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Creation and destruction of bank credit money

Creation and destruction of bank credit money

Joe Leote

I took Money and Banking in night school nearly 30 years ago. The professor, a bank manager, said the majority of bank managers probably do not understand that the banking system creates money. And a few years ago I asked a Senior VP of a local bank if he thought banks create money. He said, “No because the books must always balance.”

However I would draw attention to a useful paper [1] which introduces The General Balance Equation as applied in science and engineering:

Accumulation = Inflow Outflow + Generation Consumption

Here a quantity is specified with respect to a system such that accumulation in the system equals inflow to the system, minus outflow from the system, plus generation within the system, minus consumption within the system.

If the quantity is checking deposits and the system is a bank which records checking deposits as liabilities on its balance sheet then it is obvious that numbers recorded in the books do not flow in from somewhere or flow out to somewhere. Instead, a debit entry reduces the checking deposits and a credit entry increases the checking deposits via the customs of accounting. The process of bank money creation and destruction is best characterized as Generation via credits together with Consumption via debits.

Another MIT paper [2] describes some models which illustrate a generic structure called overshoot and collapse, where a price bubble driven by net credit generation consumes a scarce resource in the economy during the overshoot phase and then the process reverses into a price collapse. The scarce resource is creditworthy borrowers holding adequate collateral assets.

The shift from overshoot to collapse in an economic system, however, also involves a shift of investor perceptions, the generation and consumption of financial instruments, a change in prices assigned to populations of goods in the economy, and is more complex than a physical process.

References:

  1. http://www.worldscientific.com/doi/suppl/10.1142/p631/suppl_file/p631_chap01.pdf
  2. http://ocw.mit.edu/courses/sloan-school-of-management/15-988-system-dynamics-self-study-fall-1998-spring-1999/readings/generic3.pdf

Joe Leote has published a number of papers concerned with the operation of the U.S. financial system in the Social Science Research Network. The above item appeared in the understanding money discussion list (a google group hosted by William Hummel).

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