Money Series - Part 2 - Money Out of Thin Air: What does Your Politician Know?

It is natural and straightforward that banks extend loans to their customers which are paid back with interest. Banks profit from the practice of lending money by being paid interest. Most people agree that the interest is justified because of the risk the bank is taking when it is lending out money. So far so good.

But what happens when the bank is lending out money which it has created out of thin air? In part one of this series, we learned that money is created out of thin air when the bank is extending a loan to its customer.

It can be argued that the current way of creating money is a flawed arrangement and a large contributor to the system wide risks in the financial system.

It is frightening that the knowledge of how money is created is very slim among politicians and policy makers.

How does a politician reason when he/she comes to the conclusion that a bank bailout is necessary if the politician is not knowledgeable about how the bank ended up in the situation necessitating the bailout?

With the mainstream view that money creation is a complex area that is too difficult for a lay-man or a politician to understand, we have a dangerous situation. When we rely on central bank and bank experts to guide the policy making decisions, we don’t only leave important decisions in the hands of industry biased experts, we can be certain that the experts will ensure profit-maximization for their own industry.

By adopting a risk-prone business model of taking very large risks when loaning out money in good economic times, the bank can extend loans and thereby create money out of thin air. As long as the interests are paid, good times roll.

When the economic climate changes to the worse, the large profits from the risk-prone approach quickly ends up as bad debts with the result that the thin reserves are quickly depleted. By being bailed out, the bank is saved from bankruptcy and can repeat the cycle.

You and I do not have the same privilege of creating money out of thin air. When the bank is bailed out, our tax money is used for the purpose of bailing out the bank.

The bank is getting the best of both worlds. It can create money and profit from the interest in good times. When times are turning, our tax money is used to save the bank.

Moral hazard is the economic term for the above described situation. By not being moral enough to assess risks from a business perspective of survival and sustainability, the banks can profit more than it would have been able to do if it had to take the dire consequences of its risky behavior.