Why Do We Pay Interest on Money Created Out of Thin Air?
I’m pulling this one out of the “Ask Cullen” section….it’s a basic, but important question that might help many people better understand the role of banks in our economy. There’s an interesting conflict of interest (no pun intended!) between institutions who issue the social construct that allows us to do many of the most essential things in life while also being motivated by profit generation (in essence, banks issue the social construct designed for public purpose, but do so primarily with private purpose in mind). But banks aren’t inherently evil institutions just because they’re profit motivated. In fact, you could easily argue that a competitive banking system is far superior to a government run banking system where profit is not the primary goal (I’ll leave that up for readers to debate). But it’s a fact that some bankers take advantage of their power for the benefit of themselves and their shareholders over the benefits of society. But as I described in the Understanding the Modern Monteary system paper, banks are a necessary cog in the machine. Monetary Realism thinks of them as the oil that lubricates the system and the entities that disperse the power of money creation away from a centralized government. They are not the driver of growth, but like the government, can be an important facilitator. Obviously, there are a lot of moving parts here….Feel free to discuss as always….
Anyhow, here’s the Q&A:
Mark D Carmichael: Why do we pay interest on money created out of thin air?
CR: “Banks are in the business of giving you access to money before you have obtained it. So, a student can borrow money to pay for an education even though they have not worked to obtain the means by which to pay for this education. The business of giving someone money now with the expectation that they will give it back to you at a later date involves enormous and various risks for the creditor. So they charge you an interest rate on this money. Money is a social construct that must be earned (in most cases though not all public purposes). If you have not earned it then you must essentially rent it. And for renting it, you pay a fee….
That’s an oversimplified answer, but the basic gist of it.”
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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36 Comments
This gets to the root of a very philosophical question. Should the money we used be issued by profit private purpose motivated entities. The alternative is national banking, but can we imagine an army of bureaucrats handing out loans based on political motivations? I can only imagine what a disaster that would turn into. Didn’t Fannie and Freddie teach us that that model doesn’t work?
Which is why our old model of highly regulated private, profit-seeking entities with public backing worked pretty damned well. Governments are bad at maximizing return-on-capital, and private entities are bad at regulating themselves. Checks and balances, baby.
*to clarify, by old model, I mean the pre financial deregulation orgy era.
Seems like common sense, doesn’t it? I think Cullen’s primer says the social construct needs to be regulated. Duh.
YES!
No, Fannie and Freddie didn’t teach us that. It was the private financial sector that blew up the economy. That’s where the liar loans originated that were securitized by Wall St. And credit default swaps were not created by the government. Again the blame lies squarely with the private financial sector.
The public sector tore the rules down. If the government hadn’t changed the rules of the game we wouldn’t have had the blow-up in the first place. But the Clinton and Bush administrations thought it was in the national interest to break down the rules and make houses affordable for everyone.
Plus a lot of other things. Greenspan thought financial risk modeling had become so sophisticated that the banks could be trusted to regulate themselves. Yadda yadda yadda, financial collapse.
Clinton & Bush didn’t come up with financial deregulation on their own – that was years of intense lobbying, coupled with bad economic advice (ie, the “free market” is always better).
Unfortunately the private sector pretty much owns government lock stock and barrel now. So who is to blame? Everyone… the private sector, the gov, the voters, etc. We’re being run over by very clever sound bites – distractions – to allow the lobbyists to do their thing on behalf of whoever has the deepest pockets.
Lots of blame to go around here. The whole left versus right debate is stupid.
If the private sector killed the economy then why does your helpless taken advantage of govt. allow the guilty to walk the streets?
Think about that for awhile then go read Ritholtz book- Bailout nation.
But first read today’s justice dept. decision to not prosecute GS.
Dismayed- hookers turn tricks. Thats what they do. But your govt’s pimp hand has no street credit. The public sector has some ladies that are out of control because the they have no respect for the Public sector’s hand. The whores on wall st are running amok because your public sector has lost control. I’d start with letting those you complain about failing. Yeah… But that’s just too uncomfortable for everyone who wants easy fixes.
I may be the only one on the left coast who’s leaning right.
I could be more direct dismayed. But it would be rude. The public sector is the 50 in the 100
This comment is so good I don’t even know where to start.
I don’t think that answers why the Fed is paying interest right now to the banks on reserves. If banks aren’t lending right now because we’re in a balance sheet recession and there aren’t credit-worthy borrowers, why pay interest on reserves?
The Fed is in the business of maintaining a target interest rate. When they flooded the system with reserves the target rate became unusually volatile and hard to maintain. Paying IOR helps the Fed achieve their overnight rate.
See the following:
This is a totally separate issue from the question at hand. The rate on reserves helps set a floor on the fed Funds rate.
This is a nice clear, concise explanation. Thanks.
Unrelated to the post, but related to “Ask Cullen” in general:
“Ask Cullen” is a great idea, but it’s already filling up (380+ comments when I write this). It’s not very inviting to read through all the answers after the fact, which is a shame since there’s so much interesting information in there.
Maybe you need a better (i.e. more specialized) way to run this feature, the blog comment structure does not seem to be well suited.
Alternately you could run a “Best of Ask Cullen” from time to time, where the most important questions are collected and categorized.
Just two suggestions that come out of my head right now.
Thanks. I know it’s kind of becoming a mess. I don’t know what to do about that. I’ve just changed it to have 30 comments per page. That might make it more digestible.
