Creating money

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Millennie Al
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Creating money

Post by Millennie Al » Sat Nov 26, 2022 4:34 am

Someone wanted a new thread for this sort of thing, so here it is.
That page explains fractional reserve banking in a misleading way.

It's a bit like the famous missing dollar riddle. Taking their example, Alice goes into a bank and deposits $1000 in cash. The result of this is that she no longer has the $1000, and if she is confused on this point a thorough search will prove that she definitely does not have the cash any more. What she does have is a bank balance showing a credit of $1000. This is not $1000. It is a debt owed by the bank to Alice. It is easy to confuse an obligation to pay $1000 with $1000, but they are not the same thing. If you are in any doubt, imagine going into a takeaway pizza place, ordering a pizza, and paying ten pounds. You obviously do not have the ten pounds, but you don';t have the pizza either as it does not yet exist. Instead the pizza place has an obligation to provide you with the pizza. After a short delay, they will (hopefully!) produce the pizza, discharging their obligation. At no time are you likely to be in any doubt whether you have the pizza or the benefit of the obligation. (Uless you are very drunk, I suppose).

When Alice deposits the $1000, she has $0, the bank has $1000 and an obligation to pay $1000. If the bank now lends $900 to Bob, the bank has $100, Bob has $900 and an obligation to pay the bank $900, the bank has an obligation top pay Alice $1000, and Alice has $0. $100 + $900 is still $1000. If Bob deposits the $900, he is left with $0, the bank gets $900 and an obligation to pay Bob $900. So the bank now has $100 + $900 = $1000. If the bank now lends Chloe $810, the bank has $100 + $90 and Chloe has $810. $100 + $90 + $810 = $1000. And so on. At all times the money adds up to $1000. No money is created. What is created is a sequence of obligations for the bank to pay $1000, $900, etc.

It's easy enough to see why people think that an obligation to pay money is the same thing as money because money used to be an obligation to pay. On the gold standard, a pound was an obligation to pay a specific amount of gold. This is why Sterling notes have written on them "I promise to pay the bearer on demand the sum of...".

If you consider an obligation to pay is the same as money, then it's not the fractional reserve bit that creates money, but the banking bit. When Alice deposits $1000, if you consider the bank's obligation to pay her $1000 to be actual money, then Alice has $1000 and the bank has $1000, so the act of making the deposit has created $1000. What the bank does after that is irrelevant (except insofar as it could create evenmore money). In fact, it's not specific to banking. Suppose Alice lends $1000 to Bob in return for Bob writing an IOU for $1000. Since this is an obligation to pay, it's as much money as $1000 in a bank, so Alice has $1000 and Bob has $1000. If Bob lends the $1000 to Chloe, in return for an IOU, Alice has $1000, Bob has $1000, and Chloe has $1000. Chloe can now lend the $1000 to Alice in return for an IOU, leaving Alice with $2000, Bob with $1000, and Chloe with $1000. They have all gained $1000 as a side effect of the debt circle. No banking involved of any kind.

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Re: Creating money

Post by Bewildered » Sat Nov 26, 2022 7:18 am

I don’t really see where that article makes such a fallacy, but I guess you are trying to say calling credit in a bank account money can induce such fallacies?

But as far as I understand economists include it in their definition of money supply https://en.wikipedia.org/wiki/Money_supply so it doesn’t seem unreasonable to write it that way.

I thought I understood fractional reserve banking but now I have a stupid question about one thing I am confused about right now that is related to that article and other things I just googled. They describe it as if they can only lend out up to some fraction of the physical money that was already deposited with them. So if there is a new bank and their first customer deposits $1000 cash with them, and for example the fractional rate is 10%, the biggest loan they can give their second customer is $900. Is that correct? Clearly if the customer needs physical cash that’s all they can do: give $900 in cash to customer 2 and keep a credit of $1000 in the account of customer 1. Lets call this scenario 1.

