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I was asked this question recently by an academic (wh is not an economist):

Where is the best place to get an answer to this question:

Where does the extra money go when mortgage rates increase? Aside from the amount that goes to pay higher rates to savers?

The answer is I know of no such best place, so let me have a go.

Much chuntering later we are told:

It’s not simple is the honest answer, but for now, assume that banks gain unduly, the wealthy are immune from risk and inequality grows whilst real economic activity falls. And we call this policy.

Given that I am not an economics professor I’ll have to make it simpler.

To savers. Might be through higher interest being paid to depositors at banks who fund those loans. Might be in higher profit to the bank, which is owned by savers. Might be – but all will be savers. Because that’s just how it works.

Those who save capital which then becomes someone else’s investment loan gain more when the price paid for that loan rises. Why, and how, would it be any different?

37 thoughts on “This is easy”

  1. Anyone asking the potato a question forfeits the right to call themselves an academic. Then again, the mystery academic was probably spud himself

  2. “I was asked this question recently by an academic (wh is not an economist):”

    No he wasn’t.

    He engages in this infantile “I was asked by….” charade whenever he wants too talk about a topic he wants to talk about.

    He name drops whenever he can so there clearly isn’t a name to drop here.

  3. Dennis, Noting The Bright Light Emanating From Ely

    I was asked this question recently by an academic (wh[o] is not an economist)

    Well, that makes two of you.

  4. Its an interesting point though. Why does raising interest rates slow economic activity, when presumably the amount of money in the system is not altered by the rise, its just redirected? Money moves from people with debts to people with savings. Higher loan repayments become higher savings rates. Do the savers not spend their extra income? Is it because large amounts of assets are held by people for their retirement, and thus if the returns on investments rise they tend to just save the additional money? Or is it because the debtors massively outweigh the savers in number, and the savers can’t spend all their extra income?

    We all accept the premise that interest rate rises slow the economy, and the evidence would suggest thats true, but why is it true?

  5. The Meissen Bison

    @Jim – I imagine that the relative cost of money has a direct impact on the viability or otherwise of any given project.

  6. Is the answer not explained by double-entry bookkeeping, simple debits and credits?

    Perhaps Murphy should call on the expertise of a suitably qualified accountant to advise on such debiting and crediting?

  7. Jim, shurely if you are having to sink more of your disposable into a mortgage payment you don’t have that cash to splurge on a new motor?
    The savers may gain higher interest on the money in the bank but they are ‘savers’, by definition people who put their money away and are not necessarily using any additional dosh to buy stuff.

  8. @ Jim
    The savers (or, at least, some of them) pay tax on the interest they receive. So some of the money disappears down the drain into the Treasury.
    When I was young (background: “oh, no, another boring reminiscence”) there was a balance with mortgage interest being tax-deductible so it was the higher-rate taxpayers’ slice that added to government receipts but now most of us pay tax on some of our interest.

  9. Addolff exactly.

    Jim has obviously not seen Mary Poppins where David Tomlinson explains Compund Interest. 🙂

    But also we mustn’t forget that there us a margin between the savings rate and the mortgage rate, which is where the filthy capitalist banks make their money.

  10. If the money goes to banks, why aren’t their shares soaring in anticipation of higher profits?

  11. Apart from the above comment – some of the extra money goes down the drain due to the higher default rate when interest rates go up and a few loans get foreclosed, whereafter the house is sold. Money is wasted by the legal processes and money is lost when the house is sold in a hurry so for a lower price than it would command in a voluntary unhurried sale.
    The whole of the quote from Murphy is stupid and wrong. How on earth does any sane person imagine that the rich gain from building society interest rates going up? Who thinks that Joe Rothschild walks round to his local Halifax branch every week to pay in his spare cash? The rich property-owner is far from immune to risk and loses lots of money when interest rates go up as rents do *not* go up in line and the capital value drops (even for unmortgaged property) as the future rents are discounted at a higher rate.
    Why should banks gain unduly? Hasn’t he heard of competition?
    Inequality rises when economic activity rises and falls when economic activity falls because the weldare state has put a floor under incomes.

  12. “shurely if you are having to sink more of your disposable into a mortgage payment you don’t have that cash to splurge on a new motor?”

