TCS Daily

Misplaced Hand-Wringing Over Housing

By John E. Tamny - October 30, 2007 12:00 AM

In a recent speech at Georgetown Law Center, Treasury Secretary Henry Paulson said the recent moderation in home prices and the externalities from same are "the most significant current risk for our economy." His view is a conventional one held by most economists and commentators who believe the slowdown in price appreciation will take the broad U.S. economy down with it. As luck would have it, history suggests otherwise. A moderation of home prices will be a boon for the economy for re-orienting investment capital toward productive asset classes.

Housing worriers argue that when prices are rising substantially, there's a "wealth-effect" that induces owners to borrow against the value of their homes, and that these owners in turn stimulate the economy with greater consumption. At a New York Economics Club speech, Fed Chairman Bernanke pointed to the "possibility that housing weakness will spill over to other parts of the economy - for example, by acting as a restraint on consumer spending." The thinking here fails basic economic logic.

For one, it has to be remembered that one man's mortgage loan is another man's savings. There's no net consumption gain to speak of given the certainty that someone has to be foregoing consumption so that the borrower can borrow. Also forgotten is that heavy consumption at the expense of savings diminishes the capital base such that productive businesses of all stripes go wanting in their search for investment, or are forced to pay a higher rate of interest while competing for funds with prodigal homeowners.

If the owner of appreciated property sells the asset to a wiling buyer, the former is surely enriched by the sale, while the latter is that much poorer. Furthermore, as Adam Smith taught us, investments in property are "sinks of wealth" in that while a house may yield revenue to its owner, it cannot yield any to the public.

On the other hand, a mutual fund investment yields revenue to the buyer, all the while expanding the base of capital available to businesses seeking productivity enhancements that greatly benefit the economy. On a company level, as investors piled into Microsoft shares in the '90s, the latter's success led to the investment in and creation of all manner of technology companies whose parallel gains enhanced company productivity such that the U.S. economy became the standard by which the economies of less well-to-do countries were measured. Equity investments repeat themselves in ways that enrich us all.

Conversely, property is decidedly not a repeating asset. Home purchases consume wealth and diminish the capital base, while doing very little for the broad economy. Some will say that housing purchases lead to home-improvement spending that stimulates the economy, but it remains to be seen where new kitchens, expanded bathrooms and backyard pools enhance the jobs we do such that investment capital flows our way. Capital consumed is capital that won't reach start-ups eager to become tomorrow's Microsoft.

Importantly, as the U.S. economy becomes more service-oriented with companies offering up mind-driven innovations, those companies become harder to tax. With their major assets consisting of people rather than plant and equipment, companies can "play the field" as it were when it comes to finding the most pro-growth tax environment.

This is decidedly not the case when investment flows into property. According to USA Today, property-tax collections rose 7 percent last year to $377 billion. Housing is a tangible asset than can't be moved, and as a result, governments tax property values with great confidence that homeowners won't move their main domicile from Portland to Pasadena. In short, governments cheer when money flows into stationary assets, because that which can't move is easy to tax.

Lastly, it should be remembered that housing's greatest decade as an asset class occurred during the inflationary, malaise-ridden 1970s. With the dollar in free fall, housing served as a classic hedge for unsophisticated investors eager to shield their wealth amidst the dollar's fall. That real estate became the asset of choice of the new millennium wasn't so much a signal of a flush economy, but more realistically was the result of renewed dollar weakness that once again made Americans very risk averse. Not so ironically, as housing has moderated over the past year alongside a great deal of hysteria among economists and politicians about a looming recession, the S&P 500 has risen 12 percent.

Housing worriers argue that a less frothy housing market foretells economic doom. For driving investment back into productive economic sectors, a housing slowdown just might give the present economic expansion more powerful legs.

John Tamny is editor of RealClearMarkets, and a senior economist forH.C. Wainwright Economics. He can be reached



Small thinking
Housing does not drive the economy and wealth, wealth and the economy drives housing. Housing is a commodity just like cars and washing machines, just more expensive. People with liquid income seeking to move in or move up will buy a home regardless. The primary pitfall was unrealistic price escalation and lenders making loans that were doomed to fail.

I was astounded to see a guy in San Fransisco buy a 600K condo on a 100% no principle loan with a 5 year escalation clause. All predicated on continued price growth which is folly.

Loaning money is suppose to be based upon risk mitigation. This was gambling. The blame lies with banks making stupid loans and buyers who did not exercise the restraint to know better.

In 1969 Boeing almost closed the city of Seattle because it was the only major employer in town. Today, fortunately the economy is massively diverse and this is merely a bump.

The greater concern is overspending by our reckless politicians and the potential for huge tax hikes on dividends and capital formation, as proposed by candidate Hillary, and massive new entitlements to buy voters.

