by elmads

Introduction

In my previous blog “The Creation of Money Part 1” I’ve discussed two ways how money is created. One is to through “seigniorage” (Central bank printing money then the difference between the face value of money and the production costs which also becomes the income of the government) central bank and the next is through fractional reserve banking utilized by most banks today.

In this second part, we will go into the other ways how money is created. It still involves the central banks and the commercial banks, not surprising as these are the entities who handles the currency and money of a country.

Debt as Money

In the year 1704 in England, the English government made a great financial innovation and law called the Promissory Notes Act. It is an honoured cash substitute which dictates that promissory notes are as good as money. It has a written promise to pay back the exact amount of money that a person has borrowed.

The above photo is an old promissory note. It is signed by a J. Bentinck, dated at 11 April 1774. It reads; ”I Promise to pay to Richard Hoare Esq. or Order Four Months after date Four hundred Pounds for Value received, at 400 pence J. Bentinck.”.

Promissory notes have evolved to Bank Notes, an honoured piece of paper that can be used as a means of exchange for products and services. And as technology further improves and digitization became an integral part of our lives, so as bank notes. This formed the digital money that we have now, both in a form of money & credit.

Remember the fractional reserve banking system utilized by most commercial banks? where they create new money by the multiple transactions being made through lending a significant portion of their depositors’ money. In this part, we mainly put our centre of attention in the lending activity. How debt becomes money itself.

A person who borrows money in a bank could use it to buy goods and services, or to finance his/her dreams and visions. Basically, this is credit, people confuse it with proper money because almost everything now is in the digital space.

To give you context, let’s say Bank ELMADS approved the mortgage loan application of Evan worth £300,000. This is not always represented by a physical money coming from other depositors of Bank ELMADS, but can also be a newly created money via the fractional reserve system.

With the newly acquired money, Evan then bought the home that he loves, and he will start paying for the mortgage loan monthly. Let’s follow the trail of credit, so realtor Aries who assisted and supervised Evan with the deal received his commission through the sale of the house. Take note; the commission of Realtor Aries came from Evan, which Evan received it from the bank via credit (newly created money out of thin air). Then Realtor Aries used his commission from the sale of the house to upgrade his motorcycle and install new parts. The Motorcycle mechanic then used the income he received from Realtor Aries to invest in the stock market.

Can you visualize what happened here? credit has been used as money itself, and no one knows that it just started as a person borrowing money from a bank, and the bank just used their hocus pocus to make money. Now, let’s go back to Bank ELMADS’ point of view.

Bank ELMADS’ newly created money will be recorded in their balance sheet as a loan. For them this is an asset, because they are the lender, meaning a loan for them is an asset, while deposits are a liability. This is because they receive back money from lending and they shell out money for deposits.

Loans = Assets

Deposits = Liabilities

The newly created money, or known as credit will become a true profit for Bank ELMADS in this process.

Once Evan fully pays for his mortgage loan, then the DEBT in his name will disappear. The newly created money through credit disappears as well, because it now becomes a part of the real money in the economy. While the profit of the banks will remain, that profit is the interests it acquired from the mortgage loan which came from made up digital money from computers which is not being backed by a real physical money.

Debt has been essential to the growth of all the economies of the world, without it we wouldn’t be where we are. Also, most money circulating around the globe is mostly credit now, only a small fraction of it is real floating money.

Here’s an interesting question for you. If we’ve been doing this for a long time, do you think the statement “money is debt and debt is money” true?

Quantitative Easing

I have tackled this briefly in my blog titled “The Financial System – The Central Bank”. This is one of the tools of the central banks of the top economic countries around the world to stabilize prices in their economies. Everyone thought that the Federal Reserve (US Central Bank) created this newest tool back in 2009, but that isn’t the case. It was actually the Bank of Japan who first used this monetary method back in 2001, although it wasn’t called yet quantitative easing during that time. The Central bank of Japan did it to stimulate their economy as they were experiencing stagnant economic growth, a lot of bad loans and a low inflationary environment.

Quantitative Easing is a tool to encourage borrowing money for spending purposes, and increase liquidity in the economy. There are three ways how central banks do this.

