I never really understand how loan driven economy works

[johnyj]

Suppose we divide everyone in the society into two corporate A and corporate B, (or similar to an island with only 2 people), each year banks loan out 1 Billion to A and 1 Billion to B, and they do production and consumption and trade with each other. They need to return the loan plus interest. Since the money supply is only 2 Billion, where is that extra interest come from?

Obviously, it can only come from the previous savings of A and B, so if this process continue, sooner or later A and B's saving will be depleted. Of course bankers will also spend their earned interest to buy products from A and B, but since everyone have also the need to save, it can not balance itself

There is a way to avoid this from happening: Continuously issue new loan to A and B, for them to pay back the old loan + interest. And for each new loan, same rule applies, they need future loan money to payback the interest, and if they want to have some savings, even more future loans are needed

But any business have a market size limit, after reaching certain maturity, there are less and less growth, so eventually this model will be broke for any industry

Then the hope is placed on the new enterprises in the future, but that is also non-sustainable. These new enterprises must have much higher income to digest all the existing business' higher and higher sale. With existing enterprise getting more and more, the size of new enterprises will reach an impossible level to support the earnings for all the existing enterprises

As a result, the original observation might be more close to reality: Everyone's saving is depleted slowly by the banks, and saving becomes more and more difficult

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[Spaceman_Spiff]

Suppose we divide everyone in the society into two corporate A and corporate B, (or similar to an island with only 2 people), each year banks loan out 1 Billion to A and 1 Billion to B, and they do production and consumption and trade with each other. They need to return the loan plus interest. Since the money supply is only 2 Billion, where is that extra interest come from?

Obviously, it can only come from the previous savings of A and B, so if this process continue, sooner or later A and B's saving will be depleted. Of course bankers will also spend their earned interest to buy products from A and B, but since everyone have also the need to save, it can not balance itself

There is a way to avoid this from happening: Continuously issue new loan to A and B, for them to pay back the old loan + interest. And for each new loan, same rule applies, they need future loan money to payback the interest, and if they want to have some savings, even more future loans are needed

But any business have a market size limit, after reaching certain maturity, there are less and less growth, so eventually this model will be broke for any industry

Then the hope is placed on the new enterprises in the future, but that is also non-sustainable. These new enterprises must have much higher income to digest all the existing business' higher and higher sale. With existing enterprise getting more and more, the size of new enterprises will reach an impossible level to support the earnings for all the existing enterprises

As a result, the original observation might be more close to reality: Everyone's saving is depleted slowly by the banks, and saving becomes more and more difficult

I think the bankers buy stuff from Company A en B, thus supplying them with the money necessary to repay the loan.  Everybody happy.

[solex]

Suppose we divide everyone in the society into two corporate A and corporate B, (or similar to an island with only 2 people), each year banks loan out 1 Billion to A and 1 Billion to B, and they do production and consumption and trade with each other. They need to return the loan plus interest. Since the money supply is only 2 Billion, where is that extra interest come from?
....

As a result, the original observation might be more close to reality: Everyone's saving is depleted slowly by the banks, and saving becomes more and more difficult

Exactly! You have nailed the reason why the 2007/8 Credit Crisis has morphed into a sovereign debt crisis, which is morphing into a currency crisis, which will morph into a systemic collapse.

In a true capitalist model, loans are made and interest is due. The interest rate is the price of money which should be set by the market. Successful businesses/individuals pay back their loans and interest from profits, unsuccessful ones default on their loans and interest which means a loss for lenders/banks. Debt write-off is the mechanism that money is transferred from banks back into the economy preventing all the money piling up in banks - because of interest. If the losses are too great then whole banks go bust, freeing up a lot of money back into the economy. The market will set higher interest rates to reflect higher default risk. This is a true capitalist model which is the environment for a successful world-beating economy.

The problem is that the whole system is FUBAR by government intervention!

The rot started after the 1907 recession in the US at a time when economic booms and busts were seen like a force of nature, uncontrolled. When government decided that it had to control the economy, by backstopping banks with printed money, the Federal Reserve was created. It was inspired by the Bank of England which had progressively taken control of the UK money supply. In 1920 this process was complete in the UK too.

