Role and Limits of the Banking System

Bank credit is similar to engine oil, which lubricates engine components so that engine performance is improved. However, it cannot substitute fuel, which is necessary to run the engine.

Most concepts of the paper refer to a specific currency area, namely the dollar area. Therefore, the prefix $- is going to be introduced before relevant words to emphasize and remind this aspect. However, the same concepts could be expressed referring to any other currency area.

Abstract

The concept of Net Financial Assets – NFA emphasises differences between Government liabilities and bank liabilities (currently, known as “bank money”). In modern monetary systems, unemployment rates expressed in terms of specific currencies (in this paper, in terms of dollars so that it will be expressed as $-unemployment) are the empirical evidence of the impossibility for the Private Sector to net-save enough NFA. Only the choice of the Government to run a public deficit can meet the willingness of Private Sector to net-save whereas the private banking system can only facilitate exchanges of Net Financial Assets between private economic agents.

ACCOUNTING SYSTEMS

Accounting systems are composed of conventional rules which represent and measure the net wealth ^[1] of economic agents. In this regard, the Figure 1 illustrates a conventional structure of balance sheets.

As it is possible to see, the difference between Assets and Financial liabilities is equal to the net wealth of economic agents. Moreover, the net wealth is composed of real assets – which refer to capital goods – plus Net Financial Assets. In turn, Net Financial Assets are equal to the positive difference between financial assets and financial liabilities whereas if financial assets are fewer than financial liabilities they will be called Net Financial Liabilities.

NET FINANCIAL ASSETS AS MEANS OF PAYMENT IN MONETARY SYSTEMS

In monetary systems, goods and services are not exchanged with each other. Actually, they are exchanged with NFA. In particular, payments can be made through, respectively, creation of endogenous money or through final transactions.

Transfers of Net Financial Assets through creation of endogenous money

On the one hand, it is possible to pay for goods and services through the creation of new debt/credit relationships between parties of transactions. In fact, as the Figure 2 shows, in a transaction the buyer can choose to issue a credit note for the seller.

Specifically, it is possible to notice that thanks to this issue:

• in the buyer’s balance sheet, new financial liabilities are created whereas no financial assets are added. Thus, the buyer decreases holdings of NFA by the value of $ 100;
• the seller receives new financial assets in exchange for the real asset. Therefore, the seller increases holdings of NFA by the same value;
• the transaction is possible if and only if the seller is willing to accept the credit note from the buyer;
• even though Government currency – in the form of cash or bank reserves – is not used for the payment, NFA are transferred.

Transfers of Net Financial Assets through final payments

On the other hand, it is possible to pay for goods through final payments. In this case, as the Figure 3 shows, the buyer transfers liabilities issued by a third party (e.g. banknotes issued by the Government or deposits issued by a bank) to the seller.

In this case, it is important to underline that:

• the buyer decreases holdings of NFA in the form of $ 100 of banknotes;
• the seller increases holdings of NFA by the same quantity;
• in this case, the willingness of the seller to accept the banknotes is ensured by the fact that they can be used to pay taxes, as it is going to be shown in section 3.

Finally, it is possible to conclude that Net Financial Assets are the means of payment in monetary systems, regardless of what form they assume. In this sense, they can be considered the fuel of monetary systems.

THE MONOPOLY ON NET FINANCIAL ASSETS

The role of taxation

So far, we have yet to find a reason for the existence of a demand for $-NFA. Actually, the specific reason for this, is the presence of a taxation denominated in dollars (Mosler, 1995).

In particular, $-taxes are paid through final transactions in dollars, therefore, they can only be paid through $-NFA.

The two sectors of the monetary system

In the dollar area, the Federal Government is the only Institution which can create the currency required for tax payments that it can enforce thanks to public law-enforcement apparatus without external constraints both, legal or military. This characteristic gives to the Federal Government a privileged economic position compared to other economic agents. For this reason, we can divide the dollar area in two complementary sectors:

• The $-Public Sector, also called the Government, which is the financial consolidation between Central Banks together with Public Administrations in charge of creating dollars and collecting $-taxes;
• The $-Private Sector, which is composed of private economic agents ^[2] both, domestic of foreign, who use dollars.

