Debunking the “Debt-Virus Hypothesis”

Ardeshir Mehta

Started on 2 February 2011

Ottawa, Canada

Simplified on 7 February 2011

Currently, most if not all money is loaned into existence by banks, and is thus based on interest-bearing debt. There is no question that neither interest nor debt-based money are good for society, and I have written denouncing both debt and interest elsewhere.

However, there is a fairly common thesis, based on the fact that money is loaned into existence as interest-bearing debt, that if new loans are not continually being issued in ever-increasing amounts, enough money will not be created to pay the interest on existing loans; and as a result, at least some those loans will be defaulted upon, resulting in inevitable foreclosures. In essence, the thesis is that if an amount P is created as the principal of a loan (or of a combination of loans), the loan(s) cannot be fully paid back if the total amount of the debt exceeds P – as is necessarily the case when interest is charged. In other words, there would not be enough money in the economy to pay off the entire debt, and therefore some of the borrowers must perforce default. This is claimed to be an inherent feature of the system of interest-based debt itself, and to have nothing to do with the ability of the borrowers to earn enough to pay back their loans. The thesis claims that even if all borrowers could earn enough, by dint of hard or smart work, to pay back their loans, there simply would not be enough money in the economy to enable them all to do so: some of them would have to be unable to pay back their loans. In different forms this thesis has been enunciated here and here – among other places. The thesis is sometimes called the “debt-virus hypothesis” – though this is a bit of a misnomer, since the proponents of the thesis blame interest for being the problem, and not debt as such. To most of these proponents, an economy in which interest is abolished will not have the problem, even if debt continues to be a feature of that economy.

Part and parcel of this thesis is the claim that when borrowers repay loans, the principal, which was created by the bank when the loan was issued, is “extinguished”  – that is to say, destroyed – by the issuing bank. (It is agreed, however, by both the proponents and the opponents of the thesis that the interest is not destroyed, but is instead used to pay the bank’s costs and its shareholders’ dividends.)

Let us grant – even though it is debatable – that the second part of this thesis is correct, and that the principal of a loan is extinguished when it is paid back. However, the main part of the thesis is demonstrably incorrect: that is, the thesis is incorrect in saying that since only an amount P is created as principal, an amount equal to P+I – where “I” denotes the interest – cannot possibly be repaid, and as a result, some borrowers must inevitably default. The error lies in not taking into account the fact that loans are not paid back all at once, but in instalments. Each instalment includes both the principal and the interest; and it is agreed by both the proponents and the opponents of the “debt-virus” hypothesis that the interest is not extinguished. Indeed, according to most repayment schedules, the initial repayment instalments contain a greater percentage of the total interest than they do of the total principal. This can be confirmed by using any of the several on-line loan calculators.

An example of the results of a calculation made by one of these calculators, which can be found here, is given hereunder. Let us suppose that the total mortgage debt of all the people in the United States is around $14 trillion (this is probably close enough to the real figure today). For the sake of simplicity in performing calculations, let us suppose that all this money is loaned on one single date, February 2, 2011 – though not, of course, to a single borrower – for a term of 30 years at an annual interest rate of 5.3%, each instalment repayable annually. Additionally, we shall be generous towards the proponents of the “debt-virus hypothesis”, and assume that before this loan is issued, there is absolutely no money circulating in the economy; for if there were such money, that money could be used to pay off at least part of the interest.

Given these initial conditions, the repayment schedule table, calculated by the on-line loan repayment calculator provided here, will be as follows (please note that the figures in the table are in billions of dollars):

It can be seen from the table that the total amount of interest is actually greater than the total amount of the principal. Proponents of the thesis claim that since only $14 trillion were created to issue the loan, and the total mount of debt is more than twice that, there is not enough money to pay off the entire debt, and that, as a result, it is inevitable that some borrowers will default and be foreclosed upon.

However, they neglect to take into account the fact that the entire debt is not paid back all at once at the end of the period at which it is due: it is paid back in instalments, and the repayment schedule is such that at any given date, the amount of money in circulation is always enough – indeed, more than enough – to pay either (a) the next instalment, and the next, and the next … ; or, (b) there is enough money in circulation to pay off the balance due at any given date.

It is of course clear that if there is enough money in circulation to pay, either every single instalment, or to pay off the entire balance due at that date in one lump sum, then the entire debt can be paid off: and as a result, the inevitability of defaults and foreclosures does not arise.

The figures below demonstrate that both these conditions are easily satisfied, and there is always enough money circulating in  the economy to pay off the entire debt, either in instalments or in one lump sum.

