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.
If I understand correctly Table 1 shows the banks' deposits with the central bank. If that is so, then isn't the advance of the loan to Mr Carrot an expansion of broad money?
ReplyDelete"No matter what action a normal bank performs, money is only ever transferred:
ReplyDelete* 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".
This is totally misleading!
The total amount of money is, most emphatically, changed (ie increased) by a bank whenever it makes a loan.
This is so because the bank doesn't have that money to loan in the first place. It is legally permitted to lend out, at interest, money it doesn't have - to the extent of five or ten times the money it does have.
To ignore that contribution to the growth of the money-supply (greater by far than any other source of such growth) is ludicrous.
You are, I'm afraid, helping to propagate myths.
I tend to agree with robert.horwood, but I am keeping an open mind that I could be wrong and I look forward to more posts from ChaffSorter that will hopefully demonstrate one way or the other what is really going on. I suspect that ChaffSorter will eventually convince himself, having thought it through thoroughly, of the opposite position to what he currently appears to hold.
ReplyDeleteAlready the cracks are present, the 1000 shillings in interest and fees paid by Mr Carrot to OBoS must have come from somewhere, in Table 5 we can see it came from the cash in circulation. It's obvious from this that eventually the banks would own all the cash in circulation and there would be none left for the population of Somewheria.
It looks all above board at the moment because Mr. Carrot withdrew his entire loan and paid it to a different bank's customer. In practice though, when many people are taking out money and buying stuff and it is being re-deposited, the banks will not owe very much to each other (compared to the amount transacted), so their BoS deposits will remain fairly stable. This means the total amount loaned out can be much higher than their deposits at BoS (because the loans are re-deposited, remember, so their balance appears relatively unchanged overall). Since the banks are charging interest on all of this money (which doesn't exist, i.e. it's not backed by real-money deposits), they are effectively creating money (the interest never existed before) - technically it might not be called 'real money' but their customers still become indebted to pay that 'money' to the banks, and since there isn't enough to go around more needs to be created, escalating the problem. Another way of looking at it is that they are creating 'debt' rather than creating money - which (I believe) demonstrates the point that money and debt are basically the same thing.
We are told that this 'growth' is a good thing, and everyone is prospering, but the reality is that more people are simply becoming more enslaved, and forced to be productive for the benefit of the banks.
We should be productive for the benefit of all humankind, for the benefit of society as a whole, not for the benefit a small group of bankers. Money actually prevents us from doing this.
Anyway - I look forward to reading more :)
SpiritSkill said...
ReplyDelete"If I understand correctly Table 1 shows the banks' deposits with the central bank. If that is so, then isn't the advance of the loan to Mr Carrot an expansion of broad money?"
Yes - the advance of a loan is an expansion of broad money. The total money including deposits is 1,010,000 shillings, because there is now a deposit of 10,000 shillings of bank credit where there was none before, and the amount of (narrow) money remains unchanged.
I've used the term 'money' to mean MB (monetary base) i.e. all cash plus reserves at the central bank, and 'bank credit' to refer to deposits held by a retail bank customer. Do you think there are clearer, or less ambiguous terms to use, which still allows me to make a clear distinction between the two, and preferably are reasonably concise?
robert.horwood said...
ReplyDelete""In each case, the total amount of money is unchanged".
This is totally misleading!
The total amount of money is, most emphatically, changed (ie increased) by a bank whenever it makes a loan."
If you can accept my use of the term 'money' to mean cash plus balances at the central bank, then I am correct. I've found it essential to my understanding of banking and economics to distinguish between this type of money, and the amount which includes all bank credit.
I have no intention of denying the obvious reality that, as both you and SpiritSkill have said, the total amount of broad money has been increased when a loan is made. But as this is a more in-depth investigation of the banking system, I want to show that there is a distinction between the things which I'm calling 'money' and 'bank credit', and to show how they relate to each other.
In this case, Jay specifically asked whether the payment of interest causes the amount of money (meaning narrow money) to increase gradually, and my aim was to show that it does not. I hope that I have done so. Only the central bank can create new money - that is new deposits in central bank accounts or cash. That is an important concept to understand.
Jay said...
ReplyDelete"Already the cracks are present, the 1000 shillings in interest and fees paid by Mr Carrot to OBoS must have come from somewhere, in Table 5 we can see it came from the cash in circulation. It's obvious from this that eventually the banks would own all the cash in circulation and there would be none left for the population of Somewheria."
It's true that if the banks simply hoarded the interest payments that were made, they would eventually end up with all the cash. But they don't. They use it to buy goods and services, meaning that the cash gets back into the economy.
"In practice though, when many people are taking out money and buying stuff and it is being re-deposited, the banks will not owe very much to each other (compared to the amount transacted), so their BoS deposits will remain fairly stable."
This is a really important and good observation. This is how fractional reserve banking can actually occur. If everyone had their own account with the central bank, there could be no fractional reserve banking, because each transfer of bank credit would cause a corresponding transfer of money between accounts at the central bank. That could be done, but we'd just have a monopoly bank, and that probably wouldn't work in the customers' interests.
