Money as debt myth...

I know it's been a while since I last blogged.  I've been busy with trying to meet some deadlines for work and dealing with management who don't know how to do their jobs.  But I digress.

Recently, I've seen another one of those videos posted by someone who says we're all slaves to the economic system because we have a debt-based money system.  Even these 'Zeitgeisters' make a similar conclusion.  Unfortunately, these arguments start off with correct premises but they fall prey to these economic fallacies by applying way too simplistic logic that isn't true.

So let's start off with where they are correct:

1.  Money starts off as a commodity to facilitate indirect exchange over barter, which is direct exchange.

2.  Gold and silver emerge as the best commodities to facilitate indirect exchange and become the premiere 'money.

3.  People turned to goldsmiths to keep their gold safe in their vaults and in exchange, would hand out paper receipts in order to return the gold back to its rightful owner.  (Anyone with a computer science background - I like to draw the analogy that paper receipts are like pointers and the actual gold is the physical memory location on a computer).

4.  The goldsmiths, as the first known bankers, realized people started to use and accept the paper receipts as money and that people seldom used the receipts for redemption for gold.

5.  The goldsmiths took the practice of simply storing gold for receipts a step further by printing up more receipts for gold than they could redeem.  It is important to note at this point that two conditions must be met for this to take place.  One - the people whose gold is being held by the goldsmith implicitly trust the goldsmith to keep their gold safe.  Two - the goldsmith has faith that the people have faith in him because if he felt a "run on his bank" could happen at anytime - he can't get away with printing more receipts.

6.  The goldsmith gets wealthy because there is confidence in the gold receipts.  The goldsmith can now loan out the paper and collect interest on which society now has to pay down.


So the above basically describes the 'Fractional-Reserve' monetary system.  The expansion of the money supply (the gold receipts) exceeds the bank's ability to redeem the receipts for the base (the actual gold).  The paper money is now loaned out with interest and society has to pay down the principle plus the interest.

This is where the 'Money as Debt' people get it wrong.  They say that since paper money is created out of thin air and then lent out, where does the money to pay the interest come from?  That too must be created out of thin air.  So they conclude that creates a never ending cycle of more debt and more interest to which we are forever slaves to.  This is an economic fallacy.

Let me explain how it's a fallacy-

Today, money IS created out of thin air, which is the very definition of inflation.

When the new money is then lent out with interest, the debt is wiped out by paying off the principal plus the interest.  You need money to pay off that interest.

What is not correct is that there isn't enough money to pay off that interest.  What these 'Zeitgeisters' and other 'Money as Debt' advocates are doing is aggregating all the interest for all loans and assuming they mature at the same time.  What they're forgetting is bullet point 4 and 5 above, but in reverse.  If the banks required redemption on all their loans plus interest at the same time, that is, in effect, putting a run on the paper money that is out in circulation.  The money to pay the interest wouldn't exist and if at that point, the banks decided to print more money and pay themselves, it would be game over.  All confidence would be lost since they'd be screwing themselves by paying themselves with depreciated paper money, but also screwing the rest of society with depreciated paper money.

The point is - the lynchpin that allows fractional-reserve banking to work is the fact that not everyone is redeeming paper money for real money at the same time.  This allows the expansion of paper money through the loaning of paper money to work.  Conversely, not everyone is borrowing money from the banks at the same time, even if there was no fractional reserve banking.

What these people don't realize is their logic would have to apply to a 100% reserve banking system as well.  In a fixed money supply system, how would there be enough money to not only pay back the principal as well as the interest?  Their fallacy also extends into not understanding what money really is and the concept of deflation.  I will use an example.

Suppose I'm on an island with you and we find twenty one-dollar bills.  We decide that we'll use that as our money supply for us to facilitate trade.  I decide I'm going to lie on the beach all day and relax while you are busy fishing for food.  I decide to pay you $2 a fish so I can eat and you agree.  I start spending my money this way everyday to the point where you have all twenty dollars.  So now I have no money and you have all the money.

Now suppose I wanted to borrow $10 from you.  You agree to it but decide to loan me the money at 20% interest.  So that means I have to pay you back $12.  How can this happen?  It's quite simple actually.  Since I have $10, I can pay off the principle with the paper money.  Then I have to go to fishing.  Once I catch a fish, I can then sell the fish to you at the going rate of $2 a fish.  Once you buy it from me, I have the $2 I owe for the interest.  I then give back the $2 to extinguish my entire loan.  As the banker, you extracted $2 of wealth out of this micro-economy in the form of fish.

The point is, many people confuse money for wealth.  Money is exchanged for wealth.  It doesn't matter if money is based on a gold standard or a fiat money, as long as it remains fixed.   That is what matters.  The productivity of the free market will create more wealth relative to the money and prices will generally fall.  The problem is, banks, protected by the government, will keep expanding the money supply and thereby siphoning off society's productivity into their pockets.

Hopefully I explained why it's not a mathematical certainty that the money system has to collapse because principal + interest > principal.  The reason why monetary systems collapse is because governments run the money supply and power corrupts - even the best of us.  As I've explained before, the concept of government is built upon a logical contradiction.  And for that reason, it is of logical certainty that these political and monetary systems on which it is all built upon must eventually unwind.