Written by Derryl Hermanutz

The Monetary System

Summary

There is a reason why we keep having credit cycles with businesses, lives, and economies ravaged and sometimes destroyed. It all has to do with the monetary system we have chosen to use. In this essay, and others to follow, the nature of the problems with money are defined and a solution proposed.

"The study of money, above all other fields in economics, is the one in which complexity is used to disguise truth or to evade truth, not to reveal it. ...The process by which banks create money is so simple that the mind is repelled. Where something so important is involved, a deeper mystery seems only decent." {John K Galbraith, Money: Whence it Came, Where it Went (1975)}

"This article explains how the majority of money in the modern economy is created by commercial banks making loans. Money creation in practice differs from some popular misconceptions -- banks do not simply act as intermediaries, lending out deposits that savers place with them, and nor do they 'multiply up' central bank money to create new loans and deposits." {Bank of England, Money Creation in the Modern Economy (2014)}

"This means that banks can create book money just by making an accounting entry: according to the Bundesbank's economists, this refutes a popular misconception that banks act simply as intermediaries at the time of lending -- i.e. that banks can only grant credit using funds placed with them previously as deposits by other customers. By the same token, excess central bank reserves are not a necessary precondition for a bank to grant credit (and thus create money)." {Deutsche Bundesbank Eurosystem, How money is created (from the English language summary published April 25, 2017 on the Bundesbank's website)}

"There are three main types of money: currency, bank deposits, and central bank reserves. ...Most money in the modern economy is in the form of bank deposits, which are created by commercial banks themselves." {Bank of England, Money in the Modern Economy (2014)}

Three different kinds of money

Money is created by the monetary system - the central-commercial banking system.

There are 3 different kinds of money

1. currency (legal tender money);
2. bank deposits (credit-debt money);
3. central bank reserves (base money)

These are created by 3 different monetary system processes.

Central bank reserves - commercial banks' reserve account balances in their central bank reserve accounts - are banking system money that banks pay each other; not part of the economy's spendable-earnable money supply.

We use currency (the physical banknotes and coins in our pockets); and bank deposits (the spendable balances in our bank deposit accounts); as our supply of spendable, investible, savable payments media: our money supply.

Central banks issue the base money supply - reserve account balances and vault cash - to commercial banks. 

"Governments are ... not part of the money issuing banking system."

Commercial banks issue the spendable money supply - deposit account balances and cash withdrawals - to the money-using economy: people, businesses, governments.

Insofar as commercial banks are financial intermediaries, they intermediate between the base money supply issuing central bank and the spendable money supply using economy.

Governments are part of the debt-issuing, money-borrowing, money-using, debt-owing economy; not part of the money issuing banking system.

Two different money supplies

We use money as our payments media, to pay each other.

We have 2 different money supplies - the cash money supply in our pockets, and the deposit account money supply in our bank accounts - that are made of 2 different kinds of money: currency and bank deposits.

We pay each other currency by direct hand to hand payments of banknotes and coins from buyers of stuff to sellers of the stuff; from money spenders to money earners; from money payers to money payees.

We pay each other bank deposits - by check, direct deposit, online banking, debit card, etc - within the central-commercial bank-operated payments system of debiting payer account balances and crediting payee account balances.

A debit subtracts from a payer's account balance, and the credit equally adds to the payee's account balance. The deposit account "balance" is the money: bank deposits.

E.g. when you pay a merchant $100 with your debit card; or pay a $100 utility bill by online banking: your bank debits your deposit account -$100, and the payee's bank credits the payee's deposit account +$100. The money - the $100 deposit account balance - is now in the payee's bank deposit account.

If the payer and payee are both customers of the same commercial bank, then no central bank reserves are involved in the payment. The bank debits the payer's account and credits the payee's account, and the payments system payment is complete. 

"Bank deposits ... are not originally created by people depositing cash money in banks."

When we pay bank deposits to a payee who is a customer of a different commercial bank, our bank pays an equal amount of central bank reserves into the payee-bank's central bank reserve account to settle the payment.

