How do I money?

I have always known that I don’t completely understand how fiat money works, however I have recently realized that I don’t understand it at all! Maybe some of my readers can clarify my confusion.

So let’s start a national economy from scratch, without international trade: so a group of people move to a deserted island, declare independence, the people have all kind of skills, they bring all kind of materials and machineries with them, the island has all kinds of natural resources and maybe a lottery system gives some people ownership of various plots of lands and mining rights.

Now some would-be entrepreneurs would like to begin hiring people with the right skills, buying or renting various stuff, and start some businesses. It seems that there is no loss of generality if I think of the entrepreneurs as just one person for the sake of what I want to think about. She is going to need to get a loan to start her business(es). Meanwhile, the new island government created a central bank, which issues theory dollars, or thollars, which are the currency of the island. The central bank “creates” thollars and lends them to banks, then the banks keep a fractional reserve and lend to the entrepreneur. Again, for the sake of what I want to say, there is no loss of generality if I identify the central bank and the other banks as just one entity.

So the central bank lends thollars to the entrepreneur, and she uses the money to start the business and being to pay people. At this point money starts circulating in the economy, and people will hire gardeners and babysitters, and lawyers, they will give to charities, they will hire computer science theory tutors for their kids, they will buy and sell houses to each others, and, crucially, will buy whatever goods and services the entrepreneur is selling. Now she is making a profit and she can pay back the loan to the central bank and invest in more … wait, she can never pay back the loan!

That’s because all the thollars in circulation are the ones that the central bank lent her, so there is no way that, as the money circulates, she can ever make more money that she owes!

Ok, so maybe people will also take loans to buy houses and stuff, so that’s more money that circulates, but is it really the case that, overall, it is impossible for everybody to be debt-free? That all the cash that any debt-free person has needs to be compensated by an equivalent amount of debt from other people? This is not how things seem to be in practice.

Now, clearly it is possible for everybody to have positive net worth, because, at the start, people have stuff and that stuff is worth money, but it seems strange that not everybody can be debt-free.

Maybe the problem is deflation? That if the entrepreneur borrowed money to create a business that creates new wealth (because it makes stuff that people find more valuable than the value of the raw material and the value of the work that went into it), but the amount of circulating money stays the same, then there is deflation, and her debt is spiraling out of control in deflation-adjusted terms, even if the interest rate is zero?

It seems that there are only two ways in which you can have everybody be debt-free and have a positive amount of cash: (i) the central bank starts buying stocks of private companies, (ii) the government runs a deficit, and the central bank buys government debt.

Is this correct? Normally, we think of people and companies being debt-free (or having more cash than debt) as ideal, and a government running no deficit as ideal, and usually central banks don’t buy stocks (they only buy bonds, which is formally equivalent to lending), so are these three conditions contradictory?

12 thoughts on “How do I money?

  1. I think the textbook answer is that it is not, in fact, a good thing, for everybody to have a positive net cash balance at the same time. . Instead, individuals and companies who currently have higher-than-average marginal returns on capital (e.g. startup companies, students investing in an expensive education, etc.) should borrow resources from those who currently have lower-than-average marginal returns on capital. Debt is not inherently an economic negative, and in fact refusing to borrow to finance a worthwhile investment purely in order to avoid taking on debt is economically irrational.

  2. You are right, but the central bank does not cease to exist after the loan.
    With the loan, the entrepreneur will pay workers to produce something that takes non-zero time to produce. So the total amount of thollars on Trevisan Island during that time will be larger than the amount of buyable things, and the society as a whole will deposit these “useless” thollars on their saving account.

    The central bank will then give them interests by possibly making new thollars, but not necessarily with the same rate: the bank’s role is also to use these rates to control inflation, encourage investment, etc.

    An entrepreneur making rational decisions will of course estimate his gain with the borrowed money, and will not borrow money if his gain is not higher than the interests. It is then up to the central bank to keep inflation at a correct level.

    By the way, inflation is an interesting mechanism, by which money is transfered from people who own debt to the endebted of the island. Hi hope this explains the “very rational” discussions between european leaders since 2008, to some extent.

  3. Terry, you are right, I shouldn’t have said that it’s “ideal” for everybody to be debt-free, because it is clearly irrational (in the economic sense of the word) in some cases. But is it really impossible? I find it very counterintuitive

  4. Luca, cash is essentially just an accounting device that measures the difference between goods and services produced, and goods and services consumed or owned. (This is an oversimplification, ignoring the effects of gifts, taxation, interest rates, theft, fraud, waste, and other forms of wealth transfer, creation, or destruction, but will suffice for now.) As a first approximation, the only way to get cash is to produce and then sell some good or service (e.g. producing the service of teaching a computer science course in exchange for a university salary), and the only way to get into debt is to borrow cash to purchase a good or service.