Throughout the 20th century government intervention has grown and grown, the cradle to grave nanny-state which has created a massive entitlement dependency in all western economies. In hand with this bank failures are banned. So all banks get bailed out one way or another. This means that money has to be printed to maintain flows of interest. Interest rates, the vitally important price of money, being set by central banks is like having a crystal-meth addict at the wheel of your car. Capitalism has been broken by government intervention. Money supply has come increasingly from credit which monetizes future production giving the illusion of prosperity (because banks can't go bust they can lend irresponsibly to fog-a-mirror borrowers).

Excessive government debt leads to a sovereign debt crisis. Money printing leads to a currency crisis. It is all can-kicking which can go on for a long time. Think of someone falling from the top of the Empire State Building, As they pass the 3rd floor they can still report "All OK so far..."

Bitcoin can change all that. It can't be printed so bank lending in a bitcoin economy will have to follow true capitalist principles. Governments would be massively reined in, savers and producers will be rewarded for their hard work and frugality. Bad banks will go truly bust. Deflation will make everyone richer as prices keep falling. I suspect that income taxes will have to go in the trash-heap and that only sales taxes could be used for government income. The whole western economic system would hum along nicely.

[xxjs]

...

I like yuour analysis.

Debt is like money if it can be traded.

Think of an economy with no money, only debt. Say uncle Scrooge was able to collect all the money in the world. We need a unit of account for this example, so think that he did it swiftly so the prices was not disturbed in the mean time. We now have a world with no money, but still all the goods and people are still willing to work. We have a unit of account, say dollar. To trade, the buyer writes a bill for an amount of dollars and give it to the seller. The seller can later do another trade with the same person, clearing the bill, but the bill could also be traded to others. This now functions as money. It can not really be discounted anywhere, because there is no base money, but it can be used as money.

What is the difference between such a debt economy and a money economy? I can only think of one difference, that is that the bill may come back to the issuer for clearance. That means that the money supply is highly volatile.

With an economy like the current, where the base money supply is quite small but the debt is large, the money supply can suddenly be reduced if trust somehow should diminish. Wasn't that what happend in the global financial crisis of 2008? What do you think?

[kjj]

Oh god, this thread again?

Suppose we divide everyone in the society into two corporate A and corporate B, (or similar to an island with only 2 people), each year banks loan out 1 Billion to A and 1 Billion to B, and they do production and consumption and trade with each other. They need to return the loan plus interest. Since the money supply is only 2 Billion, where is that extra interest come from?

Obviously, it can only come from the previous savings of A and B, so if this process continue, sooner or later A and B's saving will be depleted. Of course bankers will also spend their earned interest to buy products from A and B, but since everyone have also the need to save, it can not balance itself

Here is the answer to your question.  The money moves through time.  All of the notes loaned out will be paid back, and a portion of them will be spent again, and paid back to the banker a second time, what we call the interest.  The net effect is that some fraction of the value is transferred to the banks, in addition to the money.

No magic is needed, no exponential or permanent growth.  Google Steve Keen if you'd like to see a fully developed mathematical model of the exact situation that you are talking about.

[notig]

Suppose we divide everyone in the society into two corporate A and corporate B, (or similar to an island with only 2 people), each year banks loan out 1 Billion to A and 1 Billion to B, and they do production and consumption and trade with each other. They need to return the loan plus interest. Since the money supply is only 2 Billion, where is that extra interest come from?
....

As a result, the original observation might be more close to reality: Everyone's saving is depleted slowly by the banks, and saving becomes more and more difficult

 The interest rate is the price of money which should be set by the market.

Bitcoin can change all that. It can't be printed so bank lending in a bitcoin economy will have to follow true capitalist principles.

I'm really interested in these two things you said. I know a lot of people of a certain economic background agree that interest is the price of money and artificially low interest rates are bad. But I have some questions.

First...... let's consider . Say you own something. You lend it to someone else... and because of that there has to be a cost since something now is better than later. So interest is that cost. but.........
A bank doesn't "have something" . It isn't lending out something that has already been worked for. It's creating new money.  So in this situation... interest isn't the price of money because this money the bank is lending is created from nothing. When you say that bitcoin can't be printed and it has to follow true capitalist principles... I think you acknowledge that fact. So when someone says "interest is the price of money" ... that can only really be true in a monetary system that is 100% backed by something. Such as copper or gold or whatever. But when you start fractional reserve lending and creating new money.... interest isn't the cost of money because it's being created from nothing (or nearly nothing).

