What's the fuss about money!

When I introduced myself to the workings of the banking system, I was pretty much blown away !!
Blown away by what ?, you may ask ! ... by ingenuity of the system or should I call it a ponzy scheme ;), yes I said it. If you follow history you would see currency blows up every 40-50 years. Normally too long for a single generation to be affected twice. So the game goes on and on, today in the more sophisticated form as totally computerized Central Bank originated Fractional reserve banking. Sorry to start with a such a negative first words, but as a human race we should be able to come up with a better system.
I was amazed of how such exploitative system can last for so long. OK, I can see how and why it can happen it was a rhetorical question. I blame it on human shortsightedness and greed. Greed I don't have problem with, shortsightedness in today age of science and technology, we should be ashamed of ourselves. Or may be it is not just our blindness, but a also a 400 years inertia. Inertia is a powerful thing as we know from physics.
As somebody once said "Power corrupts, absolute power corrupt absolutely".
My second astonishment was HOW? did it happen that money concepts and fractional banking are not taught in school, not even mentioned. It takes just 10 minutes to understand the basics at the same time money and fractional banking has such an big impact on our everyday life. I don't mean learn to be an economist, but just the basic concepts would suffice.
But enough with the ranting let's get to the 'meat' of the matter.
I will start first with the money concept and fractional banking will naturally flow from there.

What's money

In its most abstract sense Money is just a concept. Like numbers, it helps us quantify things.
The same way that physical units like km/h, kg ... allows us to compare one physical quantity with another the prices (a quantity of money) helps us to compare one good with another. At the end of the day after all the economic jargon Money is simply just a human thought a sort of a measuring stick. We use it the same way mathematician use "ratios" to compare things. What finally becomes physical and/or electronic representation of money, depends primary on willing participating community.

Ok, now that we are clear on this, lets define money as they are defined in economics. Once the need for money enters human society it has to fulfill at least three primary roles, which are normally the litmus test of what we should call money i.e. :

Unit of account

In human talk we can translate "Unit of account" -to-> "measuring stick". Via the pricing mechanism we use money to compare different goods and services. Money in this role help us account for the things we own => our assets and things we owe => our liabilities. The same way we can use meters to compare differences in length of two objects, we use the prices expressed in money to compare goods and services. Think of it as a sort of ratio. You have 1000, I have 10 000 =then=> I have 10 times more than you.
Ideally we would like money purchasing power to be as constant as possible so we can compare things with one another over different physical and time boundaries. In reality as we know this is not what really happens. Why is that the case ? Make your own conclusion after you finish reading the article. By playing the role of 'unit of account' we expect money to give us the ability to do economic calculations. So that entrepreneurs and common people alike can plan better their lives.

Means of exchange

Money is the blood of every economy, and this second role is the personification of the flow of resources. Namely the role of "means of exchange" (middle man). Normally if we don't barter or just do favors to each other we have to find a secure way we can voluntary exchange things. Again in abstract way "Means of exchange" acts like a sort of unanimous contract between two parties to use the "Unit of account" to exchange things or exchange the money itself as a substitute of the real stuff.
It is intermediary, sort of the ultimate commodity, that everybody wants, thus facilitating exchange of good and services. Making exchange possible helps society subdivide and specialize labor, thus making production more efficient, which in turn makes society more wealthy.
Let's take as example small village in which the most desirable thing is some precious stones which are not abundant, but not too scarce too. Everybody wants to have some. This makes it perfect means of exchange, everybody wanting it guarantee you that you can exchange it for anything else you may need. Because everybody wants the stones, they became the perfect facilitator of exchange, better than barter.

Store of value

"Unit of account" is the quantifying part of the money definition, "Means of exchange" is the dynamic part of the equation, and finally the "Store of value" is the time component. A required quality of "Store of value" is stability and universality over time.
Using the length and time analogy again, we don't want the definition of meter or second to change, right ? It will confuse our whole way of life. Imagine a world where the mile grows by 5% every year, what an absurdity, right. Predictability is of utmost importance.

