Short & Simple 13 – Private Credit Creation

We have seen that a national currency enters the economy when government spends, and that the recipients of the government spending can use the currency for various purposes, including to purchase goods and services. Government is therefore an original source of funds.

There is another original source of funds that gives people the ability to make purchases. This other source is private credit creation. Put simply, a household or firm can borrow from a bank or other financial institution and use the funds to spend.

A bank lends by creating two things at once.

It creates a loan, which is a financial asset for the bank and a financial liability of the borrower.

At the same time, it creates a new deposit. The deposit is a financial liability of the bank and a financial asset for the borrower.

A financial asset is a contractual claim on another person or organization.

A financial liability is a contractual obligation to another person or organization.

The bank’s claim on the borrower is the amount owed on the new loan, including any interest that is charged. This is why the loan is an asset for the bank. For the borrower, the loan is a liability. The borrower has an obligation to repay the loan plus interest.

Conversely, the new deposit is an obligation of the bank to provide currency to the deposit holder either on demand or after some specified period of time. More specifically, the bank’s undertaking is to obtain government money (cash plus reserves) sufficient to meet cash demands of the deposit holder and conduct final settlement of transactions in reserves. This makes the deposit a liability of the bank. To the borrower, the deposit is an asset. As deposit holder, the borrower has this claim over the bank.

The bank creates the loan and deposit by putting entries into a balance sheet.

A balance sheet is a statement outlining assets, liabilities and net worth (sometimes called equity). Net worth is the difference between the assets and liabilities of a person or organization. This makes it a balancing item. It ensures that total assets always equal the sum of total liabilities and net worth.

Let’s say that River Bank lends $10,000 to Minnie Motza. For simplicity, assume that the bank charges no interest. The bank creates the new loan and deposit by making accounting entries that have the impacts shown in the following ‘T-Account’:

Minnie Motza’s situation will be the mirror image of this:

This is the situation immediately after the loan and deposit are created.

The borrower can now use the funds for making purchases, by drawing down the account.

The reason that banks can commit to providing government money to deposit holders is that they are in a special relationship with government (this is discussed in part 3 of the series). In particular, the government’s bank, often referred to as the central bank, also acts as the banker for all other banks. Among the functions of the central bank is its commitment to act as lender of last resort.

This ensures that if a bank lacks sufficient reserves and finds that it cannot borrow them from other banks, it can always obtain them from the central bank, though there are conditions attached. We will leave such details for another time.

The key for now is just to understand that our capacity to make purchases comes from two original sources – government spending and private credit creation.


16 thoughts on “Short & Simple 13 – Private Credit Creation

  1. The key for now is just to understand that our capacity to make purchases comes from two original sources – government spending and private credit creation.

    It may be worth mentioning that there is another source of purchasing power — private non-bank credit — since some people are bound to notice.

    In private non-bank credit extension, borrowers incur an obligation to repay the debt to the lender in the unit of account, which is only obtainable from currency in circulation or bank deposits created by either government spending or bank credit creation.

    Most business transactions are initiated by drawing on lines of credit with suppliers, for example. Many auto loans in the US are extended by the finance arms of the manufacturers. Private non-bank credit is a big deal.

  2. “A bank lends by creating two things at once.”

    Well, not all bank deposits are created thought loans. I can deposit cash in a bank. So I give up my dollar notes and coins to the bank and, in exchange, the bank issues a bank deposit for me.

    We should never forget that bank deposits are promises to pay dollars (government money). I can withdraw my bank deposit at any time and get dollar notes and coins.

    So bank deposits are backed by government money. Actually, we can say that bank deposit’s value is derived from government money’s value.

    So is bank deposit a true private money instrument?

  3. Well, not all bank deposits are created through loans. I can deposit cash in a bank.

    Should be “all bank deposits are initially created through loans.”

    Existing funds created initially by government spending and bank credit circulate.

    Deposits circulate through drafts on deposit accounts (checks and electronic transfers).

    Cash is withdrawn against deposit accounts, used for spot transactions or saved, and deposited into bank accounts.

    Cash is obtained through the window either in exchange of previously existing cash or new cash from a bank’s vault cash that counts as bank reserves along with reserve balances at the central bank.

    Central banks distribute cash through banks and banks exchange bank deposit credits for cash at the window. That’s now non-banks obtain cash initially. When vault cash is passed through the window it becomes currency in circulation as part of M1 along with commercial bank deposits.

    Bank reserves, that is, banks’ reserve balances at the central bank and vault cash, make up the monetary base, which does not affect purchasing power in an economy.

  4. Tom and Andre, thanks for your comments.

    Tom, actually I do mention in the second paragraph that private credit creation can come from banks or non-banks:

    [A] household or firm can borrow from a bank or other financial institution and use the funds to spend.

    But it is true that I don’t go through the case of non-bank credit creation. Thanks for providing the further explanation.

    Andre, the post doesn’t really say that all deposits are created by loans. It says that a bank lends by creating a loan and a deposit.

    The post also mentions that a deposit is the bank’s promise to provide government money:

    [T]he new deposit is an obligation of the bank to provide currency to the deposit holder either on demand or after some specified period of time. More specifically, the bank’s undertaking is to obtain government money (cash plus reserves) sufficient to meet cash demands of the deposit holder and conduct final settlement of transactions in reserves.

    But your comment, like Tom’s, adds some nice details for the reader. Thanks.

  5. An important question here is whether money creation by private banks constitutes counterfeiting or a subsidy of those banks. David Hume writing 250 years ago said “yes”, as did the French economics Nobel laureate Maurice Allais.

    I also argued “yes” in this Seeking Alpha article:

    Title of the article is “To Enable Private Banks To Create And Lend Out Money, Households Must First Be Driven Into Debt”.

