How Banking Really Works

Consider a country with only one bank and only one person with any money. Lets say you’re the rich one and you have $1000, which you deposit in the bank. I come along and want to borrow the money. Usually people will talk about reserve requirements at this point, but as of 1991, reserve requirements were eliminated in Canada, by Brian Mulroney’s government, so it would be pointless to describe. Ok, so I come along and borrow that $1000. I go to a store and buy $1000 worth of goods. This is about as far as most people go in thinking about the credit process ( I know I never thought further until recently). What happens to that money that the store now has? Well, it deposits it in the bank of course. So now we have a bank with $2000 in deposits in a country that only has $1000 for a total money supply. You still have $1000 as far as you are concerned, your bankbook agrees with you. The store also thinks it has $1000 in the bank. Now think about this – the store’s $1000 is a deposit, what do banks do with deposits? That’s right, that $1000 is available for loaning out! Along comes another person that borrows the $1000 and spends it and that store now has a deposit too. The money supply is now $3000 with only $1000 of actual money in the country. Because there is no reserve requirement, the loan process can theoretically go on forever, generating and infinite amount of money from a single $1000 deposit. The only actual limit is how willing the public is to continue borrowing. Think about what would happen to prices in this country. It went from 1 person having $1,000 to 11 people having $1,000. Lots more people have lots more money so prices will, by market driven necessity, go up – price inflation (though its not quite that simple in the real world). This works only because most people are content to leave money in the bank, purchasing things by transferring money between accounts of different people. If everyone actually wanted $1,000 in cash, they couldn’t have it – only $1,000 actually exists. The other $10,000 is phantom money, just a number on a ledger. This ledger money cannot be “withdrawn”, it can only be transferred between ledger entries. The last ratio of capital to loans I saw for Canada’s banks was the 1999 June Bank of Canada Review. At that time the rate was $358 in loans for every $1 of actual cash. So if we extend that rate to our little one bank country, that means 358 loans of $1000 - $358,000 money supply from $1,000 in bills. The Business Cycle Ok, so now we get to the bad part. A year is up and its time to pay all the money back. The only money in the country that is available to pay the loans is in the deposits. Somehow, the people that borrowed the money have to get the money from the depositors to pay back the bank. If they are successful then at the end of the payback cycle, there is only $1,000 in the country. Prices that were set by a $358,000 money supply have to fall back to the pre-loan levels; price deflation. Of course, prices take some time to drop so in the meantime, you have a great depression What happened to the $358,000? Well its simple, it never really existed. Every dollar in existence had an equal debt. When the debt is paid, the dollar disappears back into the thin air from whence it came. On a balance sheet, there was only ever $1,000 in existence. Now you might think I forgot about interest, you’d be wrong! Lets say interest rates are low, only 5%, that’s $17,900. So lets say we manage to pry that $358,000 away from the depositors to pay of our debts. We still owe $17,900. The depositors get paid 1.5% interest so that’s $5,385 more we can somehow pry away to pay the interest on the loans, leaving a paltry $12,515. Get that last $1,000 of real money away from the original depositor and you’re at $11,515. No money exists to pay this interest so it simply cannot be paid. Without some external source of cash, the only possible way to get the money to pay the interest is to borrow it from the bank. These periods of boom and bust have been erroneously (deceptively?) called business cycles, They are not, they are debt cycles. Every once in a while we get so loaded down with debt that borrowing slows and the economy goes south. After enough bankruptcies and interest rate drops, we pick up borrowing again and “boom”. In the real world, banks don’t demand full payment at the end of the year. You also don’t pay a single interest charge; interest is compounded over the life of your easy payment plan. The total interest paid is MUCH higher than shown above. On the micro level, we do pay off our loans and take out others. When looked at from a macro level though, the overall debt never goes down. As one person pays off a loan, others borrow. And they borrow more than you’ve paid off – enough that both the payback amount and the interest owing are covered. In the