Monday, 6 October 2008

Where has all the money gone?

A year or so ago we only had to utter the words "new car" for a hundred financial institutions to be fighting for the right to lend us the money to buy an internal combustion engine in a shiny shell. They all had lots of money available for us to use, now they have none. Today I ask: where has all the money gone?

If we scan the various prophecies of doom about the financial world we learn that banks are no longer lending to each other and this contributes to them no longer being able to lend to us. If Bank A no longer lends to Bank Z and, therefore, Bank Z cannot lend to me, it is reasonable to infer that Bank Z does not have any spare money. It is also reasonable to infer that Bank A still has the money it might otherwise have lent to Bank Z. Problem solved, one might think, Bank A can lend me the money. Not necessarily so. The example I have given assumes both that Bank A has a big bag of bank notes in its vaults and sends them on the back of a bike to Bank Z which then gives a few handfuls of £20 notes to me. In fact the amount advanced by banks is not limited by the amount of physical money in circulation. I can illustrate what happens using an example based around the sale of a car.

Mr P owns an old Mercedes. He advertises it for sale in the local paper, someone comes round with £1,000 in cash and buy the car. Mr P now has physical possession of £1,000 worth of paper tokens. He takes them to Bank A and deposits £1,000 in his account. Bank A now has physical possession of £1,000 worth of paper tokens. Bank A knows that Mr P might want his money back at any time and when he calls for it he must be given paper tokens. It also knows that on average only 10% to 15% of the cash it receives will need to be handed out over the counter at any one time, the rest is left in the bank to earn interest. So Bank A decides to be cautious and keep 20% of sums deposited in its safe, the other 80% is put to use.

Mr Q goes into Bank A and asks for a cash loan because his car needs repairs. Bank A has received £1,000 from Mr P so it lends £800 to Mr Q and hands over forty £20 notes. Mr Q pays £800 to Mr R, the mechanic, who deposits the money in Bank B. Bank B also knows it only needs to keep a maximum of 20% in cash so it lends £600 to Mr S who needs to pay to have his leaking roof fixed. Mr S employs Mr T who is paid £600 which he puts into Bank C. Bank C is happy to keep smaller reserves so it lends £500 to Mr U who wants a new computer, which he buys from Mr V who puts the money in Bank A (yes, the same Bank A into which Mr P deposited £1,000). Bank A then lends £400 to Mr W who pays it to Mr X for services rendered and he pays it into Bank B which lends £300 to Mr Y who fancies an expensive evening of fleshy pleasure at Madame Fifi's Sauna and Hanky-Panky Parlour.

The result is that a single deposit of £1,000 has resulted in an additional £2,600 sloshing around the system (Mr P has £1,000 in the bank, Mr R has £800, Mr T has £600, Mr V has £500, Mr X has £400 in the bank and Mr Y has £300 in his pocket until the bill for "extras" arrives) and all of it has been created from a single deposit of £1,000.

Assuming all loans are repaid over one year with 10% interest the spiral unwinds perfectly: Mr Y pays £330 to Bank B, Mr W pays £440 to Bank A, Mr U repays £500 to Bank C together with £50 interest, Mr S provides Bank B with £660, finally Mr Q repays the loan of £800 from Bank A and gives a further £80 for the privilege of having borrowed the money. And all along Mr P still has £1,000 in Bank A. The single deposit of £1,000 has allowed three banks to make a total of £260 in interest despite each only charging 10%. They have to pay the depositors a little interest but on current accounts it is a tiny amount, the net result is that the banks have not only "created" £2,600 for their customers to use they have also made a return of about 25% on the only real money in the whole cycle. It is not just in the musical Cabaret that money makes the world go around.

This illustration is a microcosm (with very conservative levels of lending) of what happened before the banking world stopped turning. In the same way that Bank A borrowed £1,000 from Mr P and turned it into £2,600 of spendable cash for the other people in the chain, so when banks borrow millions they turn it into many millions more of lending. Any snapshot of the amount of money in the world economy reflects not just the real money but also the additional money "created" by commercial lending.

Now that lending has seized-up it is the "created" money which no longer exists. One might be tempted to think this causes no problem because it was all pretend anyway, however the reality is that it was not entirely pretend, it existed on a balance sheet and when things unwind someone will lose. Let me return to the example I gave and illustrate what I mean.

In that example we have a series of loans and a consequential series of deposits in banks. Assume that the first of the loans (£800 to Mr Q) is not repaid because he goes bankrupt. Two consequences ensue. Although the later loans in the chain are unaffected, the total amount of interest earned by the banks falls to £180 from £260, a drop of more than 30%. That is a big chunk of profit to remove from any line of business. Perhaps more importantly, when Mr P goes into Bank A and asks for his £1,000 they are forced to say: "Sorry old chum, we've only got £200, the other £800 went down the pan, lent it to Mr Q who turned out to be a donkey when we thought he was a thoroughbred. We did make £40 from Mr W but that went on the Chairman's Christmas bonus. Terribly sorry, c'est la vie, come back next week and we'll see if we can get some more for you."

The same applies if the problem occurs at any other link in the chain. Take Mr U who borrowed £500 from Bank C. Bank C only made the advance because Mr T had deposited £600. Instead of having £600 to repay Mr T when he wants his money back they only have £100. Although Mr T's £600 was "created" money is was real enough for him and the obligation to repay him is real. Bank C has to find that money from somewhere.

There is, of course, much more to it than just what I have described here, but this simple example shows not only how money is "created" it also shows that the pretend money gives rise to real obligations. When banks fear they might not be able to meet real obligations because their borrowers might not be able to repay loans, the consequence is a reluctance to lend which, in turn, reduces the amount of money they "create".

The answer to "where has all the money gone?" is that it never really existed in the first place.


Mark Wadsworth said...

The result is that a single deposit of £1,000 has resulted in an additional £2,600 sloshing around the system???

Nice try, but the original £1,000 was taken out of the extra 20% bits that the banks kept in reserve. The fact that man (or indeed woman) who bought Mr P's car had to withdraw £1,000 means that the banks had to sit tight for a few minutes until all the other people in the chain paid it back in again, at which stage they were back to square one.

If your analysis were correct, then money supply would have increased by several million per cent over the last few years, rather than just a few hundred per cent.

TheFatBigot said...

You know I hate to disagree with you Mr W, but (I think!) I took that into account.

Prior to the purchase of the car there was £1,000 in circulation. For the purposes of my example it matters not where it came from. Once the seller put the money in the bank and the chain started the amount in circulation went up from £1,000 to £2,600 (or £3,600 if you include the original £1,000). The increase in money supply is 260% (or 360% if you treat the £1,000 in the seller's bank account as "in circulation").

There can be no further increase in the money supply because the retention of +/- 20% limits the aggregate value of further links in the chain.

Hence, the example I gave matches the actual increase in money supply you describe.

I might be wrong, I certainly presume I am in all things until proved otherwise.