Chapter 2 - Where Does Debt Come From?

Here is the money and debt graph for the USA. Cash Currency created by the Federal Reserve Bank forms about 7% of the Money Supply and is shown in orange. The green section is credit. It is credit that acts as money even though it never came from the Federal Reserve Bank. Government debt and private debt are shown in red:

Graph of USA Money Supply and Debt. Creative Commons Attribute - Andy Chalkley.

Notice what happens around 2008. There is a cutback in lending to the private sector. This can be seen in the yellow line half way down the red section. There is also a hiccup in the Money Supply (green). Government debt expands. (The red section below the gray line.) The explanation follows.

Now we shall consider the borrowing mechanism. You walk into a bank and ask for one million dollars to buy a house. The bank officer looks you in the eye and says: “You are a good person. You have a job. Our bank will lend you the money.” On the appointed date, the bank writes one million dollars with a plus sign next to it, in the seller’s account. It writes one million dollars against a new loan account in your name, with a minus sign next to it. One million dollars with a plus sign and one million dollars with a minus sign makes zero. The loan is a sum zero transaction. It takes no money to make a loan.

How banks create credit and debt at the same time. Diagram by Andy Chalkley. Creative Commons Attribute

From that moment, there is one million dollars more money in the nation and one million dollars more debt.

Account holderBefore the house purchaseAfter the house sale
Seller0+$1 000 000
You0-$1 000 000
Bank total00
Funds required by bank to make the loan = $0
Reserves required by bank to make the loan = Borrowed

In the top graph for Australia, the green section got a little bigger and the red section got a little bigger.

From that moment, there is one million dollars more money in the nation and one million dollars more debt. Diagram by Andy Chalkley. Creative Commons Attribute

During this lending process, no transaction occurred at the central bank. No cash money moved from a vault. No customer deposits were required. Hopefully, you can conclude that money creation occurs when banks lend money. A problem is created when the debt is magnified with interest. When interest is added, there becomes more debt than money.

Interest is added to the debt. Diagram by Andy Chalkley. Creative Commons Attribute

At the end of the first year, you owe one million plus ten percent. At the end of the second year, you owe one million dollars plus ten plus ten. At the end of the third year, you owe one million dollars plus ten plus ten plus ten, and so on. The debt magnifies to exceed the money of the nation. This is one of many ways of arriving at this conclusion.

Interest after ten years. Diagram by Andy Chalkley. Creative Commons Attribute

There are many statements about this characteristic of our money system and these should not be drowned out by those that gain from the system and neither should it be ignored by persons who had a ‘formal economics education’ that fudged over this procedure. I list just a few of the many. The first one sounds like a shrill little voice shouting from inside the Bank of England waiting for the world around to wake up to reality:

Bank of England: “Money creation in practice differs from some popular misconceptions – banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.” …

“money is largely created by commercial banks making loans.” …

“Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits – the reverse of the sequence typically described in textbooks.” …

“Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.” …

“Bank deposits are simply a record of how much the bank itself owes its customers.” [1]

Please read the above again. The message becomes more apparent on subsequent readings.

Ralph Hawtrey, Former Secretary of The British Treasury: “Banks lend by creating credit. They create the means of payment out of nothing.”

Bank of England 2014: “Is it difficult to believe that the Central Bank with the blunt instrument of interest rate control can control private corporation lending habits. As inflation continues to flourish, their control appears to be a carefully controlled myth.” [1]

Marriner Eccles, Governor of the Federal Reserve. 1941: “If there were no debts in our money system there wouldn’t be any money.”

Please read the next quote one, two, or three times. Andrew packs many items into each sentence.You will not see them all in a single reading.

President Andrew Jackson 1837: “In the hands of this formidable power, thus organized, was also placed unlimited dominion over the amount of circulating medium, giving it the power to regulate the value of property and the fruits of labor in every quarter of the Union, and to bestow prosperity or bring ruin upon any city or section of the country as might best comport with its own interest or policy…Yet, if you had not conquered, the government would have passed from the hands of the many to the hands of the few, and this organized money power from its secret conclave would have dictated the choice of your highest officers and compelled you to make peace or war, as best suited their wishes. The forms of your government might for a time have remained, but its living spirit would have departed from it.” [3]

We make money from nothing and lend it out at interest. So we make money on money that never existed before we lent it out. Good Business. We write $1 000 000 in one account and -$1 000 000 in another account. Simple bookkeeping. The big joke is that there is not enough money out there for you suckers to repay us. You have to pay us more than we lent out. So we gradually take all your possessions. Creative Commons Attribute - Andy Chalkley.

