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Creating interest

1 July 2013

Worries

Many people are worried about interest, and in their opinion interest should be banned entirely, because they think:

That’s because in fact, banks do also create the interest – not on purpose, but automatically.

Definition of money

That banks create the interest, follows from the definition of money: money is coins, plus what banks owe the public. The consequence of that definition is that anything within the bank is not money (i.e., not money in the monetary sense of medium as exchange, M1/M2/M3 aggregates).

Coins and banknotes in a bank’s vaults and tills, is not money. What other banks (including the central bank) owe this bank, is not money. Banks do not have money, only the public (households and firms) have.

Debit interest

Now what does that mean for interest?

Suppose someone in the public has to pay interest to the bank, because he took out a loan. Before he pays the interest, the amount is in his checking account, where by definition, it is money, because the bank owes him that amount (and probably some more).

Then after the interest becomes due, the account holder actually pays (or the bank perform an automatic charge by direct-debit). That means a debit mutation on his transaction account (a decrease of the credit balance), so after paying the interest, the account holder has less money.

The contra entry is credit on an internal proceeds account of the bank (which after deducting expenses, may eventually result in profit).

A decrease of the credit balance of a bank client’s transaction account means a decrease in the M1 money supply aggregate. Therefore, there has been money destruction.

Anything that happens inside the bank doesn’t count towards M1. So the net effect of the borrower paying debit interest for his loan is: money destruction (which in this case makes the borrower poorer and the bank richer).

Credit interest

Now the flipside of the coin: credit interest. Just reverse everything in the above, and we see: money creation. Credit interest means an amount gets out of the bank’s possession (where it didn’t count towards M1/M2/M3), to an account held by the saver (either the savings account itself, or a transaction account of the same account holder). There the amount does count towards M1 (or M2/M3, depending on details of the definitions of those). Result: money creation (which in this case makes the bank poorer and the saver richer).

Other expenses

Interestingly, what is true of interest, is also true of anything else that a bank pays or receives.

When a bank pays out salaries for its staff, that involves money creation: the money leaves the bank where it was not M1, and goes to the employees’ checking accounts, where it is.

When a bank pays rent for a leased office, or buys computers or cables or routers, or pays an external software consultant’s invoice, pays out dividend to non-bank shareholders, etc., etc.; all of that means that money creation takes place.

Other forms of income to a bank, like commission for advice, rent for a safe deposit box, etc., like received interest, cause money destruction.

What comes in must go out

Practically all income of all kinds, eventually leaves the bank in one of the ways just mentioned.

So the end effect is, that all money destruction as a result of the bank receiving interest, is offset by money creation when the money leaves the bank again.

Reserves

What about the loan-loss reserves, other reserves, the bank strengthening its capital? In general, any part of the proceeds that do not constitute cover for expenses, and do not become dividend either?

Yes, in that case the money destruction that happens when borrowers pay interest, is not offset by a corresponding money creation. So this does cause a decrease of total money supply in the economy. Some money is removed from circulation.

But this is not an ever-continuing process. More reserves and capital makes a bank safer and more stable, so that favours leaving profits inside the bank. But shareholders want stability and ROI (return on investment), which means not leaving profits in the bank, but paying it as dividend. (Disregarding price rises for the moment.)

That results in an overall tendency of leaving enough capital in the bank, but not more than that.

Conclusion

So the conclusion is, that the practice of charging interest for loans, does not suck all the money away from the people and into greedy banks. Interest doesn’t cause a scarcity of money and doesn’t result in deflation.

Interest, with reasonably low interest rates, is not a problem for the economy as a whole, although of course, unfortunately, it can be in individual cases.


Copyright © 2013 R. Harmsen. All rights reserved.

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