Thursday, 24 November 2011

Interest and Sustainability

The remaining major foundation on which the arguments, conclusions and proposed solutions of "Money as Debt" is founded is that the payment of interest requires continuous exponential growth in money. (As we have already seen, the process of creating central bank money and retail bank credit is essentially identical, and for the remainder of this post, I will just refer to money).

The argument runs along the following lines:

  1. All money is created from debt.
  2. Debt must be repaid to the lender with interest.
  3. Since every loan requires the payment of interest in addition to the principal (the original amount lent), the total amount owed to banks must be greater than the total amount of money in existence, since only enough money was created for the principal.
  4. In order for a borrower to repay the interest, he must sell something to someone who takes out a loan for at least as much as the amount of interest outstanding.
  5. While the original borrower can now repay his interest, the second borrower now does not even have enough money to pay the principal. In addition, the amount of interest is continuing to accumulate, and no money is being created with which to pay it.
  6. The situation can only continue without default if an exponentially-increasing amount of money is borrowed in order to repay the principal and interest from earlier loans.
  7. The need to repay the exponentially-increasing loans forces people to create exponentially-increasing amounts of wealth (goods and services), and therefore to exploit natural resources at an exponentially-increasing rate, causing certain environmental catastrophe in a finite world.

This appears quite a compelling and frightening argument. It says that as soon as interest has been charged by a bank, there is now a runaway instability in the system, and stability cannot be restored without universal default and the consequent seizure of all borrowers' wealth by the banks. It took me, as a person with no experience of studying economics, many months to find the flaw in it.

In order to test the film's theory, I attempted to find a scenario in which a loan is made, interest is charged, and the borrower successfully returns both the principal and the interest to the bank, so that we have reverted to the state before the bank lent money. The film implies that this is impossible.

Here is the simplest scenario I found in which a loan is made for a good reason, and it is successfully repaid with interest, and to everyone's benefit. There are three people involved:

  1. Mr Tophat, the banker. He has just set up the Cultural Bank of Somewhereia (CBoS), and currently has no customers. For further simplicity, we will assume that the bank is not required to have any initial capital.
  2. Mr Ploughman, the farmer. He has some farmland, but needs some wheat seeds to plant.
  3. Mr Grain, the seed merchant. He has a bushel of wheat seeds for sale.

In the spring, Mr Ploughman wants to buy some seeds to plant, so that he can grow wheat. He currently has no money. He asks Mr Grain if he can have his bushel of wheat seeds, in return for a share of the harvest in the autumn.

Mr Grain considers this, but realises that Mr Ploughman is not guaranteed to have a successful harvest, so he could end up with nothing. So instead, he insists on payment in money – 100 shillings – allowing him to buy seeds from any farmer in the autumn.

Mr Ploughman has no money, so he goes into CBoS for a loan. CBoS lends him 100 shillings at 10% per year. The money, as always, is newly-created, and CBoS's balance sheet now looks like this:

Table 1 - Balance sheet of CBoS after a loan to Mr Ploughman
AssetsshillingsLiabilitiesshillings
Loan (Mr Ploughman)100Deposit (Mr Ploughman)100
Total100Total100

Mr Ploughman now buys Mr Grain's bushel of wheat for 100s, and plants the seeds. He looks after the field well, the weather is good, and there is a good harvest. Mr Ploughman now has 10 bushels of wheat seeds. He sells 2 bushels of wheat seeds to Mr Grain for 100s. (Mr Grain must do work to select the best seeds for planting, so unsorted wheat is worth only half of the original seed sown. Mr Grain uses the remaining bushel to make flour for cheese pies).

Mr Ploughman still has 8 bushels of wheat and 100s. As it is now 6 months after borrowing, the interest on the loan means that he owes CBoS 105s. He goes to CBoS and repays the 100s of principal. As we have seen, repaying principal destroys the money, so there is now 5s of interest still to be repaid by Mr Ploughman, but there is no money in existence. How can Mr Ploughman repay his loan? He appears to be stuck.

At this point, let's look at CBoS's accounts before and after the principal is repaid:

Table 2 - Incomplete balance sheet of CBoS after interest charged to Mr Ploughman
AssetsshillingsLiabilitiesshillings
Loan (Mr Ploughman)100Deposit (Mr Ploughman)100
Interest due (Mr Ploughman)5???5
Total105Total105

A balance sheet must balance, so there must be a new 5s liability to match the new 5s asset of interest owed to CBoS by Mr Ploughman. To whom does CBoS owe this 5s? It is to Mr Tophat, the owner. Banks, like other commercial ventures, are in business to make a profit for their owners, hopefully by providing goods or services of value to their customers. In this case, CBoS provided Mr Ploughman with something of value – a means of buying seeds for sowing. Let's complete the accounts:

Table 3 - Completed balance sheet of CBoS after interest charged to Mr Ploughman
AssetsshillingsLiabilitiesshillings
Loan (Mr Ploughman)100Deposit (Mr Ploughman)100
Interest due (Mr Ploughman)5Shareholder equity5
Total105Total105

Shareholder equity simply means how much money would be left if the company were liquidated i.e. the assets all sold and the lenders to the company repaid. It is the value of the company to its owners. In this case, the bank has made a profit of 5s, after having started from zero value, so the value of the bank is now 5s.

