The online Merriam-Webster Dictionary defines alchemy as “a science that was used in the Middle Ages with the goal of changing ordinary metals into gold”. Medieval alchemists believed they could transform something common (molten lead) into something precious (pure gold). Viewed through a financial lens, alchemy is about converting a lower value item into a higher value item.
But care must be exercised as attempting to turn trash into treasure caused the global financial crisis (GFC). The Alchemists of Wall Street transmuted toxic subprime mortgages into junk mortgage-backed securities and sold them as gilt-edged, AAA-rated bonds. Put another way, investment “lead” was dressed up as fool’s gold triggering the worst crisis since the Great Depression.
Notwithstanding the dubious quality of the bonds that were minted on Wall Street, financial alchemy does have a good side. Governments (or to be more precise, central banks) have the ability to create sums of money out of thin air. This “alchemy magic” is called quantitative easing (QE) and, as I outlined in an earlier post, it can help prevent an economy slipping into recession.
In the aftermath of the GFC official interest rates in the US and UK were close to zero. Both nations, therefore, had effectively run out of ammunition to stimulate their economies. While they couldn’t make money cheaper, they had the power to make it more plentiful. So they decided to directly inject more money into the economy via a non-traditional weapon - QE.
QE increases the money supply - not by literally printing more money - but by introducing liquidity into the economy electronically. This liquidity is deposited with banks in exchange for selling assets (bonds) for cash. The theory was that banks would use the additional funds to lend to customers in order to boost demand and improve a sagging economy.
The jury is still out as to whether QE has been a blessing or a curse. While QE has not worked economic wonders, the deployment of artificially created money into the bond market helped stimulate economic growth. On balance, I believe that QE has served the global economy well and proved that monetary stimulus has an important role to play in economic recovery.
Beyond QE, all financial institutions are modern day alchemists due to the wondrous generative capacity of credit. Nearly all money is borrowed into existence. When a bank makes a loan to a customer and deposits the proceeds into a bank account, new credit money is created. Thus, money borrowed from a financial institution increases the money supply.
The amount of money a bank can lend is affected by the cash reserve set by the local banking authority. Let’s say the cash reserve (liquidity) requirement is 10 per cent of a bank’s total deposits. This means the bank can lend $90 when it receives a $100 deposit. That $90 is used by the borrower to buy goods and the shopkeeper deposits the funds with his bank.
The second bank takes the $90, keeps 10 per cent and lends $81 to another person. That $81 goes back into the economy and eventually finds its way into the other person’s account at a third bank. The third bank, in turn, holds back $8.10 and lends out $72.90. This goes on until there is nothing left to deposit and lend out.
If you do the math, you will find that the original $100 eventually amounts to $1,000 in credit money and this is how banks create money through their lending activities. It’s called Fractional Reserve Banking and it assumes only a small percentage of depositors will demand their money back at exactly the same time. So, the rest is put to work as loans to borrowers.
Well, now that I’ve told you the inside story of the magic behind banking, it’s time for me to say “abracadabra” and disappear!
Paul J. Thomas
Posted Monday, March 10, 2014 0 Comments Make a comment