How bank profit affects the total amount of money

I've had a good question in the comments, and I think it's worth a complete post on it.

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)?

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:

Table 1 - All money in Somewhereia initially

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BoS to increase by the amount deposited), or withdraw cash (causing its balance at the BoS to decrease by the amount withdrawn), so there is little point in distinguishing between the two.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.

Table 2 - All money in Somewhereia after Mr Carrot withdraws loan

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.

Table 3 - All money in Somewhereia after Mrs Grape deposits cash in OBoS

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:

Table 4 - All money in Somewhereia after Mrs Grape deposits cash in IBoS

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:

Table 5 - All money in Somewhereia after Mr Carrot repays his loan with cash

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:

Table 6 - All money in Somewhereia after Mr Carrot repays his loan with a cheque

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.

Destruction of bank credit

We have examined the creation of bank credit in exchange for a promise to repay. For completeness, we should briefly look at the destruction of bank credit.

We have already seen some situations where bank credit is destroyed. Mr Smith's bank credit was destroyed when he paid a cheque to Mrs Jones or Mrs Apricot. However, in each case, the same amount of bank credit was created in the recipient's bank account, so the total bank credit in the system is unchanged.

Bank credit is also destroyed when cash is withdrawn, and in that case the total amount of bank credit does decrease. It will increase again if the money is subsequently paid into a bank account.

Finally, bank credit is also destroyed when a loan is finally repayed. The bank credit is reduced by the amount of the loan, and the corresponding promissory note is destroyed too.

More on "Money as Debt" and bank credit creation

Before going on to look at interest, it's worth looking a little more at bank credit creation, and why it's not just free wealth for banks.

The last post looked at the cost to the bank of creating new bank credit in exchange for a promissory note when it makes a loan. While the bank at first simply notes an entry in the borrower's account, what that actually does is to give the borrower control over that amount of the bank's money — he can then either withdraw cash (reducing the amount of money owned by the bank), or can write a cheque to someone who banks with another bank, directing the bank to transfer money to the bank of the recipient of the cheque.

What about if the borrower writes a cheque to someone who has an account with the same bank? Does that disadvantage the bank in any way, or is that a free meal ticket? Let's examine the accounts of that scenario. First, the bank before any loan is made:

IBoS balance sheet

Assets	shillings	Liabilities	shillings
Deposit at BoS	100,000	Money owed to bank owners	100,000
Total	100,000	Total	100,000

The bank has 100,000 shillings on deposit at the BoS. That is how much the bank is worth, and so that is how much is owed to the owners because, well, they own the bank.

Now after a loan of 10,000 shillings is made to Mr Smith:

IBoS balance sheet

Assets	shillings	Liabilities	shillings
Deposit at BoS	100,000	Money owed to bank owners	100,000
Promissory note (Mr Smith)	10,000	Deposit (Mr Smith)	10,000
Total	110,000	Total	110,000

The bank has a new asset – it is owed 10,000 shillings by Mr Smith. At some point in the future, assuming Mr Smith keeps his promise, he will give 10,000 shillings to the bank. However, the bank also owes 10,000 shillings to Mr Smith — he can take 10,000 shillings in cash (or transfer the amount) from the bank whenever he likes.

And finally, after Mr Smith writes a cheque to Mrs Apricot in exchange for a car:

IBoS balance sheet

Assets	shillings	Liabilities	shillings
Deposit at BoS	100,000	Money owed to bank owners	100,000
Promissory note (Mr Smith)	10,000	Deposit (Mrs Apricot)	10,000
Total	110,000	Total	110,000

Note that there is very little difference between this situation and the previous one. All that has changed is that Mrs Apricot has the bank credit instead of Mr Smith. The bank still has as much money as it had before – 100,000 shillings, so at first glance, it might appear that the bank is not disadvantaged in any way. But in fact the bank still has a liability to Mrs Apricot, who could withdraw the bank credit as cash or pay it to someone who has an account with another bank. The bank still has given up control of some of its money to another person, and that control could be exercised at any time. If Mrs Apricot decides to withdraw her entire bank credit as cash, the bank ends up in the same situation as in the last post where Mr Smith paid a cheque to Mrs Jones who had an account with another bank:

IBoS balance sheet

Assets	shillings	Liabilities	shillings
Deposit at BoS	90,000	Money owed to bank owners	100,000
Promissory note (Mr Smith)	10,000
Total	100,000	Total	100,000

Once again, the bank has only 90,000 shillings in money. It is entirely reliant upon Mr Smith paying back his debt in order to break even, and his interest in order to meet its costs and make a profit.

