Does Principal less than Principal Plus Interest Imply Default?

There has been some conflict over the idea that, since the majority of money (95%) is created as debt, the problem is that while what money is owed is principal plus interest, (P + I) and what money exists is merely the principal (P), it is always impossible to pay back the total, (since P < (P + I),) and so there will always be default.

Paul Grignon, from whose excellent movie   “Money as Debt II” http://www.youtube.com/watch?v=jQuEOUzA9P8 I originally gained this idea, now says the primary cause of default is secondary lending.  

http://peemconference2013.worldeconomicsassociation.org/?paper=proposed-new-metric-the-perpetual-debt-level If I understand him right.

We examine this.

WE consider a steady state economy, one which is neither growing nor contracting.  The velocity of money V we consider constant.  Banks lend out $100 at the beginning of the year.  This is all the money there is in the economy.  All money is debt.  At 6% interest.

All loans are to be paid in full at the end of the year.  Otherwise, there is no interaction between the banks and the rest of the economy.  $106 is required at the end of the year, but only $100 exists.  If we look at all of the actions internal to the economy, that is, the economy separate from the banks, none change the money supply. Only the paying back of loans, which extinguishes the money, or creating new loans, which creates money, changes the money supply.  If loans are paid early, the interest is collected. Paying early extinguishes the money, whether on principal or interest.   If the money supply is to be maintained, the loans are lent out again.  In this case $106 is still required at the end of year. Of course, the next year, $106 can be lent out, thus allowing the $6 in interest to be rolled over, along with the rest of the money in the economy,  the debt compounding. But see below.

Internal lenders, (secondary non-bank lenders,) who must first borrow the money from the banks at the beginning of the year, before they lend it, do not change the money supply. They may sell the loan, for money, but that doesn’t change the total supply of money.   Neither do they change the default rate to the banks.  In this sense: Default to secondary lenders is passed on as default to the banks.  They transmit, but do not originate.  

But this is the basic point.  If we keep secondary lenders separate from banks, the net default rate to banks does not change. The default rate is still just a consequence of the original shortage of money to pay the interest, unless the money supply is expanded.  Anyway, if the default rate is greater than the 6% interest rate, then there is money retained in the economy by other actors.  If the default rate is 8%, then 2% is retained as cash by the economy for the next year.  Indeed, we would expect a certain amount of this kind of default in an economy in any year.  Call this distributional, as opposed to secular, default. Roughly, the distributional default rate would be a constant, although this might depend on the growth rate or inflation. We will ignore this, as it is not brought about by a shortage of money, but by the distribution of money in the economy.  Because of distribution, some people will have more than enough to pay back their loans, some people will not have enough, and this will even out.  But because P < P + I, there will in addition always be some who will not have enough money to pay back their loans.

Suppose now instead the banks spend $6 throughout the year. (Interest to savers may be some of this.)  Essentially they are giving away this money, although they may demand real services for it. Then there would be $106 at end of year.  There would be no secular default, but there would be 6% inflation, with constant velocity, as the money supply has expanded by 6%, while the economy has, by assumption, remained at a steady state. The same result would happen if the banks were just to lend out $106 at the beginning of the second year, as above, thus covering what would otherwise be defaulted upon at the end of the first year.

Suppose the banks spend $10 throughout the year.  Then there would be $110 at the end of the year, and 10% inflation, with $4 remaining in circulation at end of year, when all loans were called due, and $106 collected.   But $106 would still have to be lent out, at the next cycle, as the required base money supply is now $110, and anything less, (or more,) would change the money supply, and if less, cause deflation, from $110, and if more, inflation.    

Suppose the banks spend just $3 through out the year.   Then the money supply increases by 3%, and there is 3% default.  This suggests an equation: rate of Money added + Default rate = mean interest Rate. (Rate of Money added in a steady state economy will equal the inflation rate, but it will not equal the inflation rate in a growing economy.)

Let’s look at this some more.  The increase in the money supply need not be just the banks spending money.  It could also be the government issuing money.  And this increase in the money supply could be greater than the interest rate.  Then default would be ‘negative,’ (by which we mean there would be net cash at beginning of the next cycle,) and inflation greater than the interest rate.  

Another thing that could happen is the banks could increase the rate of loaning money above $100, the first cycle.  But this would just set the base at say $110. Thus the increase in bank lending would also contribute to inflation.

