Why money disappears when loans are repaid.

Much to my frustration, 99% of the discussion of, and public information about, fractional reserve banking concerns the money creation process. Videos on the subject will often have scary music accompanying animated graphs of the money supply growing exponentially. The viewers will often be led to the conclusion that fractional reserve banking is a one way process in which the money supply can only ever increase, and the only problem with it, is inflation.

In this article I hope to correct this imbalance by talking about the other side of fractional reserve banking - the disappearance of money. It is perfectly true that when banks make loans, they create fresh new money that never existed before out of nothing. It is also true that when loans are repaid (or more specifically when the principal is repaid) that money disappears back out of existence. In a fractional reserve system, there can be periods where the net money supply shrinks. If there is a period in which banks are reluctant to make loans then the rate of money destruction through the repayment of existing loans can exceed the rate of money creation from making new loans. This is what happened in the great depression in the 30's. The money supply in the US fell by around a third. A falling money supply is every bit as problematic for an economy as high inflation.

In the current climate (since 2007) banks are reluctant to make new loans. The money supply is currently falling. It would be falling even faster right now were it not for quantitative easing. The entire crisis now is one of a falling money supply. The "Armageddon" scenario that we need to be worried about, is one of a sudden additional shrinkage of the money supply- an *implosion*.

Now lets look at the technicalities of why money disappears when loans are repaid. The first step is to consider what money is.

Money is anything which is widely accepted in exchange for goods and services. Or to put it another way - does it pass the "Tesco test". The test is to ask - can you walk in to Tescos and exchange that thing for a basket of food. If you can, then its money - if you can't then its not money.

Armed with this definition we now need to consider whether an I.O.U. is, or is not money. If I, Michael Reiss, gave "Fred" a piece of paper with the words "I.O.U. £10" and my signature written on it, Fred may be happy to take it if he knew me well enough. And indeed he could exchange that for £10 of conventional money from me at some point in the future. So the I.O.U. is worth something to Fred, but not to anyone else. That piece of paper would certainly fail the Tesco test. It is not money. To summarise:

IOU's from non-"establishment" sources are not money (but they may be valuable to certain individuals)

But now consider the following scenario. Lets say I go to a bank and ask for a loan of £100. The bank would ask me to promise to pay it back, i.e. they would ask me to write them an I.O.U. for £100 (I'll ignore the interest payment for simplicity). The bank could then give me a cheque book and tell me that I can use it to buy things up to a value of £100. But what they are giving me is effectively an I.O.U. for £100. The entire process can be considered as an exchange of I.O.U.s. The bank receives an I.O.U. from me, which according to the previous summary, is not money, though is valuable to the bank. In exchange I received an I.O.U. from the bank in the form of a cheque book. The I.O.U. from the bank DOES pass the Tesco test. I can indeed buy a basket of food with it. Notice that the bank's "I.O.U. £100" never existed before I went in to ask for the loan. The bank just created it out of nothing. The money supply increased by £100 in the process.

To summarise:

IOU's from "establishment" sources are money.
or to put it another way
Getting a loan from a bank is an I.O.U. swapping arrangement.

Now consider what happens when I pay back the loan. This can get a little tricky - so first lets consider a rather unlikely scenario which simplifies the analysis. Imagine that I used the bank I.O.U. to buy a second hand lawnmower from my neighbor. The neighbor, readily accepts a cheque for £100 in full and final payment. One week later my neighbor offers to buy my bicycle for £100. I take back my original cheque for £100 in settlement. Then I could go back to the bank and pay back my loan with that same cheque. The cheque ends the loan arrangement. The bank can tear up and throw away my I.O.U that I had given them, and at the same time I will no longer have the ability to spend their I.O.U. The money supply has now shrunk back down buy £100 in the process.

Obviously a scenario in which I pay back the loan with exactly the same cheque that the bank originally gave me is highly improbable to say the least, but it does illustrate the idea. In reality it is more likely that I will pay back the loan with *somebody else's* I.O.U. from another bank. But despite the I.O.U. exchanges that may happen between a loan and a repayment, the idea remains the same: A loan repayment corresponds to the cancellation of an I.O.U. swapping arrangement. Canceling I.O.U. swapping arrangements is one and the same thing as making the money disappear back out of existence or shrinking the money supply.

As I have said many times before, if we instead had a system of full reserve banking, then none of this nonsense would be going on. The money supply could be held constant.

Tweet