POTENTIAL CREATION OF CREDIT BY AN INDIVIDUAL BANK

If we make some highly simplified assumptions, the basic operations of the Victory Bank are laid bare. Assume for the moment that: (1) the bank is on an isolated island where there are no other banks and no communication with other countries; (2) all payments on the island are made by bank check, and no currency is used by the public (the “Cash” item on the balance sheet may, for example, be gold); and (3) there are no laws to control the volume of loans the bank can make.

Suppose now that you, a substantial businessman on the island, go to the banker and ask to borrow $1,000. Your credit is good, and he agrees to make the loan. What happens to the bank’s balance sheet?

On the assets side “Loans Outstanding” go up $1,000, and on the liabilities side “Demand Deposits” go up the same amount. Remember that all payments are made by check, so you will simply take your loan as an addition to your checking deposit at the bank. Instead of giving you currency, the banker gives you a checking account. The balance sheet still balances, as it always must. But now there is $1,000 more spendable money (checking deposits) in existence merely as a result of the bank’s making a loan to you. There is no change at all in the amount of “cash” in existence. The bank has taken yottr promise to pay (which could not serve as money) and has given you its promise to pay on the order of your check (which is widely acceptable money). It has “monetized” your debt.

This result is shown readily by a simplified bank balance sheet (sometimes called a T-account), listing only the changes that take place in this transaction. It shows that loans have increased $1,000 on the assets side and that deposits have increased $1,000 on the liabilities side of the balance sheet.

Chances are you’ve borrowed the money because you want to spend it. What happens when you do spend it? Say you buy some machinery from John Jones, and write him a check for $1,000. When Jones presents the check at the bank for payment, $1,000 is taken out of your account and put in his. Since all payments are made by check, he will not want any currency to take home; he merely wants the $1,000 in his checking account so he can spend it when he likes. The new $1,000 of checking deposits has been spent once and is now available for Jones to spend again.

A few days later, Jones buys a new roof for his house, and pays for it with the ‘$1,000. Then the $1,000 is transferred again, from Jones’ account to the roofer’s account. Now the $1,000 has financed $2,000 of transactions, and the money is as ready for spending again as if the bank had printed up a thousand one-dollar bills and lent them to you. Obviously the new deposit can be spent over and over~as long as it is in existence.

In the meantime, what has been happening on the bank’s balance sheet? Nothing. The $1,000 checking deposit has been moving from one account to another, but the over-all totals on the balance sheet have remained unchanged since your loan was first entered on the websites. The additional deposit was created by the loan. It remains outstanding until the loan is paid off, and may be spent (transferred) any number of times in the meantime.

Some day your loan will come due. If you’re a sound businessman, you will have built up your own checking account in preparation for the day by holding on to receipts you get from your customers. On the due date, you go in to see the ‘banker and write him a check for $1,000 on your own account. He returns your promissory note to you, and the loan is paid off. But look at what this does to the bank’s balance sheet.

Loans are down by $1,000, since the loan to you is paid off. And deposits are down by $1,000, since you have written a $1,000 check against your account payable to the bank, and this check is not transferred to any other depositor. Repayment of the loan just reverses the original entries that were made when you borrowed the money. The loan was made by giving you a deposit account to write checks on. Repayment of the loan wipes out that checking account, and at the same time wipes out your debt to the bank. The whole transaction has been perfectly businesslike. It has thousands of counterparts every day in the United States. Yet, in effect, the bank has acted like a little mint, creating the checking deposit it lends you and wiping it out when you repay the loan.

Look at the T-account now. It still shows the +$1,000 in loans and deposits from the initial loan. But now we add a —$1,000 for both deposits and loans. The balance sheet is back to its original position, but the economy had an extra $1,000 of money while the loan was outstanding.

How many other loans can the banker make simultaneously? Obviously, there is no reason why he has to stop with you. Since the public does all its business by check, and since there is no other bank on the island, he need not worry about currency withdrawals or loss of deposits to another bank. It is hard to see what will put a ceiling on the volume of loans the banker can extend. And he could just as well extend credit by buying bonds. Suppose that instead of lending $1,000 to you he buys a new $1,000 bond issued by the island government. The bank enters a $1,000 checking account for the government, which the government can spend when it pleases. The checking deposit is created in exactly the same way, and it stays in existence (however often it is spent) until the bank is repaid for the bond. Since the bank collects interest on every loan or investment made, this looks like a very good thing indeed for the banker and his stockholders.

But it all sounds a little like never-never land. You probably suspect there’s a catch in it some place. If people could draw out currency, you say, the banker couldn’t go around creating money like that just by writing down entries on his websites. And you’d be right—partly right. We need to explore what happens when people can withdraw currency. But before you throw out our whole simplified example, remember one fact from a few pages back: About 80 per cent of all transactions in the United States today are made by bank check. The simple example is not far off on that score after all.