2 July 2013
People often wonder: if banks can create money, why can’t we? Isn’t that unfair?
First, again I stress that although money creation is a reality, and indeed happens when a bank grants credit to a member of the public; it does not make that bank any richer. It does however give the bank an opportunity to earn more interest margin.
Money creation also happens when a bank pays credit interest, salaries, other expenses, dividend. This type of money creation often makes a bank poorer, not richer.
Now to answer the question, why it is that only banks can create money: that follows from the definition of money. That definition is as it is for good reason. If the definition of money were different, then non-bank persons and companies could create money just like banks.
In article 1 and article 10 I already showed two scenarios (very different, but essentially equivalent) of how money creation happens as an automatic consequence of credit from banks.
Of course, that is not the only kind of credit. Other forms are informal credit and trade credit. Let’s look at examples to see why they do not cause money creation, and how they could if the definition of money were different than it is.
Suppose you’re in a bar or pub with some friends. One friend offers to buy some drinks but doesn’t have cash with him. So you lend him 20 dollars (euros, pounds, whatever).
Now let’s do the math to see if there was money creation. The banknote is money. It changed hands, but the total didn’t change. There’s also your claim on the friend, because he promised to repay you in a few days.
Such a claim by a non-bank person on another non-bank person is not counted as part of M1 money. Therefore there was no money creation when the claim arose.
If the definition were different and that claim were counted, there would be money creation just like in the case of bank credit. That’s because in all cases of credit, there is a multiplication of what was there before: afterwards there is the repayment claim of the lender and the borrower has the money available.
The difference between informal credit (without money creation) and bank credit (with money creation) is merely the result of the going definition of money. It is not caused by some kind of permit that a bank has and we don’t. It does not mean a bank has a way of getting richer, that we cannot or are not allowed to use.
The definition of money, that is the whole point. Money is coins plus what banks owe the public.
This is very common. When a company buys goods or services from another company, it usually doesn’t pay right on delivery. Instead it waits for an invoice to arrive, and then after the term of payment, say 30 days, it pays.
In the meantime, the seller (creditor) is giving credit to the buyer (the debtor). The seller has this credit in its books under accounts receivable, the buyer under accounts payable.
Trade credit, like informal credit, does not cause money creation, because by definition such short-term financial claims between non-bank firms, are not considered part of the M1 aggregate or any other part of the money supply.
Again, if the definition of what is money were different, trade credit could involve money creation just like a bank credit. But it isn’t, so it doesn’t.
The central bank monitors total money supply. To that end it collects detailed periodic reports from all non-central banks in its area. The central bank knows who they are, because they are required to be registered and must have a banking license.
If credit between non-bank companies also counted as part of the money supply, the central bank would have to gather detailed weekly financial data from them too. That is too much work so it isn’t done.
Collecting data about informal credit is not only infeasible, it would also violate privacy rules.
But the above is not the most important or even the real reason.
For a creditor’s claim on a debtor to be money, it would have to be transferrable, so it could be accepted as payment by somebody else.
Suppose one of my clients I did some work for, does not pay my invoice, but instead proposes to transfer a claim on one of its clients to me as payment. Would I accept that?
Probably not. I don’t know their client, don’t know about its creditworthiness. My client probably doesn’t want me to deal with their client, to avoid that I might do business with them directly. (I don’t want that, but that’s a different story.) And my client’s client probably isn’t willing to pay me instead of my client, because they don’t know me and I didn’t do work for them.
What’s worse, if such a method of payment were accepted and commonplace, I should expect to be paid not by my client’s client, but by the client’s client of the client’s client of my client’s client. There would be very long chains of unreliable promises to pay, supposed to serve as perhaps collectable payment.
If we compare that with payments in the real world, then we see a very different picture. In the real economy, I can get an invoice paid because the debtor has part of its claim on its bank (in other words: the balance of its bank account) transferred into an increase of my claim on my bank (which may be the same as theirs or a different one).
After that, as the payee I have more of a claim on my bank, the bank I know and trust. I no longer have to deal with the payer to get to my money, to use it to make my payments. The banks serve as intermediaries between payer and payee, so those two don’t need to trust each other or even know each other, except for this one brief transaction.
In my role as payer, I can use a check or a debit card or whatever technical methods are available, to pay for the contents of my shopping cart (in many parts of the world a.k.a. trolley) in a supermarket. I can do that equally well in my own town or anywhere else in Europe, where nobody knows me and doesn’t have an idea if I am creditworthy. But they do trust their bank, and through it, my bank.
The essential point about payment is always: a transfer of part of the payer’s claim on its bank, into the claim of the payee’s claim on its bank.
Even with a cash payment, using banknotes, it’s the same principle: banknotes are transferrable claims to the central bank, which everybody knows and trusts as the issuers of banknotes.
Because transferrable claims to trusted banks can be used to make payment, they are money. Non-transferrable claims (like accounts receivable) do represent financial value, but they are not money.
Copyright © 2013 R. Harmsen. All rights reserved.