The Debt-Based Economy

In the article Where Does Money Come From? we looked at how money is created by debt in today’s economy and how the system requires that lots of people be in debt all the time. That’s the most basic issue, and you could stop right there and figure out that this might not be the best way to create money for an economy, but there are additional problems.

Savings and Investment

In order for all the debt that’s used to create the money supply to be payable—even theoretically payable—all of the debt-created money has to be spent into the economy so it will be available for paying off debt. If that doesn’t happen then there will be a scarcity of money even if enough new loans are made to keep recreating the money that disappears when debt is paid off.

Enter the guys in the white hats (or white coats maybe), the wise principles of sound money management—namely savings and investment. Most people believe that these things are good and right and wise. In a sensible monetary system, maybe they are. In the fractional-reserve, debt-based system, they can be deadly.

A penny saved is a penny held out of the working economy where it could have been used to pay debt. Savings that earn interest, compound the problem because not only is the saved money held out of the economy, it’s acting as a magnet to draw additional money out of the system. The accumulated interest money is generally added to the savings rather than spent, compounding the interest and drawing more money from the system.

Many types of investment, although they may appear to be feeding money back into the working economy, are still creating a scarcity just as if the money were saved. A lot of investment doesn’t involve buying shares of a company. Instead many investments work more like non-bank loans. Bonds and what’s called “commercial paper” are examples. In this type of investment, the investor buys an agreement (a “security”) from the issuing company or entity. The agreement states that the purchase price plus interest/profit will be paid back to the investor by an agreed upon date.

Basically the investor is lending money at interest to that company or entity. But if the investor isn’t a bank, he or she can’t just create a deposit liability the way a bank does. The investor has to use money that was already created by a bank.

To show how this affects the flow of money, let’s look at a very simplified example. (To keep it simple, we’ll ignore the interest and just look at what happens to principal.):

Suppose Mary takes out a $10,000 bank loan and pays the money to Bill for doing a remodel on her house. When the bank makes the loan to Mary, it creates $10,000 of new money. Now let’s say Bill invests the money by buying a bond or debt security from Company A. Company A spends the money into the economy by paying it out as employee compensation. Mary happens to be employed by Company A and is owed a big bonus. She’s paid $10,000, which she promptly uses to pay off her loan with the bank. The $10,000 has now been uncreated. But…Company A still owes Bill $10,000 plus interest/profit. Where is that money going to come from?

Diagram of Twice-Loaned Money

Once the debt-investor economy gets its hands on debt-created money, the money becomes twice-loaned but only once created.

Selling Loans

The selling of loans by banks is another practice that feeds this phenomenon. If you’ve taken a mortgage loan from a bank, you may have received a notice a few months later saying that some other institution had taken over your loan and you would now be sending your payments to a different address. What’s happened is that another institution has bought your loan as an investment. It is common practice for banks to sell loans this way in what is called the secondary market.

Going back to our scenario again, let’s suppose Lois wants to invest the $81,000 she has in her account by buying Fred’s loan. (In real life there are institutions involved—the banks don’t ordinarily sell loans directly to private parties, but the operating principles would be the same.) Below is what would happen to the bank’s balance-sheet section:


The sale of the loan wipes both the asset and the liability off the bank’s balance sheet—they’re still balanced, and they’ve cleared the way for making more loans. The money in Lois’s account has been uncreated just as if she had used it to pay off the principal on the loan, and the loan agreement has been taken off the Asset side of the bank’s balance sheet. However…the $81,000 debt wasn’t uncreated, it’s just moved out of the bank’s hands and into Lois’s hands. Fred is still $81,000 in debt. This has the same effect as money being lent in the secondary market. The debt multiplies while the money stays the same. Basically the situation we’re in is that we can’t create money without creating debt, but we can create debt without creating money. That’s how we got here:


A couple of important things to notice in this graph: On the money side, the lowest block is currency and the next one above that is what’s called “demand deposits”. That’s checking accounts, simple saving, or other bank accounts where depositors can take money out whenever they want. The large block above that, representing over 75% of the total, is money that’s in longer term savings deposits and certain types of investment funds. It’s money that isn’t circulating in the working economy. The producing economy is trying to operate using only the lower two blocks. And it’s trying to pay that huge debt block on the right.

