Money & Wealth: Part II

Off the keyboard of Monsta666

Discuss this article at the Money Table inside the Diner

Monetary terms

Below are a small set of terms that may prove useful for those unfamiliar with financial terminology:

Bonds – A form of loan (or more correctly debt security) where the party who issues the bond is the borrower (debtor) while the party that purchases and holds the bond is the lender (creditor). A bond will pay interest usually on a quarterly or annual basis and this interest is called a coupon or yield. Nearly all bonds mature after an agreed period of time at which point the principle on the loan is fully repaid. There are some rare instances where a bond never matures.The most commonly traded bonds are local/state government bonds and corporate bonds. There are some hybrid bonds where the bonds can be redeemed for stocks in a company. Bonds tend to offer less returns than stock but the returns are more reliable as they tend to be less influenced by market conditions.
Stocks – Are a form of equity where a party owns a share (a fraction of ownership) in a company. Shareholders are often entitled to quarterly or yearly earnings through dividends. While the level of returns in stocks is generally higher, stocks carry greater risks as they are more subject to market conditions. Unlike bonds, stocks do not mature and remain outstanding indefinitely unless the company goes bankrupt or its ownership model changes significantly.
Derivatives – Are contracts that derive their value from some other asset. For example a long-term future contract for a food item derives its value by what the value of food is perceived to be in the future. The most widely known derivative contracts are futures, forwards, option and swaps. Traditionally such contracts were used by farmers as means of insuring they received stable prices for the food they sold throughout the year to protect themselves from food prices which fluctuated quite dramatically during the year. A stable price would aid a farmer when it came to planning their future income and outgoings. In more recent years energy companies have heavily used these contracts for similar reasons.A few years prior to the financial crisis the derivatives market increased dramatically as banks began trading heavily in Repurchasing agreements (Repo) which are basically formal contracts to roll over existing debts. Collateralised Debt Obligations (CDO) which is a form of loan where 100s even 1000s of mortgage loans are bundled together and sold to other parties. Finally there are Credit Default Swaps (CDS) which is basically a form of insurance to protect the lender in case a party fails to meet its debt repayments. The issue with CDS is that the owner of a CDS is under no obligation to buy the product they are insuring against which leads to the moral dilemma where they have an incentive to make the counterparty default. To offer an analogy it would be like owning fire insurance for my neighbour’s house. Since I do not own the property I am insuring against I would suffer no loss (financial or material) from its burning and would only gain profit if a fire were started by “accident”.
Hypothecation –The process where a borrower offers collateral to secure a debt. Thus the lender “hypothetically” controls the asset should the borrower default. A common form of hypothecation would be mortgages.
Re-hypothecation – Is the process where the creditor resells the loan that was secured by collateral by the borrower. To take the example used above; the bank will resell the mortgage that you are paying off to another party and then take the proceeds from that sale. As a result the new party holds “hypothetical” ownership to the collateral, in this case the house. At least that is the theory; sometimes due to how contracts were written ownership of the loan/property can become a matter of dispute.

Main article

“The people must be helped to think naturally about money. They must be told what it is, and what makes it money, and what are the possible tricks of the present system which put nations and peoples under control of the few.” – Henry Ford, 1922[1]

In the first part of this series we explored the fundamental differences between wealth and money which described that at best; money is only a claim on wealth and is not wealth itself. In this second part we delve more into the actual mechanics of how our monetary system operates how it shapes our world and interacts with the underlying wealth that ultimately comes from the ecosystem.

Fractional reserve banking

It is perhaps one of the largest misconceptions that most of the money created in an economy comes from the central bank but this belief, even though it is promoted somewhat by various central bankers, is a false one. In fact most money creation occurs through commercial banks via the fractional reserve banking system. The system itself is largely counterintuitive in the sense that because the process generates money so easily it is rejected for being morally objectionable. Indeed this is exactly what John Kenneth Galbraith a former Economics professor in Harvard had to say about our monetary system:

“The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. The process by which banks create money is so simple the mind is repelled.” – John Kenneth Galbraith, (1975)[2]

