Saturday 31 December 2011

Splitting the zero

Two common misconceptions about banking are that:
a) Banks can create money out of thin air.
b) Banks take money from depositors and then lend it to borrowers.

There is a small element of truth to either, but clearly they are contradictory
a) If banks can create money out of thin air, then how could there ever be a run on a bank? How could banks ever be short of 'capital'?
b) Why would banks bother waiting for people to deposit money before lending it on if they can just create it?

So there must be 'something else' which most people have overlooked which bridges the gap between the misconceptions. That 'something else' is a golden rule of economics generally which is that for every liability there is an asset. It is not true to say that for every asset there is a liability*, but it is certainly true to say that for every financial asset there is a financial liability (and liabilities are of course usually financial liabilities as most debts are to be repaid in cash rather than in kind, i.e. if you have been paid in advance to do a job).

In bookkeeping, there is also the 'balance sheet rule' says that any corporate entity has both assets and liabilities and they net off to precisely £nil. Yes of course, successful companies have share capital and retained profits, which do not have to be paid out, but those are still liabilities - that money (or that value) does not belong to the company, it belongs to its shareholders.

Onus Probandy had another crack at explaining how banking and double entry bookkeeping work using his analogy of splitting the zero again recently, but he made it a bit complicated by using the ECB to illustrate the point.

i. A far simpler way of explaining banking, the golden rule, double entry bookkeeping and 'splitting the zero' is to remind people what happens when you go to the bank to take out a personal loan for (say) £10,000.

ii. Assuming you pass the credit checks etc, the bank creates two accounts for you - a deposit account and a loan account, and it simultaneously credits £10,000 to the deposit account and debits £10,000 from the loan account. No coins and notes change hands, nobody had to deposit money first, nothing, the banks just 'splits the zero'.

iii. So you, the customer, now have a financial asset (£10,000 in your deposit account, which you can withdraw and spend) and an equal and opposite financial liability (£10,000 owed on your loan account, which you will have to repay).

iv. As mentioned above, a golden rule is that one man's financial asset is another man's financial liability*. So your asset (the deposit account) is a liability from the bank's point of view (you can wander into the bank and withdraw cash, or you can make payments to other from that account), and your liability (the loan account) is the bank's asset (they will receive money from you in future as you pay off the principal and interest).

v. We can illustrate this by drawing up a balance sheet at each stage for you and for the bank, see 1) and 2) below.

vi. The balance sheet in 3) is the overall picture taking you and the bank together, you can draw diagonal lines between your asset and the bank's liability (the deposit account) and your liability and the bank's asset (the loan account). The overall position immediately after the loan is made is still a big fat £nil on all sides.

vii. "Why do the banks lend money then?" you may ask, "Their net wealth does not increase when they split the zero." Well, that's because they can charge you 6% interest on the loan and they only pay you 2% interest on the deposit. Of course, you will withdraw the money from the deposit account, spend it in the shops and the shop keeper (or his suppliers, employees etc) will pay it back in to the banking system as a deposit. So until and unless the loan is repaid, the bank will be earning £400 in interest margin. Whether you repay your loan or whether the shop keeper in turn repays a loan he had taken out earlier makes no difference - at this stage, the assets and liabilities merge into one and turn back into zero again.

viii. So what banks really want to do is to ensure that the two sides never merge into zero again, by tricking people into taking out ever larger loans, and making sure that loans are only repaid by somebody else taking out an even bigger loan. There are only so many flat screen TVs you can buy and so many foreign holidays you can go on before either
a) you reach the limit of your own willingness to get further into debt or
b) the bank no longer sees you as a good credit risk.
So the tried and tested method is house price bubbles. There is no such thing as net land wealth, of course*, so all a house price bubble means is that banks are earning more and more money for doing nothing but carry out a huge great confidence trick.* Footnote: The modified rule that for every asset there is a liability (as it applies to financial assets and financial liabilities) also applies to land, because one man's rental income is another man's rental expense; even if you are an owner-occupier, the land only has value to you because being excluded from that plot places an equal and opposite burden on 'everybody else'; alternatively, the value to you is that you alone are not subject to this burden.

