Money creation and credit creation in the private sector 101

There has been a lot of focus on the repo market lately. I get it. It’s an important part of the capital markets in the credit creation process. But its growth and contraction is part of the credit creation process **

The repo market where transactions are between hedge funds and money market investors, and those who desire leverage for whatever purpose is an important market in the credit creation process BUT is not part of the money creation process UNLESS a commercial bank or the Fed is **

A party to the transaction. Because this is largely misunderstood by even some plumbing experts it’s worth it for me to write out my understanding (maybe im wrong which would be awesome so I can learn). So here I go. **

Let’s start with the difference between credit creation and money creation.

Credit creation doesn’t need the banking system as a wholes involvement at all.

All non bank credit creation transactions look basically the same. I’ll use a corporate bond issuance in my example **

When a corporation issues a corporate bond in the market they get a deposit which they spend on the business and now owe more money. They have leveraged. The buyer of the corporate bond has swapped a deposit asset for a corporate bond asset. They have added risk. In this **

Simple example the banking system has no change at all. A deposit shifted from the buyer to the seller and unrelated to the banking system credit was created. As an aside if the buyer and seller bank at the same specific bank that is literally that. If they don’t, reserves **

are involved as the deposit shift between two banks is settled by and accompanied shift in reserves. (Ill come back to that)

This is one example of the credit creation channel that does not involve the banks. There are many examples. But all can be distilled to this example **

Deposit shift between two non bank parties and a new obligation between two non bank parties. In all examples like this NO money is created.

If no money is created does credit creation matter? Of course it does. If one party lends to another and the borrower falls on **

Hard times they default and they suffer and so does the lender. The more credit that exists the more vulnerable both savers and borrowers are to hard times. But leverage cuts both ways. In good times the borrower shareholders benefit from the borrowing and the lender gets **

repaid. Everyone wins.

So let’s include banks in the credit creation process and then talk about money creation.

Banks are heavily involved in credit intermediation. This is a transaction which is NOT money creation but one where bank takes a temporary role **

In the big short the mortgage brokers in Vegas explained how the bank they work for lends to the stripper on Friday and sells the loan by Monday. This is a credit intermediation transaction. The borrower signs the NINJA loan and boom has a deposit and a mortgage loan **

The bank has created credit and for the weekend has created money on Monday the bank sells the loan to an MBS pool which is owned by non banks (of course in this case some where banks) but let’s ignore that for a moment. The originating bank no longer has a loan at all and has a **

Deposit that came from the MBS pool buyer. If you can work through the net of all this you see the bank has not changed and a private sector lender and borrower have created credit and no money. It’s the same as the corporate bond transaction credit was created and money was not **

So one function a bank has is to temporarily create money out of thin air as a credit intermediary and then destroy that money via selling the loan to a non bank. The other function of a bank is being a permanent principal in a transaction. **

When a bank makes a loan or buys debt from a seller and keeps that new credit asset on their balance sheet they BOTH create credit and are exposed to leverage cutting both ways AND they create money out of thin air. But once again in this transaction NO bank reserves are **

Involved at all. It’s possible that the stripper buys the house with the deposit and the house seller banks at another bank. When that happens reserves are moved from one bank to another but the aggregate banking system reserves don’t change. **

So why do I create a distinction between credit creation and money creation. At the first level whether the borrowers new deposit was just credit creation or both money a credit creation. The deposit “spends” the same way. The whole point of credit creation is to take the **

Borrowed money and consume, invest in the real economy or leverage up holdings in financial assets while the lender is happy to get some interest on his cash. Credit creation is short term stimulative to the economy. BUT when the debt is repaid that stimulation turns to **

contraction. Money AND credit creation is more powerful as unless banks get in trouble the created money remains in the system and relieves some or all of the eventual contraction when the debt is repaid as the money remains. So it matters whether an economy is leveraging up **

Credit creation occurring And it matters if money creation is occurring .

My question for those who have read this far and have deep understanding of money and credit and private credits role is does shadow banking create money or just credit? **

The thread is reaching its max and I’ll have to append the important topic of Repo in this money and credit creation mechanism but first I want to remind folks about government debt. The big thing about government debt is that it doesn’t create money and finances itself **

When a government runs a deficit they hand more deposits to the economy than they tax. In order to do that they issue Treasury obligations. But the key part of this is the deficit spending MUST ultimately be saved in the short exact same treasuries that the government issues **

There is NO reason that the government debt requires leveraged buyers. It’s all self financing and always has been. Perhaps one day it won’t be but today is not that day. Anyone who tells you that the Repo market growth is because the government debt is growing and can only **

Be financed with leverage has no clue how the money creation and credit creation system works.

In the follow up thread I will discuss the role of Repo in the broad credit creation mechanism process but will leave you with the statement that **

Unless a bank is involved in the repo market Not as a credit intermediary but as a money creator the Repo market is JUST another version of a credit creation mechanism with no tie to bank reserves. There are many ways to create credit and repo is part of that. But it doesn’t finance it the government **

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