Sunday, May 4, 2014

The Banking, Car, Money Analogy

Economist have long argued about the ability of banks to increase the money supply.  An analogy of banks and parking garages may help with understanding the issue.

I made this comment in response to a post at Slackwire:

"I think we can use the parking garage analogy to improve understanding of the role of banks in money supply expansion.

Imagine a parking garage where cars were loaned to people. The car is in the garage because it is unneeded at the moment so why not lend it to others? It works if all of the cars are identical.

Now the loan of a few cars goes unnoticed but if we count all the obligations for cars, the number of obligations has increased while the number of cars has remained unchanged. 

A problem arises if all the people with claims on cars want their car at the same time. There is not enough cars.

Banks have the identical problem. Banks do not truly create money, they only create the PERCEPTION that they create money. Perceptions matter. When depositors perceive that the bank can not give all depositors their car (money) upon demand, bank runs happen and there are not enough cars (money) for all."

Previously, I made a similar comment in response to a post on Ralphonomics. This comment is a little harder to read but also includes an expanded analogy.

"To my way of thinking, the D and D statement

"The instability problem arises from the financing of   illiquid assets with short-term fixed claims (which need not be monetary or demand deposits)."

mis-characterizes the cause of instability. I believe the correct source of bank lending instability is the expectation by depositors that they can always have access to their money.

Access to money is always important to depositors because all depositors think of their deposits as being property. Stated another way, each depositor thinks of his deposit as being a placement of property into the hands of the bank for safe physical storage, identical to placement of a car into a parking garage.  All depositors fully expect to retrieve their car (money) upon demand.

Now, when the bank lends the cars (money) without permission, there are certainly more cars (money) on the street than there would be without bank lending.  More cars (money) on the street does increase activity which many think as a good result.

A potential problem lurks when all the permanent owners of cars and temporary owners (borrowers) of cars want their cars at the same time.  There is not that many cars.

So, to my way of thinking, a shortage of cars is not the same as a mismatch of when cars are available on a time sharing basis."

Money and cars share the characteristic of both being property.  It is this relation to physical existence that creates boundaries and limits for bank stability.