What is a bank loan?

When a bank makes a loan, does it create money “from thin air“? Are banks merely intermediaries, where “if people are borrowing, other people must be lending“? I consider these sorts of questions less and less helpful. Let’s just understand what a bank loan is, in terms of real resources and risk.

Suppose I go to my local bank and ask for a loan. The bank says yes, and suddenly there is “money in my account” where there was not before. Am I now a “borrower” and the bank a “creditor”?

No. Not at all. The transaction that has occurred is fully symmetrical. It is as accurate to say that the bank is in my debt as it is is to say that I am in debt to the bank. The most important thing one must understand about banking is that “money in the bank” also known as “deposits” are nothing more or less than bank IOUs. When a bank “makes a loan”, all it does is issue some IOUs to a borrower. The borrower, for her part, issues some IOUs to the bank, a promise to repay the loan. A “bank loan” is simply a liability swap: I promise something to you, you promise something of equal value to me. Neither party is in any meaningful sense a creditor or a borrower when a loan is initiated.

Now suppose that after accepting a loan, I “make a purchase” from someone who happens to hold an account at my bank. That person supplies to me some real good or service. In exchange, I transfer to her my “deposits”, my IOUs from the bank. Suddenly, it is meaningful to talk about creditors and debtors. I am surely in somebody’s debt: someone has transferred a real resource to me, and I have done nothing for anyone but mess around with financial accounts. Conversely, the seller is surely a creditor: they have supplied a real service and are owed some real service in exchange. It would be natural to say, therefore, that the seller is the creditor and I, the purchaser, am the debtor, and the bank is just a facilitating intermediary. That is one perspective, a real resources perspective.

But it is an incomplete perspective. Because in fact, the seller would not accept my debt in exchange for the goods and services she supplies. If I wrote her a promise to perform for her some service of equal value in the future (which might include surrendering crisp dollar bills), she would not accept that promise as a means of payment. I circumvent her fear by writing to the bank precisely the promise that the vendor would not accept and having the bank “wrap” my promise beneath its own. The bank’s job is not to “lend” anything in any meaningful sense. The bank is just a bunch of assholes with spreadsheets, it has nothing real that anyone wants to borrow. The bank’s role is to transform questionable promises into sound promises. It is a kind of adapter of promises, or alternatively, a guarantor. [*]

Let’s suppose for a moment that the bank’s promises are in fact ironclad. With 100% certainty, the bank will deliver to holders of its IOUs the capacity to purchase real goods and services as valuable as those that were surrendered to acquire the IOUs. Now, when I transfer to a seller IOUs the bank has issued to me in exchange for my somewhat sketchy promises, is it still meaningful to refer to the seller as a “creditor”? After all, she has already received something that is unquestionably as valuable as the goods and services she has surrendered. So her situation is flat, “even-steven”. In exchange for her real resources, she has “money in the bank” whose purchasing power is guaranteed. She bears no risk. But the bank still bears the risk that I will fail to honor my promise while it will be required to honor its own without fail. Which is the creditor then, the seller or the bank? It becomes a matter if definition.

So let’s define. A party that has supplied real goods and services in exchange for a promise of future reciprocation is a “creditor from a real resources perspective”. A “creditor from a risk perspective” is a party that bears the risk that a transfer of resources will fail to be reciprocated. When I have taken a bank loan and “spent the money”, the seller becomes a creditor from a real resources perspective, while the bank becomes a creditor from a risk perspective. The role of creditor becomes bifurcated.

More accurately, the role of creditor becomes “multifurcated”. It cannot be true that “the bank” is a creditor from a risk perspective. Remember: the bank is just a bunch of assholes with spreadsheets, it has nothing real that anyone wants. The risk that we claim sits with “the bank” must in fact fall on people who control or have controlled or might control real resources. We need to consider the “incidence” of the bank’s risk. It might be the case, for example, that the bank’s IOUs, its “deposits”, are in fact not solid at all, such that if I fail to repay the loan, the bank will fail to make good on its promises to people who supplied real goods and services in exchange for bank IOUs. In this case, the “creditors from a risk perspective” are the depositors, people who have delivered real goods and services in exchange for promises from the bank. When depositors are on the hook — and only when depositors are on the hook — there is no divergence of identity between creditors from a risk perspective and creditors from a real resources perspective. Only when depositors absorb losses it is fair to describe a bank as a mere intermediary between groups of borrowers and lenders, perhaps performing credit analysis and pooling risk to facilitate transactions, but otherwise just a pass-thru entity.

