Created by marvin chester
Last Updated December 2013
1. The Project
This is an inquiry into the Nature of Money. I am not an authority on this subject. So this exposition, capsulizing my study, is designed to make it understandable to non-specialists, like myself. For this task pictures are essential.
To assemble a large array of ideas in a small intellectual space I use viewer driven graphics like the blue trapezoid. Click on the link, blue trapezoid, to bring the figure up in the Figure Pane at the left.
Within this blue trapezoid figure click on go. The figure responds. It is viewer driven.
In all the text that follows one brings up the figure relevant to the text simply by clicking on its link within the text.Here are some of the questions that motivated my study of money:
Money is an artifact of accounting. Anyone who has done online banking or paid bills via the internet can appreciate this. In these transactions no cash is handled by anyone. Money payment is made merely by the adjusting of accounts. Money is more than mere cash. So to understand the nature of money it is necessary to examine this accounting procedure. Here we do it visually, using motion graphics to reveal the essential conceptual structure.
2. Balance Sheet
A balance sheet is an example of the double-entry bookkeeping structure that accountants have been using for centuries. (Click on the balance sheet link to bring up the figure.) This accounting method was first publically expounded in a tract by Luca Pacioli published in Venice in 1494 but dates back even further.1
In medieval times arithmetic was an arcane subject understood only by a few among the intellectual elite. Pacioli's scheme offered an organized method for commercial reckoning accessible to those not mathematically inclined. It has withstood centuries as the preferred method of accounting. And it lends itself to animation. This is the scheme that will be used.
The figure provides an example that illustrates the principles. The fictional Archibald Mises, 45 years of age, his wife Aribella and their two children constitute an economic unit.2 On Thursday, September 1, 2005, the balance sheet for this family might look like the nearby figure. What they HAVE is listed in the two ASSET columns on the left; one (green) above the other (brown). What they OWE is listed in the LIABILITIES column (red). And what they, therefore, OWN is the blue column, called NET WORTH. The difference between what they have and what they owe defines what it is that they own. Thus the meaning of the words describing these columns is contained in the equation
or put formally
We arrange for the height of each column to portray the values within them. Then the equation says that the combined height of the two head-to-tail asset columns on the left must always equal the combined height of the pair of head-to-tail columns on the right. The net worth of the economic unit - the blue column height - is deduced precisely from this 'equal height' condition.
3. Good Fortune
Good fortune: you OWN MORE. Your lottery ticket was the winner. A distant relative bequeathed you his estate. The figure shows the effect on your balance sheet. Your assets increase. Liabilities are unaffected. So net worth increases. Ill fortune is when assets decrease and so does net worth. You own less. Click on the orange oval button to see this.
The foundation upon which everything in this exposition rests is OWNERSHIP. That something may be owned - belong to an owner - is the essential feature underlying economic transactions. For societies in which this right of ownership is not protected, the animations don't describe its economy.3
Assets are of two kinds: liquid and viscous. The term 'liguid assets' is used commonly and has its common meaning here. But because I have never seen, in common use, some simple term for non-liquid or illiquid assets I will name them 'viscous'.
4. A Purchase
VISCOUS ASSETS: A viscous substance flows reluctantly and only with proding; like wet mud flowing down a slope. Viscous flow is sluggish. By contrast clear water flows readily downhill with no proding at all. Its flow is liquid. Viscous assets are not universally negotiable. Non-negotiable means not generally acceptable in exchange for a good or service. A viscous asset is one that does not flow easily between parties to a transaction.
Examples of viscous assets are titles to buildings, titles to land, furniture, bonds, shares in companies, IOUs, invoices, plus the productive capacity of the economic unit holding the assets and thus the general well being of that economic unit. Assets whose value is determined only in a transaction (when it is sold) are viscous assets. The price of a viscous asset must be negotiated so it doesn't have an invariable exchange value.
