by Fred Foldvary

There is a false doctrine about money and loans that has infected many otherwise enlightened and progressive thinkers: the ever-expanding debt-money fallacy.

The false proposition is that loans require an expansion of money, because the borrower has to pay back the loan and also pay interest, so more money has to be created, to enable the borrower to have the extra money for the interest.

Borrowing can be divided into two types: for consumption and for investment. Consider first borrowing for consumption.

Suppose Charles wants to travel, so he borrows $2000 for a big trip. He returns, and the $2000 has all been spent for the consumption. Now he must pay back the $2000 plus $100 in interest. Where does the $2000 come from? If he does not declare bankruptcy, if he pays back the loan, the $2000 principal is paid back from less future consumption. And where does the $100 in interest come from? Also from reduced future consumption.

Charles had a choice of saving some of his income until he had $2000 of savings to pay for the trip, or else shifting the trip from the future to the present day by borrowing the funds, and paying a premium to do so, the $100 in interest. Pure interest is a payment made to shift a purchase from the future to the present day.

The money used for the loan and repayment is only the form of the loan. The substance of the loan is goods, including services. In economic substance, given that the income of Charles comes from his wage, Charles is trading some of his wage for the travel service. By borrowing for the trip, Charles increased his present-day consumption in exchange for reducing his future consumption by the amount of the loan’s principal plus interest. Since Charles’s wage is his contribution to production, in economic substance, Charles is exchanging some of the goods he produces for the travel service, and to pay interest, more of the goods he produces will be traded and tendered to the lender.

This same process would occur in a barter system or with pure commodity money that cannot be expanded. Charles trades goods he produces for other goods, and when he borrows, he simply pays more of the goods he produces for the borrowed good that he gets. The extra payment is in exchange for the service of shifting the purchase from the future to the present day, and he willingly pays this extra amount, because of his time preference — wanting goods sooner rather than later.

No new money is needed for Charles to pay the loan plus interest. The payment comes from the reduction in his future consumption, as the loan shifts $100 of consumption from the borrower to the lender. The lender will consume $100 more while Charles consumes $100 less.

Now consider loans for investment, such as constructing a building, producing machines, or increasing the inventory of a company’s goods. Suppose the Kapigood company borrows $2000 to purchase machines that will make the company more productive in the future. Those capital goods that are produced by the company selling them are an economic investment.

Now Kapigood must pay back the $2000 plus $100 interest. From where will come the money? The money will come from the future sale of goods. And from where will come the extra $100 of interest? The new and better machines will enable Kapigood to produce more goods than before with the same amount of labor, and the extra sales will generate the funds by which to pay the interest, and if the investment is as productive as expected, the revenue from the extra sales will be greater than the cost of the investment, including the interest cost, so the investment will increase the firm’s profits.

What if the money supply of the economy is not expanded? Where will the money to pay back the loan come from?

The $2000 borrowed did not disappear. When Kapigood pays for the capital goods, the funds are transferred to the seller. When Kapigood sells its goods, funds are transferred from customers to Kapigood, and then from Kapigood to the lender.

But what about the $100 of interest? How, in general, will interest for investment get paid back, if the money supply does not increase?

For the whole economy, when there is lending for investment, and the money supply is not increased, then there are more goods for the same amount of money. What happens is that the price level falls. There is price deflation: goods in general become cheaper. The economy does not need extra money, because the same amount of money buys more stuff.

If the deflation was expected as ongoing, that reduces the nominal interest rate of loans. For example, if with zero inflation the nominal or quoted rate of interest is three percent, then when there is a one percent deflation rate, the nominal interest rate becomes two percent, because the lender gets a one percent return just from the greater purchasing power of the funds he will get in interest.

The Kapigood company can pay the interest because it will have more sales in the future, and people can buy more goods with the same amount of money, because the purchasing power of the money has increased.

In a pure market economy, with free-market banking, what could and usually would happen is that with greater output and more transactions, people want to hold more money, so the banks would expand the supply of money substitutes — bank notes and deposits — by the extra amount folks want to hold, by loaning out that extra amount for investments. If the real money is gold, then bank notes are money substitutes, and can be expanded if folks want to hold more.

So if output rises by three percent, and people want to hold three percent more funds after one year, the money supply would increase by the three percent. The banks do not expand the money just because there are more loans. The banks expand the money supply (by increasing the quantity of money substitutes) because the demand to hold money goes up. The expansion then takes the form of more loans. In a pure market, the banks cannot force people to hold money they would rather not hold.

So given a greater demand for money, then loans for investment, which increase the future supply of goods, are accompanied by a proportionally greater amount of money, not for the purpose of paying the interest, but to accommodate the greater public demand for money.

So loans for investment do not require a greater amount of money, since the price level will fall if the money supply is unchanged. But there will most likely be a greater amount of money, since the ratio of money to goods is usually stable, so more money will be wanted to pay for more goods. Then with the proportional increase in the money supply, inflation will be zero.

It is still the case that the money to pay back loans for investment comes from the greater sales by the borrower. The only difference is that with zero inflation, the nominal rate of interest will be the three percent rather than the nominal two percent. But the real rate of interest, the nominal rate plus the deflation rate, will be the same three percent.

The borrower for investment does not care whether there is deflation. If prices fall, then he gets less for his output, but pays less for his inputs. His profit is not affected. With deflation, the nominal rate of interest falls, so he pays back $102 rather than the $103 he would pay with zero inflation.

The ever-expanding debt-money fallacy comes from superficial thinking, from not understanding economics. Those who believe the doctrine are looking at the superficial appearance — the borrower pays back more than he borrows — and do not understand the underlying reality, that the consumption borrower pays back by reducing future consumption, and the investment borrower pays back from the greater future output. That greater output does not require greater money, since more goods can be purchased if they are cheaper, but a greater supply of goods usually generates a greater demand to hold money, which with free banking is accommodated by the expansion of money by that amount.

Those who still believe in the ever-expanding debt-money fallacy are now challenged either to change their belief, or else rebut the argument above.