I've been thinking this over for a few days and want to throw it up to the forum to get more minds on it in hopes someone can explain to me why exactly I'm wrong I'm sure I'm making a rookie mistake somewhere and look forward to being corrected.

My ultimate conclusion is essentially that a debt-based fiat currency must have the money supply continuously expanded so as to not implode.

Here's my reasoning from a simplified scenario. Assume we live in a world where there is no paper money in place just yet. Now the FED prints the first $100 bill and gives it to a person named Tom. In exchange for this currency Tom of course give the FED a $100 bond at 5% interest (ie. in one year Tom owes the FED $105). Does this now not present some sort of huge dilemma? How can Tom possible pay back $105 when there is only $100 in existence? It seems to me like the only way Tom can pay this back is if the FED prints up atleast another $5 and adds it to the system. This of course creates another problem as this new $5 is also backed by a 5% note and so we are in the same dilemma as there is not enough money in the system to pay back its interest (there is $105 in existence but we need $105.25). Does this not then mean that the money supply must continuously expanded?

Thanks in advance for the economics lesson

You are correct. So long as all new money is created as debt-with-interest, there must be new creation in the future in order for debts to be settled.

I would love to hear more people's thoughts and opinions on this as it just seems like there could be huge problems that come from this. Not even to mention that these debts are essentially also involved in the fractional reserve system whereby a default is very costly (due to the leverage).

It seems to me then that the Central Banks / Commercial Banks all must ensure that more money is printed to ensure their own survival. And they of course receive the money first which is incredibly beneficial and self-serving as inflation (the increase of the money supply, not a rise in prices) is actually great for those who get the money first (and bad for those who get it last).

Again, I'm wondering if there's more conclusions and deductions that can be drawn from this but I've just recently started mulling it over. Any more thoughts on this from anyone?

Thanks by the way xorbie.

On a seperate note, does anyone think there is a problem having a system in place that must grow each year? Such a system will have exponential growth and plotted as "$ in circulation vs time" will look exactly like an exponential function.

I am now starting to think more about this and see if this is a problem or not. I see it as a problem in something like say the human population because each new human is an additional mouth to feed, and so we must deal in absolute terms there. Money however maybe can grow like this as it is not so much important in terms of absolute figures, but only in relative figures like year-over-year?

Again...a side thought. Is cancer not essentially a dangerous system because it is simply the growth of new cells year over year constantly? In a way an ever-expanding money supply is then analagous to cancer...lol? But again, I'm not necessarily saying it is fatal because fiat currency may be more of a relative concept than an absolute one as mentioned above.

If Tom is a bank and defaults on his $100 loan, the gov't can just forgive his debt and tax their base for the difference. Problem solved! Bailouts!

The government is not involved here, I am talking about the FED. Let us instead replace Tom with the United States of America. So the FED gives the USA $100 in exchange for a $100 bond at 5%. So now in one year's time the USA must give back $105 to the FED.

Now, we of course know this is impossible as there isn't $105 in the system (it's only $100) so I don't see how you can say that the USA can simply tax the missing $5. So it seems to me like there is simply two options:

1) The USA defaults on the payment.

2) The FED prints another $5 and keeps the game going.

As for the first option, if the USA defaults on the loan then there appears to be a very big dilemma. Each of the dollars that are printed only have value because they are based on the fact that the USA is capable of repayment. So in option one, as they have clearly told us they cannot repay, the dollars now cease to have any value.

I am not sure what exactly follows after option two, but it does ensure that we have a system in place that is continuously expanding and it's very survival is dependent on it continuing to do so.

All this being said, it seems like the FED essentially must see that if option one occurs then they no longer have the ability to print up pieces of paper that bear value. So they in turn have a tremendous bias and incentive to ensure that option one remains the choice. Does this not sound like a situation which may be bad? Unstable? Open to great abuse?

Effective money supply must continuously expand (for the interests of all parties to be aligned) in any growing economy. In a non-growing economy, there's no reason for interest rates to be positive. It's irrelevant whether the money is gold, salt or paper.

Interesting.

I am wondering though if there is a particular problem with debt-based vs asset-based. Like when you suffer a loss in debt-based, is that not worse than asset-based perhaps?

