Your interest in Interest

by Paul Goodchild on October 30, 2008

I wrote last week about Money as Debt and how all money in circulation is actually a debt owed to somebody, somewhere. Ultimately this debt stops with the banks, and finally with the mother of all banks – the ‘Central Bank’ (or the Federal Reserve in the U.S.).  Why is money actually debt?  Because all money was originally issued as a loan.

And what do all loans have?  Interest!

Consider then, the following question:

If all money that enters circulation does so through a loan from a bank, where does the money come from to pay off the interest payments due on those loans?

Take a moment to ponder this.  It isn’t a trick question.

Once you begin to understand the implications of this question, hopefully the reason I feel so strongly about it should become clear.

We each should all know the principles upon which our “economy” is based.

Where does money come from?

All money is now spontaneously generated by the central banks in the form of loans.  It is impossible for any monetary system to pay off all debts (the principle of the loan plus the interest accrued on it).

Debt, failure and bankruptcy are intrinsically built-in to the system!  They are a necessity because as long as this system persists there will always be losers – people who can’t meet their loan commitments.

Once they declare bankruptcy, the slate is magically wiped clean.

We are raised in competition with everyone else in the system.  We study hard, work hard … always trying to get ahead; increase our relative value.  Granted we may work in cooperation with colleagues and business partners, but what we’re all trying to do is get ahead of the curve.  Create our own tap into the money flow so that we may eke out the existence we so desire.

The fractional reserve banking system

To explain a little further how the money makes its way into the system, we must understand the fractional reserve banking system.

This system employed by modern banking sheds some light onto how such large sums of money are generated and enter the economy.

A bank is required to keep in its possession a certain percentage of the deposits (for example from savers like you and me) it receives and is allowed to loan out the remainder to other customers.  The percentage that is kept by the bank is called the ‘reserve‘.

The ratio between the reserve and the remainder allowed for providing loans etc. is the Reserve Requirement.   Take the following simplified example:

Mr. Flush has $1000 in his possession.

He decides to deposit this $1000 into his bank for savings. If the reserve requirement is 10%, the bank receives the $1000, but must hold on to $100 dollars.  The bank is allowed to provide loans to other customers using the remaining $900.

A customer receiving this $900 loan would likely make a purchase with it, which would see that money then deposited with another bank.  The second bank, with the same reserve requirement of 10% would retain $90 and then loan out $820.

Rinse and repeat.

From that initial $1000, and through repeated application of fractional reserve banking at 10%, approximately 10 x $1000 of new money can be created by the banks and enter circulation within the economy.


Read that again: 10 x $abc of NEW money can be created by the banks.  The money isn’t based on anything real.  It’s make-believe money by the banking system.

How does the banking system break?

This system for magically creating new money is all well and good as long as the banks can satisfy every request by the depositors when they wish to withdraw their money – hence the need for the reserves.

The problem comes when all depositors come looking for their money at the same time.

If the bank has loaned out most of the deposits, how does it satisfy the demands of the depositors?

It doesn’t.

Recent examples of this problem include Northern Rock in the UK.  Customers lost confidence in the bank’s ability to provide their money upon demand and so rushed to get their money out before their worst nightmares were realised.  This phenomena is so-called a run on the bank.

This is a big problem, but it’s only the beginning.

What if, with the fractional reserve ratio of 1:9, much of the loaned money has been invested in high-risk mortgates or mortgage-backed securities.  Let’s say you lose most if not all that money, how do you even begin to pay back the money your depositors gave you.

A HUGE amount of the principle in these cases is simply wiped out – the bank is highly leveraged at 1:9 and is basically bankrupt. This is just part of the big puzzle that we are facing today.

You need to understand

If you have a firm grasp of many of the economic fundamentals helps to interpret the big events we’re hearing on the news.

Taking the time to understand gives you the confidence to navigate the system and make sound financial planning decisions.

The banks are not the sole culprits of today’s banking system.  Consumers that purchase goods and services on credit that they cannot realistically afford perpetuate the problem.

The traditional method for getting what you want is to spend within your means, to save your money until you could afford what you desire.  Normally you buy a home by saving up  for a sizeable down-payment and the gradual return of the mortgage loan.

Somehow this basic principle got lost in the rush for more, more, more.

Further Reading

Much of what I understand has come from many sources, but primarily my awareness of this has come from the following:

I highly recommend you give some time to a couple of the videos above.  If you don’t agree with some of the theories posted there, no problem.  It does no harm to expose yourself to alternative views which you are free to discount or consider as you feel appropriate.

{ 0 comments… add one now }

Leave a Comment

{ 2 trackbacks }

← Previous Article:

→ Next Article: