I.8 Assets and banking

(from the larger project of an introductory approach to Ecological macroeconomics)

Chapter 7 established money as a claim on exchange value. It also went through the roles money plays in the economy (medium of exchange, unit of account, and store of exchange value), and its attributes (storable, easily divisible, transportable, hard to produce, and widely accepted). Underneath it all was money’s macroeconomic role as a coordinating mechanism, the way in which items with exchange value are passed along through the production process toward becoming items of use value, and the way items with use value are distributed to various actors in the economy.

It also looked at one source of money, which is a sovereign state (a government) declaring a particular thing to be money, and then producing that form of money.

But it turns out that most money in a modern economy is actually produced by the banking system, rather than by the government. Yet at the same time, that bank money is backed by state money, through the functioning of what’s called the central bank.

The goal of this chapter is to lay out the function of the banking system and its role in creating money, but part of that functioning is the role of assets, so we’ll start with an overview of what assets are and the major types of assets.

The discussion of banking will start with the relatively simple mechanics of check-clearing, before going on to bank balance sheets, the creation of money, and the role of reserves and state-issued money.

The last two items to address in the chapter are the backing of money, and a closer look at the disposition of income that was touched on in Chapter 7.

Assets
Banking
  - Checking transactions
  - Bank balance sheet
  - Reserves
What stands behind money
Disposition of income

Assets
Assets are, in principle, anything with exchange value. They can be divided into productive assets, other non-financial assets, and financial assets.
Productive assets
These are things that have value because they’re used to produce other things of value: farmland, factories, warehouses, ships, … In principle the term could apply to something like a large tank full of oil, but it’s usually used to refer to items of capital rather than intermediate goods (remember, goods that are used up in the process of producing something else).

If you own any of these things, you could sell them, and you could expect to have interested buyers, because the land, the factory, whatever it is, can be used to produce something else that people want.

A productive asset doesn’t have to be physical. You could own a patent that enables you to produce things more profitably than your competitors, making people willing to pay you for the patent (which you have the right to sell); you can choose between using the patent yourself and profiting from production, or selling the patent to someone else who wants to profit from production. You could own a brand with which people have positive associations—think McDonald’s, or Disney—so that anything you produce attracts more interest simply because of the name on it; a brand is also something that can be sold.

Other non-financial assets
Your parents’ house may be worth a lot of money. Your aunt may own a Picasso that her mother bought in Paris years ago. You may own some rare jewelry, or real silver silverware handed down from your great grandparents. These are physical things, but unlike farmland or factories or patents, they don’t produce other things that you can sell. They’re valued simply for themselves.

Financial assets
The simplest financial asset is money itself, but the category includes stock shares, bonds, other debt instruments, and certificates of deposit. They all represent different types of claims on value, sometimes by way of representing claims on money.

Stock shares are literally ownership of a (very small) part of a company—a share of it. If the company has profits, you own a share of those profits (though the management of the company doesn’t have to send you your entire share of profits, or even any at all—they can use the profits to pay for expansion of the business). If someone buys the company, you get a piece of the sales price (often paid in shares of the company that’s buying your company, rather than in money). If you no longer feel like owning a piece of the company, you can sell your shares (or just some of them)—assuming you can find someone who wants to buy, but if the company is profitable, that shouldn’t be a problem. And if the company goes bankrupt, then you own—nothing.

Bonds are issued by companies and by governments, and they are a form of borrowing. When the U.S. government or General Motors sells a bond, they are borrowing money. If you buy a bond from the government or from GM, the money you paid for it is money you have lent to the bond seller. You hand over money now, and the bond gives you a claim on (more) money in the future. The government will get the money to pay you by collecting taxes; GM will get the money to pay you by making and selling cars. In either case, the ability to pay you back depends on productive activity in the future (if there’s no productive activity in the future, the government won’t have anything on which to collect taxes).

Other debt instruments is a catch-all, but the most important one here is mortgages. When you take out a mortgage, someone lends you money, usually to buy real estate. You promise regular payments over 10, 15, maybe 30 years. The mortgage is the right to that stream of payments that you’ve promised to make. Say Hometown Bank lent you money for your house, and you promised to pay them $1,000 per month, for 30 years. I might have a bunch of money sitting around but I don’t want to spend it all on consumption right now; I’d rather have a stream of money coming in at $1,000 per month for 30 years. If Hometown Bank and I can agree on a price, they can sell me the mortgage. They get a bunch of money now, and I get the right to a stream of payments into the future. In other words, the mortgage is a financial asset.

