Where is the money going?

The articles Where Does Money Come From and The Debt-Based Economy looked at how the banking system creates money by debt, and debt drives more and more debt, which demands more and more growth and squeezes the economy tighter and tighter. As more and more debt is created, more money is also created, yet there’s a constant scarcity of money. Where is it going?

Debt-Based Money in an Island Economy

To see what money creation by interest-bearing debt does to the flow of money in an economy, let’s take a very simplified example. Imagine we have an island economy in which all the money is created by borrowing. (Since in real life 90% is created by borrowing, this should be reasonably illustrative.)

Island-NoSunIn our island economy, Joe and Agnes have set up a mom and pop banking business and convinced everyone that the only money that should be used on the island is the money created by the J&A Bank, namely the J&A Note. The J&A Bank creates J&A Notes by making loans, and they charge 10% interest. For every 100 notes they lend, they get an agreement that 110 notes will be returned by the end of a year.

Let’s say we have 200 people on the island and the cost of living is about 1000 notes per year. At the beginning of the year each of the 200 people borrow 1000 notes from J&A with the agreement to pay back 1100 by end of year. J&A makes an account entry in the deposit account of each islander that they have 1000 notes, and each islander signs an agreement that they will pay back 1100 by the end of the year. To keep things simple and numbers round, we’re going to say the islanders have divided their year into 10 months rather than 12.

We now have 200,000 notes available for circulation in the economy. Commerce is happening and everyone is happy. But we also have 220,000 owed back to J&A by the end of the year. All of our debtors are making monthly payments of part principal and part interest–110 notes per month. When the bank receives the payments, they use the $100 principal payment to cancel that portion of debt for the borrower, and they put the $10 interest payment in J&A’s own account.

If nothing else is done to create notes, we will find money becoming scarcer and scarcer as the year progresses. By the tenth month all the money remaining in the working economy is not enough to cover the payments, and our debtors are forced into delinquency.

However there’s a solution to this: borrow more money. But since everyone is behind on payments on the first loan, they’re going to need a bigger loan to take care of paying off the last one plus the operating money for the coming year.

Suppose everyone now borrows 1100 for the year instead of 1000. After everyone catches up their payments from the last loan, this will again put 200,000 into circulation in the economy. But of course everyone owes more money now than they did at the beginning of the previous year.

Meanwhile, how are Joe and Agnes doing? They made 20,000 notes in one year in an economy where the cost of living is 1000 notes a year. Plus they have 22,000 owed to them in interest on the new loans.

If we graph what’s happening to money supply, outstanding debt, and money accumulating with J&A we get this:


The difference between money and debt is getting larger and larger, and J&A’s wealth is growing steadily regardless of the fluctuations in the supply of money for the working economy.

Now, let’s make it slightly more realistic. Up to now we’ve had J&A just accumulating money; they never spend any. Let’s suppose J&A start hiring people to help at the bank and they hire people to build them a big house, cook for them, sail them around the island, etc. etc. Let’s say they’re spending $1000 a month, which is going back into the working economy (and remember this is an island where the cost of living is about $1000 a year). If we graph that is looks like this:


The amounts have changed, but the trends have not. The difference between money and debt still gets wider each month, and J&A’s wealth is still making a steady climb.

Obviously what’s happening is the money and along with it the real wealth and security of the island is funneling from all the other islanders to Joe and Agnes. If Joe and Agnes remain the only banking partnership, they become lords of the island (or if the islanders wise up, maybe they get set adrift on a raft). If other investors are involved in the J&A caper, the island would end up with a two-class society—interest payers and interest receivers. The interest payers would be working hard and scrambling to stay afloat. The general trend would be that they work harder and longer and receive comparatively less and less for it. The interest receivers would be accumulating more and more resources, living more and more lavishly, and inventing new games to play with money.

Class Division

On a small island with only 200 people Earthand only one money source at 10% interest, the class division and inequity would become very obvious very quickly. On an island the size of Earth, with six or seven billion people, multiple forms of money, and multiple variable interest rates, it takes a little longer, and it gets a little more complicated. Nevertheless, this is the principle under which our economy is running.

The graph below shows average income figures published by the U.S. Congressional Budget Office (CBO). The top line represents the top 1%. Notice how it keeps getting farther and farther away from the other lines.


As of this posting, CBO figures were only available through 2009. To get an idea of what has been happening since then, we can look at a different but related statistic. The graph below shows the combined net worth of the members of the Forbes 400 Richest Americans list. (For more information, the Inequality.org site includes an abundance of graphs and statistics.)


This is the reason Occupy Wall St. was occupying Wall St. and people in economically strapped countries demonstrate in the streets. They may or may not see these exact principles, but they see that something is terribly wrong with this picture. What’s most fundamentally wrong with the picture is the creation of money through interest-bearing debt.

But it is indeed more complicated. Who in modern society are the interest payers and who are the interest receivers? Interest receivers go far beyond the bankers, as became very apparent in the crash of 2008. (When payers stop paying, the effects can go a long way.) Financiers and investors of all sorts are essentially interest receivers. That includes pension funds, insurance funds, charitable trusts, and various institutions in many areas of society. Anyone invested in bonds or treasury securities of any sort is an interest receiver, and in the current system even investing in stock in a productive company has much the same effect.

People who are paying on mortgages, student loans, auto loans, and credit cards are obviously payers, but many people in the modern world are both payers and receivers.

Financial progress in the middle class has generally been to work your way from payer to receiver. You start out buying a house and putting money into a retirement fund. You work your mortgage down and your retirement fund and investments up, and eventually you can retire as a receiver.

People who neither borrow nor invest are usually part of the interest payer class. If they work for a company that has debt, the amount they can be paid by that company is limited by its need to pay its debts. The goods available for sale in the society are generally produced by businesses with debt, so the payment of debt may be calculated into the prices.

Then there are the people who fall out the bottom of the payer class. Sometimes they become a different type of receiver—receivers of charity or receivers of welfare.

The “self-made men” that make such colorful characters in business and on Wall St. are generally people who started in the payer class and fought their way into the receiver class. They set the example for the rest of us that the American Dream can be achieved, classes are not fixed in this country, and with hard work and ingenuity, anyone can do it.

Maybe anyone can, but obviously everyone can’t. The system depends on the payers—otherwise there’s nothing for the receivers to receive.

You could say we have three main classes in the modern economy: the payers who have money taken out of their pockets, the receivers who put money into their pockets, and the middle class who take money out of one pocket and put it into the other.

If you yourself have made the transition from payer to receiver, you might hope that your children and grandchildren will be able to do the same. With relentless exponential debt growth, the transition becomes less and less possible.

Might there be a smarter, fairer, more sustainable way to operate an economy?

Better Ideas

Last modified: June 22, 2016