Now let's look at the situation after Mr Ploughman has repaid the principal:

Table 4 - Completed balance sheet of CBoS after principal repaid by Mr Ploughman
AssetsshillingsLiabilitiesshillings
Interest due (Mr Ploughman)5Shareholder equity5
Total5Total5

Now Mr Ploughman owes 5s to the bank, and the bank owes 5s to Mr Tophat. Those debts can be resolved simply by Mr Tophat buying 5s of wheat from Mr Ploughman. Since Mr Ploughman has 8 bushels left, and the cost is 50s a bushel for unsorted wheat, he has plenty of surplus to sell to Mr Tophat.

Perhaps the reader could object that in practice people don't buy things by cancelling debts with organisations which they own, even if only because the accounting would be difficult to coordinate between three parties. However, this can be easily overcome as follows:

  1. Mr Tophat instructs his bank to make a 5s interest-free loan to him, thereby creating a new 5s.
  2. Mr Tophat uses this 5s to buy wheat from Mr Ploughman.
  3. Mr Ploughman pays the 5s interest on his loan to the bank, clearing his debt.
  4. The bank pays the 5s to Mr Tophat, clearing its debt to Mr Tophat.
  5. Mr Tophat repays his 5s loan to the bank, clearing his debt to the bank.

Let's look at how much each of the three people has gained or lost:

  1. Mr Tophat has gained 1/10th of a bushel of wheat.
  2. Mr Ploughman has gained almost 8 bushels of wheat.
  3. Mr Grain has lost 1 bushel of wheat suitable for planting, but regained it and also gained 1 bushel of wheat for milling.

So interest has been charged on a loan, and everyone has gained from the arrangement. All the money created has been destroyed again – there is no exponential increase required.

I hope this has been a convincing argument that the charging of interest by banks does not inherently result in unsustainable exponential increases in debt, production, consumption and environmental destruction.

Saturday, 6 August 2011

Summary So Far

Before completing our look at the claims of "Money as Debt", let's look again at the summary of its claims which I started with on 24 August last year:

  1. People do not know how their monetary system works.
  2. Most money is created by private corporations, called banks.
  3. When someone takes out a loan from a bank, the bank does not lend out money previously deposited, but creates new money simply by pulling it from a hat in the film's portrayal.
  4. The new money is created directly from the borrower's promise to repay.
  5. The bank is getting a free lunch by creating money. It gets the borrower into debt to the bank, without having had to earn the money to lend the borrower first.
  6. The existence of interest makes the monetary system sustainable only if the economy continues to grow exponentially, and therefore the system is a primary cause of our overconsumption and destruction of natural resources.

In the light of what we have seen so far, let's address these, leaving the final one for the next post.

  • People do not know how their monetary system works.

True. At least it is for most people. I was one of these up to the point where I watched "Money as Debt", so I do appreciate that aspect of the film.

  • Most money is created by private corporations, called banks.

True. Most "money" is created by private banks. In my blog, I have gone into a little more depth, showing the difference between central bank money and retail bank credit, but both can be spent on goods and services and can validly be called money.

  • When someone takes out a loan from a bank, the bank does not lend out money previously deposited, but creates new money simply by pulling it from a hat in the film's portrayal.

True, but slightly misleading. The true part is that the bank creates bank credit by simply making a pair of entries in the accounts – a promise by the borrower to repay the bank (which is an asset of the bank), and a deposit assigned to the borrower (which is a liability of the bank). This is essentially cost-free.

The misleading part is that it shows the top-hatted retail banker pulling dollar bills out of a hat, after conjuring them into existence from the promissory note. Retail banks cannot do this, since dollar bills (or their equivalent in other countries) can only be created by the central bank. That would be the equivalent of me writing an IOU on your behalf without your permission — obviously fraudulent. A bank creates a different kind of money – bank credit, which can be redeemed at the bank for that quantity of central bank money on demand. But in order to give that central bank money to the borrower, the retail bank must have already acquired it (e.g. by selling shares in the bank), or at least be able to acquire it at very short notice (e.g. by selling, or borrowing against, its assets).

The deal between the borrower and bank is this: the bank gives the borrower central bank money now (or at a later time if the borrower desires), and the borrower has to pay the bank that amount plus some interest in the future. When a bank is solvent, everyone generally accepts its bank credit (a promise by the bank to pay central bank money) as money.

  • The new money (bank credit) is created directly from the borrower's promise to repay.

True. The bank has a new asset and a new liability, each for the amount borrowed, as described above.

