Unlearning Money: Part 2

Here's a funny thing about bank-created money:

A real estate investor sells one of her holdings, an apartment in Encinitas, California, to a young couple for $400,000. The couple finances 100 % of the purchase with a mortgage from a bank. The bank creates a $400,000 deposit out of thin air and the couple transfers the deposit to the investor. The investor feels, for a good reason, that she got paid for the apartment. One month after the transaction, the investor realizes she doesn't want to just sit on the money earning 1,0 % (from a Certificate of Deposit). She decides instead to invest it in a mortgage-backed security (MBS) which yields 3,0 %. A mortgage-originating bank has created this security by bundling loans it has made to homebuyers. In effect, the investor ends up funding homebuyers. She went, in the course of a month or so, from a rental-income-earning apartment owner to someone who has a claim on mortgage payments -- did she, or did she not, get paid for her apartment?


Of course you might argue that she got paid for the particular apartment and then invested her money elsewhere. But it's again the micro-view of money. I took this up because this is very relevant from the macroeconomic perspective. This explains how banks make loans and by doing so they simultaneously create the deposit that can later buy these loans if the bank decides to securitize those loans, i.e. sell them forward to investors in a bundle. And this is what is happening in financial markets every day. From a macroeconomic perspective, the society as a whole is not getting paid, yet. In a (very real) sense, when people buy something with money (an IOU), it's the buyer who gets paid (in assets, goods or services), not the seller. This multitude of available perspectives is what makes economics fascinating to me. At times it is also horribly confusing.

In our example above, the investor ended up holding an MBS because she preferred it to money (in this case a deposit). This is not so surprising, because money -- whether she thought of it or not -- is just another IOU. Whereas the MBS is linked to a bunch of mortgages, a deposit is (indirectly) linked to all loans on a bank's balance sheet. Here's an important point: Funding, seen from the perspective I have taken here, means "accepting IOUs from others". What it doesn't mean is "providing money". By accepting money as a payment, you accept an IOU -- you are funding someone (indirectly a bank borrower or directly a government). If you are later willing to lend the money out and accept another type of an IOU, you end up trading IOUs. Perhaps we could call it "redirecting your funding".

So when one thinks about "money flows", it's best to concentrate on who owes whom and how the positions are changing. It's best to forget the idea that there would be some "real" money flowing from A to B. There isn't.

I'll use QE as a stylized example: As part of its latest QE program, the Fed buys a Treasury Bond from Bank W. The Fed "pays" by creating reserves on Bank W's reserve account, indicating that it owes Bank W. What happened here is this: first the government owed Bank W (holder of the bond), but now the Fed owes Bank W and the government owes the Fed. If Bank W had previously bought the bond from Investor K and "paid" by creating a deposit for the investor, then the IOU chain is one link longer: The government used to owe Investor K, but now Bank W owes Investor K, the Fed owes Bank W and the government owes the Fed.

I'll elaborate all this in the coming posts.

I end the post with a riddle: Assuming that the shareholders of a bank have deposit accounts in the bank, does the bank pay dividends to its shareholders?