Whereas a transaction - a purchase - is needed to establish the value of a viscous asset, no transaction is needed to establish the value of a liquid asset. The value marked on it is a liquid asset's value. A viscous asset may also be marked with a value; but its actual sale value is negotiable. An example is an automobile with its 'sticker price'. That label only marks an offering price, not its value. Its value is its sale price. An automobile is a viscous asset.
LIQUID ASSETS: Money.6 Cash, check, payments by debit card, payments by credit card.., anything that is generally acceptable in return for a purchase. (Purchase = the exchange of a liquid asset for the acquisition of some viscous asset.)
A liquid asset is one whose' label value' is its invariable 'exchange value'. e.g. a twenty-dollar bill is always worth exactly $20. A deposit account bank balance is a liquid asset. Its 'value' is just that balance.
Liquid assets flow easily between parties to a transaction. The livelihoods of people come almost exclusively from liquid assets: pay for labor, salaries, distributed returns on investment, dividends, interest payments . Whatever it takes to function daily and enhance personal well being is gotten with liquid assets. So liqiud assets are essential to the daily flow of existence - to well being. Even the homeless and the destitute need liquid assets to survive.
The origin, growth, distribution and disappearance of liquid assets is, therefor, something worth understanding.
5. Debt Relief
The figure shows the creditor's balance sheet when a debt is forgiven. The creditor's liquid assets and liabilities are unaffected. Her viscous assets are decreased because she destroys the promissory note recording the debt and this note was one of her viscous assets. Necessarily her net worth decreases by virtue of the fundamental relation:
Whereas forgiving a debt is a voluntary act, the same balance sheet effect can occur involuntarily. An asset may suddenly decrease in value. A borrower may default on his promissory note. The creditor's asset collapse is involuntary debt forgiveness.
ASSETS are either documented (of record) or undocumented (owned by virtue of possession). In the case of the former it is really the documents, themselves, that are the assets! Without the document attesting to it, you do not own the property. Ownership by possession includes ownership of oneself4 - ones productive (saleable) capacity. Thus the forms assets take are:
1. Paper documents, held or of record e.g. bonds, treasury notes, bills, ownership certificates, titles to property, company shares, patents, copyrights, options, other contracts, debitable accounts like credit cards, deposit accounts, debit cards.
2. Undocumented. Ownership via possesion: Tools, equipment, pocket money, clothes, jewelry, personal belongings and ones own labor or productive capacity.
Documents of ownership do not, in themselves, insure ownership. Also needed is a stabile society where documents of ownership are respected. In chaotic times or under lawlessness, documents of ownership are trumped by naked force. Ownership is decided by violence or intimidation. In such societies there is constant battle since everyone must be ready to defend his ownership by doing battle. This suffocates initiative since anything created may at any moment be commandeered. These are warlord societies, ones where bands of thugs fight each other over control of territory and resources. e.g. 19th century China, 20th century Afghanistan, Africa - Angola, Sudan, Nigeria, Somalia..
These societies grow poorer as the chaos continues until they reach a bare subsistence level; until each person has nothing more that can be taken from them - devoid of ownership. No use starting a business, or organizing a service because everything is threatened with destruction or confiscation. The book, A Bend in the River, 1979 by V.S. Naipaul on Indians in Africa recounts living under threat of such conditions.
6. The Value of a Viscous Asset.
In former times items were thought to possess intrinsic value - a just value. To understand economic behavior, however, we depend upon what happens, rather than on what ought to happen. The principle that governs the valuing of assets derives from economic transactions.
The ELEMENTAL ECONOMIC TRANSACTION figure shows the exchange of liquid assets for a viscous asset. The value of a viscous asset is only determined upon its sale. It has the value assigned to it by the sale. A transaction establishes value.
Thus the viscous asset column (brown), which has no well defined value, is assigned a value! A viscous asset's value is frozen by its last evaluation (sale price).
At the time of a transaction a viscous asset has two values: one to its new owner and another to its old owner. This difference in value accrues to the old owner's net worth.
This is seen in the figure. The value of the chair to the merchant - the merchant's decrease in viscous assets (loss in merchant's brown) - is less than the increase in the buyer's viscous assets (gain in buyer's brown).
