A fair few people seem to have trouble grasping how money is actually debt, and how particularly debt-based money relates to economic growth requirements. The following is an explanation from what I have found in reading about it from a number of sources. It is long but when people start to understand the interconnectedness of debt and the economy most find it very interesting. So here goes my best shot:

All nations currently have a money system based upon the creation of money being made through the issuing of loans.

If you go to Superb Bank Plc and take out a $5,000 personal loan, Superb Bank Plc needs roughly 10% of that loan amount in deposits in their bank in order to issue you that loan. So, assuming a $500 deposit in the bank that has not been used as 10% deposit on another loan, that means Superb Bank Plc can then create $5,000 via the signing of a bank manager's pen. The bank charges you, let's say, 12% APR interest.

Before we go on to how that relates to the economy, let's explain what can happen then and how this relates to further money creation.

You now go and splash out on a second hand car, previously owned by Bob. Bob, through the sale of that car, then goes to Brilliant Bank Plc and deposits that $5,000 into his account. It's his current account, so whilst Superb Bank Plc are charging you 12% interest, Brilliant Bank Plc are only giving Bob on his current account around 0.5% interest on that same $5,000.

Here's the crux though; the banking system then does not distinguish between unpaid debt and debt that has been paid back. In fact, under this money system, both are hard to define. So, Brilliant Bank Plc, with Bob's new $5,000 deposit created by the manager's pen at Superb Bank Plc, can then create a further $50,000 on this just-created money.

Whilst they are giving Bob 0.5% interest on his $5,000 deposit, they will charge let's say 12% interest on that $50,000 created money. They can make prospectively $6,000 in the first year (before compounding takes place if you do not repay) on that $50,000, create by the manager's pen, whilst Bob only gets $25 in the first year from his $5,000 deposit. Also, you are also being charged 12% on your $5,000 loan as well by Superb Bank Plc.

You get compound growth with your savings, hence the reason why banks only give very small interest on your savings - if they didn't, over time, 12% growth per year in interest on your savings would grow to very large amounts over a relatively small number of years. Over 10 years, with no repayments, with a $50,000 loan at 12% interest you would owe the bank $155,000. On Bob's savings of $5,000 - from which that money was created - at 0.5% interest, after the same amount of years his savings deposit would be worth $5,250. A net difference of $150,000.

Why Do Some Banks Offer 6% Interest On A Savings Account, If Only For A Short Period?

You will find this often in new bank startups. Many internet banks have offered such interest rates due to lower overheads than highstreet banks. However, most of the time they then (without reporting to you directly) reduce that interest rate down to a more modest level. Why do they do this? They need deposits first in order to make loans. By inticing people to move money to their accounts via high interest, and it is notoriously difficult to get people to change banks for any reason, they may then make more and more loans. After that, their profits grow.

Now we see how and why the banks make such large amounts of profits, whilst actually producing very little, and also why it is better for them if you don't actually pay back your loan.

The darker side to this is also, that commercial banks actually decide the direction of the economy by issuing or refusing loans.

Given that created money can then be used in another bank to make more created money, it is easy to see how this process can end up generating huge amounts of debt very quickly. In fact, besides paper money, it is estimated that 97% of money in circulation is now debt. Meanwhile, the only work the bank has to do is issue enough loans in order to cover all interest payments on deposits - which in most accounts are devaluing with inflation anyway. Statistically, all that requires is well-designed marketing campaigns targetted at the general public - it is virtually guaranteed that given a marketing exposure to the population, a certain percentage will then take out a loan providing that the potential benefits are communicated well.

So how does this relate to economic growth requirements? The problem that arises with the system is this: where does the money come from to pay back the interest on loans?.

Ultimately, this money must come from the issuing of new loans somewhere else within the financial system. Otherwise, somewhere along the line, someone will be finding it impossible to pay back interest on their existing loans, and bankruptcy will follow. Also notice, for interest's sake, that many people give their labour to receive money created by the pen of bank managers, who then profit out of that loan issue without doing any work for it. Now we know why owning a bank is such a great thing in this soceity - it is almost wealth without work.

