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The Principal And Interest On Debt Myth

This article is more than 8 years old.

There are many ways that you can divide the world into two groups. Men and women, for example—with the former being about 50.2% of the population and the latter 49.8%. Or those that like math and those that don’t—where there are no accurate figures, but I’d hazard a guess at a 10% to 90% split.

The (almost) binary grouping that motivated this post is between those who reckon that banks, debt and money are of no real consequence in capitalism, and those who believe that the mere mechanics of banking guarantee that capitalism is doomed. The former includes the vast majority of economists, who delusionally model the macroeconomy as if banks, debt and money don’t exist. The latter includes most of the general public, who know that banks create money when they create a loan, and think that because banks insist on interest on loans, the money supply has to grow indefinitely.

I reckon the split in this binary division is about 0.1% in the “banks don’t matter” camp, and 99.9% in the “debt can’t be paid” group. But there is also a statistically insignificant handful who reckon that both groups are wrong.

I’m one of that handful, and both other groups exasperate the hell out of me, and my sprinkling of like-minded colleagues—hi Stephanie, Scott, Richard [both of you] and a few others. A tweet from one the 99.9% finally pushed me over the edge on Twitter this weekend—see Figure 1—and I promised that I’d devote my next column on Forbes to debunking this myth.

The myth itself is clearly stated in Bernie King’s tweet: because banks lend principal, but insist that principal and interest be paid by the debtor, the money supply has to grow continuously to make this possible. The corollary is that since debt creates money, debt has to grow continuously too—faster than income—and that’s why capitalism has financial crises.

Figure 1: The money supply must rise myth

So why is it wrong? In words, it’s because it confuses a stock (debt in dollars) with a flow (interest in dollars per year). But I’m not going to stick with mere words to try to explain this, because it’s fundamentally a mathematical proposition about accounting—that money must grow to allow interest to be paid on debt—and it’s best debunked using the maths of accounting, known as double-entry bookkeeping. So if you want to know why it’s a myth, brace yourself to do some intellectual work to follow the logic.

Firstly, in the following tables all accounts are divided into either Assets, Liabilities, or Equity. Loans (and bank reserves, which I’m not discussing in this post) are an Asset of the banking system. Deposits are a Liability. Equity is the net worth of the banking system—so it’s where interest on a loan is paid.

The tables may be a challenge to read at first, because they follow the double-entry bookkeeping convention that enables accountants to keep track of financial flows without making a mistake. This is that Assets are treated as a positive sum, while both Liabilities and Equity are treated as negatives. Following this convention, any transaction is shown as having a net zero effect: the sum across any row in the following tables must be zero.

 Also following accounting conventions, the source of any transaction is shown as a positive while its destination is shown as a negative. For example, if I lent Bernie King $100 from my bank account, it would be recorded as shown in Figure 2 with a plus against my account and a negative against Bernie’s:

Figure 2: A loan from Steve to Bernie seen from the Bank's perspective

  Assets (shown as Positive) Liabilities (shown as Negative) Bank Equity (shown as Negative)
  Bank Loans Steve’s Deposit Bernie’s Deposit
Steve lends to Bernie   +100 -$100
         

It might look strange at first, but from the bank’s point of view, its liability to me has fallen by $100. If I had $1,000 in the bank, the bank records this as minus $1,000. After I make the loan to Bernie, it now records its liability to me—my deposit—as minus $900. So from the bank’s point of view, +$100 has been added to my account, thus reducing its liability to me.

From my perspective of course, my bank deposit is an Asset—as indeed is the loan to Bernie. So in my accounting table, exactly the same transaction shows up as a fall in the asset of my bank account, with an offsetting rise in the asset of Bernie’s debt to me—see Figure 3. There the signs of the entries are intuitively obvious. The same applies to the way the loan is recorded in Figure 2, once you realise that it shows the transaction from the bank’s point of view and not mine.

