by Keith Weiner
My articles My offerMy siteAbout meMy videosMy books
Follow on:LinkedINTwitterSeeking AlphaFacebookAmazonGoogle +
There is a populist idea of money printing. The idea is that banks can just print what they want, enriching themselves in a massive fraud. But, does it really work this way?
Let’s start with a simple case, which is clearly not money printing. We will build a series of examples by adding one element at a time, working our way up to banks, and the central bank. Then we can examine this idea of printing.
Henry Homeowner finds the perfect house, goes to a bank and gets a mortgage. He is clearly not printing (the bank isn’t printing what it lends to him either, so please bear with me until the end). This example illustrates the concept of the balance sheet. Henry did not get one penny richer merely by borrowing to buy the house. It is true that he now has a house, an asset he did not own previously. However, the house is balanced by a mortgage, a liability he didn’t have before, either.
Next is Barry Bondholder, who gets a loan to buy a bond. Now he has an asset (the bond) and a liability (the loan). Would anyone say that Barry printed money? Barry is only different from Henry, in that he bought a bond instead of a house.
Next, consider the case of Frank Flipper. He takes out a balloon mortgage to buy a house. He paints over the olive drab walls, and adds some new carpet without cat pee. He sells the house for a profit, and repays the mortgage. Then he does it again. Is Frank printing money while he flips houses? Frank differs from Henry, in that he has to sell the asset to repay his short-term funding.
Frank’s brother, Magnus, scales up Frank’s business. He sets up a process with the bank to automate borrowing and repaying. Funding the mortgage to buy a house is as simple as pressing a button. When he sells, another button repays the mortgage. He develops such high turnover, that he is always buying a new one just as he is selling an old one. The loan repayment of one replenishes his credit, just in time to get the next one. Is Magnus printing money? Magnus is different from Frank, because his good credit persuades the bank to give him discretion to initiate his own loans.
Next let’s look at Bob Banker, Barry Bondholder’s cousin. Bob sets up a credit line to grow his bond business. When he finds a good bond, he can hit a button to borrow the funds to buy it. Would you say that he’s printing money? Like Magnus, Bob can borrow what he wants.
Bob’s son, Morgan, expands the family bond business by borrowing from retail savers and corporations. Does Morgan finally cross the threshold into money printing? Morgan is different from the others. Morgan’s business is a bank, using depositor money
Finally, let’s look at Bill Trader. His firm buys and sells Morgan Banker’s debt. He is a market maker, and his trading provides liquidity to Banker debt paper. He is so successful, that wholesalers begin to accept it in payment of their invoices, because it suits them better than the alternatives. Does Bill turn Morgan into a money printer?
These examples could all take place in a free market, but unfortunately, we don’t have one. We have central banks. A central bank is similar to Henry, in that it issues liabilities to fund the purchase of assets. Like Barry, the central bank does not deal in houses, but bonds. Like Magnus and Bob, the central bank has discretion to issue liabilities whenever it wants to buy an asset.
A central bank is quite different, but not because it can print money. Unlike the wholesalers who accepted Banker paper, creditors today accept central bank liabilities only because they are forced to. Central banks have no incentive for prudence, as Bill and Morgan did. The law gives them cover to dispense with any need for care, or even honest dealing. Demand for central bank debt paper is seemingly unlimited, at least so far.
The central bank is not printing, but borrowing. It does not get anything for free, but merely expands its balance sheet. It has a new liability to balance its new asset. In our banking system, there is no such thing as printing. Also, despite popular misconception, the debt paper of the central bank is not money, but credit. We’ll let an expert banker give the proper definition.
“Money is gold, and nothing else,” said John Pierpont Morgan, in his testimony before Congress in 1912.
4 comments
Skip to comment form ↓
Larry Gies
2015-12-30 at 05:18 (UTC 2) Link to this comment
Bank accounting entries for transactions in first and second examples:
Notes Receivable. €xxx,xxx
Demand Deposits €xxx,xxx
Henry and Barry have €xxx,xxx in their checking accounts. Where did their money to purchase house/bonds come from?
Keith Weiner
2015-12-30 at 22:57 (UTC 2) Link to this comment
Let’s walk through the mechanics. It’s important to accurately trace the flows.
When you take out a mortgage to buy a house, you don’t get cash in your checking account. You get a house (and a mortgage liability to match). The seller of the house gets cash in his checking account.
A more specific question would be: what is that cash? Is it gold? No. Is it physical, printed Fed notes? No. It is a bank liability.
This leads to the next question. What gives the bank the power to issue liabilities at its own discretion? In a free market, it is only due to the bank’s good credit. In legal tender law and banking regulation, it’s the power of the state.
One way of looking at this is that the bank is not restricted to deposits as its only source of funding (i.e. liabilities) and cash as its ownly backing (i.e. assets). It can also have a liability to the home sellers (or his bank, more precisely) and it can also have an asset that is a mortgage.
Larry Gies
2015-12-30 at 23:35 (UTC 2) Link to this comment
Keith Weiner wrote in the above: “When you take out a mortgage to buy a house, you don’t get cash in your checking account.”
Okay then, you own your home free and clear or at least have equity because the dwelling is valued greater than encumbrances. You give a first or subordinate mortgage to the bank in return for credit to your demand deposit/checking account.
On the bank balance sheet Mortgage Receivable increases (Debit) $xx,xxx and your checking account balance increases (Credit) $xx,xxx.
The money supply—demand deposits—increased $xx,xxx.
Where did that money come from?
Keith Weiner
2015-12-30 at 23:41 (UTC 2) Link to this comment
“Okay then, you own your home free and clear…”
No, you own the home (asset) and owe the mortgage (liability).
“have equity because the dwelling is valued greater than encumbrances.”
If the bid in the market is greater than your mortgage, then you have positive equity. This is not cash (until you sell).
“You give a first or subordinate mortgage to the bank in return for credit to your demand deposit/checking account.”
OK, you borrow against the equity. So the bank credits your account. This credit is your asset, and that can confuse an understanding of the bank.
The bank adds both a liability (the account balance to you) and an asset (the mortgage). The bank is not restricted to having only cash as its asset. Indeed there is no point to running a bank if it can only cash (that’s a vault, not a bank).