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

From: Chuck Willer [mailto:chuckw@coastrange.org]
Sent: Fri­day, March 30, 2007 6:02 AM
To: Steve Keen
Sub­ject: [US Soci­ety for Eco­log­i­cal Eco­nom­ics] Ques­tion on Sus­tain­able Cur­rency
Dear Steve,A thread is going on the US Soci­ety for Eco­log­i­cal Eco­nom­ics list serve (usec­oeco) in response to Muriel Strands (below 1.) ques­tion about the nature of money rel­a­tive to a non-grow­ing econ­omy. I have placed a response by Josh Far­ley (below 2.)  who offers one answer.  I thought that you are an econ­o­mist that would have a use­ful sug­ges­tion or com­ment. Do you have a sug­ges­tion I could pass along?Your Debunk­ing web site is excel­lent and I visit and rec­om­mend it often. About a month ago, my wife asked me across the kitchen “what are you lis­ten­ing to?” I said “it’s a mp3 by Steve Keen, he’s talk­ing about econo­physics and even quotes Joe McCauley!” She just shook her head and walked away.Best wishes,Chuck Willer
Cor­val­lis, Ore­gon

To: usecoeco@yahoogroups.com
From: Muriel Strand <auntym@macnexus.org>
Date: Mon, 26 Mar 2007 17:30:41 –0700
Sub­ject: [usec­oeco] ques­tion re sus­tain­able cur­rency

in his book “power down” richard hein­berg says that a debt-based cur­rency such as US$ won’t work for a homeo/static stable/contracting sus­tain­able econ­omy because if there is no growth then there is no new money to pay inter­est on exist­ing loans so they will default, pos­si­bly lead­ing to a crash.

is this true? if so why?

what could a cur­rency be based on that would avoid this alleged prob­lem?

thanks, muriel

From: Joshua Far­ley <Joshua.Farley@uvm.edu>
To: mail­ing list usecoeco@yahoogroups.com
Date: Tue, 27 Mar 2007 14:24:29 –0400
Sub­ject: Re: [usec­oeco] ques­tion re sus­tain­able cur­rency
In the cur­rent sys­tem in the US and most other coun­tries, most money is
loaned into exis­tence by banks. When you take out a mort­gage, you are not bor­row­ing money that actu­ally exists–the money comes to exist only after the bank writes you a check. When you pay back the loan, the money cre­ated ceases to exist. How­ever, you must also pay back the inter­est.
This means that the amount of money being loaned into exis­tence every year has to increase so that pre­vi­ous loans plus inter­est can be paid back. When an econ­omy is grow­ing, more money is required to chase the increas­ing num­ber of goods and ser­vices being offered, so there’s no prob­lem. If the econ­omy is steady state or con­tract­ing, then no new money is needed. With­out this new money, peo­ple would not be able to pay back their exist­ing loans.
There are sev­eral ways to solve this prob­lem. My favorite is to take away from banks the right to cre­ate new money and return it to the gov­ern­ment. The gov­ern­ment could loan money into exis­tence inter­est free, e.g. for activ­i­ties that pro­mote the pub­lic good.Josh

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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  • So if the banks decide to hoard the repaid prin­ci­pals, thereby cre­at­ing a defla­tion, and then
    loan it to their cor­po­rate cronies after the price level has dropped … ?

    Do you have a con­spir­a­to­r­ial view of finance?

  • Richard Glover

    Although most of the paper made per­fect sense, I was unclear about the source and nature of endoge­nous money. Endoge­nous sug­gests it is part of the sys­tem, rather than an ini­tial injec­tion of cash by (say) a gov­ern­ment.

    Credit/debt and money are dis­tinct, ok. I would like to explore this in 2 direc­tions.

    1 If ban­knotes are involved, they pre-exist the set­ting up of credit, and may be pushed into cir­cu­la­tion. On repay­ing loan in ban­knotes, they will still obvi­ously exist, even though credit/debt is destroyed. 

    2 If only bank money was involved in a loan, this will (I believe) add to the money sup­ply at the point of the loan. When the the loan is repayed, the money sup­ply will return to its pre­vi­ous level. In this sense, money that is cre­ated will be destroyed. 

    I believe the bank money is not endoge­nous money. Any help on this point would be greatly appre­ci­ated.

  • Hi Richard,

    I sug­gest you read the Rov­ing Cav­a­liers post: bank money is endoge­nous, and though many of my Post Key­ne­sian col­leagues also believe that money is destroyed when debt is repaid, I think this is based on a fun­da­men­tal mis­un­der­stand­ing of debt.