Certificates of deposit (CDs) are somewhat like bonds from your perspective as a buyer: you pay some money now and get more money back later. There are three differences, however. First, a CD is sold by a bank, which is in effect borrowing from you in order to lend out to others, as opposed to GM, which is borrowing from you to expand its factories, or the government, which is borrowing from you to fund either its operations or some construction project. Second, most bonds make small payments along the way, and then when they “mature,” you get back your “principal,” the money you originally spent to buy the bond. In contrast, a CD typically gives you nothing along the way; you buy a CD for $1,000 now, and in a year the bank gives you back $1,050. Third, bonds are readily transferable while CDs are not. If you buy a bond and then decide you don’t want it anymore, you can probably find someone who’s willing to buy it from you, just as you can probably find someone to buy stock shares you no longer want to own. But there’s no convenient mechanism for transferring ownership of CDs from you to someone else; you just have to wait until it matures and then take your money (you can take it early, but banks charge a penalty).

Money has a few different forms. The most obvious is currency (paper bills, coins), but the balance in your checking account is almost identical with currency. Sure, there are places that accept currency but not checks, but if you’re paying a phone bill by mail, you’ll find they accept checks but not currency. The balance in your savings account used to be considered somewhat less like money than currency or checking-account balances, because to get at it you had to physically go to the bank and either move money to your checking account or withdraw currency. Today, many savings accounts allow you to take out currency through an ATM, and most banks will let you transfer money between savings and checking through their website, so the distinction between savings accounts and checking accounts is basically moot at this point.

Credit-card lines: sort of like money, but not an asset. You go to a restaurant, eat your meal, and pay your $30 bill with a credit card. You got a thing with use value—the meal. The restaurant got some actual exchange value—once the transaction clears, their bank balance will be $30 larger. Your credit card is acting a lot like money—or rather, the available credit line on your card is acting a lot like money: if your line is $5,000, and you’ve already spent $5,000 without paying the credit card company back, then the card itself won’t buy you squat.

But your credit-card line isn’t an asset, it’s not something you can sell to someone and get money. It’s only something you can use to buy things, thereby taking debt upon yourself.

Banking
The previous chapter discussed money’s role as a coordinating mechanism in the economy, but for a better understanding of how money works and where it comes from, we have to look at how banks work. We start with how a checking account functions, which leads us to the bank balance sheet. The balance sheet in turn sets up how money is actually created by banks (as opposed to how it’s created by entrepreneurs building water mills in fictional villages growing homogenous food). The balance sheet raises the issue of banks’ need for credibility and how they establish that. The role of the central bank grows out of this need for credibility.

Checking transactions
Imagine four people—Grant, Schultz, Lin, and Nehru—and they have checking accounts at two different banks—Hisbank and Herbank. The four people start off with the following balances in their accounts.

HisBank			HerBank
Grant’s account	$2,000		Schultz’s account	$1,500
Lin’s account	$1,200		Nehru’s account	$3,000

Grant writes Schultz a check for $200, and Schultz deposits it in her account. HerBank increases Schultz’s balance to reflect the new situation:

HisBank			HerBank
Grant’s account	$2,000		Schultz’s account	$1,700
Lin’s account	$1,200		Nehru’s account	$3,000

At the same time, Nehru writes Lin a check for $250, and Lin deposits this in his account, so HisBank increases Lin’s balance by $250:

HisBank			HerBank
Grant’s account	$2,000		Schultz’s account	$1,700
Lin’s account	$1,450		Nehru’s account	$3,000

Now HerBank and HisBank get together. HerBank says, “Your customer Grant wrote a check for $200 to my customer Schultz. We’ve increased Schultz’s balance; now you owe us $200.” And HisBank says, “Your customer Nehru wrote a check for $250 to my customer Lin. We’ve increased Lin’s balance; now you owe us $250.”

Once they combine these claims, all that’s left is that HisBank owes HerBank $50. HisBank goes and reduces Grant’s balance by $200, to reflect the check that Grant wrote, and HerBank reduces Nehru’s account by $250, because of the check that Nehru wrote:

HisBank			HerBank
Grant’s account	$1,800		Schultz’s account	$1,700
Lin’s account	$1,450		Nehru’s account	$2,750

The net result of all of this is that we had $450 worth of transactions, but only $50 ever moved from one bank to the other. The rest was just offsetting adjustments to this or that account at one bank or the other.

