Saturday, August 30, 2008
Here are two recent reader emails and my responses to them. The first asks the question, “Why does money have to disappear when debts get paid down?” and the second asks why I favor an inflationary outcome over a deflationary outcome. Since I think each of these reflects a possible source of broad interest, I decided to give them full responses and turned them into this weekend’s report.
Where does the money go?
Dear Chris,
My name is XXXXX, and i am the head of the fixed income portfolio management at one of the biggest savings banks in Spain. I have just read your articles on debt-based monetary system and the need for debt to grow for ever or collapse…
I quite agree and understand that every new dollar created is backed by debt (govt debt in the Feds balance sheet and private debt in the banking balance sheets ), but what I do not quite see is your statement that if all the debts were to be repaid at once all the dollars will disappear from the economy… What happens to the amount of equity in the economic system? equity is not debt, right? It is hard to understand that if all the debts were to be repaid at once my savings would disappear…
Besides, could that collapse be avoided by lowering Interest rates to zero (Japan) and that would allow to deleverage the system gradually (no need for increase in debt to repay interests) ?
Dear XXXXX,
I understand the source of your confusion, as it seems that when you look at your bank account there is money in there that belongs to you.
The trick here is understanding how banks work. Here are the five bits of data that you need:
- At any given time, any bank will have no more than 10%, but usually closer to 3% of the sum of all individual bank accounts in the form of liquid reserves (US banks anyway; I am not sure about Spanish banks).
- The remaining 90%-97% of the money in individual bank accounts has been loaned out. That is, it’s not down at the bank. That’s not how banks work.
- Money is created when loans are made.