Creating Money, Destroying Money
I'm becoming convinced that the money system that we are all using right now is on the verge of collapse.
In our current money system, money is created in several ways:
1. The central bank (in the US, the Federal Reserve) buys something, such as government securities from the open market, which creates money. This is called "open market operations". Prior to the purchase, the money was not part of the money supply (did not circulate), so it did not exist. The central bank simply "creates a zero", with, for example 1 Billion dollars of assets (money), and 1 Billion dollars of liabilities. There appears to be no limit to how much money the central banks can create in this way.
2. Banks received this "high-powered money" as payment for the government securities, and this money becomes an asset of the banks.
3. The central bank requires the member banks to maintain a certain percentage of their deposits (more specifically liabilities) as money (as opposed to other assets like loans to others, bonds, etc). In the USA, for banks in the USA, the highest reserve requirement is 10%. This means that the banks must have a deposit of 10% of their money with the Federal Reserve Banks (less any cash they might have in their vaults).
4. The banks are thus able to create ("lend" in banking parlance) ten times the amount of high-powered money. Thus, if the Federal Reserve purchases 1 billion dollars of government securities (on the open market), then the bank money supply (M1) increases by 10 billion dollars (although not necessarily right away).5.
5. If the bank has more high-powered money (M0) than the reserve requirement, then they can "create a zero" in the same way. For example, if a person comes in and asks to take out a home equity loan for $100,000; then the bank, after having the owner signing a mortgage note for $100,000, which becomes an asset of the bank, simply writes a balancing $100,000 into the account of the home owner, this is a liability of the bank.
So, we see that money is created in two places, one is by the central banks, who have the authority to create money as they see fit, and buy things, which puts the money into circulation; the second is the banks, who have the authority to create money anytime they "lend", so long as they have some reserves.
Controlling the money supply is then more difficult than some believe.
While the central banks can increase the amount of high-powered money in the system, they do not have control over the actual level of reserves of the banks. If the central banks "inject" money into the economy, and the banks keep this money as reserves without issuing new loans, then the impact is limited to the actual amount of money the central banks create, rather than the 10 times as much.
If the banks are in this situation, where their reserves are higher than required, then they can practically at any time, increase the money supply on their own, without the consent of the central banks.
In the same vein, when the central banks wish to contract the money supply, destroying money, they sell their securities into the market. This brings money into the central banks, which can either be considered as out of circulation, or simply destroyed and non-existent.
The same thing happens continuously with banks. Banks are being paid the principle on their loans on a daily basis. Each day, the banks are "owed" less money, which means their assets are worth less, which in turn means that their overall balance sheets are smaller, meaning less money in the economy. To counter this, the banks attempt to make more loans, so as to bring their total assets up to their maximum legal level.
If the central banks wish to contract the money supply, and the banks are not totally loaned up, then taking selling 1 Billion securities will only contract the money supply by 1 Billion, and not the expected 10 times.
At the moment, the US central bank, the Federal Reserve, appears to be limited in how much they could contract the money supply, because they have purchased "mortgage-backed securities", which may be either impossible to sell, or only possible to sell at a major loss. The more "mortgage-backed securities" the central banks buy (for above market prices), the less control the central banks appear to have over the money supply.
Complicating matters, the amount of money in they economy is not the only thing that determines how much spending is going on. For example, one might think that if there were 1 trillion dollars in the economy, then only 1 trillion dollars of things could be bought/sold. This is not the case at all. Once one think is purchases, that money can be used to purchase something else, then something else, and so on. If there exists exactly 1 trillion dollars at any instant, then it could be that 1 trillion of purchases were made, or 2 trillion, or 4 trillion, depending on how motivates people, on average, are to buy things, and of course, on how available things are. This is called the "velocity of money" or the "velocity of circulation".
The end result is that the people, not the leaders of the central bank, have the greatest amount of control on the money supply and the economy. While the central banks can "inject" or remove high-powered money from the economy, they have a limited ability to determine how much "loan" money will be made, how quickly "loan" money might be paid off, or even how fast or slow the money will be spent that people have.
