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The Downfall of Keynesian Economics and the U.S. (Part 1 of 3)

Axel,
You essentially make Mr. Jones' point for him. Yes, financial flows are circular but the trouble with your idea, that Ben the banker will recirculate the money that is necessary for the farmers to pay their interest, is in misunderstanding the mechanics of "lending" by banks. It's not literally "lending" as banks don't lend from some stock of money they hold.

When a bank makes a loan it creates the money out of nothing. If you studied some financial economics you can look this up in your textbook. This is a simple fact, not a controversial opinion. When the loan principal is repaid the money ceases to exist.

I'll quote from my financial economics textbook:

"Through the creation of a deposit by making a loan or acquiring a security, a depository institution increases the money supply by the amount of the created deposit." ..."the liabilities of banks and other depository institutions have the peculiar characteristic that they are money."

A bank's balance sheet loks like this:

A = K + L

Assets (loans, which are the "debts" of borrowers) = Capital (bank stocks, common and preferred shares and long term debentures held by banks) + Liabilities (customers' deposit balances at the bank: these liabilities "are money").

Every loan creates an asset on one side of the balance sheet and a liability on the other side. When the loan principal is repaid both the asset and liability are written down to zero. The "money" which began its existence as a deposit in your account, ends its existence when your account is debited in the amount of the loan principal.

The loan added that amount of money to the money supply; your repayment deleted that amount of money from the money supply. The money came into existence as your loan and it ceased to exist with your repayment.

My text gives an example:

"The depository institution makes a loan for $1000 to a business, crediting the business's demand deposit with that sum of money. ...the business now holds money which previously did not exist. ...The money supply expands by $1000. When the loan is repaid a corresponding contraction of the money supply will occur, unless the institution replaces the loan with another of equal value."

This is Mr. Jones' point: the ONLY source of new money is new loans, and all loans are "debt" to the borrower, which has to be paid back. In Mr. Jones' example a total of $300 of new money is created and when that loan principal is repaid there will be no money left in the system.

Paying off your bank debts eliminates money. There is no extra money for the banker to recirculate into the system. If all 3 farmers manage to repay their loan principal there will be zero money left in the system so none of them will be able to pay their interest.

When farmers A and B repay their principal and interest the money supply is reduced by $200, leaving a total of $100 of money in the economy. The banker owns $20 of that money which he earned as his interest. If farmer C manages to collect ALL the money that remains in the economy, including the banker's $20, he will be able to repay his principal $100 and that $100 will cease to exist. Unless some other person takes out a new loan and adds new money and debt to the system, there is no money left for farmer C to pay interest to the banker.

The problem with your "circulation" theory of money is that the amount of money in the system diminishes as loans are repaid and ultimately somebody is left owing money that does not exist.

The simplest way to understand this is to see the system as a whole. All loans collectively create an amount of money P, the loan principal. At the same time as the money P is created, an amount of monetary debt is created P + I, the interest. As P is repaid it ceases to exist in the system, and if all P is repaid your are still left with I, the interest everyone owes the banking system.

Over time as many new loans are created and repaid the system ends up with a massive deficit of money available for everyone to pay their interest. That deficit equals I, the total amount of interest money that is owed but was never created.

Historically this monetary deficit is periodically corrected by recessions and depressions with massive defaults on loans. Banks write off defaulters' debts without collecting and eliminating the money that is owed, so "free" money is left in the hands of whoever sold stuff to the borrowers. This makes it possible for the non-bankrupt to continue paying off their bank debts.

That's the simple arithmetic of our banking system. "Fractional reserve" is kind of a red herring, as all this means is that banks must hold an amount of cash sufficient to meet the cash withdrawal needs of their customers, typically about 4% of total deposits.

Banks make no interest on their cash holdings and they owe the cash to their central bank--the issuer of cash as "Federal Reserve Notes"--so cash shows up on the liability side of the balance sheet.

But cash only changes the "form" of the money depositors' hold. If you withdraw $100 cash from the bank your credit balance is written down by $100 so there is no change to the money supply. Cash does not change banking arithmetic at all, though it perhaps confuses the issue with additional complications.