If we step back to view a bank balance sheet as a whole, the same kind of principle is at work, just with more categories and with different effects.

Bank balance sheet
The two big categories of a bank balance sheet are:
  - Liabilities and equity
  - Assets

Liabilities
Liabilities are things the bank owes to other people or to other entities. This is usually their customers’ accounts: if you have $2,000 in a bank account, the money is yours, but the bank in some sense “has” it, so they owe it to you.

Assets
Assets are things the bank owns or has possession of. If you bring in $1,000 in cash and deposit it in your account, your account balance goes up by $1,000—the banks liabilities just increased—but the bank now has the cash you brought in—the bank’s assets also went up by $1,000.

Another important thing on a bank’s asset sheet is outstanding loans. Say you ask the bank to lend you $500, and they give it to you. Presumably you promised to pay them back, with interest (maybe the interest is $50, so the total you pay back will be $550). From your perspective, that promise is a liability: you owe the bank $550. From the bank’s perspective, that same promise is an asset: they own your obligation to pay them in the future.

A third type of asset is reserves at the central bank. We’ll explain them in more detail later, but the basic idea is that, if you’re a bank, you have an account at your country’s central bank, and your central bank reserves are the balance in that account.

The last type we’ll mention is government bonds, which are debts of the government (in the U.S. they’re called treasury bonds). These will be important in discussing monetary policy in Part IV.

Equity
Equity is the value of owning the bank, what’s left after you balance out assets and liabilities. This will be clearer later on with an example.

Balancing your balance sheet
As the name suggests, your balance sheet has to balance. What that means is that your liabilities and equity have to add up to the same amount as your assets.

To get this example going, we’re going to cheat a little bit and assume that money already exists. You and some friends want to start a bank, and you’ve got $500. So you set up a legal structure, call it “OurBank,” and you give OurBank the $500. That’s the bank’s first asset.

It doesn’t yet have any liabilities—it doesn’t owe anybody anything. But you and your friends own it. And how much is that worth? Well, OurBank has $500 sitting in the vault and nothing else, so $500 would be a pretty reasonable guess for its value. That’s your equity.

“OurBank” balance sheet, Day 1
Item	Assets	Liabilities and equity
Founding capital (the money you put in)	$500
Equity		$500
	$500	$500

And now you get yourselves an actual depositor. Grant walks in with $1,000 in cash, opens up an account, and deposits his cash in it. The cash is now under your control, so it’s an asset to OurBank. But Grant now has an account with a balance of $1,000, and that’s a liability to the bank. Here’s the revised balance sheet:

“OurBank” balance sheet, Day 2
Item	Assets	Liabilities and equity
Founding money plus the cash that Grant deposited	$1,500
Grant’s account balance		$1,000
Equity		$500
	$1,500	$1,500

Now Lin comes into the bank and wants a loan of $400, and you think he’s a good risk. One way to provide the loan is to take $400 of the bank’s cash and hand it to Lin. That will reduce your assets by $400. On the other hand, Lin has promised to pay the money back, with interest. Let’s say he’s promised to pay $450. That promise is a new asset. When you combine those changes, the asset side of the balance sheet has gone up by $50, so the liabilities-and-equity side has to go up as well. You haven’t picked up any new liabilities, so the extra $50 must be an increase in your equity—an increase in the value of owning the bank.

“OurBank” balance sheet, Day 3
Item	Assets	Liabilities and equity
Cash, minus the $400 lent to Lin	$1,100
Grant’s account balance		$1,000
Lin’s promise to pay in the future	$450
Equity		$550
	$1,550	$1,550

But there’s another way of making a loan. You don’t have to actually hand someone cash in order to make them a loan. You can just as well create a checking account in their name and say that there’s money in it. Say Schultz comes in and requests a $600 loan; she promises to repay $660 later (the $600 principal, plus $60 in interest).

Rather than taking $600 cash out of your vault and giving it to Schultz, you create an account for her, and simply declare that it has $600 she can spend. This gets counted as a negative asset. And you also list Schultz’s promise to pay $660, which is a positive asset. Taken together, your assets have gone up by another $60, and as before, there’s no way to balance that out other than by a corresponding increase in equity.