By analogy, let's imagine that the playground bully takes ten pence from every other child in your class every day, that's the bully's asset/income and every other child's liability/expense. But one day, you do him a favour (like giving him an alibi), and so he stops taking money from you. You might consider yourself to be ten pence a day richer than all the other children, and indeed you are, but only because you are neither payer nor recipient of ten pence (like an owner-occupier). If the bully later gets expelled, you cease to be ten pence a day richer than all the other children and your 'wealth' disappears.

The modified rule clearly does not apply to buildings and improvements on land, as there is no such thing as a negative building or a negative improvement, and if one person builds a building, he does not impose a burden on other people. He might diminish the rental value of neighbouring plots of land by building the building, and most bits of land ultimately belong to other people (who thus might feel themselves burdened by the building), but...
a) Unless the planning department is staffed by complete idiots, the increase in the rental value of his land/buildings is at least equal to the fall in the rental value of neighbouring plots (so worst case, total rental values are the same) and
b) More subtly, by reducing the rental value of those neighbouring plot, he also reduces the burden which being excluded from those plots places on 'everybody else'.
The new building is real net wealth and the change in net land wealth is precisely zero because it was zero before and is still zero afterwards.

14 comments:

Sackerson said...

Which leads us onto the horrid question of interest, and where the money for that comes from, and what happens if nobody ever defaults.

Anonymous said...

Interest comes from economic growth (higher money velocity) when it's wisely invested.

AC1

Antisthenes said...

I am confused I fail to see the distinction between splitting the zero and the bank producing money out of thin air. The bank produces an asset and a liability and so does the customer. Fine so far but where does the bank get the money in the first place to lend to the customer? For arguments sake let us say the bank has no deposits therefore no cash in the till and the customer demands his assets in cash where does it come from?

Mark Wadsworth said...

S, people pay interest because they want to bring forward consumption or investment (I don't see a big difference between the two) and other people receive interest because they are happy to defer consumption/investment.

AC1, yup, it comes out of future income. But it doesn't really matter because one man's interest expense is another man's interest income. It is also a zero sum game in bookkeeping terms.

And your explanation is probably too complicated. Maybe I 'own' a farm and rent it to somebody, and the rent is a certain percentage of his harvest. I could as well sell him the farm on credit and charge him interest of a certain percentage of his harvest.

And I could then convert the loan and the percentage of his harvest to their monetary equivalents. So interest is just the profit share taken by the banks, which is fine if the profit is really there, but terrible if their is no profit in the first place (i.e. interest paid on loans taken out to buy residential land).

Anonymous said...

Well some humour http://www.zerohedge.com/news/friday-humor-unspinning-%E2%82%AC100-bill-or-how-european-bailout-really-works

AC1

Mark Wadsworth said...

Anti: "let us say the bank has no deposits therefore no cash in the till and the customer demands his assets in cash where does it come from?"

Forget about coins and notes, it would be perfectly feasible for everybody to pay everything by debit card or credit card, that's just details.

If you want to drag coins and notes into the equation, sure, banks have to have a small percentage of their assets in actual coins and notes because some people like using cash, but if our hero withdraws cash, the chances are the shop keeper will pay it back in cash as well.

And don't forget - coins and notes are not net wealth either, they are financial assets, so there is an equal and opposite liability on the issuer (the BoE correctly records notes in circulation as a liability).

So as soon as the bank has split the zero, it can scurry off to the BoE, create a deposit account for the BoE and be given some notes and coins in return.
Or a cautious bank might do this before it splits the zero for a real life customer. The thing only goes tits up when the BoE refuses to deal with the bank any more (see e.g. Northern Rock).

Remember - if a bank deposits money with the BoE it records it as an asset and the BoE records it as a liability. So if a bank has notes in the safe, it also records those as an asset and the BoE records it as a liability. And a bank might think "I have no use for this asset, the loan account, so I will sell it to the BoE for £10,000 in cash". And so on.

Mark Wadsworth said...

S, AC1, to extend my farm analogy (that interest payments are just tantamount to a profit share)...