Apart from the aforementioned qualities, most of the time we also want money to have some other qualities. Mind you by listing them here I'm not implying money have to be all of them, but that it is desirable. Here are some of them: I want to embolden the last quality mentioned, it is often forgotten and on the first sight looks very surprising to want the ultimate "measurer" in the economy to be useless for any other purpose, but if you stop and think for a second you will see it makes perfect logical sense. Because if money have other uses apart of purely money functions they will compete with themselves in their different roles.
There is no intrinsic value, not just because value is subjective, but also because value is "functional". The two valid arguments about value in connection to money we can ascribe are value-of-use and/or value-of-exchange. When I say "useless for any productive purpose" I mean that money should lack value-of-use, but have value-of-exchange in abundance.
Typical example in today world could be silver. if silver becomes widely used again it will compete with its use as money and its use in all sorts of manufacturing goods. All goods that use silver all of a sudden will become very expensive or the manufacturers will have to find substitutes. I don't say it can't happen, I'm just saying not been useful in any other means makes something better candidate to be money. Both gold and paper currencies are useless for any other uses in the grand scheme of things.

Before I end up here I want to make one important distinction in definitions.
Currency is not Money, but Money is Currency.
Currency need to provide only the "Means of exchange" test and to some extent "Unit of account", but normally it does not provide the "Store of value" function (You can speculate that for a short periods of time it may fulfill it, but...).
All the world currencies currently Dollar, Euro, Yen ... are just that Currencies, they don't provide the "Store of value" role for the simple reason that if you save in any of those currencies you will lose at least 3-4% purchasing power every year.
No fiat currency in human history ever survived, ever. The average life expectancy of a fiat currency is 39 years.
TODO: At some later point I will address gold, silver, bitcoin and other things. The web is full of many conflicting opinions on those, I will probably add one more confusion.
My shocking conclusion thus far is that at the moment there is no such thing as MONEY used widely in the world as a whole ;)
I hope I don't offend any economist with this statement, but I've just applied simple logic. There is no such thing that passes the litmus tests.
All we have is wanna be substitutes of MONEY.
If we shrink the time frame to several years we can probably call the Currencies - Money, if on the other hand we pick timeframe of a century and more we can probably say that Gold is Money, but those are all IF's.
What we call MONEY was not my main goal here. What I wanted to achieve was to give you a gut feeling of what we are looking and thinking when we are talking about money. By laying out the basics I hope I have given you some initial impetus to dig further. Start asking questions which you didn't before. Make more informed planning and investment decisions.

How fractional banking work

Ok let me start with the one-line description first and then we will go back to the implication of the scheme :

Fractional Reserve Banking is a system in which the banks hold a fraction of the money they lend
i.e. they lend more money than they have in possession.

Here is how the system work. Lets try with example of 10% reserve banking. This means that the banks have to hold at all time 10% of the total amount of money it lends, the other 90% money the bank creates from thin air and lends it to people, companies and governments for interest. Let say The Bank has $100 to start with (given to them by Santa Claus): So 100$ initial capital produced 900$ and now the system has 1000$.
We wont go now into more details, but just so you know even the first $100 were created from thin air by the Santa Claus (Central Bank).
The banks collects X% interest on those 900$ that was lent, this is how they make their money from lending.

Here is one factoid for you: The last four currency crises in USA happened in 1896, 1934, 1971, 20??, almost as clock work every ~40 or so years. By crisis I mean devaluations, one day you had savings the next you didn't.

How exactly the current system works ?

The current system is Fractional system, but differs in several major ways, to the point it no longer looks like a Fractional reserve system explained earlier. Papers published by both the Fed (money multiplier myth) and UK cenral bank paper shows that at least from 1980, probably begining of the century the banking system works on the principle of fractional-capital, rather than fractional currency-reserves.
Lets explore the differences.
First difference : You may have got the impression from the explanations earlier that the depositors have to first deposit the money, so that the bank can "multiply" them i.e. the precondition is that the bank can not make the loan unless there is corresponding currency reserves deposited beforehand ready to be multiplied. I call this the "push"-model of Fractional banking.
The current banking system does not work in this way, instead the current system is sort of "pull"-model. In this model the bank does not have to back its loan issuance with currency reserves, the limiting factor is primary the so called Capital-ratio ( I will explain in a min). And even this capital does not have to be available at the moment of creating the loan, the bank has a certain period within which she can acquire the needed capital after the loan was already originated.
In the original description the Fractional-Reserve-Bank works as intermediary between the savers and the borrowers. That is no longer the case. (We will see later why this is not good).
The ability of a Bank to issue credit so easily is possible because of the Second big difference, the current system for all intents and purposes has a fractional reserve ratio of ~0%. Not in reality, but in practice that is what happens.

How is that possible ? Doesn't this mean that the banks can expand the credit to infinity ?

