Wednesday, November 16, 2011

How a loan comes to be

This diary is motivated as a rebuttal to many wrongheaded ideas I hear in the blogosphere. Some I even held myself in the not too distant past. Not because I had ever put much thought into them but precisely because I hadnt put much thought into them. Funny how really thinking about something can clear the muddle away.

The idea I want to address in this diary is the nature of a loan. Specifically a loan from a bank

Now, we all know what a loan is right? We dont have something so we get it from someone else with a promise to pay it back. A cup of sugar from your neighbor, ten bucks for lunch from your buddy or even $5,000 from a parent or close relative for something really important. This would be what is called the micro perspective. What an individual does with his individual transactions and the motivations behind them. At any given point in time there are countless billions/trillions owed in this way. One important thing about these loans, they really dont have much macro impact (other than if everyone welched on these we'd have half the population pissed....... hmmmm maybe just like now after all.... but I digress) There is no monetary macro impact in terms of affecting aggregate demand is probably a better way of saying this. Why? Well I think its safe to assume if I lend $5,000 to my brother I dont need it myself. If I did I wouldnt lend it right, so this isnt money that would otherwise be spent on some good or service immediately. But my brother likely did spend it on something so my loss was his gain and we net to zero. I am expecting that he will "lose" $5,000 later when he can and give it back to me but again it is a net to zero in terms of the macroeconomy. No new money has been created to augment aggregate demand. This is the situation being talked about in this parable

This parable is trying to illustrate that one $100 bill can pay off thousands and thousands worth of debts. And this is true. But only if you are talking about the types of debts described above where its between two private sector actors and involves cash or its equivalent (a demand deposit account that one writes checks off of). This is not the case when everyone is indebted to what is functionally an outside third party like a bank.

A bank loan is verrrrrrry different. In spite of what many smart economists think (Mr Krugman Im talking about you here) when we go to a bank and get out a loan its not operationally, functionally, any-"ally" equivalent to what I described above. It involves something entirely different. The thing is I suspect banks know this but they are happy to let people continue to believe false beliefs. Probably cuz those false beliefs benefit them, or so they think. Anyhoo, what I would like to persuade you into seeing is that when you borrow "from" a bank you are not borrowing the accumulated savings of thousands of other people who are so generous to let you use their money for a venture (and "all" they want in return is some compound interest) but in fact you are borrowing from YOU!. Doppleganger whoever that lives a few years ahead and is so optimistic about his life he will promise almost anything to someone who is willing to make his dreams of a small business a reality.

Now, Im not claiming that when thousands or millions of people pool their resources that something greater than the sum of individual parts cant come to fruition and that banks dont in someway, in our modern economy, facilitate that. Thats not my intent at all, my intent is to show that at its most fundamental level what a bank loan IS.

I think this is important because just like if you dont know what matter is you have no way of coherently deconstructing and possibly reconstructing it, if you mis understand what bank loans are your attempts to restore them will fail when they cease to be the monetary support for the economy that they once were. Now, whether or not we should be relying on bank credit to support commerce at our previous levels is ANOTHER discussion to have.............. but not here.

SO lets do a short thought experiment which, I think, demonstrates my point.

Imagine ten people who are all consuming every bit of their income. They have nothing to save because they spend everything to live. Now imagine that only one guy finds a way to consume less and can therefore accumulate savings. At this point could a bank (Im going to take a cue from neo classical econ and “assume” a bank into existence) take his savings and lend them to any of the other nine people?? Of course not. Everyone else is consuming all their income, they have nothing to borrow. A bank could however loan the saver some money against his future disposable income. That loan is created out of thin air and is an addition to present money supply. Once each of the other nine people in that are able to accumulate savings by not using all present income for consumption, they can then become a borrower against THEIR OWN potential income stream.

It requires no one elses savings for me to get a loan, only my own potential future income beyond consumption.

Banks make claims on each borrowers own savings and future income and no one elses.

This realization makes it clear that all efforts to restore lending which focus on the banks side while ignoring the income of average Americans is destined to failure.

Are there any economists who talk like this? Who talk about repairing the citizens balance sheets not the banks? Who talk about income support instead of asset price inflating? Yep .............. the ones who study MMT

Study it!!

Bring on the discussion!


  1. No use of the phrase "fractional reserve banking" and none of the word "reserves".

    I accept that a bank can lend money against future disposable income. But that is not the same as lending future disposable income today. The future disposable income is collateral for the loan. The money for the loan comes from somewhere, from reserves I think.

    In object-oriented programming you use words (programming language) to describe or create an object. Then you create "instances" of that object which can be used in the program.

    In AutoCAD you can draw a car maybe, and then make it a "block". This is like making an "object" in OOP. The block is a definition or a description of the lines and circles you used to draw the car.

    After you have created the block, you can insert "instances" of it into the drawing, as many as you want, which look just like the original car you drew.

    I think of "reserves" as like the original block in autocad or like the description of an object in OOP.

    I think of "bank money" as like the instances.

    You can spend all day shopping. But you only need to have money when you get to the check-out. You only need money for a moment. That is why our money -- which is mostly "instances" -- usually works. It is only when everybody rushes to the check-out at once that instances are insufficient.

    These are just loose thoughts. I'm not arguing anything.

  2. Thanks for the reply Art

    I think you, like so many (including myself until the last couple years) still view a bank as a place that "has" money to lend . When in fact its a place that "creates" money to lend. Reserves, I think, are best understood as the way the government keeps score of all the money things that are being exchanged. I think when there is a liquidity or solvency crisis they flood the system with reserves simply because they have no idea where and how many claims are going to end up being made within the system. They require banks to hold these reserves to make sure all legitimate claims are paid and no one has an unsettled account. Its my impression that with all the CDSs and other shadow banking assets out there, they have no idea how much will be needed to settle claims as they are made. It is likely untold trillions. They need to be able to handle the claim and possibly at a later date use a court system to handle ones that turn out to be fraudulent.

    Again this is me talking I havent read any stuff like this directly form the sites I visit.

    I said nothing about fractional reserve because fractional reserve lending is truly no longer applicable. Its a gold standard idea that is obsolete. Now THAT I did get from Mitchell, Mosler, Wray and even a non MMTer Steve Keen.