Banks do create credit from nothing but they need to get the money back again to balance their books.
First I want to back track a bit. Many of those spruiking that banks were creating money from thin air suggested that only one side of their balance sheet received an entry. Their argument is the when a bank lends you money they create an asset – a loan to you. This money enters the system and as you pay down the debt the money created disappears. This is just not standard (double entry) accounting practice.
Banks do balance off their accounts with a deposit to your account or borrowing more money from other banks, or people. They must attract a deposit to balance off their books or they must use their reserves. However the other bank can create a loan – an asset to the other bank – to the bank that has lent you the money. They essentially swap IOU’s and this does increase the base money supply and is essentially creating money from nothing.
The velocity of money and the blurring effect it can have on calculating base money is a factor. In the increase in base money over the past 10 years But there can also be brief periods where lending massively outstrips loan repayments and deposits and this would increase the money supply. Although this effect should unravel.
The affect of default – which decrease that money created – and debt repayments from savings decrease money creation. The velocity of money can compensate for this but generally during conservative times people pay down debt while decreasing economic activity – spending. So both the money expansion ceases and the velocity slows.
The amount of money gambled in financial capital, forex and derivative markets in Australia. ($1,000AUD)
Of course if they just continued to give each other credit in theory the system couldn’t crash.
Again “in theory” this should create inflation and higher interest rates thus correcting the boom. But this only occurs if the increase in money supply actually filters through to the real economy. Much of it stays in the capital and derivative markets.
David J Campbell
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