Circulation of Money – in Context

Money circulates through the economy, perhaps changing hands many times. Sometimes the money is exchanged for something else of value. Sometimes it is saved – temporarily placed in storage. Sometimes it is exchanged for a promise to repay it later. Sometimes it is taken by force. Sometimes it is given as a gift.

However, there is not a fixed amount of money circulating. There is a life cycle to money, from creation, to circulation, to destruction, and it typically works like this:

Money flow in the economy, from creation to destruction, ignoring interest

  1. Money is created, in the form of a bank deposit, when a customer borrows from a bank. Simultaneously, the bank records that the borrower owes it that same amount of money.
  2. The borrower exchanges the money for goods or services from someone in the rest of the economy.
  3. The money begins to circulate in the economy, each time being exchanged for further goods and services. This is the part of money's life cycle shown in the typical circular flow diagram.
  4. Before the time the loan is due for repayment, the borrower sells something in exchange for money, and places it on deposit with the bank, thereby removing it from circulation. (The money need not be obtained from someone in the chain of sales starting from the original borrower. Money is fungible, so all that matters is that the same quantity is removed from circulation as was originally introduced).
  5. The loan is removed from the bank's books, and simultaneously the money (the deposit) is destroyed.

This is a (slightly) simplified version, since it does not consider interest. However, that is a straightforward addition to the scenario, and is shown later. For now, the questions of why new money has value, and what effect there is on the transfer of goods and the provision of services in the economy, will be considered.

Why is money valuable?

Some economics text books claim that money, as it exists in most of the world today, has value simply because the government declares that it does, and because people expect that it will be accepted in exchange for goods and services. I am convinced that they make a fundamental – and dangerous – error. Money really has value because it is backed by legally-enforcible promises to (produce and) sell goods and services.(*) It is not just that sellers have an expectation that the money which they receive, when they sell something, will be accepted in exchange for goods and services later – it is that the legal system makes this a reasonable expectation.

When money is created, the goods and services for sale are likely not to increase immediately, so there is an initial imbalance. However, having spent the borrowed money, the borrower must subsequently sell goods or services to someone somewhere in the economy in order to repay the loan. So this new money ("created from thin air", as some like to say) is valuable for the very good reason that it can be used to buy something valuable which would otherwise not have been brought to market – the produce of the borrower. The new money, and the additional goods and/or services brought to market in order to repay the loan, match exactly.

There are two assurances that these additional goods and services will in fact be brought to market.

  1. Bank suing borrower. Having borrowed the money, the borrower is in debt to the bank. If the borrower fails to repay, the bank can sue the borrower, obtaining the help of the legal system to force the borrower to pay the amount owed to the bank, and the situation is as described above where the borrower willingly repays the loan.
  2. Bank guarantee. (See diagram below). It may be that the borrower has insufficient assets to repay the full amount of the loan, or the bank may decide that the cost of recovering the outstanding debt is too high to be worthwhile. In this case, the bank must write off that part of the loan defaulted (£d in the diagram): the bank's owners must pay this remainder of the original borrower's debt themselves. As with the borrower repaying, they must either sell goods or services to obtain the money, or use money obtained from having already sold goods and services. Either way, the money is removed from circulation, bringing the available (or due to be available) goods and services back in balance with the amount of money in circulation.(**)

Money flow in the economy, from creation to destruction, ignoring
	  interest, when the borrower fails to repay £d of the
	  £P loan

Banks can be seen as insurance companies. They insure the value of the money which they create, promising that if the borrower does not sell additional goods and services worth as much as the new money created, the bank will do so itself.

(*) Unfortunately, both types of money may be called fiat money. I prefer to use fiat to refer to money simply declared by the government to have value, and to refer to modern money as promise-backed money.

(**) In a well-run banking system, the owners are not allowed to promise to refund the bank after a borrower has defaulted. Instead they are required to lend a fund to the bank – its capital – which is depleted (and must be renewed from either profits or further loans from the owners) as and when borrowers default. But the effect is the same – the failure of borrowers to repay reduces the assets of the bank's owners.

