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I have the impression that everyone has more net money than in the past. By net money I means cash + money lent to others - money borrowed from others. If this is true, where does the extra net money come from? Is it right to say that originally all the extra net money comes to the world as interest paid by the central bank for the reserve deposit of commercial banks?

I read that commercial banks create money by making loans. But when one person borrows money from banks, his net money doesn't increase. And when people make transactions, money just goes from one to another. How does it come that finally everyone has more net money than before?

Edit:

I have a second thought that my impression is simply wrong. It's only true to say that generally everyone is wealthier than in the past. If we look at the richest businessmen in the world, their "net money" as defined above can often be hugely negative, but they are still wealthy since they possess a lot of other things like buildings, factories etc.

And besides those business men, the "net money" of the government is also hugely negative(almost every country's government has a large public debt). So if the "net money" of the popluation as a whole remains more or less constant(in the spirit of "loans + cash == liability deposits" mentioned by @Lumi), a few entities having hugely negative "net money" make others's net money increase, so one could have the impression that the "net money" of the majority of the population has increased.

Petite Etincelle
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  • @dismalscience thank you for your edition. In fact I am wondering where the net money is created. I don't know if it is created during a lending process or somewhere else. – Petite Etincelle Jun 22 '15 at 21:15
  • Ah, so to clarify further, are you interested in money creation specifically, or wealth creation generally? – dismalscience Jun 22 '15 at 21:16
  • @dismalscience I am interested in the net money creation. I understand when banks make loans there is more money in circulation. But I don't understand why as time goes by, everyone has more net money – Petite Etincelle Jun 22 '15 at 21:18
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    So the short version (I'll let someone else write up a formal answer, it's pretty interesting) is that there are three separate things going on: one is the creation/destruction of money as loans are made and repaid, a second is wealth creation through production in the real economy, and the third is the general trend increase in the money supply that is controlled (in large part) by the central bank. – dismalscience Jun 22 '15 at 21:26
  • @dismalscience Sorry, I still don't see at which step the net money is changed. The central bank can let commercial banks make more loans to increase money supply, but how does this change the net money amount? Hope I can get more illustration. – Petite Etincelle Jun 22 '15 at 21:38
  • What is the difference between the money supply and the "net money amount"? – Steven Landsburg Jun 22 '15 at 21:45
  • @StevenLandsburg If a bank makes a loan of 100 to a person, the money supply increases by 100, but the net money amount doesn't change – Petite Etincelle Jun 22 '15 at 21:48
  • @PetiteEtincelle: I have no idea what "net money amount" means. Can you explain? – Steven Landsburg Jun 22 '15 at 21:48
  • In particular: Every loan increases the amount that one person lends by exactly the same amount that it increases the amount that some other person borrows. So if I take you literally when you say "cash plus lending minus borrowing", it seems we can simplify this to just "cash". But you seem to mean something different. (?) – Steven Landsburg Jun 22 '15 at 21:51
  • @StevenLandsburg Yes by net money I just mean cash plus lending minus borrowing. With this definition, in my above example of 100 loan, the money supply increases by 100, but the net money doesn't change. Am I right? – Petite Etincelle Jun 22 '15 at 21:53
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    So instead of inventing the confusing phrase "net money", why not just use the word "cash"? – Steven Landsburg Jun 22 '15 at 22:21
  • @StevenLandsburg Just to be closer to reality. I don't know what the answer could be so I try to be precise, since one person's banking deposit can be seen as money lent to others for the person and money borrowed from others for the bank – Petite Etincelle Jun 22 '15 at 22:24
  • The answer to your question is that cash comes from the U.S. Mint. – Steven Landsburg Jun 22 '15 at 23:09
  • @StevenLandsburg U.S. Mint doesn't print money and distribute it for free, right? When the central bank lends money to commercial banks or buys government bonds, the net money of commercial banks or government doesn't change. Are there some activities of the central bank which can be seen as giving money for free? – Petite Etincelle Jun 23 '15 at 06:20

4 Answers4

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Suppose I define "net appliances" as dishwashers plus appliances lent to others minus appliances borrowed from others.

Suppose I build a refrigerator and lend it to you. Then your "net appliances" have been reduced by one, my "net appliances" have increased by one, and the total of the world's "net appliances" has not changed.

On the other hand, the world does now have one more refrigerator, which suggests that "net appliances" was never a very interesting notion in the first place.

