From: cbbrowne@csi.uottawa.ca (Christopher Browne)
Subject: Monetary "theory"
Organization: Dept. of Computer Science, University of Ottawa
Distribution: na
Date: Tue, 15 Dec 92 06:15:11 GMT

In article <Bz9CH6.1vn@teleride.on.ca> stevew@teleride.on.ca (Stephen M. Webb) writes:
>In article <Bz2ooC.Hn3@watserv1.uwaterloo.ca> tjdoran@watserv1.uwaterloo.ca (DORAN TJ - BIOLOGY) writes:
>>
>>Let's say banks have to have 10% (for the sake of easy math) of the cash they 
>>loan out on hand at any one time. Imagine someone deposits $100. The
>>bank can add $100 to the 'assets' side of their ledgers and add $100
>>to the 'liabilities' side. They then loan you $90 (the maximum amount
>>they can lend out).  
>
>I'm glad you're not my accountant.  If I deposit $100 in the bank, I'm loaning
>the bank $100.  That means I have a $100 asset and the bank has a $100
>liability.

He explained it fairly tersely, but quite accurately.

>>The first bank (Bank 1) now adds $90 to its 'assets' column. New
>>Money.
>
>Okay, $90 asset and $100 liability.  Go on.
>
>>You take your $90 to Bank 2 and deposit it. Bank 2 then adds $90 to
>>both sides of its ledgers and proceeds to loan out $91. Again, a
>>bank is adding money it has lent out to its 'assets' column. And so
>>on, and so on... 
>
>Bank 2 adds a $90 liability and loans out $81 (assuming you made a typo).
>This cycle continues in a negative arithmetic progression.  What is the sum
>total of net assets and liabilities?  Zero.  No money created.

Net assets?  Certainly zero (or maybe $100).  But the cash supply
isn't based on the net - it's based on all of the entries on the debit
side.

>Okay, so when I loan $100 to Bank A, they have this $100 liability, I
>have this $100 asset, and they have $100 cash.  When they loan $90 to
>Bank B, they then have $10 cash and Bank B has $90 cash.  Cash has
>been neither created nor destroyed.

Yes, but that asset that you have is treated as if it were cash.  The
money supply generally describes something that's broader than merely
"currency".  THAT form of money is usually referred to as "M0".
There's a sequence of increasingly broad definitions of "money."  M1
(the most common index used) considers as "money" the assets that
commonly serve as media of exchange, such as currency (M0) and
checkable deposits.  M2 is an even broader aggregate that includes
things like term deposits, savings accounts, and some other such
items.  There's even an M3 that includes some other sorts of financial
assets.

M1 is considered to be a very useful measure of the "available money."
"Legal Tender" may never be created by a bank, but they DO make money
seem to exist in many places at once, which is in effect just as good
as creating money.

>If you can explain to me how a bank can add the loan I made to it to
>both sides of its leger, I'd be satisfied that loans create money.  I
>will also become very rich, since I could take a loan out of the
>bank, further loan the amount to myself at 0% interest, pay back the
>bank with the second loan, and come out ahead just by never paying off
>my own debt.

How do they add the loan to both sides of the ledger?  Easy.  They
borrowed it from you, and then lend it to someone else.  They make
money because the interest that they pay you is lower than the
interest that they charge to that "someone else".

If you give the loan to yourself, it's YOU that pays the interest.
There's no creation of money until there's at least THREE parties
involved in the transaction.  Two just isn't good enough.

>I could then repeat the cycle until I could pay of the
>federal debt with pocket change, doubling my assets every 24 hours if
>I choose.  I could start my own late-night paid programming show and
>tell others how to become rich using other people's money. 

What happens is that what is essentially the SAME money winds up as a
cash balance for several people.

Let's start drawing T accounts (what?  Don't know what a T account is?
One of the most useful accounting shorthand devices ever invented.
Nobody would EVER pass 4th year Consolidation Accounting without
knowing it.  I had to take the course TWICE, but that's another
story...)

Step I:  The Deposit

Let's look first at Mr. A.  The guy with the $100.  He puts it in the
bank of B.  The effects:

   MR A's Bank Balance
=========================
    $100    |

 Bank of B's Cash Balance
=========================
    $100    |

Bank of B's Deposit Liability
=========================
            |   $100

If you add up all of the debits on the left, and all of the credits on
the right, you get:

    $200    |   $100

The difference between 'em is the $100 that Mr. A started out with.

The money supply is arguably $200, the cash balances of both Mr. A.
and the Bank of B.  It's arguable that Mr. A's money just got doubled.
And we've just started.

Step II:  The Loan

The Bank of B. now has $100 in cash.  It's not much use for them to
just hold onto it - they want to get some return on it so that they
can actually pay interest to Mr. A.  They won't pay MUCH interest to
Mr. A, but there will be SOME.

So they loan most of it out.  Say $90.  They loan $90 to Ms. C, who
with her husband, Mr. D. has just bought a house.

So, we have:

Bank Effect:
Debit Loans Outstanding:   $90
Credit Cash:                       $90

Ms. C:
Debit Cash:                $90
Credit Loans O/S:                  $90

So far, the debits and credits balance one another.  It doesn't look
like any cash has been created, does it?

But wait a minute...  Let's see what everybody's cash account looks
like.

   MR A's Bank Balance
=========================
    $100    |

This wasn't changed by the transaction.  Mr. A. still has a deposit of
$100 in the bank.

 Bank of B's Cash Balance
=========================
    $100    |
            |    $90
-------------------------
     $10

With the two transactions, the Bank of B has only $10 on hand.  That's
ok.  Ms. C owes them $90, and they can use the "payable on demand"
clause if they absolutely need that $90 back.

But wait - Ms. C has some money too.

 Ms. C's Cash Balance
==========================
     $90    |

Altogether, these three cash balances add up to $200, which is
considerably more than the $100 that Mr. A started with.  And that
$200 will wind up being what M1 looks like.
-- 
Christopher Browne                |     PGP 2.0 key available
cbbrowne@csi.uottawa.ca           |===================================
University of Ottawa              |  The Personal Computer:  Colt 45
Master of System Science Program  |  of the Information Frontier
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