That is not how modern banking systems work. Bank depositors are almost entirely protected. The actual incidence of bank risk is, um, complicated. In theory, the risk of loan nonpayment falls first on bank shareholders, then on bank bondholders, then on uninsured depositors, and then on the complicated skein of taxpayers and other-bank stakeholders who back a deposit insurance fund, and then finally on holders of inflation-susceptible liabilities (which include bank depositors). In practice, we have learned that this not-so-simple account of the incidence of bank risk is inadequate, it cannot be relied upon, that the incidence of bank risk will in extremis be determined ex post and ad hoc by a political process which favors some claimants over others when the promises that a bank has guaranteed prove less than valuable.

This may all sound confusing, but one thing should be absolutely clear. Under existing institutions, there is little coincidence in the roles of creditor from a real resource perspective and creditor from a risk perspective. Our banks are machines that permit vendors to surrender real resources in exchange for promises the risks of which they do not bear. The risks associated with those promises do not go away. They may be mitigated to some degree by diversification and pooling. They might be modest, in the counterfactual that banks were devoted to careful credit analysis. But these risks must be borne by someone. The function and (I would argue) purpose of a banking system is to sever the socially useful practice of production-and-exchange-for-promises from the individually costly requirement of assuming the risk that promises will be broken, in order to encourage the former. The essence of modern banking is a redistribution of costs and risks away from people who disproportionately surrender real resources in exchange for promises. Under the most positive spin, modern banking systems engineer an opaque subsidy to those who produce and surrender more real resources than they acquire and consume by externalizing and ultimately socializing the costs and risks of holding questionable claims.

Unfortunately, there are a lot of ways of acquiring protected claims on banks besides producing and surrendering valuable real resources. This divergence of “creditor from a real resources perspective” and “creditor from a risk perspective”, between the party to whom real resources are owed and the party who bears the cost of nonperformance, creates incredible opportunities for those capable of encouraging loans that will be spent carelessly in their direction. Incautiously spent loans are unlikely to be repaid, but the recipients of the money never need to care. Industries like housing and education and of course finance depend heavily on this fact. When industries succeed at encouraging leverage that will be recklessly spent or gambled in their direction, they create certain gains for themselves while shifting risks and costs to borrowers and the general public.

Banks are not financial intermediaries in any simple sense of the word. When they “make a loan”, they serve as guarantors, not creditors. The borrower does not meaningfully become a debtor until the loan is spent. Only then do creditors emerge, but the role of creditor is bifurcated. The people to whom resources are owed are not the same as the people bearing the risk of nonperformance. The question of who actually bears the risk of nonperformance has grown difficult to answer, and concomitantly, incentives among bank decisionmakers for caution in creating that risk have weakened, especially relative to the benefits of cutting themselves in on some share of borrowers’ protected expenditures. This bifurcation of the role of creditor also explains why creditors as a political class are relatively indifferent to the upside of a good economy but extremely intolerant of inflation. A good economy means better higher values and better performance on outstanding loans, but creditors who are owed resources but are absolved from risk do not care about the performance of the loans that have become their assets. Those fluctuations, like fluctuations of the stock market, are somebody else’s problem or somebody else’s gain. Protected claimants, people who are owed money by banks or the state (which is itself a bank), can only lose via inflation. They understandably work within the political system to oppose inflation, which would force them to bear some of the cost of the bad loans whose misexpenditures were, in aggregate, the source of much of their wealth.


[*] Update: JW Mason of the remarkable Slack Wire gently chides that I ought to have attributed this point to Minsky. And indeed I should have! From Stabilizing an Unstable Economy (Nook edition, p. 227):

[E]veryone can create money; the problem is to get it accepted.

Banking is not money lending; to lend, a money lender must have money. The fundamental banking activity is accepting, that is, guaranteeing that some party is creditworthy. A bank, by accepting a debt instrument, agrees to make specified payments if the debtor will not or cannot. Such an accepted or endorsed note can then be sold in the open market.

Update History:

  • 8-Jul-2012, 8:10 p.m. EEST: Added update/footnote with attribution to Minsky, many thanks to JW Mason.
 
