A Treatise on Unsound Money: Part 4
Written by Derryl Hermanutz
The trouble arises, therefore, because the act of saving implies, not a substitution for present consumption of some specific additional consumption which requires for its preparation just as much immediate economic activity as would have been required by present consumption equal in value to the sum saved, but a desire for “wealth” as such, that is for a potentiality of consuming an unspecified article at an unspecified time. The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy, much more specious than the conclusion derived from it, that an increased desire to hold wealth, being much the same thing as an increased desire to hold investments, must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished. – John Maynard Keynes, “The General Theory of Employment, Interest and Money”
If the earners spend all the money back into the economy buying assets and consumer goods, they will keep up the inflation at the level caused by the first round spending. The economy’s entire demand curve (the price level) has moved up and will stay up as long as the same amount of money keeps being spent on the same amount of new goods and assets that are being produced and sold. But the same amount of money is NOT spent, because people use some of their incomes to repay old debts that financed previous consumption, and some people “save” some of the first round money that they earned (debt retirement is counted as “savings”, but I use the term to mean positive accumulations of money that you do not owe to anybody; net money that you own).
And in the 1970s we saw what Mill had described, “money transferred to foreigners“, namely the OPEC Arabs who were collecting all the high oil prices that we were paying. The Arabs weren’t spending their petro-billions into America’s consumer economy. That money “leaked” out of the American economy, starving the economy of recycled spending, which reduced demand and production and employment. So you had high cost push inflation in the midst of economic recession, because the high cost was generated outside of the US economy, and the spendable money that was paying those high costs was leaking out of the economy. And we got “stagflation“.
Banks do not lend out their depositors’ savings. Savings are a “cost” to banks, and banks who enjoy the power to create money would not want ANY depositor savings if they were not required by law to balance their balance sheets, which boil down to Assets = Liabilities, just like any other corporate balance sheet must net out to $zero (a bank’s “capital”, K, is the same as “shareholder equity and retained earnings” on a non-bank balance sheet: the company “owes” its capital and its retained earnings to its human owners, so K is on the liability side of the company’s balance sheet).
When a bank makes a loan it is actually “buying an asset“. At the primary level the asset is the interest bearing loan that the borrower has promised to pay. If the borrower makes his interest payments on time, then the bank has a “performing loan” on the asset side of its balance sheet, a “performing asset“. At the secondary level the asset is the collateral that the borrower put up against the loan, something of saleable value that the borrower forfeits to the bank if he fails to repay his loan.
Banks make zero income on loan principal repayments. The bank created the loan principal as a credit which it added to the borrower’s bank account balance, offset by a debt charged to the borrower’s loan account. The borrower initially spends the loan money out of his deposit account, but later earns money and deposits it back into the account. To make a loan payment, the bank debits his bank account balance and reduces his loan account balance by the same amount.
There was no ‘money printing‘ done when the loan was made. Nothing ‘real‘ or ‘substantial‘ was loaned out. The entire process was done right then and there on the bank’s books. The bank created the loan as a positive number and the debt as a negative number in its accounting ledgers. Numbers in bank accounts function as “money” – it is electronic, it is virtual, but it can be used the same way as any other form of money. When the borrower makes a principal repayment the positive number in the borrower’s bank account is reduced, and the negative number in his loan account is equally reduced. That’s it. Bank loans create money, and repayment of loan principal destroys that money.
The bank didn’t have the “money” that it loaned him, and the bank doesn’t have the money when he repays his loan principal. The “money” and the “debt” exist only as a balance sheet equation of positive and negative numbers that net out to zero. Banks create credit and debt, which only exists as numbers in bank accounting ledgers (computers now). The credits and the debts net out to zero, so the bank starts with no money and ends with no money. Banks earn income on the interest (and various fees for services), not repayments of loan principal. Principal repayments merely extinguish loan balances, leaving no money and no debt on the bank balance sheet.
The bank loan created a new deposit in the borrower’s bank account, but the borrower spent that money out of his account. The recipient of the spending might deposit the money in a different bank. Banks who are allowed to create money (“depository institutions“) have a legal requirement to balance their balance sheets, hold an equal amount of assets and liabilities. A bank’s assets are its interest-paying loans. A bank’s liabilities are (mainly) its depositors’ account balances. Banks attract deposits because they “have to” for legal reasons, not because they “want to” for commercial reasons.
So if the bank’s borrowers spend their loans, and the money gets deposited in a different bank, the bank needs to attract other deposits in order to balance its balance sheet, which is a “legal” requirement, not a “monetary” requirement (i.e. banks don’t need or use their customers’ deposits to fund new loans). So banks offer interest on deposits. Banks don’t “need” deposits in order to make loans, because banks are not allowed to lend out their depositors’ account balances (unless you buy a CD or other term deposit instrument from the bank, but a CD is NOT a “bank deposit”). Banks make loans by creating “new” bank deposits in the borrowers’ accounts. I keep repeating this because most people can’t seem to believe that this is how our money systems work. If reality, observation, logic and arithmetic cannot break through the astonished veil of disbelief at the sheer fraudulent-looking audacity of allowing private businesses to create money out of nothing, maybe repetition will work.
In the gold standard days banks didn’t lend out their gold or their depositors’ gold. They lent out “claims” on their gold. The claims functioned as money. Gold standard banks created the economy’s circulating money supply by creating claims on money, and they created claims as a multiple of the actual money they ever had on hand to honor the claims. Banks create and lend out claims on money, money that they do not possess. That is how the institution of “banking” has operated these past 600 years, since the Medicis realized that governments were too stupid to figure out how to create money for themselves, and that there’s good money to be made by charging interest on loans of credit that you enjoy the power to create out of thin air. So the bankers got rich collecting interest on money they created out of nothing, and governments, and later the private sector, got into the permanent debt we find them in today.
