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Why is deflation and depression inevitable in debt based monetary system like ours?

Economics / Deflation Jul 30, 2010 - 03:49 AM GMT

By: Mansoor_H_Khan

Economics Best Financial Markets Analysis ArticleMoney is civilization’s most liquid asset.   An asset is something of value.    Most liquid means that this is the asset most employees want to get paid in and this is the asset most vendors demand for payment.    For United States of America most employees demand payment in U.S. dollars and most vendors price their products in U.S. dollars and demand payment in U.S. dollars.

The next point to note is that prices of most products and services (by far) in the United States are determined by:
  1. Demand for the product
  2. Supply of the product
  3. Total Supply of Dollars

The first two items listed above are intuitive the last listed item listed above (#3) is not intuitive.  That is correct:   the total supply of dollars available in the economy has a very, very strong influence on prices. 

Let us continue.  Total Supply of Dollars is comprised of:

  1. Coins -  Coins are created by the U.S. Mint.
  2. Paper Bills - Paper Bills (like the Dollar Bill in your wallet).   Paper bills are printed by the U.S. office of printing and engraving.
  3. Bank Deposits -  Bank deposits are created by the banking system.  Any money accessible by “writing a check” counts as money.

Coins and Paper bills are put into circulation by the U.S. government by simply spending them.   How bank deposits are created is the key to understanding deflation and depressions.   Bank deposits believe it or not rule our world because they comprise 95% of the money circulating in the economy.  Money rules our world.  More precisely, those with the power to be able to create new bank deposits (i.e., bankers) rule the world.   Even politicians are easily manipulated by those who hold the power to create money (i.e., bank deposits). 

So how are bank deposits created?

A bank deposit is created when a borrower applies for and is approved for a loan.   The actual creation of the bank deposit is nothing more than a booking entry to a “checking account”.    The act of funding a loan is simply the act of increasing the balance in the checking account of the borrower.  This can occur directly (the bank can simply increase the balance in the checking account of the borrower if the borrower’s checking account happens to be in the same bank) or the bank can just “write a check” and give it to the borrower to spend or deposit it in his checking account.

Don’t worry too much about “how the check clears”?   This is not important to understand deflation and depressions.  Think of the newly created bank deposit (i.e., new money) as the loot and clearing checks between banks is just how the benefits of this loot is shared among the banks.

Think of the banking system as a one “giant bank” in your mind.  Think of it as one giant ledger which keeps tracks of who has how much money.  As individuals write checks to each other the increases and decreases are just entries to this giant ledger.   All new money (bank deposit) creation is simply an adjustment to this huge ledger.  Nothing more.   Sounds too good to be true.  It is true.  Banks however cannot just keep increasing the money supply without worrying about inflation.  Inflation is the balancing force.   The central bank can do various things to reign in bank lending when it is worried about inflation.

Actually, there is another balancing force.   Since new money is created when a loan is funded a bank must find credit worthy borrowers in order to increase the money supply (this last point is not 100% correct, I will explain later).  

So far so good.  So what is the problem?   The problem is that most money in the economy is born (i.e., created) when a loan is funded.  And the next point is even more important: 

Money dies when a loan is paid back by the borrower!

Yes.  That is correct.  When a borrower uses money (in most cases another bank deposit) to pay interest and principle to the lending institution the bank deposit used as payment “dies”.   Under normal circumstances this is not an issue because new borrowings (new bank deposit creation) normally more than offsets the money (bank deposits) destroyed when loan balance and interest charges are paid down.

So do you see that if the net of borrowings (creation of bank deposits) and paying loans back (destruction of bank deposits) is not such that more money is being created than being destroyed then we will have deflation (due to decrease in money supply) and eventually a depression.   

Eventually all debt based money creation systems (like ours) reach a point where the private sector refuses to borrow more because it will eventually become too indebted (even at zero percent interest rates) and the banks will get to a point where they will be too hesitant to lend because they will see the onset of deflation coming.  Some people call this “Peak Credit”.   But it may take a long time to reach “Peak Credit”.   Our current cycle of credit expansion started in 1940 (start of WWII) and ended in 2007.  Depressions are usually resolved via resets (massive defaults) and can easily lead to wars and chaos.   

So why would we ever design a monetary system which has to end in a deflationary collapse?  The answer is very simple:   It keeps bankers in power.

Of course, the resolution to this problem is very simple.   Bank deposits should be born (created) as equity and not debt just like Coins and Paper Bills.

Mansoor H. Khan

About the author: I am an Electrical Engineer by training (Bachelor of Engineering from Stevens Institute of Technology). I also have a Masters of Business Admnistration degree (MBA) from the University of Virginia.

© 2009 Copyright Mansoor H. Khan - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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