Summary

The creation of bank credit in exchange for a promise to repay is not a costless operation for a bank. It involves giving control of money to the borrower. We saw in an earlier post that if Mr Smith pays someone with an account at a different bank and then fails to pay back the loan, the bank owners lose money. Above we saw that the bank owners would lose money even if the borrower pays someone who banks with the same bank.

One major argument of "Money as Debt" is thus shown to be deeply flawed. The fact that banks can trivially create bank credit by writing an entry in a book or putting an entry in a computer database does not mean that bankers are evil top-hatted thieves who get something for nothing, steal wealth from others and force others to become indebted to them.

There is still the film's assertion that the existence of interest requires exponential growth in the economy. This argument will be discredited in a forthcoming post...

Creation of bank credit

Long before I understood that there is a difference between money and bank credit, I occasionally idly wondered how much "money" existed, whether that amount changed, and what happened when new notes were issued and old ones destroyed.

When I followed someone's advice to watch a 47-minute animated film on Google Videos called "Money as Debt" by Paul Grignon, I was dumbfounded. The film argues that the monetary system is fundamentally flawed: that it leads to people being permanently indebted to banks, and requires an ever-growing economy in order to be sustained, due to the existence of interest. I highly recommend watching it, because it contains some very important insights. (Go to video.google.com, search for "Money as Debt" and it should be at the top). But I strongly caution you not to take all that it says at face value, because it contains some fundamental errors, and I will argue that its suggested solutions to what it alleges are the failings of the current monetary system are not only deeply flawed, but actually extremely dangerous, and based on an incorrect analysis of the monetary system.

The next few posts will examine the arguments of "Money as Debt", and proceed to refute some of them. This will require several posts to discuss as it represents over two years of research on my part.

Summary of "Money as Debt" film

The film mentions money and bank credit, but being an introduction it does not dwell on the difference and refers to both as money. I wrote in an earlier post how money and bank credit are fungible — as long as a bank is not insolvent, you can spend bank credit on goods and services in exactly the same way that you can spend money, and you can convert between bank credit and money, so in many ways it is a valid approach for an introduction to the monetary system. But there are places where this simplification can be (deliberately?) misleading.

The essential points of the film are:

1. People do not know how their monetary system works.
2. Most money (actually bank credit) is created by private corporations, called banks.
3. When someone takes out a loan from a bank, the bank does not lend out money (bank credit) previously deposited, but creates new money (bank credit) simply by pulling it from a hat in the film's portrayal.
4. The new money (bank credit) is created directly from the borrower's promise to repay.
5. The bank is getting a free lunch by creating money (bank credit). It gets the borrower into debt to the bank, without having had to earn the money to lend the borrower first.
6. The existence of interest makes the monetary system sustainable only if the economy continues to grow exponentially, and therefore the system is a primary cause of our overconsumption and destruction of natural resources.

This last point is particularly serious, and deserves careful consideration. If we have created a monetary system which by its very nature causes us to destroy our futures, it needs to be changed.

It took me a lot of thought to realise that there is a subtle, but major, flaw in the argument.

Analysis of "Money as Debt" – Part 1

I fully agree with the film's argument that people do not generally know how the monetary system works, and that this is a bad thing. Since people who do work in the finance industry are responsible for the control of vast resources around the world, it is important that the people outside the industry understand what the industry is doing to ensure that their interests are being considered too. It would only take a small number of lessons at schools to explain how the monetary system works.

The film is also almost correct in that banks create money at the point of a loan being made. But in fact, the bank creates bank credit, and the difference is crucial. To understand why this is not a free lunch for the bank, here is an example scenario, based on the one in the film. We need to look at the balance sheet of the bank, showing its assets (what it owns) and its liabilities (what it owes).

