Sunday, November 11, 2012

Debt based money does not exacerbate indebtedness.

I had a go at this question here a week or two ago. That explanation was a bit convoluted. So I’ll try something simpler, starting with a simple barter economy.
Debt exists even in barter economies. For example someone on a desert island with just a few families might want to be supplied with food while building themselves a new mud hut. And they might persuade the neighbours to supply them with food during the construction work.
The value of the food loaned would come to the same thing as a mortgage. And the neighbours would probably not lend the food for free: they’d want some compensation for lending the food, and that compensation equals interest.

Money is introduced.
Now suppose the islanders introduce money. One method would be to have everyone agree that a limited and equal number of tokens be allocated to everyone (as in a game of Monopoly). Another example of that form of money creation comes with baby-sitting economies.
Producing that money WOULD INVOLVE costs: making the tokens, having someone or some committee responsible for distributing them, etc.  So while the tokens themselves would be free, recipients of the tokens would probably have to reimburse those doing the manufacture and distribution of the tokens. I.e. recipients would have to pay for administration costs. But administration costs apart, that form of money is “debt free”, which to the opponents of debt based money is a big merit. However, the merit is entirely illusory, and for the following reasons.

Debt based money.
Suppose the desert islanders go for a different model of money creation, namely having one person act as a private bank, and lending money into existence. Inhabitants would pledge assets to the bank, which in turn would credit the accounts of the “pledgers” as appropriate.
But where does that money come from? Just as in 2012 real world economies, the money created by the private bank comes from nowhere, which means the bank has no reason whatever to charge interest for “lending out” the money. And if there is no interest, what’s the problem with the “debt” part of  “debt based money”?
Moreover, it’s debatable as to whether there actually is any NET DEBT because the bank owes “pledgers” collateral, while pledgers owe the bank an approximately equal amount of thin air money. But if you want to argue that debt does exist, then to repeat, no interest is charged, so what’s the problem?
The bank would of course have to charge for administration costs (as in the case of debt free money). But administration costs are not the same as interest. The reason why no interest need be charged is that no one has foregone consumption or leisure (administration costs apart) in order to bring the money into being. That’s in contrast to the above “neighbours” WHO DO forego consumption or leisure in order to supply the hut builder with food, and who therefor charge interest.
Thus assuming commercial banks get their costings right, they won’t charge interest simply for providing an economy with a money supply.  When it comes to LOANS, i.e. supplying someone with an above average amount of money for an extended period, that’s a different kettle of fish. Reason is that if one person is to borrow and spend a significant sum, someone else has to forego consumption, else aggregate demand becomes excessive.
And I’m not suggesting that in the real world private banks ACTUALLY DO avoid bringing about excessive demand (think pre-crunch asset bubbles). I was just making the simplifying assumption that they don’t.
Another simplifying assumption, which astute readers will have noticed, is that I assumed the initial introduction of money had no inflationary or “excess demand” effect. That could only come about if there were some compensating deflationary effect: like restricting barter transactions when money is introduced.

It follows from the above argument that strictly speaking, banks DO NOT charge interest. That is, banks’ expertise is in judging who is credit worthy, getting collateral off them, etc. Having made a loan, the bank simply extracts the interest from borrowers because that interest is demanded by those funding the bank (i.e. shareholders, bondholders, depositors, etc). And of course the bank charges for administration costs in doing this.
Now what’s the point of the middle man, and incurring the administration costs? I.e. what’s the point of the bank, once the loan has been made? Not much. That is, having made the loan, the loan might as well be handed over to those funding the bank: that cuts out the middleman. And that’s the logic behind collateralisation. Of course collateralisation has its problems, but it also has some underlying logic.
Also, note that in the case of loans, it is largely true to say that no money is created. Reason is that where a bank makes a loan lasting more than a year or so, the counterparty (i.e. depositors funding the loan) will probably have their money in deposit or “term” accounts. And that so called money is quite likely not to be counted as part of the relevant country’s money supply. And that’s CERTAINLY true where its bondholders or shareholders doing the funding.
Thus the whole idea that we pay interest in order to obtain money looks like a nonsense.

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