Steven Landsburg
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    When you build a refrigerator, your "net appliances" has increased by one. And when you lend it to me, neither my "net appliances" nor yours have changed, isn't it? – Petite Etincelle Jun 27 '15 at 21:39
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    When I build the refrigerator, I have a) not acquired or lost a dishwasher; b) not made any loans; c) not done any borrowing. Therefore my net appliances do not change. When I lend it to you, you have a) not acquired or lost a dishwasher, b) not made any loans, and c) borrowed one refrigerator. Therefore your net appliances have been reduced by one. Please take a minute to check your arithmetic before posting. – Steven Landsburg Jun 27 '15 at 22:12
  • Yes, I see your points, with your definition your arguments are good. But in your terms, my question is asked with the definition of "net appliances" as all the appliances I have now plus appliances lent to others minus appliances borrowed from others. – Petite Etincelle Jun 27 '15 at 22:27
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    No, that's not your question, unless you've changed it. You defined "net money" to be cash plus money lent minus money borrowed. Cash, of course, is one kind of money. I defined "net appliances" to be dishwashers plus appliances lent minus appliances borrowed. Dishwashers, of course, are one kind of appliance. My setup is exactly the same as yours. – Steven Landsburg Jun 27 '15 at 22:34
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    You also might want to work through what happens if instead of building a refrigerator and lending it to you, I build a dishwasher and lend it to you. Hopefully you don't need anyone to walk you through this. Next you can work out what happens if I build a dishwasher and trade it to you for a refrigerator. Or any other scenario you care to think about. Any question you can ask about net money has a perfect analogue with net appliances. – Steven Landsburg Jun 27 '15 at 22:37
  • For me, cash is all the money I have, besides the money I lent to others(including bank deposit) and I have no debt actually – Petite Etincelle Jun 27 '15 at 22:39
  • It unfortunately doesn't always help to make physical analogies with this stuff. For example (to take a fairly common mistake made in the financial press) - let's say I lend you a washing machine for 1 day, take it back, and then lend it to you again for the next day, and do this 365 times. Have I lent you 365 washing machines, or 1 washing machine? Note, that as I only used the washing machine at night, the total amount of washing that can be performed in the world has dramatically increased through this mechanism. – Lumi Jul 02 '15 at 13:44
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    @Lumi: You've lent me 365 days of washing services. It doesn't make a bit of difference whether you call it one washing machine for 365 days or 365 washing machines for 1 day each. I continue to maintain that nothing is lost in the physical analogy. – Steven Landsburg Jul 02 '15 at 13:55
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    @StevenLandsburg - then why did you have to (quite correctly) rename the washing machine to washing services? – Lumi Jul 02 '15 at 14:24
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    @Lumi: Because I wrote a little sloppily in the first place --- at a level of sloppiness that, I think, is quite usual for this kind of informal discussion and rarely causes any important confusion. But of course it can't hurt to be a little more precise, just to make confusion even less likely, so I'm glad to acknowledge your point. – Steven Landsburg Jul 02 '15 at 15:34
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No, it's not correct to say that extra cash money comes into the world as interest paid on the reserve accounts of commercial banks.

In today's banking world, physical cash money is printed on demand. That is to say, the commercial banks estimate how much money they need to satisfy demand from ATM's and customer cash withdrawals and buy that amount from the central bank. In turn the central bank buys the cash from the treasury. The money they use to buy it with, is the electronic liability deposit account, that sits on the other side of the double entry book keeping used by banks.

It is of course possible for politicians to intervene in this process, and then this happens:

US Physical Coin surplus

As to the equation: net money = cash + money lent to others - money borrowed from others.

This is incorrect as written, since as usual in economic discussions on money, we have the confusion introduced by the banking system as to what exactly is money? Money lent or received from others can be physical cash, but it can also be money created as a liability deposit account as a result of a bank loan. Because a loan itself is just a contractual agreement to repay money over time, it's also not strictly correct to say that money lent to other must equal money borrowed from others, since there's no notion of time in that statement, or repayment over time.

If we take the larger definition of money, i.e. the total sum of cash and bank liability deposits, then this is more or less continuously growing as banks generally lend at a faster rate than loans are repaid. (Check your central bank's web site to see what's currently happening to your countries money supply, there are considerable variations in this.)

While it's true in a banking system where banks are only allowed to make customer loans that loans + cash == liability deposits, most banking systems today also allow banks to sell loans using securitzed lending, or covered loans. This actually allows banks to originate more loans than money, and as a result at the same time as we have a growth in the general money supply - due to banks generally lending at a faster rate than loan repayment occurs, there will be slightly faster increase in the total amount of bank originated debt.

So in some sense of net money that includes all the money supply, i.e. bank deposits and cash, it is debt that is growing faster than money, and not the other way around.