Figure 3: The loan from Steve to Bernie from Steve's perspective

  Assets Liabilities Steve’s Equity
  Steve’s Deposit Bernie’s Debt
Steve lends to Bernie -$100 +$100    

The final preliminary before the proof is that in the following Figures—which are all generated by my free modelling program Minsky—the flows per year are shown as words rather than numbers. So “Wages” represents the flow of wages per year from the Firms to the Workers, the payment of interest is shown as “Interest”, and so on.

So here goes. Consider the simplest possible financial system, with just three social groups: FIRMS, WORKERS, and BANKERS. The FIRMS have taken out loans totalling 100 million. They then pay Wages to WORKERS, and Interest on the loans to BANKERS. WORKERS and BANKERS then consume the output that FIRMS produce (with CONS_W representing consumption by WORKERS and CONS_B representing consumption by BANKERS). There is no new lending in this model (shown in Figure 4) so if the myth were true, this system should crash, since Interest could not be paid—because, according to the myth, it can’t be paid because the BANKERS have only lent the money ($100 million) but not the Interest ($5 million per year).

Figure 4: Financial flows in the simplest possible system

I hope that previous sentence is enough to dispel the myth—did you see that I was conflating dollars with dollars per year? But if not, hopefully Figure 4 will do the job, since the sum of the entries in each column tell you how the relevant account changes over time.

The three accounts FIRMS, WORKERS and BANKERS will be constant if the following conditions apply:

Cons_W + Cons_B = Wages + Interest (the entries in the FIRMS column);

Wages = Cons_W

Interest = Cons_B                                                

Those three conditions are easily met in this simple model. Now of course the real world is much more complex than this simple model, but that’s not the point. Believers in the myth argue that it’s a simple mathematical fact that interest on debt can’t be repaid without borrowing more money from the bank than it first lent. If so, that “simple mathematical fact” should turn up in the simplest possible model. It doesn’t because it’s not a fact, but a confusion of a stock of money with a flow of money over time.

The loan is denominated in dollars. The money created by the loan is denominated in dollars. The economic flows that money enables are denominated in dollars per year. So long as those flows are large enough to enable the FIRMS to make a profit after paying Wages and Interest, then they will have no difficulty in paying the Interest—and they certainly don’t need to borrow more money every year to repay it.

So how large do those flows have to be? To get a handle on that, I’ve added some flow rates to the Minsky model—with the key ones being how fast the FIRMS turnover the money they have , how much of output goes to WORKERS as Wages , how quickly WORKERS and BANKERS consume , and the rate of Interest . The default values in the model—which you can play with if you download Minsky from here and install it, and then load this model into it—are that the firms turn over their accounts every three months (¼ of a year), that Wages represent 50% of Output, that WORKERS turn over their accounts every week (roughly 0.02th of a year), that the much wealthier BANKERS take a year to spend the sum in their account, and that the rate of interest on loans is 5%.

With those values, this simple model settles down to the FIRMS account having $90.65 million, WORKERS $4.35 million & BANKERS $5 million, for a total of $100 million. Output of $362.6 million per year is split into $140 million in profits per year for FIRMS, $217.5 million in Wages per year for WORKERS, and $5 million per year in Interest for BANKERS. The velocity of money—the rate at which the stock of money turns over—is 3.62 times per year (see Figure 5).

Figure 5: Simplest possible financial system with default values for parameters

Now it’s possible to choose values for the parameters that make this outcome untenable—in that gross profit by FIRMS is insufficient to pay the annual interest bill. For example, if you set the rate at which firms turn over their money to once every 7.6 years, gross profit falls below $5 million per year. But that would be a rather sclerotic capitalist economy, given that the velocity of money would then be 0.12 times per year.

Now of course the real world is far more complicated than this, and clearly there is a tendency in it for private debt to grow faster than GDP, as the empirical evidence manifestly shows—see Figure 6. But the causes of this phenomenon are far more complicated than a simple mathematical certainty because banks lend money, but not money plus interest.

Figure 6: Private debt ratios around the world

But that’s not because of a mathematical certainty, but other complex aspects of capitalism like the ones detailed by Hyman Minsky in his Financial Instability Hypothesis. If you really want to understand what’s happening in the global economy today, forget this simple myth and study up on Minsky instead.