Now before you get too depressed, please be reminded that these are just numbers, and it’s just money, which is based on agreement. These are the actual numbers that are being generated in our current system, but they’re not logical or sensible and really not very real. What is real in the real economy is the people, talent, knowledge, technology, infrastructure, resources, etc., and most importantly the good will, industriousness, and positive intentions of the people. Those things don’t have to change because of some loony numbers.

But since we’re talking about the loony numbers…

The working economy is trying to pay that huge mountain of debt out of those two comparatively tiny blocks of money. Clearly it doesn’t have a prayer. So what it does instead is try to avoid default. It does that by paying the interest, paying enough principal to keep from going delinquent, and…by borrowing more money. Though it may often appear to be engaging in wasteful abundance, the producing economy is suffering from a severe scarcity of money, and it’s working under a system where the only way to get more money into the system is to borrow it. So we have a vicious circle where the necessity to pay the existing debt creates this horrible scarcity of money, and the only way to relieve the scarcity is to borrow more money, which aggravates the scarcity, which is only relieved by borrowing more money…

Essentially it’s operating like a pyramid scheme. In order to stay alive it has to grow, and the only way it can grow is to cannibalize and destabilize itself further. The more it grows the more and faster it has to grow, and the more unstable it becomes. The graph below shows the decade by decade “progress” of this phenomenon over the last 50 years. (This shows the same statistics as the previous graph in 10-year increments (up through 2012) and without the breakdown of the components.)


Notice that in 1962 debt was just a little more than twice the supply of money. In 2012, it’s almost exactly four times as much. The graph below shows the same figures only without the adjustment for inflation, which gives a slightly clearer picture of what’s happening mathematically.


Following the tops of the debt bars you can see the steepening curve. If you’re familiar with the concept of exponential growth, you may recognize what’s often called a hockey stick curve.

Exponential growth, for those not familiar, is when something grows by multiplying itself. If something grows by a percentage, eventually it will double. If it continues to grow by the same percentage, it will double again in the same period of time. Averaged over the last 30 years, debt in the United States has been doubling about every 10 years. It was previously doubling faster than that, but it was slowed down by the bursting of the dot com bubble and it was slowed slightly by the crisis of 2008. If the trend continues we will have $80 trillion dollars of debt by 2022 and $160 trillion by 2032. The numbers are becoming completely disconnected from the real world.

*The federal debt statistic shown does not include debt held by internal government agencies such as the trust funds for Social Security and Medicare. Figures are taken from: U.S. Federal Reserve Statistical Release H.6, Money Stock Measures and U.S. Federal Reserve Statistical Release Z1, Section D.3. Credit Market Debt Outstanding (These figures do not include what’s called “financial sector” debt, which is debt agreements between financial institutions such as banks, brokers, and insurance companies.)

Grow or Die

Debt isn’t the only thing forced to grow in this economic model. To feed the expanding debt, the whole economy has to grow. It has to expand whether the people in it need it to or not. Manufacturing must increase, sales must increase, and consumption must increase. Businesses have to expand to stay afloat. Their marketing departments are furiously dreaming up more and cleverer ways to convince more and more people that they need to buy more and more stuff—stuff that uses valuable resources to produce and then often gets sent to landfills a few years later. But we have to do this to keep the economy going. Mouse in wheel

Further, since the money scarcity and debt pressure keeps increasing, economic growth becomes more and more of a squeeze play. Businesses in the working economy must grow, but overall they have less and less money to do it with, so they’re continually trying to get more from less. The trend is to cut the work force, cut wages, cut benefits, cut the quality of the product or service, and of course, outsource the labor to foreign countries with low wages and poor labor protection—anything that can be done to get more out of less.

In the context of the debt based economy, it makes sense to travel 10,000 miles to the other side of the planet and set up operations to produce something that could have been produced at home so you can ship it 10,000 miles back to where it’s going to be used.

Now here’s another issue. In the process of creating more debt we are also creating more money, yet the scarcity of money gets worse and worse. Where is the money going?

Last modified: June 13, 2016