I have published this next video in the Economic Truths series this morning. In it, I argue that if bank loans create money, then repaying those loans destroys money. The money in question literally ceases to exist. That is one of the hardest economic truths to get our heads around.
The audio version of this video is here:
The transcript is:
Repaying bank loans destroys money.
It's another of those economic truths that doesn't make a lot of sense until you really think about it. But it has to be true because all the bank created money in the UK gets into our economy because the bank lends money to borrowers.
When the bank lends the money to a borrower, there's an exchange of promises. I've explained this in other videos.
The bank says to the borrower, I will lend you £10,000. And the borrower says, I will repay you £10,000. It is that exchange of promises that are recorded on a keyboard. One is a positive number in a current account. One is a negative number in a loan account with the two together adding up to zero, indicating that this new money is made out of thin air.
And as a consequence of that process, this new money is available for the borrower to spend. And they do spend it. And as a result, as again I've explained in another video, savings are created. The loan eventually must give rise to a saving because the banking system has to balance.
So, what happens as a consequence of the loan being repaid? The money that was created is destroyed.
I stress that word destroyed. It just doesn't quietly disappear. It literally no longer exists, because the promises that created that money have been fulfilled. If money is about a promise, and that is all it is because all money is debt, then once the debt is repaid there can be no more money. It is as simple and straightforward as that.
The money that did exist because the loan was created. now no longer exists because the loan has been repaid.
This has enormous consequences, however, for our economy because what you can immediately see is that when we are dependent on only two types of money in our economy, one created by the government which will be the subject of other videos and the other - probably the bigger part in most economies including that of the UK - created by commercial banks as a result of their making loans to people like, well, you and me, we are entirely dependent on this money created by loans. Then what happens is that if all loans were repaid, we'd have no money left.
That is why we live in a debt-based economy. Because we have no other idea about how to create the money we need to undertake our day-to-day transactions. And, therefore, we are dependent upon people continuing to borrow money from banks in the economy to make sure we have a continual supply of new money to replace that which is repaid day-in-day-out by borrowers to banks, with their loans being cancelled as a consequence and money disappearing as a result. So, we have to live in a credit economy, and we have to live in an economy where people borrow.
But that's really worrying because, as we all know, in economic downturns, people don't borrow. They lose the confidence to do so, they don't go out and spend, and as a result, the money supply falls. And that is why we get recessions.
So, what we need inside any economy is a system of balance, which is that when the economy is doing well, and banks create lots of money because people want to borrow, we have a situation where the money supply is strong. And therefore, the government doesn't necessarily need to inject a lot of money into the economy.
When the economy is weak, when people don't want to borrow, when there's a threat of recession, when people feel it's too risky to actually take on another repayment of whatever the loan might be for, then the government has to inject more money into the economy to make sure it all works.
How do we know this happens, and what's the evidence? Well, it's very simple, really. After 2008, when there was the global financial crisis, people did not want to borrow. Banks were at risk, they looked pretty dubious, people felt very nervous about the state of the world, they didn't want to go out and borrow money to buy anything, and therefore, the government had to create vast quantities of new government-created money to inject into the economy to simply keep it moving.
Quantitative easing did that. That's what it was for, it made good the shortfall in bank lending to ensure that there was enough credit money available in the economy to keep it functioning.
And the same happened all over again when we had COVID. Because for exactly the same reason, people weren't borrowing. They couldn't even get to a shop to borrow, to buy, to do anything else. And, therefore, the government had to shut down. There was nothing unusual, nothing wrong, sinister, or to be worried about about this process. It was just the government filling in where the commercial banks frankly failed, and people didn't want to borrow.
And they had to fill in because the commercial bank loan repayments were going on because that's what the loan agreements required.
So, the economy was at risk of running out of money and the government made good the shortfall.
The reason why there was that risk It was because when a commercial bank loan is repaid, whether it's a loan, whether it's a mortgage, whatever it's for, when it's repaid, the money that was created by it is destroyed. It's gone. It's disappeared. It's as if it never existed because the promises that created it have been fulfilled. Over and done with. Finito. Ended.
And you have to understand that if you're to understand why we live in an economy where credit has to always be produced or the government has to make good the deficit and that there's nothing sinister about the government doing that. It's just necessary to make sure there's cash in the economy to keep us all going.
We'll deal with government money creation in another video. For the purposes of this video, the fundamental point is repaying a bank loan destroys the money that it created.
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Germans are famously not that interested in Consumer Credit so how does their money supply work?
Loans to business
As a single sentence you are right, more bank loans to business in Germany will offset lower consumer credit to some extent…. but I think this is a bit more complicated.
First, Germany does not have its own currency so, as a start we need to look at the Eurozone as a whole.
Adjusted for size, the Eurozone money supply is (a bit) smaller than in the UK. Countries (or currency zones) that have a lower propensity to borrow will have a lower supply of money.
Second, we can look in a bit more detail at Germany by looking at TARGET balances. Each German bank will have a bank account (Reserve account) with their National Central Bank (Bundesbank); each Italian bank will have an account with the Bank of Italy. The Bundesbank and Bank of Italy each have an account at the ECB. When an Italian buys something from a German their bank account with (Bank A)will be debited, Bank A’s account at the BoI will be debited, the BoI’s account at the ECB will be debited. The Bundesbank account will be credited… and so on until the German gets a credit in their bank.