    As such, an individual with a positive cash balance is simply someone who has consumed fewer goods or services than he or she has produced, whereas an individual with a negative cash balance is someone who has consumed more goods or services than he or she has produced. Since net consumption and net production must match (modulo the caveats above), it is thus impossible for everyone to have a positive cash balance (or conversely, for everyone to be in debt).

  5. Here is another way to think about it. Originally, the people of the island used to swim out beyond the reef, dive down, and collect thold shells. Pretty to look at, they became the de facto currency for barter. Since one could collect them, people could exchange them for goods and services.

    When the central bank came along, it decided to use a less bulky means of exchange and introduced paper currency. It also had the advantage of giving better control on the total supply of currency in the market. Initially, the bank bought all of the supply of thold shells and put them in a vault.So people started off with no debt but a supply of cash. People could also of course continue to find more thold shells and exchange them for cash. In the beginning, the thollars had to be backed by a “commensurate” pile of thold shells in the vault. So even if you borrow thollars from the central bank, you can technically be debt free, as long as you are allowed to pay back the debt in thold shells.

    During some economically turbulent times, the central bank decided that they needed to increase the supply of thollars. It decided to break away from the thold standard and just print more thollars. This did create this situation where in total, people had to be in debt, as you describe.

    But as we know from the paradox of thrift, everyone being in debt is not a good situation for the economy. There are ways to get around that, similar to finding thold shells.

    One way is stocks. When a company IPOs, it takes a large amount of thollars from the public, in exchange for a piece of paper (or bits, these days). Thollars flow from public to company, but the company does not think of itself as being in debt to the public. These pieces of paper do the same function as thold shells. New thold shells have been created, and more thold shells in the system means people can be debt free.

    But you are right that there has to be conservation of cash vs debt. This can be fixed by the treasury continuously buying up thold shells or pieces of paper from the public and issuing more thollars. So there are thollars being thrown into the system without creating debt.

    Also, banks don’t necessarily mind being in “debt”. A bank can borrow 100 thollars from me, and exchange that in the market for a thold shell or a piece of paper (say a stock, or a commodity future). So the 100 thollars are back in the economy. Technically, the bank is in debt in thollar cash terms, but because it has this piece of paper that is believed to be worth 100 thollars by the bank, the bank is happy to be in this state and does not consider itself indebted. It seems like everyone can now pay back their debt, except for the bank, but the bank doesn’t feel indebted. Similar effect happens when the piece of paper that the bank was holding goes up in value: more thollars can be paid back without anyone feeling indebted. In effect, the system has created equivalents of thold shells out of thin air, and so no one is indebted.

  6. Thanks to all, especially Terry, for explaining this to me really clearly (like to a five year old). So in order for everybody to have non-negative cash, the banking system needs to have assets. Such assets could be treasury bills if the state is running a deficit, and they could be stocks if one does distinguish between a central bank and private banks, and assumes that private banks make investments, and they could be assets like thold that the central bank at some point bought with cash.

    I think my confusion came in part from the fact that I assumed that the “amount of cash in the US,” which I guess it’s called the “money supply” would be the sum, over all people and other entities, of their net cash balance (cash assets minus debts), which has to be zero, up to the value of the bank reserves. Instead I guess one should take the money supply to just be the sum of all assets, which also equals the sum of all debts (again, up to reserves). So, as described in the bank of England document (thanks, Phillip Somerville! It’s a very nice document) when a bank makes a loan it increases the money supply or it “creates” money.

  7. Anyone know why central banks inject money into the system by loaning it as opposed to, say, simply giving every citizen a fixed amount of money created from thin air? Seems like such a method makes it possible for everyone to have non-negative cash. (Haven’t read the BoE document yet, but intend to.)

  8. Gus, the BoE paper says that central banks don’t… directly.
    Retail banks essentially create the money ‘out of thin air’ when they lend.
    There’s been some good discussion across the blog-o-sphere about this ‘revelation’ as I believe it runs counter to orthodox economic theory.
    I can’t locate some of the more credentialled commentary I’ve read just a.t.m, but the following piece has some interesting observations to make on bank liquidity versus solvency during the recent GFC.

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