How fortunate is Smiling Dave! The whole Keynesian internet has decided to educate him about his total ignorance of how banks function, teaching him some basic accounting at the same time.
They are taught, and are trying unsuccessfully to explain to Dave, that this is how reality works:
Fellow walks in and asks for a loan. Bank writes him a check, and scribble whatever in their account books. Fellow brings in a pile of cash eventually to repay his loan. Banks scribble new whatever in account book. Result: The bank has exactly the same amount of money as if he never repaid the loan at all. That pile of dollars on their desk does not exist. The scribbling made it disappear.
Guys, grow up. Think. There is a pile of money on the table that wasn’t there before. How can some scribbling make it disappear?
Devil’s Advocate: But Dave, what if he repays with a check?
SD: Then the bank presents the check to whoever wrote it, and get cash.
DA: But they scribble in their accounting books that the cash disappears. Of course that must turn on some gizmo that shoots that money straight into the Twilight Zone. How can you not understand that?
SD: I dunno. Maybe if we try it from a different angle.
Let’s pretend the cash really does disappear, for the sake of argument. Fine. Then why do the banks care if they are repaid at all? They cannot spend the money he gives them, because it disappears. Why don’t they just let him keep it?
DA: Because they are not a charity.
SD: What if Krugman and all the other Keynesians are right, that our problem is not enough spending? Why can’t the banks show some good citizenship and let people just keep the loan money the bank gave them, so we can get some spending going? After all, once repaid, the banks can do nothing with it. It’s destroyed the moment it enters their sanctuary.
DA: You are right, that’s a great idea. I guess they just haven’t thought of it.
SD: More to the point, why did Lehman Brothers have to go bankrupt, triggering the Great Recession according to some people? Why didn’t the other banks, as a courtesy, just write Lehman Bros. a check, and tell them not to bother to repay?
DA: For that matter, why do banks ever need bailouts from the govt? Why can’t they just write each other checks, and waive repayment?
SD: Why are there taxes? Why don’t the banks just write checks to the govt, and tell it not to bother to repay? Why all the bitterness about raising the debt ceiling? Forget about debts, just have the banks give gifts of checks to the govt. Problem solved.
DA: OK, I give up. What’s really going on, Smiling Dave?
SD: All they tell you about banks about in the schools is technically true. It’s the interpretation that is lopsided and wrong.
They forget to tell you that when a bank writes you a check, it is writing out an IOU. The bank is saying in that check that they owe someone money. If they write a check for a billion dollars, that means they owe whoever has that check a billion dollars. Whenever they write a check, they get deeply in the red, deeply in debt. And when someone comes along to cash that check, they are in deep trouble, because banks write these IOUs with no regard to their ability to actually cough up the money when presented with the IOUs.
So for every check they write, they are in deep trouble [which is why they don’t handout checks for free]. Someone might try to cash that sucker, and the bank won’t have the money. They write this all up in their books. We owe someone out there a billion bucks. When the person repays his loan, they breath a huge sigh of relief. Now we have the money to cover that check we handed out.
DA: So when Teacher told me the money disappears, what he really meant was that the money doesn’t disappear, but is instantly used to balance the books, to erase that crushing billion dollar debt the bank has?
SD: Yeppers. If you owe the Mob ten grand, and you work and slave and get the money and repay them, would you say your ten grand “disappeared”? Not if you know what you are talking about. The money was used for an important purpose, to pay your debts. It did not disappear.
DA: Dave, this whole discussion was in the context of people repaying loans means there will be less spending. And you said that is not true. That the moment the bank gets repaid, it now has money to spend.
SD: If Bank A is in debt a billion dollars, and Bank B is debt free, who will spend more? Who will lend money to people?
DA: I see your point. But maybe the banks will never find anyone new to lend to. And everyone is saying they aren’t lending anyone anything.
SD: Actually, they are lending the Fed money all the time, every day.
DA: But if the money is given to the Fed, the Fed certainly won’t spend it, will it? I mean, there is no 40 billion a month of QE going on, is there? I mean, they are thinking about deciding to someday taper, or something like that. So of course we are in big trouble.
SD: Uh huh.
DA: Not to mention that all the govt numbers show the money supply is shrinking like a deflated balloon. Help!
SD: I don’t believe it. Govt stats are all lies anyway.
DA: Watch out Dave, that just turned a lot of people off.
SD: Not my fault.
ADDED May 26, 2015:
Thinking about it again, I have a scenario where money disappears.
Smith wants a loan of $100. Bank A gives him a check. He uses the check as money to buy a lot of hamburgers. Then he repays his loan to the bank in cash. Nothing has disappeared yet, because the bank has $100 of cash to spend, and the burger store has a $100 check it can also use as money and buy things with. But if the burger store, instead of using the check to buy things, goes to the bank, presents the check, and says it wants cash for it, then money has disappeared. The check, which is the newly created money, is no longer out there. Come to think of it, this is true whether Smith repays or not.
Bottom line, the money disappears, not when Smith repays his loan, but when someone, either Smith or someone else, presents the check to the bank and wants money for it.
And even then, it has not totally disappeared. The bank, although it will rip up that check, can go ahead and write a new one to somebody. And they will. That’s what they do. It’s why they are in business, to write checks.
Smiling Dave on Austrian Economics. 
If Government stats are all lies, where do you find numbers you can trust?
