Promises only bind those who believe them
The saying goes like this,
Loans create deposits
It might not sound like much, but this is how money is actually created. You’d think it would be printed as paper bills by a central bank or minted into coins. Not anymore, to a large extent. Paper money and coins are indeed “money”, but they make up only a small percentage of the reserves available in the economy. Let me try to break it down to you in a simple example.
I Promise to bay the bearer, etc.
When a bank grants you a loan, it basically credits your bank account with the loan amount, 10 000 dollars for example, and records a liability of the same amount on its balance sheet. You can withdraw this amount in cash or use it to buy a car. Or a piano. Or groceries. It is real money.
Now you might be a dreamer and believe in equilibrium, that in the grand scheme of things, banks use only the cash deposited by people, as loans to debtors. Well not really.
Banks are allowed to lend much more than the liquidity or capital at their disposal. That’s a net creation of money.
Out of thin air.
And don’t bother with the liability side, the minus amount in dollars recorded on the bank balance sheet. It cannot be used to fund anything. It cannot be withdrawn in cash. It is just an accounting entry on a balance sheet account. A reminder of the debt you own the bank. Nothing more. A promise if you will.
The bet at hand
The bet at the heart of the game is that loans will allow debtors to create enough value in due time to pay them back, through their hard work or the rise in value of their property or investments.
This bet kind of works out when the economy is fine, but not so much when banks lend money without decent credit controls, to people they know damn well cannot repay the loans.
It works even less when bankers are convinced that dot com compagnies of the early 2000s or the real estate market of the late 2000s have more value in them than what they are truly worth, and end up massively lending to people who are investing in such assets.
The bet is off in this case, quite obviously, since the debtors cannot create value out of thin air, be it called dot com or sub-primes.
In the end, this is how most of the money circulating in the economy is created. Legally. A number credited on an account, which retains its value as long as the promise behind it trustworthy.
And as we say in France, in a tongue in cheek expression, promises only bind those who believe them.
Can you believe that?
Let the board sound