Commercial banks debit and credit their customers' deposit account balances to make (clear) the payments.

Central banks debit and credit commercial banks' reserve account balances to settle the payments.

Bank deposits - spendable bank deposit account balances - are not originally created by people depositing cash money in banks.

We do not have cash money 'on deposit' in our bank deposit accounts.

We have cash money in our pockets.

We have bank deposits in our bank accounts.

'The money supply' - the economy's supply of spendable, investible, savable payments media - is originally created in the form of the deposit account money supply: when commercial banks create new bank deposits to fund their bank loans and bond purchases.

Borrowers pay the new deposit account balances to payees.

Then we create the spendable cash money supply by making cash withdrawals and holding our money outside the banking system in the form of the cash money supply in our pockets.

The government or central bank does not print cash money and spend it into circulation.

Currency is sold into the economy by the central-commercial banks.

Commercial banks buy currency from the central bank and pay with debits to their reserve account balances. E.g. the central bank debits your bank's reserve account balance -$100,000, then sends an armored truck delivery of 5000 $20 banknotes to your bank's vault. Your bank stocks its cash drawers and ATMs with the banknotes.

"We do not have cash money 'on deposit' in our bank deposit accounts."

Then we buy the currency from our commercial banks and pay with debits to our deposit account balances. E.g. you slide your debit card into the ATM and punch Withdraw $100. Your bank electronically debits your deposit account balance -$100, and the ATM pays out 5 $20 banknotes. You have converted $100 of the deposit account money (bank deposits) in your bank account, into $100 of cash money (currency) in your pocket.

Commercial banks spend their reserve account balances (base money) settling our payments system payments to payees at different banks. And commercial banks spend their reserve account balances buying currency from the central bank to get vault cash, so our banks can convert our deposit account balances (credit-debt money) into cash withdrawals (legal tender money).

Commercial banks and shadow banks

Brokerages, investment banks, etc - financial institutions that operate in the savings-funded capital markets financial system - are "shadow banks".

Shadow banks do what most people mistakenly believe commercial banks do: get money from their depositors then lend out and invest their customers' money.

Shadow banks are deposit-taking financial intermediaries.

Commercial banks are deposit-creating monetary system institutions; depository institutions; deposit-creating institutions. Commercial banks create the form of money they lend: bank deposits - spendable deposit account balances.

The "balance" is a number in a bank account, nothing more. Bank account balances are electronic digits in banking system accounting software: digital money that is paid out (spent) by debiting (subtracting from) payer account balances, and paid in (earned) by crediting (adding to) payee account balances. Most of the debiting and crediting is performed electronically by banking system accounting software; not by bank workers typing on keyboards.

"Shadow banks are deposit-taking financial intermediaries."

To originally fund (put money in) your brokerage account: you transfer a balance out of your commercial bank deposit account, into your brokerage cash account. Your commercial bank debits your deposit account balance in the amount of the transfer, and your brokerage credits your cash account in the same amount. The balance has been transferred - by a debit and a credit - into your brokerage cash account.

Then you invest your cash balance buying income-paying financial assets. Stocks are dividend-paying equity assets. Bonds (and money market funds) are interest-paying debt assets.

When you buy assets, your broker debits the buy money out of your cash account balance; and the asset seller's broker credits the buy money into the seller's cash account balance. The brokers transfer the assets out of the seller's brokerage account into your (buyer's) brokerage account.

The stock issuer pays quarterly dividends, and the bond issuer pays semi-annual interest. The dividend and interest payments are debited out of the (share-issuing) corporation's or the (bond-issuing) government's bank account balances, and the payments are credited into your cash account balance.

Customers have no direct administrative access to debit and credit our own bank accounts. When we write a check, or make an online banking or debit card payment, we are authorizing our commercial bank to debit the payment amount out of our account; and we are directing the banking system to credit the payee's account. When we want to buy financial assets, we authorize our broker to debit the buy money out of our cash account, and we direct the seller's broker to credit the buy money into the seller's cash account. Banks debit and credit their customers' accounts.

