Debt in a Money-Based Economy

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ELI5: The implication of cancelling all world debt.

Would it solve any problems apart from the debt, or make many more?


 * Question


 * Answer by /u/Hapax_Legoman

Best answer
Okay, so let's do a little exercise here. We're going to build a money-based economy with fractional reserve banking from scratch. You'll understand why in a minute.

In order to keep this simple, we're going to stipulate a couple of things from the start. First, we stipulate that in this imaginary world we're constructing, everybody tells the whole truth all the time. Second, we'll stipulate — and really, this is just a consequence of the first thing — that everybody just takes everybody else's word for everything. Those are the ground rules, okay?

Now, we want to have a money-based economy in this world. That means we need money, obviously. Money does not currently exist in this world we're imagining, so we need to invent it.

Poof. Money exists.

There, that was easy. Money now exists in this world because everybody agrees that it does. That's all it takes, literally.

But that's just the first step. Because while we've all agreed that money exists, we haven't actually created any money yet! Money exists, as a concept, but nobody has any. Walk up to any person on the street and ask him how much money he has; he'll tell you that he doesn't have any.

So clearly, now that we've invented money as a concept, we need to go about creating some money, so we can get it moving around.

To do this, we're going to invent two institutions. The first institution we invent is called the treasury. Poof. The treasury exists. The treasury is an institution that we empower, purely by consensus, to borrow and spend money. That's all it can do, okay? Borrow money and spend money.

How does the treasury borrow money? It borrows money by issuing bonds. A bond is, in essence, a promise to buy the bond back at some future time. For instance, I might offer to sell you a one-year bond for $100; you give me $100, and I give you my promise to buy the bond back from you after one year for $100. It's essentially a very specific and formalized type of loan. (In the real world, bonds are sold with interest, but we don't care about that right now.)

So we empower the treasury — by consensus — to issue bonds, and sell them, and then spend the money it raises by doing so. This is what the treasury does.

But remember, nobody actually has any money yet. So there's nobody for the treasury to borrow money from; nobody can buy the treasury's bonds. So clearly we aren't done. We need another institution, which we're going to call the central bank. Like the treasury, the central bank exists purely by consensus; poof. A central bank exists. And like the treasury, we give the bank certain specific powers: The central bank can buy and sell treasury bonds. And that's all.

But wait. We just got through saying nobody has any money yet. So where does the central bank get money to buy treasury bonds? We give the central bank the power to create money to buy treasury bonds out of thin air. The central bank, then, is the source of all money. But remember we also said the central bank has the power to sell treasury bonds; that is, the central bank can exchange one of the bonds it's holding for some money that somebody in the economy has. When this happens, that money — the money the central bank takes in exchange for the treasury bond — disappears. It ceases to exist.

The central bank, therefore, is both the source of all money, and a money sink. Money can come out of the central bank from nowhere, but any money that flows into the central bank disappears forever.

And that's it. We're done. We now have a money-based economy.

Well, almost. We have all the pieces, but we haven't actually set them in motion yet. What we need to do is have the treasury issue a series of bonds, say $1,000 worth in total. Then we need to have the central bank create $1,000 and use it to buy those treasury bonds. Then the $1,000 goes from the central bank to the treasury, and then the treasury spends it. Thus does that money we created at the central bank go into circulation.

Once the money is in circulation, though — that is, once the treasury has spent it, by giving it to people in exchange for goods or services — interesting things continue to happen to it. Here's a person, Alice we'll call her, who gets some money from the treasury. Maybe she helps to build a road or something, and the treasury pays her $100 for her labor. Whatever. Point is, Alice gets some money.

Alice goes to the bank — not the central bank, but just an ordinary commercial bank — and asks to open an account. The teller says "Okay, how much money do you want to deposit?" And Alice says "One hundred dollars, please." The teller — who just takes her word for this, because remember, everybody tells the truth all the time — says "Okay, now we have your $100, but you can come back and ask for it any time you want." This is what's called a demand deposit account. It's an account into which you deposit money with the understanding that whenever you want, you can demand it back. Alice is happy with this, so she leaves.

