Making Money

This is a little essay to illuminate the reasons that economic systems around the world are failing to deliver economic growth, and are slipping back into recession despite the best efforts of governments and central banks to stimulate their respective economies. The problem is that demand for goods and services is not growing, and even shrinking. People can only buy what they can pay for with either cash or credit, so aggregate demand is limited to the sum of people’s disposable income and net newly created money, which Steve Keen calls the “credit impulse.” Why, when the Fed is supposedly printing money at a great rate, does it not flow through into lending and spending?

Money (or debt – same thing) is created by debtors committing to making a stream of payments in the future. A creditor (someone who believes that the debtor will pay, from the Latin credere, to believe) effectively buys the debtor’s commitment from him, exchanging value now (typically of a discounted amount) in return for the future stream of value. Similarly, when a debt is repaid or repudiated, money is destroyed.

When a new debt is given credit by a second party, the new debtor has created a financial asset out of thin air. The transaction with his creditor has given him new spending power – in other words, money. He has monetized his promise. Note that it is the debtor who is ultimately responsible for money creation. When I said before I was creating money when I worked in the bank, that was true, but only because I was completing the promissory notes on behalf of the debtor, not as a result of any action the bank took on its own account.

I’m avoiding using the term “borrower,” because it is misleading in our current financial system. It is misleading because it implies that the creditor is a lender, that is, actually gives up something of value when it purchases the debtor’s promise. In most cases, the creditor exchanges for the debtor’s promise its own newly created promise, that of making payments on the debtor’s behalf at his demand to third parties up to the agreed amount. This is different from borrowing, say, a cup of sugar, where the lender ends up short a cup of sugar until the borrower returns it. A creditor bank borrows the cup of sugar from the Fed as needed and does not need its own sugar. However, when I talk about the financial system I don’t limit the generality to just banks. A huge part of the financial system, often called the “shadow” banking system, is made up of creditors that are not banks – GE Financial for example – but act as banks in all respects except that they don’t accept deposits. A bank-type creditor is one whose balance sheet liabilities are mostly payables – deposits, debt and so forth – and has a very limited amount of capital. In essence, it deals mostly in OPM – Other People’s Money. Only when an asset, a loan, loses value in part or entirely does the bank’s capital come into play because the bank’s liabilities – promises – are still unchanged and the loss in value of the asset must be made up from the bank’s capital account. On the other hand, an example of a creditor that is a true lender would be Apple Corporation, which has huge amounts of retained earnings, capital in excess of paid-in capital that has not been distributed to shareholders. When it lends – invests – that money, it is dealing in its own money because shareholders have no claim on the distribution of that money. In all cases, a loss in value of a loan or investment is subtracted from the capital account. Since Apple is lending capital and will not lend more than its capital, its losses will not cause it to run out of capital and become bankrupt. Many European banks, now in the spotlight, have capital that is less than 3% of the value of their assets, so that even minor losses in the value of their assets can bankrupt them. And are doing so.

  • Creating money depends on there being debtors to create new debt, who are both willing to do so and are credit-worthy.
  • The banking system can easily be bankrupted or lose its creditworthiness by even relatively minor losses in the value of its portfolio of financial assets.

Governments and central banks have concentrated on bailing out failing banks, on the premise that bankrupt banks cannot lend and therefore cannot create the new money needed to sustain demand growth in excess of productivity growth.

They have mostly forgotten or ignored the critical role of the debtor, except to the extent that the Federal government has increased its deficit spending and thence its borrowings. However, the increase in government borrowing has been only just large enough to offset the money destruction resulting from net debt reduction by the private sector. The credit impulse (which can be seen on the Fed Z.1 Flow of Funds report) is more or less zero and declining.

Worse, the one area where lending is active, student loans, is serving to cripple the one cohort of consumers that has unbesmirched credit and might have served to revive money growth in the future, by saddling them with huge non-dischargeable debts that will prevent them from borrowing, for example to buy houses. Read this piece and this to understand the devastating consequences of this pernicious practice.

The past destruction of the creditworthiness of the consumer through a series of government-sponsored credit bubbles and the ongoing practice of stripping the creditworthiness of future consumers combine to ensure that economic growth will be limited to productivity growth for the foreseeable future. In the intermediate term, growth will be much less than that (and negative) as the repayment and repudiation of existing debt creates a negative credit impulse. Government’s ability to increase its borrowing to make up for the decline in private credit is limited by the risk of the government’s loss of its own credit-worthiness, as witnessed by the US’ loss of its cherished AAA rating – to say nothing of the shenanigans in Europe which are largely precipitated by a much weaker banking system than the US.

We continue to see attempts to kick the can down the road. But the donkey – the consumer – is overloaded with debt and baggage such as past defaults, lost employment, deficient pensions, and on and on. The neo-classical economists at the Fed (and the New York Times) simply don’t understand this.  Their models, unbelievably, ignore private debt. The eventual outcome is inevitable. Can-kicking by creating more government debt simply means more debt to liquidate and lengthens and deepens the recession or depression. Right now, if we assume that a total debt/GDP of 150% is reasonable we’re looking at a 20 to 30 year process to get there. This is a generational problem that began in the early 1980s. As I’ve previously mentioned, I look to Japan to see more clearly how this plays out when the end game begins, I think the Japanese are either there or very close to there. In many ways, the Japanese are better situated than the US, so it may not be as helpful as I would like, but it will be better than nothing as a guide.

Edit: Apparently the Fed is beginning to get a clue – tonight, from the Fed’s WSJ mouthpiece, John Hilsenrath:

The housing bust left behind millions of people with credit records damaged by plunging home prices, lost jobs, past overspending or bad luck. Many are now walled off from the low interest rates engineered by the Federal Reserve …

Fed officials are weighing new steps at their policy meetings Tuesday and Wednesday, following a period of disappointing jobs growth and financial turbulence in Europe. … The credit divide factors into their thinking.

Interesting, but the basic problem remains – too much debt already (see donkey). Bernanke isn’t bothered about breaking the law, so he may do something really bizarre. He is much more dangerous than Greece. Timeo Danaos argentariae et dona ferentes. Forgive me, Virgil, I just couldn’t resist.

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