It’s been over ten years since the Bank of England published Money creation in the modern economy, yet despite that, I run into people daily parroting untruths about how banking works. As part of the update to the UK Accounting Model, we will enhance the banking chapter to cover how lending institutions work and highlight some of the intriguing artefacts that a proper understanding reveals.
Here’s one for today.
As we know, loans create deposits. A loan of £100 creates £100 of deposits.
It’s important to note that the mainstream statements about the effects of interest rates often present a misleading picture.
… higher interest rates may mean you are less likely to want to take out a new loan to buy things unless you need to.
If you can save money, you might be more tempted to as interest you will get on any savings rises.
Given that loans create deposits, it cannot be the case in aggregate that people can save in deposits and take out fewer loans. We can only have more loans and more deposits or fewer loans and fewer deposits.
Therefore, in aggregate, the ‘saving’ part of mainstream theory actually means ‘paying back loans with acquired deposits’.This observation leads to an interesting implication within the banking system.
Consider a scenario where interest rates rise, and you decide to hold a deposit of £100, living off the interest it generates. In that case, a corresponding £100 loan has to exist permanently somewhere in the system to balance that deposit.
For as long as somebody holds the deposit, a matching loan quantity is locked in place and cannot, in aggregate, be paid off. There are insufficient deposits circulating to cancel the loan.
Increased financial savings, in terms of holding deposits, will stop an equivalent amount of loans from being repaid, forcing them to be refinanced or defaulted.
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