Overall, then, this means that for debt to be constantly repaid, new industries and new markets must constantly be found and consumption of goods and services must therefore also rise, otherwise those new markets and industries would not be successful at generating sales. This is why our current economy requires growth and therefore growing consumption of products to remain coherent.

Why Does Inflation Occur?

This is fairly simple. If money is being created through loans at a rate faster than goods, products and services are being consumed, then the value, or purchasing power, of money decreases. This is bad for lenders, because this decreases the value of the money with which they are being paid back. It's also bad for consumers, because they can consume less with the money they have as prices of goods and products rise.

Why Does Deflation Occur?

The opposite case. If money created through loans is at a rate slower than the consumption of goods and services, then the value or purchasing power of money increases. This is good for the lenders, because this increases the value of the money with which they are being paid back. This is also good for consumers, because they can consume more with the money they have as prices of goods and products decrease (in theory).

Why Don't We Want Deflation Then?

Well, that would mean the economy wouldn't grow, wouldn't it? If less and less money were being created via the issuing of loans (causing deflation), we would hit the same problem as described before: at somewhere along the line, someone would find it impossible to pay back the interest on their existing loan, and bankruptcy would follow. In extreme cases, this can cause economies to go into financial cannibalism with a cascade of bankruptcies, if the economy doesn't recover to resupply the issuing of new loans.

How Is Growth Regulated?

Obviously, this system can easily exponentially cascade out of control. Therefore, in the US the Federal Reserve, in the UK the Bank of England, and in Canada the Bank of Canada control the base rate of interest. All commercial banks add their own level of interest onto this base rate, and therefore an increase in base rate means usually an increase in commercial bank interest rates will follow. I believe an increase in base rate also generally means an increase in interest rate on savings deposits. It also means mortgages and other forms of debt will also become more expensive.

Therefore, if the regulating bank increases base rate, a decrease in consumption generally ensues because consumers have less spare cash with which to pay for consumables, leading to a decline in economic growth as businesses get less sales. However, this cannot go on forever, as if growth in goods and services does not continue (i.e. consumption), at some stage, someone will be finding it impossible to pay back interest on their existing loans, and therefore bankruptcy will follow. It would also increase the percentage of the population who are unemployed because businesses receive decreased cashflows. Therefore, interest rate increases can only exist for a certain period of time and must be lowered in order for continued growth to occur and the paying back of loans. This is why after raising interest rates incrementally the regulating banks generally decrement interest rates afterward in some degree to provide a 'swingback' effect.

The regulating banks are also responsible for increasing money supply - through printing it in accordance with economic growth (demand for money). This means there is enough cash to supply the demand by the consuming population and commerce can continue unhindered - and therefore economic growth.

How Is This Related To Energy Supplies?

It is obvious that goods and services take energy to create and supply. A person supplying accountancy services requires a minimum amount of food per day. A machine creating a product requires a fuel/electricity supply. Therefore, unless efficiency of production increases at the same rate as growth in production, the economy requires increasing supplies of energy to function (i.e. to fuel ever increasing consumption of goods and products) - otherwise production will have to slow, which means a slow in growth of products or services supply, which means someone, somewhere will be finding it impossible to pay back interest on loans and bankruptcy will follow.

Notice two key points:

(i) In theory, this system can allow the creation of infinite wealth.
(ii) Accordingly, this would require infinite matter and energy in order to sustain infinite consumption.

Obviously, over the long term, this system is unsustainable, no matter what the energy considerations.

Therefore, the balance of this system is a constant balance between the supply of energy and efficiency of production. If energy supplies cannot increase with growth, or efficiency of production cannot increase with growth, or a complimentary combination of the two, with increasing consumption of goods and services, someone somewhere along the line will be finding it impossible to pay back interest on their existing loans and bankcruptcy will follow. It is easy to see if some major disruption to energy supplies, or efficiency increases (the first case is more practically likely) occurs then this will therefore lead to increasing bankruptcies. If a long-term interruption to energy supplies or efficiency ensues, this leads to increasing bankruptcies, a decrease in the supply therefore of goods and services, a decrease accordingly in consumption, and an increase in unemployment coupled with a decreased or negative economic growth.

