I am by no means an economic master, as my question will show. But I am very interested in free markets and the assault that our free market has received over the past hundred years or so from too much regulation, our nearly vanished manufacturing base, a cancerously growing federal government, a counter productive central bank, and the corporatism and monopolism that has been the result.
I have heard it discussed by many (yet not in any of the Austrian material I have thus far read) that the Federal Reserve charges our government interest to borrow money and therefore the American taxpayer must pay back the entire national debt plus interest. If this is the case, where will the money ever come from to pay that interest if all money is created by the Fed? A simple example is this: a central bank creates 10 dollars and this is the only money that it ever creates; it then loans this 10 dollars to somebody at 10% interest. Where is that 1 dollar of interest ever going to come from to equal 11 total dollars repaid if the central bank only ever created 10 dollars? The total pool of money is smaller than the principle plus interest and therefore the debt can never be repaid in full.
Debt based monetary system requires sufficient new debt to be issued to equal the amount of the interest payments on past debt. This is in order to pay interest on the debt.
Without money supply continuously expanding you will either suffer deflation or past debts won’t be paid and you will have debt default.
It’s a little hard to get your head around. I thought about this for a while on how money is just a medium of exchange and actual expansion in production or wealth generation could allow one to earn money to repay their debt… therefore you wouldn’t need perpetual ever expanding money supply. However, my thinking led to round-about confusion and it always led me back to the above conclusion. Primarily because when fractional reserve fiduciary credit money (bank check) is paid back the credit money is essentially wiped off the book / destroyed. But the debtor is left owing more ( = lender’s profit - not to get destroyed) than was borrowed. New debt must be issued to create this new money that serves as the interest profit considering all new money comes from the issue of new debt.
Step 1. Banker lends builder $10.
Step 2. Builder buys cake from Baker
Step 3. Baker deposits money with banker
Step 4. Builder builds home for banker and banker pays builder $10
Step 5. Builder repays debt to banker (without the creation of ANY new debt)
So, all that is required to in order for debts to be serviced is for the lenders to be spending (not issuing debt, but consuming) at levels equal to the interest payements on the loans that they have extended. There is absolutely no requirement, what so ever, for new debt to be issued in our current monetary system merely in order that existing debts might be serviced. Existing debts and any new debts do not get serviced by way of more debt but by way of the supply of goods and services.
In the case of the Fed, which is privately owned, I believe around 95% of the interest on government debt has actually been rebated over the past 10 years. Additionally, 6% of Fed profits get paid to the Fed shareholders each year in the form of dividends (so this is money that gets potentially spent in the economy) and the remainder of the Fed profits apparently get rolled into the Federal Government’s balance sheet (although I never managed to get anyone to explain the mechanics of that particular piece of the puzzel to me).
but at the end of the transaction the builder repays the banker $11, not the $10 he borrowed considering $1 interest. The banks/lenders balance sheet increased by $1 in earnings. If there’s only one bank in town where did the $1 come from? If the money supply remained constant then the builder must have earned it by providing a good or service to the baker and earning $1 from the baker to pay in interest. Therefore, the baker’s account declined by $1 and it indirectly went on the bank’s balance sheet as interest earnings. In such a scheme, over time, the bank/lender will slowly accumulate all the money or savings of the community. In order for everyone’s accounts to keep a constant balance while the bank profits the money supply has to increase, doesn’t it?
Almost like 3 guys playing a poker game. The one who keeps winning is collecting from the balance sheet of the other two. Eventually he has the whole pot.
OK sorry, I forgot about the interest. That doesn’t change anything though. Imagine that 20% interest was due on the original loan ($2):
Step 6. Builder builds new garage for banker and banker pays builder $5
Step 7. Builder repays final $2 interest on loan… and is now sitting on $3 in assets (plus he ate some cake). The banker now only has $7 where before he had $10 - but then he also has a shinny new home and garage so he can’t complain too much. For the baker it’s business as usual but he does technically have $10 in demand deposits at his disposal.
If the baker and builder provide sufficient goods and services to the banker then repaying the principal and interest on any debts they contract with the banker shouldn’t be a problem. It is not more debt that they need to pay back the interest, but production - their productive output is what is used to pay off the interest. The total quantity of money in the system is irrelevant to this fact since by increasing their productive output, with a static sum of money in the system, the result will be to increase the velocity of money and thus the amount of work that each monetary unit can perform.
All Myth. The actors in your situation do not just sit around looking at the dollars. They exchange the dollars with one another for goods. So the Government in this case is paying for things, mostly labor, thus putting the dollars it received in interest back into the economy. Even in the simple case you gave the individuals exchange the same dollars for stuff and hold different amounts of the combination of stuff and dollars. Actors in the economy just continually sell and resell the dollars to one another. What builds in the case of a fixed money supply is the pile of stuff and not the pile of dollars.
Inflation is the building of the pile of dollars. Even though possible, there has never existed an inflation free economy. The most inflation free banking systems were based on gold that is constantly mined thus inflating the amount of gold and reducing the value of gold relative to other stuff.
Banks profits don’t just accumulate but get paid out to the owners of bank shares. Quarterly dividends or stock price increases or banker bonuses puts the earnings back in the hands of people, who spend it on goods & services. Keeps the money going around and around.
In the poker analogy, at the end of the night the winner takes home his winnings. Outside the game the winner does transactions with his poker buddies in order for them to earn their money back. One friend chops some wood for him while the other paints his fence. The winnings are earned back by the friends and they can therefore go back to playing poker the following night. They all have money to play again.
I think that this myth is fundamentally based on a mix up between dollar VALUE and the number of dollar CURRENCY UNITS.
The interest rate means that the full repayment of the debt will represent a greater VALUE than the VALUE of the dollars which were originally borrowed.
It does NOT mean that more dollar CURRENCY UNITS must be produced for the debt to be repayed. For sure, the debt is actually repayed using dollar currency units (unless there is a default and the creditor by court order confiscates physical property, not dollar currency units(!), from the debtor which represent the same value), but that simply means that THE SAME dollar currency units are USED MORE OFTEN.
Compare with the metric system! If we build longer and longer goods, will we run out of meters in order to measure them? No, we’ll just use THE SAME rulers and measuring tapes MORE OFTEN. (He he, well, that particular analogy maybe didn’t make anyone any the wiser, not even myself. I hope I haven’t seeded a new myth now…[:P]).
While the propagation of the “interest rates per se means that more money must be created”-myth has done good damage to the confidence of the FED system in the eyes of many internet users, which I kind of welcome, it is as a matter of fact simply wrong and it must be said.