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Source link: http://archive.mises.org/13670/what-does-debt-based-money-imply-for-interest-payments/

What Does “Debt-Based” Money Imply for Interest Payments?

August 23, 2010 by

My modest point in this article is to correct the widespread misconception that in a system of “debt-based money” further rounds of inflation are mathematically necessary to avoid default on previous loans. FULL ARTICLE by Robert P. Murphy

{ 80 comments }

J. Murray August 23, 2010 at 8:11 am

A more simple explanation – arguing the necessity of new money to pay off interest assumes that the recipients of the interest will do nothing but sit on it.

G. Franklin August 23, 2010 at 12:08 pm

Not exactly. The argument that money isn’t necessary requires that the lender spend 100% of collected interest. There are two possibilities:

1. Smith spends 100% of collected interest. Then, no new money is required.
2. Smith spends less than 100% of collected interest (eg. he sits on some or lends some.). Then, new money would be required to prevent default/slavery.

Since 100%s never exist in the real world, it seems that new money would always be required even if this is not “mathematically necessary”.

Matt C. August 27, 2010 at 7:29 am

Money as Debt II
http://www.youtube.com/watch?v=_doYllBk5No

Further information on the circular flow fallacy:
http://paulgrignon.netfirms.com/MoneyasDebt/disputed_information.html#disputed2

I don’t agree that we should hate gold, like the documentary says, but the argument against debt-money is basically an additional argument for a commodity standard.

arnoll August 29, 2010 at 8:32 am

3. Smith spends more than 100% of collected interests (takes a loan).

Empirically, over time, 100% seems to be the case.

Alex August 23, 2010 at 9:57 am

Even though, as Prof Murphy argues, under our current monetary system, if all debt were extinguished there would be a zero money supply (except for coins, which are sold by the government), what would be the government’s incentive to allow a zero money supply? In other words, though Prof Murphy’s scenario of a zero money supply is theoretically possible under our current monetary system, practically speaking it would not occur.

J. Murray August 23, 2010 at 10:15 am

Zero FRNs maybe, but money won’t just vanish because people will make it a point to use something else.

exile August 23, 2010 at 10:13 am

Thanks Dr. Murphy,

I posed a similar question a while back and didn’t really get a satisfying answer:
http://mises.org/Community/forums/t/3375.aspx

So if I understand correctly, the interest payments come by “borrowing” that money “at 0% interest” from the “lender”. The “lender” gets some kind of good or service in exchange for their “0% interest loan” which explains why they would ever want to do this kind of “loan”

J. Murray August 23, 2010 at 10:18 am

Why not? That assumption only works if the money itself is the end-desire. We use money to buy goods and services. Very few people stockpile money for the purpose of just having it. We all want things and saving money is what we do when we want to use it for something later. If the lender can skip a step in the process and straight barter for the good or service he would otherwise spend the money on, he would do so. The only reason a lender would refuse interest payments of a good or service he would otherwise want is if he wishes to utilize that money at a later date.

gene August 23, 2010 at 10:42 am

Why would the debtor want to borrow money only to have to “work” for the creditor to repay it? it seems to assume the disadvantaged position of the debtor, which of course is accurate.

The debtor [in a free system] would only want to borrow capital in order to earn a return. But with interest, he can’t even pay his own wage without paying more back to the creditor.

If he earns a return, that must come from somewhere, someone else must incur debt, create new money or work for the producer, creating an endless cycle of new debt or labor debt.

If the new product is sold only at “cost”, there is no reason to incur the loan [no return].

It would seem that any capital that collects interest must increase productivity and lower price [not to mention non productive capital must extinguish]. which in turn would lower both wage and return to capital until the absolute floor is reached. If not, we just go round and round until the other extreme is reached, infinite labor and interest debt.

J. Murray August 23, 2010 at 10:57 am

The example was provided by removing the intermediarty trade good (money) from the equation. The problem is you took the example on a too literal sense. In a two person economic system, would this work out well? It wouldn’t. Then again, in such a system, there wouldn’t be money as there is no longer a problem of impossible multi-lateral trades.

In a complex economic system with billions of actors, the situation presented isn’t exactly going to happen. Your Reducto ad Absurdum won’t work here. People have different preferences to hold onto money. The debtor doesn’t literally provide labor direct to the lender. But he still works, still produces, to pay back the interest.

The lender still spends the interest by purchasing something in the economic pool that the borrower contributed to. Your Reducto ad Absurdum can only work in the impossible case that all economic actors demand repayment of all debts at the exact same time. Due to time differences, such activity never lines up. Some other actor provides money to the borrower, pays off the lender, and the lender then spends the interest back into the market pool.

Money won’t just thin out indefinitely. You assume the interest rates will remain static. As the monetary system is thinned out by obligations, interest rates for unobligated funds will increase until it reaches a point no one wants to borrow anymore. The debts are then paid down via trade, debts are dissolved, removed from the system, then borrowing can proceed again as the unobligated funds pool is replenished.

Eric August 23, 2010 at 11:38 am

I too once had this debate. It took me a few weeks to sort things out. Here’s a few of the other things I came up with:

1. If all debts were distinguished all at once, then a new commodity would become money. We’d be back to the state of the economy just before barter transformed into commodity money.

2. If, instead, more debts are repaid than new loans, over time the money supply would shrink and therefore the value of the money would increase and fewer dollars would be needed. It’s the same argument Rothbard uses about the total stock of a commodity money, such as gold, not needing to change.

3. When the borrower needs to find the additional money to repay the loan PLUS interest, he creates some new wealth which is traded to someone else for money, e.g. he makes some bread. This production offsets the interest payment.

As long as this new production exists, the ratio of the supply of existing dollars (so far unchanged) to the total productive wealth in the economy is slightly less. This increases slightly the value of each unit of money. (But not immediately in a large economy).

If the production is a consumable that is extinguished (e.g. food) then, when it is gone, the ratio of the stock of money to wealth adjusts back. It’s the same as if the borrower simply pays the interest in his new production of bread and the lender then consumes it.

If the borrower instead does a service to repay the interest, that service is “consumed” by the lender and it’s the same result – except the lender is theoretically happier by the service. Or, he can use the freed up time to create new wealth etc.

gene August 23, 2010 at 11:44 am

okay, that makes sense.

but, if the interest is greater than the value created, then the ability to pay back will grow increasingly smaller which will entail creating more debt [out of nothing or out of labor or product].

so it would seem the interest has to creat greater value [or at least equal including interest], more productivity, etc, or it is creating greater debt [less value].

in other words, for the system to be productive and freely competitive, capital must be productive and competitive. once you remove that, you create debt and obligation without the corresponding value. so, if you “gaurantee” the return to capital in any form and the enterprise is unproductive [or the rate uncompetitive] then either labor debt or monetary debt is created.

Interest is due to capital and the return of principle is due when the enterprise is productive and produces at least equal value. If it is non productive, then the return of interest and possibly principle, depending on the degree of loss, is a loss to the system. the debt must be repaid thru the future loss of value. basically, the mention in your article of the bank taking from the community becomes reality.

If this cycle continues, its possible no matter the increase in productivity, the product becomes increasingly devoted to repayment. ‘good money after bad’.

as long as the return to capital is based on its productiveness and not forced repayment or gaurantee, then everyone benefits and interest [and debt] is warranted.

no different than a lazy worker who still gets paid. if there is enough of them the firm goes under. if you gaurantee all the lazy firms with lazy workers, then at some point, there is not enough product to go around. if lazy capital keeps getting paid, same result.