  • The bank is getting a free lunch by creating money (bank credit). It gets the borrower into debt to the bank, without having had to earn the money to lend the borrower first.

False, but with a hint of truth. The bank must have the ability to provide central bank money on demand to anyone with bank credit, so it must have already earned the central bank money to lend to the borrower. It also runs a risk of losing money by lending — the money loaned cannot be recovered if the borrower fails to repay and the loan is unsecured. Even if the loan is secured, the amount recovered may not be the full amount of the loan e.g. a loan for a car.

The hint of truth is that banks know that not all of their bank credit will be redeemed for money all of the time, so they can increase their gearing (or leverage, as our American cousins call it). This is slightly simplified, but if a bank knows that only 10% of its bank credit will be redeemed for money at any point, it can lend 10 times as much (100% / 10%) as its owners invested. If the bank charges 5% interest per year, that means that it is making a huge 50% return per year on the original investment. However, with the big profits comes the potential for big losses. It only takes 5% of borrowers failing to repay for the profit to be wiped out completely.

  • The existence of interest makes the monetary system sustainable only if the economy continues to grow exponentially, and therefore the system is a primary cause of our overconsumption and destruction of natural resources.

False. This needs a whole post to discuss. Watch this space – I'm half-way through writing it.

Friday, 6 May 2011

Creation of money

It's time to look at how money is created.

Money from debt


Money in a modern monetary system is created by the central bank.

Once upon a time, there was no official currency of Somewhereia. Even so, barter had become too inconvenient — when Mr Courgette, who had two cows, wanted to buy a bag of flour, he didn't want to buy enough flour to be worth one cow, and besides it would have halved his cheese production. And he couldn't just sell one leg of a cow, because it would be unethical and make it harder to milk. What he really wanted was to get some flour, combine it with some of his cheese to make two cheese pies, then sell one cheese pie to pay for the flour, and eat the other cheese pie.

People had taken to using spoons of various sizes as money. After all, spoons are quite useful, and people were happy to exchange their flour and/or cheese for spoons. A small teaspoon was worth one bag of flour. Mr Courgette could pay for the flour with a teaspoon, make his two cheese pies, sell one for a teaspoon, and eat the other.

But one day, the dictator of Somewhereia decided (for reasons which we may examine another time) to create a fiat currency – the Somewhereia shilling. A fiat currency is one which the government simply declares to be the official currency. It would enforce this by only accepting taxes using shillings, and would enforce the collection of taxes by having harsh penalties for people who refuse to pay taxes using shillings. This created a demand for shillings because people needed them in order not to be put in prison (or worse). The government also created a law saying that any private debt can be paid in shillings — if Mrs Lemon owes Mr Aubergine some money, Mr Aubergine can ask the law courts to force her (using the resources of the state) to pay, but if Mrs Lemon agrees to pay the debt using shillings, Mr Aubergine cannot force her via the courts to pay with spoons or cheese pies instead.

The dictator of Somewhereia decided to use a central bank model with a debt-based currency for his shillings. There were other possible approaches, but he decided to use that one. He set up the Bank of Somewhereia, with no assets and no liabilities. The BoS created an account for the government, but with a zero balance – there were still no shillings.

Now the dictator wanted some shillings, so he asked the BoS for a loan of one million shillings for ten years. The BoS agreed to make the loan in return for a promise to repay the money plus 4% interest annually. So the dictator asked his government treasurer to print ten pieces of paper (unrelated to the ten years), each with a flattering picture of the dictator and the words 'Treasury of Somewhereia – One hundred thousand shilling bond.' Near the bottom of the piece of paper was a horizontal perforation, and from there to the bottom of the bond were nine vertical perforations making ten detachable coupons. Each coupon had the words 'Treasury of Somewhereia – Four thousand shillings' printed on. The treasurer sent these pieces of paper to the BoS, which wrote in a book that the government account now contained one million shillings. (The effect of having these coupons is interesting, and will be investigated later — when the government borrows money, it has to pay back more than it borrowed, just like other borrowers in the economy).

The government now had some money to spend, and it started to spend it — mostly on gold statues of the dictator to put up on plinths in the market square, and people to guard them. Since the people of Somewhereia didn't have accounts with the BoS, the government paid them with cash which it withdrew from its BoS account.

This then is how new money is first created. It is essentially identical to the creation of bank credit when a normal person or business takes out a loan, as was discussed earlier. A bond is equivalent to a promissory note — it is a promise to repay money in future, so it represents a debt, and money is created in exchange for the promise. When the bonds mature (i.e. have to be repaid) at the end of the ten years, the government must have sufficient money in its account (100,000 shillings for each bond) at the BoS to pay back the million shillings. At that point, the money is destroyed, again just as bank credit is destroyed when a loan is repaid.

More money?


