It is a simple fact that any significant cancellation of such debt which is not quickly followed by new debt of at least equal magnitude is bad news for any modern economy, because it means that part of the nation's money supply has been destroyed. And the perpetuation of such a situation will inevitably produce a recession. Thus a debt imperative is attached to the operation of the financial system in every capitalist economy today [3]. The institutions licensed to create new credit may be regarded as debt pushers; they have a vested interest in persuading as many people as possible to go further and further into debt.

Secondly, within modern economies the supply of money tends to grow on a regular basis. It is obvious that this growth partly reflects the growth of population. Economists are also aware of a current requirement for monetary growth to precede or at least accompany new production, otherwise the producer has no way of paying for the goods he produces. Thus we find today that productive growth and monetary growth are strongly correlated. This connection might seem at first to imply that very little monetary growth would be required if the economic system could be made truly sustainable -- meaning a system which embodies zero population growth, conservation of the natural resource base and protection of the environment. However the current reality is that monetary growth has a momentum of its own which is independent of these factors. That's because the producing and consuming sectors are not the only parts of the economy that require the creation of new money on a regular basis.

The investment sector, sometimes described as the paper economy, relies on both the payment of interest on time deposits and the re-investment of the interest returns - on an ongoing basis. The growth of this unearned income is a compounding process and is essentially exponential. Furthermore, even real interest income (ie, income corrected for monetary growth) tends towards positive exponential growth if interest rates happen to be excessive. A tendency for the interest component of debt to grow non-linearly is the first major flaw of our financial system. It feeds back and contributes to the cyclical nature of economic activity in the shorter term, as well as the necessity for monetary growth in excess of productivity growth over the longer term.

A related difficulty is that at every point in time the supply of money available to the public is insufficient to pay off the aggregate of principal and interest due on all loans, because some of the income received by the lender from previous loans has been locked up within the investment sector. Banks, for example, direct a small portion of their income (known as retained earnings) into deposits with other banks and other financial instruments within the banking sector. This increases each bank's capital, and assists banks in the management of their liquidity and risk. Also, a large part of the dividends of banks and other corporations (many of whose shares are held in trust by large investment houses) are reinvested in ways which return substantial unearned income (interest on bank deposits, rent, property and land investments, etc). These processes translate to a tendency for a shortfall of money within the transactive sector of the economy, which can only be made up for by an ever-increasing level of borrowing. The result is a spiral in the growth of debt and money [4].

There are strong incentives for new money - arising from new debt - to migrate from the productive sector to the investment sector, thereby inflating the prices of existing assets including property and shares. Available economic statistics reveal that the velocity of transfer can be relatively rapid. Thus compounding interest may be thought of as a major mechanism by which money is continuously siphoned off from the productive/transactive sector into the investment sector. An interesting aspect of this process is that banks are always seeking new reserves in order to meet the needs of their lending operations, and one mechanism for achieving this goal is to persuade customers to move their deposits from non-interest bearing accounts into time accounts, which possess no (or little) formal reserve requirement but pay considerable interest. This is often a less expensive way for banks to acquire reserves than by borrowing from the financial sector.

A simple example of the cumulative impact of interest is provided by a bank loan of $1,000 to be paid off by a customer at, say, 7% interest. Let us assume that the borrower pays off the loan after twelve months, thus providing the bank with a net income of $70. That's not the end of the story, because the repayment of principal frees up some bank reserves, thus allowing the bank to make a loan of new credit money to another customer. The process of successively lending amounts of $1,000 to different customers can be continued indefinitely, providing only that there is an incentive for customers to continue borrowing. In many respects the entire operation is equivalent to an ongoing loan to a single individual in which only the interest is paid off each year.

Let us also suppose that, of the $70 received each year as bank income, around 98 percent of it is spent in order to meet the bank's costs, with the remaining two percent retained as bank capital. Under the BIS Basle accord of 1988, there is a minimal capital adequacy requirement of 8 per cent of regulatory capital to risk-weighted assets. This means that in principle any increase in bank capital can translate into an increase in the bank's ability to create new credit money equal to a maximum of 12.5 times that capital increase (dependent on the willingness of the bank to lend and the public's willingness to borrow, but when economic times are good neither of these are a problem). A capital adequacy ratio of 8% implies that the ratio of risk weighted assets to total bank capital (ie, the weighted financial assets which may be 'supported' by that capital) is 100/8 = 12.5. Thus for this case an increase in bank capital equal to two per cent of its income, translates into an ability to advance new loans (i.e., to create new credit money) equal to 25 per cent of that income.

If this process were to be continued for several decades, then simple arithmetic shows that total debt owed to the bank after that time would be many times the original $1,000. In reality there is a constraint on the

debt-to-money ratio (with an upper limit of around two), due to a need for money to exceed accumulated interest at every point in time so that the requirements of the industrial sector can be serviced. This constraint on debt growth is effected through the cyclical behaviour of the economy -- the so-called "business cycle" -- which in crude terms is an inflationary period followed by a "correcting" recession.

It is worth also reflecting on the fact that within Australia, as in the U.S., the money supply has been growing at a long-term average of 8-10%. This may be compared with a population growth rate of no more than 1%, and real (as opposed to nominal) productivity growth of the order of 2%. Neither of the latter two factors can account for most of the monetary growth we have experienced. It is also particularly noticeable that total debt, interest due on total debt, and all of the monetary aggregates exhibit an almost identical long-term (average) growth rate. This is revealed in the attached diagram plotted for the U.S. economy (based on official figures) over the time interval 1960 to 1984, which demonstrates a secular [5] growth rate of around 10% in that country over that time span.

For the reasons elaborated above, and because industry and commerce rely heavily on borrowing from financial institutions, it follows that productive businesses are absolutely obliged to keep increasing their profits to ensure that a stable return can be provided on the growing investment pool. The main way to increase profits is to increase sales volumes because to simply increase prices is, by definition, inflationary. Therefore businesses are obliged to sell more and more .... whether people want their products or not. And if the public don't initially want it, they can be persuaded to buy the stuff through pervasive advertising techniques. In modern capitalism the name of the game is to persuade people to purchase what they don't really need.

In summary, our financial system is the essential framework around which all economic activity takes place, however it can be argued that the current system possesses some fundamental design flaws. These are revealed by the existence of a financial growth imperative, primarily traceable to society's inordinate levels of debt and interest on debt. The latter feature is also connected with a perceived need for financial saving as the means of funding the retirement phase of each citizen's life. Saving for retirement is now compulsory in many countries, which explains why the superannuation industry is booming. As a result, a large part of the money supply is increasingly tied up in time deposits and other paper investments. These features of the modern economy contribute significantly to the requirement for financial growth and overall economic growth. Consequently it can be argued that the debt-based operation of our financial system is a major driver for a range of social and environmental evils, including economic injustice and inequity, social decay, and environmental degradation.

A number of reforms aimed at solving this problem have been proposed by heterodox schools of economic thought, and even by a few orthodox economists in the past. The best known reform suggestion is to re-regulate the financial system to the extent needed to allow suitably constituted government agencies to create a much greater fraction of the nation's money supply, with the commercial banks creating a reduced fraction. And, most importantly, the publicly-created money would need to be both debt-free and interest-free [1]. The publicly-created money could be introduced into the economy as funding for capital works, new public infrastructure, infrastructure maintenance, and for a range of environmentally-oriented projects, including the development of alternative energy technologies.

Footnotes and references:

Note: This is a revised and extended version of an article published in the June 2005 issue of the newsletter of Sustainable Population Australia and also in the December 2005 newsletter of the CSIRO Sustanability Network.

 
John Hermann -- August 2007