I don't quite understand why in a non-growing economy interest rates won't be positive. Are they not always positive so long as one prefers an oz of gold today over an oz of gold tomorrow?

I need to think about this a lot more, but appreciate the response.

Your example is to narrow (in the context of your example the answer is yes), in a normal economy you don't have 100% of the money being loaned at anyone time, and you don't have 100% of the loans + interest due on one date) Because the percent of money being used for loans can change, and the velocity of money can change you do not *need* expansion to occur.

Effective money supply can grow via decreases in prices as well as increases in monetary units.

If an economy doesn't grow how is the average person borrowing money going to make enough to pay back the loan + interest.

Does not having all the money loaned out, or the velocity of money fluctuating, really change anything though? I don't see how we can escape the fact that, assuming a 5% bond rate, every $100 that is created only has value so long as ATLEAST a further $5 is created. Now of course it must be created before the maturity of the bond but I feel that that is a red herring. I don't see how exactly the statement above in bold can be made invalid. I feel like this same dilemma would exist under all debt-based regimes. I see an asset-based regime differently as don't feel the statement , "every gold ounce that is mined only has value so long as ATLEAST a further 0.05 gold ounces is mined" is valid.

I'm sorry but I don't quite get the point of this statement...I'm sure there is one, I just don't understand economics well enough to find the argument

I'm assuming this statement has to do with the negative interest rates? I still don't see how exactly interest rates go negative. I am of the understanding that interest rates are positive when one values today more then tomorrow, are zero when one values today as much as tomorrow, and negative when one values today less than tomorrow. I don't see how the last period occurs as it seems it is always better to have it today then tomorrow as having it tomorrow is sort of included within having it today.

On a separate note, if the FED must expand the money supply for the papers to still have value, I am curious as to how they go about ensuring that enough paper is added?

It seems to me they have three potential options:

1) Add less money to the system then the required interest

2) Add EXACTLY enough money to perfectly cover the required interest

3) Add more money to the system then the required interest

Now for option one, as mentioned above, it seems to me like this would destroy the whole system as it must lead to a default on the debt which in turn renders all the fiat money worthless (this is not even to mention the fact that this default would also occur under a leveraged fractional reserve system). As this option would destroy the very system that the banks benefit from, creating value from nothing, I would imagine they would certainly ensure this is not the case. As such, I think that option one is unstable/unsustainable.

Option two if it were done perfectly I could perhaps see working. I only wonder how exactly the FED could ensure that all of the new money added finds its way exactly into the hands of those needing to pay the interest. Would there also be a problem with calculating how much must be added? I guess this is similarly along the lines of the problems with economic calculation under socialism.....to whom and in what quantity? As such, I think that option two is effectively impossible.

Option three to me seems to be the most likely final result. Mainly as a result of incentives not making option one desirable, and option two as an impossibility. Surely if one pumped enough money into the system they could ensure that all those needing to get ahold of that interest payment would be able to do so. And so things would seemingly be ok. However, it seems to me that this is now on an irreversible course to hyper-inflation. My reasoning being that, using the 5% bond as an example, we know that they must add 5% to the money supply annually. Now by pursuing option three they in reality are adding 5.01% to the money supply annually. The function of money supply growing at a rate of 5.01% vs time will inevitably dwarf the function of money supply growing at a rate of 5%. As such, as one moves along the x-axis (time) they will find that the amount of money being added to the system as a percentage of the total system is in fact increasing. This is obviously the consequence of the Y2 - Y1 value growing where Y2 is a function growing at a rate faster than the function Y1. For this reasoning I feel that hyperinflation is inevitable if option three is pursued. As such, I think that option three is unstable/unsustainable.

So in summary:

Option 1 = Unstable / Unsustainable?
Option 2 = Impossible?
Option 3 = Unstable / Unsustainable?

A three man economy. Bob the banker, Larry the lumberjack and Arron the assembler.

Bob has 100$ he wants to loan out, Larry has $20 and some wood he cut down and Arron has 0$ and the skill to take the pieces of wood from Larry to make a chair.

Bob Loans Arron the 100$ @ 5%, Arron buys Larry's wood for $100, now Larry has $120 and no wood. Arron builds the chair and sells it to Larry for $110, and pays back 105$ to Bob.

