The “money as debt” fallacy.

Google the phrase “money as debt”, and you’ll find numerous claims that the money created by commercial banks is a form of debt, or that for every pound of such money, there is a corresponding pound of debt.

This idea is seems very plausible because whenever the commercial bank system creates £X of new money the recipient of the new money seems to be “in debt” to their bank to the tune of £X.

But dig a little deeper, and the latter “in debt” idea falls to pieces.

We’ll start with a barter economy.

When trying to solve a problem, it’s a good idea to take the simplest possible case of the problem and solve that. Then add the complexities later.

So let’s start with a simple barter economy where citizens decide that barter is inefficient and that instead, they’ll allow commercial banks to set up and do what such banks normally do: accept collateral from anyone wanting a stock of money and crediting the accounts of those people with money produced from thin air. So banks set up and embark on their “thin air” trick.

Now at that stage, there isn’t just one debt, namely the obligation on the “collateral supplier” to pay back the thin air money to the bank: there are two others.

Debt No. 2: there is an obligation on the bank to give back the collateral to the collateral provider when the latter has paid back the thin air money. So that, so to speak, cancels out debt No. 1.

Debt No 3: thin air money actually consists of an entirely artificial debt owed by the bank to the customer. And the basic promise made by the bank to the customer is that the bank will transfer the debt to someone else when instructed to do so by the customer: an instruction that can be conveyed to the bank with a cheque, debt card or by other means.

Having said that the latter debt is “artificial”, it is actually very real in the sense of being legally binding. That is, when someone writes a cheque for £X drawn on bank A and it’s deposited in bank B, bank B at the end of the working day will want £X worth of central bank money from bank A. And if bank A cannot come up the money, then bank A is on the path to bankruptcy.

To summarise, there are two debts worth £X owed by the bank to the customer, and one debt worth £X owed by the customer to the bank. And that nets out to £X owed by the bank to the customer: quite the reverse of what we hear from the “money is debt” brigade!!!!

So at this stage, i.e. where banks have credited thin air money to customers accounts, but before customers have spent any of the money, banks are in debt to customers.

Interest.

The interest paid or not paid on a debt is absolutely crucial, because if no interest is paid, the debt really doesn’t matter. To illustrate, if the Bank of England plonked a billion pounds worth of freshly printed £50 notes in my garage, I’d then owe the BoE a billion. But that would be no problem for me as long as I don’t have to pay interest!!

So is any interest paid in respect of any of the above three debts? Well the quick answer is “no”. But let’s run thru those debts just to verify that.

Re debt No.1, the thin air money owed by the customer to the bank, the question as to whether interest is charged here is a bit complex. You have been warned!

On initially crediting a customers account with thin air money, the initial charge/s made by banks varies widely from bank to bank. In particular some banks structure their charges in very deceptive ways so as to draw in customers, in much the same ways as supermarkets have so called “loss leaders”.

But let’s assume that bank charges strictly reflects costs.

So . . . on initially accepting collateral and crediting a customer’s account, a bank will incur administration costs: e.g. the cost of checking up on the value of the collateral, other staff costs, bank building maintenance costs, etc etc. So the bank will charge customers for those costs.

Of course some banks CALL THAT CHARGE “interest”. But it’s not interest at all!!! (In contrast, other banks call the relevant charge an “overdraft arrangement fee” or something like that).

What is interest?

In view of the obvious need to distinguish between genuine interest and other charges, let’s clarify exactly what “interest” is.

Interest arises even in barter economies. That is, if in such an economy one person lends a house or any other asset to a second person, the former will normally want some sort of payment. The first person will have forgone the use of, and enjoyment of the asset, and will want a reward for that sacrifice.

The payment made by the second person may well include something for items OTHER THAN  interest. For example the above house owner may pay the insurance or any number of other costs involved in maintaining a house, and the owner will want those costs reimbursed by the tenant. But that doesn’t detract from the basic point here, namely that asset owners normally want a reward simply for forgoing the use or enjoyment of the asset. And that is what’s called “interest”.

