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MONEY
WHAT IT IS
HOW IT WORKS
Some writers claim that interest due on bank loans is a time bomb. They argue that bank loans provide only enough money for borrowers to pay off the loans and none to pay the interest due. That means additional borrowing is required just to cover the interest on previous loans. The public’s debt to banks must therefore be compounding at the average interest rate on loans. The popular name for this hypothesis is the debt virus. The debt virus hypothesis is based on
a very incomplete model of money flows between the banking system and the
non-bank public. In reality, money flows in both directions in about
equal amounts. Deposits lost when interest is paid on bank loans reappear
as deposits somewhere else in the banking system. They are
created directly or indirectly as a result of bank spending. An alternative but equivalent way of stating the debt virus hypothesis is as follows: Assume bank loans are all rolled over but no new loans are made. Interest payments on existing loans would end up completely draining the money supply. We will focus on the alternative case because it is easier to understand. In either case the economy would crash. Interest payments on existing bank loans would result in a reduction in bank deposit liabilities, and thus free up reserves. The question to be considered then is what would banks do with the freed-up reserves. A bank can use the excess reserves to (1) pay for its operating costs, (2) pay dividends, (3) buy securities as investments, (4) buy deposits at other banks, or (5) hold the excess reserves to earn whatever interest the central bank pays on them. It should be obvious that options 1 and 2 create new bank deposits dollar for dollar, and thus do not drain the money supply, defined as total deposits plus currency in circulation. Option 3 does the same, although in some cases indirectly. For example, suppose a bank uses its excess reserves to buy securities directly from the Treasury. It pays by crediting the Trreasury's account at the bank with a new deposit. (For simplicity,we assume the Treasury has an account at the bank.) Then how does the purchase of Treasury securities result in new deposits for the public? The answer is through government spending. When government spending exceeds tax revenues, the deficit is covered by the sale of securities to the public. The spending itself creates new deposits equal to the value of the securities sold. Thus when the bank buys new Treasury securities with its interest earnings, equal deposits must have been created somewhere in the banking system. It is evident then that option 3 represents no net drain on the money supply. If the bank uses the excess reserves to buy deposits at another bank as in option 4, the receiving bank would then have acquired excess reserves. It may hold a portion, but would generally use them as in options 1, 2, or 3. Thus any loss in deposits from option 4 would be small and self-limiting. Option 5 would indeed drain deposits dollar for dollar but would be self-limiting because banks can normally earn more from buying securities than they earn from interest on reserves.It is clear that banks return nearly all of their earnings to the public one way or another, thus any drain on deposits is small and limited. But the debt virus hypothesis asserts that without additonal bank lending, the interest paid on existing loans would drain the entire money supply. Obviously that is not true, so the hypothesis is false. |
