Banking: A picture book

on Saturday, July 30, 2011

The worker pans for gold, and the banker's building is empty. The banker holds no gold and no assets other than his building:
The worker wants money, so he gives the raw gold to the banker:

Who takes the raw gold:

Turns it into gold coins:

And returns the coins to the worker:

This is the process of making "commodity money." Now the banker has an empty vault again:

What happens if the worker wants paper money? He gives the gold coins back to the banker:

Who accepts them:

And holds them in his vault:
He prints up some new paper money:
And gives the notes to the worker:
He agrees to exchange the gold for the paper at any time, and the worker uses the money instead of carrying all of those heavy coins around:

What happens if the worker owns a car, free and clear, and wants to turn it into paper money, just like raw gold? The basic process is the same, except that the car is not first converted into small pieces. The worker gives the banker his car and its title:

The banker accepts ownership of the car, just like he previously accepted raw gold. Instead of weighing gold, he judges the car's value, and prints more paper money:

Now the worker has converted his car into paper money that the bank created from "thin air." The money can always be converted to gold at the bank at a fixed rate, but the banker no longer holds enough gold to redeem all the paper money; some of his assets are no longer gold. By accepting a car in exchange for paper money, the banker is engaging in "fractional reserve banking," because only a portion (fraction) of his reserves (his assets) are gold. To redeem all of the paper money, he would have to sell the car for gold. 

What happens if the worker wants to continue driving the car?

The banker loans the car to the worker. The bank now owns the car, and charges interest on the loan:

The banker also requires that the worker pay down the loan to zero over the next few years, using the paper money:

After a few years of payments, the worker has paid off the loan, and all of the notes he received in exchange for the car have been returned to the bank (plus interest):

The banker destroys the notes as they are repaid:

And returns the title to the worker:

And everything is back where it started:

Today, the process is the same, except that the paper money can no longer be exchanged for gold. It can only be exchanged for the car, by paying off the loan, but the basic process is the same as before. Today bankers convert cars and homes into paper money, instead of converting gold or silver to paper currency.

Previously, the banker agreed to redeem any note in gold or silver. Today, he'll only redeem the notes according to the bank-loan contract. Previously, anyone could redeem the notes, but today, only people with loan contracts can redeem them. If the Fed goes completely crazy tomorrow, and rampant inflation makes the notes worthless, anyone who has a car loan or a home loan can still use the worthless notes to take ownership of their home or car.

Anyone holding more outstanding bank-loan debt than they hold in cash is somewhat protected from inflation. If you have a $1 million home-loan and dollars are suddenly worthless tomorrow, you can exchange a wheelbarrow filled with worthless dollars for a $1 million home. Inflation works in your favor if you hold loan agreements denominated in dollars.

NOTE: A bank doesn't loan out notes it holds in checking accounts. Each bank loan generates new money from thin air. The bank may invest the gold or car (its assets) in very safe investments, but new loans always create new money. New dollars are exchanged for real assets. Checking accounts are not bank equity; they are not owned by the bank. The bank is providing a holding service, like a bank that accepts gold coins and agrees to guard them for a fee.

NOTE 2: Astute readers (or those who have seen the Zeitgeist movie too many times) may wonder how, absent the gold standard, workers can pay back more dollars than they originally accept. How can there be enough dollars in the world to pay the interest on the loan? The answer is that the banker prints up some "fake" notes and spends them. His goal is to print up just enough notes so that the the man can repay his loan. Today this process is known as "Quantitative Easing." The Fed literally prints money from thin air and spends it, usually purchasing government bonds with the "fake" new money. Banks are  compensated for their work in this way. The interest on bank loans is an investment activity not unique to banking -- anyone can loan their assets at interest. Bankers are specifically compensated for the service of turning assets into paper money when they print and spend "fake" dollars -- dollars that are not exchanged for real assets, but are simply printed and spent.

NOTE 3: Printing "fake" dollars does not create inflation, per se, because the new money that bankers create through the loan process is worth more than the original asset. Ask yourself, would you rather be paid $10,000 in cash, or paid with a car that recently sold for $10,000? The reason you would choose the currency is because of its liquidity. It is easy to spend the money, and easy to buy bread and milk with it, and everyone will accept it. A car is much harder to exchange, even though it is "worth" the same amount. The money's liquidity makes it worth more than the car, and the banker's fake notes offset this by increasing the supply of currency.