4 ms·

Inflation doesn't happen here. Bad debts actually take money out of the system. Recapitalizing the banks just add back the destroyed money. Modern monetary p

by ww520 11y ago

Inflation doesn't happen here. Bad debts actually take money out of the system. Recapitalizing the banks just add back the destroyed money. Modern monetary policies don't "print" money anymore. Debt creation and destruction are used as the primary mean to create and destroy money. Below is a very simplified version of money creation, skipping many other aspects. The banks lend their deposit out to the public and money is created out of the thin air and starts to circulate in the system. The banks are regulated by the central bank to maintain a certain reserve ratio on the deposit so there is a maximum level that can be lent out and that becomes the limit on the money supply. When loans are paid back, the money is destroyed but the returned money can be lent out again thus the money supply is not changed. Central banks can influence the money supply by setting the interest rate. Lowering rate causes more loans to be made thus expanding the money supply, conversely for raising rate. Now when a loan has gone bad, there is no money paid back to the bank. The bank is short of that amount of money. It still has to maintain the reserve ratio and can't lend that much out again. The money is gone; essentially it has been destroyed from the system. So a bad loan actually shrinks the money in circulation, lowering the money supply. Too many bad loans would cause a credit crunch - the banks simply can't get the loan money back to re-lend them out and thus there's not enough money to go around. Here's where the central banks step in. They recapitalize the banks (fancy word to create money out of the thin air), by either giving created money to the banks to write off the bad loans, or in the U.S. case in 2008 the Fed buying the bad debts from the banks with new money it created out of the thin air. In either case the banks get money for getting rid off the bad debts and can lend again, re-balancing the money taken out of the system due to bad debts. Thus the money supply is back to normal and life goes on. The bad debts held by the central banks are simply some numbers on some papers, whose value are questionable. Someday it might be decided that they are worthless and, puff, they are gone. The Chinese central bank is basically using the same mechanisms to deal with bad debts.

narrator 11y ago
Bravo, someone who gets it. The subtle difference with China is when the bailout happens, the government doesn't go into debt to do it and stick the taxpayer with the eventual interest bearing burden of the bailout. Instead, they print the money. This creates moral hazard. I think China's political system is better at dealing with banker moral hazard than ours is unfortunately.
- ww520 11y ago
  Well, their bankers making the bad loans and the people failed to repay the loans might go the jail or got executed when illegal lending involved. Here bonuses are reduced.
  - altcognito 11y ago
    I was just about to say, your OP was a great quick summary, but glossed over the loss of risk/punishment inherent in the system. Consider the loophole closed.
slv77 11y ago
Couple of points... - There has been no economy that has been able to grow debt as fast as China has without accumulating a large amount of bad debt. This is just as true for the US in the 1920's, Japan in the 1980's, Greece, Spain, Iceland, Portugal, Brazil, Mexico, etc. - China has grown debt to GDP at a breathtaking pace. - Savings and debt are opposite sides of the same coin. Once a loan goes bad the debtor's promise to provide economic value is broken. At this point somebody has to bear the loss through a reduction in future consumption, there is no free lunch. - There are choices in how those costs are allocated. For example they can be through the bankruptcy courts, inflation, reduced interest in savings, taxes and reduced social services (by taking it on the government balance sheet) and external default. - How those losses are allocated are politically sensitive. They can and often lead to revolution and war. - Savy investors are aware of these trade offs and will attempt to position themselves to avoid losses. - The central bank has its own balance sheet which aren't just numbers on that can be written off. A central bank which bought bad debt and then wrote it off would be insolvent and would require recapitalization itself. - Giving money is the prerogative of government. A central bank who gives money in the guise of a loan would quickly find themselves in conflict with the government. That is why the US had both TARP and QE. - Even if the government gave permission for the central bank to montetize the bad debt Savvy investors would know that monetization of bad debt would lead to inflation. Investors would respond by hoarding commodities, capital flight and leveraging assets (which is happening now). This is happening now (capital flight, accelerating debt growth, hoarding of gold)
- ww520 11y ago
  Fair points. There will certainly be turmoil and pain in a downturn. The main thrust of my comment was to dispel the notion that recapitalizing banks or QE to write off non-performing loans would cause uncontrolled inflation. This misconception is a misunderstanding of how fiat money creation and destruction work in the modern economies. The oppose is true. Not doing those would cause credit crunch. The Great Depression at 1929 was the result of credit freeze when banks saddled with bad debts could not function at normal money creation. I'll address one of your points. Central banks writing off the debt it bought would not go insolvent and don't need recapitalization by others. Central banks can create all the money they need at will. Insolvent is when you can't pay back the debt. The central banks don't owe debt. They own the debt; they can do however they like with them, including forgiving the debtors. The mandate for central banks, at least in the U.S., is to keep inflation at a modest low rate window and keep unemployment low. Everything else is secondary.