Now in crediting the accounts of customers, does a bank transfer any sort of real asset to the customer? The answer is “no”: all the bank has done is to write numbers in a ledger – or as is the case since the advent of computers, type numbers into a computer. So at that stage, there is no reason to charge interest. Administration costs – yes. But interest  - no.

Debt No.2.

This is the obligation on the bank to give collateral back to the customer, and a typical house owner certainly does not charge their bank interest here. (Things are a little different in the World’s financial centres where interest or some other charge is often made for lending out collateral, but  we’ll ignore that.)

Debt No.3.

This is the fact that thin air money is an artificial debt owed by banks to customers. Again, it is unheard of for customers to charge their banks interest on that so called “debt”.

To summarise, none of the above three debts are of any significance because no interest is paid in respect of them.

The customer spends their thin air money.

The next step is that a customer spends some of their thin air money. And “spending” means giving money to someone in exchange for  REAL ASSETS or REAL goods and services. Now let’s stop the clock again.

The recipient of the money has forgone the use of real assets or goods. And as explained above, people who make that sacrifice normally want interest.

In fact in the real world, it is normal practice when one firm supplies goods to another the expect payment within a month, and to charge interest if payment is not forthcoming after a month or two.

Reverting to our hypothetical economy, if someone who supplies goods and gets paid has no intention of doing anything more (e.g. spending the money they got) they’d just lodge the money in a bank deposit account and would try to get interest on it. And you cannot blame them: they’ve lost REAL ASSETS OR GOODS, and got nothing REAL in return. So they’ll want interest.

To summarise, once our original bank customer makes some sort of PERMANENT withdrawal of their thin air money by spending it, that means someone else has sacrificed real goods or assets and will want interest as a reward.

In short, people who deposit money in banks for a significant period normally try to get interest on that money, which in turn means banks have to pass on that interest to . . . well, to the people who have so speak helped themselves to goods or assets belonging to others.

In other words, when a bank charges genuine interest (as opposed to administration charges or admin charges which are CALLED “interest”), the bank is simply acting as a go-between and between two people, one of whom has supplied goods or assets to another (just as they might have done in a barter economy). And as is the case in a barter economy, the person conferring said assets or goods will try to get interest.

To summarise, where a bank charges genuine interest, that  is not a charge for creating money: it simply reflects the fact that one person has supplied assets or goods to another, and quite understandably wants interest. And the bank is simply acting as go-between.

Is money in a deposit account really money?

The above arguments are supported by a procedure adopted by those charged with measuring the money supply of countries round the world. That is, while money in current or checking accounts is almost invariably counted as money, money in deposit accounts tends not to be so counted. And the longer the “term” of the deposit account, the less likely the so called money in that account is to be actually counted as money. Plus, the longer the “term” of a deposit account, the more interest it tends to pay.

Put another way, as regards so called money which is quite clearly money (i.e. money in current accounts) interest just doesn’t enter the picture – little or no interest is earned normally on current accounts. So if anyone wants to claim there is a debt here, or that for every pound of money there is a pound of debt, then IN A SENSE they are right. But the real flaw in the latter claim is that no interest is paid in respect of the debt.

So just as where I’m in debt to the tune of a trillion trillion, the debt is immaterial because no interest is paid.

Established banking systems.

To recap, we’ve considered the scenario where there is initially no money, and commercial banks create money and that money is spent. Another and more realistic scenario is where a commercial bank system has been going for decades or centuries, and that system effects a money supply increase (as it was doing like there’s no tomorrow just prior to the recent crisis).

In fact, much the same reasoning applies. To illustrate, a bank will charge for ADMINISTRATION costs, but will not charge genuine interest for initially creating money. Interest payments only arise where one entity has lodged money in a bank for a significant period with a view to getting interest, which means the bank has to pass that interest on to entities that have WITHDRAWN money for significant periods from the bank.

But banning “debt money” WOULD reduce debts.

Having argued that commercial banks “debt money” does not increase debts, there is actually one transmission mechanism via which a ban on commercial bank money creation WOULD reduce debts. It’s as follows.

The above ban would obviously constrain lending by commercial banks, and the effect would be deflationary. But that could easily be countered by having the government / central bank machine create and spend new money into the economy. The net result would be that all participants in the economy would have more money and would thus not need to incur so much debt.