The destruction of money and the crisis

Money can be created, as I indicated, and destroyed. And I am not referring to burning banknotes. The simple act of repaying a loan is a destruction of that virtual money implied by the debt itself. If I sign a promissory note and others use that promissory note as payment, that promissory note is money. If I cancel the debt of the promissory note, the promissory note ceases to exist; that money disappears from circulation. In the moment before my payment, both monies existed—the promissory note and my money—and the moment I cancel it, the promissory note ceases to exist. Destruction of money.

Likewise, the fact that the Central Bank charges interest on the money it lends to commercial banks is, in effect, a destruction of money. To understand this, let’s suppose we are in a situation of a stagnant and maximally indebted population. Debts do not increase and, therefore, no more money is created. The interest that enters the Central Bank ultimately comes from the money that is in circulation, so this money decreases and falls into the bottomless pit that is the Central Bank, which has the capacity to create and destroy money at will. This is a destruction of money, but it is controlled. If they do not want to destroy more, they simply lower the interest rates, but a central bank cannot set negative interest rates. In Japan, they are close to zero, but they do not reach it.

The subprime crisis has been a case of money destruction, at least temporarily. The poor-quality US loans were covered by bonds that were sold as high-quality but which now nobody wants, causing them to lose almost all their value in the market. Although they are still fundamentally backed by the houses that served as collateral, they are worthless in the market, and therefore, bonds, promissory notes—debt, after all—cease to have value. This disappearance of the value of this paper has, in fact, represented the disappearance of immense amounts of money held mainly by Western banks, especially American ones, of course. This disappearance of said money from the banks’ assets has caused them to incur multi-million dollar losses and has led to their balance sheets being unbalanced and requiring them to borrow more money to cover, among other things, the money they themselves have lent. The increase in requests for loans between banks has caused the interbank interest rate to rise and requests for money from central banks. This has caused the current liquidity crisis, the subprime crisis. Not the losses themselves, but the need for huge loans.

The American government’s idea of buying or guaranteeing the assets backed by subprimes can solve the problem because it gives these products value again. When the market believes that these products possess value, they will be bought and sold again, they will regain value, thus improving banks’ balance sheets and reducing their need to borrow, causing interbank rates to fall. The new problem will be the massive debt that the US will incur for these purchases.

Another factor to consider in the issue of money destruction is the problem of trade balances. The brutal increase in imports of Chinese products and oil—the latter due to its rising price until July 2008—represents a massive outflow of Western currencies to these countries, and much of this currency does not return to the Western banking system. If these countries reinvest that money back into Western countries, the money returns to the system, but if they simply keep it, for example, in the form of foreign exchange reserves, they create a problem similar to the destruction of money. That money becomes “disappeared” money, at least temporarily. This disappearance forces an increase in loan requests between banks, increasing the Euribor, and an increase in requests for money from central banks by commercial banks, generating a liquidity crisis similar to that caused by the subprime crisis. In fact, both phenomena have occurred simultaneously during the last year. The drop in oil prices over the last two months will help the balance, but if oil prices rise again, problems may return before the current ones have been solved.

Central banks have no choice but to supply the interbank loan market and increase the availability of money to lend to banks to solve the problem. This is what some analysts are waiting for. This increased creation of money may have the side effect of causing Western currencies to fall against those of the countries where the money is flowing, which I think may be quite beneficial for our economies in the long term, as we will import less from China and export more to the Middle East and China, rebalancing our trade balances.

As George Soros says, “the banking system must be recapitalized” to get out of the financial crisis.

[Vía: economía, destrucción del dinero en relatividad.org]