Posted on by Art Powell

Generally accepted wisdom tells us that excessive debt is a serious problem although some people question why government debt to a central bank is problematic. After all what is wrong with one government agency owing money to another? Why not just let the debt build up?

In this case the generally accepted wisdom is probably correct because debt is an important part of our money supply. If we were to lose our money supply our economy would be in big trouble.

Money is a complex part of our economy and I suspect few people, including a lot of economists, really understand how it works. Fractional reserve banking is complex but I have found it relative easy to understand. I have explained it in the essay LETS go to market: Dealing with the financial crisis on this weblog and there are numerous explanations that can be found with any search engine. I encourage you to figure it out.

About 90 per cent of our money supply is based on the debt created in fractional reserve banking. This is a problem for three reasons.

The first is that the money supply needs to be flexible up and down. The amount of money we need to facilitate the exchange of goods and services must be proportional to the quantity of goods and services we need to exchange. I know economists like to model the economy on a least squares regression formula which gives an upwards line with a steady slope. However, the reality is that the economy behaves like a fractal which means there are a series of ups and downs and more ups and downs within each trend. The amount of money needed varies with each up and down but fractional reserve money can only keep on increasing. This sort of works when there is continuous economic growth but if growth slows or reverses, then there are problems.

The second problem with fractional reserve banking is that interest is charged on the debt created. This adds a purely financial demand for more money in that it is not needed for exchange of goods and services. If all outstanding debts plus interest had to be repaid at the same time there would not be enough money in the economy. From time to time this feature of fractional reserve banking catches up with us and we call it a financial crisis.

The third problem is that when there is a financial crisis lots of people lose their savings. The need to save for a rainy day, or retirement, is a part of our psyche and fully exploited by the marketing arm of the financial industry but there are three ways in which we can lose our savings: a financial crises, inflation or a major economic downturn. these are more likely when the economy is not growing or declining. With the current economic climate most of us would probably be better off to live for today and worry about tomorrow when that day comes. The best way to secure one’s future is probably a market garden.

These are real problems and from time to time they cause havoc in the lives of most of us. Therefore we are right to worry about excessive debt. The good news is that there are other ways of creating money and the bad news is that money is such an emotional concept that most people are not prepared to consider other ideas.

One of the other ways of creating money is discussed in my ebook Funny Money: Adapting to a down economy which is available free from the link at the top of this weblog.

We tend to take money for granted so long as the economy is working but it is such an important concept that we would do well to try to understand it and make changes. I cannot see that happening so in the meantime we should remember the advise of Shakespeare: Neither a lender nor a borrower be.

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Filed under: Economics | Tagged: banking, debt, Economics, financial crisis, fractional reserve banking, money |