The buyer's viscous assets increase exactly by the amount of liquid paid.
What the buyer pays, more than compensates the merchant for her viscous asset decrease. And the difference amounts to an increase in the merchant's net worth.
The amount of cash received equals the amount of cash paid. Hence the net liquid assets in the world are unchanged. The net effect of this elemental transaction on the world is an increase in the value of its viscous assets and a corresponding increase in its net worth!
7. The Net Effect of a Transaction.
The net effect on the world of the elemental transaction just discussed is shown in this figure. The liquid assets in the world are unchanged. There is an increase in the value of the world's viscous assets and a corresponding increase in its net worth!
What is the value of an asset one month after the purchase? One year? Ten years after? Answer: There is no way to know its value. So we persist in our principle: it continues to have the value assigned to it by the last sale. Upon resale it acquires a new value - whatever is paid for it. This principle guides accounting practice. Accountants record the 'original' value of an asset on the balance sheet as long as the asset is held. Some allowance for an asset's potential change in value is made in 'depreciation' - subtracting value for aging of the asset according to its expected lifetime of usefulness.
Other asset valuation conventions are concievable. We might imagine a daily reappraisal of all viscous assets. Then the value assigned to viscous assets would fluctuate daily. But the daily reappraisals would not be objective! No two appraisers agree on the value of something.
There is one clear exception. A daily reappraisal might be made objectively in the case of an active market in securities - stocks, bonds... . Security market prices are reported daily so you can reappraise your portfolio at the end of each day relatively objectively. And there is a method of accounting called mark-to-market accounting which does just this.
With the exception of businesses whose entire assets are actively marketable securities, the height of the viscous assets column is effectively a fiction since there is no way to measure its value except upon sale of the assets.
We don't want to catalogue viscous assets by name. It's inconvenient. Though they don't inherently have the units of dollars, a $ value assignment enables one to speak quantitatively. The $ value listed in a balance sheet is the viscous asset's "sticker price" - not its value but only an estimate. The result is a balance sheet with $-valued assets.
Transactions of significant magnitude are generally exchanges of paper - exchanges of documents of ownership (deeds, stock shares..) and documents of debt (promissory notes, bonds..). Of course documents of debt are also documents of credit.
GENERATION OF ASSETS
The assets so far envisioned are wholely present: a chair, an automobile, property, shares of stock, bonds... Suppose the asset is not purchased whole but manufactured. For a chair its value to its owner is what it cost. But for unassembled assets the computation becomes more problematic in how this cost is assessed.
Assigning a $ value is an even more subtle business for intangible assets: patents, copyrights... Then there is mining, logging and farming where the assets are created - not purchased, even in parts. Artists and writers create assets out of nothing!
Besides goods (physical assets) one purchases services. Auto repair, legal, medical, financial services. Brokers render service. So do massage therapists and casino operators. All involve labor. How are these to be quantified in $ as viscous assets?
I postpone consideration of this problem.
What follows certainly applies in the simple case where an asset is both purchased and sold whole. As when a merchant sells his wares or when an investor buys and sells securities. How the following may apply to a broader range of assets depends upon incorporating the subtler forms of assets into a logical unified structure.
8. Credit, Debt, Liabilities
A liability is an obligation that one possesses to fulfill some promise. Something is owed. It is documented by a promissory note; an IOU. The acronym IOU is commonly understood to stand for the words, "I owe you."
The one who owes the obligation - the borrower - is a debtor. What he owes is a debt. The document that specifies what is owed (the promissory note, the IOU) is held by the creditor (the lender), the person to whom the obligation is owed. This document becomes part of the lender's viscous assets. It's animated in this figure.
When the debtor agrees to borrow and gives his note to the creditor the debtor's (red) liabilities rise in the amount of the debt. And the creditor's (brown) viscous assets rise by the same amount - the value of the note.
When the loan is 'paid off' the debt is said to be retired. The note is redeemed - destroyed or invalidated. The debtor's liability is reduced by the elimination of that note. The creditor's viscous assets are reduced. The 'account' is closed. When a bank deposit account is drawn down the liabilities of the bank decrease.
