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Self-funding

Idea 31 July – 1 August, text 1–3 August 2012

Learning by explaining

When I started to write the articles in this series, I thought I knew enough and understood things well enough, to be able to explain them to others and to correct their misunderstandings.

Now, after having finished seven articles, I find that I understand much more than when I started writing. It looks like explaining a subject is a good way to learn to understand it better myself too.

I experienced this effect before: in the year 2000 and after, when describing the pronunciation of Portuguese.

Central banks

The role of central banks I didn’t quite understand at the start of the writing process, and now too, further study is required. I do believe central banks can create money at will, simply by physically printing extra banknotes. They have the monopoly of doing that.

Historically, banknotes are the recognition of deposited coins, or other valuables like gold. That is why in a central bank’s balance sheet (I’m linking to a German Wikipedia page here, because there is no proper English one), banknotes in circulation appear at the credit side: they represent a liability of the central bank, not an asset.

One of the tasks of a central bank is to keep price inflation down to an acceptable level. Extra money in circulation can cause price inflation. So central banks will be wary about putting extra money into circulation. But they sometimes do.

Suppose a central bank prints banknotes and sends them to a commercial bank as a loan. On the central bank’s balance sheet, that means an extra amount at the credit side (representing the banknotes in circulation), and that same amount at the debit side (representing a claim on the commercial bank, in other words, the credit granted by the central bank to the commercial bank).

Technically, these banknotes do not represent M1 or M3 money, because cash in banks (central or otherwise) does not count as such. The banknotes are MB money, however. And it is clear that the central bank created it, as money that didn’t exist beforehand.

Commercial banks

If a central bank can create money like this, why can’t a commercial bank? Or can it?

In my first chapter, I argued that money creation does happen in commercial banks, but also that there is always funding. That means the money for a loan isn’t created out of thin air, but it always comes from somewhere: from a depositor, a shareholder, or the central bank.

I stated that this funding, and the money creation, together constitute a paradox. There seems to be a contradiction, although in fact there is none.

I return to the moment after step 1 in my first article. This is the bank’s balance sheet:

Description Debit (assets) Credit (liabilities)
Cash 100
Checking account (demand deposit) of Villager A 100

With a reserve requirement of say 10%, and 100 dollars of cash in the vault, the bank is allowed to issue 900 dollars in loans. Now suppose it gives all this money to Villager B, all at once. But not in cash. Instead the amount is made available in a checking account, so Villager B can write checks from it, or (in countries where that is customary) make payments by money transfer.

That leads to this balance sheet situation:

Description Debit (assets) Credit (liabilities)
Cash in bank 100
Checking account (on demand) of Villager A 100
Checking account (on demand) of Villager B 900
Loan facility for Villager B 900

(As noted before, I disregard the capital requirement for now. That is incorrect, but I do it to keep things simple, to avoid confusingly dealing with several subjects at the same time. See also parts 8 and 9.)

What we see is an increase in the balance sheet total, as a result of adding 900 dollars at the debit side and the same 900 dollars at the credit side.
(Such an increase is sometimes called a ‘balance sheet extension’ or ‘balance sheet elongation’, but largely in bad translations from German (‘Bilanzverlšngerung’) or Dutch (‘balansverlenging’), and in English documents written by non-natives, such as this one. ☺ )

The money supply suddenly went from 100 dollars (on demand account of Villager A; cash in bank doesn’t count as M1 money), to 100 + 900 = 1000 dollars (because the 900 on demand dollars of Villager B do count as M1 money).

So the bank made money from nothing! The bank created money from thin air! There is no funding, the borrower doesn’t get money from a depositor!

So I was wrong?!

So the people whose misunderstandings I wanted to correct, were right after all? Commercial banks can and do create money at will, out of thin air? Are all my previous articles (1 thru 7) invalid, should I withdraw them?

I don’t think so. It took me some time to see through this. But then I suddenly did (in the evening of 31 July 2012, while very tired, and thinking without pen and paper and without a computer).

Self-funding

What I described here in chapter 10, in essence is exactly the same thing as what happened in chapter 1 and chapter 2, except that now, quite a few steps have been skipped. But the end situation is the same.

In chapters 1 and 2, the credits were issued as cash, and the borrowers immediately took that cash out of the bank. Later, usually via other parties in the economy, the credit amounts returned to the bank. This resulted eventually in all the cash being back in the bank, and the maximum allowable amount of money creation had taken place, by various steps of credit granting.

Here in chapter 10 on the other hand, all those steps are brought together in a single transaction between the bank and this one Villager B. Villager B takes out the full maximum amount of cash of the loan (900 dollars), and immediately puts it back in the bank, in an on demand account.

The loan has been granted to him, but he doesn’t use any of the money for now. It is available to him in an on demand account, ready for future use.

In the bank’s accounting system, this is recorded in two separate entries: the loan itself (an asset for the bank, left side of the balance sheet, debit entry), and its availability to the borrower (a liability for the bank, right side of the balance sheet, credit entry).

Cashless

Taking the cash out of the bank, and depositing it in the bank again, right after that, of course has a zero net effect. So if we eliminate both steps, nothing really changes. The operation has become cashless, involving only what German speakers call Buchgeld (‘book money’) and what in Dutch is called giraal geld (‘giral money’, ‘giro money’).

It is this elimination of cash, that makes the funding of the loan invisible. The loan is still funded, that is, the money that the bank uses to issue the credit is still coming from somewhere. It comes from the borrower himself, who doesn’t yet use his credit, but only later.

We could say that the credit is self-funded. Hence the title of this article.

Should I rectify? No!

The paradox I mentioned in part 1 is indeed there, but worse:

I insist that all my previous articles (1 thru 7) in this series are correct, because the principles outlined there still hold. Only the technical details are different, which may obscure what is essentially happening.

As I already explained in my introduction, this is a result that I didn’t expect at all, when I decided to start writing this series of articles.


Addition 25 August 2012

About the subtopic ‘funding’ see also part part 11.


Addition 29 October 2012

After criticism in Dutch-language discussions here and here, I changed the wording somewhat, to make it explicitly clear when I mean banknotes that the central bank brought into circulation.

It is important to distinguish these from banknotes that are (still or again) in the central bank itself, i.e. not yet in circulation or taken out of circulation.

Banknotes in circulation are represented on the credit side of the central bank’s balance sheet. Banknotes not in circulation are not on the balance sheet at all.


Copyright © 2012 R. Harmsen. All rights reserved.

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