We looked above at the loan of money to the government directly by the central bank. While this is essential for starting the monetary system going, in practice money is rarely lent directly to governments by central banks once a certain amount of money has been created. In fact, it may not be allowed at all (at least in principle, although quantitative easing is suspiciously similar to this). Let's look at what actually happens, and that will eventually lead on to seeing the other way in which money is commonly created.

After the government has borrowed enough shillings, and started spending them, people throughout Somewhereia now have money. Some of them may eventually accumulate enough money to be able to set up a bank.

Let's assume that six months later, the government has spent all of its million shillings, and that October Bank of Somewhereia (OBoS) has accumulated 100,000 shillings. Unfortunately, the government hasn't got any money left to pay the guards to look after the gold statues in the market square — it desperately needs 20,000 shillings or they will desert their posts. But the government has an empty bank account at the BoS. How can it pay the guards?

There are three main options:

  1. It could tax the people of Somewhereia.
  2. It could borrow more money from the BoS.
  3. It could borrow money from someone who has some of the million shillings originally created.

If a government has ongoing costs, it should pay for these through taxation. However, if it has unexpectedly high costs or an unexpected shortfall in taxation income, and is in danger of running out of money, raising taxes will probably not bring the money in quickly enough. For example, raising income taxes will probably not produce extra income until the end of the month. So borrowing money as a short-term measure makes sense as long as measures are taken to reduce spending or increase income (taxes) to bring the income and expenditure back in balance.

Typically, governments do not borrow from the central bank, but instead auction bonds to whoever decides to buy them (often commercial banks). This is criticised by the Money as Debt film, but that is a discussion for later. Let's assume that the government decides to borrow 20,000 shillings for 2 years at 4% interest, and the only interested buyer is OBoS.

Here is the location of all the money in the economy before the new bonds are issued:

Table 1 - All money in Somewhereia before new bonds issued
Locationshillings
Agricultural Bank of Somewhereia (ABoS)50,000
Industrial Bank of Somewhereia (IBoS)80,000
October Bank of Somewhereia (OBoS)100,000
Government of Somewhereia0
Cash in circulation770,000
Total1,000,000

The government treasury prints another couple of bonds, each with a value of 10,000 shillings, with their respective coupons. OBoS buys the bonds, and here is the new situation:

Table 2 - All money in Somewhereia after new bonds issued
Locationshillings
Agricultural Bank of Somewhereia (ABoS)50,000
Industrial Bank of Somewhereia (IBoS)80,000
October Bank of Somewhereia (OBoS)80,000
Government of Somewhereia20,000
Cash in circulation770,000
Total1,000,000

Now the government can spend its newly-acquired money, and have the statues guarded for a few more months. Of course, it will have to pay interest on the debt to OBoS, and repay the 20,000 shillings at the end of the two years. Both of these will presumably come from taxation.

Note that there are still 1,000,000 shillings in total. The government just borrowed some of the existing money. Let's look at where some new money could come from.

Imagine that OBoS has agreed to lend 85,000 shillings to Mr Lentil, who wants it to buy a sports car. But the sports car dealer banks with IBoS. When Mr Lentil pays the dealer with a cheque, the 85,000 shillings will eventually move from OBoS's bank account to IBoS's bank account at the Bank of Somewhereia. Unfortunately, OBoS doesn't actually have 85,000 shillings in its BoS account. What can it do? Here are three possibilities:

  1. It could borrow some money from another bank – perhaps IBoS itself. The assumption is that in the not-too-distant future, there will be a day when the net transfer between OBoS and IBoS will be in the other direction, and the loan can be repaid. In this case, existing money is transferred.
  2. It could sell an asset, such as its government bonds, to raise the money. Again, it is existing money which is transferred.
  3. Or it could borrow from the BoS (the lender of last resort) itself.

Borrowing from the BoS is very simple. OBoS calls BoS, and the conversation goes something like this:

OBoS: I'd like to borrow 20,000 shillings for one day please.
BoS: Certainly, as long as you pay a reasonable rate of interest and give us a good security. We really hate making a loss on our loans, don't you know.
OBoS: I've got these government bonds with a face value of 20,000 shillings.
BoS: That'll do nicely, sir.

So the BoS takes temporary ownership of the bonds, and deposits a further 20,000 shillings in OBoS's account, making a total of 100,000 shillings, and allowing it to transfer the 85,000 shillings to IBoS. But note what has happened now:

Table 3 - All money in Somewhereia after OBoS borrows from BoS
Locationshillings
Agricultural Bank of Somewhereia (ABoS)50,000
Industrial Bank of Somewhereia (IBoS)80,000
October Bank of Somewhereia (OBoS)100,000
Government of Somewhereia20,000
Cash in circulation770,000
Total1,020,000

There is now more money in total. It has increased from 1,000,000 shillings to 1,020,000 shillings. That extra money exists until OBoS repays the loan later.