So what is the fractional reserve system? In essence it is the process of how banks lend out money that is a multiple of the amount of deposits (or reserves) held in their vaults hence the term fractional reserve as the reserve amount is only a fraction of the total money supply. To make this clearer it is best to offer a real life example of a working process of this system in action. Suppose we had a fractional reserve system with a 10% reserve requirement. In this scenario the amount of money in circulation will be ten times greater than the amount of deposits held. In other words 90% of the money created will come from commercial banks through bank loans while the original $100 came from the central bank. The process occurs because when a person deposits $100 into a bank the bank will loan 90% of this deposit out and retain the remaining 10% as reserve. However in this process of loaning money out the money supply has increased to $190 and not $100 as one may initially suspect. This is because the extra credit issued does not come from the account of the depositor as commonly thought but is in fact money created out of thin air. This process of loaning new money while retaining the 10% reserve amount will be repeated numerous times until eventually the amount of money in circulation will be ten times greater than the reserve amount, in this case $1000. If this process sounds a little complicated then it may prove useful to watch this video:

Note: While this video does explain the process of fractional reserve banking well caution must be exercised against its conclusions made against the Fed. The primary influence on money supply comes from the commercial banks and the fractional reserve system and not the central bank. It should also be known that the free banking era was marked with less financial stability than the post Fed period (1913+) as there was no lender of last resort.

As a note while the example described above may sound dramatic in reality the reserve requirements for countries such as the UK is lower than this as the Bank of England does not actually set compulsory reserve requirements and reserves have been cited as being as low as 2.1% as of 2010 of the total money supply.[3] The table below illustrates how the money supply grows after the first person is given $100.

Transaction No: Amount deposited Amount lent out Reserves
1 100.00 90.00 10.00
2 90.00 81.00 9.00
3 81.00 72.90 8.10
4 72.90 65.61 7.29
5 65.61 59.05 6.56
6 59.05 53.14 5.90
7 53.14 47.83 5.31
8 47.83 43.05 4.78
9 43.05 38.74 4.30
10 38.74 34.87 3.87
Total 651.32 586.19 65.13
1000.00 900.00 100.00


Who owns the depositors money?

A simple question with a surprising answer and one that should definitely be noted in the case of bank runs. When someone deposits money into a commercial bank the deposited money is no longer the property of the depositor as the ownership of that money is transferred to the bank. What happens is the depositor becomes an uninsured creditor to the bank and owns some bank equity/shares or bank stock that the bank is obliged to pay back with cash.[4]While this may sound complicated what it really means is that if the bank went into a state of bankruptcy then the depositor is a mere uninsured creditor and unless their money is insured by the government which it will be (at least on paper) if the deposit is less than $/£100,000. If however the deposit is greater than this this amount then the depositor will be at the mercy of more senior creditors that will be paid first. It should finally be noted that the most senior creditors are the customers that deal with derivative contracts[5] which is mostly conducted by the too big to fail banks. Seeing as the notional value of those contracts is $639 trillion as of June 2012[6] it becomes questionable how much money any creditor below those senior creditors will receive considering this amount is a multiple of the global economy which is valued at around $70 trillion[7]

It is this fact why the banking system is inherently unstable because if people ever decided to withdraw their money in mass then the bank could not meet this demand as they do not have sufficient funds in their vaults.

The reason this system can remain viable however is because the banks know that people generally do not withdraw all their money at once. In fact they have found that if their reserves are sufficient to meet the demands of net withdrawals (that is deposits minus withdrawals) then they can remain solvent at least on an on-going basis. This last point is crucial because banks make most of their profits by loaning money so if a system can allow them to loan money by a multiple of the underlying value of deposits then it follows that their profits would increase by a multiple amount also. The important issue here is to match their reserve amount to that of net withdrawals and not total amount lent out (as commonly perceived). Banks must also make an assessment of the risks taken when extending credit as the capability of its lenders to payback loans issued by the bank will vary and if a bank can attract more creditworthy lenders then that will mean the bank’s capital (which is mostly loans) will be of higher quality.

