The Money System in Five Minutes

The Government pays Builder Co $1,000 for repair work on a Commonwealth building. The payment comes out of the Government's account at the RBA. The RBA adds $1,000 to Harbour Bank's settlement balance, and Harbour Bank credits Builder Co's account.

Notice what is new: Builder Co has $1,000 more in its bank account and owes nobody anything for it. The private sector's net financial assets (what it owns minus what it owes) have risen by $1,000. Builder Co gave up real work in return.

Builder Co owes $200 in tax. Every entry from step 1 runs backwards for $200: Builder Co's deposit falls, Harbour Bank's settlement balance falls, and the Government's account at the RBA rises.

Tax takes net financial assets back out of the private sector. After steps 1 and 2 the Government has spent $1,000 and taxed $200, a deficit of $800, and the private sector is exactly $800 better off in financial assets. That is the sectoral balances identity in miniature: the government's deficit is the non-government sector's surplus, to the dollar.

The Government's account is now $800 lower than when we started. The Australian Office of Financial Management (AOFM) tops it up by selling an $800 Treasury bond at a tender. Harbour Bank wins it and pays with $800 of its settlement balance.

For the private sector, this is a swap, not a loss: Harbour Bank gives up $800 of settlement balances (which earn interest at just under the cash rate) and gets an $800 bond (which usually pays a bit more). The private sector's net financial assets are still up $800; they are now held as a government bond. The Government's account is back where it started, and it now has $800 more debt, which is the same thing as the private sector's $800 of extra assets.

Sam borrows $5,000 from Harbour Bank to buy a used car. Harbour Bank does not take the money from anyone else's account. It records a $5,000 loan (an asset: Sam owes the bank) and credits Sam's account with a new $5,000 deposit (a liability: the bank owes Sam). New money has been created. This is what the Bank of England and the RBA mean when they say bank lending creates deposits.

But look at Sam: a $5,000 asset and a $5,000 debt. Bank lending creates money without creating net financial assets for the private sector. Only the government sector (and the rest of the world) can add those. That is the single most important difference between bank money and government spending.

Sam pays $3,000 to a car dealer who banks with Coast Bank. Two banks are involved, so they settle between themselves in central bank money: the RBA moves $3,000 from Harbour Bank's settlement account to Coast Bank's. Sam's deposit at Harbour Bank falls; the dealer's deposit at Coast Bank rises.

Payments between banks move settlement balances around, but only transactions with the government (and the RBA's own operations) change their total. If a bank runs short, it borrows from another bank overnight, or from the RBA, at an interest rate tied to the RBA's cash rate. That price, together with capital rules, finding creditworthy borrowers and making a profit, is what limits bank lending. Banks do not need to collect deposits before they lend, but they are not free to lend without limit.

A month later Sam repays $1,000 of the loan from his account. Harbour Bank cancels $1,000 of his deposit and $1,000 of his loan. That money no longer exists.

Bank money is created when loans are made and destroyed when they are repaid. When households and businesses borrow faster than they repay, the money supply grows; when they pay down debt faster than they borrow, it shrinks. That is why private debt, not only government debt, matters for the economy.

None of the steps above needed anyone to find money first. The Government paid from an account the AOFM keeps funded; Harbour Bank created a deposit by lending. So what stops the Government from paying for a thousand repair jobs, or Harbour Bank from lending to everyone?

For the bank: the borrower has to be able to repay, and the bank has to hold enough capital and settlement funds and make a profit. For the Government: the real resources. If Builder Co's tradespeople were idle, the $1,000 brought unused labour into use. If they were already flat out on other work, the Government is bidding against everyone else for the same workers and materials, and the likely result is higher prices, not more repairs.

Both MMT and mainstream economists accept that real capacity matters and that inflation is the warning light. Mainstream economists add a second limit that MMT economists play down: the government's budget constraint over time. Debt has to be serviced, through future taxes or, failing that, through inflation, so interest costs and debt levels count too. The two sides also disagree about how close the capacity limit usually is, and about which tool should keep spending within it.