Industrial Bank of Somewhereia (IBoS) has been created. It currently has no customers. But it has 100,000 shillings deposited at the central bank, the Bank of Somewhereia (BoS). Where that deposit came from will be the subject of a later post.

Here is the bank's balance sheet:

IBoS balance sheet

Assets	shillings	Liabilities	shillings
Deposit at BoS	100,000	Money owed to bank owners	100,000
Total	100,000	Total	100,000

The bank's first customer, Mr Smith, arrives. He wants to buy a car, so he can travel to work to earn a living. He signs a promissory note – a legally-binding document which states that he will pay back 10,000 shillings plus 5% annual interest over a period of 5 years. In return, the bank creates a deposit of 10,000 shillings in Mr Smith's bank account. Now the balance sheet looks like this:

IBoS balance sheet

Assets	shillings	Liabilities	shillings
Deposit at BoS	100,000	Money owed to bank owners	100,000
Promissory note (Mr Smith)	10,000	Deposit (Mr Smith)	10,000
Total	110,000	Total	110,000

Mr Smith can now buy his new car. Suppose he writes a cheque to the current owner, Mrs Jones. Also, assume that she banks with a different bank – Agricultural Bank of Somewhereia (ABoS).

As we have seen earlier, writing a cheque to someone who banks with a different bank requires a transfer of money to the other bank's account. So now the balance sheet of IBoS looks like this:

IBoS balance sheet

Assets	shillings	Liabilities	shillings
Deposit at BoS	90,000	Money owed to bank owners	100,000
Promissory note (Mr Smith)	10,000
Total	100,000	Total	100,000

After Mrs Jones pays Mr Smith's cheque into her ABoS bank account, and the cheque is processed through the cheque clearing system, the owners of IBoS no longer have 10,000 of their original 100,000 shillings in the BoS. By creating bank credit for Mr Smith, it obliges them to transfer money at Mr Smith's request. They are now entirely reliant upon Mr Smith to pay them money in order to get their 10,000 shillings back. If Mr Smith wrecks his car and then declares bankruptcy, the bank owners will have lost 10% of their money invested in the bank — the loan asset has to be "written off" (removed from the balance sheet), and the "Money owed to bank owners" would have to be reduced to 90,000 shillings.

As the film points out, it is very easy for IBoS to store an entry in a computer saying that Mr Smith now has a deposit of 10,000 shillings of bank credit. They seem to be getting something for nothing. But what we see above is that the film omits to mention what that entry actually means, namely that it obliges the bank to transfer money at Mr Smith's request.

Summary

New bank credit is created all the time by banks in the private sector in return for a promise by the borrower to repay. This bank credit can be converted to cash or can be transferred directly to another bank account using a cheque, debit card or a direct bank transfer. Creating the bank credit for a customer is giving that customer the right to withdraw or transfer money, so it is not a free lunch for the bank. Unless the borrower repays the loan in full, the bank (and therefore its owners) will lose money.

The effect of interest, and whether it requires continual exponential growth in the economy (quick summary – it doesn't) will be discussed in a future post.

Money, bank credit and wealth

Money is not wealth.

Bank credit is not wealth.

Wealth is what you can buy with money or bank credit - goods and services. If this isn't immediately clear, imagine a country called Somewhereia which has a population of 10, and produces exactly two things: flour (1000kg/year) and cheese (100kg/year). (The staple diet of Somewhereia is cheese pies). There are 1000 shillings of money in Somewhereia - some in the Bank of Somewhereia and some in cash.

Somewhereia is a dictatorship. The dictator of Somewhereia decides one day that he wants everyone to be richer. So he decrees on the first day of 2010 that the BoS and the retail banks double the deposits in each bank account, and that anyone presenting a bank note or coin printed or minted before 2010 at the BoS can exchange it for two new ones dated 2010, each for the same number of shillings as the original.

Is Somewhereia now wealthier? Clearly not. All that's happened is that a shilling dated from 2010 onwards is worth half a shilling from a date up to 2009. Everyone can buy exactly the same quantity of goods and services as before. If anything, the situation is a bit worse, because people had to put in effort to modify bank balances and take money to the BoS to exchange, when they could have spent that time and effort producing flour and cheese so that they could consume more cheese pies.