Despite this safeguard and careful assessments of risk banks have gone bankrupt on a continual basis and this is especially true in a country without a central bank. The two main safeguards that are made against a bank run are interbank lending (notable examples include Federal Funds Rate, LIBOR and Euribor) where numerous banks can exchange loans to one another. These loans would serve to cover any surge in withdrawals that took an individual bank by surprise and would allow them to meet this extra demand until the situation returned to normal. It is only if withdrawals remained high for a protracted period of time or the problem was more systemic in nature that greater action would be warranted. The second and final line of defence against bank runs comes in the form of the central bank who acts as a lender of last resort.

Quantitative Easing

While the central bank has numerous tools to mitigate a bank run (they can lower the reserve requirements for example) the most powerful way of protecting bank is to engage in open market operations, more specifically the purchasing of bonds by issuing credit to the commercial banks themselves. If a central bank lends out money they are increasing the reserves of the commercial banks which allows them to meet their lending obligations (which is often an issue when many loans are no longer repaid). There are two notable points to remember in all this, unlike what is commonly depicted in the media, quantitative easing is not direct money printing. The central bank loans money to its clients (the commercial banks) in exchange for financial assets. In most cases the assets in question are government loans more commonly known as government bonds (or gilts in the UK) however these assets can take other forms with the most notable example being Mortgage Backed Securities (MBS).

This exchange of financial assets while often overlooked forms a crucial role in maintaining financial stability. If a central bank actively buys financial products such as sovereign bonds or MBS they are creating artificial demand for these products. As a result two things will happen. First the book value of those loans rises which strengthens the balance sheet (remember loans are assets to banks). As the value of these assets or collateral rises then the ability to repay existing debts will rise. More crucial however is the fact that interest paid on those loans decline allowing banks and governments to make interest payments more easily.

In fact it is these purchases and the orchestrated nature of quantitative easing (the central banks often give ample warning before undergoing such programs) that undermine one of the central tenets of central banking. That is many of the advanced economies have laws in place that prevent central banks from lending directly to the treasury or directly funding a government deficit. These measures have been put in place to prevent this form of intervention leading to runaway inflation as this money creation does not go into the wages of government employees which would act as a huge driver of inflation (this would be the case if it were paid to the treasury directly).

The central banks across the world however have in effect circumvented this rule as the commercial bank buys the government bonds from the treasury who then turns around and sells those bonds (which are likely worthless without this money printing) to the central bank. This dynamic of buying and selling bonds or other financial instruments that are almost worthless to central banks is not limited to bonds and occurs with other financial assets. In effect the central bank is acting like the big “bad bank” and is the party that buys all the bad or “loser loans” from the commercial banks that either no else will buy or will not buy in sufficient quantities to make the loans valuable or even viable. However what is significant in these transfers is that the liabilities of the debt repayments shift from the commercial banking sector onto the taxpayer.

It is likely that this dynamic has allowed governments and banks to remain solvent as this demand for loans created by quantitative easing has been chiefly responsible for keeping interest rates down. If these programs were stopped or worse the interest rates set by the central bank were raised then the rise in interest rates would likely render many economies and banks insolvent. The fact that countries such as the US, UK and Japan run high fiscal deficits means that every year the interest rate threshold to remain solvent will need to decline year after year unless these deficits can be closed.

The second important point – which IS highlighted by the media – is the actual transfer of credit. It is often said that quantitative easing will lead to mass inflation as this “printed money” will be added to the commercial banks reserves and the banks will then lend this new money out to businesses and people creating a huge rise in the money supply via the fractional reserve system mentioned earlier, the so called money-multiplier effect. While this theory sounds plausible the reality is this has not been the case. If we look at the total money supply we find that despite unprecedented amounts of quantitative easing (in the case of the US $85 billion a month) the total money supply has been increasing at slower rate than prior to the financial crisis:

So why the lack of money growth? The reason for this is the banks see few opportunities to make a profit in lending so instead they hang onto the money. This lack of lending is also reflected by the fact the velocity of money; that is the measurement of how quickly money is exchanging hands has declined markedly since the 2008 crisis and has plateaued since around 2011:

Nominal interest rates: Typical rate you will see in the brochure of a bank when it advertises its interest rates.