Summary


We saw before that when retail banks lend, bank credit is created. Now we have seen that something very similar happens with a central bank: when it lends, money is created. The basic difference between the two is that the money's value is derived from the promise of the Bank of Somewhereia, but bank credit's value is derived from the promise of the retail bank.

Thursday, 2 September 2010

How bank profit affects the total amount of money

I've had a good question in the comments, and I think it's worth a complete post on it.

Jay said...

I've watched Money as Debt and read all your posts to this blog so far and I have a question:

As the banks make loans(+. -), charge interest(+), charge fees(+), make investments(+), pay employees(-), pay suppliers(-), pay interest(-), write-off bad (unsecured) debts(-), etc. they balance their rates and charges to ensure that they can cover costs and losses and still make a profit.

As bank credit gets transferred around between the banks and cheques/debits/etc. are all balanced up at the end of the day, since they are still making a profit their accounts at the Bank of England (deposits) will steadily grow - even if on a particular day it might go down and on other days it goes up, overall it has a general upwards trend.

Once their account balances in the Bank of England have grown, does that mean that what was previously bank credit (on the commercial banks' books) is now actual money (in their Bank of England accounts)?

The short answer is that none of the banks' actions that you've listed affects the total amount of money. To see how this works, let's consider each action in turn.

To start with, let's say that there are 1 million shillings of money in total. Three people have managed to acquire enough money to start up a bank each, and they set up accounts with the Bank of Somewhereia (BoS), depositing most of their cash in exchange for balances in their accounts there. Here is where all the money is:

Table 1 - All money in Somewhereia initially
Locationshillings
Agricultural Bank of Somewhereia (ABoS)100,000
Industrial Bank of Somewhereia (IBoS)100,000
October Bank of Somewhereia (OBoS)80,000
Government of Somewhereia20,000
Cash in circulation700,000
Total1,000,000

Where a location in the table is listed as a bank, that means either its account with the BoS, or cash in its tills or ATMs. The BoS allows a bank at any point to deposit cash (causing its balance at the BoS to increase by the amount deposited), or withdraw cash (causing its balance at the BoS to decrease by the amount withdrawn), so there is little point in distinguishing between the two.

Cash in circulation means cash anywhere other than in a bank's tills or ATMs.

Bank makes a loan


Let's say that OBoS lends 10,000 shillings to Mr Carrot. Mr Carrot now has bank credit of 10,000 shillings, but no actual money has changed hands. If Mr Carrot withdraws the full amount as cash, OBoS's money (BoS balance or cash in tills or ATM) is reduced by 10,000 shillings, and the amount of cash in circulation increases by 10,000 shillings.

Table 2 - All money in Somewhereia after Mr Carrot withdraws loan
Locationshillings
Agricultural Bank of Somewhereia (ABoS)100,000
Industrial Bank of Somewhereia (IBoS)100,000
October Bank of Somewhereia (OBoS)70,000
Government of Somewhereia20,000
Cash in circulation710,000
Total1,000,000

If Mr Carrot now buys something from Mrs Grape, he pays her some cash. This obviously does not affect the total amount of money.

Mrs Grape could keep the cash, in which case there is no further movement of money. But she might decide that it is safer to deposit it in the bank instead.

If Mrs Grape has an account with OBoS and deposits the cash there, OBoS's money is increased by 10,000 shillings, and cash in circulation is decreased by 10,000 shillings. Again, there is no change in the total amount of money, and as far as money is concerned, we are back to where we started.

Table 3 - All money in Somewhereia after Mrs Grape deposits cash in OBoS
Locationshillings
Agricultural Bank of Somewhereia (ABoS)100,000
Industrial Bank of Somewhereia (IBoS)100,000
October Bank of Somewhereia (OBoS)80,000
Government of Somewhereia20,000
Cash in circulation700,000
Total1,000,000

If Mrs Grape actually banks with IBoS, and pays the cash into there, we instead have this situation:

Table 4 - All money in Somewhereia after Mrs Grape deposits cash in IBoS
Locationshillings
Agricultural Bank of Somewhereia (ABoS)100,000
Industrial Bank of Somewhereia (IBoS)110,000
October Bank of Somewhereia (OBoS)70,000
Government of Somewhereia20,000
Cash in circulation700,000
Total1,000,000

Note that IBoS has more money at BoS than it started with, and OBoS has less. But the total is the same.

If Mr Carrot had paid Mrs Grape by cheque, debit card or bank transfer, then either Mrs Grape banks with OBoS or another bank. If she banks with OBoS, the bank credit is transferred, but no money is transferred, so the total amount of money is not affected, and we are left with the same situation as Table 3. If she banks with IBoS, money is transferred from OBoS's account at the BoS to IBoS's account at the BoS, and we are left with the same situation as Table 4. Again, there is no effect on the total amount of money.

