Re: Aggregate debt

From: William F Hummel (wfhummel_at_comcast.net)
Date: 06/13/04 

Date: Sun, 13 Jun 2004 21:04:14 GMT

On 13 Jun 2004 11:49:10 -0700, mikevilkin@mail.com (Michael Vilkin)
wrote:

<snip>

>Here is a theoretical question.
>Suppose, the banking system lends total of $100 B at 20% interest per
>year and collects $20 B in interest. So, $20 B is taken out of the
>economy. Now $20 B sits in banks' own accounts.
>
>Banks have certain expenses, so banks return back to the economy $10 B
>per year out of those $20 B.
>In this case $10 B will be taken out of circulation, and money supply
>will fall by $10 B.
>I don't say that the banking system really does this every year. This
>is just an example.
>
>Do we agree that money supply may increase or fall depending on the
>amount of interest earned - $20 B in this case - and the amount of
>money banks return to the economy, which is $10 B in this case?
>
>To keep money supply from falling, the banking system has to create
>new money with new debt. If the banking system will not create $10 B
>of new money, money supply will fall by $10 B in this case.

As I explained earlier, credit money is endogenous which means the
amount ultimately depends on the demand for bank credit. The amount
will increase or decrease as economic conditions change, and thus vary
the demand for credit. There is nothing unusual about a decrease in
credit money in the short term. However on average over the long
term, the amount will increase because the real economy has a growth
bias.

Banks need to grow their capital in order to back the ever-increasing
demand for credit money. They return most of their earnings to the
non-bank sector in operating costs, dividends, and bad loan writeoffs.
A typical return on equity is about 10% if the bank is well-managed.
They need about half of that just to stay even with the growing demand
for credit.

You are arguing that interest on bank loans is a positive feedback
which _forces_ banks to lend still more so the borrowers can pay the
interest on those loans. I claim that applies only to a decaying
economy, in which banks themselves would fail. If borrowers can't
service their loans, including paying back the principal, banks cannot
survive.

A sort of equilibrium could exist if bank capital remained constant,
which implies all of their earnings are returned to the non-bank
sector in various ways. In that case borrowers in the aggregate could
cover the interest on their loans out of income they earn off of
banks.

Normally however the economy is growing. In that case banks could
grow their capital along with the borrowers who would be able to cover
the interest on their loans mainly from income earned from banks. A
bank might lend to cover interest payments if that is seen as only a
temporary cash flow problem. However if the business is failing, the
bank will normally take a hit along with the entrepreneurs.

Your simple scenario is a case of not seeing the forest for the trees.
One can always argue along those lines, but it doesn't bear much
relation to the real world. I presented data on growth in the
aggregate capital of banks relative to the growth in national income
as evidence against the debt virus thesis, which you seem to ignore.
I think it is up to you to reconcile your analysis with the evidence.

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