real world, we rarely stop borrowing. If we do, the money supply shrinks because we’re paying off credit and interest and that money simply disappears – the magic of the balance sheet. When we DO have bouts of low borrowing and high payback, it’s called a recession or depression. The economy goes south and we all suffer. This is why the interest rate set by the bank of Canada has such an effect on the economy – it controls the availability of credit. High interest means less borrowing and visa versa. From WWII until 1967, Banks in Canada were quite restricted in the amount of money they could create. Reserve requirements meant that every loan created from that original amount would be smaller. A $1000 loan with a 25% reserve requirement meant that $250 would be deposited with the Bank of Canada as a security for the depositor and $750 could be loaned out, creating a $750 deposit for someone else; each loan getting progressively smaller. Banks were also restricted in the types of loans they could make. There were no credit cards or household loans. Credit cards weren’t really needed because we (almost) all had a decent amount of money of our own. Household loans were done by finance companies – which simply loan actual money. Every loan meant their deposit got smaller – no ledger money created. Government created a much larger share of the new money supply every year, between 25% and 50% and this was more than enough to cover payback rates and interest. The total money supply grew almost exactly in sync with growth in output, resulting in very little inflation. In addition, the money government created (And I don’t mean borrowed) was money that did not have to be collected in taxes. GCM entered the economy through spending on programs and infrastructure, allowing us to create all the wonderful things like Universal Healthcare and the St. Lawrence Seaway. The 1967 bank act drastically reduced restrictions on bank credit. It took a couple of years to get going but the “credit boom” caused the massive inflation of the 1970s and early 1980s; fueled primarily by real estate loans and credit cards. In the 70s, the Bank and Government of Canada adopted “Monetarism”. This economic policy from the Chicago School of Economics was fairly simple. Too much money creates inflation so stop the creation of money. Since every dollar created by government was a dollar that couldn’t be created by banks, Government was severely restricted, giving banks the lions share of money creation. Monetarism worked too well. The supply of money choked off but, since we had no sufficient money supply to pay loans and interest, we had to keep borrowing. The higher debt and higher total interest meant prices had to keep going up in order to finance that debt. No extra money was available for growth so the economy stagnated. Price inflation coupled with economic stagnation = stagflation. It was not the only impetus for price inflation – both unions and companies had gotten used to inflation so both kept raising their prices in anticipation of price inflation equal to what they had been experiencing up until then. Being that money powers NEVER give up profit unless forced to, going back to restrictions on banks and more GCM was not an option. So how to continue the debt/money creation cycle of ever increasing debt/money supply without causing price inflation? It became apparent that the only part of the money supply that was creating price inflation was the money that was actually being spent in the marketplace. So the trick would be to get as much of the new money into areas of the economy that did not include spending on goods and services; investments, savings, that sort of thing. Monetarism introduced a new method of looking at money by dividing it up into three categories, Money level 1 through level 3 (M1-M3). M1 was fast moving money. It is the money in your wallet and in your chequing account. M2 was all of M1 plus money in slower to access areas such as savings accounts and some types of stocks and bonds, short term deposits and the like. M3 was all of M1 and M2 plus the non-liquid money. Long term deposits and other things where you cannot get your money out for a specific amount of time. Of these three it was plain that M1 was the major cause of price inflation. They needed a way to direct new money into M2 and M3 and keep it out of M1. Its easily verified by looking back through history that the poorer the lower and middle class is, the less price inflation you see. Once you’re income passes a certain point, more income does not equate to more spending – at least not on any of the “basket of goods” used to gauge price inflation. The trick then, is to keep as much of the new money out of the hands of lower and middle class people as possible (though that’s where they wanted the debt). The answer was obvious: NAIRU – the evil that’s name must