Step 1, I own the farm and farm it myself, I keep the whole harvest.

Step 2, I employ somebody to help me out, paying him a third of the harvest as his wages, with two-thirds for me.

Step 3, I promote him to partner, we share the work on the farm and split the harvest half each

Step 4, I go into semi-retirement, he does most of the work and gets two-thirds of the harvest and I get one-third for my input.

Step 5, I retire from farming, he does all the work and gives me a quarter of the harvest as a pension.

Step 6, I just sell him the farm on credit (no up front payment) on the condition that he continues to give me a fifth of the harvest as interest payments.

This is just a sliding scale, the harvest is what it is and it has to be split up somehow between the owner of the capital (who gets profits or interest) and the people doing the work (who get wages or profit share).

For sure, land is not capital or net wealth, as I explained in the post, but let's gloss over that.

chefdave said...

Good post Mark, boringly I agree with all your points as usual but perhaps I can add a little theory of my own. Although very few people understand banking(even most money reformers in my experience) their suspicion may arise from justified feeling of unease with modern banking. Under barter or if I issued my own IOUs the transaction is transparent and the liabilities confined. You can't redeem a Chefdave IOU round at Mark Wadworth's! "Fiat" is different though because there's unusual interplay between the public and the private. The debt is issued privately by banks but if the debtor defaults the bank then has to 'socialise' that loss by recouping the money with either higher IRs/job losses/lower profits etc. The asset has disappeared but the liability still exists, but it's all annonymous from the customer's point of view as they don't know what's going on behind the scenes. Therefore a mechanism exists that allows people to extract wealth without offering anything in return. I know there are bankruptcy laws and that LVT would help minimise this risk, but also I can't help but think that some people feel overpowered by corporate institutions that seem to have complete control over the money supply.

Mark Wadsworth said...

CD, thanks, yes, sadly the truth is usually quite boring, slow and mundane, which is why the quick lie usually wins the argument hands down.

"people feel overpowered by corporate institutions that seem to have complete control over the money supply"

True.

I'm not a bank-basher as such, but handily, I have found that I can usually channel a bank-bashing conversation round to the topics of rent seeking generally, and hence land values and hence to LVT.

If I am on form, I also point out the government deficit spending is just another form of theft (if I am talking to a left winger) or even use this as an 'in' when talking to a right winger about rent seeking (and thence to land values etc).

chefdave said...

Yes, it's often tricky getting the conversation around to where it needs to be. Conversing with both the left and right sometimes feels like talking to aliens because their points of reference have been so mashed up by a century's worth of neoclassical economics.

Inevitably you get accused of being a rabid right winger by the left and a Communist sympathiser by the right, but when it's online it doesn't really matter (not for me anyway!)

Mark Wadsworth said...

CD: "Inevitably you get accused of being a rabid right winger by the left and a Communist sympathiser by the right"

Yup. To amuse myself, I accuse those who think of themselves as left wing as being the ultimate rent seekers and those who think of themselves as right wing as being Blue Socialists.

Robin Smith said...

I agree the return to loans of money( economic land) is rent proper. Not interest.

This is an excellent sounding post. But it seems to reinforce the fantastic deception that money is wealth. Or that money is something that can be owned. Or that book keeping by splitting zero can be used to manage money as well as wealth.

Another confusing term used is "financial asset". What on earth is one of these exactly? Is it wealth or money? It cannot be both as above.

Very very confusing.

Mark Wadsworth said...

RS, the post says none of those things.

A financial asset is merely the opposite of a financial liability. The two cannot exist in isolation and one cannot exist without the other. They are simultaneously created from, and ultimately net off to, precisely nothing.

As I've said to you before, the answer to the question "How much money is there in the world?" is "Precisely none. Because money includes all financial assets and all financial liabilities."

Surely nobody in his right mind would describe 'precisely nothing' as wealth? In the same way, nobody but the bully would view the flow of ten pence from each child to the school bully as wealth.

Anonymous said...

Basically "Splitting the zero" is akin to recording people exchanging their own time which they also get for free. A currency whose volume that tracks the volume of time exchanged will be stable in purchasing power.

AC1