Is perpeptual expansion really a requirement for modern banking?

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Futuo's picture
Futuo
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Is perpeptual expansion really a requirement for modern banking?

I've been having a conversation with a friend over facebook about the Fed and how money creation works... I'll show the basic gists of the conversation so far, and would be willing to share the entire conversation with anyone who wants to see it. He makes a point that I'm not entirely sure how to refute, and would like some suggestsions. Here goes:

 He challenged that "...perpetual expansion is a requirement of modern banking. Yes I want proof numerical expansion is a requirement, it didn't logically follow from what he [Martenson] said."

My response:

You have x amount of money in existence. But, to get that x amount of
money loaned out in the first place, you have to promise to pay back
with interest, call that z. So, x amount of money exists, and x+z is
owed. Because x+z is greater than x, you must print out more money so
that enough exists to pay the combined x+z. However, that newly loaned
out money p, has interest of r: this keeps compounding until some
critical point. That's how I understand it. Reviewing that argument,
it's based on the assumption that money is loaned into existence. I'm
sure you'd agree with that loan/debt/interest scenario I set-up above
in terms of bank credit. You take out a loan from the bank, and agree
to pay back with interest. Your answer to the problem of paying the
interest with new/more money would be from what you gain from work,
investments, whatever, and that's fine. However, let's look at government. As the Fed says, "...when the Federal Reserve writes a
check, it is creating money." So it writes a check, which is then
loaned to the government on interest...and the only way for that
interest to exist, to be paid back, is to take out another loan. Etc,
etc, etc."

He makes a bunch of responses here, which I don't think really matter and were just for clarification. So, I said:

 "Let's look at your response to the variable scenario. Sure, the debt z
is smaller than x. That's great. But you forgot that your initial
capital, in this case x, isn't just the magic amount of money the world
starts with. That x is taken out as debt. When i take out $1,000 as a
loan, I don't just pay back the interest...I pay back the principal +
the interest. So, although the interest may be smaller than the
principal, the fact of the matter is that the principal (x) plus the
interest (z) is always going to be greater than the principle (x).
Seeing as the principal (x) is the only amount of money in existence,
and it requires an additional amount (z) in dollars to be paid back,
the money to pay that interest (z) must be created somewhere. That
necessitates another loan."

To that, he simply said: "But the new loan can be smaller than the first and get infinitely small."

 To which i'm thinking that he's right: the new loan can be smaller than the first (will it always be?) and get infinitely small. I feel like all loans will have to be smaller, if z is less than x. In writing this, i've realized I conceded that "the debt z is smaller than x." Is that necessarily true? Does that matter? Is continual expansion still an issue if the expansion is always smaller?

 So I responded with: "Even though the new loan can be smaller than the first and get
infinitely small, isn't the loaning out of that new loan still an
increase in growth of the money supply to continually pay the existing
interest...?"

To which he replied: "No because every time you pay some back you are reducing the money
supply, so if you back more than you borrow there is a net decrease."

Is he right? If not, why? If yes, what are the implications? 

This is probably very boring and hopefully it doesn't seem whiny...there's got to be someone else out there who doesn't totally understand it, though, so if one of you gurus would drop by and sort this out it would really be great. An explanation on the macro level (using x's, z's, whatever) of how this initial money creation works would help; a sort of demonstration as to why there must be continual expansion.

 Thanks!

 

 

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Re: Is perpeptual expansion really a requirement for modern ...
Futuo wrote:

I've been having a conversation with a friend over facebook about the Fed and how money creation works... I'll show the basic gists of the conversation so far, and would be willing to share the entire conversation with anyone who wants to see it. He makes a point that I'm not entirely sure how to refute, and would like some suggestsions. Here goes:

He challenged that "...perpetual expansion is a requirement of modern banking. Yes I want proof numerical expansion is a requirement, it didn't logically follow from what he [Martenson] said."

My response:

You have x amount of money in existence. But, to get that x amount of
money loaned out in the first place, you have to promise to pay back
with interest, call that z. So, x amount of money exists, and x+z is
owed. Because x+z is greater than x, you must print out more money so
that enough exists to pay the combined x+z. However, that newly loaned
out money p, has interest of r: this keeps compounding until some
critical point. That's how I understand it. Reviewing that argument,
it's based on the assumption that money is loaned into existence. I'm
sure you'd agree with that loan/debt/interest scenario I set-up above
in terms of bank credit. You take out a loan from the bank, and agree
to pay back with interest. Your answer to the problem of paying the
interest with new/more money would be from what you gain from work,
investments, whatever, and that's fine. However, let's look at government. As the Fed says, "...when the Federal Reserve writes a
check, it is creating money." So it writes a check, which is then
loaned to the government on interest...and the only way for that
interest to exist, to be paid back, is to take out another loan. Etc,
etc, etc."

