[quote] But if you borrow $1,000 from your local bank, they book the loan as an
asset, and create a $1,000 deposit in your name as a corresponding
liability. This $1,000 deposit is literally created from thin air. The
only constraint is that the local bank had to have at least $100 of
reserves on hand. [/quote]
Not in so much. Saying that the banks create money out of thin air is a deep mischaracterization that leads to even deeper misunderstandings. If they truly created the money out of thin air, then they’d have no concern about recollecting the money at a future point.
In reality, the action of a bank lending varies quite profoundly, depending on the type, the length, and the manner of the lending. A simple loan has an interesting characteristic of 'drawing money from the future. To fully explain this examples are really necessary:
Lets say you have Bob and Joe. Bob has one $10 bill, and both are on a raft in the middle of an ocean. Joe has an apple, and Bob buy that apple for $20 so we have:
Bob Joe
-10d $10
So in other words, Bob promises to pay Joe more money in the future. Joe gets to hold the $10 bill. Notice, there are no ‘new’ bills. This is because money hasn’t been printed.
Now, latter Bob catches a fish, and Joe buys the fish from Bob for $30. To complete this exchange, Joe gives Bob $10 then calls Bob on his debt, getting the $10 back. He then pays Bob $10 again, and then promises $10 more in the future. Notice how the bill changed hands 3 times in this described interaction. This is the monetary effect of huge debts, in effect, extreme monetary velocity.
Now create an even bolder senario. Its five days later and the distribution is:
Bob Joe
$10 -100d
Now Joe has somehow gotten his hands on fresh water. Bob, very thirsty, buys that water for $300. So Bob gives $10 calls on the debt, to get $10 and repeats for an insane 21 exchanges of that $10 dollar bill. Bob then takes a debt of -190d. Notice that debts are getting very very large compared to the number of bills. This is one example of leverage. That is, as long as Joe and Bob feel comfortable allowing the other to sink really deep into debt and refrain from ‘calling’ each other on it when the other can’t pay. Everything is fine and dandy.
Unfortunately, real life doesn’t work this way. Sooner or later one party takes on more debt than he can ever repay (even if all commodities are inflating insanely as in the raft example.), or one party ceases to concern himself with the intent of ever repaying back (Hey, thinks Joe, why bother paying back? I’ll just keep taking and then and when Bob finally gets angry, refuse to give him anything back!).
That is, all loans are based on trust. Trust that the other party will pay and trust that the other party can pay. The rational that debts can be larger is also quite sensible. More goods are always being produced in the future (even if the economy is smaller). As such, even if there is no build up of wealth a person can ‘consume’ enough ‘consumable goods’ over a period to add up to the value of a larger debt. As such, debt does not automatically presume that future will be larger than the present, but rather, that the future will be large enough. (And if debt is really high, like in the USA, it does become a larger than the present issue).
However, nothing in this raft constitutes the effect of printed money. Indeed, debt creation is far and distant from money creation. Let us consider the same situation as before Bob and Joe on the boat, but this time they are using a ‘seashell’ to stand in for the $10 bill. Lets call them $s. So we have:
Bob Joe
$s1 -10d
Now, Joe and Bob reach an abandoned island beach. Joe being a cunning man refrains from paying Bob back and instead, quickly grabs up 10 seashells and gives them to Bob. Joe, has in effect ‘printed’ $s10.
So we have
Bob Joe
$s11 0
Which is exactly the same (inflationary effect accounted for) as:
Bob Joe
$1 0
That is, this exchange is no different than Joe simply outright saying he has no intention of ever repaying Bob back. Indeed, the only difference is that when the economy starts back up again (because Joe and Bob forgive each other and work out a reasonable arrangement – Bob swallowing his losses, Joe finally agreeing to pay the original debt (now 11x as big!) in full, or some variation there of). there are $s11 instead of $1s. That is, an inflation of 1000%.
To put it another way. Printing money, and debt creation are as different as night and day.
–
Steve