Monday, June 11, 2012

Fiat currency and banks

There are some people who believe that going back to the gold standard will save the world. It might indeed solve some problems but remember that most countries started on the gold (or silver) standard and have all, even the Swiss, come off it. There must be a reason. Quite often, it involved a war or two. So there must be problems that exist because of the gold standard that are solved by having a fiat currency.

But, still, even then, there are loads of people who get upset that "banks just create money". Sighs. Okay, in a fiat currency system, banks are required to hold assets to balance their liabilities. These assets can be all sorts of things: capital from shareholders, buildings, debts they are owed by other people or businesses. It's the last that seems to bother folks.

Let's look at it. I run a business - we are currently owed about £20k by various customers, about £5k of which is overdue. I am allowed to carry all of this £20k at 100% of nominal value on my books. Indeed, if I wish to write it off, I am supposed to show that I have taken due care to recover the debt before I can count it as a loss.

So, how does it work with a bank? Well, lets say you earn £2000 cash a month, and your outgoings are reasonably spread out. You are loaning your bank, in effect, £1000. What can the bank do with that £1000? Well, it could sit on the books as a cash asset. This is the modern equivalent of stuffing it under the mattress - say, a safety deposit box. It isn't the real business of a bank - that's lending money. Okay, now the government will say that the bank has to have a certain %age of that in "low risk, high liquidity" assets*. Let's call it 10% (which is about the right value.) The bank now has £900 of your money that it can lend out to somebody else. It does that - so it now holds a debt of £900. Let's look at the arithmetic. Assets = £100 low-risk stuff + £900 higher-risk stuff. Liabilities = £1000 to you. The bank is even. Okay, it will have to put some money aside for credit risk - the chance that it won't get the £900 back from its debtor so will have to pay you back out of shareholders' funds. But that's why banks charge different rates of interest. And have secured and non-secured loans - to manage that risk.

Now, let's say that that £900 is used to buy a car. And the seller happens to be at your bank. So he deposites the whole £900 to pay for his holiday next year. The bank now has £900 cash, £100 cash-like and £900 debt. Balanced out by a £1000 liability to you and a £900 liability to the car-seller. What does it do with the cash? Well, it lends it out. £90 into (hopefully not Greek or Spanish) government bonds. £810 to somebody who wants a new carpet. So it now has £190 bonds or cash and £1710 in debts owed. Liabilities - £1900. Balanced. 

There is no magic money tree. Every loan the bank has made has been funded by folding green stuff or its electronic equivalents being given to the bank. The same as if you were depositing gold or silver. All that is happening is that banks, like other businesses, are allowed to treat debts as assets.

What happens when it all goes wrong? Well, that's another post.

* Note that these include government bonds. And the Greek government was insisting until quite recently that Greek banks treated Greek government bonds in this way. Which was entirely logical but completely insane.

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