He makes a bunch of responses here, which I don't think really matter and were just for clarification. So, I said:

"Let's look at your response to the variable scenario. Sure, the debt z
is smaller than x. That's great. But you forgot that your initial
capital, in this case x, isn't just the magic amount of money the world
starts with. That x is taken out as debt. When i take out $1,000 as a
loan, I don't just pay back the interest...I pay back the principal +
the interest. So, although the interest may be smaller than the
principal, the fact of the matter is that the principal (x) plus the
interest (z) is always going to be greater than the principle (x).
Seeing as the principal (x) is the only amount of money in existence,
and it requires an additional amount (z) in dollars to be paid back,
the money to pay that interest (z) must be created somewhere. That
necessitates another loan."

To that, he simply said: "But the new loan can be smaller than the first and get infinitely small."

To which i'm thinking that he's right: the new loan can be smaller than the first (will it always be?) and get infinitely small. I feel like all loans will have to be smaller, if z is less than x. In writing this, i've realized I conceded that "the debt z is smaller than x." Is that necessarily true? Does that matter? Is continual expansion still an issue if the expansion is always smaller?

So I responded with: "Even though the new loan can be smaller than the first and get
infinitely small, isn't the loaning out of that new loan still an
increase in growth of the money supply to continually pay the existing
interest...?"

To which he replied: "No because every time you pay some back you are reducing the money
supply, so if you back more than you borrow there is a net decrease."

Is he right? If not, why? If yes, what are the implications? 

This is probably very boring and hopefully it doesn't seem whiny...there's got to be someone else out there who doesn't totally understand it, though, so if one of you gurus would drop by and sort this out it would really be great. An explanation on the macro level (using x's, z's, whatever) of how this initial money creation works would help; a sort of demonstration as to why there must be continual expansion.

Thanks!

Futuo,

You are absolutely correct as I understand the CC. This is the crux of the issue right here:

So I responded with: "Even though the new loan can be smaller than the first and get
infinitely small, isn't the loaning out of that new loan still an
increase in growth of the money supply to continually pay the existing
interest...?"

To which he replied: "No because every time you pay some back you are reducing the money
supply, so if you pay back more than you borrow there is a net decrease." 

No matter how "infinitely small" each new loan gets, mathematically you can never completely pay off all the loans that have been made. Thus you can never "pay back more than you borrow".

E.g.: If you borrow $1.00 at 10% interest, you have to pay back $1.10.

To get the extra 10 cents, you have to borrow 10 cents at 10% interest and you now have to pay back 11 cents.

To get the extra 1 cent, you have to borrow 1 cent at 10% interest and now you have to pay back 1.1 cents (ignore the fact that our money doesn't have denominations below 1 cent).

To get the extra 1/10 cent, you have to borrow 1/10 cent at 10% interest and now you have to pay back 1/10 cent plus 1/100 cent. And so on, and so on, ad infinitum.

POTUS's picture
POTUS
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Re: Is perpeptual expansion really a requirement for modern ...

Futuro typed-

Quote:

perpetual expansion is a requirement of modern banking

That statement is where the problem lies, since there is no such "requirement".

The reality is that what has been observed in Central Bank policy around the world is a general tendancy to expand the money supply over time, but it is not a "requirement". When money supply is expanding, it is called inflation, or perhaps more accurately "monetary inflation".

Your friend typed-

Quote:

"But the new loan can be smaller than the first and get infinitely small."

The point your friend is getting at here, and in his other comments, is that money supply can also decrease. When money supply is decreasing, it is called deflation, or "monetary deflation".

In inflation, new money gets printed through some type of debt creation (or exchange of something of "value" in the case of central bank to central bank transactions.)

In deflation, as money is paid back, it is retired from circulation. New money doesn't have to be printed. Think of it this way, under "deflation" you can pay your loan back because someone else isn't going to get a inflationary new loan.

I think the point that you are getting confused over is that there is a difference between "requirements" of money supply for the banking system and the practical need for any and all debtor governments, including the USSA, to keep printing money to fund their debts if they continuously spend more money than they take in revenues.

