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Edition 01 : 23 January, 2012.

Edition 02 : 21 October, 2012.

Edition 04 : 09 February, 2013.

 

(VERSION EN FRANÇAIS PAS DISPONIBLE)

 

Summaries of monetary reform papers by L.F. Manning published at http://www.integrateddevelopment.org

 

The referenced papers :

 

NEW Capital is debt.

 

NEW Comments on the IMF (Benes and Kumhof) paper “The Chicago Plan Revisited”.

 

DNA of the debt-based economy.

General summary of all papers published.(Revised edition).

How to create stable financial systems in four complementary steps. (Revised edition).

How to introduce an e-money financed virtual minimum wage system in New Zealand. (Revised edition) .

How to introduce a guaranteed minimum income in New Zealand. (Revised edition).

Interest-bearing debt system and its economic impacts. (Revised edition).

Manifesto of 95 principles of the debt-based economy.

The Manning plan for permanent debt reduction in the national economy.

Missing links between growth, saving, deposits and GDP.

Savings Myth. (Revised edition).

Unified text of the manifesto of the debt-based economy.

Using a foreign transactions surcharge (FTS) to manage the exchange rate.

 

 

(The following items have not been revised. They show the historic development of the work. )

 

Financial system mechanics explained for the first time. “The Ripple Starts Here.”

Short summary of the paper The Ripple Starts Here.

Financial system mechanics: Power-point presentation. 

 

 

THE MISSING LINKS BETWEEN GROWTH, SAVING, DEPOSITS AND GDP

 

By Lowell Manning  manning@kapiti.co.nz  VERSION 3  21/10/12

 

Key words:  debt, debt model, deposits, deposit interest, domestic credit, Fisher equation, GDP, growth, inflation, revised Fisher equation, saving, savings, systemic inflation, unearned income.

 

CONTENTS:

 

1.        EXECUTIVE SUMMARY                                                               

2.        BACKGROUND                                                                                                 

3.        THE DEBT MODEL                                                                                         

4.        DEBT AND DEBT GROWTH                                                                        

5.        THE MISSING LINKS                                                                                     

6.        CONCLUSION                                                                                  

 

ACKNOWLEDGEMENTS

 

The author wishes to thank Raf Manji and the Sustento Institute for their ongoing support of this research and Terry Manning  of NGO Bakens Verzet for his perceptive critique and editing of the drafts.

 


This work is Licensed under a Creative Commons 3.0 Attribution – Non-commercial – ShareAlike licence.

 

 

1. EXECUTIVE SUMMARY.

 

This paper brings together the concepts explored in a series of earlier papers for which links are given at the top of Page 3.  It summarises the main elements of two of them,  “The Savings Myth” and “ The DNA of the Debt-Based Economy”.  Those two papers show how the current account and exchange settlement processes work, the principles of production in the debt- based economy and the concept of systemic inflation.

 

Section 3 describes a debt model that can be used to analyse the debt-based economy and concludes with Figure 8. Figure 8 shows  “DNA” helices that relate GDP to accumulated Saving and Growth. The debt model is a form of the well-known Fisher Equation of exchange revised so it can be applied to a debt-based economy.

 

Section 4 uses the concepts in Sections 2 and 3 to explain debt growth in more detail. It shows that when the current account is balanced the overwhelming cause of exponential debt growth is the unearned income derived from the interest banks pay on banking system deposits. Figure 11 shows the process of debt creation based on the banks’ risk based capital, the influences of the central bank and how government debt is generated.

 

Section 5 explains how the differences between the historical orthodox “fractional reserve” explanation of debt expansion and the existing risk-based capital method of debt expansion arose. The orthodox explanation was based on a Savings and Loan model of banking that was discarded decades ago prior to the implementation of the Basel I accord in 1992.

 

The paper shows that interest on the accumulated investment debt (the GDP according to “The DNA of the Debt-Based Economy”) can only be paid out of productivity gains made available from new productive investment.  If the productivity gains are insufficient to fund the interest, the productive sector must inflate to make up the shortfall.

 

There are systemic connections between debt, deposits and GDP.  In New Zealand between 1978 and 2011 the relationship between the monetary aggregate [(M3-repos) – the dynamic production deposits My] / GDP was lineal.  That means there is a systemic link between the exponential growth rates of the monetary aggregate and GDP.