J. Murray August 23, 2010 at 1:20 pm

Again, not a problem. This is making the assumption that absolute prices and wage rates must remain the same or increase. Prices can downward adjust over time as the end concern is not how much money you get for the product but what you can buy with that money. Improvements in productivity will result in lower and lower demands for capital as it now takes less to produce the same or more. Further, the interest rate issue again comes to play. There will not be a death spiral so long as there isn’t a force manipulating interest rates on the fixed money supply. The more debt taken on by the system results in higher and higher interest rates, which in turn shuts down borrowing.

Further, this also assumes that borrowing is absolutely necessary for expansion and growth. Since debt is not a necessary precursor to growth, business can continue to expand despite high interest rates. That’s all debt is – one party managed to save up resources to lend to others. It doesn’t say that the party wanting to expand can’t build up its own resources for such a purpose.

Eric August 23, 2010 at 1:46 pm

“If it is non productive, then the return of interest and possibly principle, depending on the degree of loss, is a loss to the system. the debt must be repaid thru the future loss of value. ”

If the borrower does not repay, or repays only a portion, then the loss is primarily to the lender. If the borrower squanders the loan, but still repays, the loss is the borrowers. In both cases the result is less “stuff” available in the world. The ratio of money to stuff changes slightly and this will eventually be seen in a slight change in the purchasing power of money. (I assume here for the analysis that demand for money and the supply of money remain unchanged.) It is in this sense that there is a loss to the system overall. But the loss is mostly felt by the lender or borrower.

Also, there is no intrinsic value of stuff (or money). All value is subjective, in the minds of humans. What changes is the RELATIVE value of one stuff (and money) to all other stuff. And this is generally different in each human mind.

I can visualize this when I look at one of my stock tools, a depth chart, which shows how many bids and asks of varying prices there are for a particular stock. The gap between them tends to be the “current” market price. As this gap moves left and right, the current price changes.

There can also be loss of value WITHOUT any corresponding loss of stuff. If I simply tire of something, say a piece of music, then it’s value drops – even though the product still exists. In this way, something is NON PRODUCTIVE only in the minds of humans. It depends on how humans subjectively value the end product of a process of production. Oil was once considered a slimy mess that got in the way of other useful things.

pussum207 August 23, 2010 at 12:19 pm

Hi Bob.

I am wondering whether an alternate, and perhaps more general, way of saying what you have in this post is as follows:

Even if, consistent with general Austrian practice, the level of the interest rate is assumed to be determined by time preference, the sustainability of a positive interest rate requires an expectation of productivity growth. In the presence of a fixed money supply (or monetary equilibrium with a non-fixed money supply), growth in real output requires a decline in the average price level. Some of the fixed money supply previously devoted to previous levels of output at previous prices is thus “freed-up” and can be allocated to the new output and to the payment of interest.

Is this not right or am I missing something?

Smack MacDougal August 23, 2010 at 12:43 pm

With every article, Robert P. Murphy becomes ever more like Paul Krugman.

First, Robert boasts, “…I explained the sense in which our fractional-reserve, fiat financial system is built upon debt-based money. In this perverse arrangement, new dollars come into existence through the creation of government and private debt.”

Of course, all Robert did was put into his writing, his false beliefs about money creation. In truth, money accretion — new notes and coins joining existing ones in circulation — based on demand to hold cash and by no other means.

Robert’s claim that “…if the private sector and the federal government ever began seriously paying down their debts, the supply of US dollars would shrink.” amounts to foolery with zero basis in economics.

Robert makes another crazed, false belief claim when he expresses, “Although it’s true that if everyone tried to pay back his or her debts at the same time, the world would “run out of dollars.”"

His claim is laughable. It’s been well-known and proven since the late 1800s, that the amount of commerce arises independent to the amount of money in circulation.

The amount of dollars extant in the hands of people arises strictly from their want to hold cash over using credit instruments.

Robert goes forward with another expressed false belief when he claims, “In our fractional-reserve system, commercial banks literally create new money when they advance new loans to borrowers.”

Commercial bankers buy money and debt by selling other debt based on their credit. In doing so, these bankers increase the efficiency of money. They act no differently than the retailer who buys Ralph Lauren shirts on credit and then paying on this revolving credit with cash and credit gained through sales.

Many who have attacked Paul Krugman have called for Krugman’s Ph.D. to be stripped from him. Perhaps it is time to make the same demand from all who lack a true knowing of economics — all relevant matters of man regarding wealth; and no, it’s not the “science of scarcity.”

JGIles August 23, 2010 at 1:09 pm

Ok Smack, let’s try this one more time. When someone on this site says “money”, they do NOT, repeat, do NOT mean only coins and bills. They mean the total MONEY SUPPLY, which includes a great deal of what you refer to as “credit instruments”. Your strangely narrow definition of “money” once again makes you out to be an idiot.

Since that’s so, your sneering comment has exactly zero relevance to this article, and indeed zero truth behind it. Try thinking about it again, this time including the ENTIRE money supply, and see if you can work out what Murphy’s saying. Use pencil and paper if you need to.

Smack MacDougal August 23, 2010 at 11:51 pm

You amuse JGlles,

Mere words have sent you into out of control rage.

That you lack a suitable intellect to get a fiduciary money and credit system is not my responsibility. That you lose control and resort to name calling reflects upon your characters and thus your upbringing and your breeding.

Good luck with your freak outs as you struggle to navigate through your living.

JGiles August 24, 2010 at 6:57 am

You don’t understand, Smack. I’m not calling you names because I’ve “lost control”; I’m calling you names because I enjoy pointing out foolishness whenever I see it. Perhaps someone will notice, and not make the same mistake you are making.

Your incomprehension of the simple fact that credit = money sadly cripples your ability to understand economics. It makes it quite annoying when you come to a serious economics site, say something utterly false based off of your incorrect understanding, and then loftily dismiss those who correct you.

Smack MacDougal August 24, 2010 at 11:00 am

You amuse, JGiles. Again!

Look at you go, backpeddling!

Your comments reveal intense paranoia that evil bankers have pulled a fast one over Americans conjuring money from thin air. Meanwhile, only the U.S. Treasury has legal authority to mint money.

You conflate money with credit simply because both entities have the power of purchasing. Sadly, even the great Murry N. Rothbard made this mistake.

In short, you don’t get money, credit, commercial banking, central banking and thus the whole of economics.

Yet, keep trucking on with your amusing false beliefs. You provide much entertainment for the rest of us reading these comments.

Matt C. August 27, 2010 at 7:56 am

“His claim is laughable. It’s been well-known and proven since the late 1800s, that the amount of commerce arises independent to the amount of money in circulation.”

Not when investments come from nominal debts. Maybe private banks could offer inflation-adjusted debt repayment given their own measures of general inflation or deflation in the economy?

As for the innocent bankers argument, I think it’s a bunch of garbage:
http://mises.org/books/desoto.pdf
http://mises.org/journals/qjae/pdf/qjae1_4_2.PDF

Besides the malinvestment, the free banking people forget that private citizens could print the money that private banks could, creating debilitating inflation and unstable currencies outside the bank’s control, unless you start granting monopoly privileges to bankers through the state. People would print bank money instead of work for it. Why should only banks get to do that? FRB is a fraud, plain and simple.

“increase the efficiency of money”

Cute. Very cute!