Perpetual money expanision is a (practical) requirement of a destitute government's central bank, but not a "requirement" of the "modern banking" system.

So, it appears that I must agree with your friend, sadly. 

You might want to consider changing the subject in your facebook discussions.

Good luck in extracting yourself from this one! Hope the two of you are good friends.

Best regards,

 

POTUS 

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cmartenson
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Re: Is perpeptual expansion really a requirement for modern ...

To that, he simply said: "But the new loan can be smaller than the first and get infinitely small."

This leaves out the element of time and a working understanding of how our money system interacts with the economy.

Loans are almost never a single interest payment, given once, for an outstanding principal balance.

Example:

Conditions:  $100 borrowed at 10% interest.  $100 is the total money in the economy.

Year 1: $110 owed. 

(A) If $100 paid back + $10 borrowed, the economy falls off a rail because now there's only $10 where $110 is needed.  Default ensues.

(B) If the $10 is borrowed to pay off the interest and the $100 is left to circulate, then next year $11 is owed (interest on both the $10 and outstanding $100).  As we carry this example forward (where principal loan balances are carried forward) then the outstanding credit amounts grow exponentially.

Example B matches our observations of how our credit/economy systems actually function.  Credit and money growth has a nearly perfect fit to an exponential function (R^2 over 0.98).  Given that this is true, then I lean towards example B as the better descriptor of the actual process.

The statement that perpetual expansion is a requirement of modern banking is a statement about what modern banking needs to run effectively (or even at all as we are now witnessing).

Modern banking simply chokes and dies without continual expansion so we can it a requirement.  No, it's not a legal requirement, nor even a stated one, but it's the same as claiming that seeds are a requirement of farming or that steering wheels are a requirement of automobiles.

While we can cleverly imagine ways these might be untrue statements, those wouldn't provide a very useful fit to the actual world.  

What I do is pick which hypotheses and theories best fit the data and then seek further data points that will either confirm or refute the ideas. There's a ton of physical experience demonstrating that every time credit growth dwindles we have massive economic and banking crises. 

For now I stand by the claims that our monetary (and credit) systems are exponential in nature, that they have been since at least 1971, and that our institutions have become utterly dependent on the perpetual continuation of this method of growth. 

It is an analytical framework that has been both explanatory and predictive.

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Re: Is perpeptual expansion really a requirement for modern ...

Any debt based money system that charges interest, requires a constantly growing amount of debt in order to satisfy existing interest-debt obligations.  Since only the principal is created, the interest must be siphoned off the money in circulation.  If borrowing slows down too much, then the circulation will diminish - a recession or depression will ensue. 

One solution is to simply eliminate all interest.  Since money is really created from debt, why should anyone profit through interest?  A common misunderstanding is that banks lend "their" or "depositors" money - they don't.  Over 97% of all money borrowed is simply created.

If all interest were eliminated, then the amount of money in circulation would be at least as great as the value of the assets represented (purchased through loans).  If loans stopped or slowed down, nothing would be adversely affected since the full amount of the debt is already in circulation.

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Re: Is perpeptual expansion really a requirement for modern ...

 

I think the problem is abit more subtle than the Crash Course inevitably portrays it. I'll try to explain what I think is happening. Banks get people who have more moneythen they need to deposit it on a savings account, and loan the money out to people who have deficits. As you know, they charge interest on the loans and pay part of that interest to their depositors. But that mean that people who started out with more money then they need, get an extra source of income, while people who have less money then they need, get extra costs. To summarise: the rich are getting richer and the poor are getting poorer.

Now obviously banks and creditors have their expenses, so some money is bound to flow back to the debtors. And in some cases a debtor has some luck and is able to switch to the creditor side of the economy -- think of Bill Gates. But in general, a lot of rich people will only be trying to become even richer through the banking system, so they frustrate the flow of money to the debtors. They might try, for example, to get a president elected that gives them a tax cut, although they really don'tneed it (or deserve it).

So the sum total is: money flowing from debtors to creditors. Obviously, the banks have to exhaust their debtors some time, leaving them to little money to pay off their debts. And that would result in something like the current credit crisis.

 

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Re: Is perpeptual expansion really a requirement for modern ...
Quote:

Conditions: $100 borrowed at 10% interest. $100 is the total money in the economy.

Year 1: $110 owed.

(A) If $100 paid back + $10 borrowed, the economy falls off a rail
because now there's only $10 where $110 is needed. Default ensues.

