How the financial system came to be

 

The goldsmiths tale

The short animation film Money As Debt explains how the financial system came to be. It is an interesting story. Once upon a time when gold was internationally accepted as money, goldsmiths fabricated gold coins of standardised weight and purity. They were a trusted source of these gold coins. They owned a safe where they stored their gold. Other people wanted to store their gold there too because those safes were well guarded.

goldsmithsafe
Money As Debt: guarded safe

And so some goldsmiths began to make a business out of renting safe storage. People storing their gold with the goldsmith received a voucher certifying the amount of gold they brought in. At first these vouchers could only be collected by the original depositor.

Later this restriction was lifted so that any holder of the voucher could collect the deposit. From then on people started to use these vouchers as money because paper money was more convenient than gold coin. Depositors rarely demanded their gold and it remained in the vaults of the goldsmiths.

goldsmithmoney
Money As Debt: gold smith paper money

Modern banking

Some goldsmiths also had another business, which was lending out their gold at interest. Because depositors rarely came in to collect their gold, they discovered that they could also lend out the gold of the depositors at interest. When the depositors found out about this, they demanded interest on their deposits too. At this point modern banking started to take off and paper money became known as bank notes.

Borrowers also preferred paper money to gold coin, so the goldsmiths, who had now become bankers, found out that they could lend out more money than there was gold in their vaults. Bankers started to create money out of thin air. This is fractional reserve banking because not all deposits were backed by gold reserves. The new money was spent on new businesses and that hired new people so the economy boomed.

When depositors found out that there were more bank notes circulating than there was gold in the vaults of the goldsmith’s bank, the scheme could run into trouble, but mostly it didn’t. Depositors received interest and this enticed them to keep their deposits in the bank. People trusted their bank as long as they believed that debtors had no trouble repaying their loans.

Bank runs

Sometimes people started to have doubts about their bank and worried depositors came to the bank to exchange their bank notes for gold. This is a bank run. The bank could run out of gold and close down because not all the gold was there. The bank’s bank notes could then become worthless, even when borrowers had no problems repaying their debts. The money that the bank had created out of thin air suddenly vanished. This was a financial crisis.

bankrun
Money As Debt: bank run

As a lot of money had suddenly disappeared people had less money to spend. This could hurt sales so that some businesses could go bankrupt. Those businesses could not repay their debts at other banks. Depositors at those banks could start to fear that their bank would go bankrupt too. This could cause more bank runs and more money disappearing, so that things would become even worse. This is an economic crisis. This is the way a financial crisis could trigger an economic crisis.

centralbank
Money As Debt: central bank

Regulations and central banks

Measures have been taken to forestall financial crises and to deal with them if they occur. Banks needed to have a minimum amount of gold available in order to pay depositors. Central banks were instituted to support banks by supplying additional gold if too many depositors came in to collect their gold. Central banks could still run out of gold but this was solved when the gold backing of currencies was ended. Nowadays central banks can print new dollars or euros to cope with a shortfall.

Regulations limit the amount of loans banks make and therefore the amount of money that exists. But everyone can lend to anyone. Alternative forms of financing circumvent the regulations imposed on banks. For example, corporations can issue bonds or use crowd funding. Human imagination is the only limit to the amount of debt that can exist. As long as people expect that those debts will be repaid, even if it is with new debts, there is trust in these debts. But the financial crisis of 2008 demonstrated that trust in these debts can suddenly disappear.

What is the use of banks?

Turning debt into money

The previous episode about money discussed some imaginary trades between you, a hatter, a lawyer, a barber and a fisherman. It is shown that if people promise to pay this might suffice for payment. So if the fisherman promises you to pay next week for the hat you just made, you could say to the lawyer that you expect the fisherman to pay in a week, and ask her if you can pay in a week too. The lawyer could then ask the same of the barber and the barber could ask the same of the fisherman. If all these debts cancel out then no cash is needed.

In most cases debts cannot be cancelled out so easily. A hat may cost € 50, legal advice € 60, a hairdo € 30, and the fish € 20. If you are the hatter, you could lend € 10 to the barber and the lawyer could lend € 20 to the fisherman. Perhaps the lawyer doesn’t trust the fisherman because he smells fishy. But if the lawyer trusts the barber and the barber trusts the fisherman then the lawyer could lend € 20 to the barber and the barber could lend € 20 to the fisherman.

