n 2011, almost all money used in the West is based on debt-with-interest. What effects can we expect this to have if for some reason (for example peak oil/resources, war or natural disasters) the economy ceases to grow on a per-capita basis?
Debt creates a kind of imperative for growth in the economy - growth in both the quantity of money and the quantity of goods and services - or it leads to structural defaults, inflation or both.
Imagine a debt-based currency economy where the average annual interest rate is 5%, the money supply grows at 5% annually, and the quantity of goods and services available also grows by 5% annually. This is a stable situation - on average, debtors will be able to repay creditors, and both will be better off for it. The economy will experience neither price inflation nor price deflation, on average, since the money supply is growing at the same rate as the availability of goods and services.
Now, imagine an economy where the average interest rate is 5%, the money supply grows at 5%, but the supply of goods and services does not grow (0%). This economy will experience persistent price inflation, as the quantity of money increases but the supply of goods and services remain constant.
Finally, imagine an economy where the average interest rate is 5% but the money supply grows at 0% annually. In other words, 1X of money exists at the end of the year, but 1.05X of money is owed to creditors at the end of the year - in this situation, large-scale structural defaults are inevitable, regardless of how many additional goods and services are produced. The situation will be disastrous for the average debtor, as the average debtor will be unable to repay on account of the structural mathematics. In situations like this, taking on debt is akin to gambling, even with a prudent business plan.
To sum up, it seems that a debt-based currency is only a stable social arrangement if both the money supply and the real economy are capable of expanding at least in parallel with interest rates demanded. A debt-based currency without a growing real economy results in inflation without tangible benefit, while a debt-based currency without growth in the money supply leads to structurally inevitable defaults and a consolidation of wealth by creditors at the expense of debtors, without any tangible benefits for the economy.
If this line of reasoning is accurate, it may explain why lending money at interest - 'usury" - was taboo for so much of history. Until the industrial revolution, most economies were incapable of sustained, signifigant growth. How much an economy could produce was set by how many peasants and craftsmen it had, so the growth imperative that comes with debt made no sense at best. Observations that "usury" was socially destructive were probably often accurate in pre-modern economies, similar to how gambling at casinos and lotteries in hope of economic benefit can be harmful today - a few win but the majority lose through involvement with it, and the main outcome is to concentrate wealth without adding much value to the economy.
Economic growth rates are today very low in the West by historical standards. What happens if, for whatever reason, they dip to zero, or even below zero, for a year or more?
Also, is a "growing" economy necessary for prosperity, or is it only necessary to satisfy the requirements of a debt-currency based economy? Could there be an economy where the quality of goods increases year after year, resulting in increasing standards of living, while population, resources used, dollars spent and hours worked all stay stable? If so, would such an economy be possible with a debt-based interest-bearing currency, or what type of currency would be best suited to it? Could an economy fixed or even shrinking in scale, but innovating and improving in quality be desireable?
Creating green colored printed pieces of paper or worse, creating entries in an electronic ledger, do not create real wealth. Savings created by deferred consumption is the only thing that creates real wealth. Just because the amount of money and real growth are temporarily the same does not necessairly mean that the growth is in products and services demanded by consumers. Eventually consumers will make their preferences known causing a bust.
I'm not sure I follow as to how savings can create wealth. On the contrary, I would think that work, either done by humans or machines, is the only thing which can produce wealth. Savings are mainly useful for accessing or organizing the products or proceses of work.
Savings indirectly creates wealth through investment in the future.
Say you make and sell 1 widgets a day by hand. You then use all of the earnings to eat way too much and you become a fat and happy man.
But then suppose that instead of eating soo much you save a little for future use, now you're not getting any fatter and might be a little sadder.
After some time, you take your savings and hire an inventor to build you a machine that makes and sells 3 widgets a day with your help.
From then on your gross earning are nearly tripled and you can become even fatter and happier than ever before.
We are the soldiers for righteousnessAnd we are not sent here by the politicians you drink with - L. Dube, rip
Oh no, not again... To have debts with positive interest rate ANY fixed amount of money is enough.