 

32 Responses to “What is a bank loan?”

  1. vbounded writes:

    Don’t forget about the bulk of workers who have no power to increase their wages, and for whom inflation results in an reduced standard of living due to increasing the cost of tradable goods they consume. And who will never have enough savings to stop working as long as they are physically able.

    Please explain how these people will be helped by inflation. Unless you want to give workers bargaining power to increase their wages by creating trade barriers, these arguments immoral and designed to shaft developed world workers for the benefit of developed and developing world capitalists. Which is the typical beneficiaries of globalists, like Summers, DeLong, Krugman, Geithner, Bernanke, etc.

  2. JW Mason writes:

    I assume you are aware that Minsky made this exact point, when he defined the fundamental economic function of banks as “acceptance.”

  3. allis writes:

    Interesting point that bank is debtor to borrower. I happened today to read the banking articles by A. Mitchell Innis. He notes that a debtor always has the right to repay the creditor and have his loan cancelled. If I go to the bank and pay off my loan, both my debt to the bank and the bank’s to me are paid off. However, suppose the bank sold my loan and can’t “rip it up.” Has the bank violated the loan terms? Isn’t this the problem many homeowners had who paid off their mortgages, or so they thought, but found themselves still being foreclosed on?

    Innis makes the point that when gold was brought to a mint, actually what occurred was a sale:
    the gold miner sold the gold for a minted coin, and the mint bought the gold with a minted coin. Might we say that I buy a demand deposit with my loan and the bank buys my loan with a demand deposit? Isn’t this how repos work? But then, if the bank has the right to sell my mortgage (on account of the transaction was a “sale”) how can I ever pay off the mortgage, when I don’t even know who holds it?

    Innis articles are provocative; I strongly recommend them.

    http://www.ces.org.za/docs/what%20is%20money.htm
    http://www.ces.org.za/docs/The%20Credit%20Theoriy%20of%20Money.htm

  4. Philip Wallach writes:

    You may well know this already, but you would love reading legal cases from the early- to mid-19th century about bills of exchange and guarantors. I was a part of a research project that required me to read through every Supreme Court case in the 1830s and 1840s, and a huge portion of the cases were about allocating the responsibility for bad debts. Looking back on that era, at least superficially, it is easy to appreciate the modern system’s ability to relieve most everyone from having to think hard about these matters–even if, as you say, the ultimate allocation of responsibility may include many people, whether they know it or (especially) not. Along these lines, it would be interesting to see you re-write this post about a monetary system in general. How does the use of any currency at all complicate the ultimate allocation of risk-bearing responsibility? When I accept US currency, aren’t I always making an implicit bet on the US military, or somesuch? Isn’t modern society premised in large part on trading local and personal risk-scrutiny for a willingness to gamble on sovereign health?

    As with many of your posts, this one was a great read and really made me think. But I think you overstate things quite a bit with the blanket statement: “The question of who actually bears the risk of nonperformance has grown difficult to answer.” This just seems false for a huge range of commercial relationships, including financial ones. I think it would be very useful for you to say exactly which kinds of relationships you are actually referring to.

  5. Dan Kervick writes:

    A “bank loan” is simply a liability swap: I promise something to you, you promise something of equal value to me. Neither party is in any meaningful sense a creditor or a borrower when a loan is initiated.

    Wouldn’t it be better to say that both parties are creditors? Anyone who accepts an IOU in exchange for something in a transaction is a creditor – even if the thing exchanged is another IOU.

    In exchange, I transfer to her my “deposits”, my IOUs from the bank. Suddenly, it is meaningful to talk about creditors and debtors. I am surely in somebody’s debt: someone has transferred a real resource to me, and I have done nothing for anyone but mess around with financial accounts.

    But you are not the creditor. What you had in your possession originally was a a transferable bank IOU. The person who sold you the good or service was willing to accept that IOU in exchange for the good or service. Once you have conveyed it to them, you are not in their debt. They hold a debt of the bank; it is the bank that has the debt. The seller is now a creditor, but they are a creditor of the bank. You have made payment, and your role in the transaction is complete.

    The rest of this seems very confusing, and needlessly so. The bank isn’t “wrapping” or supporting or underwriting or guaranteeing your debt. Imagine the bank’s debt is expressed in a bankbook with a positive balance in it. The bankbook says on the front, “This debt is transferable, and is owed to the legal possessor of this bankbook.” You say to the seller, “Will you take this bankbook in exchange for that car?” If they say, “Sure”, and become the bankbook’s legal possessor when you exchange the bankbook for the car, then the bank now owes the seller a debt.