If Hillary's tax scheme is enacted then prepare for a real recession.

Wealth Isn't Housing
When people buy homes they're merely exchanging wealth, with no productivity enhancements materializing. That's why a re-orientation of money away from the dead-money housing sector is so important.

When we save and invest, we provide money for entrepreneurs. It's impressive how economists today miss this basic point. In truth, the greatest threat to the economy is a stronger housing market because it signals that money is moving in a non-productive direction.

"money is moving in a non-productive direction."
Maybe we have too much wealth?

It takes time to adapt to change, even if that change is positive.

So many now around the world are benefitting from a global economy, once they reach a level of physical infrastructure like the the first world economies, they will than have to decide what to do with their wealth.

Safety and security are of prime importance. When people believe they have the social infrastructure in place where they can trust their wealth won't be taken by the government, then that wealth will need a place to invest.

Wouldn't a stronger housing market suggest people don't trust the world economy to protect and grow their wealth? And isn't the same true for gold?

Yes, Indeed.
Charles Merril (yes, one of those THOSE Merrils) believes--who knows why--that there is going to be a stock market crash and, what's more, it shall be even worse than 1929's. (Goes to show why Merril-Lynch has been losing billions, methinks.)

So, he is (while advising his friends to do the same) liquidating everything he can and using all the money to buy gold.

Well, that's good for me--I have a little bit invested in e-Gold. He and his followers can jack up the price for me.

The creation of wealth...process...

Wealth is created when raw materials are converted into finished goods across a productive process involving direct labor and some overhead burden regarding capital goods.

Home building qualifies as such a manufacturing process whereby wealth is created.

Mortgage lending is also a value added (financial) service that creates wealth in the form of interest income. Taxable earnings.

Rental units also qualify as income producing (portfolio) assets that generate profit margins.

Deal with these issues and then let's talk about your investment, savings and consumption paradigm. Thanks.

Should have read the fine print
If the following point was mentioned in the article I must have missed it.

For the middle class, their primary store of wealth is in their home equity. And the current soft spot in the housing market has wiped that out. For the investing classes, this unfortunate come to pass is only of importance if they have some subprime mortgage backed securities in their portfolio.

The author says "Housing worriers argue that when prices are rising substantially, there's a "wealth-effect" that induces owners to borrow against the value of their homes, and that these owners in turn stimulate the economy with greater consumption."

But the worst effect has been on those who've purchased homes only during the past three or four years of the boom. For them, their mortgages are often higher than the value of the homes. No way they can refinance to get extra cash. They can't afford to pay off the loan they already have.

In fact they can't afford to sell the house. They don't have enough money.

Worse, if they got a subprime loan, those loans are resetting right about now. The only thing that changes is that their payments go up-- frequently up to 50 percent.

I know, I know. They should have read the fine print. Too bad these people are often just chumps, who don't know how to assess a loan that sounds too good to be true. Without gullible folks such as these there would be no such thing as an adjustable rate, no prepayment mortgage.

So there are in fact some people wringing their hands. Their loss is another's gain.

John...let's talk about this...
You said: "For one, it has to be remembered that one man's mortgage loan is another man's savings. There's no net consumption gain to speak of given the certainty that someone has to be foregoing consumption so that the borrower can borrow. Also forgotten is that heavy consumption at the expense of savings diminishes the capital base such that productive businesses of all stripes go wanting in their search for investment, or are forced to pay a higher rate of interest while competing for funds with prodigal homeowners."

You are suggesting here that there is only a certain specific amount of liquidity available in the financial markets and that mortgages compete for those funds with corporate borrowers. This proposition (no matter how intuitive it might seem) is simply wrong.

Banks create money. A well managed banking system is able to expand the supply of money to fulfill each and every one of the suitable funding opportunities the global economy might generate.

The problem recently was that the banks also seemed willing to fund certain inappropriate loans (subprime mortages, of course, were the mistake du jour).

Unless you want to get into yet another discussion of collateralized debt instruments in the mortgage industry let's simply say that last Spring the financial journalists were all agonized (and wringing their hands) over excess global liquidity and cheap dollars, etc.

Now you want us to believe that there is not enough money to go around? Simply doesn't work that way.

Life's hard.
It's even harder when you are stupid.

John Wayne (?)

Banks do NOT create MONEY...they create CREDIT.
Money and Credit are two different things.

