How money is created, with help from the archives

[Gregg]

I'm going to first dig up some old posts to start it out, then we can carry on....

[Gregg]

Just a few quick comments, at random, because I'm making lasagna...

A Note, promissory note, mortgage note, etc....

The borrower "creates" the note in the sense that they sign and agree to the terms of it, and the bank (or whatever) agrees to accept it based upon the conditions that the borrower has said he would abide by.
The bank (or whatever) then puts money somewhere, usually as a check to someone the borrower is paying money to, like a car dealer, home builder, drug dealer (or whatever). In theory, the lender could open the drawer and hand out hundreds for the amount, although almost always that's one of the conditions in the note, for instance, legal language that in effect means "we're not gonna pay this to you personally in silver coins, we're gonna send a check to the car dealer" , but hey, if you can get a bank (or whatever) to agree to give you cash money, have at it. They're still gonna want a car title, warranty deed or something in exchange that helps them secure the collateral.
Now, since on any given day they might in fact lend out more money than they have real live capital in the bank, they need something to back up that check they sent to the car dealer, because they don't (contrary to sovidget mythology just magic money into existence, if they don't do something that check will bounce just like yours or mine if we don't have the money in the account), so they take that note and hopefully its written in such a way that its a "negotiable instrument", meaning that first, it meets the requirements of both federal an state regulations for how the thing is written, and second, the terms, including the characteristics of the borrower meet certain conditions. Anyhow, if its up to snuff as a negotiable instrument, it can be easily sold in what's called the secondary market. That is a group of money things (mutual funds, other banks, insurance companies and rich guys, oh, and Hedge Funds....can't forget the hedge funds) that BUY these negotiable instruments, usually as pools of more than one, but often just individually. Some buyers buy them one at a time and then package groups of them as CBO Bonds and such which also sell on the secondary market but if you think about it that should be called the thirdendary market .

So, the bank (or whatever) sells the note that the borrower created and gets their cash back, and the buyer gets to collect the payments the borrower has to make. The "Note" might be sold more than once, and, especially in Mortgages and municipal bonds, they actually split the cash flow where one end buyer might have the right to only the interest portion of the payments received and someone else gets the repayment of principal (and if the borrower wins the lottery and pays off the mortgage early they get a lump sum and are done)

Ah, but young padawan, there was indeed some money created here. Money created on more than one level, and somewhere in all those notes and checks and CBOs and Hedge Funds the actual money supply, the amount of money the Federal Reserve has issued notes and credits and electrons for, has increased.

The Borrower has, by creating the note, agreed to create the amount of money that is new wealth generated by the transaction, over the course of the agreement. And this is important, the money is only created WHEN THE MONEY BORROWED AND THE INTEREST is repaid to the entity that holds the rights of the notes obligation. That bit means that you, Sovidgit, cannot declare that you created the money and therefore, by some logical dance don't have to pay it back, are wrong.

When you buy a house, say, and to simplify it this is a new house (existing homes do the same thing but the mechanics are more complicated for reasons not relevant to this discussion) and you pay, say $200K for it, a lot of money was created, by a lot of people and or companies etc... Unless you have a few years, just trust me on this concept but the end result is that money was created by all those people paying off their own mortgages or car loans or investing their savings...whatever they do with the coin they earn. You didn't create that money, they did and for all intents and purposes that money came into existence when that check the bank (or whatever) wrote based upon your note was cashed. But like I said, that is not the money you created, its the money they created, it just gets born when they get paid for creating it. And not all they they are paid is the new money, in fact, most of it is just a relocation of the existing money supply, but the things they did that made the economy larger than it was is in fact new money. Now since the money they are being paid isn't located anywhere yet, someone, somewhere, needs to fire up the printing press and make some Benjamins cause eventually all those electrons and account credits and debits and checks and such are gonna be reduced to someone wanting to buy a pack or Lucky Strikes at a place that doesn't take credit cards or checks.

