[WalterBright]

Some good questions. The answer isn't simple, but I'll try.

It comes down to how banks work with fractional reserve banking. (To keep this post short, I'll refer you to google if you don't know what it is.) Banks loan out a multiple of their deposits. In other words, banks create money when they make loans. Amazing, isn't it? But, banks don't loan money unless there is collateral. The next part is tricky to understand. If I, Picasso, create a painting I create value. I can use the painting as collateral for a bank loan, i.e. because I created value, I also indirectly created money!

With me so far? Next, what happens when I repay the loan? The money disappears!

If you think about it, you'll see that the money supply, through the blind forces of Supply & Demand, tracks the value in the economy, almost like magic. While the gold it represents can sit buried in a vault somewhere and needn't actually be traded.

Inflation happens when the government prints money that has no collateral, and has no correspondence to added value in the economy and so it dilutes the value of the money that is already in circulation.

[lagrange77]

> Banks loan out a multiple of their deposits. In other words, banks create money when they make loans. Amazing, isn't it?

I've heard about that, and it's really amazing.

If i understand it correctly, the loan interest i have to pay is money that also does not exist yet, at the point of time, when i get the cash. The bank faces the risk of me not being able to generate (get from others, who potentially also take loans) that extra money, so they demand a collateral as an insurance against that risk.

> Inflation happens when the government prints money that has no collateral, and has no correspondence to added value in the economy and so it dilutes the value of the money that is already in circulation.

What instance decides, if some printed money does or does not have collateral?

[jollybean]

This is kind of a misunderstanding.

Banks retain assets for loans they make. They don't print money.

But imagine this scenario: you deposit $10 at bank A, they loan that $10 to person B, that person B puts their $10 account at Bank C, thank bank loans out that $10 to person D etc..

You can see all of a sudden, $10 turns into $100! or $1000 in assets!

So what we require banks to do is keep a part of the assets they receive. So if they get $100 in deposits, they can only lend out $90 i.e. they have to keep '10% in reserve'.

This means that banks are leveraged at 90%.

It also means that if there is a calamity, and a 'run on the bank' or it loses 10% of it's assets, the bank is wiped out.

So what all of this means is that there is 'leverage' in the system, and it means there is 10x money going into the economy than is released by the Fed. It definitely adds a lot of flexibility to the system. Banks are still responsible for evaluating risk of their loans and paying the price if they fail.

"The interest on the loan" is mostly a function of risk and the cost of that bank managing that money i.e. getting the depositors to loan you the money in the first place.

The OP's definition of 'inflation' is a bit warped.

Inflation is when there's more money than demand for stuff.

If stuff is harder to make or is more rare, prices will go up irrespective of money supply.

If you throw money in the economy for no reason inflation will happen.

But most economies are expanding a bit, and so they need more money in the supply to keep prices stable, which is why we like to have just a bit of money printing.

All money loaned out - even given out by the central banks has collateral. The Fed keeps mostly TBills (Government Debt) and real estate as collateral.

[WalterBright]

> They don't print money.

Oh, absolutely they do. That's why currency is called "banknotes". The banks printed them. Each bank printed their own banknotes. You can find their images in numismatics books.

In 1914, the government took over the function of printing banknotes. But the banks still print money. We just call them "cashier's checks", "money orders" and "travelers' checks". But more normally, they simply credit your account with created money.

> If stuff is harder to make or is more rare, prices will go up irrespective of money supply.

That isn't inflation, because extra dollars are not being created. For example, tomatoes going up in price in the store because of crop failure isn't inflation, because more money doesn't appear in your pocket to pay the premium. What happens is you wind up with fewer dollars in your pocket, meaning you buy less of other things, and with the annoying Law of Supply and Demand, the prices of those other things drop.

[jollybean]

Listen, you are really confusing yourself and others here.

That banks used to print notes in the past is not relevant in this discussion, when we talk about 'printing money' what we are referring to is how money comes into circulation. Physical bank notes are barely relevant to the equation as it makes up a tiny portion of the money supply, and of course, they are only printed by the Central Bank.