Zorg August 23, 2010 at 1:34 pm

“Commercial bankers buy money and debt by selling other debt based on their credit”

How does that (whatever it means) refute the fact that banks create money?
The supply of “dollars” used to be measured in millions, then billions, now
trillions. Where do they come from?

Is this your answer?

“Of course, all Robert did was put into his writing, his false beliefs about money creation. In truth, money accretion — new notes and coins joining existing ones in circulation — based on demand to hold cash and by no other means.”

Oh, I see. It’s not “money creation,” it’s “money accretion”. Genius.

Oh, and it’s not caused by the system but by “the demand to hold cash”!
Always blame the victim.

Ha. This is hilarious! What you mean is that if people withdraw cash, then
the fraud of FRB is exposed, so then they must meet the cash demand
which they promised but can never legitimately meet since it was “loaned” out.
Yeah, it’s called being caught in a lie. There isn’t enough money
there for the depositors to take out in the first place. That’s the whole
scam.

Smack MacDougal August 23, 2010 at 11:57 pm

Bankers do not create money. Bankers buy money with credits. People who use the banking system call forth cash and it is this act alone that creates money.

Money accretion means new notes and coins joining in circulation with existing ones. It’s not money creation.

Money is mere notes and coins. All else are contracts that get settled in money.

No nefarious scheme is being conducted by anyone. While I am not a fan of central banking or fiduciary money, it is not a scam. Persons who believe so, believe so because they do not get money, credit, banking and central banking.

DD5 August 23, 2010 at 1:50 pm

Smack,

Smack yourself in the head because you’re an idiot.

Smack MacDougal August 24, 2010 at 12:01 am

You amuse DD5.

Mere words made you react as a puppet gets pulled from its strings.

You display the weakest mind, above all, as you seek to gain status within the group by attacking the outsider (me) who holds the dissenting opinion.

Ah, group dynamics makes human behavior so predictable.

The Kid Salami August 23, 2010 at 3:45 pm

“Commercial bankers buy money and debt by selling other debt based on their credit”

You’re on another thread now giving the same “argument” while refusing to define what you mean by “money” or “credit” or, well, anything really. This really is unseemly. Would you mind giving us your definitions so we can get a look into your reasoning?

“It’s been well-known and proven since the late 1800s, that the amount of commerce arises independent to the amount of money in circulation.”

And please point out where I can read this “proof” you refer to.

Eric August 23, 2010 at 3:57 pm

I’ll merely add that I used to wonder at how so-called economists like Paul Krugman could win a Nobel Prize. Then I discovered that there IS NO NOBEL PRIZE IN ECONOMICS.

Rather, what’s called the Nobel Prize in Economics is actually a prize in economics in memory of Alfred Nobel.

And who funds it? Why a bank in Sweden. The CENTRAL BANK of Sweden. Sveriges Riksbank, Sweden’s central bank.

That ought to explain why they gave one to Krugman, the propagandist for Keynesian fractional reserve banking!

szh August 23, 2010 at 12:45 pm

Can’t we simply assume 5% default rate in 5% int rate in the economy. Some do collect interest some don’t even collect principal and recover partially through property repossession. Mathematically defaults should be source of interest for those who manages to collect interest. Another source is equity investment where dividend rate even unknown in advance. Overall the system will survive, won’t it? Suppose the system is 100% equity financed. Some will loose equity some will increase stakes. Economically debt is not very different, there is only legal difference i.e. the way property goes to most effective hands.

Zorg August 23, 2010 at 1:07 pm

I get the point about interest here, but what about this statement:

“When Sally pays back her business loan, that $900 is extinguished; the community’s money supply (measured by aggregates such as M1 and M2) will drop by $900.”

Are you failing to distinguish between stock and flow here? Gary North
wrote an article a while ago addressing this point of money being “extinguished.”
Loan balances are extinguished, but the money previously created still exists.
It’s just an asset of the bank now. It’s part of their reserves. It will get loaned
out again, or perhaps they will sit on it for awhile.

When you say “the community’s money supply…will drop by $900,” I assume you
mean that this money no longer flows “out there,” but is socked away by the bank
as reserves. But it doesn’t disappear. So if “everyone paid all debts down,” then
money would move from debtors to creditors. People can be both. Ultimately, at
any given time, they are either net creditors or net debtors. So let’s say all debts
that can be paid are paid, and no more loans are allowed to be issued until ALL
debts are paid or have defaulted.

Is this not just the “deleveraging” and “unwinding” of credit? How does any
*money* previously created as “dollars” by the banks somehow cease to exist? Granted, banks
might fold due to being over-leveraged, but it just means that they couldn’t
extract the money from the debtors fast enough to pay off their creditors. And
there’s a chain reaction, so other banks might fold because they couldn’t get
paid. But somebody out there has those “dollars”. So it all shakes out in terms of
each person or entity’s stock, but this money is never “extinguished”. And during
this process, obviously credit will cease to flow and money will be harder to come
by because it all goes to pay debt.

So your statement about money being “extinguished” is using the term “money supply”
to refer to the amount of money flowing in the economy, right? If so, you should not
use “extinguished” at all.

If I am confused on this point, and money in this system is in fact regularly extinguished,
please enlighten me. But when I say “the money supply,” I’m thinking of all the money
ever created that is out there somewhere. If people just mean that less money
is flowing for goods and services at the moment because it’s being diverted to pay
down debt, then they should clearly distinguish this from the concept of money
disappearing into a black hole.

I think people misunderstand all this because of the concept of money being digital
nowadays. So if it’s digital, then it must pop out of existence at some point as easily
as it popped in, they think. If it’s the case that this is built into the system, I don’t see
it. It would happen if people abandoned the system en masse simply because it would
no longer be regarded as money, in which case it would be a remnant of a previous time
like old bonds and other IOUs people find in attics, basements, and vaults. But as long
as people hold “dollars” as money, I don’t see how they disappear just because various
balances are wiped out throughout the system.

Money just changes hands.

Am I right or wrong?

JGIles August 23, 2010 at 1:24 pm

You would be right, except that banks do in fact literally create money.

When a bank makes a loan, this is essentially a promise to your credit card company that the bank will pay them. You purchase something, the credit card company pays for it, the bank pays them, and you pay back the bank. Do you notice that you’re on that list twice?

You see, the bank promised to pay for, say, up to $500. And you “spent” $500. But the bank doesn’t have $500, it only has $50.

So what happened is that the bank, yes, created $450. It promised ten times more than it could deliver. When the credit card company comes for the money it was promised, the bank gives THEM credit, too.

So the bank started with $50. Right now, the bank has guaranteed $450 to the credit card company over and above what it has, and you’ve guaranteed the bank $500 plus some interest. Then you make your profit on whatever it was you borrowed the money for, and pay back the bank.

Now the bank has $500 plus some interest (say $20) and the credit card company has $500 of credit from the bank. Right?

So, wait. The bank started with $50, you started with nothing. Now there’s a total of $1020 in the system. $520 came from you, that’s the money you made and paid back to the bank. Where’d the other $500 come from? Thin air! That’s what “credit” is; it’s money out of thin air, pulled forward from the future to be used today. It’s a promise to pay, which banks make without actually having the necessary funds. Since credit is treated the same as money, making a promise without having any cash to back it up effectively does increase the supply of money, for a short time.

Zorg August 23, 2010 at 1:52 pm

Ok, I’m calling credit-money “money” because it is treated as money by the
system and by us. We use it as money. There is a stock of it out there
regardless of how it came to be. After it exists, it’s existence does not
depend on the fact that it is owed. It will not cease to be just because it
changes hands.

