Yves here. Given the intense nature that news from the Middle East has taken, though, it may be time to moderate our broadcast by returning to our discussions of Modern Financial Theory, for the benefit of readers familiar with the area and newcomers alike. The effects of paying off a bank loan (and writing off the principal in a loan rescheduling) are not well known, as they result in reduced cash flow.
Note, loose money will not do much to stimulate economic activity; businesses decide whether or not to expand based on their industry conditions and niche. However, the ones that do well are those where interest is one of their biggest business costs, such as in financial institutions and leveraged speculators. But hard currency can hinder commercial activity; it may be expensive or impossible to get the necessary loan.
This asymmetrical operation of monetary policy is not well understood. It used to be that the Fed pretended to understand that; when it will lower interest rates during recessions, it will only keep them a quarter lower and then begin to tighten. It was under Greenspan, in the dot-bomb era, that he took the unprecedented step of keeping interest rates at negative real interest rates for nine full quarters. Greenspan was very bullish on the stock market and believed (against any hard evidence) that stock market declines would disrupt the real economy, so he was eager to cut stock prices. He did, but the biggest gainer was the mortgage….and we know how that movie ended.
Richard Murphy has been producing short videos that provide an accessible introduction to the findings of Modern Monetary Theory and other banking and economics topics. I hope you will spread this post.
By Richard Murphy, part-time Professor of Accounting Practice at Sheffield University Management School, director of the Corporate Accountability Network, member of Finance for the Future LLP, and director of Tax Research LLP. Originally published on Fund the Future.
By Richard Murphy, part-time Professor of Accounting Practice at Sheffield University Management School, director of the Corporate Accountability Network, member of Finance for the Future LLP, and director of Tax Research LLP. Originally published on Fund the Future
I published the following video in the Economic Facts series this morning. In it, I argue that if bank loans create money, repaying those loans destroys money. The money in question does not really exist anymore. That’s one of the hardest facts in economics to get our heads around.
The audio version of this video is here.
The transcript says:
Paying off a bank loan destroys money.
It’s one of those economic facts that doesn’t make a lot of sense until you really think about it. But it must be true because all banks create money in the UK that flows into our economy because the bank lends money to borrowers.
When a bank lends money to a borrower, there is an exchange of promises. I have explained this in other videos.
The bank says to the borrower, I will lend you £10,000. The borrower says, I’ll pay you back £10,000. That is the exchange of promises recorded on the keyboard. One is a positive number in the current account. One is a negative number in the loan account when the two add up to zero, indicating that this new money was created out of thin air.
And because of that process, this new money is available for the borrower to use. And they use it. And because of that, as I also explained in another video, savings are created. Loans must ultimately result in savings because the banking system must underwrite.
So, what happens as a result of the loan repayment? The money created is spent.
I emphasize that deleted word. It doesn’t just disappear quietly. In fact, it no longer exists, because the promises that created that money have been fulfilled. If money is about a promise, and that’s only because all money is debt, then once the debt is paid back it’s no longer money. It’s as simple and straightforward as that.
Money that was there because the debt was created. now it is gone because the loan has been repaid.
This has huge consequences though for our economy because you can see right away that we rely on only two forms of money in our economy, one created by the government which will be the subject of other videos and the other – probably a large part of many economies including the UK’s – created by commercial banks for their lending to people like me and you, we are completely dependent on this money created by the loan. Then what happens is that if all the loans were paid back, we would have no money left.
This is why we live in a debt dependent economy. Because we have no other idea about how to generate the money we need to do our daily activities. Therefore, we depend on the people who continue to borrow money from the banks in the economy to ensure that we have a continuous supply of money to replace what is paid each day by the borrowers to the banks, and their debts. being canceled as a result and money disappearing as a result. So, we have to live in a debt economy, and we have to live in an economy where people borrow.
But that is very worrying because, as we all know, in a weak economy, people don’t borrow. They lose the confidence to do so, they don’t go out to spend, and as a result, the supply of money falls. And that’s why we get recessions.
Therefore, what we need within any economy is a balancing system, that is when the economy is doing well, and banks are making a lot of money because people want to borrow, we have a situation where the supply of money is strong. Therefore, the government does not need to inject more money into the economy.
When the economy slows down, when people don’t want to borrow, when there is a threat of recession, when people feel that it is too risky to make another payment on any loan, the government should inject more money. in the economy to ensure that everything works.
How do we know this is happening, and where is the evidence? Well, it’s very simple, really. After 2008, when there was a global financial crisis, people did not want to borrow. Banks are in danger, they looked doubtful, people felt very nervous about the state of the world, they didn’t want to go out and borrow money to buy anything, so, the government had to create a lot of new government- create money to put into the economy so it just keeps going.
Quantitative easing did that. That’s what it did, it created a shortage of bank loans to ensure that there was enough credit in the economy to keep it going.
And the same thing happened when we had COVID. Because for the same reason, people were not borrowing. They could not even come to the store to borrow, buy, do anything else. And, therefore, the government had to shut down. There was nothing unusual, nothing bad, bad, or worrying about this process. It was only when the government filled in that the commercial banks clearly failed, and people did not want to borrow.
And they had to fill in because the business bank loan payments were ongoing because that’s what the loan agreements required.
Therefore, the economy was in danger of running out of money and the government was making good on that deficit.
The reason why there was that risk was because when the money borrowed from a commercial bank is paid, whether it is a loan, whether it is a mortgage, or whatever, when it is returned, the money created by it is destroyed. It’s gone. It has disappeared. It’s as if it never existed because the promises it created have been fulfilled. It’s over again. Finito. It’s over.
And you must understand that if you are going to understand why we live in an economy where debt must be produced all the time or the government must correct the deficit and that there is nothing wrong with the government doing that. We just need to make sure there is cash in the economy to keep us all going.
We will deal with government money creation in another video. For the purposes of this video, the bottom line is that paying back a bank loan destroys the money it created.
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