Final tally: Bob has $105, Arron has 5$ and Larry has $10 (and a chair instead of lumbar).

I think the above situation works out fine because it is simply an exchange taking place within the economy....what I would like to do is to zoom out a bit further and examine how those original dollars came into being and whether or not there is a huge fundamental problem within the system.

Here is the same scenario but starting just a little bit earlier on in the process:

The FED gives Bob $100 in exchange for a $100 bond at 5%. The FED gives Larry $20 in exchange for a $20 bond at 5%. So in one year's time Bob will owe the FED $105, and Larry will owe the FED $21. Ultimately, at the end of the year the FED will need $126.

Now onto the exchange....

Bob has 100$ he wants to loan out, Larry has $20 and some wood he cut down and Arron has 0$ and the skill to take the pieces of wood from Larry to make a chair.

Bob Loans Arron the 100$ @ 5%, Arron buys Larry's wood for $100, now Larry has $120 and no wood. Arron builds the chair and sells it to Larry for $110, and pays back 105$ to Bob.

Final tally: Bob has $105, Arron has 5$ and Larry has $10 (and a chair instead of lumbar).

And once the exchanges are completed....

The FED now comes knocking for its $126. But alas, even if it takes all the money from Bob, Arron AND Larry it will come up short by $6. Seems like the dilemma is still there.

This isn't how central banks come into existence, they usually co-opt some form of money already being used, and they don't demand all $ given to them at the outset to be distributed (can you imagine the backlash if they did?).

I'm talking about monetary units - it's pretty simple math that I'm quite amazed that Austrians continue to miss - if all growth comes via price reduction (as opposed to increase in leverage or increase in monetary units, which are two other options), there's no reason to invest in growth. Thus, there will be no economic growth in such an environment. Before anyone comes in and says investing will be even more profitable if no one else is investing, this is in fact not true - the false assumption is that by investing in an environment where no one else is investing, one will be able to capture a larger share of the economic growth. But if no one else is investing, the economy won't grow - there's nothing about the natural laws of economics that says economies must grow. In fact, looking at the #'s, it's rather clear that money supply expansion is a rather important factor in stimulating economic growth.

Here's a simplified version of the math:

Net tradable wealth / monetary units = Leverage (any significant increase in this is indicative of 1) money being bypassed, 2) increase in credit and generally not sustainable)

Net tradable wealth in year 1 = Net tradable wealth in year 0 + labor income + surplus return on capital (including depreciation) - consumption

Rate of return on capital = (Net tradable wealth in year 1 - labor income + consumption) / Net tradable wealth in year 0 - 1

Rate of return on cash = 0 = Net tradable wealth in year 1 / Net tradable wealth in year 0 / ((Leverage in year 1 * Money supply in year 1) / (Leverage in year 0 * Money supply in year 0)) - 1

If you hold leverage and monetary units constant and make one assumption (that labor income >= consumption; this seems like a generous assumption given that consumption as a share of GDP runs at 70% and reported labor income as percentage of GDP somewhat lower, but this is because much labor doesn't get counted as labor. On an intuitive level, one would think that labor income must account for all consumption and some investment for the economy to grow - otherwise we're collectively spending beyond our means, but somehow our past investments are digging us out of them - this seems unlikely if you consider the basic balance sheet picture and income mobility we've experienced, as well as the nature of economic growth we've experienced) surplus return on *all* capital will be equal to or lower than return on cash (which is zero btw)

Given the rather large risk premium required by any investment projects over cash (historically usually between 4% to 15%, depending on the project) even significantly relaxing the assumption doesn't change the extremely low incentives to invest. Thus investments will not be made on a large enough scale to allow the economy to grow. This is in fact an economically efficient outcome - when faced with the impossibility of extracting from cash-holders the benefits they are getting from economic growth, the system deviates away from the save-invest-and-grow model to the maintain-and-subsist model in order to avoid economic growth (any appearance of purpose is accidental, of course). There's nothing wrong with the latter and in fact we may eventually want to switch to something more like than in the future, but the cold fact is, economic growth driven by investment is nearly impossible to sustain in an economy with constant money supply.

