Monday, February 2, 2015

On Unpayable Interest, or: Confessions of a Monetary Crank

There is a fairly widespread misunderstanding -- if not among experts, then at least among laymen -- when it comes to "money creation" through bank lending and the need to pay interest on a loan. This misunderstanding has led many people to argue that there is a (logical) problem with interest payments. Their logic is this: Because the amount of money created equals only the principal of the loan, the interest payments are left uncovered and so we need to keep on creating more and more money through additional lending -- or else. You can find this kind of statements, for instance, here (500,000+ views) and here.

This is illogical.

Money circulates in the economy. Same money pays for many different things while it is in circulation. One of these things is interest. Money is only "destroyed" when it is used to repay -- partly or fully -- the principal.

 From a theoretical point of view, there is nothing that could keep us from paying the interest due on our loans even if the amount of money in circulation got decimated tomorrow. If, hypothetically, all debts were repaid, there would be no interest to pay. Well, then we wouldn't have any money left to pay for anything else either. But there's no need to fall in despair: We can always* create money if we really need it!

* This is a conditional statement, and refers now, specifically, to the purely hypothetical situation where all loans had been repaid -- a situation we will never face in the real world.

On Monetary Cranks

Learning how money is created through lending gives you a new perspective. I call it a "demigod perspective", as it can bring you a certain feeling of superiority. Think about it: 99,99 % of people just don't get it -- but you do! It gives you a chance to make fun of smart people who a) are academic economists, b) work at a commercial bank, or c) work at a central bank. They should naturally know better!

The problem with any demigod perspective is that it tempts you to think that even the experts (of the field in question) must be idiots. You might start calling them "experts" or even empty suits, to separate them from real experts like you. You might behave very much like Milton Friedman in some of his TV appearances, the only difference between you and him being that he knew much, much more about what he was talking about and behaved in a more civilized way. It is hard for you to hide your superiority, just like it sometimes was for Friedman.

Even very smart people might not realize that they must be wrong too -- and not only in thinking other smart people idiots. The latter is obvious. What is less obvious is how "monetary cranks" get money wrong.

Dennis Robertson, a Cambridge economist, wrote this in 1928 (via Naked Keynesianism):
"those who have Found the Light about Money take up their pens and write, with a conviction, a persistence and a devotion otherwise only found among the disciples of a new religion. It is easy to scoff at these productions: it is not so easy always to see exactly where they go wrong. It is natural that practical bankers, vaguely conscious that the projects of monetary cranks are dangerous to society, should cling in self-defence to the solid rock, or what they believe to be so, of tradition and accepted practice. But it is not open to the detached student of economics to take refuge from dangerous innovation in blind conservatism."

In 1928! It seems some of us are repeating the mistakes of our grandfathers. Well, we all do it from time to time, but most of our grandfathers were not monetary cranks. Think, for a second, what this must mean. Yes. Most of them had no freakin' clue about money creation by commercial banks.

A confession

I have been a monetary crank. I still am, some of the time, although I mostly keep it to myself, as I have always done (a-crank-in-a-closet). For all I know, this post could be just another sign of it! But I consider myself a bit wiser already. An idiot, for sure, but a wiser idiot. I don't think it's constructive to attack experts who don't know how "money" is created. Well, it might be suicidal to do more or less the opposite here -- to attack cranks like me. But on the whole, it could be constructive. I keep my fingers crossed.

A suggestion

If you have been an idiot like me, consider admitting it. It might make you feel better. But most importantly, it will make it more likely that other experts don't consider you a "monetary crank". Who knows -- they might even reply.

(To be clear: I often put money into scare quotes, because for me, money-as-a-medium-of-exchange doesn't really exist anymore. But I saved you from "money", this time.)


  1. Hi. A question on your statement " If, hypothetically, all debts were repaid, there would be no interest to pay." I did check the SSB i Norway, and it reads that there is about two times more debt K2, than amount of money M2. And the difference is increasing with almost the same rate at the interest rate?. So how can you "repay" all debt? I still have not got any assuring answer about where the interest come from?

    1. Hi Arild!

      Thanks for the question. I think you need to focus on how "money" circulates in the economy. As you correctly point out, M2 does not equal the amount of debt in the economy. But M2 can be used to pay back almost any debt (debt owed to a friend, for instance). Only in the case of bank debt, like a mortgage, M2 (in this case, a deposit) gets "destroyed" as the debt is repaid. In all cases of "non-bank debt" (corporate bonds, etc), M2 continues to circulate in the economy -- even when it is used to pay back this non-bank debt.

      When M2 is used to pay interest on a loan, it is never destroyed. So 100 units of M2 can be used to pay interest worth 1000 units (100 units at a time, ten times).

      So, in theory you could repay all debt, with interest, by using only 1 unit of M2. We have a lot of flexibility in these matters, as "money" is never what is ultimately owed. Ultimately, goods and services are what is owed. That's why you can repay your creditor -- if you run out of "money" -- by returning the car (in case of a car loan), or by working for her.

    2. Hi, thanks for answer, but i still don't get it..

      I did ask the SSB about how much of K2 is money producing bank loans, but they could not tell..

      If we fokus on the money producing bank loans.
      If have loan of 1000 units money producing. Next year i owe 1010 units. (if i fail to pay the interest..) . Do the bank have different accounting on money producing and non producing interests. Outside the bank it is only 1000 units of M2, or do the M2 increase by the interests?

      The forwarding of loan, is that what is called "fractional banking"?
      The book "Where does money come from" says ther is not such a thing, and they don't say a word about the interests, not in the you tube version anyway ( SSB recomended me that book/youtube)

      i am soooo confused..!-)

    3. There's nothing bad in being confused. This is what I wrote in the end of my first post:

      "Slightly confused? Out of initial confusion will emerge new understanding. I'm confused myself, but I'm working on it by unlearning and learning."

      I suggest you read my first three posts. It might help, or then it might make you even more confused -- I can't give any guarantee. But you won't learn much if you're not confused first, because that confusion is what makes you search for the "truth". Many of us don't bother, so they choose to remain ignorant.

      You can find an answer to your question also in this video I found yesterday (the answer starts at 1:13:53):

      Have a look and let me know if it helps? My answer is still the same: Paying interest does not "destroy" "money", so over time we can pay even 1,000,000 units of interest with only 1,000 units of total M2. But to really understand how this works, you probably must study the monetary system a bit more. Good luck! :-)