The Availability of Money and the Causes of Crash
How is money made?
Did you say by working? You're wrong. Maybe by selling goods or services? Wrong again. You don't make money when you work. You don't make money when you sell things. In fact, YOU don't make money. At all. Ever.
Working, or selling stuff, allows money to be TRANSFERRED from one place to another. When you go to your job and work, you do not create any money. The money already exists. It exists in your employers account. And in exchange for your work, it is transferred into yours.
Working does not create money. Working only transfers money.
Selling does not create money. Selling only transfers money.
I apologize if I'm being didactic, but this point cannot be stressed enough. It is absolutely key to understanding the nature of the problem facing the economy right now. Our day to day activities do not create money. They only transfer it around.
So, where does the money come from? Well, where do you keep YOUR money? Obviously, the bank.
Unlike us plebes, banks DO create money. And I don't mean print it. Forget all that green stuff in your wallet. Tangible currency represents only a tiny, tiny fraction of the actual money supply. The vast majority of 'real money' doesn't really exist at all. It's just numbers in a computer somewhere.
Banks create money. In theory, they can only create a certain amount of it. And that amount is supposed to be governed by the Federal Reserve. But the Federal Reserve can only do so much. In fact, they only have three major buttons they can push.
The first is the funds rate. This is how much banks charge each other for overnight loans. Next is the discount rate. This is how much a bank pays to borrow money from the Fed. And finally, the reserve requirements. This is supposed to determine how much money a bank can invent. With these three buttons, the Fed is supposed to guide our economy down the wide path of prosperity. But what happens, when the road starts to curve?
So, we're driving along and all of a sudden, the tech bubble bursts. We swerve to avoid a wreck, only to get hit by a bunch of terrorists flying airplanes into buildings. We swerve again. The Fed is worried about a crash. So, to avoid it, they do the only thing they can do. They start pushing their buttons. They start pushing buttons 1 and 2, lowering the rates and effectively telling the banks to get out there and Loan. More. Money.
What they don't realize is that button #3 is broken. The reserve rate that is supposed to limit how much banks can lend no longer functions. Thanks to new funding sources, most of the loans created by banks have nothing to do with their reserves. They can invent money at will. So the banks are unleashed with no way to control them, while the Fed helplessly watches and mashes buttons.
With nothing to stop them, the banks go nuts. Money is cheap and widely available. The banks are practially giving it away for free. And the people can't get enough. The table is set, the guests are seated. The housing boom begins.
Jump a few years into the future.
Housing is a runaway train, and the someone needs to put the breaks on it. They now realize button 3 is jacked, so they go back to pushing buttons 1 and 2 over and over again, raising the rates. Stop lending! They are practically screaming now. But the banks listen! They stop inventing money... and the magic money machine STOPS.
But do all those loans that the banks made disappear, too? Nope. Those are still on the books. And people still need to pay for them. But look at what just happened... they turned off the machine. There's no more money available.
The money supply dried up!
So, let's ask another simple question. What happens when the demand for something (money) remains the same, but the supply shrinks? Welcome to Surviving the Crash.
Did you say by working? You're wrong. Maybe by selling goods or services? Wrong again. You don't make money when you work. You don't make money when you sell things. In fact, YOU don't make money. At all. Ever.
Working, or selling stuff, allows money to be TRANSFERRED from one place to another. When you go to your job and work, you do not create any money. The money already exists. It exists in your employers account. And in exchange for your work, it is transferred into yours.
Working does not create money. Working only transfers money.
Selling does not create money. Selling only transfers money.
I apologize if I'm being didactic, but this point cannot be stressed enough. It is absolutely key to understanding the nature of the problem facing the economy right now. Our day to day activities do not create money. They only transfer it around.
So, where does the money come from? Well, where do you keep YOUR money? Obviously, the bank.
Unlike us plebes, banks DO create money. And I don't mean print it. Forget all that green stuff in your wallet. Tangible currency represents only a tiny, tiny fraction of the actual money supply. The vast majority of 'real money' doesn't really exist at all. It's just numbers in a computer somewhere.
Banks create money. In theory, they can only create a certain amount of it. And that amount is supposed to be governed by the Federal Reserve. But the Federal Reserve can only do so much. In fact, they only have three major buttons they can push.
The first is the funds rate. This is how much banks charge each other for overnight loans. Next is the discount rate. This is how much a bank pays to borrow money from the Fed. And finally, the reserve requirements. This is supposed to determine how much money a bank can invent. With these three buttons, the Fed is supposed to guide our economy down the wide path of prosperity. But what happens, when the road starts to curve?
So, we're driving along and all of a sudden, the tech bubble bursts. We swerve to avoid a wreck, only to get hit by a bunch of terrorists flying airplanes into buildings. We swerve again. The Fed is worried about a crash. So, to avoid it, they do the only thing they can do. They start pushing their buttons. They start pushing buttons 1 and 2, lowering the rates and effectively telling the banks to get out there and Loan. More. Money.
What they don't realize is that button #3 is broken. The reserve rate that is supposed to limit how much banks can lend no longer functions. Thanks to new funding sources, most of the loans created by banks have nothing to do with their reserves. They can invent money at will. So the banks are unleashed with no way to control them, while the Fed helplessly watches and mashes buttons.
With nothing to stop them, the banks go nuts. Money is cheap and widely available. The banks are practially giving it away for free. And the people can't get enough. The table is set, the guests are seated. The housing boom begins.
Jump a few years into the future.
Housing is a runaway train, and the someone needs to put the breaks on it. They now realize button 3 is jacked, so they go back to pushing buttons 1 and 2 over and over again, raising the rates. Stop lending! They are practically screaming now. But the banks listen! They stop inventing money... and the magic money machine STOPS.
But do all those loans that the banks made disappear, too? Nope. Those are still on the books. And people still need to pay for them. But look at what just happened... they turned off the machine. There's no more money available.
The money supply dried up!
So, let's ask another simple question. What happens when the demand for something (money) remains the same, but the supply shrinks? Welcome to Surviving the Crash.
posted by SalsaFix at 12:56 AM
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