“OurBank” balance sheet, Day 4
Item	Assets	Liabilities and equity
Cash, minus the $400 lent to Lin	$1,100
Grant’s account balance		$1,000
Lin’s promise to pay in the future	$450
Schultz’s account	($600)
Schultz’s promise to pay	$600
Equity		$610
	$1,610	$1,610

Notice what your bank just did: it created money. When you made your loan to Lin, you took money from your bank and handed it to him. Lin had $400 more to spend, but you had $400 less, so no money was created.

With your loan to Schultz, you didn’t take anything out of your vault. You still have the same $1,100 sitting there, but Schultz now has $600 she can spend. Of course, that $600 is sitting there on your balance sheet as a negative asset, because of what will happen when Schultz spends the money you created for her. Say she writes a check to Grant for $100. Grant has an account at HisBank, so he brings the check there and deposits it, and HisBank increases Grant’s balance by $100. At the end of the day, HisBank brings the check to OurBank and says, “Your customer Schultz wrote this check to our customer Grant. Give us $100.” And what if Schultz wrote six $100 checks, so suddenly you owe $600 to other banks? Now your cash is looking rather depleted.

But remember what happened in the checking-account balance earlier in the chapter. While you were making a loan to Schultz, HisBank was making a loan to Winston, and HerBank was making a loan to Nehru. And while Schultz was writing his checks, Winston and Nehru were doing the same thing, and some of those checks were written to some customers of yours.

This means that HerBank shows up with Schultz’s check and says, “Pay us $100,” and you say, “Well here’s a check that your customer Nehru wrote, for $80. Here’s $20, and we’re even.” So when you make the loan, you figure that Schultz is going to spend that money before she pays it back, and you’re going to be liable for those checks she writes—there will be claims against your bank. But you also assume that other customers of yours will be getting paid for things, and they’ll bring those checks in and you’ll then have claims against other banks.

Reserves
We’ve been telling the story as if the bank’s only positive asset, other than people’s promises to pay, were the cash in its vault. But cash actually makes up a very small portion of a bank’s balance sheet. A bank can own pretty much any kind of tangible asset described earlier in the chapter, and an asset that pays interest is preferable to cash, which pays zero interest (as long as that other asset has a small enough chance of losing value). Most of what acts like cash is actually the bank’s Federal Reserve balance.

Recall the discussion of state-issued money near the end of Chapter 7. Something is “state money” if the government (the state) imposes a tax and declares that the money issued by the state is what people have to use to pay their taxes. Thus “state money” is money that is backed, ultimately, by the credibility of the government.

The Federal Reserve is somewhat like the bank for the banks. You might have an account at First Federal Bank on Main Street, with a balance that represents how much you can withdraw or write checks for. In turn, First Federal has an account at the Federal Reserve, but what’s in there is, essentially, state-issued money.

When you write a check to your landlord, she deposits it at her bank, and then your bank and hers settle up. When you write a check to the IRS to pay your federal taxes, the IRS brings the check to your bank, and your bank settles up by transferring some of its reserves—some of its balance at the Federal Reserve—to the U.S. Treasury.

In other words, your bank’s balance at the Federal Reserve is a valid medium for payment of taxes; it is, therefore, state-issued money.

We now have two kinds of reserves. Reserves are anything a bank can use to settle up with other banks at the end of the day. Currency and Federal Reserve balances count equally as reserves. If OurBank owes HerBank $20 at the end of the day, they can send HerBank $20 in currency, but they can also contact the Federal Reserve and say, “Reduce our balance at the Federal Reserve by $20 and increase HerBank’s balance by $20.” Either way, OurBank now has $20 less, and HerBank has $20 more.

We can redraw the OurBank balance sheet to show very little currency and a much larger Federal Reserve balance. The currency and Federal Reserve balance are added together to get Total reserves.

“OurBank” balance sheet, Day 5
Item	Assets		Liabilities and equity
Currency	$50
Federal Reserve balances	$1,050
Total reserves	$1,100
Grant’s account balance			$1,000
Lin’s promise to pay in the future	$450
Schultz’s account	($600)
Schultz’s promise to pay	$600
Equity			$610
	$1,610		$1,610

Note that reserves generally don’t earn interest. If I lend you $400, I expect to get back $440. If I hold $400 as currency, it will always be … $400. And if I have $400 in Federal Reserve balances, it will always be … $400.

