Everybody who has studied the monetary system has probably heard of the “interest can’t be repaid” problem. Because you lend only the principal and not the interest on the loan, there simply isn’t enough money to solve all debts. As the total amount of debt grows, the interest payments become an increasingly bigger problem. But is this all true? Does the interest payment on loans really drain the money system? It’s time to clarify a tough misconception about our debt-based monetary system…
Imagine you go to a bank to get a loan for $1.000, a loan which will be paid back in twelve terms of one month with an effective annual interest rate of 10%. This means you will have to gather $1.100 somewhere to pay back this loan. Because you’ve only borrowed a $1.000, where should the $100 of interest come from? Imagine you are not alone in this situation, because everybody with debts has to get the interest somewhere. All interest that has to be paid with money not created when people signed those loans.
When everybody has to pay back each loan they have, plus interest, there would indeed be a shortage of money. It’s a mathematical problem that is easy to solve, because repayment would stop beyond the amount banks originally lent to consumers and businesses. But this is not how the monetary system works in practice. Loans often have to be repaid in terms, which means that only a fraction of the total money supply is needed to service the debt load we have. Also keep in mind that only the principal amount of each loan is removed from circulation, not the interest you pay to the bank. It is very important to understand that interest payments to the bank flow back into the economy. The bank has to pay interest to depositors, wages to their employees, operational costs for their buildings and equipment and it has a profit which goes to the shareholders of the bank. All this money does not disappear from circulation, instead it remains within the monetary system like a closed loop. The interest you pay to the bank simply flows back into the economy, as long as the money is not hoarded by savers, bank employees and shareholders.
Because only the principal amount of each loan is ‘created out of thin air’ and is removed from circulation upon repayment, there is essentially a balanced system. The supply of money can expand or contract based on the willingness of people to borrow money, but there is no mathematical problem in servicing the debt.
As long as the money circulates within the economy, there is always enough around to repay loans with interest. Once the velocity of money slows down, because people for example prefer to spend less and save more, then it becomes increasingly difficult for debtors to repay their loans. In an environment of deleveraging (reduction of the total debt load), it becomes harder for debtors to meet their obligation to the bank. The reduction of the money supply leads to deflation, making it harder for debtors to fulfil their obligations. When people take on more debt, the money supply increases and inflation will follow. This is why central bankers keep a close eye on credit growth and use the interest rate mechanism to control the money supply.
Debtors versus savers
You might have noticed that, within our monetary system, debtors and savers have opposing interests. Savers want to hoard money (reducing the velocity of money), while the debtors prefer a higher velocity of money. I higher velocity of money makes it easier to repay loans. Finding a balance between the interests of debtors and savers is one of the greatest challenges in this debt-based monetary system.
The idea that debts cannot be repaid because the interest has not been created is not true. As long as debt is repaid in terms and banks spend all the money they receive as interest on loans, there is always enough money to go around to service all debts over time. Think of it as a closed loop, in which the interest payments circulate bank and forth between banks and the economy. Because the money circulates, it can be used multiple times to settle interest payments. The total supply of money will contract or expand, based on the demand for credit in the economy.