Wealth is generated when people produce more goods and services (that people wish to consume). For example, if everyone in Somewhereia works for 9 hours per day instead of 8, they can produce 12.5% more cheese and flour (assuming that the raw materials are plentiful), and so consume 12.5% more cheese pies. Or if someone manages to find a way to waste less flour when producing it, say by pouring it into bags through a funnel instead of just tipping it straight from a large sack, then there is more flour to go round and overall the people of Somewhereia are better off.

It all goes back to the axiom that in order for something to be consumed, it must first be produced, as discussed in an earlier post.

Cheques, debit cards and bank transfers

Last post discussed the idea that there is money, and there is what you have in your bank account which people usually treat as money, but is actually not the same thing, namely bank credit. This post describes a little more about the similarities and the differences between the two, and how they relate to each other.

First – what is money? It is cash (coins and Bank of England notes), and balances held at the Bank of England. Who has a Bank of England account? It used to be that anyone could have a current account at the Bank of England, but nowadays it seems to be only the government and the banks. (I'd be grateful if anyone could provide more information on that). I have read that there was a move in just the last few years to force other account holders to move to the commercial banks. I even saw that HMRC has been moved to Nat West (part of RBS), so if RBS were to be or become insolvent then collected taxes could well be lost.

Where do Bank of England notes come from? Well, the Bank of England essentially has an ATM. A bank can ask the Bank of England for a withdrawal. The Bank of England reduces the balance in the bank's account, and sends round a big van with lots of new Bank of England notes, which the bank can load into an ATM, put in the cashiers' tills, and/or put in the petty cash box. The same process can work in reverse - the bank can send back some tatty old Bank of England notes (which are then shredded) and have their balance increased.

Where the original balances at the Bank of England come from is a subject for another post.

So, banks have accounts with the Bank of England. Let's look again at the example from the last post, where I have opened an account with Lloydclays Bank of Corporation (LBoC). I paid in £20 in Bank of England notes (money), and had my account credited with £20 of bank credit. LBoC put the money in the till — it belonged to them at that point. What happens if I write a cheque for £10 to Fred Madeupname, who also has an LBoC account? It's fairly simple:

Cheque processing

1. I write a cheque showing the amount and my bank sort code and account number.
2. I hand the cheque to Fred.
3. Fred completes a paying-in slip showing the amount and his bank sort code and account number.
4. Fred hands the paying-in slip and the cheque to a cashier at his local branch of LBoC, who checks that the amounts match.
5. The branch send both slips of paper to a national cheque-processing centre.
6. The cheque-processing centre reads all the details from the paying-in slip and the cheque, re-checks that the amounts match, and sorts the cheque into a pile to be sent to LBoC in case manual checking is required later. It also adds an entry to an electronic file to transmit to LBoC at the end of the day indicating the amount to be transferred, which account's balance is to be reduced, and which account's balance is to be increased.
7. When LBoC receives the electronic file, it reduces the balance in my account by £10, and increases the balance in Fred's account by £10.

The end result is that my bank credit is reduced by £10, and Fred's bank credit is increased by £10. No money was involved.

Now let's instead assume that Fred has an account with a different bank, say Hong Kong of Scotland (HKoS). The process is almost the same, except that:

• The cheque sorting centre adds entries to two electronic files. LBoC are told to reduce my balance by £10, and HKoS are told to increase Fred's balance by £10.
• The Bank of England is notified that it must reduce LBoC's balance by £10 and that it must increase HKoS's balance by £10.

The Bank of England isn't interested in getting a notification of every single cheque written, so the amounts transferred are aggregated into a single transfer per pair of banks per day.

Note that in this case, there is a transfer of money. £10 was transferred from LBoC to HKoS — Bank of England deposits were modified.

Debit card processing and bank transfers

Let's say I use my LBoC debit card at Sainscose to pay for some shopping. What happens then? Well it's basically the same as the cheque processing, except that the whole thing is electronic, outsourced to a card-processing company, and quicker.

