Intro textbooks typically wrong
Double-entry bookkeeping has been around for several centuries, and of course banks use it. Every debit has a matching credit, each loan a matching deposit. That intro Economics textbooks focus on the deposit instead of the loan has always struck me as rather weird.
Consider an individual commercial bank and view matters from its perspective …. in simplified fashion. Say the loan is a residential mortgage on a house to be lived in by the borrower. There is no disputing that the bank creates the mortgage (jointly with the borrower). It did not exist before, and with the loan being approved, now it does. ..As well, there is no disputing that the bank makes a matching deposit (minus some fees). But that money soon exits the bank, so the overall total on deposit at that bank does not change, except fleetingly, due to this new mortgage.
Now, this deposit was a transfer from another account within the bank, an internal account — and no, not labelled ‘magic money’ to indicate funds created from nowhere. Instead, call it a sort of slush account which must end each day with a zero balance. (Or call it a day account, as most bankers do.)
Banks normally have sizeable liquid assets, among them gov’t Treasury bills. So a transfer to the borrower’s account from the day account, putting it in the red, means the bank will sell a like amount of liquid assets in order to bring that account back up to zero, while maintaining the ratio of assets to deposits it feels safe to have. [Simplified example, remember.]
This is the same as when, on the day, withdrawals have exceeded deposits. ..Again, a liquid asset needs to be sold in order to get funds to zero out the day account plus restore the desired ratio of assets to deposits. …Of course, the reverse happens on a day when deposits exceed withdrawals, and some of the excess is used to zero out the day account, before buying a liquid asset, (if that is indicated.}
Asset Creation
In this way the bank alters its asset mix by replacing a lower yielding asset [which it sold] with one of higher yield [the mortgage]– but also exchanging a liquid asset for a long~term one. ..So it will earn more, provided the mortgage payments are kept up, that the mortgage performs well, putting this in bankers’ jargon.
Liquid assets are items readily sold. A new loan jointly created with the borrower is not a liquid asset (later, with a history of regular payments, it is sellable.)
Notice that total assets of the bank do not increase even though it just created a new financial asset. However, total financial assets in the economy do increase due to it. Asset creation is what a bank does when it makes a new loan, while the deposit is mere bookkeeping.
<<note:_ This can be viewed as a joint endeavour by bank and borrower. Say it is a mortgage: the borrower signs a contract agreeing to provide a series of payments over many years that in total will both retire the mortgage and provide a stream of interest income to the other party to the contract, who initially is the bank. (Who sometime in future may sell the mortgage on to a third party.) ..As payment for this new jointly created financial asset, the bank deposits into the borrower’s demand account the agreed amount the mortgage is for. In doing so it is in effect buying that stream of future income. ..This is what ‘lending’ amounts to: ..the creation and purchase of a new financial asset. >>
Consider: __ The bank can only safely lend out a certain proportion of its total deposits. It must keep some reserve in order to meet the day to day demands of customers for withdrawals. And it likes to keep that reserve as fully invested as it can, as getting some interest on those funds, however little, is better than none.
The bank here is a mere conduit for money flow. …Stated simplistically: in this example it sells an asset to get the money it deposits in the borrower’s account, which is soon withdrawn by the borrower — the asset created is important to the bank, the money flow is largely not.
Money Supply
Yet, even though the money flow is of no immediate importance to the bank, it may be important to the economy. In a narrow sense the bank is augmenting the money supply as defined by economists as M1, and so may be said to be ‘creating money supply’. But this is not creation of money: it is merely shifting funds from one category to another. That is: ..It sells an asset that is not part of M1 and creates a demand deposit that is part of M1.
For many decades now many intro textbooks of Economics include the claim that banks ‘create deposits.’ Few would say an individual bank can do so. However, most do say that the banking sector, banks in aggregate, ‘create deposits’ and then these economists develop a ‘money expansion multiplier’ to depict the extent that this may take. Why create this multiplier?
Surely, if no bank alone can ‘create’ a deposit, why suppose a group of the similarly ineffectual suddenly can? ..This is like saying no man can have a baby, yet a parade of men can. It defies logic. ..What it overlooks is the obvious….. Banks accept deposits created by depositors.*
So where did they get the funds? From increased activity in that economy, for the most part. ..The money supply is elastic and expands to accommodate such enhanced activity.
Really, it is an expenditures multiplier that is involved: ..as spending creates income for others who in turn spend creating income for yet more people, and so on. ..This is not confined to bank lending as the means of creating expenditures. Leases likewise finance spending, as one example. ..Of course, businesses and individuals make deposits in banks from their enhanced revenues, but why credit banks for such deposits? …Why claim the banking sector ‘creates’ them? ..Such is a very peculiar perspective.