If you just borrow $10, it means that the economy has $0 because those $10 were interest, so the bank lends them to you without giving you any actual money, right?

To me it seems that if you borrowed $100 at the beginning, you are stuck for the rest of your life with increasing debt just for the interest. So, year2: $10 of debt, year3: $11 of debt, year4: $12.1 debt, etc

 

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Re: Is perpeptual expansion really a requirement for modern ...

 

The central bank can intervene in both directions print debt & buy assets (exchange money for assets the process we see at the moment) and do vice versa (buy back debt & sell assets). This is the main tool (besides i-rate) how  the c.b controlls money supply. The main point is money in existence & the value of  the economy have to go hand in hand. If not - an adjustment is due via deflation, where the money supply gets less in comparison to the value of the economy or via inflation, where the value of the economy adjusts to the money supply. Both processes lead to Purchasing Power destruction if money supply gets too excessive. Per se interest is not the problem as long something of value is produced for society - on the contrary - if the created value is bigger than the interest society gains. No one can contradict, that society has advanced and brought more wealth to the world in form of efficiency, technology, living standard (although not equally (fair?) distributed). The main problem is that money supply and the value of the economy are off rail and are in an painful adjustment process at the moment, with fossile energy, the main driver of wealth, getting slowly scarce.

Comments are appreciated

thx, Kamen 

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Re: Is perpeptual expansion really a requirement for modern ...

xpromache: The most concise way that I can put forth the problem is this: The only way to get enough money to pay the interest on the previous debt is to take on more debt to cover the old interest.

This implies that, regardless of anything else, debt expansion must absolutely occur and it must occur at least fast enough to match the interest payments on the previous year's debt.

Your last line is correct if you assume that the money and debt do not increase. As long as the money supply (and debt) are increased, somebody, somewhere in the system will have money that you can use to pay your interest off...But then that person will need to get more money to pay their interest off.

You'd be amazed at how many people get extremely confused over this concept. I have explained it to people with MBA's and even small business owners and the implications of this never really seem to hit before their attention span wavers. I am absolutely not a socialist, but I've been accused of it, as people misunderstand my statement that the Federal Reserve system coupled with our debt money structure is not only not sustainable, but also immoral. There is a big difference between loaning money with interest when the money being loaned is coming from debt-free savings vs. having all of the money in the entire system loaned out at interest.

I hope this clarifies a bit.

Mike

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Re: Is perpeptual expansion really a requirement for modern ...

Thanks, I'm not confused at all (anymore). I understand now that the money supply must grow continously, I wonder if all those people on TV who want economic growth to resume, actually understand why this is needed. And I understand that this system is simply not good for a world where things just stay constant: population, amount of food, etc.

One question still: when the world (or US) was running on gold standard, shouldn't that mean that the limit to the growth of the money supply was imposed by the rate at which new gold was discovered? But if banks could create money through loans (without creating the corresponding gold), then the gold standard meant nothing, did it?

I'm asking this because I've seen people arguing on some websites that if the gold standard was in place we wouldn't have this "crisis". 

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Re: Is perpeptual expansion really a requirement for modern ...

xpromache: You raise some good questions and I'm happy that you have such curiosity.

The growth in the money supply on a gold standard is limited by the amount of gold that backs the paper currency and the laws that regulate it. That is, if we had, say a $1,000 / ounce fixed price of gold and we were using US Dollars, then the only ways for our money supply to grow would be to dig up more, recycle gold being used industrially, OR have a trade surplus (imagine that) in which we have a flow of gold into our country. At the global level, this third method is cancelled out and doesn't have any impact.

And your worries about banks creating money out of nothing are warranted, but they are taken to an extreme. There are different levels of "gold standard" and it is affected by the laws and regulations in the system. In a fully redeemable gold standard, you could go to any bank or to the government itself and redeem your paper money for the gold that backs it. In theory, there should be no restrictions whatsoever, because it is your gold.

Banks make money by loaning and charging interest. Any time money is loaned, it is not in the bank and so all the gold could not be redeemed at once. If depositers got  the sense that the banks were loaning out too much money (too much fractional reserve action going on) or were making risky loans, the depositers could withdraw their money from the bank and the bank would very quickly get a signal that they better re-establish trust with their depositers. And in a fully redeemable gold standard, the primary reason to deposit gold in a bank is convenience. But, for those that have better peace of mind leaving the gold at home, then that would make more sense too. In that scenario. If everyone did it, then banks would be out of business.

Cheers!