[johnyj]

Oh god, this thread again?

Suppose we divide everyone in the society into two corporate A and corporate B, (or similar to an island with only 2 people), each year banks loan out 1 Billion to A and 1 Billion to B, and they do production and consumption and trade with each other. They need to return the loan plus interest. Since the money supply is only 2 Billion, where is that extra interest come from?

Obviously, it can only come from the previous savings of A and B, so if this process continue, sooner or later A and B's saving will be depleted. Of course bankers will also spend their earned interest to buy products from A and B, but since everyone have also the need to save, it can not balance itself

Here is the answer to your question.  The money moves through time.  All of the notes loaned out will be paid back, and a portion of them will be spent again, and paid back to the banker a second time, what we call the interest.  The net effect is that some fraction of the value is transferred to the banks, in addition to the money.

No magic is needed, no exponential or permanent growth.  Google Steve Keen if you'd like to see a fully developed mathematical model of the exact situation that you are talking about.

That only answered part of the question, it only make the system running if A and B would never have any saving. It is saving make the life more secure and have more spending elasticity, in current system it is not possible to have saving for everyone, someone's saving is another one's debt

But I have come out with an excellent analysis, talk about it later

[solex]

A bank doesn't "have something" . It isn't lending out something that has already been worked for. It's creating new money.  So in this situation... interest isn't the price of money because this money the bank is lending is created from nothing. When you say that bitcoin can't be printed and it has to follow true capitalist principles... I think you acknowledge that fact. So when someone says "interest is the price of money" ... that can only really be true in a monetary system that is 100% backed by something. Such as copper or gold or whatever. But when you start fractional reserve lending and creating new money.... interest isn't the cost of money because it's being created from nothing (or nearly nothing).

This is mixing several issues; the pros and cons of different monetary systems, and where money comes from in fractional reserve lending. Whatever the case (except during extreme hyperinflation) money always limited, so has always has "scarcity" which means it can be used as a store of value to exchange products (the reason it exists).

Just considering an example of a bank with money to lend and just 2 customers. It will only lend to cover costs, risks and make a profit. You want to borrow $1000 and so do I. The bank determines it needs to lend at a minimum of 4% before it makes a profit. Because I will will pay 10% and you only 8% then this (small) market influences the bank's decision, assuming the same duration of the loan and same credit-worthiness of the prospective borrowers, then the bank will want to lend to me as you will pay less for their money.

Central bank manipulation screws this market because the CB may want the official rate at 2% (in order that the government can borrow cheaply). There are many problems arising, but one is that it severely distorts market perception.

[notig]

A bank doesn't "have something" . It isn't lending out something that has already been worked for. It's creating new money.  So in this situation... interest isn't the price of money because this money the bank is lending is created from nothing. When you say that bitcoin can't be printed and it has to follow true capitalist principles... I think you acknowledge that fact. So when someone says "interest is the price of money" ... that can only really be true in a monetary system that is 100% backed by something. Such as copper or gold or whatever. But when you start fractional reserve lending and creating new money.... interest isn't the cost of money because it's being created from nothing (or nearly nothing).

This is mixing several issues; the pros and cons of different monetary systems, and where money comes from in fractional reserve lending. Whatever the case (except during extreme hyperinflation) money always limited, so has always has "scarcity" which means it can be used as a store of value to exchange products (the reason it exists).

Just considering an example of a bank with money to lend and just 2 customers. It will only lend to cover costs, risks and make a profit. You want to borrow $1000 and so do I. The bank determines it needs to lend at a minimum of 4% before it makes a profit. Because I will will pay 10% and you only 8% then this (small) market influences the bank's decision, assuming the same duration of the loan and same credit-worthiness of the prospective borrowers, then the bank will want to lend to me as you will pay less for their money.

Central bank manipulation screws this market because the CB may want the official rate at 2% (in order that the government can borrow cheaply). There are many problems arising, but one is that it severely distorts market perception.