Why Was This System Created?

The system was designed by humans and created to place greater pressure on society to grow in wealth, leading in theory to greater quality of life through the general increasing supply of money to society whilst the value of the currency remained the same (no inflation/deflation). It has assumed that if an individual is able to purchase more products and services to consume, that the individual's quality of life will be greater. It also, incidently, means ever increasing profits for banks which increase with economic growth.

The price has arguably been greater stress on society. It also means there is, unless productive output per population can increase, that increasing population numbers are required to fuel increasing production and consumption, coupled with the requirement for ever increasing supplies of energy assuming that efficiency does not increase with every increase in production and growth in the economy.

What Could This Mean For Stockmarket-Tracker Pensions?

Over time, the value of the stock market tends to increase with growth in the economy. This makes sense, as the number of companies increases or current companies grow in size with the increase in money supply - this is in fact a requirement, as unless companies become more efficient, growth in size/numbers must increase with increasing production and consumption. Therefore, a breakdown of the economy of compound growth (dicatated by compound interest payable on debt) will directly correlate with what is called a 'stockmarket crash'. If the growth in the economy does not happen, compound growth in pensions that are tied to the stock market (which many pension schemes now are, with the dissolvement of most final salary pension schemes in large or small companies) cannot occur and therefore pension funds cannot compoundly increase in value over a long period of time.

In fact, the dissolvement of final salary pension schemes may have been caused directly by the fact that this money system started up in 1971. Therefore, whilst many baby boomers started their careers before this money system was created, their final salary pension schemes are more or less an artifact of the previous money system. Of course, even with a final salary scheme, compound growth in a company's size is roughly required in order to satisfy it. Therefore, an ending of final salary pension schemes may suggest the lack of confidence in continuing economic growth into the future.

Conclusion

I hope this explains why, unless energy supply from oil, and the the energy form of oil (efficiency/cost) can be replaced, a failiure of the economic system is inevitable and will occur through ever increasing bankruptcies, decreased consumption and production, and (if one follows the requirement for an increase in population for more production), a corresponding decrease in population for this economy to remain coherent.

Feel free to comment or correct anything that I've said - I'd also welcome any other additions, or if required corrections to the material.

Mark

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Good article. This should go in the FAQ, when we have one.

This doesn't seem quite right. My understanding was that banks loan out money that people deposit in them. But, they can't loan out all the money they hold in savings and other interest bearing accounts because then they wouldn't be able to give depositors their money upon request. So banks are allowed to loan out a fraction of the money in their deposit accounts maybe 90%. The amount varies, but has an upper limit set by the central bank. The central bank can tighten the money supply by requiring banks to keep a larger fraction of money in deposit accounts in "reserve," or loosen the money supply by lowering the fraction.

Clearly, the assumption on the part of the bank is that the people who deposit money there won't all decide to withdraw their funds at once, i.e. a run on the bank. The problem is that runs can become self-fulfilling prophecies. People hear reports that a bank is shaky and start withdrawing money. Pretty soon, the bank is shaky and the shakier it gets the more people will want to cash out their accounts causing the bank to become shakier still.

I think from there, your idea of banks creating money still holds. Essentially, if Bob deposits $5,000 in Big Bank, Inc. Then Big Bank Inc can turn around and loan out 90% of that or $4,500. Voila! $4,500 in new money in the economy. Say that $4,500 goes to Jane who uses it to buy something from Jim who then deposits it in his bank, Not So Big Bank Inc. Not So Big Bank can then take that $4,500 and loan out 90%, or $4,050. So now, after two iterations, the original $5,000 has created another $8,550 in new spending. Clearly, this can go on and on, increasing the total amount of money in the economy. However, your premise is still correct, that the economy has to continue to grow in order for old loans to be paid off.

This is where I got the 10% deposits for loans information from http://www.prosperityuk.com/prosperity/ ... owbcm.html. It appears to be correct - it was taken from a mainstream Economics textbook.

Mark

Of course, if all money is removed in deposits from the bank, there is no 10% deposit required in order to make that loan. Also, I used to work at Barclay's Stockbrokers, and I asked one of the managers there about it. He said 10-20X the amount in deposits was allowable for the purposes of creating credit - i.e. 5-10% in deposits.