Mike

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Re: Is perpeptual expansion really a requirement for modern ...
cmartenson wrote:

To that, he simply said: "But the new loan can be smaller than the first and get infinitely small."

This leaves out the element of time and a working understanding of how our money system interacts with the economy.

Loans are almost never a single interest payment, given once, for an outstanding principal balance.

Example:

Conditions:  $100 borrowed at 10% interest.  $100 is the total money in the economy.

Year 1: $110 owed. 

(A) If $100 paid back + $10 borrowed, the economy falls off a rail because now there's only $10 where $110 is needed.  Default ensues.

(B) If the $10 is borrowed to pay off the interest and the $100 is left to circulate, then next year $11 is owed (interest on both the $10 and outstanding $100).  As we carry this example forward (where principal loan balances are carried forward) then the outstanding credit amounts grow exponentially.

Example B matches our observations of how our credit/economy systems actually function.  Credit and money growth has a nearly perfect fit to an exponential function (R^2 over 0.98).  Given that this is true, then I lean towards example B as the better descriptor of the actual process.

The statement that perpetual expansion is a requirement of modern banking is a statement about what modern banking needs to run effectively (or even at all as we are now witnessing).

Modern banking simply chokes and dies without continual expansion so we can it a requirement.  No, it's not a legal requirement, nor even a stated one, but it's the same as claiming that seeds are a requirement of farming or that steering wheels are a requirement of automobiles.

While we can cleverly imagine ways these might be untrue statements, those wouldn't provide a very useful fit to the actual world.  

What I do is pick which hypotheses and theories best fit the data and then seek further data points that will either confirm or refute the ideas. There's a ton of physical experience demonstrating that every time credit growth dwindles we have massive economic and banking crises. 

For now I stand by the claims that our monetary (and credit) systems are exponential in nature, that they have been since at least 1971, and that our institutions have become utterly dependent on the perpetual continuation of this method of growth. 

It is an analytical framework that has been both explanatory and predictive.

IMHO The example "A" is too simplistic. In real world, we have a large money supply split into millions of small debts/credits all with different maturities/due dates.

I wanted to check by myself: "trust youself" not others' statements.

Therefore I wanted to disprove Chris' statement: "perpetual expansion is a requirement of modern banking". That is, to prove "the total money supply must not grow", it's sufficient to prove "the total money supply may remain constant" (as long as there is enough money for the economy to function). Here goes:

Day after day, only a tiny portion of the total money supply is paid back as principal+interest and on the same day some new loans are made for the principal. The interests paid are incomes for the bank or the Fed.

The fact that's it's a bank does not make any difference here. Banks and the Fed are just like any other business with incomes and expenses, paying dividends to their shareholders... which all come from or return to the economy.

So the money supply does NOT have to grow exponentially. It will remain constant iff each time a principal is paid, there is a new loan for the same amount. It's not required the create new fresh money for the interests, which are banks' incomes retuning to the economy. There is no shortage of money.

I do not argue about the moral/immoral aspect of the monopoly of money creation in the hands of the private banking cartel. In particular the Fed which is the primary cause of inflation. Central Banks argue that "inflation is a requirement of modern economy", which is a fallacy as proved by Chris. IMO this fallacy is more important to oppose, because it implicilty means that "perpetual money expansion is a requirement of modern economy".

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pleaseremoveme
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Re: Is perpeptual expansion really a requirement for modern ...

@fujisan

The necessity of growth escaped me too, but the fact is that the money supply was growing exponentially upto the crisis. The reason, however, is not that new loans must be made to pay the interest on existing ones. The reason is that banks in order to stay profitable and competitive had to invent ever growing investment opportunities, and seriously believed that had found them. 

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Re: Is perpeptual expansion really a requirement for modern ...

Hello all.

This thread is similar to a couple of others - I have just written out an example (found here: http://www.peakprosperity.com/comment/15386#comment-15386) that brings me to the conclusion that new borrowing must at least equal the amount of principle that is paid or defaulted upon.  The whole equation turns exponential when new borrowing is taken on in order to pay interest on existing debt.  To me this indicates that the amount of debt can not go down without causing major chaos like we have now.  My guess is that the end result is the same in real life - the system eventually gets to big, and new lending can not keep up with defaults and repayments, particularly when the greed factor has gotten to the point where anyone with a pulse can get a loan, resulting in a debt load that is impossible to sustain.

Just my two cents.

I look forward to hearing others thoughts on this.

All the best,

Reuben

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