not be spoken. NAIRU is the acronym for Non-Accelerating Inflation Rate of Unemployment. In other words, if you can keep enough people unemployed, all that new debt money won’t cause “excessive” inflation. Permanent inflation had to be accepted because it was the only way to pay loans and interest without shrinking the money supply, they just wanted it as low as possible so as not to upset the applecart. From 1946 until the early ‘70s, unemployment in Canada hovered around 3.5% and GDP growth rarely dropped below 4%, regularly hitting 5% or more. Since all these banking changes it was determined that 7.5% unemployment was optimal for keeping M1 low while growing M2 and M3. A secondary finding was that GDP growth over 3% made it very difficult to keep unemployment that high. For the last 30 years, the Bank of Canada has striven to keep unemployment between 7%-8% nationally and growth below 3%, resulting in “inflation rates”, the rise in the cost of a basket of goods that every class would be buying, between 1%-3%. The direct instrument for controlling inflation is unemployment. Unemployment is regulated by interest rates. The relationship between unemployment and interest is indisputable as you’ll see in the charts I’ll provide links to at the end of this article. Today, actual money, bills and coins, make up only a tiny portion of our total money supply; about $44 billion if I’m not mistaken. This is all reflected in M1 (chart links to follow). M3, which is the total money supply, totaled over $800 billion – all but the $44 billion in cash being “ledger money”. Interest payment on the federal debt alone, at just over $500 billion, was $13 billion last year. Just think of how much interest is truly being paid to banks through interest on the money supply. We are “renting” our money supply from banks and paying them an ever increasing amount for the “privilege” of letting them create money. Just how freaking backwards can you get! Another note about government debt; the Bank of Canada is the creditor for the governments of Canada. If a government needs to borrow money (provinces and municipalities who cannot create money themselves) the Bank of Canada will lend the funds at about 1% interest. From that interest it pays its own operating costs and the excess is paid to its stockholder – the government of Canada. Instead, all levels of government have been borrowing on the open market, paying HUGE amount of unnecessary interest. The loss of GCM revenue is why we have the GST. Without the big infusion of GCM each year, the ability of government to fund programs and infrastructure took a huge blow. To make up for part of this, the GST was introduced. "If all the bank loans were paid, no one could have a bank deposit, and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash, or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless situation is almost incredible -- but there it is." - -- Robert H. Hemphill, former Credit Manager, The Federal Reserve Bank of Atlanta, Senate Document #23, page 102, January 24,1939 Enough talk, here comes some links to charts; the data comes from Statistics Canada, I purchased the data myself online direct from Stats Can. If anyone wants to check up on it, you can start at http://www.statcan.ca Total money supply and federal government debt from 1946 to 2004 http://politicsofmoney.net/images/moneysupply.gif Total money supply by division (M1-M3) 1946-2004 http://politicsofmoney.net/images/divisionofmoney.GIF NAIRU vs Interest Rates and CPI changes in Canada 2001-2004 http://politicsofmoney.net/images/NAIRUCAN.gif NAIRU vs Interest Rates and CPI changes in the USA 2001-2004 http://politicsofmoney.net/images/NAIRUUSA.gif This shows that the same monetary policy has the same effect in the USA. In keeping with the relationship between Canada (cheap producer) and the USA (rich consumer), NAIRU for the USA is 4.5%. They keep the money supply under control via the US dollar’s status as petrodollar and world trade dollar so don’t need as high an unemployment rate. An advantage no currency has had until recently, When the Euro was introduced and started encroaching on that status. Consumer debt in Canada from 1943 to 2004 http://politicsofmoney.net/images/consumercredit.gif Remember the deep recession of the early 90s? Look at consumer debt in this next graph, starting in the late 80s. Lack of borrowing caused that downturn and only growth in debt brought us out of it. See if you can pick out the other recessions just by looking at the slowing in growth of credit. You’ll see the credit graph predicts the forthcoming recessions. Is this understandable? Please comment so I know if I’ve gotten the message across. If you don’t, won’t, or can’t believe this that’s fine – I just want to make sure my writing isn’t getting in the way of the message.

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