Inside Money: The Shadow Banking System
Guest Contributor

28 March 2009

Posted by Alex Gould

Hi Everyone,

Thanks again to John and Ken for having me on the show today and to the whole team (Ben, Devon, Daniel, et. al.) for their organization and professionalism.

MAJOR NOTE:  I am an Instructor in the Department of Economics at Stanford University, NOT at the GSB (Graduate School of Business) at Stanford.  Given the flow of the show, I didn't feel that it was appropriate to make the correction on the air as it would have been disruptive.  BUT, I am making it now.  :)

I'm sorry we only had part of an hour to talk about the mysteries of money.  There was obviously a lot more we all wanted to cover.  I have gotten several e-mails from folks already asking me about my opinions of the stimulus package and also three separate messages asking me to clarify my remarks about how banks can simply create money.  I wrote a long response to each, and also suggested an interesting video that was sent to me early this afternoon about the same subject.  I will reproduce my own explanation and also provide the link as well.  If you did not understand my (too brief) explanation on the radio and response to the caller, do not despair.  Following what really happens with a fractional reserve/shadow banking system is not easy until you really get into it and also suspend a bit of reality... :)
So here you go:
The best way to think about it all is this... 


The Federal Reserve controls what is known as "high powered money" or the monetary base.  This is total outstanding currency (notes and coins) and reserves (bank reserves) in the system.

However, this is NOT the money SUPPLY.  Basic money supply (currency plus deposits) is partly a function of the monetary base, but it is also a function of the checkable deposits that banks create.  Although there are many definitions of money supply depending on how liquid you want it to be, this should give you some idea. 

So, for example, when a bank receives a deposit and keeps some percent as reserves and lends out the rest, it is still accountable to its depositors at any time for the money they have deposited, even though a large percent of it has been loaned out.  So, let's say for example that $1,000,000 is deposited at Bank 1 by Person A and the bank takes some of those funds and extends a $900,000 mortgage to Person B at the same bank and keeps 10% as reserves (this percent is probably high in reality).  Person B signs a loan document agreeing to pay back $900,000 plus interest to the bank and pledging their new home as collateral.  So the bank puts $900,000 in Person B's account, Person B buys the home from Person C and then $900,000 will end up in the bank account of the home sellers (Person C) at, say, Bank 2.

So what has happened here?  Bank 1 is still on the hook for $1,000,000 of deposits to Person A even though $900,000 of the dollars have disappeared from that bank and is elsewhere in the system.  Person B is on the hook to Bank 1 for $900,000 plus interest for the mortgage they owe.  And now Bank 2 has $900,000 of deposits of which it can create $810,000 of new loans and the process goes on.

So, no HIGH POWERED money has been created by running the printing presses or by the Fed crediting banks reserve accounts.  However, money in the form of checkable deposits (i.e. banks' extending loans and funding those loans by crediting the accounts of the loan recipients) HAS been created and it is a form of leverage (i.e. debt.)  And it continues through the system as banks create loans based on deposits.  Remember that checkable deposits are part of the money supply, and it is money that people spend, so it is also money.  And the government lets the banking system do this!!!

I hope that helps.  Someone also e-mailed me (this afternoon) the link to an interesting video about money that might help all of you - I watched it quickly but it appeared to cover the fundamentals pretty well and to raise some great questions, although there is certainly a lot more to say.  See what you think:

Please do not hesitate to ask if you have more questions... this is not easy stuff but once you begin to grasp the fundamentals, you can ask the harder questions about how our financial system and economy operate and the direction(s) in which we could go next.

All the best,

Comments (9)

Guest's picture


Saturday, March 28, 2009 -- 5:00 PM

Hmm, I don't live in SF, so I will tune in when it

Hmm, I don't live in SF, so I will tune in when it gets uploaded on the past programs.
Well, I don't know what was talked about and what wasn't, so if I repeat things...sorry.
Well, I like to think back to the story about the island of Locche(sp?). On this island, it was agreed upon that all the giant boulders will be the currency. So when one family sells the house to another, the ownership of the boulders simply go to the other family. Then one day, a man decided that he wants to move the boulder to his own resident. He loaded the boulders onto a ship. Unfortunately, the ship and the boulder sunk down to the bottom of the sea along the way.
is the money lost? No! The boulder is still there, at the bottom of the sea. It still represents value, it is just that we don't see it.
Similarly, the US currency behaves the same way (since we left the gold standard). The currency, or money, are simply agreed upon boulders that we trade with. Even if the currency aren't visible (ie maybe in the bank), we can still trade it.
The financial crisis is cause, among many other reasons, a misinformation. One day, the man accidently wrote down that he has 2x more boulders than reality. In short, he just created values. Eventually, someone will figure it out...and there goes a boom in the economy. Hope that helps.
Here is my philosophical question. I feel that the phrase, money makes the world go round, is inherently wrong. Let us imagine that tomorrow morning, all of the dimes became stone x. After some brief panic, we finally calmed down and conclude that although it is not a dime, we can substitute it as a dime. over time, this stone x becomes the new representative for dimes.
Then this shows that money isn't really concrete. How can something non-concrete make the world go round? It must be something that money represent that makes the world go round rather the physical thing we call money.
And I argue that it is human greed and desires that make the world go round. It is merely that we human exhibits greed and gain desires through this medium we call money. Then my question becomes:
Even in a world without money, with unlimited resources (which is inherently contradictory to economics), will there still be greed?
In physics, there is a concept where essentially the power to create anything out of its fundamental particles. If we ever harness such ability/technology, then we can create a jean at our will (or anything we desire). There is almost an unlimited amount of fundamental particles..and it's recycled into the universe (conserved). In this world, is there no greed?
Ben Zheng
Note: I apologize for my grammar and lack of formal structure. Please excuse the HS student. X_X

Guest's picture


Monday, March 30, 2009 -- 5:00 PM

Great show. Very informative. And I agree with the

Great show. Very informative. And I agree with the guest, an hour was far too short!
Of course, after listening I kept mulling the banks, the bailouts, and the stimulus package and oddly enough settled on the notion of philosophy and infrastructure.
This wasn't entirely a left hand turn for me, for as an independent business journalist living in Charleston, South Carolina, I've written a great deal on ports, international trade, supply chain issues and the vast improvements we need to make to the nation's (and world's)infrastructure to enhance trade efficiencies.
All of which is a long way to say, has infrastructure and its uses and misuses been the subject of philosophical inquiry in the past (I don't know of any direct examples), and also are there philosophical "schools of thought" or approaches, you'd like to see considered as proposals for major infrastructure projects go forward.
A little off thetopic of the program itself, but it's what I was thinking about immedidately afterwards.

Guest's picture


Monday, July 27, 2009 -- 5:00 PM

Our monetary system is based on debt. Alex demons

Our monetary system is based on debt. Alex demonstrated this with the example of how banks extend credit, by maintaining a mere 10% of our savings funds in the bank. The vast majority of the money in our society is created in this way, and because of this, banks hold all the cards to fueling our economy. Their decisions, on to whom and on what conditions to lend money, determines our economy, ultimately determining whether money is spent on schools or on skyscrapers, on healthcare for botox treatements and viagra and balding old guys or to cure malaria and TB and AIDS. Our monetary system is sick and corrupted and needs reform. The FED needs to be nationalized. Banks should not be allowed to play the stockmarket and neither should our retirement funds.
This website is a great source of information and I recommended it highly.

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