Money creation with credit

Finally, there is starting to be lots of talk about the money creation process.

This is the most widely misunderstood area of economics. Because Milton Friedman did not understand how a fiat money system works, we are now stuck with his version of the process which is not just wrong, but totally backwards. Banks do not need reserves to lend. They acquire reserves through borrowing at the federal reserve when they lend.

As result of following Friedman, we throw billions at the banks in a hope that reserves spur lending. This cannot work, and our experience to date with TARP shows this to be the case.

How is money created? There are two methods. Banks can create money with credit, but the net money created is zero, as the credit eventually has to be repaid. The government can create money with deficit spending. These are the only two methods of creating cash money. However, because money is simply a medium of exchange, we have situations where money-like script is created because people accept it as a form of payment.

Because economists - and many many other people - think that money is created only by the fed purchasing treasury securities, the debate in our country is about the wrong problems and nonsense solutions to those problems: inflation instead of deflation, government deficits and the "solution" of balanced budgets, and a free market allocation system that somehow seems to favor Goldman Sachs over 40% of the U.S. population


Steve Keen gets to part of it in this post. Money can be created by banks. Credit extended is money created. The amount of money created by private banks is the credit extended. Importantly, the amount of money created is exactly equal to the assets of the banks, so no net money is created. While there is more money to spend temporarily, in the end, the debt must be repaid or written off by the banks. In either case, the money is then destroyed.

This is why we are facing deflation right now. Because money was lent that cannot be repaid, the banks must write down this debt. This destroys money. As credit contracts, the amount of the money in the system decreases, causing deflation.

Steve's model is fantastic, and I am glad to see that it has some predictive power. I am going to download it and play around with it for a while to see what I can add.