Enter the all encompassing evil empire local Federal Reserve Bank. Not to be confused with the Federal Reserve Board, which is a government entity (search my posts for a good description of the difference, I've explained it before and like I said, I'm in a bit of a rush here)

I have to break this up here, continued in next post....

[Gregg]

And we're back, dinner is done and now I'm eating while I type, and negotiating with a veteran of the 298th Airborne Wiener Dog Assault Squadron about how much she is gonna get, but I digress.

Remember back in the beginning when the bank (or whatever) wrote a check to the home builder and in fact didn't have that money setting in a drawer to cover the check? As I said, that check is gonna bounce unless someone puts money in an account to cover it. Well, as I explained, that note is going to usually sold on the secondary market, and thus the bank (or whatever) will get the money (that was created when the builder and his cast of dozens paid their mortgages but isn't actually anyplace just yet) to cover the check. Of course, the secondary market isn't Ebay so they don't get that money same day. So what do they do? There's not any (or whatever) here, this has to be a bank or, since the 80's, savings and loan for this but there are other methods that serve the same function for other lenders, clears the checks they write through the local Federal Reserve Bank. If the bank needs short term cash to bridge the time from when the check needs to clear and when they get proceeds from selling the note, the Fed will cover it, through several functions but usually and for the sake of simplicity here lets say they front the money from the Discount Window. To borrow from the Fed a bank must have "good collateral" and the Fed defines what that is. Interestingly, what is good collateral is a judgement call and what is good today may not be good tomorrow, and even what is good for Citibank is not always good for Chase. (the other major mechanism for getting money short term is the Money Market, a private system that works a lot like the Discount Window as far as function, although it is limited to relocating existing money, whereas the Discount Window can create new money.)

So, anyway, when a bank borrows from the Fed, (actually its more accurate to say that when the funds associated with a note that creates new money reaches the Fed because those funds always, eventually reach the Fed either through lending or Open Market Operations, but again, let's keep this simple) the Fed covers the check, notes that XYZ Bank owes them the money and to the extent that new money has been created they then make this money into existence on the books of all the institutions involved.

Okay, me and Chili Dog are gonna finish dinner, I may come back, but until then Patriotwhatever, there is your answer. Yes, banks loan money, its just that the actual acts of what happens when they do confuses a lot of idiots who try to apply Sovidgit logic to it in order to reach a predetermined, if misguided, sound bite answer.

[Gregg]

Why Tax Protesters despise the Fed is understandable though. It's a complicated setup of a very complicated system of an insanely complicated process. As such, it lends itself to being misunderstood even by those with the best intent, but when those who are a little conspiracy theory bent start writing about it on the internet among other like minded people it reaches a critical mass of stupid quickly. Toss in the ones who are spinning conspiracy for a profit who deliberately distort it (and any politician however mainstream who climbs the ramparts to start screaming "audit the Fed" I count among these) and add a little bit of the internet, and you get....well, Ron Paul.

But just to give a few debunks out of thousands which space and time prohibits, here are a few things I'll say about the Fed that are actually true, you can look it up!

The "Fed" most people refer to is actually "The Federal Reserve Board of Governors" a government agency whose members are appointed by the President, approved by the Senate and whose budget is fully funded by the private Federal Reserve Banks, The Federal Open Market Committee and the 12 Federal Reserve Banks.

The Federal Reserve Banks are private corporations. They are not owned by secret rich foreigners, the Queen, or the Rothschild family. They are in fact owned by the member banks in their region who buy special stock that gives them theoretical equity but the traditional rights of a shareholder are different and more limited than other private corporations. The stock does pay a dividend every year of 6% of the invested equity and that is the only profit of the Federal Reserve System going to anyone but the Treasury of the United States.