That could become complicated quite easily. And this is where banks come in. Banks can lend money because they know the financial situation of their customers. The fisherman can borrow money from his bank to make payments because the bank knows that he has an unstable but good income and a vessel that can be sold for cash if needed.

If the fisherman borrows money to pay for the hat you made, this money ends up in your account. You can use it to pay the lawyer. And so the fisherman’s debt becomes the lawyer’s money until she uses it to pay the barber. People that have a deposit lend money to the bank and the bank is lending this money to those who have a loan, in this case the fisherman. Depositors trust the bank even though they do not know the people the bank is lending money to.

Most people think of money as coins and bank notes but more than 90% of the money just exists as bookkeeping entries in banks. When a fisherman borrows money from his bank, he can spend it on a hat. This means that the bank creates money and that this money is debt. Most of our money is debt so the value of money depends on the belief that debtors pay back their debts. This seems scary and it keeps quite a few people awake at night.

Some people argue that debts and banking are a fraud because they are based on a belief. But banks and debts help to boost trade and production by creating money that doesn’t exist to start businesses that don’t yet exist to make products which will be bought by the people those businesses will hire with this newly created money. Banking and debts are at the basis of the capitalist economy.

Banking as bookkeeping

Banking is more or less just bookkeeping and balance sheets. Balance sheets can be used to explain the magic trick banks do, which is creating money. Balance sheets are simple. There are no intimidating formulas, only additions and subtractions. The important thing to remember with balance sheets is that the total of the amounts on the left side must always equal those on the right side.

On the left is the value of your stuff and your money. On the right side is the value of your debts. Your net worth is what remains when you sell all your stuff and pay off your debts. It is on the right side too in order to make it equal to the left side. Your net worth can be a negative value. If that is the case, you might be bankrupt because you can’t repay your debts by selling your assets. The left side is named debit and the right side is called credit. Your balance sheet might look like this:

debit
credit
house
€ 100,000
mortgage
€ 80,000
other stuff
€ 50,000
other loans
€ 30,000
cash, bank deposits
€ 20,000
your net worth
€ 60,000
total
€ 170,000
total
€ 170,000

When you buy a car, you own more stuff, but also another loan or fewer bank deposits as you have to pay for the car. This is because debit always equals credit. When you drive the car, it goes down in value, as does your net worth, because debit always equals credit. If your salary comes in, your bank deposits as well as your net worth rise because debit always equals credit. If you pay down a loan, the amount in your bank account as well as the amount of your loan goes down because debit always equals credit. If debit doesn’t equal credit then you have made a calculation error.

Also for a bank the total of the amounts on the left side must always equal those on the right side, so that debit always equals credit. Your debt is on the debit side of the bank’s balance sheet. You have borrowed this money from your bank. The bank owns this loan. Your bank deposits are on the credit side of the bank’s balance sheet. The loans of the bank are paid for by deposits. Banks lend money to each other. This may happen when you make a payment to someone who has a bank account at another bank. Your bank may borrow this money from the other bank until a payment comes the other way. The balance sheet of a bank may look like this:

debit
credit
mortgages and loans
€ 70,000,000
deposits
€ 60,000,000
loans to other banks
€ 10,000,000
deposits from other banks
€ 20,000,000
cash, central bank deposits
€ 10,000,000
the bank’s net worth
€ 10,000,000
total
€ 90,000,000
total
€ 90,000,000

How banks create money

Banks create money. How do they do that? It is easy if you understand balance sheets. Assume that you, the hatter, the lawyer, the barber, and the fisherman all have € 10 in cash. Together you decide to start a bank. You all bring in the € 10 you own so that you all have a deposit of € 10 and the bank has € 40 in cash. The bank allows everyone to withdraw deposits in cash. This is no problem as long as the total of deposits equal the total amount of cash. After everyone has put in the deposit, the bank’s balance sheet looks as follows:

debit
credit
cash
€ 40
your deposit
€ 10
deposit lawyer
€ 10
deposit barber
€ 10
deposit fisherman
€ 10
total
€ 40
total
€ 40

First, there was only € 40 in cash. Now there are € 40 in bank deposits too. You might think that the bank created money. Only, that isn’t true because the depositors can’t spend the cash unless they take out their deposits. In other words, the depositors don’t have more money at their disposal than before. If you look at the total, there is still € 40. This is bookkeeping. You have to write down the total twice as debit must equal credit.

But now things are going to get a bit wild. The fisherman comes to you and he wants to buy a hat. The hat costs € 50 but the fisherman has only € 10 in his account. To make the sale possible, the bank is going to do its magic. The fisherman calls the bank and asks if he can borrow some money. The bank grants him a loan of € 40 and puts the money in his deposit account so that he can spend it. And look:

debit
credit
cash
€ 40
your deposit
€ 10
loan fisherman
€ 40
deposit lawyer
€ 10
deposit barber
€ 10
deposit fisherman
€ 50
total
€ 80
total
€ 80

Who says that miracles can’t happen? The amount of deposits miraculously increased from € 40 to € 80 so € 40 is created from thin air. There is still only € 40 in cash but the fisherman’s debt created new money. This is how banks create money. And that is only because bank deposits are money. This is all there is to it. So much for the mystery. The fisherman then pays € 50 for the hat. And so it becomes your money:

debit
credit
cash
€ 40
your deposit
€ 60
loan fisherman
€ 40
deposit lawyer
€ 10
deposit barber
€ 10
deposit fisherman
€ 0
total
€ 80
total
€ 80

And now comes the dreadful part that keeps some people fretting. Everyone can take out his or her deposits in cash. There is € 80 in deposits and only € 40 in cash. If you go to the bank and demand your € 60 in cash, the bank would go bankrupt, even when the fisherman pays off his loan the next day. You could bankrupt the bank by buying € 50 in fish with cash. If you go to the bank to get € 50 in cash it would not be there so the bank would go bankrupt before the fisherman can pay off his loan with the same cash.

A bank could get into trouble in this way even when debtors repay their debts. Clever minds already figured out a solution. Central banks can print the needed cash. If the European Central Bank (ECB) prints € 20 on a piece of paper and lends this money to the bank, there would be enough cash to pay out your deposit. Banning the use of cash and only use bank deposits for payments would be another option. So, after the ECB deposited € 20 in cash, the bank’s balance sheet might look like this:

debit
credit
cash
€ 60
your deposit
€ 60
loan fisherman
€ 40
deposit lawyer
€ 10
deposit barber
€ 10
deposit fisherman
€ 0
deposit ECB
€ 20
total
€ 100
total
€ 100

After you pay the fisherman, he can pay off his loan, and the bank will have enough cash to pay out all deposits. The bank can repay the central bank and everything is fine and dandy again. In this case the bank could not meet the demand for cash but the value of cash and loans wasn’t smaller than the deposits (the bank’s debt). After the fisherman pays back his loan and the bank pays back the ECB, the bank’s balance sheet might look like this:

debit
credit
cash
€ 40
your deposit
€ 10
loan fisherman
€ 0
deposit lawyer
€ 10
deposit barber
€ 10
deposit fisherman
€ 10
deposit ECB
€ 0
total
€ 40
total
€ 40

If banks can’t create money, trade would be difficult. If the hat is € 50, the legal advice € 60, the hairdo € 30, and the fish € 20, and you, the lawyer, the barber and the fisherman all have only € 10, nothing can be bought or sold. If the bank lends € 40 to the fisherman, he can buy a hat from you, you can buy legal advice from the lawyer, the lawyer can buy a hairdo and the barber can buy fish. Debt is the basis of the capitalist economy. Nearly all money is debt, and without debt the economy would come to a standstill.

How much money can banks create?