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Don’t tell anyone, but I don’t really care about statistics. Theory interests me more.
More knowledegable people are able to see through the statistics, as it were, to get better numbers.
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Dave, if you simplify it, the money destruction is clear.
Tom has $100. It is the only money in existance. The bank writes you a check for $90 (they don’t have any money at all in this simple version, but the whole reserve ratio thing is really just a convention). There’s now $190 in existance. You go buy a hammer and some lumber from Bill with your $90 and set to work building Tom a deck. Once you complete the deck he pays you $100. You pay the bank the $90 principal plus, say, $9 interest. You have $1, the bank has $99. The amount of money in existance is back to $100.
Everything gets slowed down and the percentage that the bank ends up with is considerably reduced when you re-introduce the complicating factors (reserve requirements, redemption risk, central banks etc) but the idea is the same. The money supply increases each time a loan is made. The money supply decreases each time a loan is repaid.
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“You have $1, the bank has $99.” You forgot Bill, who has a check for $90 he can spend.
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Right you are. Guess I jumped the gun there.
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Oh, Oh, Bill is exactly the trick. He banks his check and ends up with $90 cash. The bank has $9 and you have $1.
How about that?
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Now we are on the same page, the starting point from which my article begins. So reread it to see my reply.
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Ah. Ok. Umm. Are you making an extra distinction between scribble money and touchable money?
I’ve been thinking about it recently, and a couple of different analogies. I’m not sure I’ve got my head around it and I’m not sure I’ve got everything straight. I don’t mean to waste your time, but what do you think of this:
Family holiday. The kids like monopoly, but last year when the family got back from holiday the shoe and the dog were missing and every time they’ve played since then they run out of monopoly money (everyone secretly blames Timmy – he has a habit of hiding stashes of money during the game and then forgetting them). So this year mum takes a little sheet of glossy paper and a whiteboard pen. Each time the rules allow for an increase in your account (eg, pass go), mum dutifully updates your balance. If someone buys a property from someone else, she deducts from the one and adds to the other. But then she needs to use the bathroom. She quickly writes out a bunch of notes and gives them to each player, deducting the matching amounts from their accounts. Its only enough for the time she’s away – most of their money still sits as entries on the ledger in her pocket. But for the duration of her absence, the kids exchange properties for the notes. When she gets back they hand the notes in and she tears them up at the same time that she increases their balances on the ledger.
The real world financial system is of course more complex, but the principle is the same. The central bank assigns banks with points according to a set of rules (it purchases bonds or MBS off the banks, or it loans them the points). Those banks then assign points to individuals and companies according to a set of rules (reserve ratio requirements etc). When we transact electronically there’s only the accounting to worry about (pure scribble money). And sometimes we convert the scribble money out into touchable money for convenience.
My point here is that with the kind of money we have now, the scribbles are the real thing. More real than the physical tokens which are sometimes used to represent it.
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So when a loan is repaid, the new money that came into existence with that loan goes out of existence. This doesn’t occur by “zapping” the physical tokens. This occurs by scribbling.
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Hi, I think Money is not destroyed when a bank collects a debt. Bank function depend very much on the debt collection process. Unless if it is not handle properly then it will become bad debt and non performing asset.
Thanks for this post.
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YW.
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Al Gore here. I’m writing in response to “If you owe the Mob ten grand, and you work and slave and get the money and repay them, would you say your ten grand “disappeared”? Not if you know what you are talking about. The money was used for an important purpose, to pay your debts. It did not disappear.”
That’s not for us to decide, because assuming we are dealing with checkbook entries on a computer, I would say that values can disappear into thin air. If we are talking physical currency then what you said is true.
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Good to see you, Al. Glad to see you are reading my humble articles. I presume you are Al Gore from the liberyhq forums, and not Al Gore the politician.
If Smith borrows $100 from a bank, and they do not give him cash, but a check, and he eventually repays them by giving that very same check, unspent, right back to them, then I agree that the money has disappeared in a sense. I imagine the bank will just tear up the check and be done with it. Not that the $100 ever entered the economy anyway, since he never used that check for anything.
But if Smith borrows from bank A, and he repays them with a check from bank B, either his own or someone elses, bank A is not going to sit on that check from bank B and not do anything with it. They are going to go out there and get $100 from Bank B, which they will spend. So it’s the same as if they got repaid with physical currency, as far as I can see.
LATER: Thinking about it again, I have a scenario where money disappears.
Smith wants a loan of $100. Bank A gives him a check. He uses the check as money to buy a lot of hamburgers. Then he repays his loan to the bank in cash. Nothing has disappeared yet, because the bank has $100 of cash to spend, and the burger store has a $100 check it can also use as money and buy things with. But if the burger store, instead of using the check to buy things, goes to the bank, presents the check, and says it wants cash for it, then money has disappeared. The check, which is the newly created money, is no longer out there. Come to think of it, this is true whether Smith repays or not.
Bottom line, the money disappears, not when Smith repays his loan, but when someone, either Smith or someone else, presents the check to the bank and wants money for it.
And even then, it has not totally disappeared. The bank, although it will rip up that check, can go ahead and write a new one to somebody. That;s what they do. It’s why they are in business, to write checks.
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My days in office are over, LOL.
In the 2nd situation, I can’t see how new money is created, because while bank A is $100 richer, bank B is $100 poorer.
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