Furthermore, the process of 'money creation' you refer to just simply doesn't exist:

It is the Fed's job to create enough money to 'grease the wheels' for all the credit transactions needed in the economy, not the banks (although they used to do that as well in the past).

reading the fine print
Why don't these dummies just live the those quaint government ghettoes, they charmingly call projects? Don't you just wish the government would expand that? Why don't they contral say, 50% of all housing? Why not 100%? My solution would be that they don't control any of it. And that we also don't subsidize the dummies. Andl also that the goverment doesn't print so much fiat currency which causes such distortions in the economy.

as usual, roy see's a crisis where there is none
roy whines:

"For the middle class, their primary store of wealth is in their home equity. And the current soft spot in the housing market has wiped that out."

1) For most of the country, this "soft spot" has only lead to a slow down in which housing prices are rising.

2) For those few areas that are seeing housing prices fall, only those who bought in the last year or two are affected.

Between 1 and 2, only a small percentage of people who own homes are caught in this bind. Hardly the entirety of the middle class.

Additionally, the only places that are seeing prices fall, are those places which saw huge run-ups in the last 5 to 10 years.

As always, the biggest drop in prices is occurring at the high end of the market. Which typically are not the houses the middle class is buying.

Finally, when buying something, the smart investor ALWAYS reads the fine print. That roy seems to feel that govt should protect them from the consequences of their own stupidity, is precisely why roy continually finds himself on the far left wing of the political spectrun.

Trust and Wealth
I agree with the above. In times of economic uncertainty, particularly with money, there is as Von Mises once wrote "a flight to the real." That's what we're seeing right now. This isn't a good thing because when wealth flows into the tangible assets, there's less capital available for entrepreneurial productivity.

But consumption is just a wealth transfer. I'm not saying we should all live out on the street so that all our income is saved for entrepreneurs, but when earth assets are outperforming equities, this is a negative. First because entrepreneurs can't as readily access capital for productivity enhancements, and second because hard assets are easy to tax.

Loss and Gain
I'm not saying we shouldn't be sympathetic to those hurt in the latest real estate boom. Far from it. First off, were the dollar stable, there would not have existed the market incentive to plow so much capital into tangible assets.

Beyond that, this is merely an economic discussion. When wealth is flowing into the real, this detracts from true economic growth.

I agree
Amidst all the talk about a housing bust, the major indices such as Ofheo don't register a decline in home values, but instead a decline in the rate at which home values were rising.

Banks have to have money in order to create money. If capital is being consumed, there's less money available for other capital-driven concepts. Forest would have us believe that banks can simply manufacture capital. They can't, instead they can simply lend capital made available to them.

Balance of trade
That's why I never worrried much about 'balance of trade'.

The Saudis have a lot of money from selling oil and I would guess they don't buy as much stuff as they sell (oil).

What do they do with their wealth? Do they bury it or burn it?

No. They invest in the country, they invest out of the country. They spend a lot on themselves, too.

"Prince Walid, who is a nephew of King Fahd of Saudi Arabia, earned a reputation for shrewd investing in downtrodden companies with his purchase of Citibank shares in the early 1990's. Bad real estate deals had driven the shares down then to less than $10, and the prince made billions when the share price of the successor company, Citigroup, rose through the late 90's. His investment vehicle, the Kingdom Holding Company, has stakes in other hotel chains, including the Four Seasons."

But the point is 'our' oil money doesn't vanish.

Consumption versus durable assets...
Real estate is one of the most reliable assets in an economy, in a portfolio or on a Balance Sheet. Raw real estate (with or without counting improvement value) constitutes one of the underlying income-producing factors of production necessary to create wealth.

No less than investing in other sorts of capital assets, real estate is clearly not consumption. Indeed, most capital equipment depreciates far more rapidly regarding its resale or salvage value than amortization schedules reflect. If you buy it right then real estate is the one hidden asset on a mature balance sheet that holds its value into perpetuity.

Banks will lend you working capital against your real estate far more readily than they will take your factory tools as know this stuff, John...

Whether it is hard for the government to tax us or difficult, they will, indeed, take what they need to serve their own interests anyway.

People don't seem to know where money comes from...
Here we are all depending on the magic of financial capitalism to save and feed the world...and we do not even understand the most fundamental underlying process: the creation of liquidity. Astounding. And dangerous.

Banks take deposits and then lend up to 90% of those funds. But the original 100% (plus daily interest) still exists. In that sense there might now be 190% (nearly a doubling) of this money almost immmediately. Of course, if that 90% amount goes into another bank account then the second bank might lend 90% (with a 10% reserve requirement) and an additional 81% of the original amount is created.

Therefore, we have 271% of the original money after only two lending rounds...of which 171% is entirely new money that was literally "created" by the banking system.

The government has certain open market operations that might be deployed to influence the behavior of commercial banks...but the process of creating money is completely the magic of banking itself.

If some of that money "leaks out of the banking system" (as cash) into consumption events that do not result in bank deposits then there is still plenty of money within the banking system to seed these liquidity creation (credit funding) events.