You are correct to think that ... In the new system the brakes on the unlimited Credit expansions are now mostly left to the monetary policy of the Central bank and the willingness of customers to borrow (if we exclude the shadow banking system). Savers as we see has almost no say of how much the credit can expand.
Let me explore this in some details.
Let say a person (buyer) decides to buy a house from house-seller. The buyer takes the loan from Buyer-bank and gives a check to the house-seller, which in turn deposits the money into Seller-Bank. Because at the moment we care only what happens with the banks I will show only their Balance sheet changes.
When a Bank creates a loan on the Asset side of its Balance sheet it also creates a Demand deposit (for the borrower/house-buyer) for the same amount on its Liability side.
Reserves Deposits
Reserves Deposits
Loan New deposits
Reserves Deposits
Reserves Deposits
Loan Deposits
Reserves from B1 New deposits
Reserves Deposits
Buyer BankSeller Bank| Buyer BankSeller Bank| Buyer BankSeller Bank

For our further discussion we are interested in two things. What are the possibilities and the constraints on the system. We saw in the old-style Fractional banking the amount of loans is dependent on the amount of deposited money. (If the bank has $100 deposits with reserve ratio of 10% she can issue loans up to $900) The new-system is in a sense two-tier, tier 1 is the deposit storage and tier 2 money creation. Loan origination is no longer dependent on the deposit-reserve-ratio, but on the capital-ratio (will explain in a sec ;)). The deposit-reserve-ratio role now is only requirement for how much reserves (vault cash + deposits at the Central bank) the bank has to hold against the customer deposits it has almost nothing to do with loans (i.e. money creation).
Currently this deposit-ratio is in the range 3-10% (Deposits reserve ratios).
Let me repeat again : Customer deposits no longer constraint how much money a bank can create only how much cash the bank can redeem (short term) in case of run-on-the-bank.
OK, how then are the banks constrained, so that they don't flood the market with money ? The mechanism is twofold : Capital ratio is a ratio of the bank equity against its assets and is calculated in the following way :

Capital = Assets - Liabilities
Capital-ratio = Capital/Weighted-assets

Risk-Weighted-Assets include : In general loans to other banks, mortgage loans and ordinary loans to bank customers

So for short you can think of it as Equity/Loans ratio.
Currently the requirement in the Federal reserve system uses ~8% capital-ratio. Here is the current state of the US banks : Capital/Risk-Weighted-Assets ratio
So it seems we have Fractional-Capital pull-banking, rather than Fractional-Deposit push-banking.
The second instrument that the Central banks use to control the money creations (Loans) is the interest rate.
Assumption 1 : If the banks have to borrow capital-reserves and have to pay higher interest for them, then it is supposed they will do it less and vs. versa.
Assumption 2 : When the Central bank prints BASE MONEY it provides more capital floating in the market, rates should go down, banks can acquire capital for lower price ..ergo more loans are created, credit is expanded.
Both assumption are correct, except both assume that there will be Borrower on the other side of the transaction, which is not the case as we can see from the post-crisis years after 2008.

How does QE works ?


Dynamics of the system

In this section we will discuss the dynamics of the system, so we can understand the benefit and drawbacks. At the moment I will just list the points I will elaborate on later.
  • Profit-loss ?!
  • broken-connection between Savers and Borrowers ?! Goal mismatch.
  • Capital value can fluctuate (stock market), deposits value does not.
  • Wrong models based on aggregates, rather than human interaction.
  • Savers buy real assets to escape the devaluation
  • Savers opt out of the system
  • Capital outflow?
  • Borrowers capacity hits a ceiling
  • Flooding the system with base money, predispose for future inflation shock
  • Investors crowd on riskier and riskier investments, but gov deficits does not crowd private spending
  • ??? LOANS can be repackaged and sold for reserves ==> No practical limit? on money creation as long as there is anyone willing to borrow Plus another Bank can become a borrower via shadow-banking!
  • In the old-FRB CB can still create as much $$ as needed out of thin air (political decision) .... vs business decision
  • Production of money is regulated by arbitrary policies vs. profit motive ( Ex: ink+paper^ price ^=> printing more i.e. checking account + loan ^=> more loans)
  • More severe inflation/deflation because the credit creation and destruction is not balanced.. ex: Japan. Capital-fractional banking expansion is constraint only by CB %, deflation is unstoppable once ppl are not convinced.
Conditions for deflation : Conditions for inflation : Money velocity Money stock

Economics and Politics references