by ww520 11y ago

narrator 11y ago

Bravo, someone who gets it. The subtle difference with China is when the bailout happens, the government doesn't go into debt to do it and stick the taxpayer with the eventual interest bearing burden of the bailout. Instead, they print the money. This creates moral hazard. I think China's political system is better at dealing with banker moral hazard than ours is unfortunately.

ww520 11y ago
Well, their bankers making the bad loans and the people failed to repay the loans might go the jail or got executed when illegal lending involved. Here bonuses are reduced.
- altcognito 11y ago
  I was just about to say, your OP was a great quick summary, but glossed over the loss of risk/punishment inherent in the system. Consider the loophole closed.

slv77 11y ago

Couple of points... - There has been no economy that has been able to grow debt as fast as China has without accumulating a large amount of bad debt. This is just as true for the US in the 1920's, Japan in the 1980's, Greece, Spain, Iceland, Portugal, Brazil, Mexico, etc. - China has grown debt to GDP at a breathtaking pace. - Savings and debt are opposite sides of the same coin. Once a loan goes bad the debtor's promise to provide economic value is broken. At this point somebody has to bear the loss through a reduction in future consumption, there is no free lunch. - There are choices in how those costs are allocated. For example they can be through the bankruptcy courts, inflation, reduced interest in savings, taxes and reduced social services (by taking it on the government balance sheet) and external default. - How those losses are allocated are politically sensitive. They can and often lead to revolution and war. - Savy investors are aware of these trade offs and will attempt to position themselves to avoid losses. - The central bank has its own balance sheet which aren't just numbers on that can be written off. A central bank which bought bad debt and then wrote it off would be insolvent and would require recapitalization itself. - Giving money is the prerogative of government. A central bank who gives money in the guise of a loan would quickly find themselves in conflict with the government. That is why the US had both TARP and QE. - Even if the government gave permission for the central bank to montetize the bad debt Savvy investors would know that monetization of bad debt would lead to inflation. Investors would respond by hoarding commodities, capital flight and leveraging assets (which is happening now). This is happening now (capital flight, accelerating debt growth, hoarding of gold)

ww520 11y ago
Fair points. There will certainly be turmoil and pain in a downturn. The main thrust of my comment was to dispel the notion that recapitalizing banks or QE to write off non-performing loans would cause uncontrolled inflation. This misconception is a misunderstanding of how fiat money creation and destruction work in the modern economies. The oppose is true. Not doing those would cause credit crunch. The Great Depression at 1929 was the result of credit freeze when banks saddled with bad debts could not function at normal money creation. I'll address one of your points. Central banks writing off the debt it bought would not go insolvent and don't need recapitalization by others. Central banks can create all the money they need at will. Insolvent is when you can't pay back the debt. The central banks don't owe debt. They own the debt; they can do however they like with them, including forgiving the debtors. The mandate for central banks, at least in the U.S., is to keep inflation at a modest low rate window and keep unemployment low. Everything else is secondary.