The next person in line at the bank is Bob. Bob doesn't have any money — he didn't get one of those cushy government jobs — so he wants to borrow some. He asks to borrow $50, which he'll pay back in a month. The teller says this sounds fine, so she takes $50 which Alice deposited and gives it to Bob. Bob takes that $50 and uses it to buy something from Carol, who then takes the $50 and deposits it in her own demand deposit account at that same bank.

Alice's $100 — which she got from the treasury, which got it from the central bank by issuing a series of bonds — has now multiplied. In addition to the $100 Alice had in her account, Carol also has $50 in her own account, $50 that was created out of thin air when Bob borrowed it.

And those are the two ways that money is created in our economy. Some of it is created by fiat — that is, the central bank wishes it into existence and then uses it to buy bonds from the treasury — and the rest is created by borrowing.

But notice something. Every dollar that gets created in this imaginary toy economy we created is accompanied by a dollar of debt. The central bank creates money to buy treasury bonds, and treasury bonds are debt. Banks create money when they lend out their cash reserves, but those loans are also debts. In other words, every dollar that exists is backed — that's the jargon term for it — by debt.

Which means if you just waved a magic wand and declared that all debts are forgiven … all the money would vanish. Every red cent of it, from everywhere, instantly.

Of course, if you have a magic wand you could also say that the debt disappears but the money doesn't … but remember, it's debt that's backing the existence of the money in the first place. If you make the debt disappear, the money can linger — as a number in a ledger with a dollar sign on it, or whatever — but the thing that backed the money no longer exists … which means the money is worthless. It would all revert to being unbacked, meaning it wouldn't be real any more, in the economic sense. Having $20 in your pocket that's unbacked by debt would be no different from just pretending you have $20 in your pocket. You might be able to find somebody who's dumb enough to accept your pretend money in exchange for goods or services, but you aren't guaranteed to, because your pretend money isn't actually worth anything.

So long, long, very-very long story made short? If you waved your magic wand and made all the debt go away, you'd either explicitly or effectively be making all the money go away too. Because money and debt are two sides of the same coin; you can't have a dollar without somebody, somewhere owing somebody else a dollar.

Source.

/u/LWRellim
The problem with this explanation is that this is NOT how a "money based economy" comes into existence -- in fact it is a wholesale lie (a non-truth).

''Remember that first stipulation, about "everybody telling the whole truth all the time" ... yeah that.''

What the explanation completely ignores is that a functional economy (even in this little imaginary toy world) would have to pre-exist the money, and that some means of exchanging goods would already exist.

Furthermore, there would be a BIG PROBLEM with the "new" (never before known) money that the treasury created.

The problem is that when the treasury tried to "spend" it, it wouldn't be able to do so. Why? Because no one would want it. No one VALUES this newfangled "money" and no one would know how to price anything -- neither goods nor labor (how many hours of road construction labor will "Alice" have to do for her $100? Answer: no one has a clue).

Likewise, why would "Bob" want to borrow the $50 in newfangled "money" -- he has lived his whole life without it so far, and none of the people that he trades goods with want it, so what compelling reason would there be for Bob to take out the loan? Answer: None.

So what is the MISSING PIECE of this puzzle? DEMAND. There is no DEMAND for the newfangled "money" (which keep in mind in THIS wholly fictional explanation, the money is paper money -- it is NOT linked to any pre-existing commodity {i.e. no gold or silver})

So the second BIG QUESTION is: How does a government create DEMAND for something that (initially) only IT has.

There is only one answer: TAXATION.

The government must demand that it's citizens PAY the government -- and it must demand that (at some future date) each citizen must pay a certain amount of these taxes in the form of this "newfangled money".

And then to set some VALUE on that money (in terms of the real, actual, economy that existed BEFORE the newfangled money) the government must ALSO allow payment of the taxes in the form of some designated good, and must (at least to start with and until everyone is using the "money") establish some FIXED exchange, say 5 bushels of wheat = $100, or 1 chicken = $10.

So (remember everyone is being totally HONEST here and telling the WHOLE TRUTH, not just some partial truth) it is not merely that money is based on DEBT, but that the DRIVING form of debt is an equally magical ("poof") amount of "debt" that the government has created and imposed onto the population (with a wave of a magic wand, known as "taxation legislation" and a "legal tender law").