    Let’s suppose for a moment that the bank’s promises are in fact ironclad. With 100% certainty, the bank will deliver to holders of its IOUs the capacity to purchase real goods and services as valuable as those that were surrendered to acquire the IOUs.

    That’s not what it means for a promise to be ironclad. The bank hasn’t promised to deliver value. It has only promised to deliver dollars. As in any transaction, it’s up to the seller to determine for themselves whether the amount of dollars accepted in return for the good sold is equal in value to the good sold. If the seller sells me a very good car for a $5 bank IOU I have in my possession, there is no sense in which this shows there is something defective or non-ironclad about the bank’s promise.

    She bears no risk.

    Well, perhaps. But only because banks are generally reliable, and most bank deposit balances are now guaranteed by governments. But in ye olden days, banks sometimes did not pay. They sometimes went bankrupt, and some of their creditors never got paid.

    Remember: the bank is just a bunch of assholes with spreadsheets, it has nothing real that anyone wants.

    False, I believe. Whenever there is an IOU, we can logically ask what that IOU is an IOU for. And in our system, there is a hierarchy of credit instruments. Bank IOU’s are IOUs for the government’s money, and that money takes the form of either reserve account balances or physical cash. If you have a $10,000 demand deposit balance at the bank, it owes you $10,000 on demand. If you go to the bank and demand $10,000, they have to give it to you. If they don’t you can sue them, since they have defaulted on a debt.

    Our banks are machines that permit vendors to surrender real resources in exchange for promises the risks of which they do not bear.

    I’m not sure I get this. Suppose that commercial banks were not financial intermediaries between government liabilities and regular borrowers. Suppose instead there was only one bank – the government owned one that issued the base form of money and legally final instrument of debt settlement. All monetary transactions are conducted with units of the monetary base. If you accept this government money in exchange for some real good, are you taking a risk? Yes, in one sense, since there is a risk in monetary exchange in any monetary system. You are taking a risk that the issuer of the money, in this case, will not follow a policy that tends to preserve the value of its money in exchange, insofar as this is possible and disregarding factors such as changes in the real costs of real goods and services.

  6. Dan Kervick writes:

    One additional comment SRW: It’s looks to me like you are trying to describe the function of a bank without ever once mentioning the word “money” or recognizing that we live in a monetary economy. You are picturing the bank as though it were merely some kind of clearinghouse or mercantile exchange in a barter economy for the exchange of real goods and services, which in some cases are exchanged for credit for future delivery of other goods and services. But although money might be viewed as a kind of credit instrument, that doesn’t mean a monetary system exists whenever you have exchanges of goods and services with both spot delivery and future delivery on credit. You don’t have a monetary economy as soon as you have pigs, grain and IOUs for pigs and grain.

    Money is a particular kind of instrument, not just a label for the social existence of credit in general. And once you have money in a system, you also have a peculiar kind of IOU: IOUs for money. A bank is not a generalized exchange that diffuses or socializes credit risk in the exchange of real goods and services on credit. It is a particular kind of specialized market in which the only thing that is exchanged is money and IOUs for money.

    Debt instruments can also be used as payment instruments, and in our society these debt and payment instruments exist in a hierarchy governed by mandatory redeemability until you reach something that is issued by a government, is established by law as final payment for any kind of debt, and is not legally redeemable for anything other than instruments of the same kind, or for the diminishment of tax obligations. All theses transactions take place in a law-governed system, and the same government that issues the ultimate payment instrument also makes the laws which guarantee, among other things, that that instrument will be used as the ultimate payment instrument.

  7. [...] What is a bank loan? – interfluidity [...]

  8. bill woolsey writes:

    I think you miss the transfer of resources through time.

    The seller gets a bank deposit which can be exchanged for goods and services later.

    The borrower intially gets a bank deposit, but spends it and gets real resources now, and must return them later.

    The price of this intertemporal exchange is interest. The bank collects interest from the borrower and pays it to the depositor. It collects interest from the person who got the resources now and pays it to those who gave up the resources now.

    The stockholders, like the sellers/depositors, gave up resources now when they purchased the stock. Of course, those holding bonds in banks and other, nonmonetary deposits, give up resources in the same way. That is, they sell current resources for monetary deposits and exchange them for stock, bonds, or nonmonetary deposits.