    You might also find it use­ful to watch the video I’ll be post­ing of the talk I’m giv­ing here in Chicago to the Amer­i­can Mon­e­tary Insti­tute tomor­row. With luck I should have that posted by Sun­day.

  • Richard Glover


    Many thanks for the clar­ity of your argu­ment and analy­sis; I have found “Rov­ing Cav­a­liers of Credit”, “Keynes’s Revolv­ing Fund of Finance and Trans­ac­tions in the Cir­cuit” and your recent AMI pre­sen­ta­tion all very inter­est­ing and help­ful. All this though does prompt some ques­tions and com­ment.

    Con­trol of Money sup­ply:

    The line of cau­sa­tion being loan — deposit — reserve would seem to describe the present day sit­u­a­tion. Loans are con­strained, cer­tainly by the will­ing­ness to get fur­ther into debt, but also to some extent by reg­u­la­tion. Once it did seem reserve ratio was effec­tive (FRB in 1950s to 1970s lead­ing to growth in Eurodol­lar mar­ket). Now the Basel Accords have some effect. Rules are bent with “off-bal­ance-sheet” inno­va­tions, and FRB etc may alter the rules at times, but there is still some (albeit imper­fect) reg­u­la­tory restraint.

    If this is true, then any one of the con­straints will be oper­a­tive, and it could be a dif­fer­ent one at another time. Thus at times relax­ing the rules could seem to be causative, but at other times not. This sug­gests that money has both endoge­nous and exoge­nous aspects, the for­mer being dom­i­nant at present.

    Impor­tance of Base Money:

    I under­stand that notes and coin are avail­able on demand (surely not just the UK?). The pub­lic want­ing more notes and coin com­pro­mises banks abil­ity to lend, as they dimin­ish their cen­tral bank deposits. This (if true) again sug­gests that Basel etc is hav­ing some effect on restrain­ing bank lend­ing. The pub­lic seems to be encour­aged to use as lit­tle cash as pos­si­ble for this rea­son.

    This on-demand con­vert­ibil­ity to cash seems to be a vital aspect for there to be con­fi­dence in elec­tronic money. Our recent cri­sis has seen banks turn­ing to the cen­tral bank and gov­ern­ment for help. Again this sug­gests the lender of last resort has a vital part to play. It is as though we have more con­fi­dence in the nation than the banks in times of finan­cial cri­sis.

    Is cash a lia­bil­ity?

    Money is an asset to the holder but a debt to no-one” sounds good but I have doubts on exactly what you mean. I sit here with a £20 note, which is cer­tainly an asset to me, but only because I can go any­where I wish in the UK and obtain goods and ser­vices for it. The flip­side is that the UK is duty-bound to accept it in exchange. Thus the £20 is an asset to the holder and a lia­bil­ity to the nation. 

    For the £20 to have the great­est value to the nation as a whole, its value has to be sta­ble. This becomes a vital respon­si­bil­ity of gov­ern­ment. For the elec­tronic-to-cash con­ver­sion that helps sup­port con­fi­dence in bank money, this neces­si­tates some gov­ern­ment respon­si­bil­ity for bank money. This would espe­cially include reg­u­la­tion (pre­ven­tion?) of loans extended to asset spec­u­la­tion, espe­cially in land.

    Tem­per­ing Spec­u­la­tion:

    This does seem to be such an impor­tant issue; time and time again we have been through these boom-bust cycles fuelled by spec­u­la­tive activ­ity. This is sub­stan­tially based on land spec­u­la­tion, the most vari­able com­po­nent of prop­erty price over the cycle.

    Have you posted your view of the poten­tial for some form of land value tax­a­tion as a mod­er­a­tor of such destruc­tive activ­ity? I won­der if this also has poten­tial in lev­el­ing some of the debt moun­tains that sur­round us.

    Again, many thanks for your post­ings and I hope they con­tinue to help change the world’s under­stand­ing of money and finance.

  • I sug­gest u to use this. magia

  • sean­brose­ley

    This reminds me of Karl Marx, when he writes about com­modi­ties being bought and thereby drop­ping out of cir­cu­la­tion and thereby money chang­ing hands and mov­ing fur­ther away from its ori­gins. He then goes on to say that the longer the time lag between money being cir­cu­lated into the econ­omy between a sell and then a buy trans­ac­tion then the greater the chance of an eco­nomic cri­sis. He refers to this delay in using the pro­ceeds of sell­ing a com­mod­ity and then pur­chas­ing another as hoard­ing. And then when you have a class of eco­nomic agents who did not sell com­modi­ties to buy oth­ers you have an increased like­li­hood of an eco­nomic cri­sis.

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