There is sufficient money already inside the international banking system to fuel all the fresh liquidity needed. Remember that operational earnings (including payrolls) feed into the banks as "wealth is created" through the magic of manufacturing and certain "value added" processes such as transportation.

Even the retirement of debt whereby total liquidity might be reduced is more a matter of slowing down the rate of monetary creation in our rapidly expanding global economy.

Banks can write down billions of dollars of assets on their own books and still they have enough money to stay in the game.

If there are appropriate lending opportunities out there then the banks will certainly supply the necessary leverage to get the deal done. Rely on it. This is simply the business they are in, after all.

That isn't capitalism
that you are describing. You are describing fractional reserve banking.

It is true that fractional reserve banking is used to free up capital that can be loaned out to other parties. It is also to be noted that most nations operate under this type of system.

"Freeing up capital" in this way is not the same thing as capitalism. Capitalism is an entire system based on certain philosophical principles. Fractional reserve banking is just one practice, and it did not rise to prominence in the United States until the quite anti-capitalist 1930s.

My observations on housing downturns
"First off, were the dollar stable, there would not have existed the market incentive to plow so much capital into tangible assets."

For as long as I've known the market-- that is, since the close of WW Two, home appreciation has outperformed inflation nealry every year. The corrections take place about once every generation. And they hurt. But they only sey the market back for several years-- then it always starts moving forward again.

The other thing is that tax law has always preferred to encourage home ownership. First, it gets the votes of the American middle class-- it's basic to who we are as a people. Second, it gives banks an outlet for their unlent money. Mortgages are very useful sources of low-risk income for lending institutions flush with cash.

"When wealth is flowing into the real, this detracts from true economic growth."

I'm sure you have your own, limited definition of "true economic growth". But when real estate contracts, three things happen.

First, homeowners lose equity. As a result, consumer confidence dips. And this cuts into the bottom line of anyone who makes anything-- cars, toys, electronics, furniture etc. It also cuts into the incomes of anyone who sells anything-- the retail industry. So to me, that's a true economic impact.

Second, the construction industry lags. This takes money from the pockets of several million families. Again, commerce slows down across the board when these people stop buying. (It's easy to see when this starts to happen. You start seeing cars, RVs, motorcycles and other stuff in people's front yards with for sale signs on them.)

And third, the lenders start hurting. The last thing they want is hundreds or thousands of foreclosures. Money gets tighter.

These things all push us in the direction of recession. Which is, I'm thinking, somehow an enemy of economic growth.

Debt is good
It sounds like what you're saying is that debt is good-- because it increases the money supply.

If Tom has $50 he can lend it to Di ck-- who then can lend it to Harry. Two of them can carry the fifty bucks on their books as a credit, while the third can spend it. Presto! $150.00.

Put another way "Banks take deposits and then lend up to 90% of those funds. But the original 100% (plus daily interest) still exists."

The bank still holds ten dollars (plus a note). The borrower holds $90. That adds up to $100, not $190.

In other words Di ck, in my example, can go to a restaurant and tell the waitress "Harry owes me fifty bucks. Take my tab out of that." That'll work, right?

It takes a brilliant mind to understand this. All the dumb ones see through it immediately. Tell me that's not what you meant.

Also I don't see how a bank can "write down" assets on their books when a loan goes south. They still end up with the collateral, which is worth something. What they did was lose an income stream, while gaining a thing of value (used brick). That is the equivalent of a purchase.

If they didn't buy homes...
They'd still be paying money on rent unless they had parents who would let them live in the basement or lived outside. One way or another, having a roof over your head is going to cost you. Therefore, you're probably better off buying your house if you're planning to stay put. You end up losing money renting every month. Might as well own where you live & risk the value fluctuating as waste money on long term renting.

Capitalism and banking...

Financial capitalism has less to do with "certain philosophical principles" than (say, for instance) experiments with Communist economics did.

The Communists tried to resolve the labor-capitalist struggle by eliminating the capitalists completely and placing all of the factors of production (including the workers) into the hands of the state.

The philosophical departure from reality was to declare that the workers composed the state...when in fact the workers were enslaved by the state.

But the underlying operational flaw with the Communist economic paradigm was not so much a flawed socialism as its elimination of the magic of banking.

When the Chinese Communists added banking (and their own hard currency) back into the mix...their economy got better in a New York

Without banking the Soviets could not leverage their successful operations by underwriting rapid growth with borrowed funds. The Soviets could only reinvest their retained earnings (including the money they saved by not actually paying their workers) they crippled themselves and could not compete in the global economy...that evolved into the larger competitive arena during the past 100 years as industrial strength translated directly into military capacity.

Capitalism as we know it did not come about as a result of any particular philosophical has taken on a life of its own in spite of many such challenges and constraints. Financial capitalism in the Post Industrial Society is still a "work in progress" but it is better than anything else we know about.