EVALUATING LIABILITIES: The possible redemption price of a liability is often a matter of negotiation. Your creditor might accept, say, $900 in redemption for the note that you originally wrote in the amount of $1,000. The liability might not even be for a dollar amount. It may be, say, to return the borrowed vehicle. The liability is the vehicle. So, as with viscous assets, any catalogue of liabilities has no consistent set of units. If one wishes to imagine an appraisal value for each item as a guess at what price it would bring on the market then the liability column height would be constantly in flux. So neither viscous assets nor liabilities have intrinsically well defined $ values. But we use the same convention in evaluation: the original transaction price until a sale establishes a new value.
The balance sheet in this figure shows the estimates of Apple Computer Company for its liabilities and viscous assets for the date stated. In the figure the word, equity, is used in place of net worth. The net worth of the company is the stockholders' equity. The stockholder's equity ($5,076,000,000) is computed from the total assets ($8,050,000,000) minus total liabilities ($2,974,000,000). The amounts in the balance sheet are given in units of $1,000.
As is clear from the figure, in conventional business balance sheets the division is not between liquid and viscous assets but rather between current assets and fixed assets. But assets are always ordered by liquidity - from completely liquid to rigidly fixed. So only the cash - the topmost - part of current assets are liquid. Current assets are those expected to become liquid within a year's time. Accounts receivable and inventory are viscous parts of current assets. Their values are open to negotiation.
9. A Loan
The 'credit' animation shows the transaction of borrowing money from a non-bank lender. For the moment, I ignore any loan charges, interest or fees that the lender may demand for her service. This is the case of a cost-free loan.
Essentially, the lender buys a promissory note. She pays 'loan $' for it thus depleting her own liquid assets by that amount. But she adds the IOU (promissory note) to her viscous assets in compensation. A second click on the go button (when it reads more) assembles the explanations for what is seen in the animation.
What characterizes a transaction are changes in the four balance sheet columns - not their absolute values. In the explanatory equations, the triangle is a letter in the Greek alphabet called delta. It represents the words 'change in', as is traditional in mathematics. When the change is positive the quantity has increased. A negative change is a decrease. Delta liabilities (Δ liabilities) is shorthand for the 'change in liabilities' that arises as a result of the transaction - the change in the height of the red liabilities column.
In this transaction the borrower's liabilities column shows an increase by the amount of the IOU. This promissory note underpinning the loan is the borrowers liability. It is to be added to whatever other liabilities she may already have so it qualifies as Δ liabilities, an incease. The lender suffers a decrease in her liquid assets so for her Δ liquid is a negative amount. The loan fulfills its purpose in that the liquid assets of the borrower are 'increased' by the loan amount. The labelling shows this as Δ liquid = loan $.
10. A Bank Deposit Creates Money
The manufacture of liquid assets comes from trust in institutions.
The figure makes it visually apparent that when money is deposited in a bank the world ends up with more green (liquid assets) in it than it had before! In all the previous transactions more green in one place meant less in another. The amount of green was conserved: the amount of liquid assets in the world did not change.
Making a bank deposit increases the world's supply of liquid assets.
I confess that I didn't appreciate this thought myself until I gazed at my own animation of it! Playing it revealed the thought. The animation was constructed from the simple facts involved in the process. Below I lay out, in detail, the logic of the conclusion.
Mr. Mises sells his motorcycle for $1,000. He has decided to give up motor biking - permanently. Having no pressing need to spend the money immediately what is he to do with it? Rather than carry it around in his pocket, he deposits it in the bank. Knowing he can reclaim it from the bank, as needed, at any time, he puts the money there as a matter of convenience.
'In the bank' is as good as 'in the pocket'.
His liquid assets are not any less because they reside in a bank! He still has $1,000 liquid whether it is in the bank or in his pocket. His viscous assets are not affected by making a bank deposit, nor are his liabilities - and nor are his liquid assets. Nothing on his balance sheet is changed by making the bank deposit. He has merely exchanged his cash for the privilege of writing checks. And that is what is shown in the animation. In accounting terminology the $1,000 is listed as cash equivalent among his liquid assets.