Money comes into circulation when the Central Bank 'buys' TBills off the free market. That's when the Central Bank 'creates' money.

Then, through fractional lending, a considerably larger amount of money ends up getting into the system by way of accounting.

Finally, the 'credit market' - which is really 10x bigger than even money in circulation, and which is the real thing that matters in business, develops like a bubble on top of that.

"That isn't inflation, because extra dollars are not being created."

Yes - it is 100% inflation and you are absolutely spreading false information at that point.

The 'result' could be as simple as 'less of that product is bought' - meaning, we use 'less gas' when gas prices rise - while every other aspect of the economy remains mostly the same. That is 100% inflation.

Aside from 'buying less of the product with price increase' or 'buying less of other stuff' we can also borrow, use savings, buy on credit etc. to adjust for the price inflation - so it's not going to necessarily work out to be some kind of net price levelling in the economy.

Increasing prices = inflation [1]. That's it. It's not necessarily related to money supply.

And finally - as the economy expands, more money needs to be introduced into the system just to keep prices even. This is an example of where there is more money supply and it does not change prices.

[1] https://en.wikipedia.org/wiki/Inflation

[WalterBright]

> What instance decides, if some printed money does or does not have collateral?

A great question. No actual decision is made, it's just that there are more dollars floating chasing the same value, so the price in dollars gets bid up.

[jollybean]

This is misleading.

There is a 'decision' made and there is always collateral - at the bank, and even at the Fed.

The 'decision' that might be made, is what kind of assets to accept on the Feds balance sheet.

At a private bank, they can do whatever they want with respect to what kind of assets they accept as collateral, within regulatory requirements. They have capital ratios to uphold, but if they take stupid risks, well they are going to go out of business.

The OP is implying that money is printed out of thin air and that is not what is happening.

Your retort that 'money money, in a system of all other things being equal, will raise prices' - but the implication of 'all other things being equal' is never a reality. Economies are usually growing, in which case, they need more money to keep prices from going down actually, and, there can be external shocks, which we see every decade or so.

[landemva]

This is misleading.

The Federal Reserve assumprion of bank's underperforming loans was done in 2008 with funds created out of thin air. The value of the underperforming loans was significantly less than face value, which is why banks could not sell them on the market. The Fed gave full value with magic money it created.

[jollybean]

I think you are misunderstanding fractional lending and collateral.

Fractional lending seems a bit odd, but it's not like there is 'no collateral' - rather, there ends up being 'partial collateral'.

As it turns out, that 'partial collateral' is enough - it's actually reasonable thing to do, because the vast majority of loans are repaid, it's not necessary to fully collateralize everything on the whole.

Banks have to have some capital requirements, which means, if they 'screw up' too badly, then they go bankrupt! So they are acting in a capitalist manner and have to be careful about how they lend, and at what rates. If random bank acts irresponsibly, then random bank will go kaput by regular market forces.

Instead of thinking of fractional lending as 'missing money' think of it more like leverage.

Basically - the effect of fractional lending is that it's a 'multiplier' to whatever the Central Bank decides to do.

So it exacerbates effects in one direction or the other but on the whole, it doesn't change the real nature of the system.

The way we manage money is sound.

We need money to expand and contract, and we have good ways to measure that.

The 'danger' of fiat of course is political intervention, or a failure of controls.

We had a broad intervention in 2008 that favoured home owners over others, and there are attempts to use the Central Bank to do 'Social Justice' type things, which I think is very risky.

It's a bit like Nuclear Energy: it's very potent, you just have to watch it responsibly.

Finally - currency should be a 'current' asset, not a store of value. We just want it as a medium of exchange. So as long as it's not shifting too much one way or another, then it should work.

For 'stores of value' there are other things, like real estate etc..

"Inflation happens when the government prints money that has no collateral, and has no correspondence to added value in the economy and so it dilutes the value of the money that is already in circulation. "

This is misleading.

The 'government' does not print money, the Central Bank does. And as you indicate, the bank ultimately creates credit via fractional lending.

