No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Eleven: Money, Money, Money! 262 rate, they can loan out far more money than they have in their vault, creating money “out of thin air” as you may hear critics claim. How does this work? Well, first imagine that you need a small loan—say $20. If you go to your parents, your Mom or Dad may open their purse or wallet and see how much money they have. If they have enough and agree with what you want to spend the money on, they’ll fork it over. When you earn some money later, you’ll be expected to pay it back if they loaned you, rather than just giving you the $20. You may have an idea that a bank loan works the same way. Unfortunately, it decidedly does NOT work this way. Let’s say you go into the bank and request a loan of $30,000 to buy a 2020 Camaro SS. The loan officer will consider the purchase (what asset will be backing the loan?), and your income level (can you pay the loan back?). If the car is a good enough investment and you put enough down so that you are not likely to walk away from the loan, they will loan you the money. The decision to loan you the money may be because you put an additional $10,000 to the loan amount because the model you want is loaded with options, and you have a good job such that you can easily make the payments. What is different from how your parents loaned you $20? What step is missing? If you were careful, you saw that Mom or Dad had to look in their purse or wallet prior to giving you the money. They didn’t just assume they had it, and more importantly, they knew they couldn’t create it. The bank, however, never has to do that step. Most of us assume that when we ask for a loan, the bank has some money in their vaults waiting to be loaned. We also implicitly assume that this money is from someone else’s prior savings. But this is usually not the case. The bank doesn’t have to have money to loan; they have the power to create money “out of thin air,” so to speak. The banker doesn’t see this as how it happens, of course, but it happens nonetheless. What does the banker see? We first need to have a little bit of accounting terminology to explain. As we mentioned previously, one of the major innovations that led to economic growth was the advent of double entry accounting, where every financial transaction occurs as both a credit and debit (or assets and liabilities) to a firm. Having accounting transactions on both sides of the ledger, so to speak, reduces possibility of error since you sum both sides, and the difference between assets (what you own) and liabilities (what you owe) equals the owner’s equity. Don’t worry too much about this now; the point is that the banker keeps track of assets and liabilities in the form of a T account, and every transaction has both an asset aspect and a liability aspect. For those familiar with accounting, you can think of a T-account as a simplified version of an overall balance sheet, which would list every asset and liability that a bank had. In our T-accounts, we will simply look at a change to an account that we assume starts from a state of balance. Let’s say I want to borrow $1,000 from the bank. The bank’s T account will look like Figure 11.4 . When they approve my loan, they credit my checking account with $1,000, The bank doesn’t have to have money to loan; they have the power to create money “out of thin air,” so to speak.