13 and 19 March 2016, translated from Dutch by the author
People think that when they borrow money from a bank, it is the neighbour’s money they get (or somebody else’s who lives in the same street, neighbourhood, city of country; but it’s the basic idea that counts). The bank is an intermediary between those who have money but temporarily don’t need it, and those who need it right now but do not have it themselves.
But people also hear about money creation. When a bank provides a loan, money creation occurs. The bank makes the money themselves. So it does not come from the neighbour! The bank is cheating on us all. The bank is playing fast and loose with money that doesn’t really exist, but that the bank made up, just by typing some numbers into a computer.
That’s what people say, which is increasingly used as propaganda, and what more and more people incorrectly assume is an accurate representation of what happens. In the series of articles of which this is one, I have tried to make clear, in several ways using all sort of wordings and examples, that these two things are both true:
Yes, money creation is real, and always takes place when a bank grants a credit to a member of the public (a person, household or company).
And yes, the money a bank lends comes from depositors.
How can it both be true? Aren’t these two statements fully opposed? No, they are not. The contradiction is only apparent. We have a paradox here.
Although as said, I mentioned the paradox in several of my articles already, I am going to focus on how it can exist: a bank that passes savers’ money on to borrowers, although money creation exists.
In my very first article on money creation I looked at an example with cash money. A saver literally takes money into the bank. Sometime after a borrower gets part of it handed over by the bank and takes it out, again in tangible banknotes.
Critical comments are to be expected: in this day and age we have computers, nearly all financial transactions are electronic, money is largely plastic money. Some state that the way banks lend money has also changed completely. My articles therefore are childish and obsolete, because I base my examples on the situation of a 100 years ago, I failed to keep up with the times.
Really? What I understood no sooner than in my tenth article – that a bank can simply add the same amount to the left and right of the balance sheet to effectively book a loan – is that really new and essentially different from what happened in cash in olden times? Have banks started cheating only recently, and did governments let them get away with it? And do we all suffer as a result?
No. Because old-fashioned cash and modern electronic situation are equivalent. They are nearly identical, because the only difference is: central or non-central. And in fact not even that.
I’ll show you, using step-by-step comparisons.
In the cash example, the future saver first had banknotes. Those represent a claim on the issuing central bank. The saver deposits the banknotes in a savings bank, and in return has a claim on that bank.
For the money supply, this makes no difference. So no money destruction or money creation took place. The only money there was, were those banknotes in the hands of the future saver. That was a claim of a member of the public on a bank (on this case: the central bank), so it is money in the monetary sense.
When deposited in the bank, the banknotes are no longer money – still a claim on the central bank, but the non-central bank is not a member of the public. The saver – who is a member of the public – because of his deposit now has a claim on the bank. That claim is money.
The total money supply has not changed.
That was the old-fashioned way. The modern, electronic equivalent is that the future saver has the amount in a transaction account at a different bank than the savings bank. To deposit it in the savings bank, a money transfer takes place from one bank to the other. (Or in America: something with cheques or whatever the exact method may be. But the effect is the same.)
As a result, the amount is in a savings account at a savings bank: so the saver has a claim on that savings bank. The money transfer involves that the new bank is compensated with regard to the other bank, for taking over that claim, the claim of a member of the public. Using a clearing house or some similar mechanism this results in an extra claim of the savings bank on the central bank. The central bank in turn has a claim on the bank where the saver originally held the amount.
The amount in the savings bank’s account at the central bank plays the same role as the deposited banknotes that the savings bank put in the vault. Both that account and the banknotes represent a claim on the bank. From a bookkeeping point of view it is the same: the only difference is the physical form: banknotes versus a balance recorded in a computer.
In the electronic example as in the cash situation, the money supply has remained equal: the saver first had a claim on one bank, now on another. The bank’s claims don’t count, because banks do not belong to the public.
In the cash example, the loan was paid out to the borrower in banknotes, which he took out of the bank right away. Changes in the bank’s books affected only the debit side of the balance sheet: assets in the form of some banknotes changed character to become a claim on the borrower.
This transaction changes the money supply, so money creation has taken place. The saver still has the claim he obtained by depositing banknotes. But the borrower has banknotes in his wallet that were first in the bank’s vault or till. There, they were not money (because a bank is not part of the public); in the hands of the borrower they are (M1), because the borrower belongs to the public.
The value of the money (in the non-monetary sense of the word) remains the same (in the bank vault, they were also valuable), but the amount of money in the monetary sense, the money supply, has changed because banknotes moved into the hands of the public.
This is a clear illustration of my statement that money creation makes nobody any richer. Money creation is real, but is a consequence of the monetary definition (which is what it is for a reason) of money.
The electronic equivalent of a loan that is withdrawn immediately, is that the borrower requests to transfer the money to a different bank right away, in order to pay for something or to put it in an account at that bank and leave it there.
The effect of such a money transfer is the reverse of what we happened at the time of the electronic deposit: the bank’s balance at the central bank decreases. Now too, changes only take place at the debit or left side of the balance sheet: part of the bank’s claim on the central bank becomes a claim on the borrower.
Again, the cash case is essentially the same as the electronic case: cash leaves the vault (so a smaller claim on the central bank remains), versus a decrease of the bank’s balance at the central bank (also meaning a smaller claim on the central bank). The difference is only formal: banknotes or account.
Also when it comes to money creation there is no difference between cash and money of account: the saver keeps his claim on the savings bank, the borrower (or someone he paid) has a claim on the different bank. In total, more claims on banks by the public exist: so money creation has occurred.
On the balance sheet of the savings and credit bank we see the loan at the left, and the savings at the right. So it is actually true that the borrower borrowed the money, via the bank, from his ‘neighbour’. But it is also true that money creation actually happened.
For simplicity’s sake in my cash example I assumed an initially empty bank, a bank with no capital reserves and no cash reserves. But of course such a bank won’t get a banking licence, and shouldn’t.
For the example I am going to discuss now, a cash loan that the borrower does not use right away, we must depart from a more realistic situation, in which the bank already had some reserves, including ready cash. So the bank can pay out the loan in cash. But in this scenario, the borrower doesn’t need the money at once. The purchase will happen only next week. So the borrower returns the money to the bank, right after receiving it, i.e., puts it in a bank account, in order to be able to withdraw it next week to pay for the actual purchase.
The bank records the loan (claim of bank on borrower) at the left (debit). That left side of the balance sheet is also where the cash is withdrawn, but immediately put back. No difference on balance. At the right side of the balance sheet (credit) the banks books the money deposit, which results in a bank-balance for the borrower.
Looking at money creation: it did happen now too, because after the transaction, both the saver and the borrower have a claim on the bank, and in a monetary sense of the word, that means: money.
The same example in money of account is very simple: we skip the steps of withdrawing and redepositing the money. These steps nullify each other anyway. Instead, the loan is supplied by simply putting it in a bank account right away.
It is still the case that the borrower borrowed the saver’s money, which is at the right of the balance sheet with the loan at the left. But you might just as well say that the borrower borrowed the money from himself. That’s because he didn’t withdraw it yet, but left it in the bank. So the bank can use also that money for financing loans, as a counter value for loans, including the loan of this particular borrower himself.
That is until the borrower is going to use the loan to pay someone, who has an account at the same or a different bank. If that someone happens to be the proverbial neighbour (or some other bank client, that doesn’t essentially change anything), we are back at the beginning: the borrower, with the mediation of the bank, borrows money from his neighbour.
Copyright © 2016 R. Harmsen. All rights reserved.