Uncharted Territory

February 2, 2009

Where money comes from… – the leveraging process

Filed under: Concepts, Credit crisis, Economics — Tim Joslin @ 8:36 pm

A while back I bashed in a critique of current attempts to arrest the current economic death spiral.  Most recommendations, I noted, appear to be founded on at least one fundamental misunderstanding, as I later explained.  To recap, what I said back in November was that the “deleveraging process” must be arrested.  Later the same day, I found myself clarifying what I meant by deleveraging.

The Saturday Guardian magazine used to be full of little delights.  But first Jon Ronson was supplanted by the crass Tim Dowling.  And this week Lucy Mangan failed to appear, as did the How to… column which had announced its retirement the previous week.  The Sport section, though, retains the peerless Russell Brand.  But why oh why did he write this week:

“That’s putting the cart before the horse; actually it’s putting the horse’s unnecessary-straw-hat-with-earholes-in-it-for-the-horse’s-little-ears before the horse.”

This makes no sense whatsoever because the straw hat is not being pulled by the horse, at least not as much as the cart is.  Next time, Russell, I suggest you write:

“That’s putting the cart before the horse; actually it’s putting a-time-travelling-or-possibly-Amish-visiting-Michael-J-Fox-on-a-skateboard-hanging-onto-and-being-pulled-along-by-the-cart before the horse.”

Spouting on about deleveraging before explaining leveraging is, I now admit, putting Michael J Fox before the horse.

So, for those who have not yet followed my recommendation and carefully read Niall Ferguson’s The Ascent of Money, here, in no more than 1000 words (so at most 760 to go) is an explanation of where money comes from.

In the beginning there was gold or other designated material in limited supply, such as cowrie shells.  I’ll use “gold” as the shorthand for such kinds of money.  If you wanted to buy something you had to have an amount of gold to give in exchange sufficient to persuade the seller to part with the said good or service.  Conversely, the value of something – the amount of gold you could get in return for it – is precisely what you can persuade someone else to pay you for it.

But the trouble with gold was that you had to carry it around, and people might nick it, often employing lethal force.  Businesses – banks – arose to look after the gold for people.

A slight digression is that at some point, someone had the bright idea that rather than have people come to the bank  to collect gold every time they wanted to buy something, they could instead be given pieces of paper to give to someone who could then collect the gold from the bank themselves.  Or they could give the piece of paper to someone else in return for goods or services and that person could collect the gold themselves.  Or buy something.  Before you knew it we had paper money.

But the paper money still in theory represented an amount of gold of similar value sitting in the bank.  It’s not even necessary for the key step, though it helps.

The key step is technically termed fractional reserve banking.  Some bankers eventually realised that they didn’t need to hang onto all the gold that had been deposited in the bank.  They could lend some to other parties.  Because, with money being deposited and withdrawn continually, the amount of money coming into the bank roughly balanced that going out.  A bank which didn’t lend would always have a large positive balance of money sitting in its vaults.  A bit of a headache not least because such piles of gold or paper money were simply asking to be taken away by lethal force.  Every problem is an opportunity – simply lend the stuff out and make its security someone else’s problem.  And opportunity.

We’d now created a situation where the amount of “money” in existence – let’s say measured as borrowings – can – indeed, is likely to – far exceed the gold or paper money in all the banks’ coffers.

Sceptical?  Let me try to demonstrate by way of a simple scenario.

Let’s say there is only one commodity to buy – call it “food”.   The people able to produce this food receive gold or paper money, from their customers.  They deposit this money in a bank.  As they leave, starving customers entering the branch pass them in the doorway.  The humanitarian bank manager lets them borrow money – either gold or paper – with no limit, so their bank accounts become more and more in debt.

Now, as well as gold and paper money, we have bank deposits and loans, which we might call “virtual money”.  Most of the money we now use is virtual.  It is never turned into paper money or gold.  No need – just type in your PIN or sit at your PC.