Banks still don’t lend out their money. They lend out claims on money. But money is no longer gold. Now it is just Federal Reserve Notes (or euro, yen, yuan, etc). And the Fed will provide as many banknotes to banks as they need in exchange for Treasury securities or other high quality assets the banks bought by creating credit money to pay for them. If a bank needs cash, it can whip up some credit money to buy a Treasury bond, which it can trade to the Fed for the cash. So unlike gold in the bank’s vault, modern banks cannot run out of “money” unless they are in serious trouble and the Fed is in the process of denying them access to any more banknotes and reserve balances prior to shutting them down.
So what happens when some people save the money that they earned from the people who borrowed and spent that money? First of all, there will now be less spending money circulating in the economy. The bank doesn’t ‘re-loan‘ the savings on deposit, because the bank ALREADY loaned out that money to the original borrower whose debt is on the asset side of the bank’s balance sheet. The deposited savings are simply used to balance the bank’s balance sheet by adding a liability on the liability side of the ledger. Any new bank loan will be the creation of new bank credit money, an expansion of both sides of the bank’s balance sheet, not the relending of a saver’s deposit balance.
Since all new money (except coins which are minted by the government and sold to banks at face value) enters the economy as new bank lending and new borrower spending, there is always an equal amount of “money” and “debt” in the system (there is actually more debt than money, because loan interest is also charged against borrowers as debt, but money was created only in the amount of loan principal: no money ever gets created to pay the interest, which is a fundamental flaw in our current money systems). But if some of the money is removed from circulation as savings, then there will not be enough total money circulating for borrowers to earn and repay their debts. Debtors can only “earn” their loan repayment money, if the people who now have that money “spend” it (or if the indebted government “taxes” it to get loan repayment money).
So in addition to creating more debt than money, our current bank-debt money system sabotages its own arithmetic by making positive accumulations of savings incompatible with loan repayments. And the more money that is saved, the less spending, the less demand and production and employment and income earning, which makes earning money to repay loans even more impossible for debtors, in a vicious spiral down into irresolvable Depression. That is, unless savers squander and thus redistribute their accumulations of money, as in Mill’s description of the driver of “recovery” in the capitalist cycle.
Note: The Austrian School, led by the writing of Friedrich Hayek on this topic, has argued that the paradox of thrift which we have been discussing is not correct. The following excerpt from Wikipedia explains:
Within heterodox economics, the paradox was criticized by the Austrian School economist and Nobel Prize winner Friedrich Hayek in a 1929 article, “The ‘Paradox’ of Savings”, attacking the paradox as proposed by Foster and Catchings. Hayek and later Austrian School economists agree that if a population saves more money, total revenues for companies will decline, but they deny the assertion that lower revenues lead to lower economic growth.
Austrian School economists believe the productivity of the economy is determined by the consumption-investment ratio, and the demand for money only tells us the degree to which people prefer the utility of money (protection against uncertainty) to the utility of goods. They argue that hoarding of money (an increase in the demand for money) does not necessarily lead to a change in the population’s consumption-investment ratio; instead, it may simply be reflected in the price level. For example, if spending falls by half and prices also uniformly fall by half, the consumption-investment ratio and productivity would be left unchanged.
I remain convinced that Austrian economics does not understand productive business, the concept of producing outputs and selling them at profitable prices. What good is a nation full of high productivity plant after consumption of output collapses by half? That is the recipe for mass bankruptcy of producers. What desperate fool would invest into such an environment of massive overcapacity and extreme unemployment? Where are consumers supposed to get income to purchase outputs when half of them are unemployed? The consumption-investment ratio would be left unchanged? Please. I suppose if the unemployed half of the population died off and the unemployed half of fixed capital was bulldozed then yes, the “ratio” would remain unchanged. So what? This is not a meaningful metric. Austrians will stoop to any absurdity to preserve their morally driven, economically perverse belief in the unalloyed virtues of “saving“.
Businesses earn profits by utilizing their capital to maximum capacity and selling their outputs for more than the cost price. Austrian economists crow about the virtues of price deflation, where your money buys you more stuff. This would be great if we were all billionaires and never needed to earn a living working and investing in a profitable productive economy. Austrian economics is money-myopic. It sees the world through the eyes of people who are, to borrow Kurt Vonnegut’s charming phrase, “fabulously well to do“.
Price deflation destroys the profitability of producers who invested their money into a higher cost environment and now have to sell their outputs into a lower price environment. You have to recover your capital costs AND your production costs in your sales prices. How is this possible in a deflationary environment where your sales prices are dropping and all of your fixed costs have already been sunk at higher price levels? In the real world producers invest into a “rising” price environment with the expectation of cashing in on high profits. When prices are falling the first thing that gets put on the shelf is your expansion plans. This is economic reality, not theory. We see this repeatedly in the real world. Falling prices kill profitability and kill investment in productive enterprises.
But perhaps Austrian economics, from the perspective of the fabulously well to do, is thinking of “financial” investments of the investment bank and hedge fund variety, where winners take money from losers. There are no “profits” in a zero sum game like this, only winners and losers, bragging rights and humblings. And there is no “production” of anything at all, just a shifting around of the ownership of money. Maybe that’s why Austrian economics doesn’t understand the mechanics of earning business profits from ongoing investment and production, and exclusively focuses on maximizing the purchasing power of money that has already been accumulated in “fabulous” quantity.
The Five Parts of the Treatise on Unsound Money