In daily life, we live by some almost unquestioned principles that laborer works for salaries, business invests for returns, banks lend money for interest, federal reserve controls the target fund rate, economy is destined to go through bust and boom and life goes on. Then there are the black swans every now and then.
My question is, coherently, how these principles are holding together. In particular, I find it paradoxical how money is created into the system and thereby can be “earned” by any party. Many of us, even a lot of people in the financial fields and even economics, take it as the superial natural law but do not really know what’s going on.
Below are some crude thoughts I have as a non-academic, welcome your thoughts and any suggested readings.
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In the fiat money system, banks lend in anticipation borrowers can pay back. Risks are managed through collateral.
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This lending increases M1 and thereby M2 and as more M1/2 are in circulation, public as a whole feel wealthier. Businesses, labor, investors are seeking to earn a portion of the increase M2, which then can be converted to other form of physical assets and securities.
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But M0 is not changed in the process. And banks require payment back of principal plus interest in M0. Where does the extra M0 come from? Individually, banks borrow M0 from one another. But on aggregate, banks lend to public and on aggregate therefore have to earn that extra M0.
I can imagine three possibilities, each with its only destiny of problem:
3a. Banks continue to lend, so more M0 is made available into the system which can be earned by the borrowers to pay thier interest. Destiny of problem: the lending has to go on forever to keep the system working. More debt is created to cover the old debts.
3b. The borrowers earn the M0 held by other people in their business doings to pay back the bank. Destiny of problem: this mean wealth held by non-bankk public is drying up and channed into the hand of banks. The system will brake.
3b. The M0 held at banks are lent to the government either by choice of the depositing public or the banks. Therefore, on paper, wealth is not changed. The problem of wealth being dried up as in option 2 does not exist. Government can use the M0 borrowed to pay for services. Thereby, M0 is made available to the system to for borrowers to earn to pay their debt. Destiny of problem: Government needs to keep on borrowing but this can’t go on forever. On the other hand, it’s a problem as well if the government does not borrow. Also once raised by Greenspan, the OPMC operation cannot continue if gov’t securities pool is drying up.
So there seems to be 3 possible outcomes, there are probably others which I don’t see at this moment. And over the course, FED sets target fund rate and achieve that through REPO mostly and occassionally OUTCRY operation to change the availability of M0 in the system and thereby the interbank rate. This indirectly controls the rate of money creation. Note: REPO by itself is a debt and requires M0 to be paid up to the FED when they come due, creating another demand of M0 from the system.
So with the above interacting factors, we all try to believe the system work which then the faith itself keeps the system going. How this faith is perceived from a BANK perspective is particulary interesting to me, since the Banks are the very one which see that everything is just paper wealth and M0 is always a fuzzy matter.
When things go well, all tides ride, M0, M1, M2, money is created, paper wealth increases. On reverse, things are destructed. Wealth is then redistributed. How well an institution or a person survive is a matter of how risks are managed.
In this complex, we all act within our boundary to paddle on. I am always at awe how far humans have gone as a species yet how little we all know and it will ever be the case…