"This means the total amount loaned out can be much higher than their deposits at BoS"
Correct.
"Since the banks are charging interest on all of this money (...) they are effectively creating money (the interest never existed before)"
For the purposes of this bit, when I say money, I'll mean money plus bank credit, as you are doing.
In fact the interest is not created - the "Money as Debt" film is correct when it says that only the original loan - the principal - is created. The interest has to be paid for from money obtained elsewhere. When the principal is repaid, the same amount is destroyed as was created originally. But the borrower still owes money (the interest) to the bank. The easiest way for this to be resolved is for the borrower to provide goods or services to the bank in exchange for money which can be used to pay the remaining debt.
"Another way of looking at it is that they are creating 'debt' rather than creating money - which (I believe) demonstrates the point that money and debt are basically the same thing."
The debt and the money are created at the same time. The debt is an asset of the bank, and the money is a liability. In return for taking the risk of losing the money lent, the bank gets in return a net transfer of wealth to itself from the borrower - the interest. As long as the borrower understands what he is getting himself into, it seems a perfectly reasonable transaction to me. If the borrower doesn't like it, he always has the option to save up money before spending it instead, and never being in debt.
"If you can accept my use of the term 'money' to mean cash plus balances at the central bank, then I am correct. I've found it essential to my understanding of banking and economics to distinguish between this type of money, and the amount which includes all bank credit".
ReplyDeleteBut that is precisely what I do not accept.
I accept only the amount which includes all bank credit as money, and it is that which I refer to as the money-supply.
So we appear to be in complete agreement that that quantity is increased whenever a bank issues a new loan.
Personally, I don't see the point of the narrower definition of money-supply which you are using (or not, at least, in the particular context of a discussion of fractional reserve banking). If I have understood correctly, you see it as important to preserve a clear distinction between narrow money and credit. To me it's simply all money, because it's all used (without any differentiation) as a medium of exchange and that's all that counts for the purposes of this discussion.
robert.horwood said...
ReplyDelete""If you can accept my use of the term 'money' to mean cash plus balances at the central bank, then I am correct. (...)"
But that is precisely what I do not accept."
Sorry for the confusion. I'm not asking you to accept that what I'm calling money is the only thing that it makes sense to call money. All I'm asking you to accept is that in my posts, I've called all cash plus all balances at the central bank "money". It's easier than writing "the monetary base", and I thought it would be less intimidating and less confusing than writing simply "MB".
"So we appear to be in complete agreement that that quantity is increased whenever a bank issues a new loan."
Yes we are - when a bank issues a new loan, new bank credit is created, and for most purposes this is indistinguishable from MB money. It can be spent on goods and services in the same way as cash can.
"Personally, I don't see the point of the narrower definition of money-supply which you are using (or not, at least, in the particular context of a discussion of fractional reserve banking). If I have understood correctly, you see it as important to preserve a clear distinction between narrow money and credit."
That's right. I think it's a useful distinction to draw when going through the examples of the bank's balance sheet. It helps to explain how the bank loses money if its loans are not repaid. It's also a useful distinction to bear in mind when thinking about the situation of an insolvent retail bank. If you have £51,000 on deposit at a retail bank, which is or becomes balance sheet insolvent, you are not guaranteed to get it all back because all you have is a promise to pay you MB money, not the money itself, and the FSCS only guarantees £50,000 of deposits "per person per firm". Distinguishing MB money from bank credit also shows how bank insolvency leads to someone else - other banks or taxpayers - losing money to pay the compensation.
When you said in reply to my comment that the banks don't hoard the interest and they use it to buy goods and services I think you missed my point, of course the bank has expenses to pay: employees, cleaners, courier services, stationary, postage, buildings costs, etc. - my point was that overall they make a net profit (a lot of it), and the profit comes from charges and interest minus their costs.
ReplyDeleteOf course with the costs being spent back into the economy it simply means the inevitable (i.e. the banks own all the shillings in Somewheria) will take slightly longer, but it's still inevitable. Remember even with written off loans, they still make a profit, the banks don't pay for bad debt, their other customers do.
You accepted my second point about the amount of money being lent out (and interest being charged on it) being much larger than their narrow-money deposits, the point here was that this greatly increases the speed of the inevitability mentioned above. They can amass all that wealth and control much quicker because of it.
http://www.debtdeflation.com/blogs/2010/10/08/ami-talks-in-flv-format/
ReplyDelete"I think you missed my point, of course the bank has expenses to pay: employees, cleaners, courier services, stationary, postage, buildings costs, etc. - my point was that overall they make a net profit (a lot of it), and the profit comes from charges and interest minus their costs."
ReplyDeleteOK - so after the bank's costs have been met, there is still a profit. But consider what happens to the profit. It doesn't just accumulate at the bank. It's given out to shareholders as dividends. After all, there's no point accumulating money that you will never spend. The shareholders then spend those dividends on things that they want, allowing the money to circulate back through the economy.