Sunday, August 4, 2013

Banking Example #10: Balance Between Money & Debt

This example is meant to illustrate inside money creation, destruction, and the relationship between that and the creation and destruction of debt. It demonstrates these ideas through loan/deposit creation, principal & interest payments, and bank payments to the non-bank private sector via crediting bank deposits. It was inspired by the first answer to this question.

Setup:  One commercial bank (Bank A) and one person (Person x). No reserve or capital requirements and the bank.

 1. Initial balance sheets (balance sheets are clear, and thus equity = $0 for both parties):

Bank A, Person x
Assets Liabilities
$0 $0


2. Person x takes a loan for $100 from Bank A as in Example #1.2. Notice that both parties still have $0 equity. The inside money (bank deposits) are equal to the debt in the system. It's important to keep in mind that like in the first step of Example #1.2, there are two financial entities created here, each seen from two vantage points: the loan, and the deposit. The colors highlight this fact: each color corresponds to a different entity: the yellow cells are two views of the loan, while the green cells are two views of the deposit. Views on the right hand side are from the point of view of a debtor, and views on the left hand column are from the point of view of a creditor: so Bank A and Person x are both debtor and creditor to each other. The two financial entities (loan & deposit) happen to start off with equal values in this example, but they are independent from each other (or rather they are related, but have a degree of independence) and thus their values can change with respect to one another depending on what happens next:

Bank A
Assets Liabilities
$100 loan to x $100 deposit for x

Person x
Assets Liabilities
$100 deposit at A $100 borrowing from A


3. As per the loan agreement, Bank A charges Person x $15 for the 1st payment: $10 interest and $5 principal. Person x pays it. The principal payment destroys $5 of debt and $5 of inside money. The interest payment destroys $10 of inside money without affecting the debt. The interest payment upsets the balance between debt and inside money. This imbalance is equal to the equity of Bank A (and also to the negative equity of Person x).

Bank A
Assets Liabilities
$95 loan to x $85 deposit for x
Negative Equity Equity
----------------------- $10

Person x
Assets Liabilities
$85 deposit at A $95 borrowing from A
Negative Equity Equity
$10 ------------------------


4. Now Bank A pays Person x $10 for services that Person x has performed for the bank. This has no effect on the debt, but it creates $10 of inside money and it also happens to restore the balance between debt and money in the system (thus equity for both parties returns to $0).

Bank A
Assets Liabilities
$95 loan to x $95 deposit for x

Person x
Assets Liabilities
$95 deposit at A $95 borrowing from A


You can take Bank A as a stand in for the aggregate commercial banking sector. Person x can likewise be taken as a stand in for the aggregate non-bank private sector. The services that Person x performs for the bank are thus a stand in for all goods & services purchased from non-bank businesses for use by the bank(s) (e.g. office supplies, building maintenance, electric bill), bank employee salaries, bank shareholder dividends, and any interest paid by the bank to its depositors.

A common criticism of a bank created fiat money (inside money) system is that bank interest charges & fees upset the balance between debt and money in the system such that the debts to the banks can never be repaid. What this claim misses is that bank profits are redistributed back to non-banks when the banks credit deposit holders (to pay them).

If more banks were involved it would not appreciably alter this example. For example, if Person x held his deposit at another bank, then Bank A would need to transfer reserves to the other bank to pay him. The central bank may need to temporarily provide these reserves in the form of loans to Bank A, but Bank A could repay the central bank by borrowing these reserves from another source. This results in $0 net in permanent reserves needed. See Example 1 for how this works in the case of a deposit transfer (which is a related idea). Examples 1.1 and 5 may also be of interest.

If reserve requirements were non-zero, the central bank would have to create some permanent reserves as well, but only enough to match a fraction of the inside money deposits created. Ultimately this is not a terribly important detail. See Example 2 for more details.

5 comments:

  1. Hey Tom

    Followed a link of yours at Cullens over to Vincent Cates site and looked in on your discussion with him. I think you did a nice job with his theory and chose a very appropriate weak point, as I see things.

    First you commented on this;

    "And at some point the banks will be able to earn higher interest loaning to companies and people who will put the money into general circulation. Then they will redeploy their excess reserves and the money from Treasuries as they come due."

    And you made what I think is the right response about the only places fed deposits can go

    Then he said this... "Banks make money if we count demand deposits balances as money and the real money sent off in a loan. It is not that they really make money out of thin air. If it were just like that, why would a bank every go bankrupt? Why would they worry if people could not pay them back? Why not loan out infinite amounts at 1%?"

    And you answered with an explanation of capital constraints, which is certainly correct but I wonder if you might have missed something even more devastating to his argument. A bank is a private entity that wishes to make profit. Loaning out infinite amounts of money at 1% AND not worrying if they could be paid back are most definitely counter to the idea of making a profit. That would probably be the WORST model to use if you want to make a profit it seems to me. So until banks become simply interested in just trashing the economy, making a mockery of the money system and stop being banks I cant even fathom his thought experiment.
    I dont understand at all how he sees that as a rebuttal to the notion that banks make credit out of thin air.

    What do you think? Am I misunderstanding him? I did not read his entire page I confess. I just followed your link at Cullens and took an interest in your discussion with him

    ReplyDelete
    Replies
    1. Greg, I think you have an excellent point. I essentially told him by implication "regulatory capital constraints won't let you do that" but I think you're getting at something that's much more fundamental and should be a concern of ANY business: evaluating risk vs reward, and loaning out an astronomical amount of money implies you don't care about credit worthiness, which is a foolish risk. Nice!

      Delete
    2. Of course you are correct about the regulatory constraint but I wonder why he even wants to fathom a situation where a bank stops being a bank?

      Of course in our system where banks are actually issuing the govts liabilities for them this is something I guess the govt must consider. If banks were issuing their own liabilities in a free banking system I guess they would only commit suicide in such a scenario.

      Delete
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