But how does it help anything or anyone(besides maybe the bank?) if that person willing to pay 10% gets the loan instead of the 8% person? If you think about it...... that would be a bad thing because if they have the same credit rating.... then the person paying the 10% loan is more likely to foreclose. Well it may not be a bad thing. there is a 2 % difference so it would depend on the increased risk of foreclosure to the bank. But that's the bank's problem. What i'm trying to understand though is why people think that lower interest rates increase inflation.  If you look at what actually increases the money supply it isn't interest rates. It's Open market operations, the federal discount rate, and reserve ratios.

[solex]

In my example I assumed that the bank could only make one loan  - because otherwise it would breach capital adequacy (reserve lending) limits. Hence the interest rate determines who gets the loan.

Very low official interest rates exist now in the US, Eurozone, UK and Japan. This is because these economies have all hit a wall with the amount of serviceable private sector debt, and now public sector debt. Consumers and households are so tapped out that governments have slashed interest rates as a desperate measure to encourage the multi-decade debt-binge to extend just a bit more, or at least another electoral cycle. They want to prop up asset prices like houses and the share markets to maintain the "wealth effect". These economies are debt addicted because that it the only way to maintain GDP levels and living standards when the manufacturing base has gone out the window, labor is globalized, and too many people are dependent upon entitlements (ostensibly from tax receipts).

Inflation in money supply comes from loans from banks.  In theory lower interest rates cause inflation because it should cause more loans. But the public have lost appetite for loans and want to tighten ship. So the money from lending is not even making up for the (credit) money destroyed by debt defaults. So the gap is filled by quantitative easing, money printing.

[niko]

There is a way to avoid this from happening: Continuously issue new loan to A and B, for them to pay back the old loan + interest. And for each new loan, same rule applies, they need future loan money to payback the interest, and if they want to have some savings, even more future loans are needed

But any business have a market size limit, after reaching certain maturity, there are less and less growth, so eventually this model will be broke for any industry

It is also worth noting that the existing system, described above, inevitably leads to someone getting screwed just because. Even if everyone did a perfectly identical job in going about their business, someone will have to default, because at any point of time there is simply not enough fiat to provide for the debt+interest. Healthy competition is an illusion.
Also note, this has got nothing to do with the level of presence of government. The problem is more fundamental.

[johnyj]

There is a way to avoid this from happening: Continuously issue new loan to A and B, for them to pay back the old loan + interest. And for each new loan, same rule applies, they need future loan money to payback the interest, and if they want to have some savings, even more future loans are needed

But any business have a market size limit, after reaching certain maturity, there are less and less growth, so eventually this model will be broke for any industry

It is also worth noting that the existing system, described above, inevitably leads to someone getting screwed just because. Even if everyone did a perfectly identical job in going about their business, someone will have to default, because at any point of time there is simply not enough fiat to provide for the debt+interest. Healthy competition is an illusion.
Also note, this has got nothing to do with the level of presence of government. The problem is more fundamental.

You got the point, this is a fundamental problem: There is no total net saving in a debt driven economy

I have a detailed analysis about this, see my other posts about a saving driven economy and a loan driven economy

[knight22]

Here a good reference to answer this topic

http://www.rayservers.com/images/ModernMoneyMechanics.pdf

[johnyj]

Here a good reference to answer this topic

http://www.rayservers.com/images/ModernMoneyMechanics.pdf

Read that paper years ago, now after I totally understood the current system, I read this paper again

I am sure that either the chicago fed do not understand how it works (), or they just play those tricks again to spread the misinformation. Most possibly the later, since they are repeating that FRB money-multiplier story in this paper. That story has proved to be a scam. But it is amazing when you talk to those people graduated from financial schools, the most heard story is this FRB money-multiplier thing  

A link to my analysis of the current system:
https://bitcointalk.org/index.php?topic=142880.0

[twolifeinexile]

There is a way to avoid this from happening: Continuously issue new loan to A and B, for them to pay back the old loan + interest. And for each new loan, same rule applies, they need future loan money to payback the interest, and if they want to have some savings, even more future loans are needed

But any business have a market size limit, after reaching certain maturity, there are less and less growth, so eventually this model will be broke for any industry

It is also worth noting that the existing system, described above, inevitably leads to someone getting screwed just because. Even if everyone did a perfectly identical job in going about their business, someone will have to default, because at any point of time there is simply not enough fiat to provide for the debt+interest. Healthy competition is an illusion.
Also note, this has got nothing to do with the level of presence of government. The problem is more fundamental.