Given the trade surplus, the Bundesbank’s account at the ECB is in credit to the tune of EUR 1 trillion. (The BoI is in deficit of EUR 400bn). This is not a problem as Bundesbank/BoI are “branches of the same bank” (well not a problem unless the Eurozone breaks up – indeed a EUR 1trn reason why Germany will maintain the Monetary Union) but this (im)balance is, in effect, German lending to the rest of Europe… which creates deposits/money in Germany.
A bit complicated…. but you did ask!!
And thank you
“Countries (or currency zones) that have a lower propensity to borrow will have a lower supply of money”.
I presume the lower propensity to borrow in the Eurozone is a function of Britain’s propensity to borrow principally to mortgage houses. I will not go on to describe the state of Britain’s housing, the dilapidated state of the housing stock, and the black hole in the building programme that Rayner’s reforms, and build ambitions will not begin to address.
@Clive Parry,
Thanks for your most excellent post explaining EU banking.
This truth, destruction (and creation in an earlier video) of money by banks is – and always is/will be – an unstable process. It is unstable because human beings prone to exuberance and fear. We are also social creatures and our emotions are driven by those around us so a tendency for boom/bust is inevitable. Keeping something in unstable equilibrium requires constant attention and will end occasionally in failure…. and failure is damaging ; not an intellectually interesting exercise but damaging to real people with real lives.
So, the neoliberal idea that the process of credit creation/destruction should be left to a free market is nonsense. Indeed, some MMT folk who think there should be no government borrowing/debt miss this, too. Government debt is an essential component to a smooth running credit system… and using interest rates and open market operations to control credit is an essential part (only part) of economic management.
I would also note that 2008 was a banking/financial panic not an economic crisis. Its roots were in the financial system and flooding the system with cheap credit prevented a financial crisis becoming a broader economic crisis (ie. 1930s style deprtession).
COVID was an economic crisis that could have become a banking crisis but didn’t. Flooding the system with money was temporary stop gap but it was Government spending (furlough etc.) that prevented depression.
My point is that every situation is different, few are solved by market forces, most need State intervention – sometimes monetary, sometimes fiscal (usually both).
Much to agree with
“Keeping something in unstable equilibrium requires constant attention”.
An ‘unstable equilibrium’ is an oxymoron. There is no equilibrium, as Minsky spent his life trying telling us; and we still do not hear. There is only the delusion of equilibrium.
We go on from one stupid crisis to the next, no because of “exuberance”, but because we have a commitment to acting first, to innovating, but never, ever looking back; and seeing the trail of destruction we leave behind, and do not even bother to repair. The destroyed communities of Thatcher’s ‘reforms’ are still broken and bust, and have not forgiven anyone. In the US, the rust belt States remain left behind, but have turned to Trump in wrath, and are delivering their punishment, effectively for the destruction of Main Street after 2008, by Wall Street. Wall Street doesn’t look back, or pay for trashing America, for the benefit of very very few. The earth itself is delivering its verdict on humans never looking back at what they have done; and transforming our climate. And our first priority? How do we make short-term profit out of it, and fudge the transition without anyone noticing.
Correct
Money takes a time, possibly years, to re-pay. During that time further loans are taken out so the amount of money in circulation will increase. I would suppose the total debt will also rise and that is not a bad thing but a consequence of how the system works. The ability to pay back also grows.
In other words there is a flow and ebb. Too much flow could be inflationary. Too much ebb could be deflationary.
Someone has to be responsible for the balance. Should that be the Chancellor or the central bank? Fiscal or monetary means? IMHO that are the issues.
I don’t think we have a clear strategy.
There IS a clear strategy…. unfortunately it is a strategy that does not work!
Currently, BoE is responsible, it only uses one tool (the level of rates). Without a bigger tool kit and some fiscal coordination is destined to fail.
In 2021, £7,352-billion in loans were made, and most will be paid back. But there is also interest to repay.
That money must come out of the economy and presumably go to bank shareholders.
Bank shareholders tend to be more wealthy than others, and their money does not recirculate.
We know this because between 2020 and 2022, the increase in wealth of UK billionaires increased by £150-billion.
And the Henley Private Wealth Migration report estimates that 128,000 millionaires are set to relocate this year.
In 2023/24 approximately 3.12 million people used a food bank.
In 2022, more than 800,000 patients were admitted to hospital with malnutrition and nutritional deficiencies.
The system works for the well off.
Hi Richard….I may be jumping the gun here given that you are going to blog on government money creation but what would an economic system run predominately on government money and not commercial credit look like?
Wait…..
” The loan eventually must give rise to a saving because the banking system has to balance”.
But why can’t the money just keep circulating I.e. the stock and flow of money? the stock will eventually be destroyed, while the flow will keep on circulating. The stock of money will be replenished while the flow keeps on circulating.
Economics is equal parts fascinating and frustrating.
I’m going to have to lay down
The money does keep circulating, but it remains a net positive balance until the time that the loan is repaid. In other words, it always contributes to the stock of money until the point of loan repayment, when it no longer does so. But it is not the circulation that creates stocks of money, it is the loan that does that.