I happen to believe that Capitalism will fail to evolve further into something more sustainable if we don't get our hands around some of our own tendencies toward market stupidity...

Sorry, but you are completely wrong.
I take $100 bucks and put it into a bank account. The $100 goes into the bank's reserves of real base money (defined as cold hard cash and reserves held at the Fed).

The money in the bank account is a redeem promise valued at $100. It's not real money, but a ledger entry. It is credit owed to me.

The bank uses the $100 to either lend out to customers, lend out to other banks, meet its redemption commitments for account holders, etc. It is the 'blood' of our monetary system. Only the Fed can create base money. Well, the President can issue an executive order to the Treasury Dept but that hasn't been done since Kennedy.

The bank can take on as much credit obligations (to depositors) or issue as much credit to people willing to be obliged to it as it can safely do so. That is what the reserve requirements are for. That is why the total amount in credit it has on the books exceeds its reserves of real money by factors of close to a hundred.

If a bank can not meet its transaction commitments because it does not have enough base money to do so, it can borrow real base money from other banks or from the Fed (usually as a last resort). This is happening now in England over banks that are experiencing runs. This is why a nation's central bank's main role is to be a 'lender of last resort'. Usually, the central bank creates fiat money in the process. But, the loans are also usually short term and need to be paid back -- with interest.

Thus your statement: "Therefore, we have 271% of the original money after only two lending rounds...of which 171% is entirely new money that was literally "created" by the banking system." is completely false because you do not understand the distinction between real money and credit. Your examples are also flawed. When a bank has $100 bucks from a depositor, that is ALL it got. It can't 'create' more money.

"...but the process of creating money is completely the magic of banking itself." is also, completely false. And yes, I mean completely. There are no 'yes but!' exceptions.

Why, because:

1) Banks create credit, not money.
2) Credit and money are two distinct things that only seem indistinguishable to you and I because the 'translation' of one to the other (and back again) is so smooth to us that we don't see the distinction. It is all opaque to John Q. Public and also opaque to way to many people who should know better (economists and reporters).

I think Roy sees the Light!
Put another way "Banks take deposits and then lend up to 90% of those funds. But the original 100% (plus daily interest) still exists."

The Bank gets the money, adds a credit obligation to the depositor on its books, then 'spends' the money on something else (loans, meeting other depositors credit obligations, etc). When the original depositor shows up and says, "Where's my money?" the bank has to, in turn, cough up real money to give to the depositor from its reserves. It doesn't create money to do so.

In fact, just like if I can't pay my Aunt Mary real money for the IOU I owe her unless I earn/borrow it from someone else first, the bank can't redeem deposits either -- for the same reasons.

Another way of looking at it: I deposit $100 cash at Bank A in a checking account. I write a check to you for $50. You deposit it with Bank B. In order to honor the check, Bank A has to cough up real base money reserves held at the Fed to pay Bank B, who then adds a credit entry for that amount in its ledgers saying Bank B owes you $50 on demand more than it did before. When you show up at Bank B and demand it in cash at the ATM machine, the bank has to cough up real base money again (cold hard cash).

1) Banks create credit, not money.
2) Credit and money are two distinct things that only seem indistinguishable to you and I because the 'translation' of one to the other (and back again) is so smooth to us that we don't see the distinction. It is all opaque to John Q. Public and also opaque to way to many people who should know better (economists and reporters).

Thus, Fractional Reserve Banking is not the boogie man people think it is. In fact, it doesn't even exist as most people (incorrectly) perceive it as.

I am hard on Forest about this because I know he's smart enough to get it. He just has to get past the idea that he's been sold a completely bogus sale of intellectual goods as pertains to this issue. I say this also because I used to believe the same thing he does. I was quite a shock when I learned otherwise and I was quite resistant, believe you me.


Don't play with me now...I know you understand this stuff better than that.

However, for anyone who might be confused...

My statement was: "Banks take deposits and then lend up to 90% of those funds. But the original 100% (plus daily interest) still exists."

Your question was: "The bank still holds ten dollars (plus a note). The borrower holds $90. That adds up to $100, not $190."

The reason the bank holds onto the $10 (in this example) is that the bank holds onto at least 10% of everyone's deposits (as their overnight reserve requirement) because my $100 still exists as a live balance in my account and (statistically) 10% or less of all such funds on deposit would be required to cover withdrawals on any given day.

The reserve requirement is actually "vault cash" plus deposits at other banks whereby the first bank might cover these remittances to customers.

The point is that my $100 still exists (although the bank is only required to have $10 of it on hand (plus that same 10% of everyone else's money) while the other $90 may be lent to a third party. If he puts that $90 into a bank then this might become an additional $81 and so on.