Real interest rates: Nominal interest rate – Inflation

If real interest rates become negative it creates the perverse situation where it effectively costs money to save while it pays to loan money. This occurs because the rate of inflation exceeds the returns made through interest. When borrowing the opposite will be true. Negative real interest rates benefit highly indebted parties at the expense of savers.

Saying all that it would be a mistake to think the money is simply laying in the banks vaults doing nothing. A lot of this newly issued credit is invested and goes towards the stock market and other forms of speculation. In fact it is these cash injections that have likely fuelled the large amount of asset inflation in the form of rising stock prices. If we look at various stock indices such as the Dow Jones, FTSE 100 and other stock indices as these stock markets have seen significant increases despite poor performances in the general economy (in fact these stock indices are performing more strongly than stock markets in more buoyant economies such as China).



US stock market:
 photo DowJoneslast5.png
US economy – Notice growth rates do not reflect gains made in stock market:
 photo GDP.png

GDP figures obtained from the Bureau of Economic Analysis.[9]

UK stock market – Notice FTSE 100 has recovered all gains since financial crisis started:
 photo _FTSE.png

UK economy – The same cannot be said of the UK economy which is still 3 percentage points below 2007 peak:
 photo UKGDPgrowth.png

This is not the only reason for the stock markets to rise. Another side-effect of quantitative easing is that the artificial demand created for bonds will cause bond yields to decline, so much so that bonds no longer offer good returns for investors. As a result investors will be forced to invest their money in more risky products such as stocks due to the fact that bonds, savings accounts and real estate do not offer good enough returns to beat the current rate of inflation. This issue of low returns is particularly problematic for low-risk pension plans but it is this forced investment into stocks that has also contributed to the recent large gains in major stock markets across the world.

It is my belief that the two factors described above have been the chief reasons why we have witnessed large gains in the stock market. Both these reasons have stemmed from the process of quantitative easing either directly through money entering these markets or indirectly by forcing investors to leave the bond market due to lower returns caused by interventions in the bond market. To me it seems unlikely that the gains in the stock markets are the result of strong fundamentals in the underlying economy as low or negative growth in the economy cannot justify the gains we have seen in the stock market. It is this combination of gains in the bond and stock market that have been a boon for the government, banks and pension funds.


Most money in the monetary system is created by commercial banks and not central banks therefore the supply of money is largely determined by the activities commercial banks engage in. This statement is supported by the fact that despite the central banks intervention at an unprecedented scale through various programs of quantitative easing the total money supply is not only increasing more slowly but the velocity of money is (number of exchanges made with the money) decreasing also. This is due to the commercial banks lack of lending having a greater influence than what the central banks are doing. This leads us to the issue of inflation and deflation. While it is commonly cited that further rounds of quantitative easing will inevitably lead us to a hyperinflation end-point we must recognise that the lack of lending and more significant, increasing amounts of bankruptcies and austerity measures implemented will lead to deflationary pressures as austerity, defaults all cut spending which reduces the money supply.

At this present moment of time the inflationary pressures applied by the central banks just about equal the deflationary forces that exist in the main economy. It is this combination of inflation/deflation forces that will make the final end-point more complicated and nuanced than what people will generally expect. Please read part four of this series to find out more about this issue. For observant readers you will notice that all forms of money creation involved the use of loans thus the statement: all money is loaned into existence becomes true. In part 3 we will examine the implications of having a debt based monetary system.


[1] = My life and work (pg. 179)
[2] = ‘Money: Whence it came, where it went’ (pg. 5)
[3] = Economics 12th Edition by Lipsey, R. G. and Chrystal, K. A. (2011) (Oxford University Press. pg. 455)
[4] = Banking Regulation of Uk and Us Financial Markets (pg. 83)
[5] =The Financial Crisis Inquiry Report: Official US government edition (pdf document: enter page 76 on pdf file is page 48 on actual report.)
[6] = Amounts outstanding of over-the-counter (OTC) derivatives by risk category and instrument (Bank of International Settlements – pdf file)
[7] = GDP ranking (World Bank – pdf file)
[8] = Remarks by Governor Ben S. Bernanke (Federal Reserve Board)
[9] = National Economic Accounts (Bureau of Economic Analysis)


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