But let’s say customer 2 doesn’t need physical cash immediately. Scenario 2 is the bank has $1000 physical cash in reserve and it credits customer 2’s account with $9000. Is this allowed or is there a limit on the absolute amount of money it can lend out*? If customer 2 decides they do want some of it in cash just a short while later they have a problem, just like they would have if customer 1 decided he wanted his $1000 back after they leant $900 out in scenario 1. But it might work out if customer 2 just wants the money so he can pay customer 1 and does it via bank transfer. So the bank credits customer 2’s account as $9000, giving them $1000 in reserve and $10000 of credit in their customer accounts. So then when customer 2 pays customer 1 this ratio stays the same but now all the money is in customer 1’s account. It’s the same a scenario 1 except scaled up. The bank is owed $9000 by customer 2 and had a credit of $10000 for customer 1. But the big difference is the extent to which the money supply has grown.

*This is a massively oversimplified example and banking regulations are of course complicated so the question may be unclear. I would guess that both cases are unrealistic because they should not credit a single individual with more money than they have in reserve without restrictions on when / how much they can withdraw. It’s by having many customers such problems are avoided and they should be ok barring a run on the bank. So I assume there is some regulation in most countries to that effect. Feel free to confirm or correct that one also but to clarify though, what I am really asking is if there is also a limit on the absolute amount of money they can lend compared to deposits made, beyond the simple fractional rule. So the bank can only lend out 90% of what has been deposited as the description in that article seems to imply or can the lend out 900% of the money deposited by just crediting the lender and keeping all physical cash deposited with them on reserve ? Or maybe it’s somewhere in between or varies?

I hope the questions clear?

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Re: Creating money

Post by plodder » Sat Nov 26, 2022 12:02 pm

My understanding is that the multiplier changes. IIRC before the financial crash in 2007 uk banks could “lend” 10x the value of their holdings. This was reduced to a smaller multiplier, but there’s constant lobbying to increase it again. I am probably entirely wrong about this. But the concepts outlined in the posts above need some real stretching to explain the realities of money creation that actually happens.

The artificially cheap credit this creates is in my opinion a major reason why eg housing prices have gone up far more than demand would suggest. There are obviously benefits to having cash on tap but the risks are clear. Also there’s a fun question to ask why only banks are allowed to do this magic trick (and take a cut, naturally).

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Re: Creating money

Post by plodder » Sat Nov 26, 2022 12:03 pm

Lpm owes me £20. That means I can lend BOAF £200 and charge him interest. Yum.

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Re: Creating money

Post by plodder » Sat Nov 26, 2022 12:39 pm

Shut up plodder. Of course that kind of thing can’t be done by the likes of you. If BOAF needs £200 he’ll have to apply via our website, not yours.

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Re: Creating money

Post by Martin_B » Sat Nov 26, 2022 1:00 pm

plodder wrote:
Sat Nov 26, 2022 12:02 pm
My understanding is that the multiplier changes. IIRC before the financial crash in 2007 uk banks could “lend” 10x the value of their holdings. This was reduced to a smaller multiplier, but there’s constant lobbying to increase it again. I am probably entirely wrong about this. But the concepts outlined in the posts above need some real stretching to explain the realities of money creation that actually happens.

The artificially cheap credit this creates is in my opinion a major reason why eg housing prices have gone up far more than demand would suggest. There are obviously benefits to having cash on tap but the risks are clear. Also there’s a fun question to ask why only banks are allowed to do this magic trick (and take a cut, naturally).
Previously banks could lend 3x the value of their holdings. This was the standard for all banks who were backed by the Bank of England (my dad worked in that section) and in the 90s there was pressure to relax the rules to allow up to 5x the value of their holdings. When my dad queried the change, he was told that "Banks know about risk, that's what they do".
Those countries which still maintained a low ratio of lending weren't hit as hard by the GFC as others.
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Re: Creating money

Post by plodder » Sat Nov 26, 2022 1:22 pm

Martin_B wrote:
Sat Nov 26, 2022 1:00 pm
plodder wrote:
Sat Nov 26, 2022 12:02 pm
My understanding is that the multiplier changes. IIRC before the financial crash in 2007 uk banks could “lend” 10x the value of their holdings. This was reduced to a smaller multiplier, but there’s constant lobbying to increase it again. I am probably entirely wrong about this. But the concepts outlined in the posts above need some real stretching to explain the realities of money creation that actually happens.

