13 and 15 July 2012
If you rent a car, it means the rental company owns or leases cars that it doesn’t need itself. So it offers them for use by clients, for a day, a few days, a week, or whatever is agreed. In exchange for that, the client pays a fee to the rental company.
With a house or an apartment it’s the same thing, except that the terms of tenancy are usually longer: months or years. The principle is the same: the owner doesn’t live in it himself, so the occupant can make use of it. The occupant doesn’t own it, but pays a fee, called rent.
With money, it’s no different, except that now we call the fee or rent ‘interest’. Everything else is the same: the owner of the money doesn’t need it for some time, meanwhile somebody else can use it, without becoming the owner. But that comes at a price: interest.
So borrowing money is in fact renting money. Lending out money is basically the same as renting it out.
Some people think banks are swindlers, because they make borrowers pay interest over money that doesn’t exist, or didn’t exist before the bank created it. As explained in the first section, that is a misunderstanding: money creation is real, however, any money that a bank makes available to a borrower, is money that was first deposited by another bank client!
It is true that as a result of money creation, there is more money in circulation, more money in bank accounts, and also more money that can be used for credit granting. So at a given level of interest rates, banks can earn more interest.
Is that bad? No.
Money creation causes an abundance of money. It greatly reduces money tightness. Whenever something is scarce, its price goes up. When there is plenty of it, it becomes cheaper.
So if fractional reserve banking were forbidden, and money creation through credit granting were no longer possible, the result would be money tightness and much higher interest rates. In spite of granting far fewer credits, banks would probably still earn about as much interest as before, because of the higher rates.
The macro-economic price of eliminating fractional reserve banking would be: limited liquidity, and a stagnant and inflexible economy. It would solve no existing problems, but create new ones.
Some people who misunderstand money creating by credit granting, believe that the financial system is eventually bound to crash, because banks do create the money for the loans, but they do not also create the money to pay the interest. Thus, in their view, people must keep working harder and harder to earn money to pay interests, until there is no more money to earn.
Then their only choice is to take out more loans, to pay the interest for earlier loans. Eventually the banks repossess all the securities (collaterals), like houses for mortgage loans. Conspiracy theorists even believe that is the true and hidden purpose of all banks: to rob the population of all wealth and keep it all for themselves.
The above is a hoax. Why?
Firstly, because banks do not constantly create new money for every loan. Money creation exists, but it has already taken place in the past. Money supply varies somewhat, there is some new money creation but also some money destruction. On average, money supply is stable over longer periods.
In all cases, the money a bank uses to grant any credits, was first deposited in that bank by some other client (or even the same client, sometimes).
Well, in reality, the situation is quite a bit more complicated: some of the money for loans came from shareholders, buying equity. That’s an important point I disregarded for simplicity’s sake. And there’s interbank borrowing and interbank clearing, in which the central bank can play a role.
But whatever happens, the golden rule of accounting always holds: debit equals credit. Any money that goes anywhere always comes from somewhere. Money for a loan isn’t created on the spot out of thin air. I know I said that before, but this is so basic, that it is worth repeating it again and again.
Secondly, interest paid to a bank doesn’t stay there. (Well, some of it does, to strengthen the loan-loss reserve. But that is useful.)
Interest is part of the circular flow of income. Borrowers pay interest to the bank, but the bank uses that for various purposes so it returns to the economy, and eventually reaches those who need to pay new interest. On a macro-economic scale, interest money does not run out, there will always be enough money to pay interests.
Interest is one of the major sources of income of any bank. The others are provisions and fees.
What does the bank do with its income, part of which it receives as interest on outstanding loans?
Part of it is paid out, again as interest, to the persons and companies that deposited the money in the bank, the money the bank uses to grant loans.
For example, mortgages may be financed from money deposited by pension funds. Part of the interest paid by house owners, will then be paid to the pension fund, which can use it for paying pensions.
Other mortgage loans might be funded from savings accounts. Then too, interest received is paid back in part as interest.
In all cases, debit interest rates are higher than credit interest rates. The difference is the interest margin or spread. For the bank, only this interest margin is its true source of income.
In some cases, the credit interest rate is very low or even zero. That is usually the case with demand deposits. Then, the transformation functions (here in terms of risk and scale) are so costly, that the bank cannot afford to pay credit interest. It must use all of the debit interest for other purposes.
(In some legislations, like in the USA, paying interest on checkable accounts is even prohibited.)
For simplicity, I keep saying the money for loans comes from deposits. But in fact, part of it came from shareholders. This is even a requirement that central banks impose under the Basel Accords. (See also parts 8 and 9.)
Everything comes at a price: if costs are kept low, the bank may make a profit and be able to pay dividend. Dividend can be understood as a compensation for the money that shareholders made available for loans, just like credit interest is a compensation to savers and other depositors.
Dividend, like credit interest, must largely be earned by the bank as debit interest.
Another part of the bank’s income is used to cover operational costs. Examples are: salaries for bank employees, rent for rented office buildings, foregoing of interest for owned buildings, costs of computers, web servers, software, communication equipment, security.
As mentioned before, a bank needs to build up reserves, such as loan-loss reserves, to be prepared for what nobody hopes will happen, but nevertheless sometimes does: loans becoming non-recoverable.
The important thing is that any of the interest paid to a bank, sooner or later (later in the case of loan-loss reserves) returns to the circular flow of income. What comes in, must go out. Debit equals credit.
The fear that paying interest causes a shortage of money to pay new interests, is unfounded.
The farmer takes out a loan, for which he has to pay interest. In the example there is no economic growth, yet the toy economy is stable and there is no shortage of money. The interest can be paid and the loan can be redeemed.
Article 17 is in fact a note to articles 4, 6 and 7.
A link between interest and money creation: banks also create the money for the interest. Explanation in article 20.
Copyright © 2012 R. Harmsen. All rights reserved.