If Sainscose banks with LBoC, my account balance is decreased, and Sainscose's is increased. No money is involved, only bank credit.

If Sainscose banks with HKoS, my account is decreased, Sainscose's is increased, and a transfer of money takes place at a suitable point between the accounts of LBoC and HKoS at the Bank of England.

The same is true for bank transfers (BACS). Bank credit accounts are increased and decreased, and if the accounts are held at different banks, a money transfer is made between the respective banks' accounts at the Bank of England.

Bank credit vs money

We've looked at cheques, debit card payments, and bank transfers. As far as the bank account holder is concerned, there's very little difference between spending cash and spending bank credit. Cash and bank credit are pretty-much fungible — they can be used interchangeably when paying for goods and services. Cheques, debit card payments and bank transfers are very convenient in that they avoid the need to withdraw money, give it to the recipient, and for the recipient to deposit the money in their bank. But always remember that money and bank credit are separate things — bank credit relies on the bank being able to honour its promise to pay.

So far, we've only looked at bank credit being transferred or exchanged for cash. And cash can only come from deposits at the Bank of England, so unless there is something else we haven't yet considered, the amount of bank credit is limited to the amount of money in the system. In fact, there is something else, which will be the topic of a future post.

I know how much money you've got in your bank account

The answer, assuming you're not a bank or the government, is none at all. Let me explain.

A long time ago, banks used to issue their own bank notes. The banks promised to pay the bearer of the notes, on demand, the amount of "real" money that the note promised, say in silver coins. It was the bank that guaranteed the value of the notes, and if the bank became insolvent (i.e. owed more than what it was owed plus what it had in its vaults), the bank notes could not be paid in full. But since the advent of central banking, with Bank of England bank notes, that arrangement is long gone. Or is it?

What happens when you open a new bank account? Actually it's quite simple.

You go to your local branch of Lloydclay's Bank of Corporation, and ask to open a current account. They say, "certainly" (as long as you promise to deposit £1,000 per month). You decide to hand over two £10 Bank of England notes. What happens then? Are those notes stored somewhere for you, so that when you ask for them later, you can get them back?

No. That's not the way it works. What happens is that the bank makes a note in a book (or these days in a computer database) that it owes you £20. It then uses the £20 in Bank of England notes in whatever way it decides to. For example, it could lend them to someone else, or give them to someone else who wishes to withdraw £20 which they deposited earlier. What you've actually done is exchanged money (Bank of England notes) for bank credit. The bank promises to pay you money if you ask for it. But it can only do that if it hasn't lost the money which you deposited.

Imagine you're the first depositor. The bank then lends the £20 you deposited to someone who is setting up a company to manufacture pins. But instead of buying a pin-making machine, the borrower instead goes out, buys 10 pints of lager and drinks them. Now there's a problem. The borrower can't make pins, so he can't sell pins to make £21 to pay back to the bank (£20 plus interest). So when you walk into the bank to ask for your £20 back, the bank can't pay. So the bank credit is worthless. You exchanged some money (Bank of England notes) for a promise by the retail bank to pay you money later, but the retail bank can't pay you, so you lose. You'd have been better off stuffing the money in your mattress. Bank credit is directly analogous to a bank note issued by the retail bank - it is a promise by the bank to pay you in money (Bank of England notes) when you ask for it. But the value of the bank credit is entirely predicated on the ability of the retail bank to pay.

So having a positive balance in an account at a retail bank doesn't mean that you have money. All you have is a promise by the bank to pay you money if you ask for it and if the bank has enough money to pay you.