Interest and fees


The bank meets its costs (employees, rent, window cleaning, etc.) and makes a profit for its owners by charging interest, and perhaps fees. Let's say that Mr Carrot is charged 10 shillings as an administration fee for setting up the loan, and the loan is charged at 9.9% per year. 9.9% of 10,000 shillings is 990 shillings. Let's say that Mr Carrot pays his loan back after exactly one year, so he pays back 11,000 shillings (10,000 + 10 + 990).

How does he pay it back? He must provide some goods or services to someone in exchange for cash, a cheque, etc. (Alternatively he could steal it, or be given it). Let's assume that Mrs Grape still has not touched her deposit at IBoS, and that Mr Carrot has acquired 11,000 shillings in cash, which he now pays into OBoS. We have the following situation:

Table 5 - All money in Somewhereia after Mr Carrot repays his loan with cash
Locationshillings
Agricultural Bank of Somewhereia (ABoS)100,000
Industrial Bank of Somewhereia (IBoS)110,000
October Bank of Somewhereia (OBoS)81,000
Government of Somewhereia20,000
Cash in circulation689,000
Total1,000,000

If instead, Mr Carrot was paid by cheque, etc. by Mrs Pineapple who banks with IBoS, the situation is as follows:

Table 6 - All money in Somewhereia after Mr Carrot repays his loan with a cheque
Locationshillings
Agricultural Bank of Somewhereia (ABoS)100,000
Industrial Bank of Somewhereia (IBoS)99,000
October Bank of Somewhereia (OBoS)81,000
Government of Somewhereia20,000
Cash in circulation700,000
Total1,000,000

As always, the total amount of money is still 1,000,000 shillings.

Paying employees, suppliers, and owners


When OBoS pays its employees and suppliers for services, or dividends to its shareholders, it could pay by cash, increasing cash in circulation and decreasing its own money by the same amount.

If OBoS pays by cheque etc. to an employee, supplier or shareholder who also banks with OBoS, it simply increases their bank credit, and no money is transferred.

If OBoS pays by cheque etc. to an employee, supplier or shareholder who banks with IBoS, the corresponding amount of money is transferred from OBoS to IBoS (via their accounts at the BoS).

As always, in each case, money is only transferred, never created or destroyed.

Paying interest


Interest is payed by increasing the amount of bank credit of a depositor. No money is transferred.

Writing off bad debts


If Mr Carrot is not going to be able to repay his loan to OBoS, it is written off. No money is transferred anywhere — it has already gone from OBoS (when Mr Carrot bought his car). All that happens is that OBoS simply removes an entry from its accounts indicating that it expects to be repaid (thereby reducing its assets), and the accounts also show that the amount owed to shareholders is reduced by the same amount to bring assets and liabilities back into balance.

Making investments


Suppose OBoS decides to buy shares in a dairy.

If it pays by cash, OBoS's money is decreased and cash in circulation (held by the dairy) is increased by the same amount.

If it pays by cheque etc., and the dairy has an account with OBoS, it increases the bank credit of the dairy, but no money is transferred. If it pays by cheque etc., and the dairy has an account with ABoS, money is transferred from OBoS to ABoS.

If OBoS is later paid a dividend, the same happens as with OBoS paying dividends to its owners — OBoS's money increases, and either the dairy's bank's money decreases or the cash in circulation (held by the dairy) decreases. If OBoS sells its shares for cash, cash in circulation decreases and OBoS's money increases. If OBoS sells its shares for a cheque etc., and the payer banks with OBoS, the payer's balance of bank credit is reduced, but no money is transferred. If OBoS sells its shares for a cheque etc., and the payer banks with IBoS, the money is tranferred from IBoS to OBoS.

Again no money is created or destroyed, only transferred.

Summary


No matter what action a normal bank performs, money is only ever transferred:

  • between banks through their BoS accounts (when a cheque, debit card payment or bank transfer is processed),
  • from banks to cash in circulation (when a bank customer makes a withdrawal),
  • from cash in circulation to banks (when a bank customer makes a deposit),
  • when cash is given from one person to another,
  • when a bank withdraws or deposits cash at the central bank.

In each case, the total amount of money is unchanged.

How money is actually created and destroyed will be the topic of a later post.

Thursday, 26 August 2010

Destruction of bank credit

We have examined the creation of bank credit in exchange for a promise to repay. For completeness, we should briefly look at the destruction of bank credit.

We have already seen some situations where bank credit is destroyed. Mr Smith's bank credit was destroyed when he paid a cheque to Mrs Jones or Mrs Apricot. However, in each case, the same amount of bank credit was created in the recipient's bank account, so the total bank credit in the system is unchanged.

Bank credit is also destroyed when cash is withdrawn, and in that case the total amount of bank credit does decrease. It will increase again if the money is subsequently paid into a bank account.

Finally, bank credit is also destroyed when a loan is finally repayed. The bank credit is reduced by the amount of the loan, and the corresponding promissory note is destroyed too.

