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.