You got the point, this is a fundamental problem: There is no total net saving in a debt driven economy

I have a detailed analysis about this, see my other posts about a saving driven economy and a loan driven economy

This is almost by definition- if debt is money , and saving means saving in the form of money, then someone's saving is the other's debt. Current system force you to save in some other way, buying a property, investing, buying durable commodities. The interest part is provided by bubble in asset to create collateral to support more loans.

[johnyj]

This is almost by definition- if debt is money , and saving means saving in the form of money, then someone's saving is the other's debt. Current system force you to save in some other way, buying a property, investing, buying durable commodities. The interest part is provided by bubble in asset to create collateral to support more loans.

Oh, that's a lot of information, let me think...

I agree with that the current system strongly discourage saving in cash's form, force you to invest (or the banks invest for you), but you can see that those big companies still hold tons of cash at hand without investing? Because they need a strong cash flow to face the uncertain future, and I suppose most of the people are saving in cash's form, holding cash is both traditional and a risk management strategy

By the way, it is not always possible to find good investment opportunity, now asset bubble has busted, do we have to finance another asset bubble in order to pay the interest? Sounds unsustainable

[ecoexperiment]

Suppose we divide everyone in the society into two corporate A and corporate B, (or similar to an island with only 2 people), each year banks loan out 1 Billion to A and 1 Billion to B, and they do production and consumption and trade with each other. They need to return the loan plus interest. Since the money supply is only 2 Billion, where is that extra interest come from?

Question 1:  In this model is the assumption that there is only 2 billion in the entire world ?
Question 2: If so, has this ever happened anywhere?  The worst debt situation that the United States has ever faced would have been during the last recession and the great depressing when personnel approached 100% of GDP.

[johnyj]

Suppose we divide everyone in the society into two corporate A and corporate B, (or similar to an island with only 2 people), each year banks loan out 1 Billion to A and 1 Billion to B, and they do production and consumption and trade with each other. They need to return the loan plus interest. Since the money supply is only 2 Billion, where is that extra interest come from?

Question 1:  In this model is the assumption that there is only 2 billion in the entire world ?
Question 2: If so, has this ever happened anywhere?  The worst debt situation that the United States has ever faced would have been during the last recession and the great depressing when personnel approached 100% of GDP.

Please raise the level of abstraction, 2 billion is just an example, add as much 0 as you want, the reasoning won't change

From economy perspective, there are only 2 types of people on this planet: producers and consumers, and most of the people have both role, so it is enough to have 2 people to represent them

[johnyj]

This is almost by definition- if debt is money , and saving means saving in the form of money, then someone's saving is the other's debt. Current system force you to save in some other way, buying a property, investing, buying durable commodities. The interest part is provided by bubble in asset to create collateral to support more loans.

On further thoughts, these statements are much more complicated than I thought, for example social security, minimal wage, health care, retirement plan etc... there are many services just saved in money's form (typically a fund),  I will study it more in my island model

[ecoexperiment]

Suppose we divide everyone in the society into two corporate A and corporate B, (or similar to an island with only 2 people), each year banks loan out 1 Billion to A and 1 Billion to B, and they do production and consumption and trade with each other. They need to return the loan plus interest. Since the money supply is only 2 Billion, where is that extra interest come from?

Question 1:  In this model is the assumption that there is only 2 billion in the entire world ?
Question 2: If so, has this ever happened anywhere?  The worst debt situation that the United States has ever faced would have been during the last recession and the great depressing when personnel approached 100% of GDP.

Please raise the level of abstraction, 2 billion is just an example, add as much 0 as you want, the reasoning won't change

From economy perspective, there are only 2 types of people on this planet: producers and consumers, and most of the people have both role, so it is enough to have 2 people to represent them

My question was center around the idea that 100% percent of the currency in this world was being loaned, not the actual number.  Most banks loan out much more than they actually have but not more than society as a whole.