Money circulates through the economy, perhaps changing hands many times. Sometimes the money is exchanged for something else of value. Sometimes it is saved – temporarily placed in storage. Sometimes it is exchanged for a promise to repay it later. Sometimes it is taken by force. Sometimes it is given as a gift.
However, there is not a fixed amount of money circulating. There is a life cycle to money, from creation, to circulation, to destruction, and it typically works like this:
This is a (slightly) simplified version, since it does not consider interest. However, that is a straightforward addition to the scenario, and is shown later. For now, the questions of why new money has value, and what effect there is on the transfer of goods and the provision of services in the economy, will be considered.
Some economics text books claim that money, as it exists in most of the world today, has value simply because the government declares that it does, and because people expect that it will be accepted in exchange for goods and services. I am convinced that they make a fundamental – and dangerous – error. Money really has value because it is backed by legally-enforcible promises to (produce and) sell goods and services.(*) It is not just that sellers have an expectation that the money which they receive, when they sell something, will be accepted in exchange for goods and services later – it is that the legal system makes this a reasonable expectation.
When money is created, the goods and services for sale are likely not to increase immediately, so there is an initial imbalance. However, having spent the borrowed money, the borrower must subsequently sell goods or services to someone somewhere in the economy in order to repay the loan. So this new money ("created from thin air", as some like to say) is valuable for the very good reason that it can be used to buy something valuable which would otherwise not have been brought to market – the produce of the borrower. The new money, and the additional goods and/or services brought to market in order to repay the loan, match exactly.
There are two assurances that these additional goods and services will in fact be brought to market.
Banks can be seen as insurance companies. They insure the value of the money which they create, promising that if the borrower does not sell additional goods and services worth as much as the new money created, the bank will do so itself.
(*) Unfortunately, both types of money may be called fiat money. I prefer to use fiat to refer to money simply declared by the government to have value, and to refer to modern money as promise-backed money.
(**) In a well-run banking system, the owners are not allowed to promise to refund the bank after a borrower has defaulted. Instead they are required to lend a fund to the bank – its capital – which is depleted (and must be renewed from either profits or further loans from the owners) as and when borrowers default. But the effect is the same – the failure of borrowers to repay reduces the assets of the bank's owners.
In the situation above where the borrower repays the loan, the bank's owners' wealth is unaffected. But when the borrower fails to repay, the bank's owners are required to make up the loss. Additionally, there are costs to running an bank – paying employees to keep records, renting a place of business, keeping a secure storage facility, etc. And anyone considering investing in a banking business is likely to want to make some profit, in order to pay for everyday expenses (food, accommodation, top hats, fast cars, etc.). Therefore the bank must have some revenue, and this generally takes the form of (sometimes) fees for banking services, and (usually) interest on loans, as illustrated below.
This situation is very similar to before, but the borrower must actually sell £(P+i) of goods and services before the loan is due to be repaid, rather than just the £P originally borrowed. When the borrower pays, the £P of principal is destroyed, but the £i of interest is passed on (eventually) to the bank's owners(*) in the form of a dividend on the shares. This money can then be used by the bank's owners to buy goods and services in the economy.
Examining the net income in money for each of the agents in the economy gives:
|Borrower||+£P -£P +£(P+i) -£P -£i||0|
|Bank||-£P +£P +£i -£i||0|
|Bank owner||+£i -£i||0|
|etc.||+£P -£(P+i) +£i||0|
In each case, the agent ends up with exactly the amount of money with which they started.
However, examining the net quantity of goods and services received (those received minus those provided) for each of the agents in the economy gives:
|Agent||Value of goods obtained||Total|
|etc.||-£P +£(P+i) -£i||0|
The result is that, even though there is no net transfer of money, there is a net transfer of goods and services with value £i from the borrower to the bank owner.
Why would the borrower borrow, given that it involves a net transfer of goods and services to bank owners? There are several possible reasons:
Either way, in the short term, the borrower obtains goods and services from the rest of the economy without having to sell something first. Someone else sells those goods and services without having bought something first. The seller expects either to be able to buy something of equal value from the borrower later, or to buy something of equal value from someone else – who will buy something from the borrower later. Ultimately, the situation is only fully resolved once the borrower provides goods and services to the rest of the economy, or the borrower defaults and the bank owner sells the goods and services which the borrower was supposed to.
(*) For clarity, the diagram shows a self-employed banker. For a bigger organisation, some of the interest is paid to employees and suppliers, but the effect is the same – they are able to use the money which they receive to buy goods and services from the rest of the economy.
Yes! The bank may not have enough capital to cover all of the defaults, and the bank's owners may have limited liability, or have unlimited liability but not enough personal wealth to make up the difference.
In this case, the bank is insolvent – it has more liabilities than assets. (Another term for this is having a negative net worth). Even if all of the assets were sold, there would not be enough money left to honour all of the bank's debts to others. As a result, one or more of these creditors will be worse off than they believed they were, under the reasonable assumption that the bank would keep its promises. The situation is extremely similar to that of an insurance company not having the means to pay all of its policy holders if too many of them make claims.
How serious can this situation be? It depends on the difference between the values of the assets and the liabilities. But because banks can essentially lend as much money as they want to, there is no real limit to how big the losses can be, and therefore to how serious the problem is.