I am told that when banks loan out money sourced from their client’s funds, they are creating new money. How is that so? When someone takes out a loan, it is true that the loan amount is newly in circulation when it wasn’t before, but along with it comes the debt which didn’t exist before. So, shouldn’t the change in money supply = loan amount + debt amount = loan amount + -(loan amount) = 0?
Let’s say the person spends the entire loan amount on things that can’t be repossessed and defaults. This would still not create new money, because when the lendee defaults they are reducing the assets of the bank by the loan amount. i.e, it is as if the bank paid for whatever the lendee bought; no money was created, just traded for goods/services. What am I missing? When people say “increasing the money supply” do they just mean the money available to be spent in circulation, rather than actual new currency? Thank you!
In: Economics
TL;DR
The loan amount is an increase in general spending, and when the bank loans out your money, it’s as if that amount could be used again to buy things. Defaults don’t matter for this effect.
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Say you have $100 and decide to put it in the bank. In a world where the bank does not make loans, that $100 is effectively out of the system until you withdraw and spend it.
When the bank loans it out, that $100 can be used again by someone else.
Without loans, one $100 bill allows for one purchase of $100. With loans, it allows for $200*
The default rate is irrelevant to the increase in money supply (though it is bad for the bank, who will have to come up with $100 to pay you back!)
*this example assumes 100% is loaned out, and that it happens only once. In reality, only a fraction is loaned out, and it happens thousands of times.
What people usually mean by “reserve banking increasing or decreasing money supply” has to do with tinkering with “how much a bank has to keep in reserve from your deposit”. If they have to keep 90%, $100 becomes $111 in the total economy ($100 deposit allows for a $10 loan, which becomes a $10 deposit, which allows for a $1 loan, etc etc etc)
if they have to keep 10%, $100 becomes $1000!!
That’s the thing. The amount of money loaned by banks exceeds the amount of money actually existing. The banks don’t actually lend money. You don’t see people walk out the bank with a wad of cash in their arms. They loan electronic numbers that can be used instead of real money. In reality, banks don’t have that much money on them. They bank on the very low chance that everyone will withdraw their funds at the same time and crash the system.
So, since they’re essentially working with imaginary funds, the bank can loan more money than it has. Then, even though they’ve lent sums of money that don’t exist, the borrowers pay back real money, hence covering the gap AND adding a bit of extra dough via the interest.
Example: You have one dollar. You work with an electronic system, no real cash. You say you have two. You lend the same dollar to two people, with a 10% fixed interest rate. In reality, you didn’t lend them shit. The paper dollar is still in your pocket. But you gave them an electronic code that can be used instead of the dollar. They each pay you back 1.10 dollars. Now you have one dollar in your pocket, and 2.20 virtual dollars. Congrats, you just made 2.20 dollars from nothing.
So yea, banks really are making money out of whole cloth, but apparently it’s fine, since the treasury and gvt agrees with it.
In the case of non payers, banks don’t really give a fuck. They’re covered by the gvt and maybe some insurance company. The schmoe goes to jail, while the bank gets its pay from someone else.
Is this system sustainable in the long run? Fuck no. Best example of this is the 2008 housing crash, where they loaned so much imaginary cash that nobody could pay it back. But they don’t care. They got their backs covered (see TARP program for example). So they plunder as much as they can, and when the system inevitably crashes, they wash their hands of the responsibility, and wait for the system to stabilize again.
When the bank loans out the money, it reduces the amount of cash on hand, but increases its assets which keeps balance. The consumer increases their cash on hand and also their liability, which keeps balance. The creation of money comes with the time value of money. Right now, the loan is worth more to the consumer than its cash value because of the potential for what can be done with it. Which is why the consumer is willing to pay interest when paying it back. At the same time, loaning the money is worth more to the bank than having cash on hand because of the potential to collect interest and increase their cash on hand over time.
Going back to the beginning: when the bank loans out money they reduce their cash and increase their assets, but because of the potential of collecting interest, the asset is worth more than the cash they loaned. Thus “creating money.”
The actual money they loaned is not created, however. It is someone else’s deposited money that they are using to make a profit in return for a small amount of interest paid out to the account holder. Which isn’t nearly as much as the bank collects, but since their is no inconvenience to the deposit account holder, it is an acceptable amount.
Edit: I accidentally posted before I was finished.
So, since the bank has so many account holders and so much cash on hand they can loan out money without actually reducing the account balances of any individual account holder. This is because if any single account holder wished to withdraw all of their money from their account, the remaining deposits can easily cover the amount of the loan without causing a cash deficiency. And, since no one is losing access to their deposited money while someone is getting a cash loan the amount of money available in the economy is increases.
Edit 2: To more directly answer your question. The money supply is increased, but no actual currency needs to be put into circulation.
> I am told that when banks loan out money sourced from their client’s funds, they are creating new money
B/c when the bank gives a loan, they don’t *lose* the money their clients deposited with them, it still exists, it can still be spent as credit – as long as the bank is solvent. Whereas the loan is brand new money in circulation. Reserve ratios exist b/c of this, they can’t loan out *all* the money they have for maximum profit b/c they need to hold enough to meet their client’s demands for withdrawals.
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