Today someone proposed the theory to me that interest on debt automatically creates inflation. He was on board with the whole “inflation of money supply is bad and causes disaster” thing, but he firmly believes that interest creates that inflation. Because, according to him, “the 10% I have to pay back have to be created out of thin air”.
Now I know it’s not true. But I can’t piece it together. It was somewhere in Hazlett or Rothbard, I remember, or maybe Econ for Real People.
Can anyone refute this for me so I can understand it and explain to my guy?
The answer is the continuous circulation of money between billions of people. Money circulates throughout the entire economy, continuously changing hands. It is very possible to borrow money from another person’s savings, and then repay the debt, including interest, without inflation. You might ask “well where did that extra money to pay the interest come from?” Again, it came from the circulation. One of the other 6 billion people now has that much less physical money (not to be confused with wealth). Of course, this would be in a 100% reserve situation, which we don’t have.
Crusoe has 10 nuts, Friday has none. Friday borrows 5 nuts to keep him alive while he is making a fishing net. Using the net, he catches 20 fish (then the net breaks), and exchanges 10 fish for 5 nuts of Crusoe. Hi then returns 5 nuts principal plus 2 nuts interest. No inflation - 10 nuts are still there. And both Crusoe and Friday are provably (subjectively) better off.
EDIT: well, unlike nuts, people do not consume money, so in this example Friday has to abstain from eating the nuts he borrowed I guess we better replace nuts with tools, like knifes.
I have 100€. You have 0€. To buy a knife and become a butcher, you borrow 50€ from me. We now both have 50€. You pay 50€ to the knifemaker, who now has 50€ as well. You have 0€, he has 50€, I have 50€. You butcher an animal with your knife and sell it to the knifeshop for 100€. I have 50€, you have 100€, knifer has -50€. You pay me back 50€ + 10% interest, so 55€. I have 105€, you have 45€, knifeman has -50€.
I guess we should say that knifeman either starts with 50€ or borrows 50€ explicitly, for example from me, too. Then we don’t have negative money in someones account, which isn’t technically possible without further debt. Still, in the end, the amount of money is the same.
Guess it’s explained. Not feeling to good about it though.
100 gold coins in cirululation and 3 people: A,B, and C
A–20 coins, B–40 coins, C–40 coins
B loans A 10 coins to start a business: A–30 coins, B–30 coins, C–40 coins
A buys equipment from C for 10 coins to start business: A–20 coins, B–30 coins, C–50 coins.
A then sells products to B for 10 coins and C for 10 coins: A–40 coins, B–20 coins, C–40 coins.
A pays back B 10 original coins plus 2 coins interest: A-- 28 coins, B 32 coins, C–40 coins.
The loan has been repaid, including interest, without inflating the money supply. There is still a total of 100 coins, they just simply changed hands. It may be kind of hard to imagine with only 3 people in the example, but you can imagine how simple it would be with 6 billion buyers and sellers.
People cannot fathom a case where wealth is created and not not nominally measured. They think that if an economy is wealthier it must nominally be so as well. They don’t understand the fundamental aspect of exchange. As if exchange created new dollars somehow.
Guess it’s explained. Not feeling to good about it though.
One of the reasons you might feel it’s not entirely satisfactory is because you do not need money in small economies like this. I would even say money cannot work like money, in small economies.
Bob Murphy covers a lot of this and more in his lecture “The Theory of Central Banking” which was given in his Mises Academy class, Anatomy of The Fed. He posted it on his site:
He starts from the very basics of a loan, and goes through an example step by step and expands from there into more complicated matters.
Purchase $500 of goods and services from Everyone Else>>
$530 + $0 + $0 + $470 = $1000
<<<<<Sell $530 of goods and services to Everyone Else<<<<<
$20 + $510 + $0 + $470 = $1000
Repay loan $510>
$20 + $5 + $505 + $470 = $1000
Pay Deposits $505>
$20 + $0 + $505 + $475 = $1000
Payroll, Dividends, Expenses 5g>>>>
At the end of the cycle no new money needed to be introduced into the system to pay the interest on the loans and deposits. When the new cycle begins the Borrower and lender groups will be reset because some of the previous borrowers may become lenders and some of the previous lenders may become borrowers.
I guess we better replace nuts with tools, like knifes.