I know it’s not very kind to ask to “make it better”, especially not since you have only just redesigned the entire blog (for the better, of course).
Just keep in mind that at the current rate you will have “2894 comments” or so by the end of the year, and at some point it just becomes obviously silly
.
I’m afraid to say that any improvement would require some technical work on the blog.
Create a web forum from the various providers around the web. Link the forum to the ask cullen button.
This would package each question neatly in a thread and allow for readers to discuss more easily.
Something like V-bulletin.
You would probably want a moderator to keep it clean for you but I’m sure you could get a zealous reader to volunterr.
But if the money loaned is newly created money (or 90% out of thin air due to the fractional reserve ratio?)that is spent into the economy by the borrower, if the loan goes bad, why can’t the bank just write off the loan without and consequenses(after selling the foreclosed collateral presumably at a loss) since it was “free” money in the first place? To whom exactly does the bank owe money to at this point- the Fed?? Sorry for being so naive- I obviously don’t have a clue as to how banks actually work!!
When a loan goes bad the bank has to write down the debt and the bank’s capital goes down. This is definitely not “free” money. Write downs destroy the bank’s most important foundation – its capital.
A very good one. It took me a long time to understand it. The truth is the bank is not really losing any money because it did not have it to beginn with. It is only an accounting convention that makes it write down its capital. Change thr accounting e.g. pretend the loan is current and this zombie can live far too long and maybe forever.
Exactly!! so this whole housing bubble crisis could have been solved by just writing down all the excess loans to the “true” value of the houses.
Then all the borrowers wouldn’t be underwater and spending all their incomes on debt payments, and so they could buy stuff as usual and we never would have had a recession in the first place!!!??
Couple of problems with this;
1) If a loan is made, spent and then defaulted upon, the money has still been introduced into the economy as demand. Ordinarily the loan would be paid back and this would reduce demand meaning the consequences should be net non-inflationary (ignoring velocity etc for the minute), but if the loan is written off then the money spent in the economy would be inflationary. If you repeat this process to the tune of a few hundred billion dollars you can see where it might lead.
2) Moral hazard – if everyone expected loans to be written off with no consequences in bad times there would be little incentive to act in a prudent financial manner.
Writing down the loans without writing down the capital of banks would be truly free money for banks. Writing down the loans with capital writedowns of banks will make most of the TBTF banks, which controll a very high % of banking nowadays, insolvent, so you get probably a depression due to full credit withdrawal. A correct approach here would be the Swedish solution – keep banking operating entities operating, while the capital structure is wiped out and restructured (via a temporary receivership). This would cause a short sharp recession probably, but then it is a reset and a fresh start of releveraging. Even better would be to regulate banking (e.g. Glass-Steagal) more properly for the next credit cycle.
+1000
+1000 x 2 x 10 + 1000= ver well said
Cullen,
I meant this question many times and finally have the opportunity to do so since it seems relevant here.
What role does M2 Monetary velocity in MMR?
Does it have any meaning?
I ask because according to FRED, it has has never been this low since they started tracking it which looks to be about 1958 or so.
Cullen has described the system as a flow of payments. If there’s no flow then there’s no V. If there’s no V then there’s no economic activity. I don’t know if Cullen thinks differently, but it seems like a fact that higher velocity is consistent with higher economic activity. No?
An interesting question that is related to this discussion is: how easy is it for banks to increase their capital? My thinking is: if it’s easy, then the fear of bad loans and having to write down some of their capital is hardly a deterrent. Whereas if it’s difficult for a bank to increase it’s capital, then that would make the bank much more likely be to responsible in it’s lending / loan creation process.
So, is increasing capital difficult for banks?
p.s. My feeling is some sort of return to glass-steagle makes sense. I think there ought to be depository instituions where people can just put there money and it’s not used for profit. So it seems to make sense for a nationalized banking system where depositors simply get a very low interest payment (maybe index to inflation?). Then there can be investment banks that offer higher returns, but higher risk. And if you choose to put your money there, then you run the risk of losing it. I’m not familiar with the details of how all this would work, but it seems like common sense.
Deposits were definitely “used” for profit in Glass-Steagall. What they were used for was much more limited, however. 3-6-3 was the rule. Borrow at 3%, lend at 6%, hit the golf course by 3PM.
Wouldn’t higher capital requirements do the trick? This would essentially force banks to become better risk managers because they’d be forced to reduce overall risk when they hit their capital thresholds.
They help, but if you’re operating under the assumption that assets you hold are fairly solid, and they aren’t, I’m not sure more stringent capital requirements would help if those assets go bad all at once. This is effectively what happened with the subprime crisis.
Higher capital ratios/lower leverage certainly would have helped keep more banks solvent, but if we’d required better lending standards at the outset (Cullen’s require 20% down rule) you wouldn’t necessarily need higher ratios.
Higher capital ratios can put a serious crimp in bank profitability, and a bank’s willingness to lend to even creditworthy borrowers, as the margins start getting perilously thin.
It is the interest that makes the principal seem real.
We have been doing that for our public debt for years: we roll over the principal and pay the interest.
It gives the principal some much needed backbone.
Don Levit
We pay the interest to help make the principal seem real.
We have been doing it for years for our debt held by the public.
We roll over the principal, but actually pay the interest.
It gives the principal some much-needed backbone.
Don Levit