The FOMC controls (in theory) the size of the Money Supply by either buying US Government bonds on the Open Market (paying cash and increasing the Money Supply) or selling those securities (receiving cash and retiring it, reducing the Money Supply) The FOMC is not allowed to buy new issue securities directly from the Treasury which would be directly affecting the debt of the United States, they can only buy these securities on the open market which means that they are just transferring current debt from public to semi-public debt, held by the Fed which pays the dividends ultimately back the Treasury and in a minor side benefit actually reduces the deficit, if just a little bit. The important part about buying on the open market is that it affects the money supply by either putting out cash or retiring it, and it does not create any new government debt. If they hadn't bought it the interest would have been paid to a private holder.
In general the FOMC is restricted by law to buying ONLY Government Securities, but in fact, as demonstrated in 2007-2008 if the Board of Governors wants to do something, they can find a way to legally do it. I almost believe Ben Bernacke has the power suspend the law of gravity.
This, like most of this post is a HUGE GENERALIZATION of the larger concept. If you want to go deeper into FOMC operations, theory and such, get a Masters in Finance and/or Economics and come see me, it's complicated even for me to discuss and while I'll talk to anyone who is genuinely curious I've talked to enough who are just looking for an answer they like that I've tired of it and avoid that when I can.

The whole shebang makes a profit, every year. They pay first the Member banks their 6%, pay the entire system's bills and what's left is paid to, wait for it....The Treasury of the United States. The only way the Queen gets a cut is if she has some Savings Bonds she wants to sell.

The Fed was founded for among other reasons the fact that the US Economy had gotten too big for private bankers to smooth out cyclical ups and downs in activity and money supply. A triggering event on this theme was the panic of 1907 when JP Morgan and some of his friends put together a package to prevent a recession or other consequences. The public, led largely by small business owners and farmers, demanded the end to a system where a few large banks and rich bankers controlled the economy. (gee, that sounds familiar, don't it?) People demanded some system to regulate banks.

I'm gonna paste a Wiki thing here because I'm lazy....

The Board of Governors of the Federal Reserve System, the Federal Reserve banks, and the individual member banks undergo regular audits by the GAO and an outside auditor. GAO audits are limited and do not cover "most of the Fed’s monetary policy actions or decisions, including discount window lending (direct loans to financial institutions), open-market operations and any other transactions made under the direction of the Federal Open Market Committee" ...[nor may the GAO audit] "dealings with foreign governments and other central banks." [82] Various statutory changes, including the Federal Reserve Transparency Act, have been proposed to broaden the scope of the audits.




The big part is to tell Ron Paul and such to STFU, at least until we get to audit Congress. The part in red is what they are technically screaming about and if you look at it, those are policy things, not "where did the cash go" things and as such are really none of Congress's business, as a matter of law. One reason the Fed is independent of, well, everyone not a deity, is so they can make those decisions based on whether its a good idea as opposed to will it garner a few votes.
Congress was never intended to be able to threaten, coerce or influence the Fed in any way, and whether you like or understand that or not, every night when you say your prayers thank someone for that fact. Any elected official in charge of the Central Bank is about as twisted as North Korea being on the UN Commission for Human Rights.
This stuff is insanely complicated, lets leave it to people who have spent their entire adult lives studying it, not the whore who got the most votes in West Virginia and has been doing so longer than anyone else on the committee.

[Gregg]

One thing that I often see the ignorant screaming about is "The Fed loaned XXX bank YYY TRILLION !!!" which, might be technically true but shows a misunderstanding of how the discount window works and a way that it was never intended to work but does.

