Modern Banking is Like a P.O.W. Camp

on Tuesday, October 4, 2011

This is a continuation of a previous post, describing the economics of a WW2 POW camp, in response to a reader's question:

"So what benefit is it to a bank to take deposits? Seems like printing money for loans (and getting back interest) at no cost is a pretty good business to be in! They can offer loans with no risk at all, just print more money, and if someone defaults, they just seize the asset (and even if it's worthless, it is no cost since printing money is free)."

Banks take deposits because the amount of lending they are permitted to do is regulated by the Fed, based on their total customer deposits, but they are not necessary for banks to create paper currency. There are two distinct, separate steps involved -- issuing new paper, and the service of guarding paper that has already been issued.

Imagine the POW camp's store prints new money and trades it for a wool coat, and places it in the store, available in trade for the new money. This is one way to create currency, and does not require deposits of the paper currency with the store. If the store offered to keep paper money in a lock-box at the store, that would be a distinct and separate service unrelated to the process of printing new money.

The operation of modern banks is quite complex. To see how banking works in terms of POW camp paper money, the process would be as follows:

1. John knits a wool coat from yarn.

2. Bob wishes to buy the coat for 50 POW dollars, but does not have enough money.

3. The camp's store brokers the deal; it buys the coat from John with 50 dollars it prints from thin air.

4. Bob buys the coat from the store on credit, owing the store 50 POW dollars, and agreeing to repay the debt over five months, paying 11 POW dollars per month (one dollar per month as an interest fee).

Modern banking is the same, but the wool coat is a house or car and the terms of the loan are longer. Banks broker deals in exactly the same way, making it easier for a home-builder to sell to a person who lacks the capital to make the purchase.

Notice that in this system there is not enough paper money to both pay off all the loans and the added interest payments. To correct this problem, the store would need to purchase supplies and keep them off the shelves, balancing the amount of supplies and paper. This is why the Fed engages itself in "quantitative easing," purchasing assets with new money, and keeping them off the market.

Later, if the value of paper falls in value, the store would be able to place additional items on the shelves to raise the value of paper -- by making it less plentiful relative to the supplies available in the store.