I note a considerable amount of interest in some ideas by Chris Martenson – who has a website and offers tutorials entitled ‘The Crash Course’. He suggests that the current way we are living is unsustainable and we’d better start preparing for when it all goes pear-shaped (which will be pretty soon according to him). There are three pointers to this alarming turn of events – two fairly genuine, I think, and one based on a misunderstanding.
The two issues I would share his concern about are Climate Change and so-called ‘Peak Oil’ – the impact of the likely future decline in oil production as reserves are exhausted. Their exact impact is, of course, open to ongoing debate.
His misunderstanding involves the impact of interest payments on the monetary system. Now Dr Martenson is a neuro-toxicologist by training, rather than an economist. Otherwise he would probably be aware that the problem of how interest can be paid when all money is created through lending is one that has troubled many economists, particularly those of the monetary circuit school, to which I would describe myself as loosely attached. But in fact it has a very simple solution, once one learns to distinguish between money stocks and money flows.
Martenson’s concerns about debt and interest are summarised in the following quote from his site (which he attributes to a Steven Lachance):
A debt-based monetary system has a lifespan-limiting Achilles heel: as debt is created through loan origination, an obligation above and beyond this sum is also created in the form of interest. As a result, there can never be enough money to repay principal and pay interest unless debt is continually expanded.
Martenson makes it sound even worse by suggesting an exponential growth in debt that results from the need for more debt creation to pay the interest. Now this seems alarming, and it is in some ways, but not quite in the way described.
The quantity of debt, and the money created by it, is at any instant in time a fixed stock. But, over a period of time, this fixed stock of money can be used to carry out a much greater monetary value of transactions. If the rate of circulation of money (the technical term is the ‘velocity of money’) were infinite, the value of total transactions carried out with any quantity of money would also be infinite! Obviously it isn’t infinite, but the point remains that the quantity of money is not on its own an absolute limit to the value of transactions in a time period. This is because transactions are a flow, not a stock.
As an analogy consider a pond, out of which water flows and is then pumped back in. If we measured the capacity of the pond as 100 litres, does this say anything about the possible rate of flow out of and back into the pond? In fact even if the water flowed out at 100 litres every second, as long as it was pumped back in at the same rate then the flow could continue at 6000 litres/minute – 60 times the capacity of the pond every minute – indefinitely! If, on the other hand, 100 l/s were pumped out, but only 90 l/s pumped back in, the pond would be empty in 10 seconds and the process would come to a halt. So the ‘sustainability’ of a flow depends not on its absolute rate, but on the differences between flows in and out of stocks.
Interest payment is a transaction, so it is a flow. What matters therefore is not the absolute quantity of interest, but whether the flow of interest payments from the borrower back to the bank is matched by a flow of payments to the borrower. Since the money paid as interest does not disappear after being paid to the bank, but is spent by the bank – as wages or dividends, or on physical capital, it returns to the rest of the economy. As long as it finds its way back to the original borrower, it can then be used once more to repay the loan.
Let’s go through this process step-by-step using some diagrams.
Here the bank makes a loan of £100 to a firm, and the firm immediately makes a wage payment of £100 to households. The interest charge is 10% of the loan. The stock position of each economic unit is indicated. I treat the debt as ‘negative money’ for the bank, but this is not important to the analysis. The important thing to note is the net money stock position of the non-bank economy, which is now +100.
The firm sells its initial output to households for £10, and then pays this to the bank to discharge its interest obligation. The net non-bank stock position is now +90.
The bank now uses the money it has received as interest to pay wages, dividends or to purchase physical capital. The net non-bank stock position is again +100.
The firm now sells the rest of its output to households for £100. The net non-bank stock position remains +100.
The firm now repays its loan to the bank. The net non-bank stock position returns to 0.
In summary, the firm has managed to match its flow of money back to the bank of £110, with a flow of £110 in sales revenue. But at no time has the non-bank sector had a total stock of money exceeding £100. This model of the monetary economy is simplified in various respects, in particular by suggesting that interest is paid in a lump sum, and by suggesting the existence of only one firm. Interest is normally a continuous flow over the lifetime of a loan, but as long as the total interest plus repayment and the revenue flows match over the time of the loan, the picture is essentially as shown. The presence of multiple firms (some of them providing goods to other firms) complicates the flow, and produces uncertainty for firms, but it has no impact on the feasibility of loan and interest repayment.
None of what I have said should be taken to mean that a monetary economy is trouble-free. Far from it, as I have pointed out in several other pieces on this site, Understanding Money (pdf 83.9Kb) in particular. But there is no urgent inevitability about the collapse of the monetary system. In a sense, this perhaps makes it more important to understand what is needed to tackle the real problems of our monetary economy. These are primarily the periodic tendency for large quantities of money to be held (saved) instead of spent, the fact that money issue is increasingly divorced from real value creation, and that the significance of money flows and stocks for real human and social welfare is very poorly understood.
Professor Steve Keen of the University of Western Sydney has also investigated this issue, and comes to the same conclusion using a dynamic mathematical technique. You can see a video of his discussion.