This situation is highly unsatisfactory - it (rightly) causes people to panic easily. If a rumour goes around that bank X only has £1 million, but owes £2 million to depositors, then people who rush to withdraw their deposits will get all their money back, while the slower ones will get nothing, so a bank run ensues. Two important safeguards are in place for (some) depositors:

1. Banks are required by law to maintain capital. This is a certain amount of money (or investments which can easily be sold for money, such as risk-free (cough!) government bonds) which the bank must keep in order to pay depositors in the event of losing money on their loans. In the case above, the bank made a bad loan to the supposed pin-maker, and so the owners of the bank (the shareholders) have to pay the £20 to you. As long as the losses do not exceed the capital, only the shareholders will lose money. But if the losses are greater than capital, someone else will lose money. This requires a second line of defence for the depositor:

2. In the UK, the Financial Services Compensation Scheme (FSCS) is a government-run guarantee of some deposits for individual and some other types of depositor. (Similar schemes operate in other countries e.g. FDIC in the USA). When a bank cannot meet its obligations, the government takes money from other banks and building societies to pay back the depositors of the failed bank, or if absolutely necessary takes money through taxation to pay.

I want to emphasise again: if the bank's losses are greater than the bank's capital, someone else will lose money. The only question at this point is who. Because the government has decided that depositors will be protected, the money is instead taken from other banks or building societies, or from taxpayers. This is actually a subsidy from good banks and building societies which manage their risks well and/or from taxpayers to bad banks which chase slightly higher returns with much greater risk.

In principle, the FSCS ought never to be invoked. The shareholders, who would lose their capital in the event of the FSCS being used, should prevent the bank from losing this much money. But if the bank's directors and employees can make high-yielding loans that look like a reasonable risk-reward compromise to shareholders in the short run, and they pay themselves big bonuses as a result, then the shareholders may not be able to organise themselves quickly enough to prevent the losses.

This blog has looked at money and bank credit. In a later post, I'll discuss the different forms of money. It's not just bank notes, you know, but it's not much more than that.

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Update [2015-03-23]: Removed description of Bank of England notes as "real" money, as it is controversial, but not particularly important here.

My use of the terms "money" and "bank credit" have also lead to some controversy, as people have (rightly) pointed out that bank credit is a form of money. (In the UK, bank credit is counted in the M4 measure of the money "supply" or, as I prefer to say, the quantity or stock of money. What I have called money in my blog is the monetary base – money created by the central bank.) My intention is to use simpler non-technical terms here, since terms like "monetary base" used to make my eyes glaze over. But I do need to distinguish between central bank money and retail bank credit, since it is very important in understanding why the ability of banks to create money does not allow them to consume without producing.

What gets consumed must have been produced

In my studies, I've found that understanding economics is made much harder by considering money.  It's often been very helpful to ignore the money, and concentrate just on the production and consumption of goods and services.

One immediate consequence for me of looking solely at the goods and services was that it became crystal clear that there is a fundamental law that in order for something to be consumed, it must first be produced.  Perhaps that seems obvious, or perhaps it just seems obvious in retrospect, but when the communiqué of the G20 talks in London was published, it seemed as though we were supposed to be impressed by the "$1.1 trillion dollar programme of support to help the world economy through the crisis and to restore credit, growth and jobs." But the G20 leaders were producing exactly nothing themselves.  At best, their actions would encourage others to produce more than they would otherwise have done.

The next step is to consider not just total world production and total world consumption, but what laws govern the production and consumption of individuals and groups. First I'll consider a situation where there is no coercion and no ability to store goods. Then I'll show how coercion affects the relationship between production and consumption. Finally, I'll introduce storage.

Production and consumption without coercion or storage

Any individual or group (family, organisation, town, public sector, private sector, nation, world, universe) can consume:

What they produce
minus what they give in trade
plus what they receive in trade
minus what they give away as a gift
plus what they are given as a gift

Pretty simple, but quite profound. Remember, this applies to any individual or group.

Production and consumption with coercion, but no storage

Once we introduce the idea that an individual or group can take from another individual or group, perhaps by force, deception or theft, we have a small modification - in bold.

Any individual or group can consume:

What they produce
minus what they give in trade
plus what they receive in trade
minus what they give away as a gift
plus what they are given as a gift
minus what is taken from them through coercion
plus what they take from others through coercion

Production and consumption with coercion and storage

Finally we consider storage. For example someone could decide to forgo consuming ripe strawberries now by making them into jam, thereby reducing current consumption below their level of production. But they can eat the jam later, thereby increasing consumption beyond their level of production. Again the modification is in bold.