    Re the abstract, unfortunately Seeking Alpha have merged the abstract with the main article, so I’ll contact them now and ask them to put that right. The abstract at the time of writing this is the first two paras of the article, and is thus.

    There are two main forms of money: state issued money (so-called “base money”) and money created by private banks. It is perfectly feasible to have either type of money predominate, and in most economies nowadays private money predominates.

    Introducing private money to an economy that uses only base money increases demand. To counter that extra demand, base money must be confiscated from households, which drives some people into debt. Conversely, if in 2017 real world economies private money were banned (as advocated by several Nobel laureate economists), that would be deflationary. In turn, that would require government to create and distribute significant amounts of base money to households, which would reduce their need to borrow.

  6. My point is that a great deal of non-bank credit is provided by firms that are not financial institutions.

    Most vendors give terms. The standard in the US is 30 days. Larger firms may negotiate more generous terms like 60 or 90 days, and vendors comply owing to the volume involved. The US government is a huge volume buyer and gets a whopping 180 days to pay.

    This means that many vendors, especially smaller ones, need lines of credit to finance operations owing to the float. They figure this into cost and recoup it through price to the degree they have the market power.

    This is a very big deal in business.

  7. PS: I’m not sure how I initially misinterpreted Tom’s first comment. It is perfectly clear! I must have expected it to say something different, and somehow read into the comment something that wasn’t there …

  8. Peter, one of the reasons I brought it is that economists often overlook things that are obvious to business people.

    I recall taking Econ 101 in college with a prof who was obviously clueless about business and how the world actually works.

    My friends and I were, like, WTF!

    But he pretty much told us what would be on the test, bless him.

    All I recall now is elasticity.

  9. Re Tom’s claim that private non-banks also create credit, that’s correct, but the word credit has two different meanings: bank created credit is not the same as non-bank created credit.

    Banks create a form of credit which is widely accepted in lieu of genuine Fed issued dollars. So in effect, private banks create money.

    In contrast, non-bank entity A can lend $X to non-bank entity B, but the loan itself is not easily transferable, thus it does not really constitute money, though the fact of granting the loan probably boosts demand. Indeed, Steve Keen has been banging on about the fact that demand is related to indebtedness for years.

    The distinction between bank and non-bank create credit is not 100% sharp: in the World’s financial centres all sorts of strange bits of paper are accepted in lieu of money. But for about 99% of normal commercial transactions (buying cars, houses, groceries, etc) the distinction is pretty clear.

  10. Thanks, Ralph. Good observations. I think you and Tom are both pretty much in agreement. (Tom can correct me if not.)

    [T]hus it does not really constitute money, though the fact of granting the loan probably boosts demand

    Yes, I think that’s right. The context set up in earlier parts of the series was the question of how spending could occur independently of income. The answers (apart from drawing down past savings) were government spending and private credit creation. That is why Tom mentioned credit from non-banks, because I had neglected to include it in the post.

    The additional distinctions that you, Tom and Andre have drawn in the thread all help to fill in the picture nicely. Cheers.

  11. If you are going on holiday for a few days, have a read of the first 150 pages of particularly if you don’t know your money market funds from your central counterparties.

    Only man can make his life this complicated with so little benefit to improving the well-being of society. It is often said in the UK, only 7% of the City of London financial sector needs a banking regulator, the other 93% needs a gambling regulator the same as every other Casino. 😉

  12. “Money” is one of those weasel words that are ambiguous enough to mean what the user wants to mean.

    The technical definition is in terms of money supply measurement. Purchasing power is usually measured in M1, chiefly customer deposits in commercial banks and currency in circulation. M2 is a development of M1, mostly transfer of funds from deposit accounts to time accounts to take advantage of the greater interest. M3 is no longer used in the US.

    Importantly, the monetary base, which includes central bank liabilities that are bank assets — reserve balances at the cb and vault cash — are not used directly in the economy for exchange and so they do not affect purchasing power. There is no direct causal relationship from the MB to M1. Rather the relationship is inverse, the MB being an accounting residual.

    If “money” is defined in terms of purchasing power however, then non-bank private credit certainly does increase purchasing power in the economy in the short run. It doesn’t in the long run since loans must be paid from funds created either by government spending or bank credit. Non-bank credit increases risk in the system since it’s repayment is contingent on other factors.

    Modern economies run mostly on private credit. The ratio of funding that comes from government spending is low compared to bank credit plus non-bank credit generated by financial and non-financial entities.

  13. True, private bank lending is the dominant form of M1 creation, although in terms of expenditure on goods and services, government spending is critical — between roughly 30 to 55 percent of GDP across OECD countries.

    So in terms of spending that is independent of income, government spending is the bigger part of the story (since much private consumption expenditure can be regarded as induced out of income).

  14. One could judge the ratio of capitalism to socialism by the ration of private credit to government spending. The greater the relative amount of government spending, the more socialistic the economy, and vice versa.

    A corollary to this is the ratio of public debt to private debt. The greater the relative amount of public debt, the lower systemic risk.

    Total US Government Spending, federal, state and local, was increasing briskly, year on year, in the mid 2000s from $4.4 trillion in 2005 to $6 trillion in the depths of the Great Recession in 2009. Fore several years after the end of the recession total government spending leveled out at $6 trillion. But in 2015 spending started to increase again. per year.

    Viewed from a GDP perspective, total government spending was steady at about 33 percent GDP in the mid 2000s and then jumped, in the Great Recession, to 41 percent GDP. But in the subsequent economic recovery total government spending has steadily declined as a percent of GDP down to about 34 percent GDP in 2015.

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