Thursday, May 8, 2014

What about bank money? Can't the Private sector save by itself?

In the previous post we discussed the three financial sectors that affect money in an economy. We now look within the Private sector to the banking system. 

It is very helpful to separate money into two categories:
  • Government money (note: the terms Government and State are used in this blog interchangeably when referring to a currency-issuing sovereign)
  • Bank money, which is "created" whenever banks issue loans (mostly via simply crediting your bank account with numbers representing the amount of the loan). 

Bank money used to be quite separate from government money. In the past banks would issue their own IOUs or bank notes and often their value would differ from one bank to another. These bank notes would not be accepted by the government in payment for taxes but would circulate as money locally because people needed the bank money to retire their bank debt. Think of the national currency as the US Dollar and the local money could be First Bank $1 Note. It gets confusing because we use the same term for both - the dollar - and so we think of bank money and government money as the same thing. 

The distinction has become further blurred because our government has agreed to insure (FDIC) bank money so that if a bank goes out of business we don't lose our savings. This is a good thing. Furthermore, the central bank now provides a system for all banks to move money between themselves to clear transactions, so that all bank money and government money are now exchangeable at par. It all looks the same to the average person.

But there are differences in how the two types of money function.
  • Net inflows of Government money (spending less taxes) into the Private sector have no corresponding financial offset in the private sector. They result in net financial savings mostly in the form of bank reserves, Treasury bonds, bank account balances, and cash. [Note the logical and very real implication: our so-called "national debt" is actually our nation's financial savings.] 
  • However, all bank-issued money has a corresponding private sector liability. For every bank dollar saved there is a bank dollar owed. While some individuals or a businesses might be net saving, others are net in debt. When viewed in the aggregate, the Private sector cannot save financial assets from bank money (bearing in mind that they may be accumulating non-financial real assets such as houses or machinery). 

Bank money is formed by private sector borrowing. Many of our economic "boom" periods have been characterized by a large expansion of private borrowing (very often in excessive amounts and followed by inevitable "busts"). Banks create new money with every loan they issue. Bank money does impact the real economy: in a very positive way when it is used to build productive assets, and in a very negative way when it is used to speculate on existing assets or over-leverage businesses or households. But from a strictly financial sense, it is only Government money or a Foreign sector surplus that adds to Private sector net financial wealth. 

In the aggregate, we can't save money without an outside source injecting it into our economy. 

Think of it this way: if everyone saved and kept saving, then by definition there would be less and less money circulating to buy the output of all the producers, which means less money to pay wages (and make loan payments). Without some injection of additional money from either net exports or government deficits, unemployment would rise and wages would fall. This is, in fact, part of what is going on in the US today.

Some countries can get away with no deficits from the government sector (i.e. no injections of money into the economy) because they have a large enough trade surplus to make up for the amount of money the private sector desires to save. However, simple math tells us that all nations cannot be net exporters, and even those that do often can't keep up with the national savings level and still require some form of government money source (e.g. less taxes or more spending).

More private sector debt can give an appearance of financial gain, but eventually it will reach Ponzi-type levels where new debt is required just to pay the interest on the old debt, and as defaults rise, the overextended banking system busts as it did most recently in 2007-2008.

Once again, we reach our same conclusion that the monetary system can and should be used as a tool to benefit the nation. This tool can be used in many ways, from providing for full employment, lowering tax burdens, investing in education or infrastructure, and much more. We don't have to be afraid of using it!

Let me emphasize that this discussion is about the monetary system, not the real things money buys. Real wealth can be accumulated through ownership of land, capital goods, etc. We are strictly addressing how to use the monetary system properly to ensure enough dollars are always present to provide for full employment and a prosperous nation.