Can Commercial Banks Create Money out of Thin Air? #3 The “creation of money” by private banks in the process of lending leads only to the removal of money from the economy.

When a government creates money by spending it adds money to the economy first, but that money later mostly returns to government through the normal process of taxation as successive financial transactions take place and increased economic activity reduces the need for social spending. The “creation of money” by private banks in the process of lending leads only to the removal of money from the economy. We see in a graph of three sector balances that when the private sector is borrowing, government finances grow and deficits fall. Therefore money must be being removed from the economy as the equity of the private sector falls.

However on the face of it, creation of money by private banks through lending acts to add money to the economy, and it is only when those loans are repaid that money is removed from the economy. The question is: how is it Government revenues quickly improve, so much so that there can be a budget surplus, and a corresponding private deficit when the private sector are on what some may describe as a credit binge?”

A credit binge may occur in the context of an investment bubble in housing or the share market. Investment & growth accelerates for a time increasing government revenues and decreasing mandatory expenditures. But, if the government isn’t providing sufficient net income growth via deficit spending, the boom is unsustainable.

So how does it all work?

Let’s look at what typically happens, in double entry bookkeeping terms, when a bank issues a loan for 300k. Initially, it creates a asset liability pair of 300k in its own accounts. (300k,300k) (assets liability) The customer receives the 300k but also has a liability of 300k to repay the bank. The bank acquires an asset of 300k in the form of a loan but still retains 300k in liabilities in terms of its own issued IOUs.

So the bank still have (300k,300k), the borrower has (300k,300k).

This all nets to zero and, as can be seen there is no new equity created from the bank lending, but the borrower does have 300k of available liquidity. As the reason for borrowing is the creation of spending power: maybe building a house, or investing in a business, or whatever, the position soon becomes:

The bank: (300k, 300k) The borrower: (0, 300k)

It is not possible to say exactly what will happen in any every case but, typically, the 300k is disipated into the economy. Much of that 300k eventually goes back to the government as various taxes are applied as it changes hands multiple times. 20% VAT. Income tax at 30% plus etc. That’s not to say that the lending per se has caused the money to return to the government but as the reason for borrowing is nearly always for spending, that’s the end result. That is why government finances ‘improve’, in neoliberal terms. As liquidity rises during a boom, incomes and spending also rise, and thus government revenue rises; additionally, demand for government assistance tends to wane, so naturally there is a narrowing of any deficit, and possibly an ‘achievement’ of a surplus,
at a rate far faster than can be accounted for by the repayment of the loan itself. That is really neither here nor there in comparison.

The end result of a boom is of course the inevitable bust. The boom-bust trap is a tempting one for governments of a right wing neoliberal disposition. That’s nearly all governments! Even the supposedly left of centre ones. Seemingly, during the boom time, they are reducing the government deficit and simultaneously simulating the economy. I’m cautiously optimistic that the recent recovery in the USA may be genuine but that remains to be proven.