But this transaction does change the bank's balance sheet. In accepting the cash, the bank acquires more liquid assets than it had before - by just the amount of the deposit, $1,000. Simultaneously it acquires a liability of $1,000. The liability is the obligation to pay, upon demand, whatever Mr. Mises says it should pay - up to $1,000. The checkbook that Mises gets from the bank represents this liability. The bank deposit doesn't affect any viscous assets the bank possesses. Nor does it change the net worth of the bank. And this state of affairs is exactly what is depicted in the figure. Both the bank's liabilities and its liquid assets rise by $1,000 and nothing else changes.
The incontravertible conclusion is that, as long as Mr. Mises doesn't draw down his account, the world contains $1,000 more in liquid assets than before. It is clearly visible in the animated accounting of the figure. The total amount of green increases. How are we to understand this?
The animation offers the answer: the increase in the bank's liquid assets matches the increase in its liabilities. In effect, the bank's increased liability is being treated as money. The bank's promise to pay (its liability) is perceived as being as good as the money itself. The deposit is what generates this 'promise to pay' so depositing money ends up creating it. And, of course, closing the account, annihilates $1,000 of the world's liquid assets.
The key issue in this story is the matter of trust. Mises 'trusts' the bank, else he wouldn't put his money there. And he patronizes the bank only because others in the community will accept his checks drawn on this bank. In fact, the trust is not so much in the honesty and integrity of the individual bank, as it is in the FDIC gaurentee that the U.S. Government will see to it that Mises gets his money back. It's 'enforceable trust' on which Mr. Mises relies.
Mises may draw on his account by writing checks. He may also draw on it via his DEBIT CARD. A debit card is an electronic checkbook. When the check Mises writes gets back to Mises' bank, his account is debited, i.e. depleted, by the amount of the check. The bank pays the payee and debits Mises' deposit account. The debit card is a substitute for writing checks. It allows an immediate debiting of Mises' account. It eliminates the time it takes for the payee to get the check back to Mises' bank and thus to collect his money.
11. A Bank Loan
When the lender is a bank the two transactions - loan plus bank deposit - coalesce into one. The borrower, instead of receiving cash, receives a checkbook (and/or a debit card) with which he can call, at his leisure, on his recently acquired liquid assets - on his account at the bank. The balance sheet changes are shown in the Bank Loan figure. (Again, I ignore loan charges, as I did previously in the non-bank loan discussed in Section 9, with its 'credit' figure.)
Unlike the private lender, whose liquid assets decrease when he makes a loan, the bank is left with just as much liquid assets as it had at the outset. It still has money to lend!
The bank makes the loan adding the promissory note to its viscous assets. This appears on the balance sheet as 'accounts receivable' in the assets column. But the bank's liquid assets are unaffected because the borrowed money doesn't leave the bank. It is deposited with the bank. A deposit account in favor of the borrower is listed among the banks liabilities. The bank must pay on demand - its liability - but it needn't pay until demanded.
So the bank's liquid assets are unaffected! It has just as much liquid assets after the loan as before! Most - but not all - of its liquid assets are available for loan. It must hold something in 'reserve' to pay demands from its account holders.
Effectively, when the bank lends money, its lending pool is only drained by a small fraction of the loan amount. It has about as much to lend after making a loan as it had before. The only limit to its lending is the legal reserve requirement. The bank must keep enough cash reserves on hand. At least in the amount of a fraction - fixed by law - of its liabilities to its depositors. See Section 16 below.
12. Credit Cards
How are we to view credit cards in this balance sheet scheme of things? We do it by diagraming every detail of the transaction and then see how they play out in motion. Motion diagramming. Three animated balance sheets represent the three participants in the transaction.
MERCHANT: The merchant's inventory is depleted by the sale. The chair being sold is a viscous asset in this inventory. Thus the amount of merchant's brown decreases.