Your problem here is basic- I can invest and make money WITHOUT the economy growing by capturing greater market share, even in a zero sum game there are incentives to invest.

So terrible. So much wrong in such a few sentences. Growth doesn't come from price reduction; rather price reduction comes from growth. Why are prices falling? Because the supply of goods and services is growing relatively more quickly than the supply of money, i.e. the economy is growing faster than the money supply. If everyone stopped investing and simply hoarded, that growth would halt, and the incentive to hoard would vanish. Hence there is an equilibrium point in the middle that corresponds to positive growth.

I already showed that the equilibrium is in fact that of zero or negative growth - care to explain where my math went wrong?

So economic growth in this environment depends on entrepreneurial stupidity?

What the hell are you talking about? If everyone is stagnant in terms of investing one entrepreneur investing would stand to gain market share, and hence wealth, even if no one else is investing at that time.

Btw, isn't it funny that when you look at the math underneath, the Austrians have everything completely backwards? Note that even in your model, useful saving in the form of investments in productive capacity (as opposed to hoarding goods, which has a negative rate of return in a growing economy) which I'm sure the Austrians would proclaim is the source of economic growth, increases in response to lower effective interest rates.

If that's your point, then it's irrelevant - depreciation is part of the return on capital. If not investing means you lose market share, that must go into determining the price of capital. That capital tends to depreciate over time hardly gives you reason to own capital. In an economy with fixed money supply, cash neither depreciates, nor loses market share without further investment.

I initially thought you meant you could simply invest better than others - as in the lure of the possibility of outplaying other entrepreneurs leads to investment. That is at least mathematically possible (negative risk premium). Your clarified scenario is not.

That's humorous. You made a factually incorrect statement here

This is also incorrect because human productivity is not constant throughout a lifespan.

Your problem seems to be in thinking that a person can only invest if they have money, this is incorrect. Money is in fact the dependent variable since it is simply a mechanism for exchange through time and relies on the availability (and the expectation of availability) of goods and services. The logical conclusion to draw from your posts is not that money is necessary for investing to occur, it is that money becomes unnecessary without investing.

The positive return on investments cannot be determined in advance, and the ratio of which investments actually end up being useful is dependent upon many things, a primary one being the rate of investments.

Btw, this is what I'm saying, with the additional caveat that growth comes from investment. The problem, if you follow the simplified math (there's much that isn't incorporated, such as rent and untradable wealth, but feel free to point out how this changes the conclusion, because as far as I can see, it doesn't), is that if growth is expressed as price reduction, as opposed to growth in nominal price of capital, cash hoarders are getting paid for nothing and there's no reason for anyone to want to invest in increasing productive capacity over simply hoarding cash. The equilibrium, therefore is simply zero to slightly negative growth - this isn't necessarily what will happen because large swings in leverage are possible, but it's easy to see that the system is unstable around a fairly undesirable mean.

It is factually correct. Before I try to make your argument for you (I almost did here again), do clarify what you mean, since it's fairly obvious that the statement is correct. Borodog has a good point about the equilibrium here - try and see for yourself where that equilibrium must be.


I fail to see its relevance and I did take fixed income retirement into consideration before writing the first post.


I like how you throw around random words like they mean something, but refuse to address the simple math. There's no possible way, in the given scenario, for capital to outperform cash! Are the assumptions wrong? Is the math wrong? If not, how could this be? And yes, money becomes less necessary if investing is down to maintenance, and this is exactly what I predict in such an economy - purchasing power of money goes down over time, as the economy fails to maintain its productive capacity.

I'm not assuming anything beyond what's presented - it's all in the math. Money not being used for exchange is taken into account in the calculation of leverage - introduction of barter, money-substitutes (including debt-based expansion of secondary monetary aggregates), money-indexed credit contracts, etc will increase the effective leverage. That's the whole point of this exercise - that if money supply doesn't expand to accomodate the increase in the productive capabilities of the economy, either real money will effectively be abandoned (via increase in leverage) or if something makes it difficult for money to be abandoned, it will stop the economy from growing.


This sounds great, but as has been demonstrated, once you have a fixed money supply (and other conditions are met) net investment in the economy is only profitable if the economy is shrinking.