Debt-Based-Interest-Payments, Debunking Mises

What Does “Debt-Based” Money Imply for Interest Payments?

Mises Daily: Monday, August 23, 2010 by Robert P. Murphy

Having studied this article and the Fractional Reserve Question for 29 years, I, Byron Dale,would like to make some comments.  I will add my comments in red, bold and italics. 

In a previous article, I explained the sense in which our fractional-reserve, fiat financial system is built upon debt-based money. In this perverse arrangement, new dollars come into existence through the creation of government and private debt. Going the other way, if the private sector and the federal government ever began seriously paying down their debts, the supply of US dollars would shrink.

These observations are not common in Austrian economics, but they are discussed quite frequently in radical critiques of banking and “money-changing” per se. (For a great presentation, watch this video  it is ZEITGEIST 2: ADDENDUM on youtube (FULL MOVIE!) – PLEASE SHARE from 3:00 to 18:00.) This is one of the very best videos that I have seen.  There are a few things that I don’t agree with. Everyone should watch it.  It shows clearly what could be done with a wealth based money system. Such critics claim that the charging of interest itself is unnatural. In the context of our present, admittedly perverse, system, these reformers argue that the people have to take on more debt, because “there’s not enough money in the economy” to pay back the principal and interest from their previous loans.  Up to this point I would agree with Robert Murphy– From here on, there are many things that I would disagree with.Although there is a grain of truth (not just a grain of truth, it is absolutely true) in this claim, in its crudest form it confuses stocks with flows. Although the critics are right to castigate our current system, they are wrong (absolutely right) when they say that interest payments require a constantly growing supply of money.

The Apparent Problem

The Factual Problem is that debt based money is a totally unworkable money system that make very rich masters out of the bankers and slaves out of the people.

In our fractional-reserve system, commercial banks literally create new money when they advance new loans to borrowers. In a previous article, I walked through an example where a bank first takes in $1,000 in currency as a deposit from a teenager named Billy. Then the bank gives Sally a business loan for $900. In the act of doing this, the bank creates $900 more money in the economy; Billy still has his $1,000 in his checking account, but now Sally can go to Home Depot and spend $900 on goods, pushing up prices. Over the years I have observed many shoppers leave Home Depot with more than $900 worth of goods and have never seen that push up the price of the goods for shoppers that went to the store the next day or next month. The truth is most businesses like Home Depot offer discounts, rebates, special financing, anything they can to get people to buy their products or services as there is always more goods and products than there is money to buy them with.

When Sally pays back her business loan, that $900 is extinguished; the community’s money supply (measured by aggregates such as M1 and M2) will drop by $900. But beyond her principal payback, Sally also owes the bank $45 in interest. When the smoke clears – assuming Sally didn’t default on her loan – the bank’s shareholders end up with $45 in extra equity, while the money supply of the community goes back to its original level. This is true.   However, what Mr. Murphy doesn’t address is that the banker received the $900 he loaned at interest, as free money.  The banker ended up with a $45 profit by simple fraud.  Mr. Murphy also leaves out the fact that with our current money system, all the money we use has been loaned at interest by the bankers.  This includes the $1,000 that Billy deposited in the bank.  Billy could not have had the $1000 in the first place unless he or someone else had not borrowed it from a banker. 

The only way Sally can pay the banker back the $945 she owes is to capture back the $900 she borrowed plus $45 that some one else borrowed and is paying interest on.  If the banker would add that money to his bad loan account that money would be taken out of circulation and would not be available for the original borrower or any one else to use.  However, the original borrower would still owe that money and must pay interest on it, or be foreclosed on.

 Additionally, if Billy’s $1000 was the only money existing at the time the bank created another $900 as a loan to Sally, Billy would be the only one for Sally to sell too.  If Billy’s $1000 was borrowed, (under our current money system if the money exists it was borrowed from a bank) where would the money to pay Billy’s interest come from?  Under our debt based money system if any debt money ‘exists’, regardless of location, or who has it, the original borrower still owes that money and must pay interest on it or be foreclosed on.

Interest and time makes the debt grow.  Time and interest does not make the money supply grow. The money supply only increases with more borrowing.