The amount of money a bank can create is limited by the bank’s capital, which is the bank’s net worth. Regulations stipulate that banks should have a minimum amount of capital. This is the capital requirement. If the capital requirement is 10%, and the bank’s capital is € 10,000,000, it can lend € 100,000,000, provided that there are enough deposits. If the bank makes a loan, a new deposit is created. If the deposit leaves the bank, the bank must borrow it back from another bank or cut back its lending. That is because debit must always equal credit.

debit
credit
mortgages and loans
€ 70,000,000
deposits
€ 60,000,000
loans to other banks
€ 10,000,000
deposits from other banks
€ 20,000,000
cash, central bank deposits
€ 10,000,000
the bank’s net worth
€ 10,000,000
total
€ 90,000,000
total
€ 90,000,000

When a deposit leaves the bank, it ends up at another bank. The other bank can use it for lending, provided that it has sufficient capital. There may be a reserve requirement, which is a minimum of cash and central bank deposits the bank must hold. If the reserve requirement is 10%, the bank can lend out as much as ten times the amount of cash and central bank reserves it has available. In the past reserve requirements were important as people often used cash and could go to the bank to demand their deposits in cash. For that reason banks needed to hold a certain amount of cash.

Pictures:
– Deutsche Bank building CC BY-SA 4.0. Raimond Spekking. Wikimedia Commons. https://commons.wikimedia.org/w/index.php?curid=12171

100 Brazilian real

Currency

Self determination

A currency is the money that is in use within a nation. US dollars, Chinese renminbi, Korean won and Brazilian real are all currency. A national currency promotes national self-determination. It allows a nation to pursue its own economic policies, although the options are limited by market forces.

Local or regional currencies can supplement national currencies, most notably when communities or regions are closely integrated and want to achieve some economic independence. A supranational currency like the euro reduces national economic independence. The issue of self-determination makes currency a political subject.

Reserve currency

Reserve currencies facilitate international trade. In the past decades the US dollar was the reserve currency. This arrangement allowed the United States to enjoy a higher living standard and a large military paid for by foreign nations.

But this gave foreign nations a competitive advantage. By buying US Dollars for their reserves, competitors of the United States were able to suppress the exchange rate of their currency and sell their products cheaper. This harmed US businesses.

Furthermore, the reserve status of the US Dollar made the FED responsible for the international banking system. The FED had to rescue foreign banks during the financial crisis of 2008 so that the US taxpayer ended up backing foreign banks.

International Currency Unit

It may be better that the international reserve currency is not a national currency. The future International Currency Unit can be a weighed average of national currencies. It may require an international central bank to guarantee stability in the international financial system. As long as central banks make political decisions, an international central bank would be a troublesome construct.

Only when central banks do not set interest rates and do not print currency, it might be feasible to introduce an international central bank. This might be possible when the International Currency Unit is a Natural Money currency. The underlying currencies may need to be Natural Money currencies too. With Natural Money interest rates are not set by central banks so the role of central banks is reduced.

50 euro
50 euro

The euro

The euro is a difficult construct. The nations of the euro zone are sovereign but have given up their national currencies. This produced political and economic tensions. Countries in Northern Europe feel that they have to pay for the debts of Southern Europe while countries in Southern Europe feel they are faced with austerity dictated by Northern Europe. The available options appear making the eurozone a federation like the United States or reverting to national currencies.

Returning to national currencies doesn’t have to end the euro. National currencies can be introduced alongside the euro. Alternatively, the euro can become a weighted average of the national currencies making up the euro zone. Existing balances in euro will remain in euro. In the latter case the future euro would look like the proposed International Currency Unit. It could be a step towards introducing an international currency and an international central bank.

Cryptocurrencies

Cryptocurrencies are debt-free and do not need a central bank. They promise an alternative payment system independent from governments and banks as well as an alternative way to issue stock. Proponents of private currencies believe that private currencies like cryptocurrencies can supplement or even replace existing currencies issued by governments and central banks.

Currency is important for political self-determination so governments have usurped the prerogative to issue currencies. Private currencies can undermine the power of governments. Cryptocurrencies also facilitate crime, scams and tax evasion, so they their use is likely to become regulated or even banned in the future. Governments may also start to issue cryptocurrencies themselves.

Until now cryptocurrencies have not been stable. Payments are cumbersome and prone to fraud. Regular currencies don’t have these disadvantages. Cryptocurrencies without a holding tax don’t allow for negative interest rates. As negative interest rates may be needed to ensure a stable economy without crises, these currencies may not be suitable as a means of payment.