Mark

Actually, with a 10% reserve ratio, Superb Bank Plc can only create $4,500 of "new money" on a $5,000 deposit, not $50,000.

Sorry! $500 means they can create 10-20X that amount of money. 10X $500 is $5000 - it's not $5000-$500 - they can create 10X $500. Therefore it's $5000.

Sorry to keep on rejecting your ideas!

Mark

Extract from Rich Dad, Poor Dad 2: The Cashflow Quadrant by entrepreneur Robert T. Kiyosaki. This is another book that covers money creation, quote:

They Don't Need Your Savings

Besides, banks really do not need your savings. They don't need much in deposits because they can magnify money at least 10 times. If you put a single $1 note in the bank, by law, the bank can lend out $10 and, depending upon the reserve limits imposed by the central bank, possibly as much as $20. That means your single $1 suddenly becomes $10 or more. It's magic! When my 'rich dad' showed me that, I fell in love with the idea. At that point I knew I wanted to own a bank, and not go to school to become a banker.

That means the $500 might even allow the creation of $10,000, depending on reserve limits.

Mark

That's why we have the FDIC. Here in the states, anyway. Not sure if there's an equivalent in the UK, but there probably is.

I think it's really generous for you to volunteer to admin our FAQ section...



All kidding aside, we really do need someone to run the FAQ if anyone is interested.

I'm linking to this in today's breaking news. Thanks Marek. Also, would yo mind if I reprinted it in the articles section of my site?

Matt

I have seen this theory of money presented many times. It has a serious flaw which is that it equates Money In Circulation with the circulation of money.

Think of it this way. If two people make up an economy, and there is only one dollar in circulation, but these two people exchange that dollar 100,000 time this year, then each of these people is making $100,000 per year. If you throw the banker and his interest on a loan into the mix, then the money simply needs to be circulated with the banker a little more in order to repay the debt.

Yes, the banker is making a killing by getting money circulated to him simply by giving it out, but the interest does resolve itself. Putting more money into the economy described above would simply change the amount of money the two people would charge each other for their services.

Viper - no, because the value of the currency remains the same under this system. Therefore the value of $100,000 remains twice the subjective value of $50,000.

Matt, by all means put the artcile on your site.

Mark[/u]

Actually Matt, wait a bit. This is my analysis of the situation. I have a degree in Physics from one of England's most prestigious University's and I'm going to go into research, so I'm qualified to talk about energy analysis, but before you reproduce it I'd like people to read it and give their opinion of the analysis before you publish it on your site. After that, by all means.

As someone has pointed out before, I don't want people to go away with images in their head that aren't absolutely correct. I'd rather it be appraised first by what I can see is a pretty educated audience before it's found by prosepctively everyone who searches for 'peak oil' on Google first.

Cheers

Mark

I believe VMA is correct

it works this way

say there is only one bank in the world that is the resevoir for all the money in the economy. ie there is no hard cash and money lent out is immediately just transfered from bank account to bank account. (Not a bad aproximation for modern banking system).

Given that there is a 10% reserve requirement, and the bank has "real" money in the vault of 100$ (this is the reserves). The bank can in effect lend out 900$. First lending $90 to Bob. Bob now deposits this money in the bank. The bank then lends 81 dollars to Charley who deposits in the bank. The bank can then lend out $72.9 to David who deposits it back to the bank. The bank can then lend $65.61 to Emily...... and so on.
If taken to infinity the bank will have lent out $900. Ie The bank "system" created the money. The individual bank still has to balance the books and can not lend out money it hasn't borrowed from a depositor.

Now when you have multiple banks it does't fundamentally change the system. there will just be paper exchanges between the different parts of the banking system. Where did the original $100 come from? The government makes it by selling a bond to the central bank. The central bank never intends to redeam this money and in essence the government recieves free money from the central bank. However compared to the overall budget for the government the annual free money it receives from the growth of the money supply is not that large, and it is hidden in the government books by the polite fiction that the central bank could in theory redeem these bonds.