On the basis of the previous definition, the $-Public Sector is the monopolist of the $-NFA because it is the only supplier of $-NFA for the $-Private Sector and – as a consequence – is the price setter of $-NFA (Mosler, 1995). Moreover, it is characterized by one peculiar property that differentiates it from other monopolists: it can influence and control the demand for its monopoly good changing the taxation level.

The demand for Net Financial Assets

In this system, the $-Private Sector demands $-NFA to both, pay $-taxes and save. Even though economic agents use dollars to buy goods and services, at the aggregate level commercial transactions have no effect because they compensate each other as an agent’s spending correspond to another agent’s income.

As a consequence, once a dollar is spent by the Public Sector into the Private Sector, either it is spent for taxation or it is saved by private agents.

Therefore, the $-Private Sector’s net demand for $-NFA is given by:

net $-NFA demand = aggregate $-taxes + net $-saving desire

At the aggregate level, the net $-saving desire is equal to the algebraic sum of individual $-saving desires in the $-Private Sector. It is called net because some private economic agents may desire to invest by spending more than their income – that is, they desire to dissave (Mosler, 1997-98).

If the total amount of $-NFA that investors want to invest is equal to the total amount of $-NFA that savers want to save, then, the net-saving desire of the $-Private Sector is equal to zero. However, this happens rarely. In fact, usually, agents want to save more than the amounts that investors are willing to invest and this generates a positive net-saving desire:

net $-saving desire = $-saving desire – $-investing desire

Se

$-saving desire > $-investing desire

allora,

net $-saving desire > 0

The private market

Given the net $-NFA demand, $-Public Sector – as monopolist of the currency $ – sets the price of dollar, that is, it sets how many goods and services it is willing to purchase in exchange for 1 dollar. In such a way, it is possible to determine the aggregate supply of goods and services that the $-Private Sector needs to sell to the $-Public Sector to obtain dollar:

Supply of goods and services to the $-Public Sector = net $-NFA demand / Prices paid by the $-Public Sector

As Mosler asserts in “Exchange Rate Policy and Full Employment” (1998): “With any tax driven currency, the price level is a function of the prices paid by the government when it spends, and the collateral demanded when it lends. In other words, the price level is a function of what the government makes the taxpayers do to get the needed units of that currency”.

Therefore, the final effect of $-taxation is the creation of suppliers of goods and services who require to be paid in dollars (Mosler, 1997-98) and the $-monopolist manages the aggregate supply of goods and services by adjusting both, $-taxation and prices it pays to the $-Private Sector.

Consequently, the Government can provide itself with goods and services – such as labor – by spending $-NFA. In particular, the Government discretionally spends $-NFA only in favor of a part of the $-Private Sector. As a consequence, other private economic agents – who are also subjected to $-taxation and work in the remaining part of the $-Private Sector which have not received $-NFA directly – have to obtain $-NFA through private transactions with agents who have already obtained $-NFA.

It is possible to conclude that – in modern monetary systems – private markets are first of all systems of exchanges of Net Financial Assets and only collaterally systems of exchanges of goods and services.

THE PUBLIC SECTOR

In the $-area, first does the $-Public Sector create $-NFA through public spending and then private economic agents can exchange them so that – at the end of a reference period, e.g. one year – they can use $-NFA either to pay $-taxes or to $-save (Mosler, 1995).

As the example in Figure 4 shows, the $-Private Sector is composed of both, banking system and non-banking system – that is, all $-private economic agents except of banks.

When the Government spends in favour of non-banking system through banking system, the National Central Bank credits bank $-reserve accounts of commercial banks. In turn, commercial banks credit accounts of beneficiaries of public spending in the form of bank $-deposits (Terzi, 2012).

As can be seen in Figure 4, $-deposits of commercial banks are assets for the non-banking system which has increased the amount of its $-NFA. However – at the same time – they are liabilities for the banking system.

If we consider the balance sheet of the $-Private Sector as a consolidated balance sheet, we find that bank deposits are, at the same time, assets and liabilities. Therefore, they compensate each other so that their algebraic sum is equal to zero. In Figure 5 we can see the balance sheets obtained.

As a result, it is possible to conclude that:

• On the one hand, public spending has increased the aggregate amount $-NFA in the form of bank $-reserves;
• On the other hand, these $-NFA are liabilities for the $-Public Sector.

+ $ – Public spending → + $-NFA

On the contrary, $-taxes destroy $-NFA that the $-Public Sector had previously created through public spending.