The artificially cheap credit this creates is in my opinion a major reason why eg housing prices have gone up far more than demand would suggest. There are obviously benefits to having cash on tap but the risks are clear. Also there’s a fun question to ask why only banks are allowed to do this magic trick (and take a cut, naturally).
Previously banks could lend 3x the value of their holdings. This was the standard for all banks who were backed by the Bank of England (my dad worked in that section) and in the 90s there was pressure to relax the rules to allow up to 5x the value of their holdings. When my dad queried the change, he was told that "Banks know about risk, that's what they do".
Those countries which still maintained a low ratio of lending weren't hit as hard by the GFC as others.
I am likely in a muddle here but I think the multiplier is way higher and I think it’s referred to here (varies by country)

https://en.m.wikipedia.org/wiki/Reserve_requirement

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Re: Creating money

Post by dyqik » Sat Nov 26, 2022 1:38 pm

plodder wrote:
Sat Nov 26, 2022 12:03 pm
Lpm owes me £20. That means I can lend BOAF £200 and charge him interest. Yum.
Nope. That's not how it works.

If LPM gives you £20 to keep for them, then you can offer BOAF a loan of £200 at some interest rate, and then take out a loan for £200 at a lower interest rate. LPMs £20 you are holding covers the risk of BOAF not being able to pay back the full £200.

You then average that across thousands of deposits and loans, so that the probabilities work on a way that make the interest rates attractive. The key is that because of your scale of operations, the risk of you defaulting on your loans is much smaller than the risk of any one of your creditors defaulting. The marginal difference in interest rates provides additional money to pay your loans even if some of your creditors miss payments.

LPM's £20 can be an obligation for LPM to pay you £20, as in your original setup, if the risk of you not collecting LPMs debt is very low. E.g. because they have a million pound turnover each year and several million pounds of assets.

This is the same reason that insurance works and provides value.
Last edited by dyqik on Sat Nov 26, 2022 1:45 pm, edited 2 times in total.

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Re: Creating money

Post by Woodchopper » Sat Nov 26, 2022 1:42 pm

plodder wrote:
Sat Nov 26, 2022 12:39 pm
Shut up plodder. Of course that kind of thing can’t be done by the likes of you. If BOAF needs £200 he’ll have to apply via our website, not yours.
You could do something very similar yourself.

Agree to sell someone a car for £1000. Instead of accepting payment in cash, accept an IOU with, say, an agreement to pay £1000 within a year. Functionally, creating the IOU is equivalent to creating money. You have loaned them £1000 and you could exchange the IOU for any other product or service provided by someone else. It all works so long that everyone involved has confidence that the IOU will be honoured.

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Re: Creating money

Post by bjn » Sat Nov 26, 2022 1:57 pm

Woodchopper wrote:
Sat Nov 26, 2022 1:42 pm
plodder wrote:
Sat Nov 26, 2022 12:39 pm
Shut up plodder. Of course that kind of thing can’t be done by the likes of you. If BOAF needs £200 he’ll have to apply via our website, not yours.
You could do something very similar yourself.

Agree to sell someone a car for £1000. Instead of accepting payment in cash, accept an IOU with, say, an agreement to pay £1000 within a year. Functionally, creating the IOU is equivalent to creating money. You have loaned them £1000 and you could exchange the IOU for any other product or service provided by someone else. It all works so long that everyone involved has confidence that the IOU will be honoured.
Which is similar to what happened in the Irish bank strikes when the whole banking system shut down for a number of months. People ran out of cash and were writing IOUs, which ended up being traded.

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Re: Creating money

Post by plodder » Sat Nov 26, 2022 2:38 pm

dyqik wrote:
Sat Nov 26, 2022 1:38 pm
plodder wrote:
Sat Nov 26, 2022 12:03 pm
Lpm owes me £20. That means I can lend BOAF £200 and charge him interest. Yum.
Nope. That's not how it works.

If LPM gives you £20 to keep for them, then you can offer BOAF a loan of £200 at some interest rate, and then take out a loan for £200 at a lower interest rate.
I could take out that cheaper loan I suppose. Who from though?

Later on you say the £20 covers the risk. It didn’t in 2007 though, did it? And funnily enough the risks and costs were transferred to the likes of Boaf, who now needs a bigger loan.