Because, please... let's NOT lie to 5 year olds... let's tell them the WHOLE TRUTH! And that whole truth is that without taxes (a magically created initial & recurring "debt") and legal tender laws that require people to use the money and NO OTHER form of exchange (with the threats of force, violence, loss of property and possible imprisonment for either not using it, or for not paying taxes) the magically created government "money" would have zero value, and no one would use it.

Source.

/u/LWRellim  (cont)

 * >I feel like Hapax_Legoman laid the groundwork and explained how things work

Well, what he wrote is partially true in the sense that "money" (as a abstract concept) CAN be whatever people agree to use.But his explanation falls woefully short of reality, and is very misleading because of that.

In part, he cheated by using the "$" symbol without any actual context (inside his toy world) -- but yet "borrowing" on an implied existing context (we all KNOW what dollars represented by the $ and numbers are -- they are "money").

If he had said the government has introduced a new "invention" of "money" in the form of Quatloos. Well, now we are properly shocked OUT of our normal context? What is a "Quatloo" worth? How long of a road will Alice have to construct to get 100 Quatloos? Does she build 100 miles of road or just 1 mile? And if Alice gets paid 100 Quatloos for building even a mile of road, then Bob borrowing 50 Quatloos is not a "small loan" but a rather huge one.

And again, what in the world will Alice or Bob DO with their 100 and 50 Quatloos? No one else has any idea what they are worth, and no compelling reason to adopt them.

You can see this kind of thing in action right now just by looking at the "bitcoin" thing -- no one has a clue what "bitcoins" should really be worth in terms of goods and services. They HAVE to resort to the EXCHANGE value versus existing functioning currencies. (Values of bitcoins have changed within the last year from an initial low a year ago of less than $1, to a high of $30+, back down to a current {as of this writing} value of under $3, that's a fluctuation of INSANE proportions, reminiscent more of a "pump & dump stock" than of a true currency.)

And this is CRITICAL to understanding currencies and "money" -- there MUST be, at least initially, an underlying (compelling) demand, and there MUST be some mechanism for establishing prices. It is one of the primary reasons that 100% socialist/communist societies cannot have truly functional advanced economies -- because by definition, they prevent the "market" from establishing prices.


 * >explained how things work (treasury/central bank relationships, bank/lender relationships, bond/currency relationships)

All of that is really entirely superfluous.

It obfuscates what is really going on, which is namely that the government is creating (aka "printing") money out of nothing, creating a "compelling demand" in a two-fold manner by (primarily) requiring taxes be paid in (and only in) that form of money, and by (secondarily) by establishing it as the ONLY form of "legal tender" (i.e. that one cannot use the court system to enforce any contract demanding payment in any other form). {One could add in a third factor, in the form of taxing any changes in OTHER forms of "money" via "capital gains" which tends to add a "chilling" factor against non-black-market use of other methods of exchange.}

But if you eliminate ANY of those, then the market will in all likelihood transition away from the "official" money that is being so manipulated (and normally inflated/devalued) via the whole treasury/banking system obfuscation.

His explanation is also false in that it makes it APPEAR that the current (treasury/banking/bond) system of "fiat" money was created in the fashion he explained; when in fact, it DIDN'T happen that way. The current system (of entirely non-commodity un-backed "fiat" dollars) did NOT begin that way, nor was it the result of some well-executed "plan".

The US dollar actually BEGAN (prior to the existence of the United States) as a "silver coin" based currency (with roots going back to the "thaler" or "Joachimstaler" in wide use throughout Europe since the mid 1500's) -- and which was (after the US government came into existence) redefined in terms of both silver AND gold, and then subsequently only in terms of gold.

The transition to the "debt-instrument/bond-base" was a long one -- taking the better part of a century, with various governmental promises, broken promises, devaluations, coin confiscations, etc -- and the ultimate "break" with gold was an accident forced by circumstance (and indeed at the time -- August of 1971 -- proclaimed as a "temporary suspension" rather than as a permanent break).

So, really, it was a "bait and switch" thing that happened over a VERY long and protracted period of time -- American society did NOT accept a "debt instrument/bond-based" currency, and the vast majority of the population (including many officials) is STILL under the impression that the dollar is (somehow) "backed by gold" when in fact it is not.


 * >you put the WHY it works into it.

More correctly I put in the only way that a "fiat" currency CAN work (either as a way to "initiate" it, or in the case of the US dollar, to sustain it's use).

Source.