How Money Gets Destroyed [Banking 101 Part 6]

This is vitally important

This is vitally important because it means that if we, the public, start reducing our debts by collectively borrowing less and repaying more, then the amount of money in the economy will actually start to shrink.

If we all collectively reduced our debts by £1billion, then the money supply of the economy will actually fall by £1billion. There will be £1billion less money changing hands in the economy.

If we significantly reduce the debt then the shrinkage in the money supply could actually cause the economy to slow down or grind to a halt. Just think of the problems caused when banks refused to lend during the credit crunch.

So although we all think it’s a good idea to get out of debt, and most of us are trying to get out of debt, as long as we keep the current system it will be impossible to reduce our collective debt without slowing down and potentially destroying the economy.

So let's see exactly how money is destroyed when a loan is repaid

Let’s start with Robert, who still owes £10,000 to Barclays but has spent the money, leaving his bank balance at zero.

BARCLAYS BANK BALANCE SHEET (Step 1)
(left side): Assets
(What the borrowers owe to bank + bank’s money)

(right side): Liabilities
(What the bank owes to the depositors + bank’s net worth)

(left side): Loan to Robert: +£10,000
(right side): Robert’s account: £0

After a few months, Robert decides to pay down £1000 of the loan. He transfers the money from a bank account with another bank, to his bank account at Barclays.

We won’t show the central bank reserves on this process because, as we saw with the clearing process, any change in the reserves would probably be cancelled out by payments going in the opposite direction, and won’t change things in any significant way.

Now Robert still owes £10,000 to Barclays, but also has an account with Barclays that now has a balance of £1000.

As a result, Barclays has a liability to Robert of £1000 – that’s the numbers in Robert’s bank balance – and Robert has a liability to Barclays of £10,000.

When Robert called Barclays and says that he wants to pay off £1,000 of the loan, all Barclays does is reduce Robert’s bank balance to zero, and reduce the outstanding loan by £1,000.

In effect, both the asset and the liability are cancelled out against each other.

BARCLAYS BANK BALANCE SHEET (Step 2)
Assets
(What the borrowers owe to bank + bank’s money)
Liabilities
(What the bank owes to the depositors + bank’s net worth)
Loan to Robert: +£10,000

Robert’s account: £1000

Repaying loans reduces the amount of money in the economy

Because the money supply in the hands of the public is made up of bank-created numbers in people’s bank accounts, repaying loans in this way actually reduces the amount of money in the economy. Money – the type of money that the public use – has been destroyed in the act of repaying the loan.

Of course, now that Robert’s loan has been partly repaid, Barclays might go hunting for another lending opportunity, and make a new loan to replace this, in which case new money will be created and the money supply will grow again. But if banks are scared to lending, for example following a major financial crisis, and the public are trying to reduce their debts, then the money supply of the economy will shrink.

Here it is in the simplest form
 

If we want more money in the economy, we need to go into more debt.

And if we want less debt in the economy, we have to have less money.