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Re: Creating money

Post by dyqik » Sat Nov 26, 2022 2:46 pm

plodder wrote:
Sat Nov 26, 2022 2:38 pm
dyqik wrote:
Sat Nov 26, 2022 1:38 pm
plodder wrote:
Sat Nov 26, 2022 12:03 pm
Lpm owes me £20. That means I can lend BOAF £200 and charge him interest. Yum.
Nope. That's not how it works.

If LPM gives you £20 to keep for them, then you can offer BOAF a loan of £200 at some interest rate, and then take out a loan for £200 at a lower interest rate.
I could take out that cheaper loan I suppose. Who from though?
A bank with investors.

It didn't work in 2008 because the risk calculations were wrong.

The answers to these questions can be found with some basic knowledge of amortisation and probability. Or just watching The Big Short. When you've done some research on your own, then it'll be worth trying to explain to you.

Also, then we'll be able to tell whether you are interested or merely JAQing off.

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Re: Creating money

Post by plodder » Sat Nov 26, 2022 2:51 pm

This whole thread is about risk management and specifically the way that our economy isn’t based on the “reality” of value but on a rolling of the dice as to how much that value might be worth as long as nothing goes wrong - and who ends up carrying the can.

Where does your investment bank get its money to loan to the bank that invented money to loan to Boaf?

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Re: Creating money

Post by dyqik » Sat Nov 26, 2022 3:04 pm

plodder wrote:
Sat Nov 26, 2022 2:51 pm
This whole thread is about risk management and specifically the way that our economy isn’t based on the “reality” of value but on a rolling of the dice as to how much that value might be worth as long as nothing goes wrong - and who ends up carrying the can.

Where does your investment bank get its money to loan to the bank that invented money to loan to Boaf?
That didn't happen in my example. The bank that lent to BOAF did not invent any money to do so.

It borrowed it from the BoE (let's call it the central Bank of England to skip a step or two), which got its money by issuing Treasury Notes that are shares of government debt to investors. Those notes are a share in a promise that the government will pay the BoE, who will pay the investors, an amount at some point in the future.

By telling the BoE to issue those notes, the government can tell its suppliers and creditors that they are transferring some of that money to them, and that that money is sufficient to discharge debts and that if they try to sue the government for non-payment of debts, the courts will reject that claim. In exchange, if the creditors of the governments creditors try to sue the governments creditors, the courts will accept the transfer of that money as discharging the debt.

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Re: Creating money

Post by monkey » Sat Nov 26, 2022 3:24 pm

Here's what the bank of England say about where money comes from and the limits to how much we can have - clicky

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Re: Creating money

Post by nekomatic » Sat Nov 26, 2022 3:39 pm

plodder wrote:
Sat Nov 26, 2022 12:02 pm
Also there’s a fun question to ask why only banks are allowed to do this magic trick (and take a cut, naturally).
Because if an organisation applies to be allowed to do this and meets the regulatory criteria to do so, we call them ‘a bank’.
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Re: Creating money

Post by dyqik » Sat Nov 26, 2022 3:42 pm

As that explains, my example didn't cover the loans that are made by banks that create money by creating new loans without borrowing from the central bank. I was wrong on thinking that was necessary.

What stops plodder from doing the same thing at the same scale is lack of confidence, arising from the small scale of his banking operations.

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Re: Creating money

Post by Martin_B » Sat Nov 26, 2022 11:29 pm

plodder wrote:
Sat Nov 26, 2022 1:22 pm
Martin_B wrote:
Sat Nov 26, 2022 1:00 pm
plodder wrote:
Sat Nov 26, 2022 12:02 pm
My understanding is that the multiplier changes. IIRC before the financial crash in 2007 uk banks could “lend” 10x the value of their holdings. This was reduced to a smaller multiplier, but there’s constant lobbying to increase it again. I am probably entirely wrong about this. But the concepts outlined in the posts above need some real stretching to explain the realities of money creation that actually happens.

