The truth is out: money is just an IOU, and the banks are rolling in it

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#1
The truth is out: money is just an IOU, and the banks are rolling in it
The Bank of England's dose of honesty throws the theoretical basis for austerity out the window

David Graeber
theguardian.com, Tuesday 18 March 2014 10.47 GMT

Back in the 1930s, Henry Ford is supposed to have remarked that it was a good thing that most Americans didn't know how banking really works, because if they did, "there'd be a revolution before tomorrow morning".

Last week, something remarkable happened. The Bank of England let the cat out of the bag. In a paper called "Money Creation in the Modern Economy", co-authored by three economists from the Bank's Monetary Analysis Directorate, they stated outright that most common assumptions of how banking works are simply wrong, and that the kind of populist, heterodox positions more ordinarily associated with groups such as Occupy Wall Street are correct. In doing so, they have effectively thrown the entire theoretical basis for austerity out of the window.

To get a sense of how radical the Bank's new position is, consider the conventional view, which continues to be the basis of all respectable debate on public policy. People put their money in banks. Banks then lend that money out at interest – either to consumers, or to entrepreneurs willing to invest it in some profitable enterprise. True, the fractional reserve system does allow banks to lend out considerably more than they hold in reserve, and true, if savings don't suffice, private banks can seek to borrow more from the central bank.

The central bank can print as much money as it wishes. But it is also careful not to print too much. In fact, we are often told this is why independent central banks exist in the first place. If governments could print money themselves, they would surely put out too much of it, and the resulting inflation would throw the economy into chaos. Institutions such as the Bank of England or US Federal Reserve were created to carefully regulate the money supply to prevent inflation. This is why they are forbidden to directly fund the government, say, by buying treasury bonds, but instead fund private economic activity that the government merely taxes.

It's this understanding that allows us to continue to talk about money as if it were a limited resource like bauxite or petroleum, to say "there's just not enough money" to fund social programmes, to speak of the immorality of government debt or of public spending "crowding out" the private sector. What the Bank of England admitted this week is that none of this is really true. To quote from its own initial summary: "Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits" … "In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money 'multiplied up' into more loans and deposits."

In other words, everything we know is not just wrong – it's backwards. When banks make loans, they create money. This is because money is really just an IOU. The role of the central bank is to preside over a legal order that effectively grants banks the exclusive right to create IOUs of a certain kind, ones that the government will recognise as legal tender by its willingness to accept them in payment of taxes. There's really no limit on how much banks could create, provided they can find someone willing to borrow it. They will never get caught short, for the simple reason that borrowers do not, generally speaking, take the cash and put it under their mattresses; ultimately, any money a bank loans out will just end up back in some bank again. So for the banking system as a whole, every loan just becomes another deposit. What's more, insofar as banks do need to acquire funds from the central bank, they can borrow as much as they like; all the latter really does is set the rate of interest, the cost of money, not its quantity. Since the beginning of the recession, the US and British central banks have reduced that cost to almost nothing. In fact, with "quantitative easing" they've been effectively pumping as much money as they can into the banks, without producing any inflationary effects.

What this means is that the real limit on the amount of money in circulation is not how much the central bank is willing to lend, but how much government, firms, and ordinary citizens, are willing to borrow. Government spending is the main driver in all this (and the paper does admit, if you read it carefully, that the central bank does fund the government after all). So there's no question of public spending "crowding out" private investment. It's exactly the opposite.

Why did the Bank of England suddenly admit all this? Well, one reason is because it's obviously true. The Bank's job is to actually run the system, and of late, the system has not been running especially well. It's possible that it decided that maintaining the fantasy-land version of economics that has proved so convenient to the rich is simply a luxury it can no longer afford.

But politically, this is taking an enormous risk. Just consider what might happen if mortgage holders realised the money the bank lent them is not, really, the life savings of some thrifty pensioner, but something the bank just whisked into existence through its possession of a magic wand which we, the public, handed over to it.

Historically, the Bank of England has tended to be a bellwether, staking out seeming radical positions that ultimately become new orthodoxies. If that's what's happening here, we might soon be in a position to learn if Henry Ford was right.



http://www.theguardian.com/commentisfree...rity/print
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#2
Do I sense another gold run? lol.

Fiat money is increasing being scrutinized, while governments keeps kicking the debt can, down the road for future generations to repay.
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#3
First thing, people should know that the deposit they have or the money they hold is created by commercial banks, not the central bank. Everyone in the main street deals with commercial banks, not the central bank. The commercial bank allows the depositors to withdrawal physical notes, which is issued by the central bank, out of their saving/checking account as a value added service. In reality, the commercial banks don't have to allow that. The deposits people are holding are merely a claim on the banks, nonetheless, they are money in every sense.

Quote:The role of the central bank is to preside over a legal order that effectively grants banks the exclusive right to create IOUs of a certain kind, ones that the government will recognise as legal tender by its willingness to accept them in payment of taxes
The author does not understand what's money and what's legal tender. The IOUs created by commercial bank are no doubt money, but not recognized by the government as legal tender. Only the notes issued by the central bank are recognized by the government as legal tender. The IOUs issued by commercial banks can be converted into the same amount of legal tender, but not legal tender.
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#4
I don't think its not that they cannot distinguish but rather deposited money is a form of IOU.
Technically, you have a statement from the bank that you have that much money with them. No different from an IOU.

I remember a video from youtube, which explains how the banks can lend indefinite money to all, as the banks are allowed to loan out a portion of savings that they have.
So imagine, A puts $100, bank loan out 80% to B, B spend money to purchase car from C, C puts in 80% back to the bank, bank loan back 80% of 80% of original money to another.
That's why bank runs are so deadly.

Maybe stretching it abit but certainly not without some grain of truth.
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#5
the thing is many people already knows about the fiat system but are too much vested into it already.

Everything about how we live eat commute are tied to this system already, ask your employer to pay your salary to you in gold coins and see what happens
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#6
One way is to barter trade.
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#7
lol, alot of European countries uses barter to avoid paying taxes. Like cutting hair for exchange of mowing lawn etc... but seriously?? Barter??
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#8
(27-03-2014, 12:59 PM)David Graeber Wrote: "In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money 'multiplied up' into more loans and deposits."

Alamak, the central bank set the price of money by setting the interest rate mah... At the same time, it also participates in OMO, to tighten or loosen money supply... Economics 101.

(27-03-2014, 12:59 PM)David Graeber Wrote: What this means is that the real limit on the amount of money in circulation is not how much the central bank is willing to lend, but how much government, firms, and ordinary citizens, are willing to borrow.

Salah, salah. Never heard of Basel III? Capital Adequacy ratio?
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#9
This guy a bit outdated. I think many people knows how the leverage works for banks. Is not a secret.
Also if paper money is backed by GOLD, i do agree on paper it acts like IOU.

Just my Diary
corylogics.blogspot.com/


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#10
Great article, thanks for sharing. Coming from a non economics background, any valuebuddies can help explain why the massive quantitative easing that USA has been has not resulted in hyperinflation in USA so far?? Is it because instead of money being spent in consumption, money instead flowed to equities inflation in USA and money flowing overseas to real estate inflation in countries like Singapore and Hong Kong?
From what I seemed to understand, China also had its own version of QE after 2008 crisis, except that it was less talked about.
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