Abstract
The mill parable of Chap. 9 was a device to get at the essence of money as a credible promise. But to understand how money works more realistically, we have to look at how banks work. We start with how a checking account functions, which leads us to the bank balance sheet. The balance sheet in turn sets up how money is actually created by banks (as opposed to how it’s created by entrepreneurs building water mills in fictional villages growing homogenous food). The balance sheet raises the issue of banks’ need for credibility and how they establish that. The role of the central bank grows out of this need for credibility, and ranges from regulation of banks to acting as a lender of last resort for them. The chapter ends with a brief discussion of fractional-reserve banking.
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Notes
- 1.
For simplicity, we’re setting aside the value of the vault itself, and the building the vault is in, etc.
- 2.
An interesting recent explanation of this process is from the Bank of England, at [1].
- 3.
This is the U.S. structure in particular and will be covered in more detail in Chap. 12 Other countries have similar systems with minor differences.
- 4.
During the financial crisis following the market meltdown of 2008, the Federal Reserve has sometimes paid positive interest on reserves, ostensibly as a way of keeping the banks healthy. There have been proposals that it should actually do the opposite, charge interest (or pay negative interest) as a way of encouraging banks to make more loans rather than sitting on their reserves.
- 5.
In the U.S., a bank that is part of the Federal Reserve system has a reserve requirement: there’s a minimum amount of reserves it has to have, defined in relation to the total deposits on their balance sheets. In Canada, on the other hand, there is no minimum requirement; it is left to the banks to determine the quantity of reserves they need in order to function reliably.
- 6.
This is only good up to a certain limit. As of August, 2014, the FDIC “insured limit” is $250,000 per depositor per bank. If you have an account balance of less than $250,000, you’ll get all your money back. If you have an account of more than $250,000, you’ll get $250,000 back. If you want to protect more than $250,000, you can have accounts at more than one bank.
- 7.
There is a caveat to this point, which is that if a bank knows that it’s insured, it also knows it can take greater risks in its efforts to earn higher interest earnings. In theory, without insurance a bank has to worry about risky loans, because if depositors see it making too many risky loans, they won’t want to be depositors anymore, and the bank will fail. In practice, many households may not be good judges of how much risk a bank is running—the people who work at the bank are supposedly experts at judging such risks, whereas almost all of the depositors are experts at something else, but not at assessing risks. And on top of that, when a bank is part of FDIC, they don’t just pay insurance premiums, they also submit to regulation of what kinds of loans they can make, so as to limit the riskiness of their portfolios.
- 8.
The following discussion will focus on the U.S. system with the Federal Reserve. The details are different in other countries, but the core functions and operations are similar.
- 9.
This relationship between taxes and money is at the core of “Chartalism”; see, e.g., [2].
References
McLeay, M., Radia, A. & Thomas, R. (2014). Money creation in the modern economy. Quarterly Bulletin, Q1, 1–14.
Tcherneva, P. R. (2006). Chartalism and the tax-driven approach to money. In P. Arestis & M. Sawyer (Eds.), Handbook of alternative monetary economics (pp. 69–86). Cheltenham: Edward Elgar.
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Seeley, K. (2017). Banking. In: Macroeconomics in Ecological Context. Studies in Ecological Economics, vol 5. Springer, Cham. https://doi.org/10.1007/978-3-319-51757-5_10
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