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There is a meme in circulation that pretends to explain why the money supply is always going up.

The meme goes like this: If only banks can create money via a loan and they charge an interest on the loan, then the money for the interest payment must be created via a different loan. Ad infinitum.

In an example: if a bank loans out $100 and asks $110 in return, then where can that extra $10 come from if only the banks can create money?

The conclusion that is offered is that the money supplied by the banks must be ever expanding.

In this post I’d like to show why this conclusion is wrong.

The easiest way to do this is through a simple example, lets go through the steps:

  1. Assume there are only two people (on an island) Ben (farmer) and John (fisher).
  2. Assume that they want to use money and Ben agrees to create & loan $100 to John and John agrees to pay back in 11 payments of $10 each. One per month.
  3. In the first month John pays Ben $10 back. Now John has $90 in his pocket and 10 payments of $10 left.
  4. In the second month something important happens:
    • Ben buys fish from John with the $10 he received from John. (He regards this as interest, i.e. his earnings on the loan).
    • John now has $100 and 10 payments of $10 to go.
  5. I do not have to spell out the rest, as you can see now how John can indeed pay back the rest of his loan.

We see what really happened here: John “gave” for $10 worth of fish to Ben for the privilege of having had the loan. And he did this without there ever being more than $100 in circulation.

It sure is nice to be a bank! most of the time anyhow…

As we can see from this example the problem with the meme is that it fails to look at two important aspects: The factor time and the fact that banks are owned and are an integral part of society. Bank earnings flow back into the society and can be used to pay back loans. (Note: A bank knows the intrinsic value of money better than anyone else, it therefore much rather has something substantial to store their wealth than a stack of paper)

The existence of interest in and of itself is thus not responsible for the increase in the money supply.

Still the money supply always seems to increase, very rapidly:

money supply

(Note that there are several definitions of money supply. M2 is an often used gauge. Picture from wikimedia.)

But if it is not the existence of interest that leads to an increase, what does?

We can identify several factors:

Growth factors:

  1. Population growth. More people can loan more money.
  2. Workforce shift. More people have entered the workforce as more women started participating and thus the debt servicing capacity per person has gone up.
  3. Productivity efficiency growth. More production per person increases the debt servicing capacity.

Financial factor:

  1. Since the early 1980’s the interest percentage has steadily fallen. The debt servicing capacity has thus increased.

Not paying back debt:

  1. The government has an ever growing deficit. Largely because it rolls-over debt rather than paying it off.

Taken together these are more than adequate to explain the increase in the money supply.

Originally posted at: 2016-12-27
Last modified on: 2016-12-27