@bbnet
Ok, but let's say I make a lot of profit selling 1 widget a day, and instead of saving anything I just use part of the income to hire the inventor. Then the same thing would happen without anyone saving anything. What's most important is the work gets done to produce the widgets...
Or, let's say I save all of the profits from making widgets in the form of gold coins buried in a box in my backyard... obviously the savings won't be producing any wealth buried in a box, in fact they'd be producing even less wealth than if they were spent immediately on products, because if they were spent it would stimulate demand for more production.
@Andris Birkmanis
In your scenario, $1100 is owed back to the lender, and $1100 actually exists at time of lending. In our current money system, if you were to add all debt owed total in the economy and compared it to all money currently existing, debt owed would be larger than the money existing by about the interest rate. When banks loan money, money is created at the time of issuance through the fractional reserve mechanism but the interest is not created simultanously. The additional supply of money required for the interest to be paid must be created through new loans.
total debt > total money suppply
This is why the money supply 'has' to grow continually from the perspective of the current debt-money system - there is always more money owed back to creditors than actually exists, which is only stable as long as new borrowers keep taking out loans and thereby expanding the money supply, allowing previous loans to be paid back. If the money supply does not expand, it is mathematically impossible for all creditors to be repaid, debtors have collateral seized, frightening away prosective debtors and possibly leading to a spiraling panic which could crash the system.
Change the sentence "At the end of the month you pay me $1100, I pay you $1100." to "At the end of the month you pay me $1000, I pay you $1000. Then you pay me $100, I pay you $100." - and suddenly you do not need more than $1000 in existence! A careful reader may notice that no money is needed at that point at all - just clear all the mutual debt. When some money IS needed, is at the moment of initial borrowing or when some people decide not to spend all the money (saving), thus withdrawing it from rotation and breaking the "nice" balance. Let's see if we can model all these cases:
1. You lend me $1000, to be returned as $1100 in 1 month. You also hire me for a month for a salary of $1100. I use $1000 to pay for housing and groceries provided by you. At the end of the month we just clear our mutual debt. Net result - you have the same money ($1000), I have the same money ($0).
2. You lend me $1000, to be returned as $1100 in 1 month. You also hire me for a month for a salary of $1100. I use $900 to pay for housing and groceries provided by you (I want to save some money, so I eat less). At the end of the month we just clear our mutual debt. Net result - you have less money ($900), I have more money ($100).
3. You lend me $1000, to be returned as $1100 in 1 month. You also hire me for a month for a salary of $1000. I use $1000 to pay for housing and groceries provided by you (I've read an article by Krugman, perhaps). At the end of the month we just clear our mutual debt, but I still owe you $100. Net result - you have the same money ($1000), I have the same money ($0), but your PDA is going to seize my property.
In all cases total debt was $1100 (or even $2200, if we feel like counting the money you owe me for my work - this depends on the contract theory we use), while money supply was $1000 - as you can see, it is not a problem at all (except for me when I overconsume)!
When you pay the inventor on a daily basis to make the machine there will still be a period of time for him to come up with a design, test the design, acquire the materials to make the machine, make the machine, deliver the machine, and train you on how to operate and maintain the machine. You won't be able to enjoy the benefits of the machine immediately. Yes the important part is the actual production but capital driven productivity gains are rarely spontaneous. You'll still have to forgoe immediate consumption and defer consumption of your savings for some time in the future.
If you spend all your gold on other stuff immediately, you might stimulate increased production of other goods but you'll miss the opportunity to triple your profits. The economy will be as it was, since you were already spending everything you made. Less people will be able to enjoy your widgets than if you were able to increase your productive capacity threefold.
While there is nothing wrong with hoarding your gold in a backyard box, you might be tempted to put some in a fairly safe investment account at your local bank which might offer you 7% interest on it. The bank will lend this gold to other entrepreuners looking to increase their productivity.
@ bbnet
Well, savings are crucial as is deferring spending, I won't disagree about that.