Lumi
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  • Thank you for your answer(and the interesting story in the link). I was thinking about something like the equality "loans + cash == liability deposits" when I defined "net money", and I have poor knowledge in economy so I don't know how to formulate my question in the right term. Just one more question: is it true that neither the treasury nor the central bank does anything like giving money for free? They just make loans that need to be repaid one day(or selling cashes against the number in electronic liability deposit accounts as you described), right? – Petite Etincelle Jun 27 '15 at 22:08
  • I've added some thoughts in my question, could you take a look? Thanks! – Petite Etincelle Jun 27 '15 at 22:21
  • That's correct, no honest treasury or central bank gives money away for free. (The commonest form of bank exploitation is to make loans to business friends with no expectation of repayment, cf. Iceland, Ukraine, Russia, et al.) – Lumi Jun 28 '15 at 01:04
  • Personally I think it's better to say simply that there is some amount of money, and a considerably larger amount of debt (especially once you start adding in corporate bonds, securitized bonds, and government debt). Economists like Krugman do take the same view as you, that one person's debt is another person's asset - which is essentially your definition of net money - but I think there are considerable structural issues this overlooks. If we think of debt as a flow of money, then how concentrated and large those flows are is going to matter quite considerably. – Lumi Jun 28 '15 at 01:09
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    physical cash money is printed on demand — sometimes ATMs are so slow and noisy it does sound like that ;-) – gerrit Jul 02 '15 at 09:58
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The answer to your question is complicated by the fact that there are (at least) two distinct types of "money" in our economy: "base money" and "broad money". You can think of base money as tokens that get passed from person to person as trade is carried out, much like a non-economist would guess that money worked. This however constitutes only a small fraction of the money in our economy. The majority, broad money, can be thought of as "spendable IOUs". We all know that IOUs can spontaneously come into existence when a loan agreement is made, and conversely disappear back out of existence when a loan is repaid. This is why, when a bank makes a "loan", they are not transferring money from savers to the borrower, but instead create spendable IOUs. Later when the loan is repaid, the spendable IOUs disappear back out of existence.

The total amount of money in an economy is therefore not necessarily always growing. Instead it depends on the relative rates of new loans being made (creating new money) and pre-existing loans being repaid (destroying money). If the rate of new lending stalls, but existing loans still have to be repaid, then the money supply can shrink. This is what happened in the great depression, where the money supply fell by around a third.

If you see an explanation of fractional reserve banking in a textbook that contradicts my explanation - the textbook is probably wrong. This can be confirmed by reading a recent paper published by the Bank of England here which totally condemns most popular textbooks.

See here for a more detailed, but jargon free, explanation that is compatible with the latest BoE paper.

Mick
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  • And also made a few mistakes of its own. I don't think calling bank deposits a spendable IOU is going to help clarify matters much - easier to stay with the idea that bank deposits are de facto money, and then deal with how they're created etc. – Lumi Jul 01 '15 at 18:51
  • See edit to original answer. – Mick Jul 01 '15 at 19:44
  • I don't think linking to your own self-published book is appropriate here. I'd also strongly recommend sticking with the language of double entry book keeping, rather than introducing yet another - as you yourself point out - confusing name for a bank liability deposit. – Lumi Jul 01 '15 at 19:52
  • Why not? My answer could be said to be self published... the link is just to a more detailed version. – Mick Jul 01 '15 at 19:54
  • Well, your version isn't jargon free - your create your own - it isn't necessarily any better than any other, it's certainly not unbiased - and it's generally felt to be inappropriate to use forums like this for advertising. Oh and you're not actually answering the original question. Need I go on? – Lumi Jul 01 '15 at 19:57
  • Re: jargon free.- I challenge you to find any jargon then is not explicitly defined in terms of non-jargon words. Normally I would agree that it is inappropriate to link to something self published, but there is a dearth of articles on FRB that are correct (as made clear by the BoE). And it does answer the question because it shows how money is created. If you can find a better article that is both correct and defines its jargon words as it goes along then I will link to that instead – Mick Jul 01 '15 at 20:18
  • Please re-read the question - the author was not asking for a description of how fractional reserve banking works, or indeed how your "spendable IOU's" - bank liability deposits are created. There are already a number of questions here with answers that address the specifics of fractional reserve banking. It's also misleading to call bank deposits an IOU. – Lumi Jul 01 '15 at 20:33
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This is in response to your new edit, and hence completely separate from my earlier answer.

The public debt does not contribute negatively to the government's "net money", because whenever the government borrows a dollar, it implicitly promises to raise future taxes by (the present value of) that dollar in order to eventually pay down the debt. Thus it has, in effect, lent a dollar to the taxpayers (who receive government services today but won't be billed for them till later).

So every dollar borrowed from bondholders is offset by a dollar loaned to taxpayers. This means that the government's net money is exactly equal to the government's cash holdings.

It remains the case that "net money" is an entirely silly thing to be thinking about in the first place, but as long as you insist on thinking about it, you'll want to get this right.

Steven Landsburg
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