 

The final section of the paper discusses the links between debt, deposits, and unproductive saving, and concludes that the entire modern monetary system is based on inflation.  In a debt-based financial system, household deposits represent the accumulated cost-push systemic inflation in the productive economy plus the accumulated demand-pull inflation of the accumulated current account balance. The net international investment position (NIIP) could be used instead of the accumulated current account balance.

 

Except for real added production, the financial system debt and deposits are determined endogenously through deposit interest and exogenously through the accumulated current account balance [or NIIP].

2. BACKGROUND.

 

This paper explores the links between Growth, Saving, Deposits and GDP discussed in some of the author’s previous papers.

 

The papers are available at www.integrateddevelopment.org

 

General summary of all papers published. (Revised edition).

The DNA of the debt-based economy.

The Savings Myth. (Revised edition)

The interest-bearing debt system and its economic impacts. (Revised edition).

Manifesto of 95 principles of the debt-based economy.

Unified text of the manifesto of the debt-based economy.

How to create stable financial systems in four complementary steps. (Revised edition).

How to introduce an e-money financed virtual minimum wage system in New Zealand. (Revised edition).

How to introduce a guaranteed minimum income in New Zealand. (Revised edition).

Financial system mechanics explained for the first time. “The Ripple Starts Here.” (Original version, not updated. This is now for historical reference only. Other papers incorporate up-dates and revisions. )

Short summary of the paper The Ripple Starts Here. (Original version, not updated. This is now for historical reference only. Other papers incorporate up-dates and revisions.) 

Financial system mechanics: Power-point presentation.  (Original version, not updated. This is now for historical reference only. Other papers incorporating up-dates and revisions.)

 

This paper relates mainly to the papers “The Savings Myth” and “The DNA of the debt-based economy”.

 

THE SAVINGS MYTH.

 

“The Savings Myth” discusses Saving in relation to the System of National Accounts (SNA) used around the world to measure economic activity and growth. The paper concludes there are serious problems with the structure of the national Income and Outlay and Capital Accounts in the SNA and that  “Saving” recorded in the SNA bears little relation to Savings = Investment as set out in classical orthodox economics.  Some of the main features in the paper are:

 

a)        A positive balance of external goods and services swaps domestic consumption goods and services for foreign capital assets. It is therefore a negative domestic growth factor in the exporting country at large and a positive growth factor for that country’s business interests. While it may reflect domestic economic activity it does not reflect domestic growth because the income is not spent where it is earned.

 

b)       A study of the nature of the current account and foreign exchange settlement processes shows there is no such thing as foreign debt. There is only foreign ownership of the domestic economy in debtor countries when there is an accumulated current account deficit there. That ownership can be direct or it can be in the form of commercial paper that represents claims on the domestic economy.

 

Figure 1 reproduces Figure 1 from “The Savings Myth”.  It shows how assets and deposits are exchanged through the foreign exchange interface.

 

FIGURE 1. THE CURRENT ACCOUNT PROCESS. [1]

 

[1] The box “foreign exchange interface” defining the thick black line representing the interface between the debtor economy and the creditor economy has been added for clarity as have minor amendments inside two of the text boxes.

 

Foreign ownership of a debtor nation’s economy drains its domestic economic growth through outgoing current account payments of interest on commercial paper and dividends and profits arising from the physical foreign ownership of its assets.

 

Foreign ownership of a debtor nation’s economy exposes it to high interest rates and the permanent risk of capital flight.

 

c)        The decline in Saving for Investment is structural. The decline arises from persistent business demand for faster depreciation allowances. Part of that demand arises from rapid innovation and planned obsolescence, but part of it is greed.  Higher depreciation provisions usually increases bottom line profits. That means faster repayment of investment principal and therefore a lower surplus for productive investment.  Less productive investment means slower growth. National Saving has been swapped for short-term profit.

 

d)       The structural decline in national Saving cannot be addressed anywhere in the world using existing orthodox economic theory and policy.