I’m only addressing the question of how it ceases to be. I don’t see how
it’s built into the system that this money is ever “extinguished” like a
loan balance is. That’s just an account. The “dollars” live on.

I’m talking about how the system works here and don’t want to get off
track by arguments over whether “dollars” are *really* “money”. Obviously,
this is all a scam, but it exists and we use it as money, so I’m only addressing
here from that standpoint.

Do dollars ever go back to where they came from? I don’t think so, as I said,
unless the system is abandoned.

JGIles August 23, 2010 at 2:12 pm

Go back to the example. I’ll assume no interest just to make it simple.

The bank has a deposit of $1000. It then makes a loan for $900. Let’s use physical metaphors and say that it gives the loanee a piece of paper that says “$900 payable on demand from _______ Bank.”

The loanee spends the loan of $900; it enters the broader economy. This money LEAVES the bank, as it is redeemed by the new holder. They then make $900 somehow and give it to the bank; that is, they take $900 OUT of the broader economy, equaling the $900 they put IN.

The bank says, “Ok, $900, that clears your debt!”, take the $900, go to their ledger books, and line out the part that says “$900 owed by ____”. Then they put the $900 back in their vault. At the end, the bank is back where we started.

But there was a period of time in there when the bank still had $1000 AND the loanee had $900. That is, $900 was created; and then it went away. Money was created and then destroyed.

gene August 23, 2010 at 1:31 pm

I don’t think you are wrong or right.

wouldn’t it have to be the “value” created, the money is irrelevant. the money can cause inflation or deflation, etc and can effect value, but the cruz is the value.

if interest causes the value of goods, products, services to shrink due to lack of real [value] return for the interest [and the forced payment of interest in present and future product], then eventually the society can run out of product. there will be nothing left to pay back the banker with and nothing for the banker to buy, no matter how much “money” he has accumulated. the interest on total debt will have exceeded the productive capabilities of the economy, even the “future” productive capabilities. the productive sector will be in eternal bondage to the financial sector [sound familiar?].

so, the interest must be productive and not imagined. capital must experience and feel the effects of risk.

if you gaurantee the repayment of capital, you gaurantee that some portion of that repayment will subtract from the overall productivity and creation of value. real free market interest then would be dependent on increased productivity and increasing purchasing power, which continually drives the rate of interest downward.

Eric August 23, 2010 at 4:33 pm

Money is created by a loan and extinguished by a repayment of that loan. That single loan transaction balances.

But if for every 10 loans repaid, banks make 11 new loans, and this happens over decades, then the quantity of money in existence will increase over that time.

How can a bank keep making more loans than are repaid? The Central Bank creates more money which it uses to buy stuff by writing a check. The sellers of that stuff then deposit the central banks check into the commercial banks. This raises their reserves and so they can loan still more money.

Zorg August 24, 2010 at 1:15 pm

“Money is created by a loan and extinguished by a repayment of that loan. That single loan transaction balances.”

The individual accounts of borrowers being paid down doesn’t convince me that
the money previously created was ever actually destroyed though – except in that account. I see the money the way the system does – that is, fungible. A digit is a digit is a digit. There is a pool of reserves which is the system’s money. That pool is either growing or shrinking in any particular bank, and that’s the thing that either triggers or halts new loan-making. The paid-off loan NECESSARILY increases reserves which will trigger new money creation through loan-making according to whatever the ever-changing regulations are at any given time.

The system is designed to do this. Therefore, this is what it IS. It is a money
creation machine. What is being described as money destruction is a necessary part of
the perpetual money creation. It’s just moving digits around in cyberspace, that’s all. It’s the flow that creates their interest profit, and it’s why they are in business by gov’t grant of
a license to do this sort of thing.

It’s like breathing. I “stop breathing” only to breathe again. When I *really* stop
breathing is when I stop breathing for good!

So the money flows from the borrower to the borrower’s debit account to the
bank’s reserve account to a new borrower. Where was it ever destroyed? If we are saying that it blinked out of existence in the borrower’s loan balance only to immediately re-appear in
the bank’s reserves, then it’s “destruction” is entirely a moot point, is it not? It’s
just accounting, which is only a representation of reality at a point in time, not reality itself.
The map is not the territory.

This kind of money will be destroyed only when this system stops being the
system that it is. This may happen through legal reforms which force money
destruction by setting much higher reserve requirements over time as old
loans are paid off and new ones are reduced, or it may happen through the
abandonment of the system either partially or in toto.

Unless the system stops being the system it is designed to be, it does NOT
destroy the money it has created, for the simple reason that money is
fungible. It recycles it over and over.

Smack MacDougal August 24, 2010 at 12:34 am

You are right, mostly.

Ignore the others who tell you their false beliefs when they make silly claims that bankers create money. Bankers NEVER create money. Bankers BUY money and debt by selling credits (debt).

Paying off a loan (contract) to a banker has no effect on money in circulation. Nothing happens to extant money. Money in circulation arises solely from those who want to hold cash and not use ATM debit cards, checks and the like, all of which are contract instruments and not money.

It is not often when money in circulation falls, but it happens, e.g., money fell from $924.7B 11-30-2009 to $920.6B on 12-31-2009 (see http://research.stlouisfed.org/fred2/categories/25 ).

When anyone pays off a loan (contract) to a banker, the banker loses a performing income instrument and nothing more.

When persons say Money Supply, in truth, they should say Money Supplied, that is credit extended by bankers. For wherever you have money supply you must have money demand, the clearing price of which is interest.

There is only money (legal tender banknotes and coins). All else are contracts of credit. What fools nearly all into false beliefs that particular credit instruments are money is the speed at which contracts clear, e.g., the ACH for checks, ATM withdrawals.

The Kid Salami August 24, 2010 at 4:56 am

“Money is mere notes and coins.” you say. Ok. But prices are determined from the “notes and coins” AND the BLANK (we don’t have a word for this yet) that people have in the bank accounts ,are they not? That is, people have a number X assigned to them, measured in units of dollars (ie. the same units as the “notes and coins”) by the bank and this number allows them to act in every transaction AS IF they had X dollars of “notes and coins” in their pockets. Alternatively, if people had all the $X worth of BLANK transferred to “notes and coins” and their bank account closed, they can act AS IF they still had the $X worth of BLANK in every way. Agreed?

So, just looking at the prices of goods and services for now, these prices are dependent on the supply of “notes and coins”+ BLANK – and I suggest that insofar as they are relevant to prices, “notes and coins” and BLANK are interchangeable. Do you agree? That is, if everyone used checks instead of “notes and coins”, and all “notes and coins” were destroyed, then the prices would stay the same, yes? Similarly, if all bank accounts were destroyed and every used only “notes and coins”, then prices would not change. Do you agree?

Or, you tell us, what would happen to prices if all “notes and coins” went out of circulation tomorrow and everyone used checks?

Smack MacDougal August 24, 2010 at 11:26 am

In spite of you being a jerk on the other blog comment thread, you have won a slight reprieve.

I am going to give you a quick, but all-important lesson.

There is one great, invariant law in economics, the Law of Prices, which dummies mistakenly say “the law of supply and demand”.

It’s the winning bids of demand in the face of supply that sets the prices of things and not “… prices are determined from the “notes and coins” AND the BLANK” as you say.