The artificially cheap credit this creates is in my opinion a major reason why eg housing prices have gone up far more than demand would suggest. There are obviously benefits to having cash on tap but the risks are clear. Also there’s a fun question to ask why only banks are allowed to do this magic trick (and take a cut, naturally).
Previously banks could lend 3x the value of their holdings. This was the standard for all banks who were backed by the Bank of England (my dad worked in that section) and in the 90s there was pressure to relax the rules to allow up to 5x the value of their holdings. When my dad queried the change, he was told that "Banks know about risk, that's what they do".
Those countries which still maintained a low ratio of lending weren't hit as hard by the GFC as others.
I am likely in a muddle here but I think the multiplier is way higher and I think it’s referred to here (varies by country)

https://en.m.wikipedia.org/wiki/Reserve_requirement
a) My dad was probably simplifying things to explain it to a non-economist (or possibly the multiplier was simpler back then).
b) My point was that back in the 90s institutions which controlled and regulated banks (such as the BoE, which regulated banks both in Britain and some abroad) were put under pressure to allow banks to take greater risks and increase their multiplier factors.

My dad, who worked for the BoE for 30 years and into whom it was ingrained that banks should not take undue risks, was horrified when political pressure was put onto the BoE. He was offered early retirement in the mid-90s (the two things may or may not be connected!)
I wouldn't be surprised if between the 90s and 2007 some banks had increased their multiplier factors to 10x or more (the Icelandic banks seem to have been particularly cavalier about risk, IIRC).
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Re: Creating money

Post by IvanV » Sun Nov 27, 2022 11:44 am

Millennie Al wrote:
Sat Nov 26, 2022 4:34 am
Someone wanted a new thread for this sort of thing, so here it is.
That page explains fractional reserve banking in a misleading way.

It's a bit like the famous missing dollar riddle. Taking their example, Alice goes into a bank and deposits $1000 in cash. The result of this is that she no longer has the $1000, and if she is confused on this point a thorough search will prove that she definitely does not have the cash any more. What she does have is a bank balance showing a credit of $1000. This is not $1000. It is a debt owed by the bank to Alice. It is easy to confuse an obligation to pay $1000 with $1000, but they are not the same thing. If you are in any doubt, imagine going into a takeaway pizza place, ordering a pizza, and paying ten pounds. You obviously do not have the ten pounds, but you don';t have the pizza either as it does not yet exist. Instead the pizza place has an obligation to provide you with the pizza. After a short delay, they will (hopefully!) produce the pizza, discharging their obligation. At no time are you likely to be in any doubt whether you have the pizza or the benefit of the obligation. (Uless you are very drunk, I suppose).

When Alice deposits the $1000, she has $0, the bank has $1000 and an obligation to pay $1000.
Money is an IOU. The original $1000 that Alice put in the bank was itself an IOU, in that case an IOU from the Federal Reserve, another bank. The commercial bank's IOU to Alice is as much money as the $1000 in notes that Alice put in the bank. We even call paper money "banknotes", that makes clear the nature of them as issued by a bank. Though the quality of the security might differ between the paper money and the bank credit.

When you know that money is an IOU, the missing dollar riddle is instantly exposed as wordplay. You immediately laugh at the ridiculous assertion that Alice has deprived herself of her $1000 by handing notes over to the bank. It's not like she handed them over to a pizza shop to buy something, that is quite a different transaction. By putting them in a bank account, she has just changed the quality of the security of it. She no longer has to worry about having the notes stolen, losing them, or damaging them. But she has to worry about the commercial honesty and security of the bank instead. She might even be paid interest in return for it - something that the central bank gets away with avoiding.

There are other forms of money, for example commodities such as precious metal used as money. Coins are mostly just tokens for the IOUs, like notes. But coins of a defined quantity of precious metal, like Krugerrands, can be used as money with the value of the underlying metal in the market for that metal. Other commodities used in this way have included livestock (camels in Arab lands, cattle in East Africa, etc), tea bricks, tobacco, rolls of cloth, etc. Cowrie shells were used as money in West Africa, in part because they were very rare locally, and appreciated like precious jewels. This use was largely killed off when Europeans with ocean-going vessels turned up in West Africa with huge quantities of cowrie shells shipped in from places they were common.

This commodity money has not precluded the IOU kind of money. Even putting a currency on the gold standard does not mean that the system of coins and notes acting as IOUs is prevented, but it does prevent the expansion of the money supply to the same extent, because the money remains exchangeable for the underlying gold or other commodity.

These days, most money movements are just changes to bank records of who has how much. This is very like traditional Yap money. Yap is an island state within the Federated States of Micronesia. On Yap, money is traditionally in the form of very heavy rock disks, called Rai stones, which are difficult to move. They are typically placed outside people's houses. People mostly pay each other using this money without moving them, they just remember who owns which one. Only occasionally are they moved after initial manufacture. Notoriously, one large Rai stone that was accidentally dropped in the sea from a boat is still accounted money, and its ownership for the time being acknowledged.

