Money As Debt

This animated video is from a while ago, but it has recently been making the rounds again. It provides good background about how the modern monetary system came about, particularly the relationship between money supply and debt, and their role in the economy.

Those of you that have taken any kind of introductory macroeconomics course will probably roll your eyes for the first 10 minutes or so, dismissing the whole thing as something you already know (like the guy in this RedFlagDeals thread), but give it a chance and watch it all the way through; or at least until the 30 minute mark. At that point it switches from education to socialist propaganda, and thus rapidly becomes less useful.

I don’t claim to be any kind of expert on the subject, but here are my comments on the video:

  • Normally money gets created when a person creates a good or service. They produce something, and this productivity has value; they exchange this value for money because it’s more convenient than bartering.
  • Loans and debt come into the picture only if that same person wants to exchange some of their future productivity for money now. e.g. Say the person needs a car for a new job, so they borrow $30,000 of “future productivity” from a bank. The implication being that they will eventually generate much more than $30K in goods and services at their new job, easily paying back the loan.
  • So given that the future productivity doesn’t exist yet, it makes perfect sense that banks must “magically create money out of nothing”, as the video repeatedly points out.
  • What’s misleading in the video is how it repeats that everyone is in debt and/or relies on debt, that this is unsustainable, and that this is caused by the fractional reserve lending system.
  • Sure, many in North America (in the US in particular) may be in debt, but that’s not the fault of the system itself. Rather it’s due to their prolonged period of low interest rates, making debt attractive.
  • i.e. If interest rates are set such that borrowing from your future productivity costs you effectively 0% interest (when taking into account inflation), it’s not really surprising that “everyone” becomes heavily in debt.
  • This situation can be perfectly healthy as long as the value created by the future productivity equals or exceeds the debt repayment schedule. More specifically, this is usually what we call a “boom period”. Everyone prospers, debt (leverage) magnifies gains, and everyone is happy.
  • It becomes bad news (or what we call a “bust”) if the future productivity never materializes. i.e. People borrowing more than they can afford to pay back.
  • In an impending bust situation the only resolution is to allow the bust to occur, meaning homes get foreclosed, loans go into default, people lose jobs, the economy goes into recession/depression, etc. Once the bad loans have unwound themselves and all affected parties have “learned their lesson” (so to speak), a new boom cycle can begin again.
  • However, it is possible to prolong an inevitable bust by enticing people to borrow even more money to pay back their loans that are about to default. The video does a pretty good job of explaining this around the 25 minute mark, and clearly such a practice is not sustainable:

This is pretty much the situation that the US has been in for the past year. As with most things, the more that something inevitable is prolonged, the more it hurts in the end.

If the Federal Reserve and the Bush Administration had any interest in doing the right thing, they wouldn’t be bailing out home owners and distressed banks. The best thing they can do is allow the debt bubble to unwind naturally; banks and brokers have to realize losses, people have to lose homes and jobs. The difficult lesson needs to be learnt (again) that borrowing from future productivity is not risk-free.

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