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
“unstable equilibrium” does exist… a pencil will balance on its end… but any slight displacement and down it crashes. And that is what banking is like and what I was trying to get at.
I call that chance tyat it happened to balance, not equilibrium
well, that was what it was called when I did my “o” level physics…..
But I guess the key underlying idea is that
1) Banking DOES deliver useful things (eg. maturity transformation, diversification,). We need banks.
2) This is an unstable activity and needs regulation to reduce that instability
3) We need to get a balance where we reduce as far as possible the risk of failure… but still retain the “good things”.
That I accept
Clive,
In mechanical engineering, I understand there are three forms of equilibrium. Stable, neutral and unstable. Unstable equilibrium is explained, and an illustration offered, here: “An unstable equilibrium happens when the system tends to move further away from its original state when given a small displacement. At this point, the potential energy of the system is at its maximum. A cantilever beam deflected beyond its elastic limit is an example of this phenomenon; once it exceeds the elastic limit, further deflection leads to instability and eventual collapse” (JoVE).
No engineer would design for unstable equilibrium, or put up with it. It is dangerous. The fact that bankers live with it, tells us all we need to know. The banking motto? Never look back (translation – somebody else will pay for our mistakes).
Nearly put
John,
Any banking system is risky because there is always a mismatch between assets and liabilities. Without that mismatch banks serve no purpose and all the good things they deliver would not happen.
The hope is that we minimize that risk by imposing capital and liquidity constraints that make an unstable system less unstable – more able to withstand shocks.
It seems (to me) inconceivable that our economy could run without credit and that credit must be delivered by banks. So, for all the problems of the banking system it is all we have and all we can do is try and manage it better.
Do banks keep making the same mistakes? YES – there are only two mistakes; lend money to people that don’t give it back and not having enough cash in the till to meet depositor withdrawals. All banking crises over 4,000 years are always a variation of one of these mistakes. And, being the foolish, greedy creatures that we humans are, we will keep making those same mistakes from time to time.
Unsatisfactory as this is, I see no alternative.
This is the role of banks
Thanks, Clive I understand this, but my point is; bridges very rarely fall down, and they don’t all fall down at once. The banking system, and that is the bankers do not have the track record of the engineers.
An illustration. The Tay Rail Bridge disaster was in 1879. Construction of the Forth Rail Bridge, the first major steel bridge structure was in 1883. It was a major step forward.
I do not believe the regulatory system post-2008 was on the same scale, or as decisive a change as with bridge-building. Our banking structure looks more like the old structure, with the bits that fell down patched up to a better standard. Tinkering. Not a fundamental rethink. Iron will not do any more, and the Bessemer system is available. Banking does not do that kind of radical reform, except when it opens it up to more risk; with digital (digital arrived because it is a big money-maker for banks, not because it reduces system risks; indeed it pushes out some responsibility on to the user, and the complexity of the digital and the interconnections systems add risk).
It is a dreadfully unsatisfactory system to me. I am not convinced that bankers are even sufficiently well equipped even to understand the digital systems they are using. And I do not care for the seduction of – look at the good things. We have added major risks to the system, and eliminated redundancy. We do not adequately assess risk. We are taking the risk instead of managing it; and leave it to Government to clean up the mess. The mess is still with us, in QE. Until the next time…..
You used the word “exuberance” the other day (a word much used by central bankers). I prefer the word “irresponsible”. I think central banks think they can control the exuberant (irresponsible) inside the tent, because there is a lot of money to be made, and a lot of pressure exerted to make it. They can’t manage it, because they never have; the list of bank crises is very, very long. We know there will be another crash, because there are so many holes in the system; so many surprises (LDI in pensions, in the last wobble). This isn’t engineering. Engineers pretty well know what they are doing. Bankers? The case, at best is open; if you are of an exuberantly optimistic turn of mind.
I understand your frustration. I share it.
You want wholesale reform… and no doubt you are right that it’s required.
My aims are more modest…. I want to tinker with things to make it better…. but I fully agree that what I argue for is not optimal.
My father was a civil engineer so I really do get your point. Indeed, no senior bank executive, with the notable exception of Bob Diamond, understood the plumbing of the money system. No wonder RBS and others failed.
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.
Great post Richard, thanks. Can I ask what happens to the interest payments? Say I borrow £200k for 25 years, that will be destroyed as the loan is repaid, but all the interest will continue to circulate?
I’d like to see our debt based money system phased out in favour of a zero based one, starting with all new money created interest free. Money is great but debt as we know it is not.
The interest reduces personal incomes and increases bank income. Of course the bank a
So pays interest, creating deposits in the process. The net difference circulates.
If I lend you a pound, a pound has been created. If I give you a pound nothing is created. Interest is just a transfer of wealth from you to the bank. Money only destroyed when principal is repaid.
Spot on
Richard, I think these truth statements are too long.
Too many words in them and need brutal editing.
What does anyone else think?
In part they are longer because we decided on the value of reiteration
Ate you talk8ngvaboyt the texts, or the videos? If only text I would do them quite differently.
Yesterday’s got 12,000 views.
I think reiteration comes over better in the videos than the transcript. In normal speech people do repeat themselves. It also means that if you feel you have missed something you do not have to try to scroll back through the video to try to find it.
Thanks
Richard,
You are not giving a university lecture in the videos. You have to present to an unknown attentions span, but a short one. Politics show that repetition works. Indeed, you reminded me of that here over a point I am tired of having to repeat. So – repetition is necessary. Horrible, but necessary in the medium which you have chosen. Unless you have a genius new idea how to use the medium, follow best practice: repetition, repetition, repetition.
Correct
I’m curious about a number of questions this raises. I’ve read here and elsewhere that most of the money in circulation is bank loans. This is surprising because my experience is that banks don’t generally lend a lot of money – not to businesses and not to individuals. They have a very high bar for lending. Are we talking about mortgages mostly? Or credit cards?
My second question is this: most money is bank loans, and bank loans bear interest. So as these loans are paid off, they destroy more money than they create. Where does the excess come from? A message above suggests that the interest paid on deposits cancels this out, does this mean that banks expect to balance deposits and loans such that this cancellation occurs?
And finally, what does the writing-off of bad debt do to the money supply? How does that affect the sectoral balances?
85% of loans are mortgages or are business loans secured on property.
The interest shifts the income of the borrower to the bank.
Bad debts do reduce money supply. But remember, they are all in the private sector so they do not change the sectoral balances.
Thanks very much for your response, much appreciated.
“85% of loans are mortgages or are business loans secured on property”.
And we wonder why we have virtually no new investment or industry or economic growth; and float on an endless asset bubble.
I got a loan from Hyundai to help me buy an electric car from a Hyundai agent garage. I have the car and it is real, though depreciating at an alarming rate. The money received by the garage paid a tiny amount towards the directors and staff of the garage, who may well have spent it into the economy. I am still paying monthly, and sometimes with lumps, to kill off the loan. Sadly there is still a fair way to go. My borrowed money has had some good (?) effects, and so it cannot really be said that the loan is simply destroyed by paying it back, because its effects are real? Sadly some of those effects reside in South Korea!
The loan pays for the car
No-one pretends that car is not of value
But you could have paid in cash
So, the loan and car purchase have to be seen as totally separate
The money created by the loan is deestroyed by its repayment
The car and the value associated with it is not