What is a bank

There are a few concepts that need to be covered:

• Wealth
• Money
• Monetary Policy
• Banks

Wealth is the actual value owned by individuals. For a given individual wealth is relative. Perhaps you like shoes, and I like jackets, so I trade my shoes for your jacket. By trading these items, we have each become wealthier; however the wealth of the society has remained the same.

The wealth of the society can be measured as the average value held for each good or service multiplied by the quantity of those trade-ables. From this it is obvious that the only way to increase the wealth of the society at large is to offer a service or make a new good.

Trades become complicated if we're only bartering. Suppose I have shoes and I need a jacket, but the jacket maker doesn't need shoes she needs a sewing needle, but the needle maker doesn't need a jacket he needs a back rub, but the masseuse doesn't need a needle she needs shoes.

One solution is to have a single organization that deals with resolving the "who needs what", and to collect and distribute the items. But when there are billions of people with varying wants, and differing degrees of desire, resolving this effectively is for all practical purposes impossible.

Instead we use money.

When we think about wealth and the problem just described, it becomes obvious what money is. Money is a representation of wealth. The very existence of money works this problem out on its own. The shoemaker gives money to the jacket maker offering the best deal. The Jacket maker uses that money to buy a needle, and so on and so forth...

(One might point out that the jacket maker could have passed along the shoes to each person in the line, hoping they would end up where they need to go. However, this just turns the shoe into money. And each person down the line would need to be able to trust that the next person down the line will take the shoe.)

However in order for money to work, the supply of money (meaning how much money total there is to go around) needs to be roughly the same size as the total wealth. If were trading in gold, we need to hope that people are mining gold as fast as new products are being made, otherwise we'll end up with deflation. Which isn't too bad when the economy stabilizes with the new money supply, but it's the transition that is painful. The opposite case is when miners are cranking out that gold, but little is happening economically. Then we end up with inflation.

Something the astute observer may have noticed, is that this means that making more money doesn't generate wealth. An even more astute observer could notice, that it can generate wealth if done quickly.

Suppose the shoemaker had a money printing machine and was ill. He wants a doctor, but cant make any shoes right now, so he prints some money. The doctor comes over, helps out the shoemaker, and take this money, and orders a suit to be tailored. This new suit has increased the wealth in the general economy, and has made up a fraction of the money added to the money supply.

As long as the tailor and the doctor both believe the money had value, then it can make up most (if not all) of the inflation it has created by actually producing more wealth.

This is why governments will sometimes print money to activate a sluggish economy. But it comes with significant risk. If the shoemaker printed a billion dollars, then no one would trust the money as representing wealth. This may result in the shoemaker getting lynched.

Of course the shoemaker wouldn't need that machine if there was a moneylender. The moneylender could pay for the doctors bill with the promise of repayment. The doctor can then use the money-lenders money to see the tailor. This would be fine. However, the doctor is probably using a bank note as currency. It is supposed to be backed by something somewhere, or at least that's the common myth.

Actually the moneylender, simply wrote the bank note out of thin air. He made money figuring, as long as the shoemaker produces shoes to pay off the debt to the banker the equation balances. Though money was created without a balance in wealth, the difference is temporary.

So the banker can semi-safely create money. So long as each time the money is created there is a promise of repayment (and a reasonably high proportion of those debts are honored), there is no problem. But what happens when everyone wants the money that the banker has created? It is hardly a workable solution to say "Well, John said he would produce enough shoes to pay off this debt, go get your money by forcing John to give you shoes." No that wouldn't work at all.

This is where monetary policy comes in. We use a monetary system called fractional reserve banking. In this system, banks get together as part of a syndicate, and agree to hold in reserve enough cash to meet demands on individual banks. Each one holds a portion of money at local branches and keeps the rest with the central bank. That central bank then moves money around to banks based upon their need. It also creates rules for how much money can be printed. It allows banks to only print an amount of money equal to some multiple of the amount of money they actually have. This ensures that the banks can't inflate the economy too quickly.

This seems almost like a workable system. The typical problems imagined above are largely avoided. There is however a series of other problems.

First of all we now have three factors that need to balance, not just two. We need the supply of money to reasonably represent not only wealth, but also debt. Because now a huge portion of our money is backed by debt instead of things.

Second, the bankers are interested in making money themselves. They do this by charging interest. This means the amount of debt the banks create is always greater than the supply of money. Again this is fine if the banks keep printing money, but only if it is done fast enough.

Money as Debt