Any individual or group can consume:

What they produce
minus what they give in trade
plus what they receive in trade
minus what they give away as a gift
plus what they are given as a gift
minus what is taken from them through coercion
plus what they take from others through coercion
minus what they set aside for storage
plus what they take from storage

Note that storage can never be negative - it is not possible to consume storage which has not yet been produced. I'll discuss debt (consume now, pay later) in another post.

And that's it. This is a fundamental law of economics, but one which needs to be kept constantly in mind when economists, politicians, bankers and journalists discuss policy. Borrowing money, setting interest rates, bailing out banks, taxing more or less, stimulation or austerity - not one of these monetary or fiscal measures can change this fundamental law by allowing the consumption of a good or service to occur in the absence of its having been produced.

Introduction

I'm a mathematician (by education) and software developer (by career), not an economist, but like many others I've been taking a very active interest in economics since 2008. I now feel as though I understand economics and banking reasonably well. The reason I'm setting out on writing a blog is that, with my new-found knowledge, I have started to realise that far too many economic arguments on news and current affairs programmes are of dubious logic or even blatantly untrue, despite in some cases having a ring of plausibility. I would like to counter this by helping others to gain the same understanding that I have acquired, which now allows me to see through the dubious reasoning which is common (though not pervasive), even in places such as BBC Radio 4 and Bloomberg. Having recently gone through the learning process myself, I hope that I can make the process easier for people who wish to understand economics better without having to try to figure it all out for themselves from a variety of good and bad sources.

In the years leading up to 2008, I had a growing sense that something seemed terribly wrong: I had been saying for years (based on intuition) that house prices had to drop because average house prices were so much higher than 3 times average combined incomes, and yet they continued to increase with no end in sight. I began to ask myself whether my simplistic understanding was wrong; perhaps the increased desire for housing, cited so often as the reason that house prices would continue to rise so quickly for many years, meant that this really could continue.

Then in summer 2007, there was talk of the investment bank Bear Stearns being in trouble over sub-prime mortgages, and there being a "credit crunch" in which banks weren't lending. It was apparently just happening in the USA at that point, but still somewhat ominous.  In October 2007, I saw an opinion piece in the Financial Times arguing that it wasn't just an American problem - the author gave examples of four acquaintances of his in the UK who had taken out mortgages which they were unlikely to be able to pay, in one case having £1,000,000 of negative equity from buying several apartments.  At 07:00 on one day in December 2007, the Today programme on Radio 4 reported on an IMF study predicting an imminent "perfect storm".  (I was barely awake for the 07:00 news, and the story mysteriously wasn't mentioned later on in the programme - I had to check the IMF web site to convince myself that I hadn't dreamt it).

In February 2008, a work colleague told me that the Federal Reserve in the USA was unconstitutional, and that fractional reserve banking was a multi-generational scam to keep people in perpetual debt slavery.  He said I should watch an animated film on Google Video called "Money as Debt", and read "The Creature from Jekyll Island" by G. Edward Griffin about the creation of the Federal Reserve.  It seemed convincing - if money is created in exchange for debt, but the debt increases (due to interest) while the amount of money doesn't, it seems that borrowers as a whole can never repay their debts.

A little later in 2008, I came across Karl Denninger's Market Ticker blog.  He's been blogging since 2007 about what he says is rampant fraud in the finance industry in the USA.  He's also someone who defends fractional reserve lending, which gave me a great opportunity to compare the two sides.

Since then, I've been spending a lot of time reading about finance and economics, doing thought experiments, and generally trying to understand the subject better.  I must have put in more effort than I did into my bachelors degree, and I believe I now have a good feel for macroeconomics, and that I can judge for myself - based on my own understanding - the truth or falsity of economic arguments made or reported in the media.

What I want to do with this blog is to help to create an environment in which people like myself - intelligent but with no formal background in economics - can sort out the wheat from the chaff of economic reporting and opinion.  I'll be presenting some (hopefully uncontroversial but often ignored) starting points and using them to see what we can understand about the economy as a whole.

I also want to get feedback so that I can continue to learn.  I've already had to change my opinions as I've learned more, and I'm quite happy to do it again as long as it increases my understanding.

Welcome to my blog.