There are limitations to the speed at which a person can spend money. If a family has an income of $100,000 per year, they can probably minimize their spending for that year, perhaps as low as $30,000 of spending in that year (if they are debt free). On the other hand, the family might be able to spend $300,000 in that year, simply by spending everything they have as income, and then taking out a loan of $200,000 to buy something. This is a full order of magnitude in the amount of spending that this family could determine.
Let's take a closer look at this.
If the family has an income of $100,000; spends only $30,000 (on taxes, food, and essentials); and takes the other $70,000 out of the banks as cash, to be saved someplace very secure (at home or elsewhere but not in the banking system). Notice, that this is the same as the central bank selling something, and removing the money from circulation. If the banks were maxed out, up to their reserve requirements, then the withdrawal of $70,000 in cash from the system, in reality, contracts the money supply by $700,000. To counter this, the central banks would have to inject another $70,000, which will take some amount of time to expand back to the $700,000 of M1 money.
Let's look at the other situation. If the family brings in $100,000; which it spends; and then goes to the bank to create (borrow) another $200,000; then the money supply grows by at least $200,000, and as long as the banks aren't close to being maxed out on their lending, this loan money might expand as much as ten times, to $2,000,000. (At least, this is how it appears to me at the moment.)
So, an individual family, with expenses of $30,000 and an income of $100,000 actually can have the impact of contracting the money supply by $700,000 (if the banks are maxed out) or expanding it by up to $2,000,000 (if the banks are not maxed out and are willing to lend).
Imagine if the average sentiment in the world was to start saving at home... or if the sentiment was to create money (borrow) up to their debt limit.
Right now, the banks most likely have lent as much as they are willing to lend. In fact, many of their assets are worth less than they would like. The mortgages they hold may be worth only 3/4 or 1/2 of what remains on as principle (if they marked the mortgages to market). In fact, in the USA, as many as 1/2 of the mortgages have principle which is higher than the homes that secure them.
Additional Reading
In actuality, the banking system has ways of getting around the 10% reserve requirement rule:
http://seekingalpha.com/article/155669-yes-virginia-there-are-no-reserve-requirements-part-2-2
http://www.marketskeptics.com/2009/03/us-banks-operate-without-reserve.html
In our current money system, money is created in several ways:
1. The central bank (in the US, the Federal Reserve) buys something, such as government securities from the open market, which creates money. This is called "open market operations". Prior to the purchase, the money was not part of the money supply (did not circulate), so it did not exist. The central bank simply "creates a zero", with, for example 1 Billion dollars of assets (money), and 1 Billion dollars of liabilities. There appears to be no limit to how much money the central banks can create in this way.
2. Banks received this "high-powered money" as payment for the government securities, and this money becomes an asset of the banks.
3. The central bank requires the member banks to maintain a certain percentage of their deposits (more specifically liabilities) as money (as opposed to other assets like loans to others, bonds, etc). In the USA, for banks in the USA, the highest reserve requirement is 10%. This means that the banks must have a deposit of 10% of their money with the Federal Reserve Banks (less any cash they might have in their vaults).
4. The banks are thus able to create ("lend" in banking parlance) ten times the amount of high-powered money. Thus, if the Federal Reserve purchases 1 billion dollars of government securities (on the open market), then the bank money supply (M1) increases by 10 billion dollars (although not necessarily right away).5.
5. If the bank has more high-powered money (M0) than the reserve requirement, then they can "create a zero" in the same way. For example, if a person comes in and asks to take out a home equity loan for $100,000; then the bank, after having the owner signing a mortgage note for $100,000, which becomes an asset of the bank, simply writes a balancing $100,000 into the account of the home owner, this is a liability of the bank.
So, we see that money is created in two places, one is by the central banks, who have the authority to create money as they see fit, and buy things, which puts the money into circulation; the second is the banks, who have the authority to create money anytime they "lend", so long as they have some reserves.
Controlling the money supply is then more difficult than some believe.
While the central banks can increase the amount of high-powered money in the system, they do not have control over the actual level of reserves of the banks. If the central banks "inject" money into the economy, and the banks keep this money as reserves without issuing new loans, then the impact is limited to the actual amount of money the central banks create, rather than the 10 times as much.
