Splitting the zero

Two common misconceptions about banking are that:
a) Banks can create money out of thin air.
b) Banks take money from depositors and then lend it to borrowers.

There is a small element of truth to either, but clearly they are contradictory
a) If banks can create money out of thin air, then how could there ever be a run on a bank? How could banks ever be short of 'capital'?
b) Why would banks bother waiting for people to deposit money before lending it on if they can just create it?

So there must be 'something else' which most people have overlooked which bridges the gap between the misconceptions. That 'something else' is a golden rule of economics generally which is that for every liability there is an asset. It is not true to say that for every asset there is a liability*, but it is certainly true to say that for every financial asset there is a financial liability (and liabilities are of course usually financial liabilities as most debts are to be repaid in cash rather than in kind, i.e. if you have been paid in advance to do a job).

In bookkeeping, there is also the 'balance sheet rule' says that any corporate entity has both assets and liabilities and they net off to precisely £nil. Yes of course, successful companies have share capital and retained profits, which do not have to be paid out, but those are still liabilities - that money (or that value) does not belong to the company, it belongs to its shareholders.

Onus Probandy had another crack at explaining how banking and double entry bookkeeping work using his analogy of splitting the zero again recently, but he made it a bit complicated by using the ECB to illustrate the point.

i. A far simpler way of explaining banking, the golden rule, double entry bookkeeping and 'splitting the zero' is to remind people what happens when you go to the bank to take out a personal loan for (say) £10,000.

ii. Assuming you pass the credit checks etc, the bank creates two accounts for you - a deposit account and a loan account, and it simultaneously credits £10,000 to the deposit account and debits £10,000 from the loan account. No coins and notes change hands, nobody had to deposit money first, nothing, the banks just 'splits the zero'.

iii. So you, the customer, now have a financial asset (£10,000 in your deposit account, which you can withdraw and spend) and an equal and opposite financial liability (£10,000 owed on your loan account, which you will have to repay).

iv. As mentioned above, a golden rule is that one man's financial asset is another man's financial liability*. So your asset (the deposit account) is a liability from the bank's point of view (you can wander into the bank and withdraw cash, or you can make payments to other from that account), and your liability (the loan account) is the bank's asset (they will receive money from you in future as you pay off the principal and interest).

v. We can illustrate this by drawing up a balance sheet at each stage for you and for the bank, see 1) and 2) below.

vi. The balance sheet in 3) is the overall picture taking you and the bank together, you can draw diagonal lines between your asset and the bank's liability (the deposit account) and your liability and the bank's asset (the loan account). The overall position immediately after the loan is made is still a big fat £nil on all sides.

vii. "Why do the banks lend money then?" you may ask, "Their net wealth does not increase when they split the zero." Well, that's because they can charge you 6% interest on the loan and they only pay you 2% interest on the deposit. Of course, you will withdraw the money from the deposit account, spend it in the shops and the shop keeper (or his suppliers, employees etc) will pay it back in to the banking system as a deposit. So until and unless the loan is repaid, the bank will be earning £400 in interest margin. Whether you repay your loan or whether the shop keeper in turn repays a loan he had taken out earlier makes no difference - at this stage, the assets and liabilities merge into one and turn back into zero again.

viii. So what banks really want to do is to ensure that the two sides never merge into zero again, by tricking people into taking out ever larger loans, and making sure that loans are only repaid by somebody else taking out an even bigger loan. There are only so many flat screen TVs you can buy and so many foreign holidays you can go on before either
a) you reach the limit of your own willingness to get further into debt or
b) the bank no longer sees you as a good credit risk.
So the tried and tested method is house price bubbles. There is no such thing as net land wealth, of course*, so all a house price bubble means is that banks are earning more and more money for doing nothing but carry out a huge great confidence trick.* Footnote: The modified rule that for every asset there is a liability (as it applies to financial assets and financial liabilities) also applies to land, because one man's rental income is another man's rental expense; even if you are an owner-occupier, the land only has value to you because being excluded from that plot places an equal and opposite burden on 'everybody else'; alternatively, the value to you is that you alone are not subject to this burden.

By analogy, let's imagine that the playground bully takes ten pence from every other child in your class every day, that's the bully's asset/income and every other child's liability/expense. But one day, you do him a favour (like giving him an alibi), and so he stops taking money from you. You might consider yourself to be ten pence a day richer than all the other children, and indeed you are, but only because you are neither payer nor recipient of ten pence (like an owner-occupier). If the bully later gets expelled, you cease to be ten pence a day richer than all the other children and your 'wealth' disappears.

The modified rule clearly does not apply to buildings and improvements on land, as there is no such thing as a negative building or a negative improvement, and if one person builds a building, he does not impose a burden on other people. He might diminish the rental value of neighbouring plots of land by building the building, and most bits of land ultimately belong to other people (who thus might feel themselves burdened by the building), but...
a) Unless the planning department is staffed by complete idiots, the increase in the rental value of his land/buildings is at least equal to the fall in the rental value of neighbouring plots (so worst case, total rental values are the same) and
b) More subtly, by reducing the rental value of those neighbouring plot, he also reduces the burden which being excluded from those plots places on 'everybody else'.
The new building is real net wealth and the change in net land wealth is precisely zero because it was zero before and is still zero afterwards.