Money - Part 3

Money has several very interesting facets. One of the facets is that - due to the odd current system we live in where private banks (not the mint or Bank of Canada) can create money on a whim - demand and supply are more or less completely unhinged. Your eyes perhaps rested on the part of that sentence where I said "banks create money on a whim", right? Well, more accurately, private banks actually create money out of nothing. If you click the link that I referenced just there, you'll note it goes to the Bank of Canada website. On the Bank of Canada website, it says:

Commercial banks and other financial institutions provide most of the assets used as money through loans made to individuals and businesses. In that sense, financial institutions create, or can create money.
The Bank of Canada manages the rate of money growth indirectly through its influence on short-term interest rates, or through the reserves provided to large deposit-taking institutions.

Which is interesting, because it basically means Canada has no real control over its money supply: money is created and destroyed by banks and other financial institutions. In a way, this makes sense: in order to make money on deposits, a bank must invest those deposits. The problem is that a bank cannot have money in two places at once. If it wants to make money on deposits, it must take the deposits out and put them into loans or the market. It can't leave them in a vault and hope the pennies have copious sex with one another. What is a bank to do? It writes your account balance on a piece of paper, and loans the money you gave them out to someone else. The person who took the loan got real money - you get an I.O.U. Poof! The bank just created money!

Perhaps this is a bit hard to take. Let's make it more concrete: you have $100. You invest it in the Bank of Bob (the initials of which, conveniently, are also BOB). I need a $100 loan from the BOB. BOB writes in your account book that you hold $100 in their accounts. BOB then gives me $100. In effect, we both have the same hundred bucks. I hold the real currency, and you have a piece of paper that says the bank will render you $100 upon demand. Let's say you leave the money there until I pay back the loan. I pay back $100 plus $5 interest. You close your account and take your $100 back, which gained $2 interest. The bank pockets the $3 difference. The $100 IOU is discharged, and the money supply effectively shrinks again. I say that the money supply "shrinks" because really, at the time the loan was created, you had $100 and I had $100, and it meant that our little economy held $200. When the loan is repaid, the bank receives $105, gives you back $102, and keeps $3.

The cozy thing about this is that the math all works out - no money is created or destroyed. The I.O.U. is discharged when I wish to take my money out... but something isn't right. We have an economy of three entities here: you, me, and BOB. You give $100 bucks you have in hand to BOB. BOB invents another $100 bucks out of it (which we can accept, it's actually an I.O.U, not real money) and gives me $100. The economy is operating with $100 real dollars still and $100 "owed" dollars: a promissory note for a hundred bucks. At the end of the loan the economy once again contains just the... hey! Wait a minute! Where did that extra $5 come from? In effect, it has to come from outside the economy, or be created someplace, or... or it is loaned by someone else to pay the debt.

Hmm. In a closed system like this, the only way for debt to be paid is further debt from other banks, which itself leads to further debt. Well, one way to make up the money is something called "quantitative easing", which is really just a fancy name for "making it up out of nothing". A lot of the extra cash that society needs to pay off debt actually comes, one way or another, from the government going deeper into debt; either through bond issue (which is to say, going into debt where the creditor is the public itself), quantitative easing, or just changing the interest rate. We discovered in the 80s that the high interest rates didn't make the money supply heed the helmsman, so I'm consistently wondering why we think lowering the yield curve will in any way correct the financial troubles of the current US economy... but I digress. My main point here is that the government makes money. Out. Of. Nothing.

In a reserve system, the supply of money versus the commodities and currencies held in reserve should devalue the currency. As I said before, however, the supply and demand of currencies are no longer correlated. Supply is just supply: it is created out of thin air by banks, by the government through quantitative easing, through bond issue, fairies, whatever. Demand relates to what the money is used to buy, not with how big the money supply is. Dollars buy you iPhones. Dollars buy you oil.

On to part 4.