It may seem that “promising to pay” by way of an entry on a bank’s ledger is very similar to “promising to pay the bearer” by using paper money.  (See there was a reason for the digression).  But it isn’t.  The “virtual money” cannot be stored.   this is a critical point to understand and I suspect is not fully appreciated.  Virtual money is qualitatively different to physical, including paper, money.

Back to the story.  After a while the bank accounts of the food-producers would be in credit by a large amount and their customers’ bank accounts would be in debt by a large amount.  The leveraging process has begun.

Of course, if all the food-producers attempted to withdraw their money at once (in a run on one or more banks), they would find that the bank could not satisfy them all.  The realisation of this fact generally creates mass panic. Whereas a more rational reaction might be for all the creditors to accept a ticket representing their place in a queue.  The bank would satisfy their withdrawal requests in order as borrowers paid off their debts.

Unfortunately we are not rational.

An important proviso

It’s easy to understand that a bank may not be able to meet all requests for withdrawals in gold or paper money (unless it prints its own, but nowadays the state has wisely granted central banks a monopoly on this function).  But if the money is virtual why don’t they just wire it to your account elsewhere?

The problem for the magic money-creating bank is that computer systems (and, still, armies of clerks and accountants) exist to enforce conservation rules similar to those of quantum physics.  Money, even virtual money, is always conserved.  If your bank account is credited, that money must be debited from another account.  And vice versa.

Think about it this way.  For you to spend any money your bank gives you, another bank must accept it (OK, if you purchase from someone else with an account at the same bank this would not apply, but eventually someone will try to use the money to make a purchase from someone whose account is held elsewhere).  To simplify a little, if the transaction would result in your bank having no money in its account with the central bank (say the Bank of England), then I’m afraid to say your money would be no good.  Your piece of plastic would be dead.  No more, defunct, an ex-debit or credit card…

And the Consequences Were…

There is an important consequence when all this leveraging is carried out with virtual money.

As I might have mentioned, virtual money cannot be stored.  Once accumulated, it is not kept in glittering piles or tidy bundles.  No, no, no.  It exists in purely electronic form in a bank account.  It must then be lent out, not least because it costs the bank money in interest.

So, for every saver there must be a borrower.  Which makes appeals for thrift somewhat meaningless.

Or does it?

What I suspect David Cameron intends to say is that (net) saving is not OK if it’s by bloody Johnny Foreigner.  And he’s right.

Because, since virtual money cannot be stored, if Johnny Foreigner is a net saver, that means we Brits (or Yanks), must be net borrowers.  And that is not a Good Thing.  Definitely not, at least if taken to extremes, as, unfortunately, it has been.

Now I’m being told it’s time for tea.  So I’ll wrap up, because we’re now moreorless at the point where we’ll be able to understand the First Mistake that has led to the current economic death-spiral.  Watch this space.

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3 Comments »

  1. […] Where money comes from… the leveraging process – loose ends Filed under: Concepts, Credit crisis, Economics — Tim Joslin @ 1:00 pm Let’s not run before we can walk – after sleeping on it, I’ve realised it’s not yet time to explain the causes of the present Great Crunch.  This post is a continuation of yesterday’s slightly rushed effort. […]

    Pingback by Where money comes from… the leveraging process - loose ends « Uncharted Territory — February 3, 2009 @ 1:00 pm

  2. […] Credit crisis, Economics, Housing market — Tim Joslin @ 4:59 pm My previous post and the one before that tried to explain where money comes from.  I described a process – leveraging – whereby banks and […]

    Pingback by Where money comes from… the leveraging process - afterthoughts « Uncharted Territory — February 4, 2009 @ 5:03 pm

  3. […] a misunderstanding of the nature of money. It’s now (mostly) not gold, not even paper, and can no longer be passively stored. It is always put to use. Possibly related posts: (automatically generated)“Why the euro is […]

    Pingback by Lex Share Quantitative Easing Misconceptions « Uncharted Territory — March 17, 2009 @ 9:02 pm


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