Because of this, banking is partly the art of managing your assets between reserves and loans. I need to have some reserves around so that I can settle up with other banks. But in general, I’d rather have my assets in the form of loans—my borrowers’ promises to pay—since those earn interest.

What stands behind money
Chapter 7 mentioned that an important attribute of money is wide acceptance. If enough people start to think a form of money will fail to be accepted somewhere, they may stop accepting it themselves, and then the whole thing can unravel and the money can cease being accepted much of anywhere at all.

In that sense, what backs a form of money—what stands behind it and gives people the confidence to keep accepting it as a form of payment—is simply people’s confidence in other people’s continued acceptance of the money. The snake is eating its own tail. But most currencies actually have something more solid than that backing them up.

From the late 1800s to the beginning of World War I, it was common for countries to be on the “gold standard.” This meant that the British pound, the US dollar, the French franc, the German Mark were each worth some specified amount of gold. When someone paid you with a 10-dollar bill, you could use it to buy other things, or you could turn it in for about half an ounce of gold.

The gold standard fell apart amid the disruptions of World War I. In the 1920s a lot of effort went into returning to it, but that may have merely helped bring on the Great Depression. Countries that left the gold standard earlier, recovered earlier.

The system was revived in a modified form after World War II, in what was known as the “Bretton Woods system.” That ended in 1971, when President Richard Nixon “closed the gold window,” ending the government’s promise to convert U.S. dollars into any specified amount of gold. No major currency has been backed by gold since then.

So what does back our currency now, other than everybody’s belief that everybody else will accept it? It’s a 2-stage process.

The balance in your bank account is normally just cancelled out against balances in other people’s bank accounts, as people write each other checks and the banks settle up with each other. But your balance is also a claim on your bank’s balance at the Federal Reserve, as becomes evident when you write the check for your taxes. That’s Stage 1.

And your bank’s balance at the Federal Reserve, as state-issued money, is backed by people’s confidence that the government will continue to impose taxes and accept state-issued money in payment of those taxes. This is Stage 2.

So the money you use in your daily life is indirectly backed by the state’s role in creating money.

Disposition of income
The last item to address in this chapter is to look in a little more detail at what happens to people’s incomes after they earn them. Figure I.8.1 is the depiction of the flow of purchasing power from Chapter 7, but with attention drawn to the bottom right area, where income gets distributed to different places, and then spent to become part of the next period’s aggregate expenditure.

We’re going to focus in on that area and expand it a bit to see in more detail what happens to the incomes people earn. The key is Figure I.8.2, below, which is the circled part of the figure above, just rotated counterclockwise (income comes in from the bottom, rather than from the left). And as in the more general depiction, income goes in three directions. First, people pay taxes, and that part of their income flows to the government. Second, people save part of their income, and that part flows into financial markets. Third, whatever income was neither saved nor paid to the government ends up in households’ hands, and ends up paying for their consumption expenditure.

Financial markets send money in various directions. They can lend money to businesses, which those businesses will then spend on private investment (building new factories, opening new stores, etc.). They can lend money to consumers, with which consumers will then buy houses, boats, vacations, college educations, etc. And they can lend money from the government (or receive money from the government, when bonds are being repaid).

Government takes the money it gets from taxes, plus whatever it has borrowed from financial markets, and spends it on government consumption (teachers, soldiers, Members of Congress) and government investment (school buildings, fighter jets, repairs to the Capitol Building).

Here’s a really important—and counter-intuitive—thing about the flows in that diagram. It looks like all the income coming in at the bottom should end up being the same amount as the expenditure going out at the top. But that doesn’t have to be true.

Looking at it in one direction, money that goes into financial markets doesn’t have to be lent back out. That would tend to cause the expenditure leaving the diagram to be less than the income coming in.

Pushing the other way, banks don’t have to receive deposits to be able to make loans. In other words, financial markets can create money on their own. When that happens, the expenditure coming out of the diagram at the top can be more than the income coming in at the bottom. Once that money is created, sent out the top of the diagram, and spent, it eventually becomes somebody’s income, so it returns back at the bottom of the diagram.

At the same time, the Federal Reserve can be creating additional reserves, giving banks the room to create still more money, funding yet more expenditure. This mechanism is part of how an economy grows, as we’ll discuss in Part III. It’s also a key piece of the mechanism of recession and recovery which we’ll examine in Part IV.