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Comment by JumpCrisscross | Hacker News Reader

> So if you give them $1, the bank can now lend $5 (without actually having it) and then make many times that $5 in interest

Sigh

This is not how it works. (It’s a common misconception, however.) Loans create deposits, not the other way. Most money is created by banks, not the central bank or mint [1].

From a consumer perspective, imagining a bank as taking your $1 and lending it out five times is okay. But systemically speaking, it’s a misleading model. The truth is the bank created $5 in loans, and through that $5 in deposits. About $4 of those deposits were then spent and ended up in other banks or bank accounts as deposits.

The loan always comes first. The BoE has a good primers on this [2].

[1] https://www.bankofengland.co.uk/knowledgebank/how-is-money-c...

[2] https://www.bankofengland.co.uk/-/media/boe/files/quarterly-...

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> The truth is the bank created $5 in loans, and through that $5 in deposits.

But for that the bank needs to hold $1 (or whatever) in reserves, so either they had excess reserves already (because “someone gave them $1, the bank can now lend $5”) or they a) get new deposits, b) get them from another bank (i.e. the money comes from previous deposits elsewhere) or c) new money is created by the central bank.

The loans are created first. At the end of the day, if reserves are inadequate, they are borrowed. This creates the overnight interbank market.

Because a dollar dealt results in a deposited, this system is self-reinforcing.

But this is not really different from the standard description: you deposit an incremental $1 (cash or a loan) into the banking system and the banking system can loan out $5 (edit: in fact, 0.9$ at first) when it decides to do so. Banks can create this new money “multiplying” deposits (or the central bank intervention is required to create “extra” money).

> this is not really different from the standard description

It is. It’s the difference between picturing a rocket propelled by expanding gases versus a vessel thrust forth by Newtonian dynamics.

It is correlation versus causality. Loans cause deposits. Deposits correlate with loans. This discrepancy is the source of money supply estimation error.

$1 deposited doesn’t create $5 in loans. $5 in loans prompts about $1 in reserves. The difference in these models explains the interbank market, per se and in terms of rates; reserves as a stochastic versus deterministic phenomenon; bank runs and much more.

Loans create deposits. Not the other way. Modern banking makes sense once you internalise this difference.

If your point is that the actual money issued by the central bank (M0) does not necessarily result in the monetary supply that could be potentially produced according to the minimal reserve requirements that’s obviously true.

Banks are not forced to loan out as much as they could, they have a choice. And because the system is not working at “full capacity” the central bank cannot control the money supply adjusting the minimal reserve requirements. They use other mechanism like short term rates (including through the interest the Fed pays on reserves since 2008).

“Loans create deposits” is of course true in the standard description as well. If banks create money (by lending out, if they want, excess reserves) that necesarily means that the total amount of deposits increases. Because the total amount of deposits (plus the relatively less important amount of physical money in circulation) is what we call money!

So the bank levies a micro tax on all holders of the currency with the expectation that their investment in the receiver of the loan will yield a better return?

> the bank levies a micro tax on all holders of the currency with the expectation that their investment in the receiver of the loan will yield a better return?

No.

Banks compete for deposits and compete to lend. The spread between those rates must pay the bank’s costs, cover its risks and turn a profit. When central banks reduce the return on safe assets banks hold, their income from lending to the government goes down. The banks thus seek to replace that income with other lending. Unfortunately, everyone in the system is doing the same thing. This competition forces lending rates down.

Savers are competing for investments next to the banks. There are lots of them crowding into bank deposits; this lets those banks lower the rate they pay. (Nobody forces savers to deposit Euros only in German banks.)

This is a system of feedback loops. Nobody is charging a tax, though banks may charge a fee for a service it costs them to provide. Depositors are free to take their business elsewhere. And entrepreneurs who think they can do better are free to launch competing financial services.

>Therefore, if you borrow £100 from the bank, and it credits your account with the amount, ‘new money’ has been created. It didn’t exist until it was credited to your account.

If that £100 is spent into the economy but is not returned, did the total volume of available £100 not increase, reducing the buying power of any £ stores? Perhaps it is not a tax because it isn't used directly by the government, but it is a burden that such a lender can enforce upon currency holders with the authority that is given to it by the organization controlling the currency.

>entrepreneurs who think they can do better are free to launch competing financial services.

Entrepreneurs cannot lend out money they never had. How difficult is it for a new company to obtain a piece of the volume of money that the currency regulator deems available for creation within a timeframe?

> If that £100 is spent into the economy but is not returned

Loans create deposits. The only way the deposit isn’t returned is if capital is destroyed.

> Entrepreneurs cannot lend out money they never had

With a banking license, yes. They can.

Once you have a banking charter, you can lend to your heart’s content. At the end of the day, you borrow to make your reserve requirement. (If you’re deficient, you die.)

Lending creates deposits. Not the reverse.

Thanks for the clarification and additional commentary below; great to learn something new.

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