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Re: Creating money

Post by Bewildered » Sun Nov 27, 2022 12:24 pm

monkey wrote:
Sat Nov 26, 2022 3:24 pm
Here's what the bank of England say about where money comes from and the limits to how much we can have - clicky
Thanks, I just read the first couple of pages but that matches my scenario 2, right, not the scenario 1 which seems to be implied by the article in the OP which does describe things in terms of lending out the saver’s money.

This was how I understood it worked until I read that article in the OP and wondered if I had somehow misunderstood things…

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Re: Creating money

Post by monkey » Sun Nov 27, 2022 6:12 pm

Bewildered wrote:
Sun Nov 27, 2022 12:24 pm
monkey wrote:
Sat Nov 26, 2022 3:24 pm
Here's what the bank of England say about where money comes from and the limits to how much we can have - clicky
Thanks, I just read the first couple of pages but that matches my scenario 2, right, not the scenario 1 which seems to be implied by the article in the OP which does describe things in terms of lending out the saver’s money.

This was how I understood it worked until I read that article in the OP and wondered if I had somehow misunderstood things…
It talks about how money is destroyed too, which has been missing from this discussion.

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Re: Creating money

Post by dyqik » Sun Nov 27, 2022 6:24 pm

monkey wrote:
Sun Nov 27, 2022 6:12 pm
Bewildered wrote:
Sun Nov 27, 2022 12:24 pm
monkey wrote:
Sat Nov 26, 2022 3:24 pm
Here's what the bank of England say about where money comes from and the limits to how much we can have - clicky
Thanks, I just read the first couple of pages but that matches my scenario 2, right, not the scenario 1 which seems to be implied by the article in the OP which does describe things in terms of lending out the saver’s money.

This was how I understood it worked until I read that article in the OP and wondered if I had somehow misunderstood things…
It talks about how money is destroyed too, which has been missing from this discussion.
I'm going to be very disappointed if it doesn't involve antimoney.

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Re: Creating money

Post by monkey » Sun Nov 27, 2022 6:35 pm

dyqik wrote:
Sun Nov 27, 2022 6:24 pm
monkey wrote:
Sun Nov 27, 2022 6:12 pm
Bewildered wrote:
Sun Nov 27, 2022 12:24 pm


Thanks, I just read the first couple of pages but that matches my scenario 2, right, not the scenario 1 which seems to be implied by the article in the OP which does describe things in terms of lending out the saver’s money.

This was how I understood it worked until I read that article in the OP and wondered if I had somehow misunderstood things…
It talks about how money is destroyed too, which has been missing from this discussion.
I'm going to be very disappointed if it doesn't involve antimoney.
I'm afraid it's mostly just paying your loan back to the bank, but there's other things.

You could try putting a couple of quid in the LHC and see what comes off.

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Re: Creating money

Post by Gfamily » Sun Nov 27, 2022 6:45 pm

dyqik wrote:
Sun Nov 27, 2022 6:24 pm
monkey wrote:
Sun Nov 27, 2022 6:12 pm
Bewildered wrote:
Sun Nov 27, 2022 12:24 pm


Thanks, I just read the first couple of pages but that matches my scenario 2, right, not the scenario 1 which seems to be implied by the article in the OP which does describe things in terms of lending out the saver’s money.

This was how I understood it worked until I read that article in the OP and wondered if I had somehow misunderstood things…
It talks about how money is destroyed too, which has been missing from this discussion.
I'm going to be very disappointed if it doesn't involve antimoney.
Brittle and flaky - could be crypto
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Re: Creating money

Post by Woodchopper » Sun Nov 27, 2022 6:55 pm

Gfamily wrote:
Sun Nov 27, 2022 6:45 pm
dyqik wrote:
Sun Nov 27, 2022 6:24 pm
monkey wrote:
Sun Nov 27, 2022 6:12 pm


It talks about how money is destroyed too, which has been missing from this discussion.
I'm going to be very disappointed if it doesn't involve antimoney.
Brittle and flaky - could be crypto
Call it Sb coin.

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