After ten such rounds of lending that $100 has become $686 and it is not nearly done yet!

OK, Roy...stop fooling around.

Baby Boomers
As baby boomers retire or trade down, don't you think there will be significant changes is the housing market?

Defining money
How is the correct amount of money determined?

It seems to me that is the tricky part of establishing the money supply.

Maybe its like DeBeers. They control the number of diamonds available keeping the market 'stable'.

Dran it Roy, you beat me to it
But then, I am busy "making" money (as opposed to "creating" it out of thin air, as Forest thinks happens) and got to the net just a while ago.

Oh, my...
This isn't a joke is it? You guys really don't understand this you?

I almost can't believe it...honest to God.

I don't know what to say.

And you...
You know a lot of the words...but you simply don't understand how it all works.

When they taught you the words...didn't they check to see that you understood the concepts?

How do you guys actually get along in the world? You really don't understand the first, most fundamental concept of what our money is about...or where it comes from.

It really is just astounding...this stuff is simply not that hard. I cannot begin to explain it...I don't know where to start even...

Don't you think it is important that you would get this much right?

I have not been "...sold a completely bogus sale of intellectual goods as pertains to this issue..." What's wrong with you? My MBA is from the Wharton School, forchristsake! I've been doing this for a living since 1973. There's no question about any of this. Are you kidding me?

You are so astoundingly wrong...
You only have barely enough information about this subject to be dangerous to yourself, Zyndryl.

You are absolutely wrong...a great deal of this you are simply making up...because you think you understand enough that you can guess the rest of it. Well you don't...and you can't.

What really concerns me is that so many otherwise bright people here do not understand the simplest elements of money and banking. How in the world can we hope to have a rational dialogue regarding financial capitalism when you all don't begin to understand any of the underlying mechanisms?

No calculus statistics...just boring financial structures...this stuff is not all that difficult.

There is no mountain of cash sitting out there looking for a place to hide, something to buy or preparing to bury us all in a tsunami of inflation.

I know that many media types made quite a lot of noise last Spring about excess global liquidity...and then this Summer there wasn't enough money so the Fed had to pump cash into the market?...Wrong! It does not really work that way...although it is often explained like this to the civilians.

I hesitate to go too deeply into all this, here...the guys seem completely confused already.

There's plenty of money and the banks can lend more as appropriate opportunities are developed. There is not too much money because virtually everything liquid is sitting in something other than raw cash.

Lots of those funds are borrowed from the banks and when the uses for them are closed out then the loans are repaid. If that happens a lot on a particular day then the banking system might have sufficient liquidity to cover its obligations and to fund its ongoing lending activities without expanding the supply of money quite so quickly as it underwrites the financial capitalism of the growing global economy.

In short, there is about the correct amount of money in the system as there should be at any snapshot in time. The mechanisms are self-correcting in this regard.

OK. Let's go through it one more time, shall we?
Money is a medium of exchange and hence a store of (consumable) value. I hope we can agree on at least that much.

And, for ease of calculations, let us assume that the (fractional) reserve requirement (which, by the way, is just an arbitrary number dictated by GOVAGs) is ZERO.

Now, when I deposit $1000 in Bank A and it lends the $1000 to Bank B which in turn lends it to Bank C and on to Bank Z which lends that $1000 to you to invest and you blow it up in Las Vegas (because that is what you wanted to invest in), are you really serious when you say that $26,000 worth of (consumable) value has been created in the process?

You must be joking.

I am NEVER into ad hominem attacks. That is why I didn't say "you must be drunk".

When you can create money from nothing...
How is if self-correcting?

At least with gold, some effort had to be expended to extract and process the metal.

It has value for jewelry and electronics, but as a store of value of wealth, it is convenient, and pretty to look at.

The value of gold as money would depend the supply and demand of gold for money and for its other uses.

As long as people are able to sell their old homes some of them will be buying new ones. Lots of homes in dying areas remain unsold though, and people have to continue living in them.

As for those retiring baby boomers, they're boosting the market for comfortable homes in rural areas where there aren't many jobs. But we don't see them much around here.

Here we get the young marrieds, accepting new employment and buying big ass homes with lots of bedrooms for their kids.

Masters of illusion
You really don't have to explain it from the top again. Zyndryl and I have both read the explanation, and understand what is being said. But we've spotted the flaw.

These illusory increases in the money supply don't spring from the "magic" of money multiplication. What it is instead is sleight of hand. If there's a run, the illusion collapses instantly and the bank can't come up with actual money.

I have no doubt you've been doing this for a long time. If nothing comes unglued, the artful scam works just fine. In fact you're probably using programs my son in law has developed, for precisely this purpose.

