The Widow's Cruse and Derivative Loans

Many bloggers are currently writing about the widow's cruse and the relationship of bank loans to money supply.  My latest tack is to consider the changes that would occur if an economy moved from a limited-bank economy to an economy with banks as we know them.

In this model, the initial economy has a completely fiat currency with no derivative loans allowed.  Here I define derivative loans as "loans from an institution that result in at least two parties having claim on the same underlying asset".

The initial economy can have banks but all loans are single party loans.  That is, all loans are clearly tied between lender and borrower, with lender well aware that borrower is spending the lenders money.  Any expansion of the money supply under this system must come from the sponsor of the fiat money supply.

The total amount of money in circulation can be measured by the difference between total amount issued less the amount borrowed back by the sponsor as the sponsor strives to maintain value of a fiat currency.  This difference should be slightly less than the amount on deposit at institutions because some portion would be held in wallets and under mattresses.

Now we will change the model to allow derivative loans (DL) by banks.  In this modified model, loans can be based on the deposits in the bank.  Money sitting in bank storage, similar to sitting under a mattress, can be put to use and  can stimulate an economy.

DL loans have three very important properties:

(1)  When the loaned money is spent, it will result in increased deposits owned by third parties.  The third parties are unlikely to deposit at the bank making the DL loan, but are likely to deposit at banks acting within the fiat money system.  The result can be measured initially from an increase in bank deposits by the amount of the loan (again excepting part held in wallets and under mattresses).

(2)  It is impossible to distinguish between Original Currency (OC) and DL.  This creates a situation of increasing DL based deposits.  This process has no upper limit.  Ever more owners can claim ever increasing deposits in accounts.

(3)  Transfers between banks are limited to transfers of OC.  This is an extremely important limitation.  Assume that a deposit holder writes a check and the check is deposited to another bank.  The second bank does not automatically credit to the bearer's deposit account.  Instead, the second bank issues a draw against the currency assets of the bank of check origin.  Two conditions must then be satisfied:

(3a) The check deposit owner must have funds adequate to cover the check.

(3b)  The bank must have currency adequate to cover the check.  This currency must be currency originally issued by government (OC), not a DL deposit.

The effect of properties 2 and 3b create a banking dilemma:   Ever more depositors have ever increasing claims on a fixed amount of OC!  Unchecked, this dilemma will end with collapse of the banking system when it becomes obvious that the system can not satisfy the the claims of all depositors with OC.

Returning to the blog question of widow's cruse,  it would seem that property 2 grants that generosity, the banks have a widows's cruse.  Unfortunately, property 3b would indicate that no cruse at all could ever exist between banks.

If these properties are correct, then important effects on money supply measurement necessarily follow:

A.  Original Currency issued by the government is the only money supply available. This can be measured as the difference between government expenses and government receipts.  Continuous deficits act to continuously increase the money supply.

B.  Original Currency exists like a "hot potato".  It does not disappear from public use unless removed by government, principally by running a budget surplus as when taxes exceed expenses.  Government borrowing does not  extinguish the OC, it merely puts it back into motion.  Measurement of OC by adding the deposits of all banks should closely match the amount of government debt held by the public. Differences between deposits and debt held by the public should be principally due to central bank efforts to control currency value.

C.  The sum of all outstanding loans has no bearing on money supply measurement. On the other hand, the sum of all outstanding loans is a vital measurement of the need by the public for future currency for loan payments.  Currency tied up in the hands of deposit holders is no guaranty that currency will be available to borrowers for loan payments.

D.  The change in bank loans is a measurement of money put into motion where it can be expected to increase GDP.  If government is repeatedly running a deficit, an increase in loans may increase tax income, thus lowering the needed level of borrowing to meet a preset budget.  This effect resulted in a rare government budget surplus in the late 1990's.  This same effect created a need for massive government borrowing beginning in about 2007 when loan failures forced massive government borrowing to maintain then existing government spending.

My conclusion is that the widow's cruse does exist like a rainbow does exist. Unfortunately, the widow's cruse only continues while conditions are correct, then it vanishes.