CARD HOLDER: The purchase is made by the card holder. Her viscous assets (brown) are augmented by the purchased item - the chair. The buyer does not pay cash; her liquid assets (green) are unaffected by the transaction. But payment by credit raises her liabilities by the amount, $. Here the symbol, $, represents the cash value paid for the item - the amount recorded on invoices and in ledger books. The obligation of future payment to the credit-card-issuing bank appears as an increase in her liabilities (red). The viscous asset - having acquired the value, $, by the sale - just matches, in value, the increase in liabilities. Thus the buyer's net worth remains unchanged.
BANK: The buyer's newly acquired liability is precisely the amount by which the bank's viscous assets increase. This asset increase is recorded as an 'account receivable' (brown) in the amount, $. The bank has the right to collect $. That right is a viscous asset. But the credit card agreement insures that the merchant gets paid. So the bank acquires a liability (red) - again in the amount, $ - in that it must credit the merchant's demand account with the amount of the sale price - $. The bank's liquid assets (green) are not affected. The columns balance so there is no change in net worth (blue).
MERCHANT:The merchant, having recorded her sale with the bank, has her liquid assets (green) augmented by the amount, $, because her bank account has this much more in it. She has exchanged a viscous asset (brown) for money-in-the-bank (cash equivalent, green) instead of the cash itself.
As in the elemental transaction of Section 6, (figure, Section 6), the merchant takes a profit from the sale; the difference between the new and old values of the viscous asset (the chair).
13. Net Effect on the World
The figure displays the effect. It is that the transaction produces an increase in liquid assets of the world by the value - $. Meanwhile the world's liabilities increase by 2$! This becomes visible after a short delay.
Because we see an increase in the world's liquid assets we may ask whether the issuance of credit produces money. The answer is that it does not.
What produces the world's increase in liquid assets - money - is the unavoidable deposit of the merchant's proceeds into the bank. These deposits create the money, not credit.
14. Credit Card Debt Retired This motion diagram demonstrates that it is the bank deposit part of the credit card transaction that produces liquid assets. In the figure the card holder pays off her debt. Hence the credit part of the transaction is removed. No liquid is destroyed by the process. The liquid that was created remains. So it was not the card holder credit that created it.
In the figure pane compare the credit card purchase, Credit Cards, Section 12, IMAGE, with the simple non-credit card purchase, Elemental Economic Transaction, Section 6 IMAGE. The essential difference is that in the former the merchant's payment is deposited in a bank, in the latter it is not. And it is this difference which accounts for the liquid assets injected into the world in a credit card transaction.
What the credit card does is to gaurentee that the merchant deposits her sales earnings; that she take her payment as a bank deposit account credit. That deposit creates money. Whether the card holder keeps the debt or pays it off, does not affect the creation of liquid assets. Effectively, money is created by accounting.
In this figure is displayed a banknote issued by a bank in Canada in 1935. In former times - before the coming of central banks - each bank issued its own banknotes. These banknotes functioned as money in the community. They were generally accepted in payment for goods or services since the holder could, in turn, use the banknotes to pay his or her own bills.
Here is the mechanics of the process. A borrower - say a merchant or a real estate developer - asks the bank for a loan. Perhaps $100,000. The borrower gives the bank his IOU backed, perhaps, by liens on his property; he mortgages his property, agreeing to pay the loan back over many years. This IOU is a long term promissory note; a viscous asset of substantive value.
In Section 11, where this process was discussed, the bank gives the borrower a checkbook as in this figure. Needless to say, it is not the paper checkbook that is money - the green, the liquid asset. Rather the liquid asset - the money - is the right to draw on the account balance at the bank from which payments are made on the checks written. In effect the bank converts long term debt - the IOU - into short term debt - the banks liability to honor the borrower's checks in amounts of perhaps a few hundred dollars each.
But paying by check is a relatively recent innovation. Even now there are places in the world where doing business by check is not acceptable. In Europe it was not commonly acceptable before the latter half of the 20th century.