So the act of making the money that enters the Money Supply is remarkably easy. The banks write one million with a plus sign in one account and one million with a minus sign in another account. There is instantly one million more debt on their books and one million more credit. The books balance. The debt magnifies with interest. The interest is the ‘income’ of the bank. The interest creates the profit for the bank. The Bank Credit is very popular because you can obtain it quickly when you need it. It helps business start-ups and business expansion. Businesses need money before they can make money. When banks make a million dollar loan, they create a million dollars of debt and a million dollars of credit. The credit gets moved from account to account as a means of payment. In this manner, Bank Credit acts as money because it enables payment. The debt stays with the borrower and magnifies with interest. Unfortunately, the sum total of the debts begins to exceed the sum total of the credit. The system must continue to prevent collapse. New loans must continuously be created to create new credit so that repayments on old loans can be paid.

There are some significant advantages of this system. Business needs money before it can make money. The availability of credit has fuelled the amazing industrial expansion of the last three hundred years. It allows us to build spacious houses. Bank Credit is so popular that it forms around 95% of our Money Supply and an even greater proportion of transaction values. Unfortunately, when one relies on Bank Credit for 95% of a Money Supply, any cutback in lending, causes a reduction in the Money Supply which causes a recession. Businesses go broke and people have less to spend. The magnitude of the Money Supply becomes a mathematical balance between the rate at which banks issue new loans and the rate that banks pull money out of the Money Supply as repayments. When 95% of the Money Supply is Bank Credit, the volume of credit issued by the banks is crucial to the economy. If the banks stop lending, there is a shortage of money. However, in this chapter, we are looking at the debt and how it is created.

Prophets of doom might get upset at this debt, but we have lived with this debt for a long time. I have concluded that we can live with debt. It conveniently makes people work very hard. It makes farmers productive. I have even listened to company bosses tell me that they prefer to hire employees with debt because they jump when they say: “Jump”. I state that we can live with unpayable debt. We are currently doing so and our society is still functioning. These unpayable debts collectively comprise an Impossible Contract. Lawyers usually give me clever explanations of what constitutes an Impossible Contract. However, to challenge this system with its impossible debt-contracts is to destroy the system. And it is the destruction and collapse of the system that is to be feared.

We can live with debt.

We can live with impossible debt.

We cannot live with a monetary collapse.

In the event of a monetary collapse, food will not leave the farms and the supermarkets will rapidly close their doors. Your gun will become your best friend, as people fight in the street over a sandwich with machine guns. If the money system collapses, you are dead or at least one-third of you will be dead within weeks. The undertakers will be overwhelmed. Monetary collapse can be more destructive than war.

Almost all money in circulation is created by commercial banks when they make loans.

Less than about 7% of all money originates from a central bank. [UK 3%, USA 7%, Australia 3.5%.]

Bank lending practices create a situation where there is ‘more debt than money’.

Bank lending creates an impossible contract where the debt is uncollectable. Collectively, the borrowers cannot repay the debts.

We can live with debt. We can live with impossible debt. We cannot live with a monetary collapse.

Abraham Lincoln, 1809-1865: “The Government should create, issue, and circulate all the currency and credits...”

Notice that Abraham says and credits:

Abraham Lincoln, 1809-1865: “The Government should create, issue, and circulate all the currency and credits...”

He knew a thing or two. He is saying that only the government should create the Cash Currency and the Bank Credit. The government has long since given up creating money. The government only creates the Cash Currency. However, the government does not use Cash Currency. You cannot even pay your taxes or government bills using Cash Currency. Citizens can only obtain Cash Currency through a bank by exchanging it for Bank Credit.

The task of this chapter is to work out where money comes from. The government has the authority to create the money of the nation. However, the government only creates Cash Currency which comprises a minuscule portion of the Money Supply. In Australia, Cash Currency is 3.5% of the Money Supply. In the UK, Cash Currency is 3% of the Money Supply. In the USA, the figure is about 7.3%. (It is the orange part in the graph above.) [There is a lot of USA Cash Currency overseas. Estimates suggest that half of USA Cash Currency is outside the USA.] The remainder is manufactured by accounting entries in banks. In the previously shown graphs, the orange is the Cash Currency issued by the central bank. The green is credit on the books of banks. Only a tiny percentage exists as Cash Currency. The bulk of the Money Supply is the green credit in the diagram, none of which originated from the central bank. The central bank only ever created $1460 billion out of a total US Money Supply of $18000 billion.

