Monday, November 14, 2011

It's Academics v. the Politicians . . . v. Economic Reality, Part III: Finance 101

A great many people (some of them even experts) believe that banks create money "out of nothing." In our previous posting in this series, we discovered that is not the case. Banks of issue (banks of deposit don't create money at all) create money the same way anybody creates money: by accepting something as money. If you (or a bank) accept something as money, then it's money. If you (or, again, a bank) don't accept something as money, then it's not money.

Yes, it really is that simple.

Now let's complicate things. When people create money between them (it takes two to make money, just as it takes two to tango), they exchange promises. The promises that a bank of issue takes in exchange for its promissory notes are called "bills of exchange." Now comes the confusing part. Bills of exchange are divided into mortgages, bills of credit, and . . . bills of exchange.

Whoa, you say. "You mean a "bill of exchange" can be a mortgage, a bill of credit and a bill of exchange?" That's right. It's confusing, but we didn't invent this terminology. "Bill of exchange" is both the generic term and the term for something specific. It's sort of like (but not much) when people refer to all cola drinks as "cokes," which really upsets the Coca Cola Company, which has trademarked "Coke," along with "Coca Cola" and the shape of the bottle, and works valiantly to prevent its brand name from becoming generic, as happened with the Zipper slide fastener. (Now you know why those restaurant workers chant their mantra, "Wedon'thavecokewillpepsibeokay?").

A bank of issue takes the bill of exchange (whether it's a mortgage, bill of credit, or bill of exchange), presumably looks it over to see if it's "good" (i.e., does the asset behind the mortgage exist and is it in the condition described, is the "drawer" creditworthy and of good character, is there sufficient collateral, blah, blah, so on, so forth), and if everything is hunky-dory (obsolete slang for "okay"), the banker takes the bill, and the borrower signs a promissory note issued by the bank.

Here's where it gets a little more complicated. The guy who issued or "drew" the bill of exchange could have used it as money directly . . . assuming that someone would accept it. This actually happens a lot. Somebody draws up a contract, and offers it to somebody else. If the "somebody else" accepts it, then it's money. If it is not accepted, then it's not money. See? Anybody can create money.

. . . anybody, that is, except those who are not creditworthy, have bad character, no collateral, and whom nobody knows. That's where a bank steps in. Everybody knows a bank. A bank's business is to be creditworthy, have good character, and obtain good collateral for all its loans.

Now you know more about how a bank creates money than most politicians and economists. Tomorrow we'll try to get around to explaining some of the more esoteric terms by means of which the experts baffle real people.


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