    But the savers do have more money to splurge on a new motor. So aren’t they for some reason?

    “The savers may gain higher interest on the money in the bank but they are ‘savers’, by definition people who put their money away and are not necessarily using any additional dosh to buy stuff”

    But don’t we laugh at the Left when they think saved money is hidden in a Scrooge McDuck style vault? The savers aren’t hiding their extra interest under the mattress, they’re putting it into the same bank it would have been in if the mortgage holder hadn’t had to pay extra in interest. The money hasn’t disappeared. So why does the economy slow?

    “The savers (or, at least, some of them) pay tax on the interest they receive. So some of the money disappears down the drain into the Treasury.
    When I was young (background: “oh, no, another boring reminiscence”) there was a balance with mortgage interest being tax-deductible so it was the higher-rate taxpayers’ slice that added to government receipts but now most of us pay tax on some of our interest.”

    So some goes to the government in tax. And do governments hold that money and delete it or something? No, they spend it with all the rest, up against the nearest wall. So that tax goes back into the economy.

    “But also we mustn’t forget that there us a margin between the savings rate and the mortgage rate, which is where the filthy capitalist banks make their money.”

    And the banks don’t pay dividends or taxes on that then? And hide it in a vault never to see the light of day? Nope, as above, it goes back into the economy.

    So I ask again how does the redirection of the money around the system slow it down? There’s not less money, all that can be changing is the amount of hands it goes through.

  13. Andrew M – LLOY, NWG and HSBC are up – certainly from the lows of autumn 2020, anyway.

    Unfortunately, higher interest rates increase the risk of mortgage defaults, which would hit profits. So there’s that.

  14. Has anyone actually done any discounted cash flow analysis? The value of a thing is the present value of the future cashflow type thing? The discount rates are usually interest rates (for probability adjusted cashflows – now I’m getting boring!). So rates going up mean the current value ascribed to a thing goes down. That means the apparent on an investment goes down. The cost of debt to fund the investment goes up. So the net value of doing things goes down. So fewer things get financed and spending goes down.
    Also higher interest rates increase the apparent marginal return on savings, so the marginal penny goes into a bank as opposed to being spent.
    Only works in the short term if we believe inflation will go down and interest rates are higher than inflation. Otherwise we are still better off spending.

  15. Jim,

    A different perspective from a simple soul.

    Just one transaction: A borrows, and buys a bike from B (as a result of B’s labour). A now has a bank loan, B a bank deposit. If B decides to spend (consume), then A now needs to produce labour in return (for B’s benefit). If B saves instead, A is effectively unemployed, because the deposit and the loan sit at the bank matching each other off rather than being cleared down.

    If people save, logically and all else being equal, that should reduce economic activity compared to if they consume. By spending their savings, that should enable increased economic activity as those with loans can then work to repay said loans.

  16. Might be in higher profit to the bank, which is owned by savers.

    Actually, lower bank profits.

    Banks make their money on spread, so the level of interest rates is not what matters. Banks actually prefer lower interest rates because higher interest rates are associated with more loan defaults, which is why banks are currently increasing their loan loss provisions.

    There is one exception that Tim Worstall has noted, which is that when deposit rates hit zero, then banks’ margins were compressed. So the rising rates increased their profits for a time when the margins decompressed.

    As an aside, my HELOC rate here in Canada has gone from 3% to 8%. Meanwhile, the bank’s share price has dropped by 20% over the last year. You can see it in the chart here:

    https://money.tmx.com/en/quote/td

  17. It is pointless bothering with this guy, as he’s so wrong. For example, in this article (but not the bit quoted) he explains why he thinks that people who borrow money are likely to be poor. However, that’s nonsense. Lots of very wealthy people and companies borrow money because, if you’re a good risk, it’s a cheaper source of money than liquidating an investment. If you look at the balance sheet of almost any large company, you’ll find substantial debts – worth far more than a typical individual borrows for a house or a car.

    @PF

    That’s only if you believe in the dragon’s hoard view of banking in which deposits are a big pile of gold upon which a dragon sits. In the real world, the money that B has saved must be lent out to C, D, or someone else. Otherwise the bank has no source of income to pay the interest owed to B.