Banks have to balance out the books every day. Banks have a hard solid number they calculate every day of their capital, reserves, and loans outstanding, among others. On any given day a bank should have some 'extra' capital reserves just as a safety net. And at one time not so long ago, the arithmetic involved was done by hand with big old desktop calculators. You wanted to have a big cushion in case the number changed more than you thought it was going to.
Now, a problem with this is, if you have $50 billion in unused reserves at the end of the day, in theory you have lost the income on that excess liquidity had it been loaned out at interest. Banks did what they could to get close to that figure, but the amount of unused capital added up to quite a bit.
Sometimes, for many reasons, a bank would end the day with too little capital... very bad. But, to fix it you could go the the Fed's discount window and borrow what you needed overnight. Once upon a time doing so was considered a little bit extreme, not a little embarrassing and a sign that someone wasn't keeping up with the business. In my lifetime it would not be unusual for the Controller or even President of a regional sized bank to lose his job for having to go to the discount window a few times.
Important point, ALL Discount Window loans are overnight. If you needed it again the next day, it was a different loan. Technically, if you needed to borrow $1 million for 3 days, you borrowed $3 million. See where I'm going with this?
So, are banks now so bad that they have to borrow all the time? Absolutely not. A bunch of quants at some of the bigger banks (BofA was the first to make a habit of it) figured out that the Discount Window was cheaper than their nominal cost of capital, and as such, from a strictly numbers point of view, it made more sense to figure out how close to your reserves you are every day, and then figure out how much you were able to borrow from the Fed @ the Discount Rate, and how much you could make if you could find someone to borrow it from YOU at a higher rate. The only penalty for going to the Discount Window was the stigma of having done so, and show a bunch of bankers how much money they're leaving on the table and they tend to lose their modesty at some amount.
Before long, and fast computers and technology played a big part, banks were figuring out how much the Fed would lend them every day, and taking pretty much all of what was available, using the funds to buy overnight commercial paper and stuff like it. So now, the banks were deliberately taking out the maximum amount every night. It's now not shameful to go to the Discount Window and failure to do so is a sign that you might be a little slow, or having trouble finding places to borrow from you. All this excess liquidity increased the money supply AND increased the velocity of the money supply, both steps that increased economic activity and were more or less good for the overall good. It also ruined a whole lot of models used to gauge money supply movement, btw.

But the point is, all of the big banks borrow a, compared to their net worth, small amount every single day. In the greater scheme of things it's not a significant amount of money. But when a bank borrows a billion a day for 30 days, well, on the books it shows up as the bank borrowed $30 billion dollars, and if you don't know the mechanics involved, well, it looks like a staggering amount. What bothers me about it is the first time I saw a sensationalist headline about it, the person quoted in the story demanding some action was a member of the Senate Banking Committee, who if he didn't know any better is scary in itself and if he did was lying through his teeth to get the crazies to come out.

In the end, it's about the same as someone making $50,000 a year having a credit card with a $1,000 balance over a year, and someone yelling that a guy earning $50,000 borrowed a third of a million dollars last year.....

[PeanutGallery]

And we're back, dinner is done and now I'm eating while I type, and negotiating with a veteran of the 298th Airborne Wiener Dog Assault Squadron about how much she is gonna get, but I digress.

If the answer wasn't substantially more than her bodyweight then she's gonna be peeved.

But the point is, all of the big banks borrow a, compared to their net worth, small amount every single day. In the greater scheme of things it's not a significant amount of money. But when a bank borrows a billion a day for 30 days, well, on the books it shows up as the bank borrowed $30 billion dollars, and if you don't know the mechanics involved, well, it looks like a staggering amount. What bothers me about it is the first time I saw a sensationalist headline about it, the person quoted in the story demanding some action was a member of the Senate Banking Committee, who if he didn't know any better is scary in itself and if he did was lying through his teeth to get the crazies to come out.

My guess would be is that he was most likely trying to score political points or aware that if he didn't go along with the "OMG think of the children" he'd be painted as someone who's giving taxpayers hard earned money to his mates in the banking cartels.

That or he was, in the best traditions of government, just warming a seat on the committee while them other fella's did all the hard thinky stuff.

Congress was never intended to be able to threaten, coerce or influence the Fed in any way, and whether you like or understand that or not, every night when you say your prayers thank someone for that fact. Any elected official in charge of the Central Bank is about as twisted as North Korea being on the UN Commission for Human Rights.
This stuff is insanely complicated, lets leave it to people who have spent their entire adult lives studying it, not the whore who got the most votes in West Virginia and has been doing so longer than anyone else on the committee.

Or which one has the most dirt on the others and is more interested in furthering their political career, which requires a totally different skillset to banking.

[Joinder]

Money grows on trees, what do you think bank notes are made of ?

[YiamCross]

Money grows on trees, what do you think bank notes are made of ?