    Anyway, the stock expeciatlly, but also junior bonds, bear more of the risk of the loans, and those with deposits, monetary and nonmonetary, bear less. Because of this risk transfer, deposit interest rates are lower.

    With monetary deposits, it is always the case that the person giving up resources now can collect whenever they want. (And only earn interest until they do.) Generally, those who borrow only have to return the resources (with interest) after some period of time. This is one of the risks that is born by stockholders in the first instance and so another reason why deposit interest is lower than loan interest.

    Anyway, the depositors, monetary and otherwise are creditors to the bank, and in particular, to the stockholders, the owners of the bank.

    My view is pretty conventional, but I think it is more or less the most useful perspective.

  9. Dan Kervick writes:

    The borrower intially gets a bank deposit, but spends it and gets real resources now, and must return them later.

    Bill, although it might seem pedantic, I think it is useful to point out that when we engage in what is perhaps misleadingly called “borrowing” money, the money that is delivered in return by the borrowing party is almost always not the exact same money as the money that is delivered initially by the “lending” party. Consider these three analogous cases:

    First, suppose I make this informal contract with my neighbor. I will give him my lawnmower now, and he must give it back to me tomorrow. He is permitted to use it until tomorrow. This is what we would usually call “borrowing a lawnmower”.

    Next, suppose I make this different kind of informal contract with my neighbor. I will give him my lawnmower now, and he must give it back to me tomorrow. He must also give me $20. He is permitted to use it until tomorrow. This is what we would usually call “renting a lawnmower”.

    Finally, suppose I make this third kind of informal contract with my neighbor: I will give him my brand new lawnmower now. One year from now, he must give me a brand new lawnmower, along with ten gallons of gasoline. I would call this “buying a lawnmower”. The price is one lawnmower plus ten gallons of gasoline. The terms of of payment specify payment is to be made one year in the future.

    For some reason, we call the bank loan transactions “borrowing and lending money”. But I think it would be more accurate to call it, “buying and selling money.”

    Also SRW is right to point out that the arrangement usually involves an exchange of IOUs on both sides. In some bank loans, the bank might deliver vault cash to you right up front. But in most cases, the bank has given you only an IOU. You are given an increased demand deposit balance. And that balance represents a promise by the bank: they will deliver vault cash to you, when you demand it, or they will make a payment to someone else when you demand it. Note that when they do make those payments, they make them with IOUs. They don’t generally deliver vault cash directly to the person you are paying. If the payee has an account at the same bank, they instead increase the quantity of the IOU that the payee holds, and correspondingly decrease the quantity of the IOU you hold.

    Ultimately, all of these IOUs are IOUs for the monetary instruments that are issued by the government. This can be seen if you want to pay someone who has an account at a different bank. In that case, your bank does not deliver its own IOU to the payee. Instead, it issues a payment demand to its own bank – the Fed – and asks it to pay the bank of your payee. The Fed will decrease the quantity of your bank’s reserve balance, and will increase the quantity of the payee’s bank’s reserve balance. The payee’s bank then it turn gives its IOU to the payee, by increasing the balance in the payee’s demand deposit account.

    I would say that any time anyone accepts an IOU as part of any exchange, they have advanced credit. They have advanced credit because they have placed faith in the promise that something will be delivered later, rather than demanding it be delivered immediately. So a typical bank loan involves an exchange of credit for credit.

  10. Doc at the Radar Station writes:

    Steve, interesting post as usual. It seems you are working through something that you started with your “stickiest price” post. I think you were toying with some sort of “equity stake” in place of the usual debt relationships. Could you elaborate on that connection? This post appears to contain an implicit topic of the moral hazard problems associated with deposit insurance (a concrete example). If we ditched insuring deposits in order to help eliminate the “bifurcation” of creditor roles and it’s attendant problems, what other change would be needed to address the dangers of uninsured deposits? This “equity stake” notion that you’ve alluded to before?

  11. RueTheDay writes:

    Couple of interesting points are raised.

    One being that the mere making of a loan does not change the aggregate level of indebtedness or have any effect on economic activity. It is only once the loans are spent that there is an impact. Until then there is just an increase in offsetting assets and liabilities trapped within the banking sytem.