  18. Charles

    That’s only if you believe in the dragon’s hoard view of banking in which deposits are a big pile of gold upon which a dragon sits. In the real world, the money that B has saved must be lent out to C, D, or someone else.

    You’re being a clown… The money that B has in his deposit account was lent out, to A. That was the whole point.
    A’s loan (in order to buy a bike) created the deposit (1 below), which was paid across to B (2).
    Following which, the bank then has a loan owed from A and a deposit due to B (3).
    No further transactions needed. No C or D needed, unless there is (quite separately) a new commercial transaction.

    Perhaps read/understand what I actually wrote (the accounting is as ‘simple’ as it gets, and as I happily alluded to…)

    If it helps – bank transactions:
    1) Dr: A – Loan; Cr: A – Current account (for the purpose of buying a bike)
    2) Dr: A – Current account; Cr: B – Current account (A buying said bike from B),
    which then leaves the bank with the balance of:
    3) Dr: A – Loan; Cr: B – Current account

  19. @ Jim
    Every transaction involves some effort (often trivial but not quite zero) and delay (ditto) so paying extra money in taxes reduces the amount of valuable resources created. That is apart from the demonstrably lower utility per pound of money spent by the government compared with that spent by the private sector – the mere existence of Capita and other outsourcing companies is a result thereof and its nickname “Crapita” is because its quality is far, far below the private sector norm.

  20. @PF – “The money that B has in his deposit account was lent out, to A.”

    You originally made no reference to B having money on deposit. And even if it was B’s money that was lent to A, after the transaction, B can now deposit the proce of the bike and is entitled to even more interest, so the bank cannot pay it all from the original loan to A. It’s this additional deposit that forces more lending.

  21. Charles

    “It’s this additional deposit that forces more lending.”

    There is no additional deposit. B didn’t have money on deposit prior to this. The money lent to A was lent by the bank to A (not by B to A) so that A could pay B in exchange for wheels (after which B did then have a deposit, and no bike). Try reading it – I even laid out the detailed transactions for you! There were only two – they were very simple.

    [and purely as illustration for the purpose of responding to Jim’s particular question before you wander any further off-piste]

    And if you don’t understand those two transactions (1 and 2 above?), it’s a bit fucking ironic that you then blithely come out with a comment like “That’s only if you believe in the dragon’s hoard view of banking”. *LOL*

  22. money is lost when the house is sold in a hurry so for a lower price than it would command in a voluntary unhurried sale.
    How do you work that out, john77? It’s a zero sum game. The money isn’t lost. If it’s anywhere, the buyer has it.

  23. Banks do not lend out deposits. Run the simulation below and note how creating a loan creates a new matching deposit liability that did not exist before. Note also how the original deposits are not affected.

    After dismissing the pop-up, click on the button that says “Issue $25 Loan” and watch how the bank’s balance sheet expands and a new $25 deposit is added to existing deposits. You can click on the button more than once. Click on the other buttons too:

    https://econviz.org/how-loans-create-money/#explore

  24. How many damn times have we been through this? Even if the observation is true it doesn’t matter. Banks go bust the moment that capital plus deposits don’t equal loans. Therefore – therefore – deposits finance loans.

    QED.

  25. Does it matter when the bank is lending the savers’ deposits to the government, via “bonds”? Last quarter we saw how a California private institution — Silicon Valley Bank — went bust by tying up loans to the US Treasury. It seems to me a real hazard when the borrower is a government and the “central bank” with power to set interest rates is ALSO the government.

  26. “Banks go bust the moment that capital plus deposits don’t equal loans.”

    Sure. Ie, debits must equal credits, which is self evidently true, for every business. The process whereby it happens shows the real picture/nature of the business.

  27. Therefore – therefore – deposits finance loans.

    Which loans do deposits finance, Tim? The existing loans or the new loans that haven’t been made yet?

    If you say the existing ones, then sure, they’re necessary because you need to keep those deposits around. But you don’t need deposits to make new loans.

    e.g.,

    Loan A creates deposit A.

    Loan B creates deposit B.

    There is no connection between deposit A and loan B. The two are completely separate from each other. Nor is there any need for an outside deposit to be brought into the bank. Now, if you’re arguing that deposit A finances loan A and deposit B finances loan B, then I would agree with you there.

