M'kay, that is understandable and sounds sensible.

But how is this related to the story of the wheel of loans and deposits that Migeru quoted?

Tangentially, I'm afraid.

The problem is that we have at least three main narratives of what banking is.

The Conventional Wisdom:

1. Alice goes up to a bank and gives it one hundred gold coins, and the bank gives her a note saying she owns 100 gold coins in its vaults.

2. Bob goes up and asks the bank to borrow fifty gold coins. The bank looks at Bob's business plan and decides to give him fifty gold coins. In return, Bob gives the bank a note saying that he will pay it back, with interest.

3. Charles goes up to the bank and asks for thirty gold coins. The bank looks at Charles' business plan, decides that it wants nothing to do with it and tells him to sod off.

You can add various complications, such as fractional reserve banking, checking accounts where the gold never leaves the vault once deposited, except during bank runs) and such. But the basic narrative is that Alice deposits money, which the bank then uses to make loans.

Paper money, it is imagined, works the same basic way. Except that instead of digging it out of a mine you print it at a central bank, a notion which is slightly ominous and invokes images of wheelbarrows and invading Poland.

The orthodox liturgy

1. The central bank prints money, and sells it to private banks, in exchange for securities of unimpeachable value (such as gold or government bonds).

2. Private banks use fractional reserve banking to create new money. The ratio between bank money and central bank money is the "money multiplier."

3. Alice, Bob and Charles go up to the bank and ask for loans. The bank looks at how much money it can create from the reserves it has, realises that it can only lend to one of them

4. The bank asks the prospective borrowers what interest rate they are prepared to pay. Alice says 4 %, Bob says 5 % and Charlie says 12 %.

5. The bank looks at Charlie's business plan, and tells him to sod off.

6. The bank looks at Bob's business plan. Since it looks OK, and Bob offered a better return than Alice, the bank lends to Bob.

7. By adjusting the supply of central bank money, the central bank can determine how many of the three the private bank is able to lend to. Allow it to lend to too many, and you get inflation. Allow it to lend to too few, and you get economic paralysis due to lack of investment.

8. If the central bank overshoots the money supply enough to enable the private bank to lend to all three, the bank will have an incentive to lend to Charles even though he has a dodgy business plan, because it has free money lying around.

Again, you can add various embellishments to this (such as the interbank market), but this is the core narrative.

What actually happens

1. Alice, Bob, Charlie and Dennis go up to a bank and ask for loans.

2. The bank looks at the borrowers' business plans. It then tells Charlie to sod off.

3. The bank asks how much margin the remaining three candidates are prepared to put down. Alice says 20 %, Bob says 20 % and Dennis says 15 %. Charlie doesn't say anything, because he isn't there anymore, but if he had been there he would have said 10 %. (Margin is the "money down" that you pay for out of your own pocket. So if you post a € 100.000 house as collateral for a mortgage at 20 % margin [or "20 % down"] then it means that you only want to borrow € 80.000.)

4. The bank wants 20 % down, so it tells Dennis that it must regretfully decline his application.

5. The bank asks what they are willing to pay. Alice says 4 % and Bob says 5 %. Charlie and Dennis aren't there, but if they had been they would have said 12 % and 5 %, respectively.

6. The bank looks up the central bank's policy rate, which turns out to be 2 %. The bank knows that its overhead amounts to 1½ % of its portfolio, and estimates that Alice and Bob both have a 1 % risk of going bust. So it adds that as well, for a total interest rate of 4½ %.

7. Since Alice can pay less than that, the bank must respectfully decline her application. Since Bob can pay more than that (and still have a viable business model), he gets to borrow.

8. Having lent Bob money, the bank now has more liabilities that it needs to provide regulatory liquidity reserves for. It therefore goes to the interbank market to borrow the money at the central bank's policy rate.

9. If the central bank discovers that banks can borrow in the interbank market for less than the policy rate, it sells some bonds. Since bonds are not valid for covering liquidity requirements, this removes liquidity from the interbank market, forcing the interbank market to ration liquidity by price. Conversely, if the central bank finds that banks must pay more than the policy rate to borrow in the interbank market, it buys some sovereign bonds, to depress the interbank rate.

The most important difference to notice is that the marginalist narrative pretends that the central bank prints money first, and then the private banks lend it out. Whereas in the real world, private banks lend out money, subject to the constraint that the loan must be remunerative given the interest rate target defined by the central bank. And only after the fact does the central bank prints money in order to defend its interest rate target.

So the central bank can't cause bubbles by "printing too much money" in an effort to keep interest rates low. What happens instead is that private banks fail to perform due diligence in steps 2 and 4. If the private bank allows Charlie and Dennis to slip past steps 2 and 4, then the central bank can't do anything about that. If the central bank wanted to crowd out Charlie and Dennis - who are bad risks - by raising interest rates, it would have to raise interest rates above 12 %, which would kill Bob's application stone cold dead as well.

Further, you will notice that Alice was actually a good risk (same margin and default risk as Bob), and was able to pay more than the bank needed in and of itself (the bank needs 2½ %, she could pay 4 %). So why did the central bank kill her investment by imposing a further 2 % return requirement? Because the central bank wants to suppress investments that would be profitable on their merits, in order to create enough spare capacity (read: Unemployment) in the economy to prevent inflation.

What Mig was proposing is that instead of steps 8 and 9 above, the central bank should offer to lend the bank money directly to cover its liquidity requirements. Because that way, the central bank can get to take a look at the bank's balance sheet (since the bank has to post collateral).

What I did was take it a step further, and argue that the central bank should demand that private banks put up the whole loan amount, but then offer to lend the bank the money that it needs to post, up to a certain margin requirement. Because then, if the private bank allows Charles and Dennis to slip through bullets 2 and 4, the central bank can say "look, Charlie is a bad risk - we won't lend you any money with his note as collateral," and then the private bank will have to go gamble with its own money (as opposed to being able to gamble with money it borrows, in effect, indirectly from the central bank through the interbank market).

Moreover, the central bank can also say "look, Dennis may be a good risk, but we're only lending you 72 % of the value of his house (and only 90 % of the value of his mortgage), because you need to put up ten percent margin on your loan, and someone - you or Dennis or someone else, we don't care - has to put up twenty percent margin on Dennis' loan." So the bank is allowed to lend to Dennis, but it has to find the proper margin somewhere.

As an aside, the Austrians are conceptually stuck in the Conventional Wisdom "commonsense" view of money. Which is why they seem to be superficially in agreement with people who actually understand money: Both groups criticise the orthodox liturgy, from a perspective that focuses on the interaction of debt with financial stability.

The difference is that the Austrians (a) are actually a step further removed from understanding money than the marginalists. And (b) have taken leave of their sanity.

- Jake

Friends come and go. Enemies accumulate.