The modern banking system has been very successful at keeping most economists, politicians, mainstream media pundits and even many bankers confused about its real modes of operation. The confusion has been so great that the Bank of England’s Monetary Analysis Directorate recently published the papers “Money in the Modern Economy: An Introduction” (link here) and “Money Creation in the Modern Economy” (link here) to help clarify how money is created in today’s fractional reserve system.
It is not often that central bankers clearly state that banks create money out of thin air. Particularly noteworthy is the statement that most money in circulation is created by commercial banks through loans. When a consumer or businessman walks into a bank and obtains a loan, a deposit is created into the account of the borrower, regardless of the amount of money held in reserve at the bank (or central bank).
An obvious problem is that the interest with which to pay back the loan is never created through this process. For example, consider a consumer who takes out a $100,000 loan with payments of $30,000 per year for five years. At the end of the loan, the $100,000 principal will have been paid back along with an additional $50,000 in interest. But, the $50,000 was never created through the process of the original loan.
So, where did the $50,000 come from? Considering that most money in circulation is created by commercial banks, it must have come from other loans taken out by other consumers or businessmen. And so, it appears, we have the foundation for a never-ending cycle of increasing debt. The interest for original loans can only be created through more loans, and so on. The end result is a spiraling of debt and the overall net increase in business output that must be spent on servicing the debt.
When consumers and businesses are no longer able to provide the productivity required to service bank debts, then the result is bankruptcy and the transfer of loan collateral to the banks. In this way, the banks clear the debt and future interest payments and, in return, get to own tangible assets (such as private homes and businesses).
In the context of the fractional reserve system, in order to reduce the interest burden, the banks can lower interest rates. This will defer the time of bankruptcy to a later point in time. (The Austrian School is quite clear on the negative effects of artificially lowering interest rates, including the supporting of poor businesses with low productivity.)
If interest rates are not only lowered, but brought negative, then the accumulated levels of debt can be decreased. (Here, too, the Austrian School is clear on the ramifications of negative interest rates to the economy, including the large increase in time preference.)
Consider a scenario of a business loan for the amount of $100,000. A loan with a 10% effective interest rate, 10 year amortization period and bi-weekly payments of $1,200, results in a net accumulated interest of $56,900. This is shown in the graph, below, for the years 2016 to 2026.
At the end of the tenth year, $156,900 in payments have been made to the bank. In order to ameliorate the effects of the $56,900 in interest (money that was created by other loans in the system), a business loan in the amount of $156,900 could be introduced into the economy with a -5.5% effective interest rate, 15 year amortization and bi-weekly payments of $510. This is shown in the years 2026 to 2041. At the end of the 15th year, the net accumulated interest is zero.
In any economic system that uses money to facilitate economic calculation and activity, the questions of who controls the money and how it is created have been asked. In a private property society, the answers to those questions are left to the market to decide in a voluntary manner. In a socialist society, the answers are left to central banks and government planners. By allowing banks to maintain a system of fractional reserve banking without much thought given to the repayment of interest on bank loans, we have allowed our economy to be subjected to inevitable booms and busts.
Can negative interest rates save the economy? In a narrow sense, yes, because they ameliorate the otherwise spiraling debt load that result from bank-created money. However, economic calculations made according to those negative interest rates will be inherently corrupted and their effects on socioeconomic health will likely be dire.