Sunday, August 3, 2008

Column #4 The Problem of "Interest"

(Week 1 - Thursday July 31)

In yesterday's column I stated that, within our present system, the money "loaned" by a banker is created with the "stroke of a pen," so to speak, when the banker writes "the check" (or electronically credits the account). Most people assume that he gets the funds from money on deposit at his bank. Not so! In the moment before the banker "signed the check" (or approved the deposit) he is passing to the borrower, the money did not exist. The moment after he "signs the check," it does exist. This is the threshold of money creation within our monetary system. This confirmed in the Federal Reserve's own publications. In a booklet published by the Fed, "Everyday Economics," the section titled "How Banks Create Money" states as its opening sentence "Banks actually create money when they lend it."

The money so created (the principal sum) will be spent into circulation by the borrower. By the contract associated with the loan, the borrower agrees to pay back the principal sum borrowed, but also a compounding "interest" fee. I stated in yesterday's column that virtually all the monetary woes in the modern world arise from the nature of this "private-bank-loan" transaction by which our money comes into being. It is this compounding "interest" fee that is the source of the problem. Permit me to explain why.

Soon after a person "borrows" money from a bank, he "cashes the check" or puts it on deposit (at the same bank, or another), typically in a checking account, and then proceeds to spend the money. As he spends the money, it enters into circulation, and becomes blended into the already existent monetary pool. That monetary pool already exists because millions of other people have, before our representative borrower came along, also borrowed money from a bank and spent it into circulation. He is only adding his little stream.

It follows, then, that the monetary pool (the public's "money supply") is the sum total of all outstanding principal balances of all money still out on "loan," at any given time, from the banking system. Therefore, the principal sum of money owed to the banking system through these loans in fact exists in circulation, and can therefore be paid back. The money to make the "interest" payments, however, was never issued, and so does not exist in circulation.

But, one might say, people make interest payments, and bank loans are satisfied all the time. This is true, but the pertinent question then becomes, if the money to make the "interest" payments was never issued, where are these "interest" payments coming from? The answer is that it is subtracted out of the principal sum of other people's loans still in circulation (what is commonly called their "outstanding principal balance"). The fact that this subtraction takes place means that when these folks come to make the payments on their loans, there will not be enough money circulating in the money supply, on the whole, to make them. Eventually, someone will be obliged to borrow more money from a bank so that these funds become available.

If we were talking about an isolated transaction here, then one could say that this was not much of a problem, but the simple truth is that principal sum of every loan (i.e. every dollar) in existence will have to be repaid, with "interest," and so over time the entire money supply is being turned back in to the banks, accompanied by a net subtraction from the principal sum of outstanding balances still circulating.

If one "follows the math" on this, one comes to see that the only practical way bank loans can be paid back, "interest" payments made, and an adequate money supply maintained, is for the participants in the economy in the aggregate to borrow more money into existence (go deeper into debt) on a continuous basis. The alternative is a catastrophic contraction of the money supply (which is what caused the "Great Depression").

Relatively speaking, there will be winners and losers in this process (and many who "win" will point out that they stayed out of debt, and offer their personal case as evidence that with hard work and diligence it can be done by anyone), but it is a virtual certainty that the mass of the people, mostly those who are the producers in the economy, will be obliged to slip further into "debt" on a continuing basis.

Eventually any society that issues money this way will find itself staggering under an unpayable burden of "debt," until, financially and otherwise, it collapses. Judging by the newspapers, we are getting very close to that point now. The sheer magnitude of the proposed "bailout" schemes ($30 billion for Bears-Stearns, $300 billion for Fannie Mae and Freddie Mac), the gargantuan and still exploding size of the Federal "debt" ($9.4 trillion), the staggering size of the "balance of trade deficit" ($700 billion last year), and the burden of financial misery people endure in their lives are all unmistakable signs that the time of reckoning with the flawed basis of our monetary system is fast approaching. The view I hear almost continuously now from people that I talk to is "This can't go on." Clearly, it can't.

This private-bank-loan process, with its compounding "interest" fee is the very engine of the economic trauma we are facing at the present time. To see this clearly would be the essential first step in setting our economic house in order.

Richard Kotlarz


John Mugge said...

Question: If bands create the money they loan, then, as the loan is repaid, by what does the bank profit? Conventional thought is that the interest is what the bank gains for the service of lending the principle. But by your scenario, does the bank gain the interest and the principle?

Anonymous said...

John, these are tough concepts to grasp, because it's not 'what we're taught'. I created a YouTube to better visualize where the problem occurs. I'm sure Richard will answer you more wisely than I can, but maybe the YouTube will help.
Best, Elaine

richkotlarz said...

John – Despite the utterly pivotal roll of the private bank loan transaction plays in the creation of our money, the bank is really a middle-man to the process. It is essentially a business that makes its living out of fees. Some of these may come from the proceeds of the “interest” payment, but the bank itself is not the “investor.” If the bank holds the contract to maturity and technically receives the “interest” payment, it is still the stockholder in the bank that receives the benefit, and so is the “investor” (the bankers salary is overtly not linked proportionally to the “interest” paid). The bank cannot gain the principal because it is extinguished when the loan is repaid. Thanks for your questions. - Rich