking. The problem is, we have a fractional reserve banking system, which allows bank to create credit from ‘nothing’. See 363 tons of US dollars to Iraq—how much money will eventually be multiplied into the economy?

Surely most money that is created through new loans will flow back to the banks as deposits or similar anyway? Am I on the right track here? The RBA, meanwhile, funds any shortfall by manipulating the open market for ES funds “to ensure that supply equals demand at the target cash rate”. In other words, they’ll create as much or as little new funds as the banks demand? So if demand for ES funds rises, so does supply, rather than price.

See What makes monetary policy ‘loose’ or ‘tight?’

I’m wondering what the alternative is. Is a dual approach to monetary policy all that’s needed? One where the reserve bank considers the outlook for inflation on the one hand, and weighs this against credit versus output on the other? A system where the cost of money would increase if credit growth deviated too far from a sustainable path?

One of the favourite but relatively radical alternatives proposed by *some* Austrian School economists is to revert to the classical gold standards with 100% deposit banking. Then, the market should price all interest rates, which means the abolishment of the central bank.

See What cause booms and busts? Introduction to the Austrian Business Cycle Theory

This is what I was trying to get a grasp of in an earlier thread. It appears to a non-economist such as myself that the argument is not about the origins or ills of money or credit growth, but rather the best way to cure a debt-induced recession/depression/deflation? The Austrians see a recession as inevitable under a government (or government proxy) controlled credit environment, and necessary to shake out malinvested and overinvested capital as quickly as possible so we can get back to business.

On the other hand, most mainstream modern economists believe that business cycles can and should be smoothed by monetary policy, that the response to an economic downturn should be the easing of interest rates. Such economists include reserve bankers ‘Helicopter’ Ben and Glenn Stevens. The latter of the two told us in 2003:

“I think it is generally accepted that, after an asset-price bust, the conduct of monetary policy is going to involve easing, and quite possible easing a lot. There is a potential issue of moral hazard here: namely that ‘bailing out’ market participants in some sense will create further incentives to gear up in the future, to the detriment of the economy’s long-term stability. […] I think when faced with a financial system and economy in distress, one just has to incur that risk.”

My personal view, based not on models or any intricate understanding of the mechanics of the economy, is that the easy-money policy approach might be more of band-aid solution than a cure. I don’t know which path would result in the best outcome for the greatest number of people over a very long time frame. But, I think the problems associated with the sharemarket and property boom in the 1980s / early 90s, the sharemarket boom of the late 90s are still partly with us (and of the recent house price boom of course). After each event (okay, not yet since the housing boom hasn’t burst), interest rates were reduced to try to keep the economy on a steady growth path and the excesses of debt were never truly unwound.

In contrast, during the boom and bust of the 1880s/90s or the 1920s/30s, bank credit declined after the event in almost symmetrical fashion, ending pretty much back where it started as a proportion of GDP. What’s more, as suggested by Mr Stevens in the quote above, the repeated bailing-out of market players only encourages them (and many more) to take on even more leverage in expectation of the next boom. I wonder whether by preventing credit from fully contracting post-boom we’ve simply saved up, delayed, and enlarged a whole lot of problems for the future? If the interventionist approach ceases to work at some point we’ll be forced to face the accumulated problems.

Back to the source of the problem. Surely the reason for the unsustainable trend in debt is that interest rates have been too low, and money too cheap? The Austrians would have us (I think) tie our money to a good of relatively fixed supply. This would naturally lead to interest rates rising when demand for credit was growing and falling when demand was falling. Instead is we have interest rates that move on the RBA’s inflation expectations. What we’ve seen recently (as during the lead up to the Great Depression) is that it’s perfectly possible for inflation to remain low even while credit (and money supply) growth gets completely out of hand.

On the ‘printing of money’ issue, is it fair to say that the Reserve Bank allows the commercial banks to create as much credit as borrowers demand at the price set by the RBA? I’ve been involved in arguments before with people who ‘prove’ by pointing out that bank liabilities match assets, that the commercial banks don’t ‘create’ money, they are restricted to lending from their deposits.

Surely most money that is created through new loans will flow back to the banks as deposits or similar anyway? Am I on the right track here? The RBA, meanwhile, funds any shortfall by manipulating the open market for ES funds “to ensure that supply equals demand at the target cash rate”. In other words, they’ll create as much or as little new funds as the banks demand? So if demand for ES funds rises, so does supply, rather than price.

Hmm. The more I think about this the less I understand. I’d appreciate any pointers or corrections…

I’m wondering what the alternative is. Is a dual approach to monetary policy all that’s needed? One where the reserve bank considers the outlook for inflation on the one hand, and weighs this against credit versus output on the other? A system where the cost of money would increase if credit growth deviated too far from a sustainable path?

I am sure you will all be very happy to know that after the hiccups of the last few years, we can now settle down to an average increase in house prices of approximately 10+ to 12%+ per annum, for the next five years. (The 100 or so suburbs shown ranged from 13%+ to 10%+ for the next 8 years).

I did a couple of simple calcs, and if this comes to pass, house prices will appreciate by 60% to 80% while wages grow by 16 to 22% (3% to 4% over the 5 year period). It got even more ridiculous over the 8 year period.

I’d like to see the details behind their reasoning, I can’t see immigration having that impact, or wages growth (unless it is associated with massive inflation, in which case getting a loan may be pretty unpleasant). Anyone have any thoughts??

It looks a bit “magic pudding” like to me.

Obviously you are on the wrong track Steve.

Does anyone have any links to historical house prices, and to monetary expansion. I would like to chart asset prices against monetary expansion, as I have a theory that CPI is low as assets appear to be excluded from the calculation, and the additional money and credit in the economy tends to flow into inflating asset prices.