Linen. Which is cotton. Which doesn't grow on trees. Except when it' a non-woven fabric or plastic, as Australian banknotes are, which doesn't grow on anything.

I was there at Overton Paper Mill when the last £1 note bank paper was coming off the machine. I used to have a bit of broke (scrap waste) tucked away but I lost it years ago. The technology going into banknotes even then was pretty impressive, though I still can't understand why as few people know exactly what all of it is.

[Daft Ada]

I remember my grand father telling me a story along the same lines as Yiams.

My grandfather worked for the comoany that made the machines that used to make (or mint) the coins.

He was the proud owner of the first 1/2 pence coin EVER pressed.

Sadly, when he died, he tooknthe location of this coin to his grave and we never found it.

[Joinder]

Money grows on trees, what do you think bank notes are made of ?

Linen. Which is cotton. Which doesn't grow on trees. Except when it' a non-woven fabric or plastic, as Australian banknotes are, which doesn't grow on anything.

I was there at Overton Paper Mill when the last £1 note bank paper was coming off the machine. I used to have a bit of broke (scrap waste) tucked away but I lost it years ago. The technology going into banknotes even then was pretty impressive, though I still can't understand why as few people know exactly what all of it is.

Thanks for info, promissory notes grow on trees ?

[Gregg]

I was there at Overton Paper Mill when the last £1 note bank paper was coming off the machine. I used to have a bit of broke (scrap waste) tucked away but I lost it years ago. The technology going into banknotes even then was pretty impressive, though I still can't understand why as few people know exactly what all of it is.

The paper that US notes are printed on is very, very hard to make, they use the clippings from blue jean denim. It is also a felony to possess any of it that isn't made into a bank note, and the Secret Service is quite touchy about that.
Yes, the same people who guard the President, which is a side job for them, their main job has always been safeguarding the currency and payment systems...

[NigelJK]

their main job has always been safeguarding the currency and payment systems...

Good to see the services over water have their priorities straight.

[PeanutGallery]

their main job has always been safeguarding the currency and payment systems...

Good to see the services over water have their priorities straight.

Presidents can be replaced, but pictures of them are permanent.

[YiamCross]

Thanks for info, promissory notes grow on trees ?

Easier than that. Public toilets have rolls of them.

[jcolvin2]

I remember my grand father telling me a story along the same lines as Yiams.

My grandfather worked for the comoany that made the machines that used to make (or mint) the coins.

He was the proud owner of the first 1/2 pence coin EVER pressed.

Sadly, when he died, he took the location of this coin to his grave and we never found it.

Perhaps it went to pay the ferryman.

[Joinder]

Thanks for info, promissory notes grow on trees ?

Easier than that. Public toilets have rolls of them.

Haha just as useful too .

[PeanutGallery]

Thanks for info, promissory notes grow on trees ?

Easier than that. Public toilets have rolls of them.

Haha just as useful too .

Depending on the situation and on your priorities sometimes they can be more useful.

[YiamCross]

Easier than that. Public toilets have rolls of them.

Haha just as useful too .

Depending on the situation and on your priorities sometimes they can be more useful.

There seems to be a considerable amount of misunderstanding about promissory notes. They are as good as the person making the promise, that's it. They're as flexible as the imagination of the person drafting them.

If Joe Bloggs wants to borrow 500 quid off me and I think he's good for it then I may well be prepared to accept a PN from him. If I'm sensible then I'll realise he may be good for it today but things could change next week and ask for it to be secured on something he owns which is of value. Like his house. Then I really need to make sure he can't sell his house without paying me back and it all starts to get complicated. The more scumbags find ways to weasle out of their obligations, the more complicated it gets.

If Joe is rich as Gates and I'm sure he'll always be good for it I might accept a note to pay the bearer on demand to the order of Joe. If other people are as confident in Joe's worth then they may well accept my note in payment of my obligations.

The mistake these idiots make is when they try to pretend that some deadbeat without a bean to their name can write a promissory note for £150k and it means something.