the plan for the future

A simple explanation

9 January 2016

There is a problem with the money we use. Most money is created by banks as a debt on which interest must be paid. If you take out a loan, new money is created. If you pay back the loan, the money disappears again. The problem is not that you have pay back the loan but that you have to pay interest. The money to pay the interest from doesn't exist unless someone else borrows this money for you. A simple example can demonstrate what I mean.

Assume that there is a small self-sufficient village that does not trade with other villages. This village needs € 1,000 to operate its entire economy. A wealthy village dweller has deposited € 1,000 in cash in the local bank for a year. He hopes to receive some interest on his deposit, which seems to be a reasonable desire. His deposit is a time deposit so he cannot touch this money for a year. The villagers can lend the money and use it for their daily affairs.

What happens? After a year the € 1,000 has to be returned, but also a petty € 50 in interest must be paid. There is a slight difficulty, a fly in the ointment so to say. The required € 1,050 simply is not there as there is only € 1,000 in cash to begin with. Then the bank comes up with a clever solution. The economy needs € 1,000 to operate and the € 50 is non-existent money that cannot be repaid, so the bank offers to lend the villagers € 1,050 at the same reasonable interest rate of 5%.

It is now clear what will take place next. At the end of the next year the debt has grown to € 1,102,50. This may not seem much but it cannot be repaid as there is only € 1,000 in cash. After 10 years the debt has grown to € 1,628,89. After 100 years it amounts to the considerable sum of € 131,501,26. There is no way of repaying this debt as there is still only € 1,000 in cash. Long before that time, the debt level may already have become a cause of some concern.

If the villagers fear the consequences of compounding interest, then nobody in the village may be willing to borrow the extra € 50 in the first year so that there would be only € 950 in the economy in the second year, while the debt remains € 1000. After two years there would be € 900 in the economy as another € 50 in interest had to be paid. After twenty years, there is no money left at all, only € 1000 in debt. Long before that the economy would have collapsed.

Of course reality is more complicated. A village is unlikely to be self-sufficient. Banks make expenses. Banks may lose money on bad loans. Depositors can spend their money so that others can pay back their loans. And debts do not have to be repaid in one year. Still, this example shows that financial crises can be caused by the interest that must be paid on debts. Central banks print extra money if this scheme runs into trouble.