Shadow banks debit and credit their customers' cash account balances, in the same way commercial banks debit and credit their customers' deposit account balances, in the same way central banks debit and credit commercial banks' reserve account balances.

Assets are not money

When you buy financial assets, you spend your cash account balance paying for your asset purchases.

Your invested money is not "in" the investment (the stocks or bonds or money market funds) that you bought. Your invested money is in the cash account of the asset seller. You spent your money (cash balance) buying the income-paying investment assets. You no longer own the money. You now own the assets.

To convert your financial assets into spendable money, you have to sell your assets to somebody who will pay their money to buy your assets. Then you can spend the money.

If nobody who has money is willing to spend their money buying your assets, how much money are your assets "worth"?

Assets are not money.

Assets are bought and sold for money.

Money is the liquidity - the payments media - that asset buyers pay to asset sellers. In the capital markets financial system, we use cash account balances as our payments money. If you have a cash account balance, then you have "money" in your brokerage account. If you have stocks, bonds and money market funds in the account, but no cash balance, then you own assets but you have no money.

Some brokerages now offer "checkable" cash accounts so you can spend the balances directly out of your cash account buying stuff in the "real" economy.

"If you have stocks, bonds and money market funds in the account, but no cash balance, then you own assets but you have no money."

Or you can transfer a balance out of your brokerage cash account, into your commercial bank deposit account, then spend the balance out of your deposit account within the bank-operated payments system.

How commercial banks create (and un-create) the money supply

People, businesses and governments who borrow and spend money that is created by banks are "debtors" who owe the borrowed money back to their banks as payment of their loan account and bond debts.

Commercial banks create the spendable money supply in the form of the deposit account money supply: by making repayable loans of newly created bank deposits to private-sector loan account debtors and to government bond debtors.

Making a bank loan or bond purchase creates a linked pair of credits/debts: a new spendable, cashable credit balance (a new bank deposit: e.g. +$1000) in the debtor's bank deposit account; and an equal new interest-bearing repayable debt balance (-$1000) in the debtor's bank loan or bond account.

Debtors spend their new bank loans and bond sale proceeds.

Debtors pay the new credit balances to payees, within the bank-operated payments system.

The new credit balances are debited out of the debtors' bank deposit accounts and credited into the first payees' bank deposit accounts.

That's where the deposit account money supply - the spendable, investible, savable (and cashable) balances in our bank deposit accounts - comes from, in the first place.

Then payees create the spendable cash money supply when we make cash withdrawals and pay with debits to our bank deposit account balances.

But most bank deposits are never cashed out.

Most money never exists in any other form than credit balances in payees' bank deposit accounts.

Debtors owe all of the credit balances back to their banks, as payment of the debtors' loan account and bond debt balances.

Repaying a bank loan; or redeeming a bank-held bond; un-creates - extinguishes; cancels out to $0/$0 - the deposit account credit balance (+$1000) and the loan account or bond debt balance (-$1000) that were created by making the bank loan or bond purchase.

The deposit account money supply - which is about 97% of all money that exists - only exists so long as debtors' debts remain unpaid.

But debtors can't pay their loan account and bond debts because payees have all the deposit account money, which we are using as our spendable, investible, savable money supply.

The commercial banks' "repayable bank loan and bond purchase" money supply creation monopoly systematically creates unpayable debts.

"debtors can't pay their loan account and bond debts because payees have all the deposit account money"

The commercial banks' debt-based money supply creation system creates ever-increasing totals of payees' bank deposit account balances that are owed back to banks as payment of debtors' unpayable loan account and bond debt balances; until debtors finally default en masse and the banking system descends into a financial crisis of creditors' uncollectable money that is owed as debtors' unpayable debts.

Banking is not the problem

Commercial banking - the business or institution of creating and allocating the economy's supply of financial credit, and overseeing loan repayments by borrowers - is not the problem.

The modern global buy-sell economy could not function without bankers and banks; digital bank account money; and the globally-integrated, bank-operated electronic payments system.

"Banks" are not the problem.

The banks' monopoly of creating the money supply as repayable "loans" is the problem.

Government issuance of debt-free helicopter money is the solution.