Repaying Bank Loans Destroys Money

Yves here. Given the fraught turn the news out of the Middle East has taken, I though it might be time to balance our coverage by returning to our Modern Monetary Theory discussions, for both the benefit of readers who know the terrain and newbies. The implications of repaying bank loans (and writing off principal in loan restructuring) are not sufficiently well recognized, as in they result in a shrinkage of money supplies.

Mind you, loose money will not do much to stimulate economic activity; businesses decide whether to expand or not based on conditions in their industry and niche. However, the ones that do well are ones where interest is one of their biggest costs of business, as in financial institutions and leveraged speculators. But tight money can constrain commercial operations; it can become costly or even impossible to secure needed loans.

This asymmetrical operation of monetary policy is perversely not well understood. It used to be that the Fed acted as if understood that; when it would drop interest rates in recessionary times, it would keep them low for only a quarter and then start tightening. It was under Greenspan, in the dot-bomb era, who took the unprecedented step of keeping interest rates at a negative real interest level for a full nine quarters. Greenspan was obsessed with the stock market and believed (contrary to any solid evidence) that the stock market plunge would afflict the real economy, so he was eager to goose asset prices. He did, but a big beneficiary was residential mortgage lending….and we know how that movie ended.

Richard Murphy has been producing short videos that provide accessible primers to Modern Monetary Theory findings and other banking and economic topics. I hope you’ll circulate this post widely.

By Richard Murphy, part-time Professor of Accounting Practice at Sheffield University Management School, director of the Corporate Accountability Network, member of Finance for the Future LLP, and director of Tax Research LLP. Originally published at Fund the Future. 

By Richard Murphy, part-time Professor of Accounting Practice at Sheffield University Management School, director of the Corporate Accountability Network, member of Finance for the Future LLP, and director of Tax Research LLP. Originally published at Fund the Future

I have published this next video in the Economic Truths series this morning. In it, I argue that if bank loans create money, then repaying those loans destroys money. The money in question literally ceases to exist. That is one of the hardest economic truths to get our heads around.

The audio version of this video is here.

The transcript is:

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Repaying bank loans destroys money.

It’s another of those economic truths that doesn’t make a lot of sense until you really think about it. But it has to be true because all the bank created money in the UK gets into our economy because the bank lends money to borrowers.

When the bank lends the money to a borrower, there’s an exchange of promises. I’ve explained this in other videos.

The bank says to the borrower, I will lend you £10,000. And the borrower says, I will repay you £10,000. It is that exchange of promises that are recorded on a keyboard. One is a positive number in a current account. One is a negative number in a loan account with the two together adding up to zero, indicating that this new money is made out of thin air.

And as a consequence of that process, this new money is available for the borrower to spend. And they do spend it. And as a result, as again I’ve explained in another video, savings are created. The loan eventually must give rise to a savingbecause the banking system has to balance.

So, what happens as a consequence of the loan being repaid? The money that was created is destroyed.

I stress that word destroyed. It just doesn’t quietly disappear. It literally no longer exists, because the promises that created that money have been fulfilled. If money is about a promise, and that is all it is because all money is debt, then once the debt is repaid there can be no more money. It is as simple and straightforward as that.

The money that did exist because the loan was created. now no longer exists because the loan has been repaid.

This has enormous consequences, however, for our economy because what you can immediately see is that when we are dependent on only two types of money in our economy, one created by the government which will be the subject of other videos and the other – probably the bigger part in most economies including that of the UK – created by commercial banks as a result of their making loans to people like, well, you and me, we are entirely dependent on this money created by loans.  Then what happens is that if all loans were repaid, we’d have no money left.

That is why we live in a debt-based economy. Because we have no other idea about how to create the money we need to undertake our day-to-day transactions. And, therefore, we are dependent upon people continuing to borrow money from banks in the economy to make sure we have a continual supply of new money to replace that which is repaid day-in-day-out by borrowers to banks, with their loans being cancelled as a consequence and money disappearing as a result. So, we have to live in a credit economy, and we have to live in an economy where people borrow.

But that’s really worrying because, as we all know, in economic downturns, people don’t borrow. They lose the confidence to do so, they don’t go out and spend, and as a result, the money supply falls. And that is why we get recessions.

So, what we need inside any economy is a system of balance, which is that when the economy is doing well, and banks create lots of money because people want to borrow, we have a situation where the money supply is strong. And therefore, the government doesn’t necessarily need to inject a lot of money into the economy.

When the economy is weak, when people don’t want to borrow, when there’s a threat of recession, when people feel it’s too risky to actually take on another repayment of whatever the loan might be for, then the government has to inject more money into the economy to make sure it all works.

How do we know this happens, and what’s the evidence? Well, it’s very simple, really. After 2008, when there was the global financial crisis, people did not want to borrow. Banks were at risk, they looked pretty dubious, people felt very nervous about the state of the world, they didn’t want to go out and borrow money to buy anything, and therefore, the government had to create vast quantities of new government-created money to inject into the economy to simply keep it moving.

Quantitative easing did that. That’s what it was for, it made good the shortfall in bank lending to ensure that there was enough credit money available in the economy to keep it functioning.

And the same happened all over again when we had COVID. Because for exactly the same reason, people weren’t borrowing. They couldn’t even get to a shop to borrow, to buy, to do anything else. And, therefore, the government had to shut down. There was nothing unusual, nothing wrong, sinister, or to be worried about about this process. It was just the government filling in where the commercial banks frankly failed, and people didn’t want to borrow.

And they had to fill in because the commercial bank loan repayments were going on because that’s what the loan agreements required.

So, the economy was at risk of running out of money and the government made good the shortfall.

The reason why there was that risk It was because when a commercial bank loan is repaid, whether it’s a loan, whether it’s a mortgage, whatever it’s for, when it’s repaid, the money that was created by it is destroyed. It’s gone. It’s disappeared. It’s as if it never existed because the promises that created it have been fulfilled. Over and done with. Finito. Ended.

And you have to understand that if you’re to understand why we live in an economy where credit has to always be produced or the government has to make good the deficit and that there’s nothing sinister about the government doing that. It’s just necessary to make sure there’s cash in the economy to keep us all going.

We’ll deal with government money creation in another video. For the purposes of this video, the fundamental point is repaying a bank loan destroys the money that it created.