More on "Money as Debt" and bank credit creation

Before going on to look at interest, it's worth looking a little more at bank credit creation, and why it's not just free wealth for banks.

The last post looked at the cost to the bank of creating new bank credit in exchange for a promissory note when it makes a loan. While the bank at first simply notes an entry in the borrower's account, what that actually does is to give the borrower control over that amount of the bank's money — he can then either withdraw cash (reducing the amount of money owned by the bank), or can write a cheque to someone who banks with another bank, directing the bank to transfer money to the bank of the recipient of the cheque.

What about if the borrower writes a cheque to someone who has an account with the same bank? Does that disadvantage the bank in any way, or is that a free meal ticket? Let's examine the accounts of that scenario. First, the bank before any loan is made:

IBoS balance sheet
AssetsshillingsLiabilitiesshillings
Deposit at BoS100,000Money owed to bank owners100,000
Total100,000Total100,000

The bank has 100,000 shillings on deposit at the BoS. That is how much the bank is worth, and so that is how much is owed to the owners because, well, they own the bank.

Now after a loan of 10,000 shillings is made to Mr Smith:

IBoS balance sheet
AssetsshillingsLiabilitiesshillings
Deposit at BoS100,000Money owed to bank owners100,000
Promissory note (Mr Smith)10,000Deposit (Mr Smith)10,000
Total110,000Total110,000

The bank has a new asset – it is owed 10,000 shillings by Mr Smith. At some point in the future, assuming Mr Smith keeps his promise, he will give 10,000 shillings to the bank. However, the bank also owes 10,000 shillings to Mr Smith — he can take 10,000 shillings in cash (or transfer the amount) from the bank whenever he likes.

And finally, after Mr Smith writes a cheque to Mrs Apricot in exchange for a car:

IBoS balance sheet
AssetsshillingsLiabilitiesshillings
Deposit at BoS100,000Money owed to bank owners100,000
Promissory note (Mr Smith)10,000Deposit (Mrs Apricot)10,000
Total110,000Total110,000

Note that there is very little difference between this situation and the previous one. All that has changed is that Mrs Apricot has the bank credit instead of Mr Smith. The bank still has as much money as it had before – 100,000 shillings, so at first glance, it might appear that the bank is not disadvantaged in any way. But in fact the bank still has a liability to Mrs Apricot, who could withdraw the bank credit as cash or pay it to someone who has an account with another bank. The bank still has given up control of some of its money to another person, and that control could be exercised at any time. If Mrs Apricot decides to withdraw her entire bank credit as cash, the bank ends up in the same situation as in the last post where Mr Smith paid a cheque to Mrs Jones who had an account with another bank:

IBoS balance sheet
AssetsshillingsLiabilitiesshillings
Deposit at BoS90,000Money owed to bank owners100,000
Promissory note (Mr Smith)10,000  
Total100,000Total100,000

Once again, the bank has only 90,000 shillings in money. It is entirely reliant upon Mr Smith paying back his debt in order to break even, and his interest in order to meet its costs and make a profit.

Summary


The creation of bank credit in exchange for a promise to repay is not a costless operation for a bank. It involves giving control of money to the borrower. We saw in an earlier post that if Mr Smith pays someone with an account at a different bank and then fails to pay back the loan, the bank owners lose money. Above we saw that the bank owners would lose money even if the borrower pays someone who banks with the same bank.

One major argument of "Money as Debt" is thus shown to be deeply flawed. The fact that banks can trivially create bank credit by writing an entry in a book or putting an entry in a computer database does not mean that bankers are evil top-hatted thieves who get something for nothing, steal wealth from others and force others to become indebted to them.

There is still the film's assertion that the existence of interest requires exponential growth in the economy. This argument will be discredited in a forthcoming post...

Tuesday, 24 August 2010

Creation of bank credit

Long before I understood that there is a difference between money and bank credit, I occasionally idly wondered how much "money" existed, whether that amount changed, and what happened when new notes were issued and old ones destroyed.

When I followed someone's advice to watch a 47-minute animated film on Google Videos called "Money as Debt" by Paul Grignon, I was dumbfounded. The film argues that the monetary system is fundamentally flawed: that it leads to people being permanently indebted to banks, and requires an ever-growing economy in order to be sustained, due to the existence of interest. I highly recommend watching it, because it contains some very important insights. (Go to video.google.com, search for "Money as Debt" and it should be at the top). But I strongly caution you not to take all that it says at face value, because it contains some fundamental errors, and I will argue that its suggested solutions to what it alleges are the failings of the current monetary system are not only deeply flawed, but actually extremely dangerous, and based on an incorrect analysis of the monetary system.

The next few posts will examine the arguments of "Money as Debt", and proceed to refute some of them. This will require several posts to discuss as it represents over two years of research on my part.