Now we can see the apparent problem: the commercial bank effectively created $900 “out of thin air” when it made a new loan to Sally. After buying raw materials, perhaps hiring workers, etc., Sally was able to create goods and sell them. This  illustration clearly shows that when the bank creates money as loans, the money supply increased before any goods were produced. This, we are taught, is the classic definition of inflation, too much money chasing too few goods. This ‘too much’ money scenario can only be created when banks increase the money supply as interest bearing loans, (based on the borrowers promise to pay and only loaning a promise to pay) with no corresponding increase in production of goods.

As soon as the interest kicks in the debt owed to the banker has grown but the money supply has not.  The money supply must be increased or it will be impossible for Sally to pay the interest on her loan with money.  We must also factor that Sally spent $900 to buy raw materials. Then she used her own, or someone else’s labor to turn those raw materials into more useable, higher value goods.  Say she wanted to sell those goods for $2,000.  This action in its self increases the need for more money. Because as Mr. Murphy has pointed out, the money supply is only $1,900, the $1000 that Billy has and the $900 the bank loaned to Sally.  If the money supply did not increase Sally would not be able to sell her goods for the $945.00 she needs to pay the loan plus the interest and the $1,055 she wants and needs to pay for the labor, taxes and other living costs.  The principal payback is straightforward enough – she was just returning the $900 that the bank originally gave to her.

However, we have to ask, where did the $45 in interest come from? In order for Sally to pay back a total of $945, she had to not only recoup the $900 from her customers that she had earlier “spent into the economy,” but she had to extract an additional $45 that didn’t come from the bank.  But it did come from the bank as a loan to someone else, as Mr. Murphy himself stated in Paragraph 1,“new dollars come into existence through the creation of government and private debt.”

In a sense, the whole operation of the bank creating money, lending it to Sally, and then receiving payment with interest, leads to the outcome that the bank shareholders have somehow (through theft by deception) extracted $45 in money that was originally held by the rest of the community.  Under our debt money system the community does not have any money unless they too have borrowed it from the banking system at interest. The $45 that Sally paid in interest is someone else’s borrowed principal that is accruing interest.) Look again at Murphy’s statement above. 

When some people realize how this works, they conclude that further debt is built into the system: After all, what if everyone in the community tried to pay off his or her bank loans?  Not only would the overall money stock constantly shrink, as the loan principals were eliminated and no new loans replaced them, but the need for paying interest on top of the principal would transfer more and more of the money held by the community into bank coffers. It appears that the public would be physically unable to collectively pay off their loans with interest, because they would be scrambling for a shrinking stockpile of dollars.

We can think of it like this: If every dollar in existence right now corresponds to the principal of someone’s loan from a bank (or from the Federal Reserve’s loan to the Treasury), then it seems mathematically impossible for everybody (including the federal government) to become debt free. In principle, everybody – including Uncle Sam – could pay back, the entire principal that was originally borrowed, but at that point there would be no dollars left in existence! So how could anyone pay back the interest still owed?

Interest Flows versus Money Stocks

Although it’s true that if everyone tried to pay back his or her debts at the same time, the world would “run out of dollars,” in general I think this critique overlooks an important distinction. When people owe interest, this is a flow concept that accrues over a period of time. In contrast, the total “money supply” is a stock concept that applies at a specific moment.

To see how this relates to our current discussion, let’s consider a much simpler example. Suppose there are two neighbors living in a community that uses actual gold coins as its money. Mr. Smith starts out with 1,000 gold coins, while his neighbor Mr. Brown starts out with none.  Here, Mr. Murphy pulls the old bait and switch that the Austrian’s are so good at and that they do often.  He started out talking about a debt based money system where all the money is created when the loan is made. Now, in the ‘two neighbors’ example, he switches to a wealth based money system where the money is not created when a bank makes a loan. Nor is the money destroyed when the loan is repaid. In this example if the gold coins had been coined under the Free Coinage Act of 1792, it would have been a wealth based money system. Mr. Smith could have had the money without borrowing from the bank and the money supply would increase as more gold was mined (with an increase in production).

Brown asks Smith if he can borrow 100 gold coins for a month. Smith agrees, but insists on a 12.7 percent APR, which works out to 1 percent interest charged monthly. So on day one of this deal, Smith has 900 gold coins while Brown has 100.

