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

Assets	shillings	Liabilities	shillings
Deposit at BoS	100,000	Money owed to bank owners	100,000
Total	100,000	Total	100,000

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

Assets	shillings	Liabilities	shillings
Deposit at BoS	100,000	Money owed to bank owners	100,000
Promissory note (Mr Smith)	10,000	Deposit (Mr Smith)	10,000
Total	110,000	Total	110,000

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

Assets	shillings	Liabilities	shillings
Deposit at BoS	90,000	Money owed to bank owners	100,000
Promissory note (Mr Smith)	10,000
Total	100,000	Total	100,000

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.