Yet, what you seem to be grasping for, Kiddo, is this label: Economic Quantities of Purchasing. There is only money — notes and coins — and credit.

Checks drawn on checking accounts and ATM cards are not money, in spite of the amazing speed at which bankers resolve these contracts. How do we know this? Both instruments lack bearer negotiability. Merchants, BY LAW, can refuse to accept checks and ATM cards as means of payment. Often, merchants do this, exactly.

What people have in their bank accounts are bank credits, debts owed by bankers to depositors, under contract. Depositors have mere right of action against bankers. This is what depositors buy when they sell their deposits to bankers.

How do we know this? Any banker who fails can get sued by a depositor for the amount of money that banker no longer can pay to a depositor. Yet, no court in the U.S. guarantees that the plaintiff depositor can collect against his right of action. FDIC is mere insurance funded by a pool of bankers and ultimately, taxpayers.

Austrian School of Economics economists get money, credit, commercial banking and central banking oh so wrong because they conflate money with credit. Because they do not get commerce and law, their analysis fails.

Zorg August 24, 2010 at 1:37 pm

“Austrian School of Economics economists get money, credit, commercial banking and central banking oh so wrong because they conflate money with credit. Because they do not get commerce and law, their analysis fails.”

No, it’s just that you can’t distinguish between a voluntary economic exchange and a hold-up, or discern the difference between real money and counterfeit, or real credit and counterfeit.

The Kid Salami August 25, 2010 at 4:48 am

“In spite of you being a jerk on the other blog comment thread, you have won a slight reprieve.”

I’m honoured.

“It’s the winning bids of demand in the face of supply that sets the prices of things and not “… prices are determined from the “notes and coins” AND the BLANK” as you say.”

You can dance around this all day – but you didn’t answer my very direct questions. If you tried to play monopoly with money which had lots of zeros added on or taken off the money amounts as they are in the box, you wouldn’t be able to without changing the prices – it wouldn’t make any sense if the first person could buy every property on the first turn, or no’one had enough money to buy any properties. You can try this at home. The prices have to adjust. It’s hard to tell exactly what you think, what with you garbling the english language half of the time, but if you’re saying that prices don’t think prices have anything to do with amount of money in circulation like I think, then you are an idiot.

As “the stuff with which people use as a means of exchange when buying goods and services (and, consequently, which people use as the unit in which the price of these G&S is measured)” is too long, it might be nice to have a word for it, say MASKETBALL. It doesn’t matter what the word is, just that we agree – you might not like us using the word “money” for this, but I don’t like you using it only for “notes and coins” either.

The word “credit” should be reserved for another scenario to which it is more suited – when someone takes their own MASKETBALL out of circulation and makes it available for a certain amount of time to someone else (for a fee most likely). This means the overall amount of MASKETBALL is the same, therefore putting no definite pressue up or down on prices. Bankers lending out fractional reserve money are NOT doing this – money from “thin air” then is a way to mark this distinction, between money saved and then lent out and money simply brought into existence by the bank pyramiding on its deposits of actual “true” savings.

This is the better distinction to make – you are putting the distinction in a confusing place, one which relies almost arbitrarily on how much “notes and coins” people want to have in their pockets out of their total “cash balance” as Rothbard puts it (the cash balance being the “notes and coins” plus BLANK)(not arbitrary at all).

“Checks drawn on checking accounts and ATM cards are not money, in spite of the amazing speed at which bankers resolve these contracts. How do we know this? Both instruments lack bearer negotiability. Merchants, BY LAW, can refuse to accept checks and ATM cards as means of payment. Often, merchants do this, exactly.”

Whilst I don’t agree with your use of the word “money” for this, I already accepted that there is a distinction to be made between “notes and coins” and BLANK if you want to make it, that’s why i said specifically to stick with prices and adjusted my vocab just for you. So why are you explaining this to me again? Is it because you are a machine aiming to pass The Turing Test and only have a set number of phrases for your responses? This would explain a few things.

“What people have in their bank accounts are bank credits, debts owed by bankers to depositors, under contract. Depositors have mere right of action against bankers. This is what depositors buy when they sell their deposits to bankers.”
How do we know this? Any banker who fails can get sued by a depositor for the amount of money that banker no longer can pay to a depositor. Yet, no court in the U.S. guarantees that the plaintiff depositor can collect against his right of action. FDIC is mere insurance funded by a pool of bankers and ultimately, taxpayers.”

Lather, rinse, repeat.

“Austrian School of Economics economists get money, credit, commercial banking and central banking oh so wrong because they conflate money with credit. Because they do not get commerce and law, their analysis fails.”

You, Smack “Smack” MacDougal, make me pine for michael the douchebag, and that’s a phrase i never thought I’d write. I’ve never met anyone so cocky on here who thought prices had nothing to do with the amount of money (sorry, the amount of “notes and coins” plus BLANK) in circulation and who said dollars weren’t fiat money because the government do not “decree the value of a U.S. dollar”,

http://blog.mises.org/13586/is-our-money-based-on-debt-2/#comment-714258

even though this, erm, isn’t what “fiat” means.

And you have a ridiculous name which clearly you think is cool but sounds like it is drawn from a 1930s disney film.

Smack MacDougal August 25, 2010 at 11:55 am

You amuse, The Kid Salami.

Your hide-your-identity screen name fits you, perfectly. And your sloppy, lame mishandling of the ad hominem amuses. What little kiddie you are.

No one has danced around anything. In short, you do not get economics. You struggle to grasp anything about economics because you ignore the bedrock law of all of economics — the Law of Prices.

Clearly, you suffer from mind disorder and are mentally unstable. You quote at length from nothing I wrote — “the stuff with which people use as a means of exchange when buying goods and services (and, consequently, which people use as the unit in which the price of these G&S is measured)” — thus, you hallucinate.

You are like many who have access to the Internet in the 21st century. You are angry because you are scared and confused. Thus, persons much smarter than you rile you up with bogey men enemies — the evil bankers.

Whenever anyone like me tries to help you, you resort to rather lame ad hominem attacks.

Enjoy your false belief living, kiddo.

JGiles August 25, 2010 at 12:07 pm

Can we have a slow clap for Smack McDougal and his invincible arrogance, please?

Beefcake the Mighty August 25, 2010 at 12:14 pm

Smack MacDougal is the intellectual equivalent of a hairy milk-dud.

The Kid Salami August 27, 2010 at 6:50 am

That is truly the very lamest of responses.

Zorg August 24, 2010 at 2:25 pm

“Bankers NEVER create money. Bankers BUY money and debt by selling credits (debt).”

And don’t forget this one:

“Logic is a wreath of pretty flowers which smell bad.”
– Mr Spock

DayOwl August 23, 2010 at 1:15 pm

While paying back the loan might reduce the money supply, something now exists that didn’t before. Sally borrowed and paid back $900. In between she created something new, something that hopefully has value. The money may theoretically no longer exist, but the good purchased with that money does. It isn’t quite zero-sum.

Smack MacDougal August 25, 2010 at 12:34 pm

You’re on the right track. Nothing is reduced.

As Sally pays off the principal of her loan, the makers of whatever she bought earned income; more stuff materialized into the economy; and even the bankers earned a little scratch for taking on the danger that Sally might not pay back the bankers.

The money supplied — credit outstanding — gets reduced, most likely, temporarily. Yet, nothing has happened to money (notes and coins) itself.

Now, bankers now own more cash to rent in the form of loans.