 

e)        Non-productive “Savings” schemes around the world (such as Kiwisaver and the so-called “Cullen” Superannuation Fund in New Zealand) distort the productive economy because they withdraw purchasing power from incomes.

 

f)        Figure 2 reproduces Figure 2 from “The Savings Myth”.

 

FIGURE 2.  DYNAMIC DEBT MODEL FUNDING THE PRODUCTION AND  PURCHASE OF NEW CAPITAL GOODS.

 

Figure 2 shows that in a dynamic economy the investment process is internal to the production cycle.  There are sufficient incomes in aggregate to buy the capital goods produced. Some incomes earned in the production of capital goods are “Saved” by employees and businesses and subsequently “Invested” by entrepreneurs who wish to buy them. The internal lending allows the production loans to be repaid.  For simplicity Figure 2 does not separately include loan interest.  Therefore:

 

Saving = Investment  (exactly as is found in most orthodox economics textbooks)

 

The internally self-cancelling production process shown in Figure 2 is mediated by the banking system. At any time, the total outstanding loans used to buy the capital goods produced equals the total outstanding principal still owing on those capital goods (the orange boxes in Figure 2).  Net capital formation, equals “gross capital formation” as shown in the SNA less principal repayments on existing capital goods.[2]

 

THE DNA OF THE DEBT-BASED ECONOMY.

 

The paper “The DNA of the debt-based Economy” extends the discussion set out in “The Savings Myth” and relates the systemic processes taking place in the productive economy to the Fisher Equation provided by Irving Fisher in 1912 [3]

 

[2] The System of National Accounts (SNA) incorrectly uses depreciation instead of principal repayments in its Income and Outlay account because depreciation is not a financial outlay.

[3]  Irving Fisher, “Elementary Principles of Economics”, 1912.  The Fisher equation has been very widely discussed in relation to the economic difficulties arising from the sub-prime mortgage defaults in the US 2007-2009.  Fisher’s work followed on J.S. Mill 1848 and S. Newcombe 1885 and preceded L. von Mises “The Theory of Money and Credit” of 1912.

 

in his well-known equation of exchange that takes the form:

 

MV = PQ                                                                                                                                 (1)

 

Where:

 

M = the amount of money in circulation

V =  the speed of circulation of that money; the number of times M is used over a given period T

P =  the price level of goods and services an economy produces during  time T

Q=   the  total quantity of monetised goods and services an economy produces during time T.

 

The product PQ is what is known today as Gross Domestic Product or GDP. Some of the main features in the paper are:

 

a)        Figure 3 reproduces Figure 1 from “The DNA of the debt-based Economy”.

 

FIGURE 3 THE SIMPLE DYNAMIC FISHER PRODUCTION CYCLE. [4]

 

[4]  “M” in the original Figure 1 is shown as “My” and “Q” in the original Figure 1 is shown as “q” (that is, Q=q x V) so the terms are comparable with those in Figures 4 and 5.

 

The economic activity shown in Figure 4 is still self-cancelling because there is no interest included on the debt. It does not show the internal Saving = Investment function of Figure 2 which focuses on the production and sale of capital goods as distinct from the broader Gross Domestic Product (GDP) that includes both capital goods and consumption goods and services.  Figure 4 describes the self-funding, self-cancelling nature of the economic cycle itself as a whole. The green boxes show the income (production) side, and the blue boxes the consumption side of the productive cycle.

 

Because the market is held weekly there are 52 weekly markets in a year and so on an annual basis the speed of circulation Vy of the money My  in the Fisher equation in that case would be 52.  Figure 2 also assumes that there is no hoarding (“saving”) of money so that all the money supply My is used each week. If that were not so either prices P or output q, (or both) would be smaller.

 

b)       Developed economies are no longer cash-based as shown in Figure 2.  Instead, they have become debt-based.  Figure 4 reproduces Figure 2 from “The DNA of the debt-based Economy”.  Figure 4 shows how debt instead of money is used in the production cycle shown in Figure 2.  It also shows how the basic production cycle relates to the System of National Accounts discussed in “The Savings Myth”.

 

FIGURE 4.  THE BASIC DYNAMIC PRODUCTION CYCLE USING DEBT. [5]

 

c)        Figure 5 reproduces Figure 4 of  “The DNA of the debt-based economy” [6]. 