+ $-Taxation→ – $-NFA

At the aggregate level, once $-NFA have been created in the form of bank $-reserves, they can be converted in any other $-liability of the $-Public Sector, such as Government $-bonds or $-banknotes whereas – at the individual level – $-NFA can assume any financial form.

As a result of the previous analysis:

• $-Deficit spending ^[3] corresponds to $-Net Financial Assets created by the $-Public Sector over a year;
• $-Public debt ^[4] is equal to the stock of $-Net Financial Assets accumulated in the economic system over time.

THE PRIVATE SECTOR

Unemployment

Excluding the role of public deficit in monetary systems means excluding the opportunity of creation of Net Financial Assets at the aggregate level. In fact, if the role of public $-deficit is excluded from the current analysis, private economic agents could increase their $-Net Financial Assets if and only if there are private counterparts who are willing to decrease their $-Net Financial Assets through transactions.

In particular, firms can increase their $-NFA by selling goods and services if and only if there are other private economic agents willing to buy those goods and services by decreasing their $-NFA. Otherwise, firms cannot sell.

Similarly, $-unemployed people – who are willing to supply labor to increase their $-NFA – can be employed if and only if there are firms or any other organizations which are willing to decrease their $-NFA by hiring them and paying $-wages for their job. In this sense, we can say that unemployment is denominated in a specific currency.

Full employment

By definition, only the $-Public Sector can satisfy the net $-NFA demand of the $-Private Sector through public spending. If public spending is not sufficient to compensate for both, total taxes and net-saving desire of the $-Private Sector, then some firms will not manage to sell their production or, similarly, some workers will remain unemployed (Mosler, 1997-98).

To better explain that, if the net $-NFA demand is not satisfied, then some individual demands for $-NFA are not satisfied. Since $-NFA are bought in exchange for goods and services or labor, this means that some agents have not been able to sell production or their labor.

In order to eliminate $-unemployment and $-overproduction, the net $-NFA supply (that is, $-public spending) must satisfy the net $-NFA demand. In formulas, $-full employment is going to be achieved if and only if:

net $-NFA supply = net $-NFA demand

that is,

$-public spending = net $-NFA demand

Since,

net $-NFA demand = aggregate $-taxes + net $-saving desire

therefore,

$-public spending = aggregate $-taxes + net $-saving desire

which can also be written as:

$-public spending – aggregate $-taxes = net $-saving desire

Since the difference between public spending and taxes is equal to the public deficit, by definition:

$-public deficit = $-public spending – aggregate $-taxes

then, the condition to achieve $-full employment can be re-written as:

$-public deficit = net $-saving desire

If the public deficit is lower than the net-saving desire, then full employment cannot be achieved. This means that “unemployment is evidence of the government deficit being too small” (Mosler, 1997-98).

THE BANKING SYSTEM

The role

Commercial banks act as intermediaries between private creditors and private debtors and facilitate exchanges of Net Financial Assets in economic systems (Innes, 1913).

To explain that, let us assume that a firm is willing to decrease their $-NFA either by hiring workers or by investing in capital goods, but it does not have financial assets – in the form of cash – to pay for services such as labor and for goods. Then, the firm borrows bank deposits created by commercial banks and spends them to hire workers or to invest in business.

In such a way, it is possible to conclude that commercial banks allow private economic agents to finalize financial transactions. More specifically, the Figure 6 shows the mechanism in the accounting system.

Firstly, the commercial bank lends to the firm through the creation of financial assets in the form of a bank deposit. However, never does the bank create NFA. In fact, lending implies creation of equal amounts of both, financial assets and – at the same time – financial liabilities.

Then, the firm – by decreasing its NFA – can make the final payment to a worker or to a seller whose NFA increase. To summarize, the commercial bank intermediates between two private economic agents: on the one hand, the buyer borrows bank liabilities and – on the other hand – the seller receives those bank liabilities by the buyer as means of payment. Finally, the bank is both, a creditor towards the buyer and a debtor towards the seller.

The previous example also helps to show the diff erence between Government currencies and Net Financial Assets. Private economic agents can make final payments without transferring Government currencies whereas they will always transfer Net Financial Assets.

In fact, the final payment is a transfer of NFA – in the form of bank deposits – from the firm to a worker or a seller. They are issued by the banking system and not by the Government which – instead – issues currency in the form of cash or reserves.