Suppose now an economy growing at 3%.  Then if the banks put in $6, 6%, we would have 3% inflation:  Rate of Inflation = rate of Money added – Growth rate.  As before, zero secular defaults.  But suppose instead the banks just spend nothing.  This will lead to 3% deflation. The default rate would still be at 6%, though, because there is the 6% shortage of money. So in a growing economy, our first equation still is: rate of Money added + Default rate = mean interest Rate. These terms are the purely monetary terms.  Inflation and the Growth rate are the terms involving the real economy.  Substituting for rate of Money added, from one equation to the other, we have: rate of Inflation + Growth rate + Default rate = mean interest Rate. Note we allow the default rate to be ‘negative’ if there is a sufficient increase in the money supply.  (Note also that if we include the distributional cause of default, we actually have:  rate of Inflation + Growth rate + Default rate > mean interest Rate.   But distributional default is a complication we are ignoring. I think it averages out as roughly a constant over time, and so does not affect the secular default rate.) 

Back to a steady state economy. Instead of all money being created by loans, we are told that there is $5 in the economy, not created by the banks as loans.  Banks lend out $100 at 6% interest at the beginning of the year.  So there is $105 at the beginning of the year.  All loans to be paid in full at the end of the year.  No other interaction between the banks and the economy.  So $106 is required at the end of the year, but only $105 exists.  All internal actions, in particular the actions of internal lenders, add to zero.  Paying early extinguishes the money.  However, unless $5 is put into the economy the next year, then the banks will have all the money. ($105) Then the next year all the money which is in the economy will be lent, that is, all the money will be created as debt.   Which the banks loan out at 6%, requiring $111.30, or default to the amount $6.30.  So we see an amount equal to the interest on all money must be pumped into the economy each year to avoid defaults.  This leads to inflation, at the rate of interest.

So we see that, in a steady state economy, unless new money is created each year, at the mean rate of interest, there will be default.  If new money is created each year, there will be inflation.    

Consider instead overlapping periods of loans.  Banks lend out $100 at beginning of year: $50 for a year;  $50 for 6 months.  Then the banks loan out the $50 again at mid year, for a year, etc.  Assume as before the velocity of money V is constant.   Then $51.50 is taken out of the economy at the end of 6 months. If then only $50 is lent back in, the banks keeping the $1.50 interest, then only $98.50 will remain in circulation.  But if we assume business as usual, and that the money will be distributed throughout the economy, then the $1.50 interest due after 6 months will be defaulted on.  This default is required to maintain the money supply, in the economy. If it is not defaulted, the money supply will contract by $150, unless the banks now lend out $51.50.

Suppose instead the banks will lend just the $50 out again.  After 1 year, then, on the first year loan $53 will be taken out, so only $95.50 will remain in circulation. So we see that with overlapping loans, the result will still be some combination of deflation, default, or increasing indebtedness with inflation.

What about with deflation?  Indebtedness can still compound.  The banks keep all interest to themselves. Then after one year, $100 is owed on $94 in circulation, and after two years $100 is owed on just $88 in circulation, etc.  This is a cumulative 6%, or $6 on the $100 which is owed.  This is constant, so the reduction in circulation each year is constant, although the percentage decrease in money in circulation increases.  6.38% decrease in the 2^nd year, 6.82% decrease in the 3^rd year, 10.35% the 7^th year, when $100 will be owed on just $52 in circulation.  This is independent of any growth, or contraction, in the in the real economy.

In this toy economy, we have either default or compounding debt, just because P < P+I.

Finally, we note again the odd consequence of distributional default, which is that the economy retains cash not owned by the banks.  Peculiarly, except for this small percentage, plus any money issued by government each year, or given away by banks, each year, all money is effectively owned by the banks.

Zero Interest and the Greek Problem

One way of looking at the problem of zero interest rate is that lenders have a lot of money to lend, but no one to lend it to, as borrowers have a lot of debt, on which they are already paying a high interest. Big supply, low demand. This is the expected end state of the lend-borrow cycle. It is a stable state, which can only be changed by sufficient disturbance. Even the massive borrowing of the government is not enough to disturb it, so the amount of money lenders are holding must be even larger. The only way to get off this state is to eliminate the debt, so the lenders can go back to lending the money to the borrowers. Note, this does not require the lenders to give up their actual money, just their claims on the borrowers.

If we suppose the borrower has nothing, then the only actual loss to the lender is the claim on the future income stream of the borrower.

If we look at Greece under austerity, its income stream will be negative for the foreseeable future. Thus, the Germans, unless they propose to buy up Greece, will do themselves a favor by forgiving the Greek debt. Lending more will only result in larger default down the road. So they will also do themselves a favor by refusing to lend the Greeks any more money, but here the problem is the producer-consumer problem: The Greeks are a net consumer of German production, and thus stimulate the German economy (at the expense of their own. See: http://anamecon.blogspot.com/2010/04/effects-of-unbalanced-trade.html ) Without the borrowed money, the Greeks won't be able to continue consuming German production.

