Wednesday, 1 February 2012

Does expanding the amount of debt free money reduce indebtedness?

Money can be split into numerous different categories. But one type of categorisation is to split money into so called “debt free” money, and in contrast, money which consists of a debt which is passed from hand to hand.

Central bank created money (monetary base) is essentially debt free. In THEORY this money is a debt owed by the central bank to the holder of such money, but central banks make absolutely no promise to give anyone anything (e.g. gold) in exchange for this money. Thus it is essentially debt free.

In contrast, commercial bank created money is essentially a debt which is passed from hand to hand. I’ll call this “debt-encumbered” money.

There is a wide-spread perception that banning debt-encumbered money and replacing it as necessary with debt-free money would reduce the total amount of debt. (The latter “replacement” equals imposing full reserve banking.). E.g. see here.

That perception is mistaken, and for the following reasons.

1. Under full reserve there is nothing to stop borrowers borrowing or to stop lenders lending as they see fit.

2. People and firms incur debt precisely because they “see fit” to do so. E.g. people looking for a place to live don’t HAVE TO BORROW with a view to buying a house. They can always rent. Indeed, renting is particularly popular in the wealthiest large country in Europe: Germany. The rate of owner occupation in Germany is the lowest in Europe.

3. I see no reason to suppose that the proportion of the population who choose to buy rather than rent will change just because a country abandons fractional reserve and goes for full reserve. Ergo the total amount of indebtedness will remain unaltered.

4. One argument for the idea that debt-encumbered money causes indebtedness runs as follows. The economy needs a form of money and about 97% of the money in circulation is debt-encumbered. Therefor to obtain money or to obtain an increased supply of money, participants in the economy are pretty well forced to go into debt. E.g. as Michael Rowbotham puts it in Ch 1 of his book “The Grip of Death”, “Thus the supply of money depends on people going into debt….”

Well that argument has been comprehensively demolished by events over the two or three years. That is, households and firms have deleveraged over recent years, which has cut the amount of debt-encumbered money. And to compensate, central banks have vastly increased the amount of central bank money!

Or take it to the extreme, if for some strange reason it became unfashionable to incur any debt at all, and households and firms paid off all or nearly all their debt, the effect would obviously be deflationary. But there’d be nothing to stop the central bank stepping in and supplying whatever amount of money was needed to get the economy back to full employment.

P.S. (same day). Here are more authors who seem to accept the idea that debt encumbered money increases indebtedness.

According to Joseph Huber and James Robertson in their New Economics Foundation publication “Creating New Money”:

“More specifically, many advocates of monetary reform (e.g. Rowbotham 1998, Armstrong 1996, Kennedy 1995) argue that issuing an overwhelming proportion of new money as interest-bearing debt has damaging social impacts. One argument, briefly, is that issuing money as debt creates more indebtedness in society than issuing it debt-free will do….”



  1. Hi, Ralph. Maybe I should come here more often!

    I don't focus on money as debt or not-debt; I focus on whether or not it comes at a cost: Do I have to pay interest to use this money, or not? Debt or not-debt is only a convenient way to talk about it.

    In the economy as a whole, macro view, there is a difference whether 97% of our money comes at a cost or, say, only 50% comes at a cost. In the latter case, the "factor cost of money" is about half what it is in the former. That would free up income to be used for wages and profits.

    I agree with your point #1; it follows from "loans create deposits".

    I think your point #2 -- People and firms incur debt precisely because they “see fit” to do so -- ignores the fact that people's views may be different in the 50% economy than in the 97% economy. This is in contrast to your point #3.

    RE your #4 -- yes, the Fed has increased the amount of debt-free money. But it isn't circulating. And the only way to get those reserves circulating, apparently, is by lending them out and creating even more debt. So that's not part of the solution.

    That's why an actual helicopter drop would work. It's why a Fed policy of PAYING OFF debt for debtors (rather than BUYING IT UP from creditors) would work. It reduces the factor cost of money.


  2. Arthurian,

    I doubt that replacing debt encumbered money with debt free money would “free up income to be used for wages..”. Reason is that those interest payments are just transfers from one entity to another (from debtors to banks and those with interest earning deposits in banks). Reducing those transfers does not make the country as a whole better off.

    Re point #2, and whether “people's views may be different in the 50% economy…” that’s the central question I address in the post.

    Re #4, You are saying that having the Fed give money to debtors has a stimulatory effect which is not obtained by buying debts off creditors. Agreed. I.e. I agree that too much of the money created isn’t circulating. This is because the twits in power in the US, the UK and elsewhere have shovelled money into the pockets of the rich or bondholders, rather than the people who really cut their spending when the crunch hit: those underwater or near underwater households.

    But my post above is not aimed at the question as to how best to bring stimulus. I’m trying to work out whether a change from “debt encumbered” money to debt free money alters the total amount of debt.

  3. RM,
    The first three paragraphs of your post are helpful to me. With your permission I will be quoting them for a post of my own.

    "I’m trying to work out whether a change from 'debt encumbered' money to debt free money alters the total amount of debt."

    Yes. This is a topic that fascinates me as well.

    My favorite part of Smith's Wealth of Nations is Book One, Chapter Six: "Of the Component Parts of the Price of Commodities". He identifies business, labor, and the aristocracy as three groups of income-earners. And he identifies a factor cost for each group.

    He rejects the idea of creating a separate group for finance. But finance is a far more significant part of the economy today than it was in Smith's time (and the aristocracy is a much less significant part). I consider finance a separate group, and I call its factor cost "interest".

    In your reply to my comment you refer to "transfers". To me those transfers are income to the group called "finance".

    I also think that if we divide the world into "those who can save" and "those who cannot", that we will find "those who can save" have a tendency to keep their savings in savings, and to keep the interest on their savings in savings... a tendency for financial wealth holders in general to let the income from their financial wealth accumulate. In other words, the income that accrues to finance STAYS in finance. It is largely not recycled back into the economy where the rest of us might earn some of it with our labor. It only comes back into the economy by increasing the total number of circulating dollars on which interest must be paid. It only comes back by adding to the total amount of debt.

  4. Arthurian, I don’t mind being quoted.

    Re your idea that wealth holders always accumulate their income, I’ve got doubts. Inequalities have certainly risen in the US over the last two decades. But if you go back much further in time, inequalities rise and fall.

    Also at the level of the individual family, there is an old saying: “clogs to clogs in three generations”. I.e. one person makes a fortune. Their offspring sit on it. And the third generation fritters it away. That saying was confirmed by some research I saw which looked at how well those who INHERIT wealth do with their fortunes. Turns out they don’t do too well: they don’t make desperately smart investments. But I can’t remember where I saw that.

  5. Thanks, Ralph.


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