When the bank lends you a $1 million to buy a house, it writes $1 million with a plus sign in the seller’s account and $1 million with a minus sign in your account. The action does not damage their balance sheet and nor does it break the rules of double-entry accounting. The million dollars with the plus sign moves from account to account as a method of payment and the debt clings to the debtor. The green in my graphs increases when loans are made and falls when loans are repaid but the debt magnifies with interest. The million in green becomes the vital circulating medium whilst the debt magnifies with interest to become unpayable. It is the methods of double-entry accounting that allows for this loan procedure to occur. Double-entry accounting requires that: ‘for every increase in one account there is a corresponding decrease in another account’. This utterly brilliant accounting system allows new account money to be created by elementary book entries. When money exists in discrete units as generated by governments, money can only be positive. When money enters a bookkeeping system, the magic of accounting allows negative money, which we call debt.

From the moment that the loan of $1 million is made, there is $1 million more money in the nation and $1 million more debt in the nation. Interest is owed on the debt at say 10%. Thus, at the end of the year, you owe $1 million plus 10%. At the end of the second year, you owe $1 million plus 10% plus 10%. We now have more debt in the nation than there is money in the nation. The debt grows exponentially in the manner that is taught in high school. If someone has $10 000 in a bank account, the money came from someone who took out a loan. The borrowed money got passed from person to person by adjustment of bank balances. The original borrower is holding around $30 000 in debt corresponding to the $10 000 balance in your account. This next graph shows the ‘Magic of Interest’:

The magic of interest. A graph by Andy Chalkley. Creative Commons Attribute.

Unfortunately, the teachers fail to teach that this creates ‘more debt than money’. This is a gross failure on behalf of mathematics teachers. I can freely hoe into them as I was a high school mathematics teacher for fourteen years and I was not teaching the obvious either. It was not in the syllabus and so I did not teach it. Collectively, the debt is impossible to repay. How could the world mathematics fraternity completely miss this elementary logic? The solution is to constantly create more loans. There is, thus, a constant need to find more people to take out loans and more items on which to hang loans. One has to be quite inventive to find new areas on which to hang loans. I have more to explain on this mechanism, but let us not overload the mind at this stage. More in later chapters.

Mervyn King, Governor of the Bank of England 2012: “... the pretence that debts could be repaid was maintained for far too long.” [2]

Mervyn is telling us that the debts cannot be repaid. Notice that he also uses the word ‘pretence’, hinting that someone knew that the debts were impossible to repay.

From a government perspective, The debts cannot be repaid - so don’t repay them. Let the debts accumulate. The lenders are not going to bankrupt your government because they would lose all. They just play manipulation games and try to put conditionalities on you. From a citizens point of view, debt is a problem that can be handled provided the borrowed money is used for gain, not exuberance. Citizens should only borrow for productive reasons. From the nation’s point of view, private debt is needed to keep the Money Supply topped up. If the debt falls, the Money Supply falls and a recession or depression ensues. You will understand the complexities by the end of the book.

The debts can never be repaid. The volume of debt exceeds the volume of money and any repayment would destroy the vital circulating medium.

In our modern monetary system, around 5% of our money is produced by a quasi-government agency of questionable ownership and even more questionable control. [UK 3%, USA 7%, Australia 3.5%.] The remaining ~95% is produced by account entries by private entities. This is not a new phenomenon. It occurred and amplified itself during all the great empires, generally leading to a monetary collapse followed by empire collapse.

A graph of Cash Currency and Money Supply for the USA. A graph by Andy Chalkley. Creative Commons Attribute.

Debt in the Roman Empire

Debt played an important role in the money system of the Roman Empire and contributed to its downfall. Debts were called ‘nomina’, which translates as ‘names’. The names they were referring to were the names in their account books of those that owed money. These nomina were transferable and became a method of payment. The debts were thus transferable and were used as money. The credit became an extension of the Money Supply. The nomina brought the benefits of an expanded Money Supply and a simplicity of payment without physical transfer of coinage but brought the disadvantage of excessive quantities of debt which eventually become unpayable.

Contraction of the Money Supply at the collapse of the Roman Era. Creative Commons Attribute - Andy Chalkley.

At the time of the collapse of the Roman Empire, many of the less well off were borrowing from the well off. The less well off, as a group, became indebted, with no chance of escaping the increasing debt. The lending of money and ‘expecting more in return’, is called usury. This usury with its wealth and inescapable debt led to the collapse of Rome. Usury played a significant role in the collapse of the great civilizations of Egypt, Persia, Babylon, Greece and Rome. When credit augments the official Money Supply, credit becomes institutionalized as the main source of money. The wealthy become more adept at acquiring assets in a competitive environment and become more skilled at modifying political procedures to their advantage. The poor become more and more indebted until the credit system collapses when the volume of debt vastly exceeds the volume of money to pay those debts.