Not enough iterations
The problems happen down the line. I have to go out now, or I'd describe this in more detail... but what happens when the borrower defaults?

A theoretical chain of events gets started. And if there's a run on the bank, the flaw is revealed. Everyone clamors for their money on the same morning-- and it's just not there. It has been legerdemained out of ready liquidity.

Remember the S&L debacle? That gave us a real good look at the process. We could see the strings holding the lady up.

Roy, what's your opion re the housing projects? eom.

You describe some of the 'fractional reserve' system. But you with you Wharton degree don't mention 'fiat money', or what if there were no FED. Was there a time when there was not FED? Was the FED brought in by stealth back then?
Would there be an economy without the FED? If there were a currency back by something, instead of nothing, could there be inflation? All this stuff has been worked out over a hundred years ago by the Austrian economists.

The logic behind the lending multiplier
Forest-- The logic you are patiently trying to get across to us all is unassailable. But it contains a flaw.

It's akin to the Uncretainty Principle, of you've read Heisenberg. You can prove the existence of all those protons and electrons, beyind any doubt. You just can't prove that they exist all at the same moment. Because they don't.

But a good living can still be made from artfully juggling this uncertain number of balls in the air, paying Paul on the day you anticipate payment from Peter-- and relying on the float to keep you above the water line.

"Anything that sounds too good to be true, probably is."

And if that doesn't work, pray that you've become so large the feds feel like they have to bail you out.


The value of any currency must be based on something measurable. When the various specie currencies were circulated (as coins, for example) then we could all agree that a certain amount of gold, silver or copper retained into perpetuity some underlying value all its own. No matter who minted those coins.

When paper currency was backed by gold or silver then the value of that paper was related to the probability that the issuing party (a bank more often then a sovereign) actually had the gold or silver in its vaults sufficient to redeem such a certificate on demand. Commerce was restrained insofar as paper money was discounted or refused as legal tender on the basis of that judgement.

Our fiat currency (the non-interest bearing Federal Reserve Note) is declared to be legal tender in settlement of all dollar denominated debts in the United States. But the underlying value of our currency is its interchangability with interest bearing Treasure Debt instruments. Indeed, such Treasury paper is held by all central banks and constitutes the underlying value for hard currencies everywhere. (If there was no US National Debt then there might be no money in the global economy.)

Unlike gold, US Treasuries yield interest that should at least cover inflation...

Of course, there were banks before the United States ever existed and, naturally, each banker earned his living by lending money. Paper notes that are "promises to pay" have always been issued in excess of "vault reserves" (whatever those were declared to be) and a loss of confidence resulting in a "run on the bank" has thereby been the ultimate exposure in this business. The US Federal Reserve Bank and the US Treasury brought about the discipline we see in financial capitalism today. Thanks.

Reserve requirement...
Near No Ad,

You said "...let us assume that the (fractional) reserve requirement (which, by the way, is just an arbitrary number dictated by GOVAGs) is ZERO..."

That is silly. The Overnight Reserve Requirement is statistically calculated to provide the banking system with reasonable flexibilty...and the economy with reliable security (that deposits are safe) in this regard. And the FDIC guarantees it!

Arbitrary not it is...(this is not some fantasy world we live in, my friend.)

Please tell my wife that I "must be drunk"...or that I "should be drunk"...or that she should buy me some more beer. We've been out of beer, over here, for almost a week. I looked in both refrigerators...nothing! Thanks.

"brought about the discipline".
Hey that's really funny what you said. And it's the exact opposite. It meant that the government could now be undiscipline and print fiat money, to give them bread and circuses, to buy votes, to keep in power because they like to control people. If you have a true gold system, then governments must have discipline and the hate that. But I know most modern economists are Keynsians, and a lot of them don't even know about true economics.

Your sense that hard currency is the result if some sort of Ponzi scheme that must eventually hit the wall might seem intuitive...but it is wrong.

Money is a liquid asset that substitutes for all the other durable and consumable assets that might be owned by someone in the global economy.

For example, no one is going to pay you for an acre of open ocean 1000 miles from dry land...because no one is allowed to actually own that asset.

As the value of those assets that might be owned increases along with the expansion of the income producing activities of the global economy...there must be sufficient money in the system to hold that value when those assets change hands insofar as they are priced in a universally acceptable currency.

In this process the money itself becomes a valuable asset but the good news is that it must be exchanged into something else almost immediately because raw cash loses some of its value through inflation every day...every hour. At the very least these surplus dollars (our favorite!) must go into an interest bearing money market account.

When dollars are exchanged for gold (Dietmar's favorite) then their value is protected as specie but their ability to participate in financial capitalism (creating wealth as working capital) is put on hold. Gold is interesting though and gold has emotional entertainment value. But there is only so much of it to serve as the underlying store of value for all the money we need.