• Printing Money – The central bank is the only one who can legally print money. Once they print all the required amount of money, they then inject it through the economy via purchasing long-term government bonds and other loan securities, such as mortgage backed securities. Take note; central banks do not purchase government bonds before, this is the reason why quantitative easing is considered an unconventional method. Generally speaking, this is financial engineering to prop up the economy.

• Encourage Spending – Commercial banks are the intermediary between the central bank and the government, businesses and the people. Without them, the exchange of the newly printed money will not be able to enter the broader financial system.
  
  Central banks do purchase bad loans as well, the so called “Junk Bonds”. One example is the bad loans of a bank from Mortgages. Mortgage backed securities are actually made by banks, such loan only become a bad loan when a borrower is not able to pay the said interest payments, or worse if they default on their loan payments.
  
  In this process the commercial banks will exchange the bad loan securities and/or other bonds, for the newly printed money of the central bank. The money received by the commercial banks will increase their balance sheet liquidity, they will then be encouraged to loan to the public the new monies they received from the Central bank.

• Lower Interest Rates – Quantitative Easing usually goes hand in hand with the Central Bank decreasing the national interest rates. Lower interest rates encourages spending. How? if the interest rates are low, then the interest that needs to be paid for debts are lower as well. This encourages more borrowing hence, easy to spend credit or shall I say money. Secondly, banks are incentivized and encouraged to loan all of the new monies to the public, again for spending.

This massive liquidity will be helpful for most people in the short to medium term horizon, but this doesn’t come without any possible serious ramifications in the long run.

This enormous quantitative easing done by the central banks started in 2008, they haven’t stopped since then. To be fair, the Federal Reserve tried to tapper it and increase the interest rate, but it had an immediate effect in the markets. We saw a decline of approximately 20% in the stock market prices during that time.

As the photo above shows, the US Central bank back in September 2017 tried to decrease their bond and other loans holding in their balance sheet, meaning they sold these securities to the commercial banks. In return, the cash will go back to the central bank, which decreased the amount of floating money in the economy. Plus, they also increased their federal funds rate, or the interest rates from 0.12% in November 2015, until it reached 2.42% in April 2019. These were done to lower the spending in the economy, and also the supply of money so as to calm down the over heating economy.

Nevertheless, the actions taken by the Federal Reserve caused for the markets to decline, as seen in the photo above. It’s actually not just the decrease of money supply and interest rate that caused that decline though, because that was also the time where there was a trade war brewing between the US and China.

Since then, the federal reserve just continued their quantitative easing, but then an expected pandemic occurred, which further pushed central banks of most countries globally to print more money out of thin air. They actually printed billions amount of their currency, while the US printed trillion of dollars. That’s why some countries were able to give money support to their people at the height of the COVID pandemic.

Our world economy is now overflowing with money, the question is, will money printing be always the solution for every problem in an economy? In the short-term I would say it is, but I do not know for the long-term though. Time will tell if the financial measures taken today, will be the best course of action for our future selves and our society.

To sum it up

Money is essential to an economy, but creating it into excess or, not creating it at all can have serious effects to a country. We’ve been following the economic theory of John Maynard Keynes for decades already, that inflation is a healthy driver of economic growth only if controlled properly. More than that can cause inflation or hyperinflation in worse case scenario, less than that can cause deflationary effects which could completely cripple an economy.

I do believe in a healthy inflationary environment, but too much financial engineering to prop up the economy is jut like putting a tape in a cracked wall. It only tries to prevent a recession, but in a over heating debt driven economy, with a lot of liquidity, creeping up inflation, global supply chain issues, lower consumer confidence and countries still recovering from the pandemic induced recession, it’ll most likely be impossible for the financial engineering to continue forever. There will be a time where the levers of the central banks need to be pulled on the opposite direction.

Nevertheless, this is a problem that even the greatest minds find it hard to look for a solution into finding price and economic equilibrium. As an ordinary citizen of this world, we may not be able to control a higher than average inflation, macro economic problems, and future recessions, but we could certainly be in charge of our finances and investment returns.

Let’s take responsibility and accountability of our financial lives.

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.