Thursday, June 11, 2009

Art Laffer on how banks lend money

In an otherwise terribly misleading and misinformed piece in the Wall Street Journal the other day, economist Arthur Laffer explained in an excellent fashion how banks create loans. Here it is below:

"The way a bank or the banking system makes new loans is conceptually pretty simple. Banks find an entity that they believe to be credit-worthy that also wants a loan, and in exchange for the new company’s IOU (i.e., loan) the bank opens up a checking account for the customer. For the bank’s sake, the hope is that the interest paid by the borrower more than makes up for the cost and risk of the loan."

So for anyone who still thinks that banks take your deposits and lend that money out or, lend their reserves, please re-read.

Furthermore, as bank credit comprises 90% of all of what we call the "money supply," if you still think that the Fed "prints money," let that go as well. Money is created in the banking system and the Fed only has marginal influence on that process insofar as it is the interest rate setter and, thus, the semi-regulator of bank profits, which should not be surprising because banks are agents of the Fed anyway.

Art's explanation of how loans are created also highlights another extremely important point, which is the fact that nearly all money emanates from a desire on the part of some private entity (an individual, a business) to issue and I.O.U. (a debt).

Thus, all "money" is really debt!

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