04 May 2010

Murphy Triple Play

Shameless Self-Promotion 7 Comments

Sorry kids, I’m still catching up on all my “real work” so I can’t resume blogging. In the meantime, here are some things you might enjoy:

* My AOL piece explaining that Social Security is already broke. (Warning: If you don’t want to get a jillion emails, don’t write an article for AOL.)

* My response to DeLong’s critique of Austrian economists.

* And all modesty aside, I think this half-hour video clip from the recent Mises Circle in Phoenix explains our crazy fractional reserve banking system, without making me look crazy:

7 Responses to “Murphy Triple Play”

  1. Daniel says:

    I’m confused by fractional-reserve banking. At 19:00 you say that if someone deposits $1m in a bank, then that bank can lend out $0.9m holding $0.1m in reserve. Doesn’t the bank actually lend out $10m holding $1m in reserve? Is that what you mean when you say that as money “cascades through the system, banks can eventually lend out up to $9m?”

  2. Blooper says:

    “(Warning: If you don’t want to get a jillion emails, don’t write an article for AOL.)”

    How many of them claimed that you are a socialist/nazi/communist/fascist/reptilian banker jew?

  3. Ash Navabi says:

    Daniel, Bob didn’t say that the “bank can lend out $0.9m holding $0.1m in reserve”, because that’s not what happens. What happens is that the bank creates $0.9m on top of the original $1m, so that now there is $1.9m of new money in the system. Then the next bank creates $0.81m, adding it to the pile (=$2.71m), then the next bank creates $0.73m (=$3.44m), etc., and it keeps going. Eventually, it all adds up to $9m in new money.

  4. bobmurphy says:

    Actually Ash, Daniel is right in terms of what I said.

    The trick is that any given bank probably won’t be able to hold on to the new loans. So the first bank gets $1m in deposits, and sets aside $100k as reserves. It has $900k in excess reserves, which it (say) gives as a mortgage loan to someone.

    Now it’s true, if the bank thought that guy would just let the $900k sit in his checking account, and if the bank thought the first depositor would leave his $1m in his own checking account indefinitely, then the bank could go ahead and create $9m total in new loans on top of the $1m in new reserves.

    But in practice, people will write checks on their lent funds. That $900k new loan will probably be spent (on a house for example) and get transferred to another bank. So the first bank can’t just create $9m in new loans right away.

  5. Ash Navabi says:

    But Bob, I don’t think what you’re describing is what the Fed says itself: see the bottom of page 7 here: http://www.rayservers.com/images/ModernMoneyMechanics.pdf

    “they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they
    do when they make loans is to accept promissory notes in exchange for credits to the borrowers’ transaction accounts. Loans (assets) and deposits (liabilities) both rise by $9,000. Reserves are unchanged by the loan transactions. But the deposit credits constitute new additions to the total deposits of the banking system.”

    To me, what you’re describing is that “bank A receives $1m from a customer A, reserves $0.1m, loans $0.9m to customer B who deposits at bank B, and still maintains that customer A still has $1m. Bank B then does the same thing, so that now customer B thinks he has $0.9m, when the bank really has kept $0.09m, and has lent out $0.81m to someone else. This keeps going, until it is believed that there is $9m in the system, but there is really only $1m.”

    But as MMM points out, this doesn’t really ‘create’ any money. I guess if this were a gold system, this would be how it worked. But I think because this is a fiat system, each individual bank has the power to actually create its own money.

    Then again, I could be totally misunderstanding something, and would be happy to be corrected.

    • bobmurphy says:

      Ash, I’m just skimming here, but here’s what I’m trying to say:

      Yes, you’re right, in the first step the bank just magically gives a loan applicant a new checking account with $900,000 in the balance. So they haven’t “given away” any of the original $1m deposit.

      But when the loan applicant buys his $900,000 house with a check drawn on the bank, the other bank where it is deposited then asks the first bank for $900,000. So at that point, the first bank has to transfer $900,000 of its reserves to the other bank.

  6. Daniel says:

    Thanks, I get it now. I wasn’t thinking clearly. I’ve done the math now and see that in a simple model banks ultimately make loans equal to the amount of deposits they hold multiplied by (1 – r) / r, where r is the reserve requirement. So if r = 0.1 and someone deposits $1m, then $9m in loans are be made. Add in the original $1m, and there is $10m total. So a central bank operation that supplies a bank with x newly created dollars actually injects x / r dollars into the economy.