Ignore the paranoids who lack the intellect to get money, credit and banking, DayOwl.

pbergn August 23, 2010 at 5:40 pm

The article is simply wrong:

FRB does not create new money… What it does is merely redistribute the money from the market participants with low time preference to the high preference ones at a profit…

In order to create new money (thus, inflation), the total quantity of money in circulation must increase, e.g. by printing more physical bank notes, or bumping up balance sheet numbers on computers owned by FED, etc…

Chris Cook August 23, 2010 at 6:08 pm

I prefer to use the phrase ‘deficit-based’ to describe the money created by credit intermediaries aka banks.Banks create credit when they create interest-bearing loans, and at the same time they create a matching demand deposit.

But banks ALSO create credit -and a matching deposit – when they pay suppliers; staff; management; and dividends to shareholders – as well as when they acquire assets, such as buying T-Bills from the Treasury.

It’s not just banks who create credit, of course. Any seller of goods and services may give customers ‘time to pay’ by accepting their IOU. If A gives an IOU to B and C then accepts A’s IOU from B in exchange for goods and services, then the outcome is a monetary system where goods and services are changing hands not FOR (say) dollars but BY REFERENCE TO dollars as a unit of measure or ‘Value Standard’.

The Ecuadorean Central Bank is currently implementing a ‘credit clearing’ system called Factorepo, where any business registered for Value Added Tax (VAT) may discount its VAT invoices with the central bank for cash now. This will enable businesses to access working capital and reduce considerably the demand for ‘fiat’ dollars in Ecuador’s ‘dollarised’ economy, although all transactions will continue to take place BY REFERENCE TO the dollar.

This is a modern day centralised domestic version of the discounting of bills of exchange which still oils the wheels of international commerce.

Note here this mechanism facilitates the credit necessary for the circulation of goods and services and the creation of productive assets. It requires no deposits, and has nothing to do with the long term funding of productive assets, which does require deposits.

Barter systems such as the Swiss WIR, and ‘for profit’ systems such as Bartercard, all offer credit, and in doing so issue their own currencies eg ‘Trade Dollars’ which are fiat currency look-alikes.

In the case of the WIR, billions of Swiss Franc’s worth of goods and services change hands on credit terms, but no ‘fiat’ Swiss Francs’ are actually used in settlement of credit.

The point is that wherever a barter system incorporates credit the result IS a ‘credit clearing’ monetary system requiring no deposits.

Credit card companies do not require deposits either of course.

The requirement in these credit clearing systems is for a framework of trust in respect of debit balances, and the reason why the WIR is still around since 1934 is that they take security over their members’ property. ie the WIR uses a deficit-based but property-backed currency.

The economic function of a bank as a credit intermediary is essentially to guarantee the credit of borrowers or trade buyers, and to back that guarantee with a fund of capital prescribed by the Bank of International Settlements.

They may therefore create credit and deposits as a multiple of their regulatory capital.

Now that banks may obtain deposits ‘wholesale’ from other banks on the interbank market, reserve requirements have become entirely irrelevant, and ‘fractional reserve banking’ -while often referred to (including on this thread) – is in fact an anachronistic expression.

In carrying out their guarantee function, banks charge ‘interest’. After paying interest to any depositors, banks use the net interest to cover operating costs and default costs, with the balance being profit.

So it is arguably only the excess profit element which creates inflation and drives growth.Finally, the credit crunch was caused IMHO by the fact that banks started to ‘outsource’ credit risk (ie their implicit guarantee) to investors:

(a) Totally – through securitisation;

(b) Temporarily – through credit derivatives such as a credit default swap (CDS) – which is essentially a time-limited guarantee;

(c) Partially – through credit insurance, by the likes of Ambac; and

(d) Toxic combinations of all three like CDOs and CDO squared.

The investors have now gone, never to return, and there is no way therefore that the pyramid of credit risk supporting property prices can ever be rebuilt.

james b. longacre August 23, 2010 at 6:25 pm

is there such a thing as debt based money?? can it imply anything at all??

Tad August 23, 2010 at 6:53 pm

Robert, I have no quarrel with your economic argument. It is theoretically possible from an economic standpoint to have long term growth without inflating the money supply on average over a lengthy period, but the normal ups and downs of the business cycle will from time to time cause that growth to slow and stop, and even contract, while the malinvestment is cleared out of the system and/or interest rates increase to the point where borrowing is less desirable.

In order for this theoretical event to occur however, requires a political system that can allow short term periodic contractions In a system of Keynesian interventionism, combined with a fiat currency system and fractional reserve, this is politically difficult to imagine.

I haven’t worked the math, but I suspect that the governmental authority creating money through fiscal policy can reach a point where tax increases cannot support government operations and service debt, because the taxation results in decreases in productivity, resulting in lower revenues. Once this point is passed, then the sovereign must continue to inflate in order to avoid default on treasury debt. Again, this represents a primarily political problem. I think we are way past this point.

Russell August 23, 2010 at 8:54 pm

Sadly true!

Brendan August 23, 2010 at 7:38 pm

I have become more interested in the legal aspect of the loan under fractional reserve fiat money banking.How does the bank come to charge interest when it does not actually loan any of its own funds to Sally? As Robert Murphy writes:. Then the bank gives Sally a business loan for $900. In the act of doing this, the bank creates $900 more money in the economy; Billy still has his $1,000 in his checking account, but now Sally can go to Home Depot and spend $900 on goods, pushing up prices.
If Billy still has the 1,000, then where did the money come from. OK, its fine to say it came from “thin air” but, isn’t there more to that than saying merely “thin air?”Didn’t Sally actually CREATE the loan with the signature on her application/promissory note? Didn’t the bank then deposit the note as an asset? Then it also created a liability, and called it the principle, and then charged interest on the so called principal.But, legally, the bank cannot say that Sally created the $900 with her signature, but in fact she did. If she created the money, how can the bank charge her interest on money it never loaned her?Isn’t the bank just a broker, and not a lender? Sally cannot take her note to the builder in most cases without the bank converting it into fiat currency. This is because of the power of the state conferring legal tender and monopoly status to the role of the bank. The bank allows Sally to easily put her note into commerce through those state privileges. But, the bank did not loan her the money. In a court of law, their are only two parties to the loan, and the bank cannot prove it loaned Sally the money from its own funds–in fact, it is not allowed to by law. Therefore, Sally loaned the money to herself, or iow she created the money.Therefore, the bank is entitled to a BROKERS FEE, but not to interest. The bank has no right to force repayment of a loan it did not make. Nor can it foreclose on real property.

Russell August 23, 2010 at 9:07 pm

Not exactly. The law and banking agreements allow banks to loan out demand deposits to Sally or anyone else on the theory that all demand depositors will not demand their entire deposit back at once. In fact, since banks are only required to maintain a 10% reserve, they are assuming that only 10% of demand deposits will be demanded back before Sally repays the debt.

And this is normally true except when people get nervous about their money in the bank and there is a run on the bank. In order to lull demand depositors into a sense of security and prevent runs. We have deposit insurance which is insured by the FDIC which charges banks a fee (which depositors and borrowers ultimately pay) to create a cushion in case their is a run on the bank. But is the FDIC cushion is not enough,then the Federal government (taxpayers one way or another) is the backstop.

All this to allow banks to lend money that from an economic standpoint, they should not be lending out because they can’t honor their demand deposit obligation to all the demand depositors. It’s an economic ponzi scheme legitimized by law. But just because it is not illegal does not mean it is good for the economy. It allows people (banks) to lend out money before they have earned it by creating value that is added to the economic pie.