  28. For God’s sake, stop this nonsense. MMT’s explanation of money creation by loan making works just fine up until 4.30pm each day, when the bank must balance its books. That’s why they have Treasury departments. That’s why they go bust if the books don’t balance. Seriously, just forget all this shit when we consider the real world. Deposits are required to finance loans. When a bank makes a loan it then goes finds the deposit to finance the loan. Which it does by 4.30 each day. The effect of this – effect note, not process – is that banks lend out deposits. There *must* be sufficient deposits plus capital to finance loans. Therefore deposits finance loans.

  29. Tim

    Phoenix’s Loan A / Loan B post has nothing to do with MMT. You reference 4.30pm, he agrees, he says “you have to keep the deposits around”. If A goes and spends the deposit, with a different bank, the bank has to ensure the net of all those (subsequent spending transactions, not the initial loan creating transactions) are dealt with by the end of the day. You are both saying the same thing.

  30. That’s why they have Treasury departments.

    Actually, no. Here’s a link to what a bank’s treasury department does. You won’t find anything in it about finding deposits:

    https://www.managementstudyguide.com/treasury-operations-of-banks.htm

    That’s why they go bust if the books don’t balance.

    No again. It’s impossible for a bank’s book not to balance. This is because equity is a residual, and rises and falls to keep a bank’s book balanced.

    When a bank makes a loan it then goes finds the deposit to finance the loan.

    Say a Bank A creates a loan which creates a matching deposit liability. Say it now receives a deposit for the same amount from Bank B (we’ll call that “Deposit B”). Because that deposit is a liability, Bank B has to transfer reserves to Bank A (we’ll call that “Reserves B”). Bank A’s balance sheet now looks like this:

    Loan A creates Deposit A.
    Reserves B received with Deposit B.

    Now, are you saying that Deposit B is now funding Loan A? Because technically, there is no qualitative difference between Deposit A and Deposit B, both are liabilities of Bank A. Or are you saying that that Reserves B in now funding Loan A? Because that presents a problem.

    For, were it the case that reserves fund loans, then Bank B has a problem in that it lost reserves which were funding its own loans.

    Of course, that doesn’t happen. All that happens is that Bank A’s balance sheet expands by the amount of reserves that it received, and Bank B’s balance sheet contracted by the amount of those reserves. Neither bank sees its loan book affected.

  31. FFS I’ve worked in a Treasury department. You collect up all the transactions of a bank during the day and then you tot it up. Then, before that 4,30 pm witching hour you go and find deposits to make it match – or, obviously lend out the excess. This used to be called the interbank or overnight market – LIBOR and all that. Now it takes place through CB reserves. But it’s the same damn thing.

    If banks do not have to balance their books each day then the overnight market would never have existed. It did. Therefore they do.

  32. @PF – “There is no additional deposit.”

    Then where did the bank get the money from to lend to A?

    And if you are tempted to believe the MMT stuff, consider that if banks can create as much money as they like, it would be impossible for a bank to even go bust. And also that the entire purpose of money is as a representation of scarcity, so infinitely available money would be useless (as is actually seen in cases where countries print excessive amounts of money and fall into a death-spiral of inflation).

  33. Then where did the bank get the money from to lend to A?

    From A.

    When A signed the loan document, A created a promissory note, which the bank then purchased with a deposit liability. Basically a swapping of IOUs.

    “Everyone can create money; the problem is to get it accepted.“ —Hyman Minsky

    As an aside, Tim confuses meeting reserve requirements with funding loans. In the US, for example, reserve requirements are 10%, so Tim off by a factor of ten, i.e., we go from funding a loan to a funding a tenth of the loan with reserves. But that’s only because these banks are greedy and not keeping buffers.

    Could a bank, keeping sufficient buffers, operate without recourse to any outside funding?

    Absolutely.

    Say a bank makes a loan for $1,000 to a borrower. The loan creates a matching deposit liability for $1,000 and the bank’s balance sheet expands. Because the reserve ratio is defined as reserves divided by deposits, the increase in deposits means the bank’s reserve ratio falls.