'Inflation' happens when the cost of goods rise faster than the money in circulation.

Thus 'inflation' can happen because 'stuff is more costly to make'. Like gas in Europe, is more expensive, not because 'money printing' but 'Russia'.

Also, inflation can feasibly happen without money printing or even a rise in inherent cost of goods, if the economy shifts in a way that ends up in excess cash.

But ultimately, if during normal course of 'growth' if there is no expansion in the monetary base, then you'll have deflation, which has bad externalizes.

So the goal then is to adjust interest rates / print or extract money from the economy so that prices stay roughly flat, with just a tiny bit of inflation. That is a dynamic process, not a static process.

[WalterBright]

Rather bluntly, a central bank is central economic planning. Central economic planning always falls short of what free markets do. The idea that a central bank is able to control the financial markets better than free market forces is shown to be false (with actual data) by Friedman in "Monetary History of the United States".

> The 'government' does not print money, the Central Bank does.

I said "print money" as a euphemism for what the Fed actually does, which is the same thing, it just doesn't involve doing the old fashioned way. They do it by issuing debt with no collateral.

[stopping]

So why is it that essentially every developed country in the world today has a central bank? How can they all be wrong? If a 100% "free market" solution was more effective than central banking, I would expect at least one of them to have given it a shot and succeeded in doing so.

Also, "A Monetary History of the United States" argues that the Federal Reserve should have done more to combat the Great Depression, not less. How can you think that the book advocates against central economic policy?

[andrekandre]

  > The idea that a central bank is able to control the financial markets better than free market forces is shown to be false

thats probably true in many cases, but that got me thinking: was the great depression a failure of central banking or financial markets?

[jollybean]

Rather bluntly, this is just not true.

I think there is an erroneous understanding/implication in your statement, which is likely leading you to erroneous conclusion.

The Fed is not 'Central Planning' so much as it is actually trying to make the market more 'neutral' in normal cases.

We'll get to the 'crisis' cases in a bit.

If we just had a hard currency, like Gold (which 'feels' neutral) we'd get into trouble, because of deflationary issues. People would treat it like Bitcoin, and as prices fell slightly would be oriented a bit towards 'store of value' as opposed to currency.

The Fed 'targets' just a 'bit above zero' inflation by policy. That is basically 'neutral'.

That is not really 'central planning', it's more like 'central neutralization'.

As for 'crisis' situations, i.e. when the Fed does start to 'intervene' and does things which you might argue are 'central planning' - well - the government in many cases can absolutely do it 'better than free markets' because only the government has the scale to do it.

For example, 'free markets' could have not have created and executed the Highway road system of the 1950s. It was of a scale and scope far, far beyond any economic actor. That required 'strategic vision' on behalf of the government. Now - private contractors actually did the 'building' - which is how we want it because the government doesn't need to hire individual workers. But it's a government project by virtue of scale and other things.

The meltdown of 2008 was a very scary time - if the government did not intervene, the banks would have collapsed, and it would have taken down the entire economy.

It would be like a human having a 'heart attack' - the heart stops - everything stops.

So the government put together a plan and intervened. A lot of it had to do with 'confidence signals' and other things, extra regulation, but it worked.

There is of course the 'Too Big To Fail' argument i.e. moral hazard i.e. banks take on more risk knowing the 'gov will save' us - that said, the worst actors did definitely lose a ton of money. Also - the problem was not just the banks, it was a systemic failure in a number of sectors.

Basically - the US had an economic cancer and no individual organization was going to be able to contend with it.

So -> intervention. Much like a war, or pandemic.

Having a fiat currency allows that opportunity. If it were a 'Gold Based Economy' it would have fallen down like a house of cards.

Like a brick building during a rare earhtquake: brick 'feels' strong like Gold, but an earthquake will ravage it, which is why you need steel reinforcement - the steel can bend and absorb different kind of tensions.

Milton Friedman is wrong.

Yes, when there is hyperinflation, it's probably because some stupid government is printing too much money, but inflation is not just a function of money printing.