    The other is the role of the banking system as interposer of guarantees. Although, here, I think the example would be a lot more effective if instead of consumer loans used to purchase goods and services, we looked at business loans used to finance increases in working capital (inventory and receivables). IMO, it is the fact that most businesses have a positive cash conversion cycle and are therefore dependent on external financing of working capital, that best explains the interdependency between the financial sector and the real economy and why a credit crucnh can have such a sudden and massive effect on output and employment (much moreso than the financing of real estate, consumer durables and business plant and equipment).

  12. [...] Source [...]

  13. Alex writes:

    “The borrower does not meaningfully become a debtor until the loan is spent”

    Are you not assuming that the bank doesn’t charge interest on the loan?

    “Incautiously spent loans are unlikely to be repaid, but the recipients of the money never need to care”

    Neither do the bankers making the loans. It’s easy for them to make a quick profit:

    http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2011/03/banks-tail-risk-agency-problems.html

    And deposit insurance means few depositors are willing to hold bankers to account for the use of their money.

    The division in banking we need is not between retail and investment banking, but between deposit-taking and lending. If someone wants to make a loan, then they should do it out of their own money. And if someone wants their savings protected from risk, let them have their government set up a scheme to protect those savings WITHOUT being loaned out.

  14. Mike Sproul writes:

    Steve:

    You get the lending/money creation process right. How about the next step: Does that new money cause inflation because there is more money chasing the same goods? Do you take the backing theory view that the new money is matched by new bank assets and therefore does not cause inflation? Do you take the “law of reflux” view that the new money will only be issued if people demand it?

  15. rsj writes:

    SRW,

    Great Post! But here, I am still not convinced that price inflation is the correct lens through which to view the political struggle:

    Protected claimants, people who are owed money by banks or the state (which is itself a bank), can only lose via inflation. They understandably work within the political system to oppose inflation, which would force them to bear some of the cost of the bad loans whose misexpenditures were, in aggregate, the source of much of their wealth.

    If we accept the view that during credit booms, prices tend to increase, and during credit busts, prices tend to fall, then it does not follow that a strategy of price stability only favors those who earned their wealth as a result of valuation errors on the part of consumers. Rather, if the state prevented the boom and the bust, then we could, ideally, have price stability while discouraging the accumulation of unearned wealth. The cold calculus is that we need the bank failures and the contraction in credit to create the price declines that result in increasing real wages, so by discouraging mass default, which must lead to deflation, we are solidifying the wealth retained by rentiers, just as by allowing the credit bubble, leading to inflation, we are encouraged the wealth creation of rentiers. A model in which deflation is caused by credit contraction/default and inflation is caused by credit growth does not lead to your conclusion.

    Admittedly the Wicksellian argument hides a lot of other potential drivers for inflation, such as conflicting claims/bargaining power and any supply-side effects. It is only to the degree that the sole cause of inflation is the conflicting claims argument, rather than the Wicksellian argument, that you can equate inflation fighting with fighting to protect the interests of rentiers.

    And I don’t believe that such an assumption is necessary. That is, if you focus purely on the desirability of default and remain silent on the inflation front, then your argument might be more convincing. It would certainly be immune to those who point out that mass default is deflationary, rather than inflationary, and that preventing mass default is not an inflation fighting policy.

  16. rsj writes:

    And I would suggest that what is happening behind the scenes is the sick nature of macro economics, in which only inflation and sticky prices are an allowed explanation for non-utopian macro outcomes.

    There is no room for the notion that the market failed most during the boom, and it is failing less during the bust. That prices can be wrong during the boom as well as during the bust, and that they can be even more wrong during the boom.

    That would be heresy, as the economy is always assumed to be healthy during the boom, and only temporarily impaired during the bust.

    Hence the bizarre obsession with inflation as a policy target, rather than worrying about debt growth, erosion of middle class bargaining power, concentration of wealth, financial sector-rent captures, deterioration of productive eco-systems, decreasing public capital, and other stuff that should make economics and exciting and interesting social science.

    Instead, we are stuck in an intellectually barren land always talking about inflation, and everything has to point to some conclusion about inflation.

    That is why I am pushing back — you are making great points about the need to default and to tilt the political scales away from rentiers, but I don’t think the issues you describe can be cleanly mapped onto an inflation management policy.

  17. [...] mortgage delinquencies soar – CNN/Money Employment Report Not Helpful – Fed Watch What is a bank loan? – interfluidity No comments [...]

  18. Nemo writes:

    (This will be slightly redundant with other comments)

    Steve, you managed to write a long post on “what is a bank loan” without once using the word “interest”?

