The Game of Banks, Debt and Money


We received a message from a reader confused about the discussion we had earlier in the week about money and how banks create it. Here’s an edited version…and our response below…

‘If the money didn’t exist in the first place, it is a mirage, a matter of mirrors, so who cares if it isn’t paid back?

‘The bank cares because they don’t get their interest but people could easily go to an interest only repayment for thirty years and bank would be cool.

‘But the capital? Pay it back? To whom? It doesn’t exist. It didn’t come out of anybody’s pocket as it was never there in the first place. It’s only a promise, but a promise on thin air. In fact, the whole economy could function like this. If everybody borrowed money to build houses, then paid the interest only in return. How would the economy be any different?

‘I borrow phoney money and pay back real, hard cash. Where does it go when it is paid back? By my reckoning, it should disappear in a flash of light as soon as it hits the bank.

‘Thus, when the central bank monetises the debt, I presume they hand over real loot for a pile of some sort of bookkeeping entries that don’t actually exist.

Money’ appears and disappears all the time. It appears when you borrow it from a bank, and disappears when you pay the debt back.

When you go to a bank and ask for credit (a loan) the bank creates the money by CREDITING your account. When you spend that money it ends up in the accounts of the people you transacted with. So in their eyes they have ‘real, hard cash’. But it got there by you borrowing ‘phoney money’ that wasn’t there in the first place.

This is the wrong way to think about it. All money is borrowed into existence by individuals, corporations and governments ‘cashing in their credit’.

It’s not ‘phoney’. Money is just a representation or denomination of wealth. To build wealth, sometimes you need credit, which is why banks do serve a purpose in society.

If you borrowed money from a bank and never paid it back, you would never have equity in your business or house or whatever. The whole concept of wealth creation (genuine wealth creation) is about the growth of equity, not debt. Rising equity wealth (or rising net worth) in a society indicates there is innovation and productivity happening.

Compare that to today where governments create more and more debt (by cashing in their credit) just to keep the system afloat. We’re not really creating wealth anymore, just more and more debt, which some people mistake for wealth.

Taking out a loan and just paying the interest on it would ultimately be bad for banks because it would indicate a lack of wealth growth in society. Banks benefit from wealth growth because it allows them to grow their balance sheets and make more loans!

In the case of central banks monetising debt, they don’t hand over ‘real loot’. The monetisation process is an attempt to turn an illiquid asset into base money. They don’t create money, they just alter the liquidity structure of the debt market by turning, say, an illiquid mortgage debt into liquid ‘money’.

The financial speculators then get their hands on this ‘money’ and make hay while the sun shines.

The ‘real loot’ is wealth, which central banks don’t have. Debt monetisation simply dilutes the wealth of all society. The process is hardly visible at first. Then it hits, all at once.

It’s not an easy topic, this one of wealth and money. Which is why it’s so easy to manipulate and bamboozle the public about what is going on.

But the more you read and think on it, the more it will sink in. And then you’ll realise we’re all being had by our monetary managers.

We’ll have more on that tomorrow, when we conclude this week’s ‘money’ theme.

Greg Canavan
for The Daily Reckoning Australia 

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From the Archives…

Money in the Time of Financial Cholera
8-02-13 – Satyajit Das

Dishonest Leaders and Delusional Voters
7-02-13 ­ – Bill Bonner

Uranium: The Commodity Like Gold Ten Years Ago
6-02-13 – Byron King

How Australia-China Relations Are Caught in the Monetary Battle Space
5-02-13 – Dan Denning

The Great Rotation Into Stocks
4-02-13 – Dan Denning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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