However, because of fractional reserve banking, Greek debt is collateral for other money. People borrowed to lend. And others borrowed to lend. That is, Greek debt is money, to its holders, and acts like money. If it disappears, those who borrowed to lend to Greece will have no collateral. The bottom line is forgiving the debt would result in a contraction of the money supply. Because the loans are highly leveraged, that is capital requirements are low, the contraction is likely to be disproportionate to the actual default. This would put additional deflationary pressures on other countries of the Euro periphery, and would also make it more difficult for these countries to pay their debts.

Refusing to lend the Greeks any more money will force the Greeks to pay their taxes, which they seem to be unwilling to do, and/or contract their public sector.

Of course, this does not address the other basic problem, which is there is too much money at the top of the economic pyramid. Since this leads to a contraction of demand in the rest of the economy for real production, there are no profitable real investments for this money to make. The financial sectors of the various nations are simply too big to be supported by the real economies. For US, see: http://anamecon.blogspot.com/2010/06/that-bloated-financial-sector.html )

Thus a large contraction of money at the top might be economically therapeutic. (And with less money to lend, interest rates might well go up, though this itself might stimulate inflation. Hmm...) However, the government should just guarantee the money of the depositors, (ie taxpayers and consumers,) rather than the banks, which need a shaking out anyway. Indeed, guaranteeing the banks just aggravates the problem.

The Banks are Forcing Debt on the Rest of US

(Check out the videos in the previous entry.)

Government issues about 5% of the money that is in circulation. The rest of it is created by banks, when they make a loan.

When a bank makes a loan, it creates the money to loan out of nothing, just adding numbers on their computer. So the total money supply is the principal of all the loans outstanding, P, plus the amount issued by the government, G. This does not include money the government borrows, which, after all, is still just created by the banks.

The banks then charge interest on the loan, on money which they have created out of nothing.

Because of interest, the total money needed to pay off all loans will be greater than all the money loaned, ie greater than the money supply in ratio (P + G + I - E)/(P + G), where I is all the interest, (not the interest rate,) and E is all the expenditures of the financial industry, if I > E. (If I < E, the opposite will be true.) This implies (I - E)/(P + G + I - E) share of borrowers will always be unable to pay off their loans. Only when I = E is the system stable, and all borrowers able to pay off their loans. Where E is less than I, this leads to an exponential growth of both the money supply and debt. Only with an exponential growth in real consumption, and thus necessarily production, can this be maintained. Since this is ultimately impossible, this spiral has no (nice) ending.

What can the government do? From the equation, it would seem not much, since G appears in both numerator and denominator, and is only a small portion of the total money supply. However, if we consider that the interest comes due at the end of the time period we are considering, it would seem that if G were to increase by I-E over that period, the money supply would remain in balance. That is, the government, if it wishes to keep the economy from going bad, would ‘print‘ the quantity I-E, that is spend that quantity in excess of revenue, but not by borrowing it.

However, for the government to borrow that money it would also add to I. While this might be useful counter-cyclically, it would be less efficient than printing it. Further, it would add to the total debt burden, and thus fail to address the long range problem: It would still contribute to a debt spiral.

So, barring government ‘printing’ at least the quantity I-E, the financial industry, by holding expenditures, E, less than the interest, I, on all loans outstanding, creates a shortage of money. There is simply not enough money to pay off all the debt and the interest. So they force the rest of the system into increasing indebtedness to them, in order to pay off the debts they already owe.. They force individuals, companies, and governments to take out more loans or default. They have simply created a shortage of money needed to repay the loans and the interest, in the real economy, while hoarding the rest of that money to themselves.

The financial industry has been doing this for years. That is why individuals, companies, governments and their countries' real economies, are gradually being ruined. That is why, in the US, for instance, total indebtedness has been climbing to over $50 Trillion, now about equal to all the US real assets. Great Britain, and many other countries are in worse shape.

http://www.comstockfunds.com/default.aspx?act=newsletter.aspx&category=SpecialReport&newsletterid=1504
(Check out the charts. The links are at the top of the page.)

The figures are incredible when you think that it’s most everybody that’s in debt. Indeed, is so called deleveraging (paying off debt) even possible, with so much debt? After all, annual interest on $50 Trillion, is about $2.5 Trillion, at 5%, which is more than the entire revenue of the federal government.
http://en.wikipedia.org/wiki/2010_United_States_federal_budget


Government austerity, by forcing all future increases in debt into the private sector, will inflict tremendous hardship and damage to the real economy.

This 'crisis' is just another step down the road, where the financial industry, in their eagerness to own it all, kill the goose that lays their golden eggs.