However, no banks I know of are offering 7% returns right now, however. The highest my personal bank offers is 0.45% right now, and that's if you have a ton of money in a money-market account. I suppose my question is what happens in a money-system like ours if the interest rates banks can pay out actually is zero, or even negative, because of difficult economic conditions. I would think for banks to be paying 7% interest in a stable manner, the economy would also have to be growing, maybe at 7%. If the economy grows at 0% for some time, I don't see how the average bank would be capable of paying out interest - where would the interest come from?
Of course, if a bank "breaks the buck" and starts losing deposits, it is bankrupt and shuts down or gets taken over. If this happens to all banks at once, won't the currency system itself collapse? When banks start paying zero percent interest, won't nearly everyone shift their money out of the banks and into boxes in their backyard? Won't that effectively paralyze capital formation? Won't it force anyone who needs to roll over debt into bankruptcy, because no new loans are available? I don't think this is entirely theoretical - it seems like something like this basically happened in 2008, but the problem was literally papered over by the Federal Reserve and Treasury giving free money to banks and allowing banks to fabricate the value of their assets.
The analogy is a shark - sharks have to continually swim forward or they can't breate. Is a debt-based currency system like a shark, in that it either moves forward (grows) or self-destructs? If so, would another system be possible - a system analagous to an octopus, let's say, which can sit motionless and be contented?
ravochol: In situations like this, taking on debt is akin to gambling, even with a prudent business plan.
In situations like this, taking on debt is akin to gambling, even with a prudent business plan.
Lending, borrowing, doing business, getting out of bed, taking a shower, or living, for that matter, involves risk. Some debts are bound to be left unpaid and some showers uncompleted.
@z1235
Sure, but some amount of risk is prudent while others are just gambling. Commuting to work in the morning involves a prudent risk - riding a bike to work in midtown Manhattan during rush hour with no helmet or health insurance is gambling - a bad risk/reward ratio.
In a growing economy, taking out a loan to achieve an economic goal is often very prudent - but in a zero growth economy, it can be more like flipping a coin for double or nothing. This is probably why lending at interest was so frowned upon in pre-modern, no-growth economies - if the economy doesn't grow, where is the interest expected to come from? If interest is paid without the economy growing, I would think it would often come from basically a transfer of assets from borrowers to creditors - wealth concentration in the context of a zero-sum economy. From this perspective, while in a growing economy, loans tend to benefit both borrower and lender, in a stagnant economy loans tend to lead to socially destructive wealth concentration without producing much benefit to the economy.
Again, this isn't totally an abstract situation, growth rates are going way down, the interest that banks can pay is going way down, and default rates are going way up - there's definitely a direct connection here:
Ok, here's the short version of my question:
If the total economy does not grow, how can interest be paid on loans?
If interest cannot be paid on loans, but the money supply is based on debt, then does not a period of zero growth threaten not only large-scale bankruptcy because most loans become mathematically impossible to pay, but also threaten the collapse of the currency system itself?
Define "economy grows", please.
"Define "economy grows", please"
Well, there are two things that have to grow. The money supply has to grow in order to create enough money to pay back existing loans. If the money supply does not grow, The interest rate will instead become the default rate, and risk sending the economy into a downward spiral.
Also, the real economy, (the production of goods and services) must grow, or else the growing money supply will devalue and inflate rapidly. Businesses which have debt leverage will have to increase their bottom line in order to pay off the compounding debt, and usually the only way to do this is by finding more customers and performing more services. Even if businesses find another way to make money, if the real economy does not grow in line with the money supply (fiat) money will devalue unpredictably and be less useful as a medium of exchange.
Reading the news today, it's intersting that even the New York Times is talking about Greece like a Greek default, even a partial default, would inflict large losses on European banks and possibly trigger the payment of 'credit default swaps' in which American banks are thought to be heavily invested - possibly even leading to a domino-style collapse. In other words, they're basically claiming that the entire global financial system is teetering in the edge of bankruptcy and even a tiny country like Greece defaulting could push it over the edge. Presumably, a simple lack of economic growth would accomplish the same thing, even a minor shortfall in growth over time. The economy seems to be super-saturated with claims on wealth that cannot be satisfied - the question seems to be whether the real economy & assetts are foreclosed on & seized by creditors (government policy) or whether the currency is inflated, reducing the debt-burden (not government policy).