Dynamics of endogenous money

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Most con­ven­tion­al and uncon­ven­tion­al com­men­ta­tors on mon­ey believe that mon­ey is destroyed when debt is repaid. I disagree–but explain­ing why takes some time. I received an email this morn­ing from a Eco­log­i­cal Eco­nom­ics dis­cus­sion list in the USA on this issue, and wrote the fol­low­ing expla­na­tion of my posi­tion. I thought that read­ers of this blog might find it instruc­tive.

On the mon­ey issue, this is one where I beg to dif­fer both with the response Josh put for­ward, and most of my fel­low econ­o­mists as well–non-orthodox and non-ortho­dox. I think it’s wrong to say that mon­ey is destroyed when debt is repaid–but to explain why, I need to both put for­ward a dynam­ic mod­el, and find an appro­pri­ate anal­o­gy.

Most peo­ple (and econ­o­mists) seem to believe that debt and mon­ey are like mat­ter and anti-mat­ter: debt (anti-mat­ter) is destroyed by adding mon­ey (mat­ter) to it. That makes a debt account a neg­a­tive mon­ey account–and there­fore to reduce it, you have to destroy mon­ey. Since inter­est if charged on debt, and repay­ing debt destroys mon­ey, an increas­ing amount of mon­ey has to be cre­at­ed to main­tain a con­stant amount of debt.

Not so. For a start, a debt account is not a repos­i­to­ry for mon­ey (or anti-mon­ey), and you can’t pay any­thing in to it. It is a record of what you owe to the bank, which a bank is oblig­ed to update when­ev­er you make a pay­ment intend­ed to reduce your debt. But the mon­ey that you pay to the bank actu­al­ly goes some­where else–which I’ll get to in a moment.

If a cap­i­tal­ist has a debt to a bank, that oblig­ates him/her to pay the bank inter­est; equal­ly, if you have a cred­it deposit with a bank, that oblig­ates the bank to pay you (a low­er rate of) inter­est on that deposit. The spread between the two–high inter­est rate times debt minus low inter­est rate times deposit–is the source of the bank’s income. So the bank is quite at lib­er­ty to spend for its own needs out of the bal­ance in the account. When it does spend, that mon­ey comes back into cir­cu­la­tion.

Dit­to for wages: work­ers won’t work with­out receiv­ing wages. When they receive a wage, it is paid into their bank accounts, and they will spend out of these–which amounts to a trans­fer back to the cap­i­tal­ists accounts. The cap­i­tal­ists make their prof­it from the gap between their sales and their pro­duc­tion costs (and the whole sys­tem is fuelled by the capac­i­ty of the pro­duc­tion sys­tem to pro­duce a phys­i­cal sur­plus over the inputs–that’s the real eco­log­i­cal issue in all this of course).

So long as no debt is actu­al­ly repaid, the amount of mon­ey in exis­tence can con­tin­ue cir­cu­lat­ing between these three class­es of accounts ad infinitum–it is not destroyed, nor does any new mon­ey need to be cre­at­ed. The sys­tem could keep on going at the same lev­el of pro­duc­tion indef­i­nite­ly, with no change in the quan­ti­ty of mon­ey in cir­cu­la­tion.

Now con­sid­er repay­ment of debt. When a cap­i­tal­ist makes a pay­ment intend­ed to reduce debt, the bank is oblig­ed to record that the debt has been reduced by that amount–but what does it do with the mon­ey? As I empha­sised above, it does­n’t “mix it with anti-mon­ey”, thus destroy­ing both mon­ey and debt in the process: instead it records that the mon­ey has been giv­en to it in order to reduce the record­ed lev­el of debt, adjusts the debt account accord­ing­ly, but now has mon­ey that it must also do some­thing with.

It can’t put that mon­ey into the same account as inter­est pay­ments go to, and then spend it: that’s seignior­age. Many crit­ics of cred­it mon­ey think that’s what banks do–and cer­tain­ly they’ve been instances of banks effec­tive­ly doing that–but as a sus­tained prac­tice, it will bring both the finan­cial sys­tem and the bank itself to ruin. So as a mat­ter of sound prac­tice, and also as a mat­ter of his­tor­i­cal prac­tice most of the time, that debt-repay­ment mon­ey goes into a sep­a­rate account. Call it a prin­ci­pal (as opposed to income) or reserve account.

Is the mon­ey that has been paid into there destroyed? No–it’s been tak­en out of cir­cu­la­tion, in that it can’t be direct­ly used to pur­chase any­thing; but it has­n’t been destroyed.

The anal­o­gy I can think of here is a bas­ket­ball game, with a reserve bench. The rules of the game spec­i­fy that there can be no more than five play­ers on court at any one time, and sev­en reserves. When one of the play­ers goes off, he/she isn’t “destroyed” when sit­ting with the reserves: s/he just becomes “inac­tive”.

Dit­to debt that has been repaid. It can’t be allowed to par­tic­i­pate in “the game”, but it is sit­ting there “in reserve” and can re-enter if it fol­lows the rules. The rules in bas­ket­ball are one play­er off, one on; the rules in the game of mon­e­tary cred­it are that this mon­ey “in reserve” can’t be spent to buy com­modi­ties, but it can be re-lent. Once re-lent it’s back in cir­cu­la­tion again–and a cor­re­spond­ing debt is cre­at­ed with it, because anoth­er “rule of the game” is that if you get cred­it mon­ey, you get an equiv­a­lent debt record­ed against you.

The repay­ment of the loan thus reduces the amount of mon­ey in circulation–which is lim­it­ed to the sums in deposit accounts–but it does­n’t destroy the mon­ey equiv­a­lent of the reduced loan. Thus out­stand­ing loans will be equiv­a­lent to the sum of deposit accounts, but the sum of mon­ey in and out of cir­cu­la­tion will be greater than the amount of debt.

I know that argu­ment goes against both con­ven­tion­al and uncon­ven­tion­al wis­dom, and it’s some­thing I only came to by devel­op­ing a math­e­mat­i­cal mod­el of endoge­nous mon­ey creation–a basic paper on which I’ve attached to this email. How­ev­er, it hap­pens to accord with Key­nes’s inter­pre­ta­tion, which I dis­cuss in the attached paper as well.

Please post this to the dis­cus­sion list Chuck–and keep in touch!
Cheers, Steve