    And you talked a lot about “risk” without once using the word “reward”?

    Once upon a time, interest was the reward (aka. incentive) for assuming a loan’s risk in the first place. Do you think this reward and risk have now been “bifurcated”? Or is interest so low that it is not even meaningfully part of the incentive?

    Serious questions; I would love to hear your answers.

  19. Adam writes:

    Could somebody help a layperson unpack this sentence:

    “The function and (I would argue) purpose of a banking system is to sever the socially useful practice of production-and-exchange-for-promises from the individually costly requirement of assuming the risk that promises will be broken, in order to encourage the former.”

    Is he saying banking spreads out the risk which would be too much for an individual to bear?

  20. Alex Godofsky writes:

    @vbounded:

    Don’t forget about the bulk of workers who have no power to increase their wages, and for whom inflation results in an reduced standard of living due to increasing the cost of tradable goods they consume. And who will never have enough savings to stop working as long as they are physically able.

    Please explain how these people will be helped by inflation. Unless you want to give workers bargaining power to increase their wages by creating trade barriers, these arguments immoral and designed to shaft developed world workers for the benefit of developed and developing world capitalists. Which is the typical beneficiaries of globalists, like Summers, DeLong, Krugman, Geithner, Bernanke, etc.

    Lower real wages don’t necessarily mean lower real incomes. If lower real wages are associated with increased hours worked (included hours worked by the formerly unemployed) then workers’ standard of living can improve even as their wages fall. In fact, this is a major channel through which monetary stimulus is supposed to increase welfare.

    That said, it is in principle possible for monetary stimulus to work without affecting real or nominal wages or prices. If wages and prices are very sticky (e.g. they are set by law), monetary stimulus can increase welfare by increasing the natural nominal level of wages and prices to the existing level.

  21. [...] What is a bank loan? [...]

  22. Peter K. writes:

    http://www.nytimes.com/2012/07/08/world/europe/icelands-economy-is-mending-amid-europes-malaise.html?_r=1&ref=business&pagewanted=all

    “Iceland also had some advantages when it entered the crisis: relatively few government debts, a strong social safety net and a fluctuating currency whose rapid devaluation in 2008 caused pain for consumers but helped buoy the all-important export market.”

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  24. I think it comes down to this question: did the bank “have all of the money” beforehand–like they first gathered together crisp IOU’s from a bunch of investors before giving them to you–or did they use their “fractional holding” power–counting on the assumption that not-all depositors will run at them for all of their cash at once–to do “fuzzy maths” of how much they need to keep on hand and how much they can give out to you.

  25. [...] Wonks What is a bank loan? – Interfluidity [...]

  26. Brito writes:

    The most useful function of a bank is maturity transformation.

  27. interesting thought by someone who said that when i use a dollar bill to either pay for or accept payment for a real good or service, it is an implicit bet on the u.s.military. but the way the modern connected, mobile, 24×7 online world is moving, it might not be long before this kind of power shifts and has some interesting consequences, especially vis-a-vis large bank v/s small societies. i explored it in layman’s language here some time back: http://kedargadgil.blogspot.in/2010/01/future-of-sovereignty.html

  28. Craig writes:

    Holy Moses. Waldman just wrote the Critique of Financial Reason.

  29. LauraS writes:

    The only education you can get about the banking system is the one that tells you to stay away from it. Making a loan is a very strong psychological effect that enables you to spend more. Paying XY money every month for the next 30 years is not that terrifying like paying the sum at once. People are not able to make clever decisions. This is the reason why Vancouver home prices are on the top.People take mortgage buy for more than they can pay and then start the cycle of paying the interests, taxes and so on.
    When the situation gets nastier, banks just lower interests to attract the last ones who still have not surrendered. In the end, we have foreclosures and empty housing all over the place. And banks? They are helped by government! This is ridiculous and I hope it will stop in the near future.

  30. [...] What actually happens when a bank loan is made?  (Interfluidity) [...]

  31. [...] wanted to add a quick follow-up to the previous post, inspired by its very excellent comment thread. (If you do not read the comments, I’ve no idea what you are doing at this site; I am always [...]

  32. [...] το PRESS DIGEST:Interfluidity: http://www.interfluidity.com/v2/3402.html Όταν μια τράπεζα χορηγεί ένα δάνειο, δημιουργεί [...]