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Re: Can the Fed stop QE?
A little double entry bookkeeping can help here.
Let's say you take out a loan for $10,000, agreeing to repay principal plus 10% interest in one year, for $11,000 total.
When you take out the loan, you gain an asset of $10,000 and a debit of your IOU agreeing to repay the $11,000 next year. At that time, the bank gained an asset of your IOU and posted a debit for the $10,000 it issued to you.
When you repay the loan in a year, you post an asset canceling the IOU, and a debit of $11,000 to repay the loan. At that time, the bank posts an asset of $11,000 and posts a debit canceling the IOU it had held from you.
But that much is rather boring. Perhaps the more interesting aspect is how the above activities affect the nations money supply.
Banks, because they deal in "safe" instruments, because they are backstopped by a central bank, and because they have obtained substantial industry power over the government, are legally allowed to leverage their lending. This is the well known fractional reserve lending. Their granting a loan to you is rather like them "investing" in your IOU. However for each dollar they hold in reserve, they typically lend ten or twenty dollars (some banks even more.) The magic is that unlike other investors, a bank does not have to borrow at interest from a third party when it leverages its lending. It can just magically generate additional bank credit out of thin air, at no cost to the bank other than reducing its lending reserve capacity.
So long as the bank is willing and able to find sufficient loan customers to consume all its reserve lending capacity, your paying off your loan doesn't matter much, because that just frees up some reserves for another loan customer. But if it is unable to find enough loan customers or reluctant to risk such loans, then your paying off your loan reduces the money in general circulation by $11,000. Prior to payoff, you had that money, and you and the bank were counterparties to an IOU. That money was in general circulation. The IOU's traditionally were not in circulation (skipping over for a moment that in the last decade, the bank likely had already securitized that IOU, helping to provide monetary feedstock to another market for securitized debt, derivatives, swaps, and such, that was leveraged another ten or twenty times !) After payoff, the $11,000 is essentially extinguished, removed from general circulation, replaced on the banks books by excess reserve lending capacity.
Considering now what I just skipped over in the previous paragraph, your repaying or defaulting the loan canceled that IOU, which if properly accounted for should remove a small piece of feedstock debt paper for the securitized debt market. If enough such debts are paid off or defaulted, then this reduces the basis of that market. This is one key reason that the big banks are reluctant to lend right now. They have enormous sums of such debt paper derivatives off balance sheet, and are struggling with digesting the collapse of that market in a sufficiently stealthy and slow pace so as to avoid going bankrupt. Medium and smaller banks mostly have various loans and mortgages on their books, rather than debt paper derivatives, so they are sweating bullets and reluctant to lend for a slightly different reason. The economic collapse threatens their existence as it threatens their loans.
Originally posted by tacito
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Let's say you take out a loan for $10,000, agreeing to repay principal plus 10% interest in one year, for $11,000 total.
When you take out the loan, you gain an asset of $10,000 and a debit of your IOU agreeing to repay the $11,000 next year. At that time, the bank gained an asset of your IOU and posted a debit for the $10,000 it issued to you.
When you repay the loan in a year, you post an asset canceling the IOU, and a debit of $11,000 to repay the loan. At that time, the bank posts an asset of $11,000 and posts a debit canceling the IOU it had held from you.
But that much is rather boring. Perhaps the more interesting aspect is how the above activities affect the nations money supply.
Banks, because they deal in "safe" instruments, because they are backstopped by a central bank, and because they have obtained substantial industry power over the government, are legally allowed to leverage their lending. This is the well known fractional reserve lending. Their granting a loan to you is rather like them "investing" in your IOU. However for each dollar they hold in reserve, they typically lend ten or twenty dollars (some banks even more.) The magic is that unlike other investors, a bank does not have to borrow at interest from a third party when it leverages its lending. It can just magically generate additional bank credit out of thin air, at no cost to the bank other than reducing its lending reserve capacity.
So long as the bank is willing and able to find sufficient loan customers to consume all its reserve lending capacity, your paying off your loan doesn't matter much, because that just frees up some reserves for another loan customer. But if it is unable to find enough loan customers or reluctant to risk such loans, then your paying off your loan reduces the money in general circulation by $11,000. Prior to payoff, you had that money, and you and the bank were counterparties to an IOU. That money was in general circulation. The IOU's traditionally were not in circulation (skipping over for a moment that in the last decade, the bank likely had already securitized that IOU, helping to provide monetary feedstock to another market for securitized debt, derivatives, swaps, and such, that was leveraged another ten or twenty times !) After payoff, the $11,000 is essentially extinguished, removed from general circulation, replaced on the banks books by excess reserve lending capacity.
Considering now what I just skipped over in the previous paragraph, your repaying or defaulting the loan canceled that IOU, which if properly accounted for should remove a small piece of feedstock debt paper for the securitized debt market. If enough such debts are paid off or defaulted, then this reduces the basis of that market. This is one key reason that the big banks are reluctant to lend right now. They have enormous sums of such debt paper derivatives off balance sheet, and are struggling with digesting the collapse of that market in a sufficiently stealthy and slow pace so as to avoid going bankrupt. Medium and smaller banks mostly have various loans and mortgages on their books, rather than debt paper derivatives, so they are sweating bullets and reluctant to lend for a slightly different reason. The economic collapse threatens their existence as it threatens their loans.
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