    Now say it’s the end of the month and ten of the bank’s customers come in and each pay $100 off on their existing loans out of their deposit accounts, for a total of $1,000. Because deposits are falling, the bank’s reserve ratio rises again, and the bank can now make another $1,000 loan. It can do this forever.

    Now, before Tim jumps in and asks how the customers are replenishing their deposit accounts, it because the people taking out the loans are paying wages to the customers and bank marks down the borrowers’ accounts and marks up the customers’ accounts. Then the customers use some of their money to purchase goods and services from the borrower, so he too can also make his loan payments and continue to pay their wages.

    If you think it through, you’ll realize that this model is stock-flow consistent, which is the ultimate test of a model.

    Stock-flow consistent models (SFC) are a family of macroeconomic models based on a rigorous accounting framework, which guarantees a correct and comprehensive integration of all the flows and the stocks of an economy. These models were first developed in the mid-20th century but have recently become popular, particularly within the post-Keynesian school of thought. Stock-flow consistent models are in contrast to dynamic stochastic general equilibrium models, which are used in mainstream economics. —Wikipedia

  34. This, from the Bank of England:

    Money is destroyed when loans are repaid:

    “Just as taking out a new loan creates money, the repayment of bank loans destroys money. For example, suppose a consumer has spent money in the supermarket throughout the month by using a credit card. Each purchase made using the credit card will have increased the outstanding loans on the consumer’s balance sheet and the deposits on the supermarket’s balance sheet. … If the consumer were then to pay their credit card bill in full at the end of the month, its bank would reduce the amount of deposits in the consumer’s account by the value of the credit card bill, thus destroying all of the newly created money.

    “Banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy.” (McLeay, Thomas, & Radia, Money creation in the modern economy, page 3)

    So banks create the money supply, but they also destroy it.

  35. “Then where did the bank get the money from to lend to A?”

    It created it. Re-read the transactions I outlined above. Transaction 1) is the creation of the loan (and of the money that you can then spend). 2) is the spending of that money.

    Charles, if you think there is something different going on with all of this, please, take me through the double entry/record keeping? Just jot it down – the process of the bank lending money to A and A then spending it, and from the viewpoint of the bank, don’t bother with A, that’ll be the reverse entries to that recorded by the bank insofar as they affect A?

    And I’m not an MMT proponent. I’ve absolutely no idea how you managed to magic that one up! A bank doing “Dr Loan, Cr Deposit” (and by deposit, we mean in practical terms one’s “current account” or “money”, that you the individual can spend as a result of now having committed to that loan) is not MMT, it’s bog standard loan creation in a banking fractional reserve system. The bank can do it on a leveraged basis subject to having sufficient equity/P&L reserves etc (ie an adequate balance sheet/capital ratio). Which of course restricts its ability to keep doing it beyond its financial means/size.

    Have a look at a typical bank balance sheet (say on Companies House) and you’ll quickly get the gist of what’s happening. It’ll have financial assets (loans and similar due to the bank) and financial liabilities (owed to customers/other banks etc) of say an order of magnitude larger than its equity capital and P&L reserves. The grossing up being the result of the fractional reserve process; ie, subject to capital ratios.

    “And also that the entire purpose of money is as a representation of scarcity, so infinitely available money would be useless”

    You do have to pay it back, that’s the whole point of the loan part of the entry! 🙂 A bank shouldn’t offer a loan (and give you the money to spend) if it doubts your ability to work (or whatever) to repay said money…. That would be very careless because then the bank would lose money. It might have to write off the loan as a bad debt, reducing its P&L…..

  36. Apols

    MMT: It’s late, I meant these transactions were not QE, which is what we typically associate with money printing in this context. But I’m no supporter of the Magic Money Tree – it’s nonsense, for reasons that many on here have spelled out before; no need to repeat on this thread.

  37. @PF – “take me through the double entry/record keeping?”

    Suppose that A pays B in cash, having got the loan in cash. Where does the bank get the cash from and why would they get it without giving something in return? How does your double entry bookkeeping handle A’s withdrawal of the cash?

    You can make it appear that the bank can create money at a whim if you assume that there’s only one bank and it holds all money on deposit. Once you allows for multiple banks or cash, it all falls apart.

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