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)?
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:
| Location | shillings |
|---|---|
| Agricultural Bank of Somewhereia (ABoS) | 100,000 |
| Industrial Bank of Somewhereia (IBoS) | 100,000 |
| October Bank of Somewhereia (OBoS) | 80,000 |
| Government of Somewhereia | 20,000 |
| Cash in circulation | 700,000 |
| Total | 1,000,000 |
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.
| Location | shillings |
|---|---|
| Agricultural Bank of Somewhereia (ABoS) | 100,000 |
| Industrial Bank of Somewhereia (IBoS) | 100,000 |
| October Bank of Somewhereia (OBoS) | 70,000 |
| Government of Somewhereia | 20,000 |
| Cash in circulation | 710,000 |
| Total | 1,000,000 |
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.
| Location | shillings |
|---|---|
| Agricultural Bank of Somewhereia (ABoS) | 100,000 |
| Industrial Bank of Somewhereia (IBoS) | 100,000 |
| October Bank of Somewhereia (OBoS) | 80,000 |
| Government of Somewhereia | 20,000 |
| Cash in circulation | 700,000 |
| Total | 1,000,000 |
If Mrs Grape actually banks with IBoS, and pays the cash into there, we instead have this situation:
| Location | shillings |
|---|---|
| Agricultural Bank of Somewhereia (ABoS) | 100,000 |
| Industrial Bank of Somewhereia (IBoS) | 110,000 |
| October Bank of Somewhereia (OBoS) | 70,000 |
| Government of Somewhereia | 20,000 |
| Cash in circulation | 700,000 |
| Total | 1,000,000 |
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:
| Location | shillings |
|---|---|
| Agricultural Bank of Somewhereia (ABoS) | 100,000 |
| Industrial Bank of Somewhereia (IBoS) | 110,000 |
| October Bank of Somewhereia (OBoS) | 81,000 |
| Government of Somewhereia | 20,000 |
| Cash in circulation | 689,000 |
| Total | 1,000,000 |
If instead, Mr Carrot was paid by cheque, etc. by Mrs Pineapple who banks with IBoS, the situation is as follows:
| Location | shillings |
|---|---|
| Agricultural Bank of Somewhereia (ABoS) | 100,000 |
| Industrial Bank of Somewhereia (IBoS) | 99,000 |
| October Bank of Somewhereia (OBoS) | 81,000 |
| Government of Somewhereia | 20,000 |
| Cash in circulation | 700,000 |
| Total | 1,000,000 |
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.
