Understanding Money as Debt

The US economy is now falling into a recession as a result of US-debt spending and the sub-prime loan problems. Essentially, the US has been financing most of their purchases with debt, including credit cards, mortgages and US government deficit spending. So, what does this mean? I will set out to explain what is money and it's impacts on the economy, society and you.

Money is a bank loan, IOU or just simply "debt"

The world operates on a fiat monetary system, where we use a paper currency backed by essentially nothing that represents wealth. What money is essentially debt, in other words, an IOU or a promissory note of a debt that must be paid off.

Most of us have been educated that money is regulated and printed by the government as we are often shown videos of a government mint manufacturing money. Unfortunately, this is only partially true-- the real manufacturers of money are the banks. How does this work might you ask? Allow me to explain.

It is commonly assumed that banks make their money by lending money deposited by the average person, where in actuality, banks lend a multiple of the amount of the money you deposit. For example, should you deposit $1000 in cash, the bank would be able to lend out $10,000 of cash (depending on the regulations) at a 7% interest rate (for example) to someone else looking for a loan to buy, perhaps, a car. The bank submits an order to deposit $10,000 in cash to the car retail dealer and then takes your car as collateral until you pay off your debt to the bank. The end result is that instead of making $70 at 7% yearly off of the $1,000 you deposited, the banks make $700 off the $10,000 it lends and all it had to do is conjure up an additional $9,000 to give to you.

When looking at the situation in this manner, money is an IOU which the borrower gets from the bank to spend to buy things. Eventually, this $9,000 must make its way back to the bank in sometime in the future to release the borrower of their obligations to the bank.

The large majority of money is created in this manner, whether be it loans for cars, houses, companies and etcetera. Quite often, all a bank needs is a down-payment on a loan to be able to loan the rest of the money required for the purchase. Thus, the majority of cash in circulation represents an IOU or a promissory note to repay the bank at in interest.

While money is loaned, the money supply must exponentially grow

Banks create money for circulation and nearly all cash in circulation is loaned out to people at interest by the banks. Should everyone stop taking loans and pay off their debt, the money supply shrinks, profits shrink and people run into a dizzying panic worrying if they will have enough cash to survive on. In order to keep the circulation of money going, the banks must encourage borrowing to keep the economy afloat. There is a fundamental problem with this model.

Suppose that the money supply is at $100 trillion and the average loan interest rate is at 7%. With the idea that all money is debt, an additional $7 trillion in value must be produced in value and paid off to the bank. But where does this money come from? It must again be loaned from the bank for people to make their interest payments and the money supply grows to $107 trillion and continues growing every year at 7%.

The money supply must grow every year because the money in circulation is all debt and incurs a cost to society at interest to the bank (both in the financial and literal meaning of this statement). $100 trillion this year becomes $107 trillion next year at 7% interest. To make up for the next $7 trillion in interest, $7 trillion of value must be created which is thus backed by the bank in collateral and loaned to society for consumption (actually, banks generally loan money faster than we can produce wealth, resulting in some inflation somewhere in the ball park of 3%). As a result, money as debt demands that production must increase exponentially to satisfy our debt obligations resulting from the money we use.

Losing the race against interest payments leads to recession

Society is locked in a race against money; to out produce what the interest rate demands. Unfortunately, there will be times when the interest payments demanded from society is less than what we can offer. Society loses wealth as the banks start to call in our collateral, fear spreads as people lose confidence in their earning capacity, they take fewer loans, the money supply shrinks, profits drops, production slows and people are out of work not knowing what to do. This process is the fundamental mechanics of a recession.

Fortunately, with the right economic policies, recessions are temporary. The burden of interest payments are reduced with interest rate cuts with the hopes of the economy/society regaining confidence, taking on loans, going back to work to continue it's race against interest payments.

Why do recessions happen?

I have partially answered this in the last section, but I wish to give further detail here. The answer to recessions happening I proclaimed is "losing the race against interest payments." Now, let me explain how the economy can lose this race.

The first way of going into a recession is by productivity not keeping up with interest rates. By default, society must continually produce more and more to meet the interest obligations of our money to the banks. This requires the economy to continually grow to meet these targets. If you ever wondered why the news reports that growing economy is a good thing is implicitly for this reason and by definition a recession is "an economic contraction."

The second route to a recession is simply not just by production not keeping up, but can also occur by taking on too much debt. This is the case for what is going on in the US sub-prime mortgage crisis that we see going on today. What occurred is society taking on far too much loans and not being able to meet their obligations. When this occurs, borrowers no longer have sufficient cash to invest in themselves or the economy to allow it to continually grow.

Exponential growth is unsustainable, both economically and ecologically

Though a "healthy economy" is considered as continually growing, this debt based (or fiat) monetary system demands that we produce wealth exponentially, year after year. Perhaps a company produces 100 houses this year, next year it must produce 107, then 114, 123, 131, 140 and 150 houses year after year. After 6 years production capacity has been increased by 50% and 865 houses have already been "consumed," and yet demand must be kept up some how to keep the economy running smoothly to meet its debt obligations.

Unfortunately, as most of us realize, the production capacity of an individual is not capable of exponentially increasing without bound year after year and society makes use of ever advancing technologies and growing human numbers to expand our production capacities. Though our creativity to continually push our productivity may seem limitless, the size of this planet and the resources it can provide is obviously constrained.

Should an economic collapse occur from a lack of resources, no changes in monetary policy will be able to solve this problem. By this time, the fundamental concepts of our debt based economic system must be changed to something sustainable.

Working and Living for Money

Explicitly, most people in general do not live for money, though implicitly this is what our activities have lead our society to do. As a result of our debt obligations to the money circulation, it is required that the economy continually grow and that we must continually produce and increase our economic productivity. In short, paying off financial obligations to the bank now or in the future will play a very significant part in our lives.

I find it rather unfortunate that we cannot enjoy our free time more, despite very impressive technological advancements giving the average person productive capabilities that far out stretch what a person might have been able to accomplish 100 years ago.

Financial independence and Freedom

Perhaps this is the topic for another essay but I would like to leave this idea with you for the time being.

With all this talk about debt and obligations of our society to this monetary system, it should be noted that a society is not necessarily free so long as it carries a financial obligation, which is largely impossible under this monetary system, that we are required to work to pay interest the loans which society has placed upon it self.

I believe that the biggest restraint on us as a society is our obligations to debt instead of living our lives on a surplus. This is probably the biggest barrier that most people have when it comes to having the freedom to do what they love versus working for money (the best case being doing what you love for money and taking the chance to try).

Further "Reading"

Much of this essay and my studies has been inspired by a variety of sources and I have found many good videos online regarding this matter. I would only consider this essay to be a primer to understanding economics, currency valuation, the stock market (booms and crashes), the roles and goals of companies, the fundamentals of the monetary system and more.

For those that are interested in learning more and perhaps some history behind how the current monetary system works I recommend the animated video Money as Debt, a 47 minute documentary on how banks posted at Google video.