If you think about it, the basic underlying economic principle that we all subscribe to without a second thought is that before we can get money, we have to work to create something people want, whether it is goods or services. We go to work, create the goods and services which are available to the market, and then get paid. So before we can spend the money and share in the economic pie, we first have to add to it. This encourages growth of the pie over the long term.

I doubt anyone would be in favor of a system whereby first we shared in the pie before working to increase it by at least the amount they consume. That is because we know that while many people would do the right thing, many would not. It is an unworkable system. But that is exactly what fractional reserve banking allows banks to do and what the Federal Reserve is allowe to do when it increases its balance sheet. Very bad policy!

Dave Albin August 23, 2010 at 9:43 pm

What the bank really did was to take $900 from Billy’s account and gave it to Sally as the loan. Billy had $100 in U.S. dollars in his account, while Sally then had $900 in her account. On the balance sheet of the bank, however, they still show $1,000 in Billy’s account. If Billy comes to the bank and demands his $1,000, the bank can borrow money from another bank to pay him. Of course, the Fed exists to shuffle money around in the event most everyone in the USA wants their money from the bank.

This is problematic for at least 2 reasons – first, with the Fed existing as a “lender of last resort”, banks take unnecessary risks when making loans, and this can lead to massive bank failures. If the banks could only lend out what they have, with no safety net, the loans would almost all be sound. Secondly, if everyone wants their money out of the banking system, should we artifically keep it afloat? Why not let it die a natural death, and allow some other system to take its’ place?

Smack MacDougal August 24, 2010 at 12:43 am

Brendan, your intuition has you on the right track.

When Billy deposits his $1,000 with a banker, he SELLS that $1,000 to the banker. In turn, the banker SELLS credits to Billy with the total amount of credits equaling $1,000. A contract gets made between Billy and the banker. This is defined in Commercial Law.

While most bankers give money on demand to depositors, they need not do so and can withhold doing so for up to 30 days. Why? Because bankers OWN the money they BUY from depositors and establish contract with depositors under regulation of banking law, such regulation requires bankers to fulfill contracts within 30 days.

This fact alone should prove to you and to anyone that no money gets conjured from thin air. In truth, all those who make this claim, sadly, do not get money, credit, banking and central banking. Thus they do not get the whole of economics.

Gil August 24, 2010 at 3:32 am

Is that a variation on the theme of “did you know if you deposit $1,000 into a bank, it’s not sitting on a table waiting for you to withdraw it but it is lent out to someone with interest”? A lot of people are still surprised to hear it.

Smack MacDougal August 24, 2010 at 12:05 pm

@Gil.

Yes, daft Americans suffer from the effects of intense indoctrination and mind control.

Look at how many defend the false belief that they have “paid into” Social Security, that some kind bureaucrat has been squirreling away their money in a trust fund with their name on it. Look at how many fail to see that Social Security and Medicare are everyday socialist welfare.

Yet, in truth, it’s more like this: Did you know that when you deposit $1,000 into a bank, you have sold that $1,000 to a banker and you have bought $1,000 worth of bank credits, which the banker can dole out to you at his discretion up to a time limit?

Gil August 25, 2010 at 2:52 am

I don’t see what the big deal is though except that if you were hoping your money was locked safely away then you’d have to pay for it.

Dave Albin August 24, 2010 at 10:23 am

No, for a period of time, someone has been shorted – the whole system is run on faith, the blinder, the better. You are technically correct in your interpretation; however, running a system like this is only as good as the dumbed-down mass of people who keep it going.

Smack MacDougal August 24, 2010 at 11:52 am

@Dave

I agree with you in the sense that most do not get business, commerce and commercial law. They fly by the seat of their pants their entire lives. For many, life has a way of working out for them in spite of their amazing ignorance.

Yet, what I offered is not my interpretation. It’s explanation of what is. It’s truth.

So when a dress shop owner takes dresses from a wholesaler on 30-day terms as evidenced by a invoice, the shop owner has “shorted” the wholesaler in your mind?

Is it not the case that those buying on credit have the economic quantities of purchasing — their credit?

The dress shop owner OWNS the dresses that she buys with her credit. The wholesaler buys a right of action against her. The wholesaler gives up her ownership in the dresses when she sells them on credit to the dress shop owner. Commercial law supports this glaring truth. Who has been shorted?

Commercial banking works the same way, exactly.

Zorg August 24, 2010 at 2:15 pm

“Commercial banking works the same way, exactly.”

No it doesn’t. Stop equating racketeering with voluntary exchange.

Zachary August 23, 2010 at 10:29 pm

I’ve been waiting for a mises.org Austrain to take on this subject for a while. Thank you Mr. Murphy.

This article leads to some interesting questions. On the whole, doesn’t this imply that borrowers must work for privileged money-creation institutions (some call them “banks” ;), either directly or indirectly, in order to make all interest payments? If so, is this not a sophisticated form of serfdom? Doesn’t this put the banks in a unique position to shape society as they can collectively steer the workforce in their desired directions?

On a societal level, banks create money out of debt, and the rest of society must “work for them” in order to pay them back. What a sweet deal for them.

Dave Albin August 23, 2010 at 10:41 pm

You are correct as long as people use US dollars. When the economy tanks, you see more stashing wealth in gold (hoarding, some would call it), or bartering (for example, people working in networks and working off debts to other people, at agreed upon rates, etc., in place of using actual US dollars). These are some ways around what you are talking about. Of couse, the government makes it harder to do these things (remember the recent article on here about the new tax on gold coin transactions above $600?) so you are forced into their system.

Russell August 24, 2010 at 7:05 am

Very sweet but not as sweet as the Federal Reserve that can create money out of thin air untethered by debt. It is a system that inherently arbitrarily interferes with demand signals in a market economy skewing the allocation of resources and tending to shrink the economic pie.

Baten August 24, 2010 at 6:06 am

Most people make the error of thinking that if one deposits 1000 $ in the bank, and the bank has 10% reserve requirement – then the bank will keep 100$ in reserve and lend the 900$ remaining.

Actually what happens is that the bank keeps the 1000 $ deposit in reserve and will be able to lend up to 10000$ to others. This is indeed money our of thin air.

Patrick Barron August 24, 2010 at 2:18 pm

How’s this for another explanation:
Brown borrows money in order to purchase resources that he combines in such a way that he provides more value than the resources purchased, for which he receives a profit. For example, he buys 100 gold coins’ worth of goods and/or labor, combines them and then sells them for 102 gold coins. He returns the 100 gold coins to Smith along with one gold coin of interest and keeps a gold coin. If he did not do this, he would either incur a loss (selling his product for less than 101 gold coins) or perhaps working for nothing (selling his product for exactly what he owed Smith). The economy can pay the extra gold coins to Brown, because they value his product above all other choices in the market and are better off. Therefore, interest is paid out of economic progress.

I would appreciate anyone’s critique of this explanation.

G. Franklin August 24, 2010 at 2:48 pm

I think the problem is that your example is no longer a closed system. Where do those extra 2 gold coins come from? The creation of new coins devalues the old coins and there’s the inflation…

Russell August 24, 2010 at 4:55 pm

I don’t see that as a problem. As the economic pie grow relative to the amount of gold, prices drop. You have deflation like in flat screen tv’s. In those circumstances more value will have to be provided than when the gold was borrowed to be able to pay it back with interest. In this scenario, it is better to work and save your own money to invest or find investors so you don’t have to pay back the loan with gold that is harder to acquire than when you borrowed it.