Summary of "Money as Debt" film


The film mentions money and bank credit, but being an introduction it does not dwell on the difference and refers to both as money. I wrote in an earlier post how money and bank credit are fungible — as long as a bank is not insolvent, you can spend bank credit on goods and services in exactly the same way that you can spend money, and you can convert between bank credit and money, so in many ways it is a valid approach for an introduction to the monetary system. But there are places where this simplification can be (deliberately?) misleading.

The essential points of the film are:

  1. People do not know how their monetary system works.
  2. Most money (actually bank credit) is created by private corporations, called banks.
  3. When someone takes out a loan from a bank, the bank does not lend out money (bank credit) previously deposited, but creates new money (bank credit) simply by pulling it from a hat in the film's portrayal.
  4. The new money (bank credit) is created directly from the borrower's promise to repay.
  5. The bank is getting a free lunch by creating money (bank credit). It gets the borrower into debt to the bank, without having had to earn the money to lend the borrower first.
  6. The existence of interest makes the monetary system sustainable only if the economy continues to grow exponentially, and therefore the system is a primary cause of our overconsumption and destruction of natural resources.

This last point is particularly serious, and deserves careful consideration. If we have created a monetary system which by its very nature causes us to destroy our futures, it needs to be changed.

It took me a lot of thought to realise that there is a subtle, but major, flaw in the argument.

Analysis of "Money as Debt" – Part 1


I fully agree with the film's argument that people do not generally know how the monetary system works, and that this is a bad thing. Since people who do work in the finance industry are responsible for the control of vast resources around the world, it is important that the people outside the industry understand what the industry is doing to ensure that their interests are being considered too. It would only take a small number of lessons at schools to explain how the monetary system works.

The film is also almost correct in that banks create money at the point of a loan being made. But in fact, the bank creates bank credit, and the difference is crucial. To understand why this is not a free lunch for the bank, here is an example scenario, based on the one in the film. We need to look at the balance sheet of the bank, showing its assets (what it owns) and its liabilities (what it owes).

Industrial Bank of Somewhereia (IBoS) has been created. It currently has no customers. But it has 100,000 shillings deposited at the central bank, the Bank of Somewhereia (BoS). Where that deposit came from will be the subject of a later post.

Here is the bank's balance sheet:

IBoS balance sheet
AssetsshillingsLiabilitiesshillings
Deposit at BoS100,000Money owed to bank owners100,000
Total100,000Total100,000

The bank's first customer, Mr Smith, arrives. He wants to buy a car, so he can travel to work to earn a living. He signs a promissory note – a legally-binding document which states that he will pay back 10,000 shillings plus 5% annual interest over a period of 5 years. In return, the bank creates a deposit of 10,000 shillings in Mr Smith's bank account. Now the balance sheet looks like this:

IBoS balance sheet
AssetsshillingsLiabilitiesshillings
Deposit at BoS100,000Money owed to bank owners100,000
Promissory note (Mr Smith)10,000Deposit (Mr Smith)10,000
Total110,000Total110,000

Mr Smith can now buy his new car. Suppose he writes a cheque to the current owner, Mrs Jones. Also, assume that she banks with a different bank – Agricultural Bank of Somewhereia (ABoS).

As we have seen earlier, writing a cheque to someone who banks with a different bank requires a transfer of money to the other bank's account. So now the balance sheet of IBoS looks like this:

IBoS balance sheet
AssetsshillingsLiabilitiesshillings
Deposit at BoS90,000Money owed to bank owners100,000
Promissory note (Mr Smith)10,000  
Total100,000Total100,000

After Mrs Jones pays Mr Smith's cheque into her ABoS bank account, and the cheque is processed through the cheque clearing system, the owners of IBoS no longer have 10,000 of their original 100,000 shillings in the BoS. By creating bank credit for Mr Smith, it obliges them to transfer money at Mr Smith's request. They are now entirely reliant upon Mr Smith to pay them money in order to get their 10,000 shillings back. If Mr Smith wrecks his car and then declares bankruptcy, the bank owners will have lost 10% of their money invested in the bank — the loan asset has to be "written off" (removed from the balance sheet), and the "Money owed to bank owners" would have to be reduced to 90,000 shillings.

As the film points out, it is very easy for IBoS to store an entry in a computer saying that Mr Smith now has a deposit of 10,000 shillings of bank credit. They seem to be getting something for nothing. But what we see above is that the film omits to mention what that entry actually means, namely that it obliges the bank to transfer money at Mr Smith's request.

Summary


New bank credit is created all the time by banks in the private sector in return for a promise by the borrower to repay. This bank credit can be converted to cash or can be transferred directly to another bank account using a cheque, debit card or a direct bank transfer. Creating the bank credit for a customer is giving that customer the right to withdraw or transfer money, so it is not a free lunch for the bank. Unless the borrower repays the loan in full, the bank (and therefore its owners) will lose money.

The effect of interest, and whether it requires continual exponential growth in the economy (quick summary – it doesn't) will be discussed in a future post.