This will here be demonstrated in stages, as follows. It is of course unquestionable that the money to pay the very first instalment, one year after the loan is issued on February 2, 2011, exists in the economy the date the first instalment is due – namely February 2, 2012 – as the following truncated payment schedule shows:

Since $14 trillion were created at the time of issuing the loan on 2 February 2011, a year later there is clearly more than enough money in the economy to pay the first instalment, namely $942 billion. Of this, $200 billion are paid towards the principal (and, according to conventional wisdom – which we shall here grant for the sake of argument – “extinguished” or destroyed), and $742 billion are paid towards the interest, which is not extinguished or destroyed, but is used to pay the banks’ costs and dividends – and which, as a consequence, returns to the economy.

In addition, the balance due at that date to pay off the loan in one lump sum is $13,800 billion; and since only $200 billion of the $14 trillion created initially to issue the loan will have been “extinguished”, the amount of money remaining from the initially-created $14 trillion is $13,800 billion – exactly enough to repay the entire balance due and thus pay off the entire debt.

Similar considerations reveal that there is enough money in the economy to pay the second instalment, and the third, and the fourth, and the fifth – as we shall see, all the way to the second-last instalment, at which stage the entire debt can be paid off by simply paying off the balance due.

At what stage will there not be enough money left in the economy to pay the next instalment, or, failing that, the balance due at that date? As we shall see, there will be no such stage! Consider the 11th year, when $2,887 billion in principal repayments would have been extinguished. At that stage, the amount of principal remaining in circulation (which is $14,000  billion minus $2,887 billion, or $11,113 billion) is still greater – much greater, in fact – than the amount of the next instalment, which, again, is a mere $942 billion.

As can be seen from the table, not only the twelfth payment, amounting to $942 billion, but even the entire balance of the loan due at that date, namely $11,112 billion, can be paid from the amount of money remaining from the original $14 trillion initially created, namely $11,113 billion.

The same applies at any stage of the loan. Examine what happens at the 20th instalment, as illustrated by the following truncated repayment schedule:

At this stage, the amount of principal which – at least according to conventional wisdom – will have been extinguished is $6,829 billion, which leaves $7,171 billion from the initial $14,000 billion created at the beginning of the loan period. This is more than enough to pay the 21st instalment, namely $942 billion. And the balance due at this date – 2 February 2031 – is $7,170, which can also be paid from $7,171 billion remaining in circulation from the initially-created $14 trillion.

No matter at which year we truncate the table, the amount of money remaining in circulation is sufficient to pay off either the next instalment, or, alternatively, the entire balance due at that date. Let us try truncating the table at the 25th year – then we get the following:

Again the amount of money remaining from the $14,000 billion initially created is $14,000 billion minus $9,953 billion, or $4,047 billion: which is more than sufficient to pay the 26th instalment, namely $942 billion, or, alternatively, the balance due at that date, namely $4,045 billion.

Even at the end of the 28th year, there is enough money left from the initially-created $14,000 billion to pay off the debt, as the following table shows:

The amount left over from the initially-created $14 trillion is now $14,000 billion minus $12,254 billion, or $1,746 billion. This, again, is enough to allow the next instalment to be paid, amounting – as always – to $942 billion; or, alternatively, to pay the balance due at that date, namely $1,744 billion.

What happens at the end of the 29th year? Let us examine the following truncated repayment schedule:

The money remaining from the $14 trillion initially created is now equal to $14,000 billion minus $13,104 billion, which is to say, $896 billion. This is enough to pay off the balance due at that date, which is $895 billion: and thus the entire debt can be paid off.

Similar calculations can be made using any other figures for principal, loan term, interest rate and repayment frequency. I invite my readers to carry out such calculations for themselves, and satisfy themselves that at no time during a course of a loan is there not enough money in the economy to repay the entire debt, either in instalments or in one lump sum – and, as a result, there is no absolute necessity for any defaults to occur. If defaults do occur, it is not due to interest being charged on the loans.

(Of course it should be clear to everyone that even if no interest were charged on loans, some borrowers could default, if for any reason they could not make their payments; defaults can, therefore, clearly not be avoided by eliminating interest.)

ADDENDUM RE. INFLATION CAUSED BY INTEREST: It is also argued by proponents of the “Debt-Virus hypothesis” that interest causes inflation. With this I agree; but the reason for interest-caused inflation – i.e., a rise in the prices of goods and services – is not always, or necessarily, what proponents of the “Debt-Virus hypothesis” claim it is. The reason for this inflation is that the interest paid on money borrowed by producers of goods and suppliers of services increases their costs, and these cost increases must be passed on to the consumer in the form of increased prices. As the above tables show, the total interest on a debt can be even greater than the principal borrowed. If the above-outlined $14 trillion debt had been issued interest-free, the same loan calculator reveals that it would have resulted in an annual payment of only $467 billion: less than half the annual payment of $942 billion at a 5.3% interest rate! If producers of goods and suppliers of services did not have to pay interest on the money they borrow – in addition of course to repaying the principal – they could lower their prices and still stay in business; and marketplace competition would compel them to do just that. As things stand, if they were to lower their prices to the same extent they could easily go out of business, because then their expenditure – of which interest is a significant part – might then exceed their income.

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