In my last post, entitled The Debt Virus, I explained how money is debt and stated that understanding the debt virus is critical to understanding current economic conditions. But how could current economic conditions lead to a collapse? Politicians and the media seem to allude to this collapse but never explain it.

Banks do not have all of the money that people have deposited in their accounts. If everyone went to their bank and withdrew all of their money, the bank would not have it all. The money has been loaned out. What would happen if everyone defaulted on their bank loans, meaning no one paid any money back to the bank? Since the money has been loaned out, if no one repaid their loans banks would only have a small fraction of the money left. The effect of defaults is to decrease the money supply. If defaults happen on a large enough scale, the money supply would contract enough to cause massive deflation. The economic collapse that is referred to relates to this situation of hyperdeflation, where there would be little money left. The collapse occurs when banks get to the point where there is simply not enough money in existence to pay the demands of depositors for withdrawals.

In the world’s current economic system, the debt virus must spread in order for the system to continue. If debt were to be eliminated, there would be no money because money is debt.

Understanding the concept known as the debt virus is critical to understanding current economic conditions. The concept consists of the following:

1. Money is created by debt.
2. When money is created by debt, only the principal amount gets created, not the interest.
3. Since interest never gets created, the only way that all interest can be paid off is through the issuance of more debt.

Because of number 3, it is inherent that debt will spread like a virus.

How is money created by debt? Through fractional reserve banking. Banks are not required to keep all of the money you have on deposit with them. They are only required to keep a fraction of those deposits and are free to loan out the remainder. But what happens to the money that gets loaned out? It gets deposited in a bank, causing the total amount of money that can be created from a deposit amount to be the deposit divided by the reserve requirement.

For example, if current reserve requirements are 10%, this means that if you deposit $10,000 at a bank, the bank can lend out $9,000 of that money. Where does that $9,000 go? Back into another bank, where that bank is only required to keep 10% of that money and can lend out $8,100 of that money. That $8,100 can be used to make a loan of $7,290. Continuing that scenario leads to up to $100,000 being created (the initial $10,000 divided by the reserve requirement of 10%).

This $100,000 that gets created is only the principal amount of all those loans. Banks require that the loans be paid back with interest. Where does the money come from to pay that interest? The only place the money for interest comes from is through the issuance of more debt. It is not mathematically possible for everyone to pay off all their bank loans at once because there is more debt than money due to only the principal of a loan being created and not the interest.

Money is debt. If there were no debt, there would be no money.

Q commented on the US Government takes over Fannie Mae and Freddie Mac as follows:

Q replied:

I think you need to be cognizant of the already battered housing marketing and how that would hurt that significantly more if interest rates were pushed up. I think there’s also a concern on other credit markets. The increased cost of credit would reduce spending as well as hurt businesses by increasing their cost of debt – thus hindering growth further.

So the question to me is how can we make sure that this doesn’t happen again? That is one for which I don’t have an answer.

My response is that artificially low interest rates are what caused the housing market to become “battered” in the first place, so what you are suggesting is akin to a drug addict looking to cure his withdrawal symptoms by increasing the dosage of the drug. In the case of the economy, interest rates are set directly by the Federal Reserve’s open market operations of buying and selling treasury securities to banks. The effect of buying treasuries increases the money supply by allowing banks to then make loans with that new money. The lower the market demand is for loans, the more risk banks have to take in order to compete for making new loans. If that new money was never there in the first place (as created by the Fed), those riskiest loans would never have been made.

The radical answer to how we can make sure that this doesn’t happen again is to eliminate the power that the Federal Reserve has over the money supply along with the entire system of fractional reserve banking (which allows banks to make loans on money they don’t have). The alternative to having a central bank control the money supply is to fix the money supply to a standard such as gold.

The less radical answer to how we can make sure that this doesn’t happen again is to prevent the Fed from making interest rates artificially low.

In a move that didn’t surprise me one bit, the government has taken the “quasi” out of two quasi-government agencies, Fannie Mae and Freddie Mac. From an article released by the AP:

Treasury Secretary Henry Paulson said allowing the companies to fail would have extracted a far higher price on consumers by driving up the cost of home loans and all other types of borrowing because the failures would “create great turmoil in our financial markets here at home and around the globe.”

I fail to understand how letting markets be free could cause “great turmoil.” Why does the government and the Federal Reserve continue to act to keep interest rates artificially low, as implied by Paulson saying that allowing Fannie and Freddie to fail would drive up the cost of home loans? Wouldn’t consumers benefit from higher rates by earning more interest in their savings accounts?