If the banks are in this situation, where their reserves are higher than required, then they can practically at any time, increase the money supply on their own, without the consent of the central banks.
In the same vein, when the central banks wish to contract the money supply, destroying money, they sell their securities into the market. This brings money into the central banks, which can either be considered as out of circulation, or simply destroyed and non-existent.
The same thing happens continuously with banks. Banks are being paid the principle on their loans on a daily basis. Each day, the banks are "owed" less money, which means their assets are worth less, which in turn means that their overall balance sheets are smaller, meaning less money in the economy. To counter this, the banks attempt to make more loans, so as to bring their total assets up to their maximum legal level.
If the central banks wish to contract the money supply, and the banks are not totally loaned up, then taking selling 1 Billion securities will only contract the money supply by 1 Billion, and not the expected 10 times.
At the moment, the US central bank, the Federal Reserve, appears to be limited in how much they could contract the money supply, because they have purchased "mortgage-backed securities", which may be either impossible to sell, or only possible to sell at a major loss. The more "mortgage-backed securities" the central banks buy (for above market prices), the less control the central banks appear to have over the money supply.
Complicating matters, the amount of money in they economy is not the only thing that determines how much spending is going on. For example, one might think that if there were 1 trillion dollars in the economy, then only 1 trillion dollars of things could be bought/sold. This is not the case at all. Once one think is purchases, that money can be used to purchase something else, then something else, and so on. If there exists exactly 1 trillion dollars at any instant, then it could be that 1 trillion of purchases were made, or 2 trillion, or 4 trillion, depending on how motivates people, on average, are to buy things, and of course, on how available things are. This is called the "velocity of money" or the "velocity of circulation".
The end result is that the people, not the leaders of the central bank, have the greatest amount of control on the money supply and the economy. While the central banks can "inject" or remove high-powered money from the economy, they have a limited ability to determine how much "loan" money will be made, how quickly "loan" money might be paid off, or even how fast or slow the money will be spent that people have.
There are limitations to the speed at which a person can spend money. If a family has an income of $100,000 per year, they can probably minimize their spending for that year, perhaps as low as $30,000 of spending in that year (if they are debt free). On the other hand, the family might be able to spend $300,000 in that year, simply by spending everything they have as income, and then taking out a loan of $200,000 to buy something. This is a full order of magnitude in the amount of spending that this family could determine.
Let's take a closer look at this.
If the family has an income of $100,000; spends only $30,000 (on taxes, food, and essentials); and takes the other $70,000 out of the banks as cash, to be saved someplace very secure (at home or elsewhere but not in the banking system). Notice, that this is the same as the central bank selling something, and removing the money from circulation. If the banks were maxed out, up to their reserve requirements, then the withdrawal of $70,000 in cash from the system, in reality, contracts the money supply by $700,000. To counter this, the central banks would have to inject another $70,000, which will take some amount of time to expand back to the $700,000 of M1 money.
Let's look at the other situation. If the family brings in $100,000; which it spends; and then goes to the bank to create (borrow) another $200,000; then the money supply grows by at least $200,000, and as long as the banks aren't close to being maxed out on their lending, this loan money might expand as much as ten times, to $2,000,000. (At least, this is how it appears to me at the moment.)
So, an individual family, with expenses of $30,000 and an income of $100,000 actually can have the impact of contracting the money supply by $700,000 (if the banks are maxed out) or expanding it by up to $2,000,000 (if the banks are not maxed out and are willing to lend).
Imagine if the average sentiment in the world was to start saving at home... or if the sentiment was to create money (borrow) up to their debt limit.
Right now, the banks most likely have lent as much as they are willing to lend. In fact, many of their assets are worth less than they would like. The mortgages they hold may be worth only 3/4 or 1/2 of what remains on as principle (if they marked the mortgages to market). In fact, in the USA, as many as 1/2 of the mortgages have principle which is higher than the homes that secure them.
Additional Reading
In actuality, the banking system has ways of getting around the 10% reserve requirement rule:
http://seekingalpha.com/article/155669-yes-virginia-there-are-no-reserve-requirements-part-2-2
http://www.marketskeptics.com/2009/03/us-banks-operate-without-reserve.html