Most conventional and unconventional commentators on money believe that money is destroyed when debt is repaid. I disagree–but explaining why takes some time. I received an email this morning from a Ecological Economics discussion list in the USA on this issue, and wrote the following explanation of my position. I thought that readers of this blog might find it instructive.
On the money issue, this is one where I beg to differ both with the response Josh put forward, and most of my fellow economists as well–non-orthodox and non-orthodox. I think it’s wrong to say that money is destroyed when debt is repaid–but to explain why, I need to both put forward a dynamic model, and find an appropriate analogy.
Most people (and economists) seem to believe that debt and money are like matter and anti-matter: debt (anti-matter) is destroyed by adding money (matter) to it. That makes a debt account a negative money account–and therefore to reduce it, you have to destroy money. Since interest if charged on debt, and repaying debt destroys money, an increasing amount of money has to be created to maintain a constant amount of debt.
Not so.Â For a start, aÂ debt account is not a repository for money (or anti-money), and you can’t pay anything in to it. It is a record of what you owe to the bank,Â which a bank is obliged to update whenever you make a payment intended to reduce your debt. But the money that you pay to the bank actually goes somewhere else–which I’ll get to in a moment.
If a capitalist has a debt to a bank, that obligatesÂ him/her to pay the bank interest; equally, if you have a credit deposit with a bank, that obligates the bank to pay you (a lower rate of) interest on that deposit. The spread between the two–high interest rate times debt minusÂ low interest rate times deposit–is the source ofÂ the bank’s income. So the bank is quite at liberty to spend for its own needs out of the balance in the account. When it does spend, that money comes back into circulation.
Ditto for wages: workers won’t work without receiving wages. When they receive a wage, it is paid into their bank accounts, and they will spend out of these–which amounts to a transfer back to the capitalists accounts. The capitalists make their profit from the gap between their sales and their production costs (and the whole system is fuelled by the capacity of the production system to produce a physical surplus over the inputs–that’s the real ecological issue in all this of course).
So long as no debt is actually repaid, the amount of money in existence can continue circulating between these three classes of accounts ad infinitum–it is not destroyed, nor does any new money need to be created. The system could keep on going at the same level of production indefinitely, with no change in the quantity of money in circulation.
Now consider repayment of debt. When a capitalist makes a payment intended to reduce debt, the bank is obliged to record that the debt has been reduced by that amount–but what does it do with the money? As I emphasised above, it doesn’t “mix it with anti-money”, thus destroying both money and debt in the process: instead it records that the money has been given to it in order to reduce the recorded level of debt, adjusts the debt account accordingly, but now has money that it must also do something with.
It can’t put that money into the same account as interest payments go to, and then spend it: that’s seigniorage. Many critics of credit money think that’s what banks do–and certainly they’ve been instances of banks effectively doing that–but as a sustained practice, it will bring both the financial system and the bank itself to ruin. So as a matter of sound practice, and also as a matter of historical practice most of the time, that debt-repayment money goes into a separate account. Call it a principal (as opposed to income) or reserve account.
Is the money that has been paid into there destroyed? No–it’s been taken out of circulation, in that it can’t be directly used to purchase anything; but it hasn’t been destroyed.
The analogy I can think of here is a basketball game, with a reserve bench. The rules of the game specify that there can be no more than five players on court at any one time, and seven reserves. When one of the players goes off, he/she isn’t “destroyed” when sitting with the reserves: s/he just becomes “inactive”.
Ditto debt that has been repaid. It can’t be allowed to participate in “the game”, but it is sitting there “in reserve” and can re-enter if it follows the rules. The rules in basketball are one player off, one on; the rules in the game of monetary credit are that this money “in reserve” can’t be spent to buy commodities, but it can be re-lent. Once re-lent it’s back in circulation again–and a corresponding debt is created with it, because another “rule of the game” is that if you get credit money, you get an equivalent debt recorded against you.
The repayment of the loan thus reduces the amount of money in circulation–which is limited to the sums in deposit accounts–but it doesn’t destroy the money equivalent of the reduced loan. Thus outstanding loans will be equivalent to the sum of deposit accounts, but the sum of money in and out of circulation will be greater than the amount of debt.
I know that argument goes against both conventional and unconventional wisdom, and it’s something I only came to by developing a mathematical model of endogenous money creation–a basic paper on which I’ve attached to this email. However, itÂ happens to accord with Keynes’s interpretation, which I discuss in the attached paper as well.
Please post this to the discussion list Chuck–and keep in touch!
From: Chuck Willer [mailto:firstname.lastname@example.org]
Sent: Friday, March 30, 2007 6:02 AM
To: Steve Keen
Subject: [US Society for Ecological Economics] Question on Sustainable Currency
Dear Steve,A thread is going on the US Society for Ecological Economics list serve (usecoeco) in response to Muriel Strands (below 1.) question about the nature of money relative to a non-growing economy. I have placed a response by Josh Farley (below 2.)Â who offers one answer.Â I thought that you are an economist that would have a useful suggestion or comment. Do you have a suggestion I could pass along?Your Debunking web site is excellent and I visit and recommend it often. About a month ago, my wife asked me across the kitchen “what are you listening to?” I said “it’s a mp3 by Steve Keen, he’s talking about econophysics and even quotes Joe McCauley!” She just shook her head and walked away.Best wishes,Chuck Willer
From: Muriel Strand <email@example.com>
Date: Mon, 26 Mar 2007 17:30:41 ‑0700
Subject: [usecoeco] question re sustainable currency
in his book “power down” richard heinberg says that a debt-basedÂ currency such as US$ won’t work for a homeo/static stable/contracting sustainable economy because if there is no growth then there is no new money to pay interest on existing loans so they will default, possibly leading to a crash.
is this true? if so why?
what could a currency be based on that would avoid this alleged problem?
From: Joshua Farley <Joshua.Farley@uvm.edu>
To: mailing list firstname.lastname@example.org
Date: Tue, 27 Mar 2007 14:24:29 ‑0400
Subject: Re: [usecoeco] question re sustainable currencyIn the current system in the US and most other countries, most money is
loaned into existence by banks. When you take out a mortgage, you are not borrowing money that actually exists–the money comes to exist only after the bank writes you a check. When you pay back the loan, the money created ceases to exist. However, you must also pay back the interest.
This means that the amount of money being loaned into existence every year has to increase so that previous loans plus interest can be paid back. When an economy is growing, more money is required to chase the increasing number of goods and services being offered, so there’s no problem. If the economy is steady state or contracting, then no new money is needed. Without this new money, people would not be able to pay back their existing loans.There are several ways to solve this problem. My favorite is to take away from banks the right to create new money and return it to the government. The government could loan money into existence interest free, e.g. for activities that promote the public good.Josh