If prices have gone up because the size of the pie has shrunk since you borrowed the gold, then your product will sell for more gold and it will be easier to repay the loan with interet. Prices are not static. They adjust relative to the amount of gold chasing them.

Tad August 24, 2010 at 7:51 pm

The principle problem here is that your example doesn’t address the original question of whether or not it is necessary to continuously inflate the money supply in a fiat and debt based economy. Your example can be construed in two different ways: first is an economy where there are at least 102 coins in the economy when we start, Smith must have the 100 coins to lend to Brown, and either Brown or someone else must have the other two in order for the transaction to be possible (Murphy’s argument supposed that Brown used one coin to pay Smith for moving his lawn, which also works.) The second construction is to assume that we started with only 100 gold coins in the economy. In order for Brown to pay Smith without providing labor or something else to Smith for which Brown is paid a coin that he then pays back as the interest, appears to require that the money supply (the number of gold coins in circulation) to be inflated.

What prof. Murphy is trying to explain to us is this: since Smith can’t eat the gold coins (or dollar bills), he will not retain 100% of the money he receives back in the form of loan payments. In a real world situation, Smith will spend some of his coins/bills to pay his staff and to buy his groceries, and so on. While Smith will hold some cash, it is better for him (and everyone else in the economy) to trade the cash (and cash equivilents) for goods which they value. The point is that, as long as the currency circulates chasing goods and services, it is not necessary to increase the number of coins or other cash in the economy in order for economic growth to occur.

Russell August 24, 2010 at 8:37 pm

In addition, the 100 or 102 gold coins can be split up into smaller coins to act as money when more goods are created and put on the market. If the pie grows and the amount of gold says the same, you will get more goods for your money and vice versa. Borrowing in a deflationary environment favors lenders.

G. Franklin August 25, 2010 at 9:46 am

Tad, I agree with this statement: “as long as the currency circulates chasing goods and services, it is not necessary to increase the number of coins or other cash in the economy in order for economic growth to occur.” But it’s important to note that 100% of the currency must circulate to prevent default. If Smith retains or lends some fraction of collected interest, then new money is necessary to cover the difference. This is the most likely situation in the real world since banks don’t spend 100% of profits from interest…

Russell, I understand your point about the growing/shrinking pie, but it seems unnecessarily complicated. Sure, the economy can grow or shrink and that affects the value of currency… But the question of this article is whether debt-money requires inflation. Under constant pie and without the lender spending 100% of collected interest, you need new currency to prevent default…

Russell August 25, 2010 at 4:06 pm

My point is that money is no different than any other commodity. If you don’t get money from one person because they don’t need your goods and services, you can get it from another for some amount of goods and services. If no one needs your goods or services, then you better go inton another business and make something else. You don’t have to expand the money supply at all. You just need enough money in circulation to fulfill the function of money, enough so that no one can corner the market for money. It need not even be backed or redeemable in any given commodity so long as it is fixed in amount amount, is not all in the hands of one person and divisible. Then money will be traded for wheat, cars, homes etc. And a borrower can always work to create something to trade for money to pay the money back with interet. After all it is borrowed from someone who has saved it and agreed to invest it. Of course, if the value of money goes up from when he borrowed it, then he will have to produce more than on the day he borrowed it to get enough to pay principal and interest. But if the borrower is inventive and figures out how to make things at less cost, it may be easy for him to accumulate enough money to repay the pricipal and interest even if the money has appreciated..

Tad August 25, 2010 at 7:59 pm

If all of the principal and all of the interest on all of the loans came due at the same time, your point would be correct. But that isn’t the case. Banks (and individuals) hold some amount of cash, but cash, by itself doesn’t serve the bank or the individual, exchanging it for other things is its purpose. Brown doesn’t pay the 102 coins all at once, but perhaps 25 gold coins and a silver coin each quarter for a year. Banks invest their profit into non-cash investments, holding only enough cash to service expected demands and, hopefully, a bit of a buffer to cover unexpected demand. Since only a portion of the principal and interest comes due at any time, the currency in circulation is sufficient. The economy adjusts to the amount of cash and cash equivalents as demand for cash changes and interest rates fluctuate.

Russell August 25, 2010 at 9:11 pm

There is your problem, fractional reserve banking. This is not allowed in mt scenario. In my world, banks can”t lend out demand deposits. They have to maintain 100 percent reserves because it could all be demanded by the depositors at any time. If they want to lend depositor’s money, they have to get the depositor to agree to a time deposit. FRB allows banks to create money (bank accounts) out of thin air and lend it to other people. The rest of us have to work for the money we would loan out by buying bonds. Very bad system!

In a real economy, people are spending money all the time on thugs that they value. There is no shortage of money to exchange for thugs.

G. Franklin August 25, 2010 at 9:10 pm

Tad and Russell, thanks for both explanations. I understand your points (and this article) much better now…

John August 30, 2010 at 12:01 pm

I hope nobody here is forgetting that while (commercial) banks can create deposits, bankers cannot personally do the same in their capacity as private citizens. A comment like “the rest of us have to work for the money we would loan out” illustrates my point.

I happen to know one girl who works in commercial banking. I hope nobody here thinks she can personally create money out of thin air. If she wants new shoes, for example, does she just create a new deposit for them? Nope. If she decided to lend me some money, the only money she could possibly lend me is the money she worked for. If I walked into her branch and asked for a business line of credit, she would ask to see a history of cash flows from my business.

The point is this: even in her capacity as a commercial banker, where she can create deposits, she can’t lend without a borrower. So when we say things like ‘bankers can create money any time they want!’, what we mean is, ‘bankers can create money any time a business wants to borrow it.’

My friend does not personally create deposits in order to buy bonds, though there are people at the branch who do just this. The only thing to remember is that nobody who works in the branch can create these deposits for their own personal use. They have to buy bonds for themselves the same way everybody else does.

And by the way, the executives in the towers don’t need to create deposits for themselves to get rich. They’re already guaranteed millions in salary and bonuses, along with countless other perks. I’m not offering this as a defense of the current banking system, but this is the way it works.

G. Franklin August 25, 2010 at 9:45 am

Tad, I agree with this statement: “as long as the currency circulates chasing goods and services, it is not necessary to increase the number of coins or other cash in the economy in order for economic growth to occur.” But it’s important to note that 100% of the currency must circulate to prevent default. If Smith retains or lends some fraction of collected interest, then new money is necessary to cover the difference. This is the most likely situation in the real world since banks don’t spend 100% of profits from interest…

Russell, I understand your point about the growing/shrinking pie, but it seems unnecessarily complicated. Sure, the economy can grow or shrink and that affects the value of currency… But the question of this article is whether debt-money requires inflation. Under constant pie and without the lender spending 100% of collected interest, you need new currency to prevent default…

Russell August 25, 2010 at 9:18 pm

You’re welcome!

steve December 16, 2010 at 1:02 am

what a useless article. replacing the actual scenario with a what if the banker accepts your labor instead of the dollars (or gold) you are contractually obligated to supply. especial if he can take your collateral.Also amazing is the same result obtained using gold( despite the week attempt to appear different) But that is the history of Austrian economics. theorize and hope it’s true, don’t bother looking for it’s proof

just like the ludwig von mises says

“the proof of a theory is in it’s reasoning”
The theory of money and credit

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