At the end of the month, after whatever buying and selling he has done with the rest of the community, Brown has (spent and earned back his 100 gold coins) accumulated 100 gold coins in his possession. He pays that back to Smith. Ah, but Brown is still short 1 gold coin. So he offers to cut Smith’s lawn and paint his fence (with materials provided by Smith). In return for this labor, Smith pays Brown 1 gold coin, which Brown then uses to pay off his interestIn this illustration Mr. Murphy proves (although it doesn’t seem that he understood what he did) that interest on any thing that can’t reproduce itself is impossible to pay.  Let’s spend some more time thinking about what Mr. Murphy just said. “Mr. Brown borrows 100 gold coins.  Then, he works for a month buying and selling things trying his best to earn a little income.  All he is able to do is earn back the 100 gold coins he borrowed.” (Which is all he could have earned back because that was all the money there was in circulation).  “He pays the 100 gold coins back to Mr. Smith.    He has not earned enough to pay the interest so he has to ask Mr. Smith for a job so that he can earn enough to pay his interest to Mr. Smith.”

In truth, all the loan did was force Mr. Brown to become a debtor slave to Mr. Smith.  It would have been a lot smarter for Mr. Brown to just go get a job from Mr. Smith in the first place. That way, he would have gained monetary income by working for Mr. Smith, instead of becoming a debtor slave just to pay interest to Mr. Smith like he did in Mr. Murphy’s illustration.) 

In the following month, Brown repeats the process: He borrows 100 gold coins up front, pays them back at the end of the month, and performs 1 gold coin worth of labor to earn the money to pay off the interest. Eventually, Brown and Smith simplify things. They constantly roll over the 100 gold coins of principal, and Brown performs a day’s worth of chores once a month for Smith as the “servicing charges” on the loan.  It’s very clear that Mr. Smith just made a slave out of Mr. Brown — In his simple illustration, Mr. Murphy has confined the transactions to just the lender and the borrower.  Which is the correct thing to do for his illustration, but what if Mr. Smith (the lender) would have decided to pay some one besides Mr. Brown to do his chores? Mr. Brown would not have been able to pay his interest, would have would have been forced into bankruptcy and would have lost his collateral to Mr. Smith.

As this simple example illustrates, a fixed stock of money can “turn over” several times a given calendar period, and thus provide the means with which to pay back a higher volume of loans. Here I must point out that the interest on the loans was not really paid with money but with labor. Try paying your interest at the bank with labor! There would be a lot more employees at the banks! Even in a community with a fixed stock of money – picture people using gold where no new gold is being mined – the capitalists can charge positive interest rates, without necessarily forcing anyone to default.  I have already explained why this last statement is not a true.

All Mr. Murphy’s illustrations have proven is how the bankers have made slaves of the people.


It should go without saying that I am not endorsing the machinations of our current financial system, nor am I defending the ethical legitimacy of the interest earned by today’s fractional-reserve bankers. Oh Really?  My modest point in this article was to correct the widespread misconception that in a system of “debt-based money,” further rounds of inflation are mathematically necessary to avoid default on previous loans. In general, this simply isn’t true, because the bankers can spend their interest payments on real goods and services, thereby returning that money to the public, which can then use it again for further debt payments.

The facts are:

1. In a debt money system even if the banker did spend all the interest paid to him back into the community that would only bring the money supply back up to the principal that was loaned into circulation. 

2. There still would not be enough money in circulation to pay the interest without someone borrowing more credit money from the banker, or increasing the money supply some other way (which is not allowed under our current debt money system).

Here, I must point out that in Mr. Murphy’s illustrations, if the bankers did spend all the interest money back into circulation to buy goods so that most of the people could have money to use, it would not really be much different than foreclosing to get the goods.  Either way the bankers would get all the goods for Free.  The biggest difference would be a lot of the money spent by the bankers would go to the lawyers and not to the borrowersThere would be no way for anyone to gain a money profit without someone else going broke. 

In a debt-money (loan-created money) system, interest paid on a loan is simply someone else’s loan principal captured in the process of commerce.

The fact is:

1. If there is no money and a loan creates the first and only $1000, as soon as interest is added, the debt becomes greater than the money supply. Let’s say the A.P.R. is 10%. At the end of a year the borrower’s total debt is $1100. The borrowed money supply is still only $1000.

End of story.