Debt Defaults and the Money Supply

Steve Saville of www.speculative-investor.com recently published an article to which he appended the following note:

"Many people believe that debt defaults cause the supply of money to shrink, but this is not so. A debt default will probably reduce the wealth of the person/company making the loan, but if the loan originally resulted in new money being created -- for example, a loan made by a commercial bank to finance the purchase of a home -- then that money will have been spent by the debtor and will remain within the economy following the loan default. Of course, if the customers of a lender default on their loans then the ability and/or desire of that lender to make additional loans may be hampered. It is therefore possible for debt defaults to bring about a reduction in the future rate of money supply growth, but debt defaults do not directly affect the existing supply of money."

(Emphasis mine).

This is a meme that I have come across on many message boards, but this is the first time I have seen it offered by a (self-appointed) analyst. The question is: "is it true?"

Let's follow through the logic.

1) A bank is established with, say $1m of capital.
2) It acquires $9m of deposits for a total of $10m of equity and liabilities.
3) The bank makes $10m of loans, say, 100 loans of $100k each.
4) The borrowers spend the money in the economy.
5) One of the $100k borrowers defaults, without paying any principle or interest.

So the money made it out of the bank and into the economy where it is trapped and can never be destroyed (according to Saville) right? Not so fast.

Let's liquidate the bank and see what we have. We sell off the loan portfolio at book for $9.9m. We use $9m to pay off our depositors. We use the remaining $900k to pay off the equity holders - $100k less than they provided to capitalize the bank.

It's clear that the $100k loan default has resulted in the destruction of $100k originally used to capitalize the bank. That's a wash, a one for one destruction of the money created through the loan.

My mental model of credit created cash is like a matter ($) - antimatter (debt) pair. They can exist seperately for a time (dictated by the terms of the loan), but ultimately the anti-matter will seek out an exact equal amount of matter to destroy. The money originally loaned into existence is either paid back or the capital backing the loan is consumed.

Naturally we can make this model more complete: What about the interest, what if we can't sell the loans at face value, what if the defaults exceed the banks capital, what if the FDIC bails out the depositers, etc, etc. It's the same in every case: someone's capital gets destroyed in equal amount to the default. If your analysis seems to leave money trapped in the economy you are not thinking hard enough (it's like the first law of thermodynamics).

I like Steve Saville's work as a well argued counterpoint to hardcore deflationists, but he is wrong on this point, defaults are deflationary.