In the current scenario, only at the aggregate level the NFA of Private Sector correspond exactly to Net Financial Liabilities of Public Sector both, in quantity and form. In fact, Public Sector creates NFA for Private Sector, by definition. Since public debt is approximately equal to Net Financial Liabilities in the Public sector’s balance sheet, then it must correspond – by accounting identity – to NFA in the Private Sector’s balance sheet.

The limits

Bank credit creates horizontal money (Mosler & Forstater, 1999) – also called endogenous money – in the form of bank deposits, which facilitate purchasing processes of private economic agents.

On the other hand, bank credit cannot create NFA whereas it only facilitates exchanges of NFA. For that reason, bank credit is similar to motor oil, which lubricates motor components so that the engine performance is improved. However, it cannot substitute the fuel, which is necessary to run the motor.

Moreover, commercial banks cannot start lending without a prior existence of private demand for financial assets. In fact, if private economic agents are not willing to decrease their Net Financial Assets exchanging them with something else, there cannot be credit expansion. In addition, despite of the willingness to spend of private economic agents, credit expansion also depends on factors such as evaluation of credit worthiness of clients.

CONCLUSIONS

In the $-monetary system, $-taxes have the effect of creating both, demand for $-NFA and a proportional supply for real goods and services to be exchanged for $-NFA. In such a monetary system, the monopolist of the $-NFA – the Government – can control both, the supply and the demand for $-NFA through $-public spending and $-taxes, respectively.

Furthermore, it can set the price level – that is the link between the demand of $-NFA and the supply of real assets – by varying the prices paid when it spends and the collaterals demanded when it lends.

Moreover, the analysis has proven that $-unemployment is the empirical evidence of the fact that the $-public deficit is lower than the net $-saving desire. Since the $-public deficit is under the control of Government, $-unemployment must be an exogenous variable which originates from fiscal policies carried out by the Government. As a consequence, only the Government can eliminate it through proper fiscal policies (Tcherneva, 2016).

Instead, the level of bank credit is an endogenous variable. Therefore, it cannot modify any condition which has been exogenously determined. More specifically, if a restrictive fiscal policy increases the $-unemployment rate and the overall willingness to $-spend of the $-Private Sector decreases, then bank $-credit will not be able to contribute to improve the situation. Instead, it will likely collapse with it.

In this regard, the monetarist approach has failed. In fact, expansive monetary policies have not ensured credit expansions and bank credit have not increased even if interest rates have been lowered and quantitative easing operations carried out.

Never can bank credit substitute Government deficit spending. In fact, credit expansions can only occur after an increase of willingness of private economic agents to spend Net Financial Assets.

As a result, monetary policy cannot address the objective to achieve full employment effectively. Full employment can only be achieved if fiscal policy aims at ensuring that the public deficit is sufficient to meet the willingness to net-save of the Private Sector.

 

Author’s Notes

---

1.^{^} Net wealth: amount of assets available to economic agents once liabilities have been served. The concept is equivalent to net worth of people and equity of firms.

2.^{^} $-Private economic agents: people and firms and foreign both, Governments and Institutions, which use dollars.

3.^{^} $-Public deficit: it is a flow variable which is equal to $-public spending minus $-taxes over a year.

4.^{^} $-Public debt: it is a stock variable, which, for the purposes of this paper, is equal to the sum of annual deficit spending over time. However, its exact definition is affected by Country-dependent rules and adjustments.

 

Bibliography

---

Innes, A. M. (1913), What is Money?, Banking Law Journal May, pp. 402-403.

Mosler, W. B. (1995), Soft Currency Economics, Adams, Viner and Mosler.

Mosler, W. B. (1997-98), Full Employment and Price Stability, Journal of Post Keynesian Economics 20(2), pp. 167–182.

Mosler, W. B., & Forstater, M. (1999), General Framework for the Analysis of Currencies and Commodities. In J. Kregel, & P. Davidson, Full Employment and Price Stability in a Global Economy (pp. 166-177), Cheltenham, UK: Edward Elgar.

Tcherneva, P. (2016), Money, power, and monetary regimes, p. 21. Annandale-on-Hudson, NY: Levy Economics Institute of Bard College.

Terzi, A. (2012), Appunti di Economia Monetaria, p. 64. Milan, Italy: EDUCatt Università Cattolica.