Before checks there were banknotes. The bank gave the borrower its banknotes. The borrowing transaction involving banknotes is portrayed in this figure
Banknotes are like checks but with printed denominations on them - $10, $20, $50. The borrower can pay for her purchases with these notes because people in the community accept them. Just like checks these notes are short term IOUs. They are redeemable on demand. You can go to the bank and, with these banknotes, pay whatever you owe the bank. Or simply deposit them into your account with the bank. Since they were generally accepted in payment for goods or services they functioned as money.
The notes of different banks were exchangable via exhange rates between them. Like exchange rates between different national currencies today. Banknotes of one bank could be exchanged for those of another using the prevalent 'exchange rates.' For example one Bank-of-Omaha-Dollar might be worth as much as 1.2 Bank-of-Deluth-Dollars.
Today exchange rates refer to the price of one national central bank 'banknote' in terms of another. The European Central Bank's banknotes are euros. The U.S. Federal Reserve's banknotes are U.S. dollars. On December 5, 2011, 1 euro bought 1.34 dollars.
16. Reserve Ratio
Reserve banking is illustrated in this figure. Click on PLAY and then, after viewing the first transaction, click on Play again. On clicking PLAY the first time we see the depositor put $1 in the bank. The depositor receives a checkbook with drawable $1. The depositor's balance sheet remains unchanged by this action as was explained in Section 10.
But the bank augments its cash supply by $1. It's green goes up by the $1 deposit. And its liabilities increase by $1 because it is liable for the depositors check writing.
As before, we see that the account balance behind a checkbook = money. This transaction shows that by virtue of deposit of $1 in the bank, there is created $1 more green in the world.
In reserve banking a bank is enabled by law to lend out a large amount upon deposit of a small amount. In the U.S. the fractional amount is set by the Federal Deposit Insurance Corporation - FDIC - an arm of the Federal Reserve. Banks need keep, in ready cash, only a fraction of what their clients could demand. The fraction is called the reserve ratio (or liquidity ratio). Illustrated is a case of reserve ratio = 1/7. In actual fact the reserve ratio has varied between 1/5 to the 1/10 of recent years.
To see how this works press PLAY again. Having augmented its liquid assets by $1 the bank may lend $6 to borrowers by giving them $6 drawable checkbooks. Borrowers thus acquire $6 of green (of liquid assets). They also acquire $6 of red - the promissory notes (IOUs) they give to the bank.
By awarding these checkbooks, the bank has increased its liability by $6; its red increases by $6. In return the bank gets IOUs in amount of $6. These promissory notes increase the bank's brown (viscous or illiquid assets) by $6 for which the borrowers get green or liquid assets of $6. The IOUs are the securities backing the issue of the checkbooks. The bank collects interest on the $6 in loans.
That a deposit multiplies5 the liquid assets in the world is called the 'multiplier effect' and the 'multiplier' is the inverse of the reserve ratio: 7. A deposit of $1 creates $7 of liquid assets. Seven $1 checkbooks are distributed as a result of a single $1 deposit.
17. Federal Reserve Banknotes
The central bank (Federal Reserve Bank in the United States) issues its notes in just the way banks did for centuries before the advent of central banks. Here, again, is the banknote issue figure for one of those banks.
One can see that 'to issue' means 'to pay' with banknotes for a long term security - the IOU. Banknotes are short term promissory notes - promises by the bank to pay on demand. The IOU is a security - an asset - backing the banknotes. It is the borrower's promise to pay at some future date. Generally there is some collateral securing the promise - a lien on property. The IOU is an asset, but not a liquid asset. So what the bank does is to print short term debt paper and pay with it for long term debt paper - for the IOU. It creates money by converting viscous assets into liquid assets.
The process embodies two essential ideas.
1. Money is an asset made liquid. It is an IOU that can be passed around.
2. And this process is fundamental to the creation of wealth and material well being.
If long term promises of repayment could not be converted into money no projects could be done. Builders would not be able to pay their workers or their suppliers. To do so, their promise to pay on project completion in the future must be converted into the cash they need now. Farmers would not be able to buy their seed corn. Their promise to pay when the crop comes in must be converted to cash in order to buy the implements to seed, nurture and then harvest the crop. Only when the crop is sold is there money to pay off the bank loan.
