The Compounding Debt Fallacy

It's pretty well known that the US federal government is in debt to the tune of twenty trillion dollars. The Economic Collapse Blog is reporting that, if we account for personal debt as well, such as mortgages, students loans, credit card debt, etc, that number balloons to $41 trillion. That comes out to $329,961 per household, which amounts to 584% of median household income. The numbers are almost numbing and don't even account for corporate debt, state & municipal debt, or debt in the form of unfunded liabilities likes pensions, Social Security, and Medicaid.

You might be asking yourself how it is even possible that we could have so much debt. Can the size of the debt really exceed that of the monetary supply? Is the whole system intrinsically insolvent? Let's look at a couple relevant articles that are highly placed in Google searches on the subject. The first is from ZeroHedge, titled It Is Mathematically Impossible to Pay All of Our Debt. They assert,

There is no way in the world that all of that debt can ever be repaid.  The only thing that we can hope for now is for this debt bubble to last for as long as possible before it finally explodes.

Hoping for the debt bubble to last as long as possible is short-term, almost malicious thinking. The longer bubbles take to pop, the worse the resulting turmoil. In general, the longer the market ignores reality, the more severe the eventual correction will be.

The other item is from Simon Thorpe's blog, in an article titled Global Debt is now 2.5 times the total Money Supply - the system is clearly unworkable. He paints a similarly gloomy picture but goes even further to offer an explanation into how our monetary system would allow debt growth to outpace the monetary supply, as well as offering a systemic fix for the issue.

How on earth did we get into this situation?

For me, the answer is pretty simple. Commercial banks create money when then make loans to individuals, businesses and governments. But when they do this, they create enough money to make the loan, but don't create the money that will be needed to pay the interest. Thus, if a bank creates $1 trillion in loans with interest at 2% and waits for 20 years, the total amount of debt  in the system will have increased to nearly $1.5 trillion. This is what has been happening for centuries, but the effects of that compound interest have now become totally out of control.

It is clearly time for us to change the system. All money should be created interest free. Full stop.

Both his analysis and his conclusion are very wrong. He's wrong because of a very common misconception about the economy, which we'll dub the Compounding Debt Fallacy. The author keeps a blog and a video series dedicated to the discussion of economics and still falls into the trap. We'll walk through the reason his analysis is wrong. After that, you'll have a better understanding of our debt-based monetary system than the vast majority of Americans, even many who dedicate a substantial amount of their time to the study of economics.

The Compounding Debt Fallacy is something like this.

When banks make loans, they create debt that must be repaid out of the monetary supply. Thus the debt will compound perpetually until there isn't enough money to repay the debt.

Or something like that. It's pretty much what Mr. Thorpe was saying in the above quote. These people are often consumed with the notion of runaway debt creation. But they miss two very big aspects of the process. First, the bank actually does create currency when it issues debt, and second, that currency is destroyed when the loan is repaid. Think of debt and money like matter and anti-matter. They are equal and opposite to one another, and, when they meet, they annihilate each other. Some time ago this blog did some thought exercises on the subject of debt creation in a fiat monetary system. Let's run through one again to try to understand all this.

Suppose there is $100 in the monetary supply. (Which also means there's $100 in national debt.) You work in the economy, which means that you trade your labor for money out of the monetary supply. You make enough that you can dedicate $2 each year to housing. The house you want to buy is $10. What do you do? Remain homeless for five years until you save enough to purchase the house? Probably you'll go to the bank for a loan.

The bank says, "We'll loan you ten dollars for a house, and you must repay us a dollar a year for ten years, and it will be paid off. But you must also pay us an extra dollar a year in interest as our service fee."

Noting there is a cold front moving in, you respond, "Ok."

The bank deposits ten dollars into your account. Where did it come from? In our system of fractional reserve lending, the money was simply created. As long as the bank has 10% of the loaned amount on reserve -- in this case, a dollar -- they can generate the loan. They create a mortgage contract and then give $10 to the seller of the home. Here's the part where people who only see one side of the equation lose their minds. Some say, "They created money out of thin air! Runaway inflation! Unsound monetary policy!" Others say, "They created debt out of thin air! Debt bomb! We're all debt slaves!"

The bank created both, the money and its complementary debt. Now the money supply is effectively at $110. Eventually, the bank gets their $10 dollars back. They then use that money to cancel the mortgage bond. This is the part everyone misses. The bond and the cash annihilate each other and we're back to where we started, with a money supply of $100 and privately held debt of $0. The only long-term effect of the mortgage is the transfer of wealth from you, the homebuyer, to the bank, in the form of interest payments. But that's just exactly what we expect to happen. You pay them for providing a financial service.

What's happening here is that people don't understand our fractional-reserve fiat monetary system, so they aren't making the proper critiques or offering valid fixes. For instance, the author's suggestion that all money be lent interest-free is absurd. So he wants all banks to go out of business, and no one gets a mortgage. Cool. People think of money as an asset-backed system, but the dollar is a contract-backed system. In an asset-backed system, the value of money comes from the value of some commodity. Not terribly long ago, US coins contained silver, giving them value, and the paper dollars had value because they were (supposedly) redeemable for gold. So holding a dollar was as good as holding it's equivalent in gold.

Today's money has value because it is created out of debt, and someone has the legal obligation to repay that debt. If the government did not enforce contracts (one of its primary duties), the currency's worth would be equal to its BTU value on combustion. If the government of the United States ever collapses (**crosses fingers**) the dollar will be destroyed with it.

There's nothing wrong with a contract-based monetary system, but that doesn't mean that in practice it is being operated properly, or that it is remotely solvent in the long-run. Going back to the original article, how is there $41 trillion in debt if the money supply is significantly smaller? This is an important question. It's not because banks issue home loans. Either the money supply is somehow not being properly accounted for, or something is very screwy in the way things are being done. The fact that we don't constantly hear people asking the question why doesn't the debt equal the value of the money supply? means that (a) a lot of people don't understand the modern monetary system, and (b) the people who do understand the modern monetary system mostly decide, for whatever reason, not to ask that question.