Interest

In the situation above where the borrower repays the loan, the bank's owners' wealth is unaffected. But when the borrower fails to repay, the bank's owners are required to make up the loss. Additionally, there are costs to running an bank – paying employees to keep records, renting a place of business, keeping a secure storage facility, etc. And anyone considering investing in a banking business is likely to want to make some profit, in order to pay for everyday expenses (food, accommodation, top hats, fast cars, etc.). Therefore the bank must have some revenue, and this generally takes the form of (sometimes) fees for banking services, and (usually) interest on loans, as illustrated below.

Money flow in the economy, from creation to destruction, with
     interest charged on loans

This situation is very similar to before, but the borrower must actually sell £(P+i) of goods and services before the loan is due to be repaid, rather than just the £P originally borrowed. When the borrower pays, the £P of principal is destroyed, but the £i of interest is passed on (eventually) to the bank's owners(*) in the form of a dividend on the shares. This money can then be used by the bank's owners to buy goods and services in the economy.

Examining the net income in money for each of the agents in the economy gives:

Each agent's net income in money as a direct result of a loan.
AgentNet IncomeTotal
Borrower+£P -£P +£(P+i) -£P -£i0
Bank-£P +£P +£i -£i0
Bank owner+£i -£i0
etc.+£P -£(P+i) +£i0

In each case, the agent ends up with exactly the amount of money with which they started.

However, examining the net quantity of goods and services received (those received minus those provided) for each of the agents in the economy gives:

Each agent's net receipt of goods and services as a direct result of a loan.
AgentValue of goods obtainedTotal
Borrower+£P -£(P+i)-£i
Bank00
Bank owner+£i+£i
etc.-£P +£(P+i) -£i0

The result is that, even though there is no net transfer of money, there is a net transfer of goods and services with value £i from the borrower to the bank owner.

Why would the borrower borrow, given that it involves a net transfer of goods and services to bank owners? There are several possible reasons:

  1. The potential borrower might see a business opportunity to create and sell something of value – specifically greater value than the cost of the raw materials, the pay of any employees, and the cost of the interest. If the only thing which the borrower lacks is money to pay for the resources needed, borrowing is a good decision. The bank owners benefit (from the payment of interest which can be used to buy goods and services), the borrower benefits (from the wealth created – not shown in the table above), and the rest of the economy may benefit from access to the useful goods and services which were not previously available.
  2. The potential borrower may need a short-term loan in order to benefit in the medium term. For example, someone who does not have a car, but has an offer of employment in a place not served by public transport, may well benefit from borrowing to buy a car, and therefore be able to take advantage of the extra income. This is fairly similar to the investment example above – the borrower invests in the means to provide his labour to a potential customer for mutual benefit.
  3. The potential borrower may believe he has a good opportunity to speculate. If he believes that, say, shares in a particular company are likely to rise in price, he could benefit personally from borrowing money, buying the shares, and then selling them later after the price has risen. If he is mistaken, however, he must find something else to sell to repay the loan.
  4. The borrower may simply want to consume something now, and delay paying until later, deciding that the benefit of buying early is worth the interest cost. This may be an expensive way of consuming.

Either way, in the short term, the borrower obtains goods and services from the rest of the economy without having to sell something first. Someone else sells those goods and services without having bought something first. The seller expects either to be able to buy something of equal value from the borrower later, or to buy something of equal value from someone else – who will buy something from the borrower later. Ultimately, the situation is only fully resolved once the borrower provides goods and services to the rest of the economy, or the borrower defaults and the bank owner sells the goods and services which the borrower was supposed to.

(*) For clarity, the diagram shows a self-employed banker. For a bigger organisation, some of the interest is paid to employees and suppliers, but the effect is the same – they are able to use the money which they receive to buy goods and services from the rest of the economy.

Can anything go wrong?

Yes! The bank may not have enough capital to cover all of the defaults, and the bank's owners may have limited liability, or have unlimited liability but not enough personal wealth to make up the difference.

In this case, the bank is insolvent – it has more liabilities than assets. (Another term for this is having a negative net worth). Even if all of the assets were sold, there would not be enough money left to honour all of the bank's debts to others. As a result, one or more of these creditors will be worse off than they believed they were, under the reasonable assumption that the bank would keep its promises. The situation is extremely similar to that of an insurance company not having the means to pay all of its policy holders if too many of them make claims.

How serious can this situation be? It depends on the difference between the values of the assets and the liabilities. But because banks can essentially lend as much money as they want to, there is no real limit to how big the losses can be, and therefore to how serious the problem is.