To explore currency (banknote) issue by the central bank we view the whole nation as an economic unit. Its wealth is held in a treasury. Into the treasury go the taxes it collects - its income. Out of the treasury come all payments of government obligations. Senator's salaries are paid by the U.S. Treasury. From the treasury comes Social Security payments, soldiers pay, the pay of all government officials. Also from the treasury come payments to the myriads of private contractors who perform services for the government.
The treasury - like the farmer or the developer - borrows money. With the treasury as borrower the banknote figure is replaced by this Federal Reserve Banknotes figure. U.S. Government IOUs are called U.S. Treasury Bonds. (Treasury Bills and Treasury Notes are shorter term - less than 10 years - viscous asset IOUs.) Bonds are promissory notes that need be repaid only many years after their sale - 10 or 30 years. They are sold to investors and the money the investors pay for them goes into the Treasury. The Treasury must pay the interest that is due each bondholder every year and it must eventually redeem the bond. i.e. repay the loan that the bond represents when the time comes. The bondholder buys the bond for its income (the interest payments) and because a U.S. Government Bond is considered to be an essentially risk free investment. Nobody expects the government to renege on its debts.
The Federal Reserve Bank buys these bonds on the open market with banknotes i.e. with printed paper certificates called Federal Reserve Notes. Thus every Federal Reserve Note issued is backed by a valuable asset: a bond of the U.S. Government. Like the banks of old it issues (pays with) its banknotes for long term thoroughly safe securities which it holds as viscous assets. These holdings provide the basis for the value of its banknotes.
The Federal Reserve Banknote graphic portrays the process functionally, not literally. The Fed does not buy bonds directly from the Treasury. The Treasury sells them at auction in the open market. The Fed buys them from investors.
In modern times the method whereby the government prints money to pay its bills is this: The Government Treasury issues (i.e. sells) bonds which the Central Bank then buys with 'bank notes' that it prints. In the U.S. the law says that the government may not exceed the debt allowed by Congress. So the debt ceiling must be raised periodically to permit the Treasury to sell bonds in order to have money printed by the Federal Reserve to pay its debts.
18. The Money Supply
I prepared the graphs from the data given at the Federal Reserve site http://www.federalreserve.gov/releases/h6/hist/ using Tables 2 and 3 of the 'Money Stock Measure, H.6' historical data section.
As measured by the Federal Reserve, the money supply, M2, consists essentially of the sum of two main components; the amount of specie (currency) in circulation plus the amount of money in bank deposits. These two components are shown separately for the 49 years between January 1959 to January 2008. It is clear that bank deposit money is about eight times the amount of circulating currency.
I end this exploration with a summary of some things that the animations brought to my attention:
1. Money is created when a bank deposit is made. A bank deposit increases the total supply of money in the world; by a multiplier connected to the reserve ratio. Of course, a deposit account withdrawal destroys money.
2. Every profitable transaction results in an increase in both the value of the world's assets and in the world's net worth.
Are changes in net worth = changes in well being? Is the world better off from each profitable transaction in it? The rich say wealth does not make happiness but wealth seems to make the poor very happy.
That, on each profitable transaction, the value of the world's viscous assets also increases suggests a natural rate of inflation. Assets acquire ever higher value. So it looks superficially like trade produces wealth - but inflation with it.
I'm not sure that these observations are valid conclusions; they are merely suggestive.
3. I am impressed by how dependent the whole system is upon social stability and peace. For exchange and trade to work there must be in place peaceful methods of resolving disputes over ownership; methods other than by brute force or by conquest. Contracts must be enforcable. Laws are needed as are judges. Without banks there is no institution to provide liquid liabilities (promisses to pay on demand) and thus to create liquid assets. Trust in institutions is the essential element in the creation of money. And it is money that facilitates trade. (And thus material well being!)