Let's cut to the chase here. When any bank makes a loan, it is granting unequal access to the monetary machinery that defines an economy. Unequal access because one bank depositor must first earn money to put on account while the borrowing depositor only needs to have a consenting decision.
Sadly, the title of this post comes close to being a canard. In fact, the whole discussion about two very different bank actions, whether banks create money or use money owned by others, comes close to being a canard.
That said, how in the world did I come to this perspective shifting conclusion? It was after I wrote the following material discussing private banks in the world of real fiat money.
Let's begin with some background observations:
Money is mechanical but the users are human.
Every monetary transaction has two decision makers involved--the money owner and the property owner.
In the preceding post (Government Always Pays Using Real Fiat Money), we postulated that private banks were not allowed to create money. That assumption limited our thinking about private banks without changing one iota what banks actually do. In this post we will relax that stipulation to uncover some unexpected relationships. Hopefully, by doing this exercise, we can better understand the mechanics and inflationary implications of money creation.
The Duration of Money Issue
Economist typically agree that money comes into existence mechanically upon the click of a bank record keeper or roll of the printing press. They also tend to agree that money disappears from existence when a bank debt is marked paid or paper money is recovered by the issuing authority. Between these two points in time, any money created continues to exist and will be claimed as wealth by some entity.
As more money is created, the money supply must grow. Recorded histories of unchecked money supply growth coincide with bouts of unchecked inflation which takes us to the idea that average prices must somehow be related to the instantaneous supply of money.
However, an instantaneous relationship of money supply to inflation is not supported by the historical record. There must be a time lag but what would be the cause of the lag?
We will revisit the the entire inflation issue after we think a little about how money comes to have value.
The Valuation Issue
When we examine the theoretical gap between money creation and the reuse of existing money, we uncover the question of valuation. Exactly how is money evaluated? There is a huge difference between the two bank actions involving money.
Real Fiat Money (RFM) is money backed by governmental promise. Economist have always struggled in figuring out how RFM achieves relative value and we will continue to dance around that question. We will, however, take careful notice that there is a huge difference between how private banks and central banks treat the valuation of money. What we find here is a key to valuation. Private banks are careful to take collateral pledges in exchange for money loaned, and express reluctance at making personal loans based only on the pledge of the borrower to repay. Central banks [which many consider to be fundamentally government banks] on the other hand, routinely accept the pledge of government to repay, an action that equates to making a personal loan without collateral.
This contrast of opinion on the importance of collateral takes us to the question of valuing collateral. There is simply no fundamental relationship between fiat money and the value of anything. There is only the instantaneous decision of two entities exchanging property and the historical record of exchanges thereby built. From the historical record of exchanges, we might come to expect a value of money. It follows that newly created money, so long as it indistinguishable from previously created money, should carry identical value. Thus, money created by the central bank should carry a value based on the national accumulated record.
However, there is the human trait of predicting the future to consider.
Inflation and the Spending Habits of Borrowers
Now we'll return to some thoughts about inflation.
When a borrower accepts loaned money, he is accepting the same economic spending position that is enjoyed by other people who have first earned money to achieve that position. For people who have earned money, the size of their account is their record of success at working. For the borrower however, the size of the deposit account is of little matter--it's all presently unearned so it's in the 'yet-to-be-earned' category. This disparity sets up conditions that result in a time lag between money supply and prices.
Any inflation that results from money supply increases is due to borrower spending habits. Now here we have an important difference between borrowers representing the private sector and borrowers representing the public sector. Private sector borrowers tend to borrow to build a specific project or purchase an identified property. Proceeds from this type of borrowing (noticed by increases in money supply) could be expected to be spent rapidly [which sets up conditions for business cycles. Both borrowers and lending agents see the same conditions so all players tend to act together. Hence, when conditions are favorable, everyone wants to borrow (or lend). A situation that reverses when conditions look not-so-good.]
In contrast, entities borrowing for the benefit of the public sector tend to disperse borrowed funds over longer time periods to members of the public that may be less than eager to spend/re-spend. Many members of the public are themselves saving for personal business reasons and will not spend rapidly any windfall that comes their way. For at least these two reasons (there may be more), money borrowed (or created) by the public sector should not be expected to generate price increases as rapidly as those observed from private sector borrowing.
A Revisit: Do Private Banks Create Money?
As we discussed the issue of RFM and private banks, we seemed to be focusing more on borrowers rather than on lenders. This makes sense. All banks create money by making a deposit entry. The borrower assumes the same spending position in the economy as that enjoyed by deposit account holders who first deposit funds earned by hard work.
All banks expect borrowed money to be returned by borrowers. If all borrowed money was returned at one instant, there would be no money remaining in the economy! That thought sets us up for considering what happens when defaults occur.
When private bank lending encounters a default situation, borrowed money has been declared uncollectable. This does not mean that the money is nonexistent. It means that the money can no longer be legally collected by force of law from present money owners. At this moment, we can say that private banks have successfully 'printed' money into existence and money is now in the ownership of the general public.
The thought of default on loans highlights what happens when money is created. With normal private bank lending, each loan only increases the money supply during the life of the loan.
What about central banks? In my view there is no money creating difference between private and central banks but there is a huge difference between private and government borrowers. Both are expected to repay lenders but government has a weighted preference for loan rollover rather than loan payoff. Obviously, if a loan is rolled over forever, there is never an instant in time where there is no money in the economy. This is the second circumstance, along with default, where we can say that we have 'printed' money permanently into the possession of the general public.
Concluding Comment and Conclusions
The actual, behind the scenes, mechanical act of creating money has little importance in economics. It is the actions of the borrower and successive money owners that have economic effects.
Private banks increase the money supply when they make loans. They, at the same time, allow a borrower access to the existing money supply and economic structure. Thus we see the money supply as measured by bank deposits increase while, at the same time, existing money seems to be reused thereby leaving the existing money supply unchanged. This situation gives rise to the idea that we need to have at least two valid ways of measuring money supply.
Central banks, as an arm of government, can make a choice of deciding whether they are relending money they previously loaned into existence or or are lending newly created money. Economist can ponder and write about the paradox.
(c) Roger Sparks 2021