Banks create the liquidity required to transact business in an orderly manner through responsible lending practices. There should be about the correct amount of money out in the world to get the job done, if the banks behave.

Remember that leverage costs me money. I need to have some debt or I am under-leveraged insofar as the reasonable return on my opportunities to earn a margin are greater than my "cost of capital" I need that cash. However, when there is a surplus of funds on my balance sheet and my money market yields less than my debt costs makes business sense to pay down a high interest short term line as long as I am certain I will have access to those funds later when I might need cash flow support. When in doubt regarding the behavior of my banker I might pay a premium to hold onto somewhat more cash than you might think prudent. Does such cash contribute to "excess liquidity" in the financial system? Perhaps. Will that extra money create a problem? Perhaps, not.

Again, this is not a Ponzi, Roy. Our money is real. The underlying value of the asset base in the global economy is real. That value is expanding and it needs to keep growing until everyone in the world has food, clothing, shelter, fresh water, clean air, medicine, freedom and security. Television sets, cell phones and a beer. We are not nearly there yet.

You provide NO proof the back up your Myths.
Show me WHERE a bank can create MONEY. Money is (a) cash, as in notes and coins and (b) reserves held at the Fed. THAT is ALL money is. While CREDIT can be denominated in money, CREDIT is NOT MONEY.

The Fed only requires that when banks create CREDIT, the have to limit it to a ratio of the MONEY the bank has on reserve at the Fed or in its possession as cash. That's all 'fractional reserve banking' is. It involves not one cent in the CREATION of MONEY. Period.
When I cash a check drawn on an account at Bank A, Bank A pays CASH it did not create nor can create. When I deposit that check instead at Bank B, Bank B gets MONEY reserves at the Fed in Bank A's account transferred to its Fed account, unless Bank B also owes MONEY to Bank A because of transactions drawn against Bank B by Bank A's customers. In which case, it is just a simple book-keeping operation. Either way, when a check is redeemed at a bank, it doesn't pay it in CREDIT it created. It has to fork up MONEY it did not CREATE. Why is this so difficult to comprehend?

I am not making this up. This is WHAT happens. So, unless you can prove are WRONG. Also, if anyone is confused here, it is you. You don't know the difference between CREDIT and MONEY. Anyone who believes that Fractional Reserve Banking allows banks to CREATE MONEY does not know that difference as well.
That is why all the conspiracy myths about fractional reserve banking being legalized counterfeiting are all bunk.

Then the Wharton School Should Close Down
Sorry, but if you can't comprehend the technical difference between MONEY and CREDIT and which entities in our society CREATES/DESTROYS which, then all the MBAs in all the world can't help you.

The only break I'll cut you is that I suspect you and your buddies at Wharton use the term MONEY to mean both real money and credit interchangeably, thus throwing more fuel to the Fractional Reserve Conspiracy fire. What I don't know is if you are doing it intentionally to protect your flawed assumptions or are just plain ignorant.

here we go...
You are talking about amounts of assets and liabilities denominated in CREDIT, that is true. But that doesn't INCREASE or DECREASE the amount of MONEY that changes hands.

I deposit $100 at a bank in CASH in the form of a demand deposit (not a CD to make this easier to understand). The bank has ALL $100 at the time I deposited it. My account has NO money in it -- just a promise for the bank to pay it upon demand and to pay interest. Together, the bank and I CREATED into existence CREDIT, pure and simple. Now, the bank can put that $100 in CASH into reserves or lend it out or even give it to the Tooth Fairy as far as purposes of this discussion is concerned. But NO MONEY was created. If the bank goes insolvent and I show up in line during the bank run, I can be screwed unless the FDIC that guaranteed the banks promise to pay on demand the amount denominated in dollars in my account. But unless some burns or shreds or destroys the cash I made my original deposit with, the MONEY involved can not be destroyed.

All the reserve requirements do is limit the amount banks can extend themselves in outstanding demands that can be placed upon it by a certain ratio. Forest's examples of that are correct.
Where he is wrong is his belief that the increased velocity of monetary transactions -- the bank loaning the $90 of the $100 I deposited to someone who in turn puts it in another bank -- somehow increases the money supply. It does not. There is more credit created at some other bank (money the borrower is owed upon demand in another account), but that is CREDIT, not MONEY.

Banks do not create MONEY. They do not INCREASE the MONEY SUPPLY.

That's a Red Herring, Forest
Answer his question: Was $26,000 'created' or not?
$26,000 in 'value' may be in place and certainly $26,000 in monetary transactions could have taken place, but that is not the same as $26,000 created in MONEY, is it?

And, the CREATION of money is what we've been talking about back and forth on this thread, you are aware?

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