Bank lending creates a sizeable volume of new financial assets in an economy, and new assets allow new spending. ..But banks are not the only source of them, at least not without help. The companion item ..Types of Financial Assets.. discusses several more.
{* Dog walkers know that about deposits!}
___from the website…. regionalseats.ca/wp/
Deposits & the ‘money supply’
Let Logic Prevail About Inflation
That “banks create deposits” is a myopic perspective regarding the money supply that dates back to at least 1920 and a book by one Chester Phillips, a professor of Economics at Dartmouth in the USA. In his book Bank Credit the professor took great pains to dismiss the notion that any individual bank could ‘create’ a deposit.
So this naïve idiocy that has disgraced at least some Intro to Economics textbooks over the decades cannot be laid at his feet. ..He specifically stated that in order to make a loan, the bank must already have the funds on hand to make a matching deposit into the borrower’s demand account.
However, noting that bank deposits and loans rose more or less together, said professor did attempt to explain this phenomenon for banks in aggregate. ..He did claim the banking system created deposits even though no one bank could do so. This defies logic. ..If one bank cannot, then neither can a group of the similarly ineffectual. ..It is like saying: “No man can have a baby, yet a parade of them can.”
The process was indirect, the professor explained: any one bank making a loan put money into the borrower’s chequing account, which soon disappeared and then showed up as deposits in other banks, which enabled them to make loans. This was repeated with still other banks getting deposits that enabled them to make loans, etcetera.
In short, because depositors made deposits, banks were able to make more loans. He even developed a rather complex formula to show to what extent this could happen for the banks as a system. These days this is known as the ‘money multiplier’ and is a simpler formula. It is nonsense, but more on this shortly.
Financial assets
It is sloppy to claim ..banks are making these deposits, even if indirectly. What they are making are loans, and they are not ‘creating’ the money related to these loans.
What they are creating are financial assets in the form of promissory notes, mortgages, and the like. ..One way to think of this is the bank __ purchasing a stream of future interest income__ in the form of a loan, for which it pays the other party to the loan agreement, the borrower, the amount of the loan (called the principal) and puts that in said borrower’s demand account at the bank.
Now this may seem an odd way of putting it, but consider a mortgage contract. Canadian banks quite often bundle some mortgages together and then sell the bundle to a third party, usually a pension fund or insurance company, while still administering those mortgages on behalf of their new owner.
The mortgagees will have no inkling this has happened, since they are still dealing with the same bank in the same way regarding their mortgages. Canadian banks also guarantee a minimum return for each bundle to its purchaser based on the purchase price. ..Should that not be met some month in future, the bank will reconfigure the bundle by taking back some mortgages in arrears and replacing them with ones of similar value that are up to date with their payments. In that way the guaranteed return will again be met.
This more clearly indicates why such loans are financial assets, for they may be sold on. Or think of a really large loan for hundreds of millions of dollars to some corporation and running for several years.
It may be too large for comfort for one bank, so it offers part of it to other banks, thereby forming a consortium of lenders. As far more money is involved, it may seem more appropriate to call this a new financial asset in an economy, yet it is not that different from a mortgage really. And banks are not the only entities who create such financial assets. [see the item Types of Financial Assets.]
Banks like to keep fully invested, and typically hold sizeable liquid assets. So when the bank puts money in the borrower’s demand account, it may need to sell some sort of liquid asset it owns, such as a government Treasury note, in order to obtain the money for that deposit.
Considering only this one loan, this is an exchange of assets that leaves the bank with the same amount of assets as before. But it has sent one it formerly owned back out into the world, and so that economy experiences an increase in financial assets, all things being otherwise unchanged. This has implications.
Expenditures
Usually people getting loans want to buy something with the money received. So this financial asset newly created facilitates spending in an economy. Which is typical of other financial assets as well. And when the seller is paid, the money involved will often be deposited in some bank or other financial institution. The seller might soon also be buying something, if only inventory.
Spending begets spending, which is good for an economy, and the extent this reaches may be foretold by an expenditures multiplier. This is what matters, not the bank deposits which merely reflect increased spending activity. ..The so-called ‘money supply’ is elastic and normally of little importance. If it becomes important it will be due to extraordinary circumstances.
Ordinary levels of price inflation are due to increased spending allowing various vendors to charge somewhat more or discount less, especially in the goods and services supplied by oligopolists. ..The ‘money supply’ as such has nothing to do with it. What facilitates increased spending is an increase in financial assets within an economy, of which bank loans are only a part. The monetarist theory of inflation is obviously wrong.
To sum up: __Banks [and others] create financial assets, which increases expenditures and also creates the conditions for vendors to increase prices; depositors make deposits throughout all this spending. ..The ‘money supply’ has no connection with this except as a consequence.