 

[5] “M” in the original Figure 2 is shown as “My” and “Q” in the original Figure 2 is shown as “q” (that is, Q=q x V) so the terms are comparable with Figures 3 and 5.

[6] Three minor text amendments have been made to make Figure 5 easier to read.

 

Figure 5 shows what happens when interest is introduced into the financial system. 

 

The result is a build up of debt and interest external to the productive cycle.  The productive cycle is then, in aggregate, no longer self-cancelling.  Instead, it produces unearned income in the form of interest on deposits that must be funded by the productive economy.  Unearned income, by definition, produces nothing because it is not backed by productive activity. In Figure 5 If is the average interest rate paid on deposits. Ms in Figure 5 is the accumulated pool of unearned deposit income.

 

FIGURE 5 .THE DYNAMIC PRODUCTION CYCLE WITH DEPOSIT INTEREST AND SYSTEMIC INFLATION SHOWING THE POOL OF RESIDUAL DEBT MS WHERE PRODUCTION Q IS ASSUMED CONSTANT.

 

The price change formula P=P*(1+ If % /(Vy *100)) shown at the bottom right of Figure 5 refers to a single production cycle producing the (constant) economic   output q.

 

d)       Figure 6 of  “The DNA of the debt-based Economy” is reproduced as Figure 6.  Figure 6 shows that, assuming the deposit interest rate If  and output q are more or less constant, physical inflation is half of If %. The figure P* If % /(Vy *100) is the rate of change of Price P. It must be mathematically integrated to give the numerical inflation. This aggregate increase in the annual GDP output caused by the price increases shown in Figure 5 is called systemic inflation.

 

FIGURE 6. SYSTEMIC INFLATION.

 

Subject to several qualifications, systemic inflation is therefore equal to half the average interest rate paid on deposits. [7]

 

[7] The qualifications are that incomes rise with inflation plus productivity growth, that there are no changes in indirect taxes included in the price level P, and that aggregate net contributions to non productive savings schemes are funded by debt from outside the productive economy.

 

At this point, the financial system is made up of:

 

i)         the self-cancelling cycles of production shown in Figure 4 that includes internal Savings = Investment as shown in Figure 2, funded by a dynamic pool of transaction account debt  supporting the productive transaction deposits.

 

ii)        the systemic inflation arising from deposit interest shown in Figure 5 represented by the accumulated unearned income.

 

iii)       the accumulated debt, including government bonds, borrowed to service the current account shown in purple at the bottom left of Figure 1. Deposits corresponding to that debt arise from the sale of debtor country assets together with commercial bank foreign exchange borrowing to satisfy the foreign exchange settlement requirements (top left of Figure 1).

 

iv)      any expansionary “bubble” debt representing debt borrowed outside the productive economy to fund the purchase of existing assets.

 

3. THE DEBT MODEL. [8]

 

At any point in time in the debt system there are five broad blocks of deposits and some circulating currency in the domestic financial system.

 

They are:

 

Mt  The transaction deposits representing the productive debt My - M0y so:

 

My =  Mt + M0y                                                                                                                       (2)

 

M0y is the cash in circulation included in My and used to contribute to productive output.

 

Mca is the accumulated domestic deposits representing the sale of assets to pay for the accumulated current account deficit. It equals Dca defined below less the Net Foreign Currency Assets (NFCA).

 

Ms is the accumulated deposits arising from unearned deposit income on the total domestic banking system deposits M3 (excluding repos). [9]

 

M0 is the total cash in circulation so that  (M0-M0y)  is cash hoarded by the public and not used to generate measured GDP.

 

The total of  Mt + M0y + Mca + Ms, is provisionally assumed to be the monetary aggregate M3 (excluding repos) published by most central banks monthly, less the amount of cash in circulation M0 except for the part M0y that is included in My.  M0y is assumed to have the same speed of circulation as My. In industrialised countries, the contribution of cash transactions to the measured output of goods and services (GDP) has been declining in recent decades and their contribution to the GDP has been provisionally calibrated for the purposes of this paper. [10]

 

The total debt in the domestic financial system is assumed to be the Domestic Credit, DC debt aggregate published by most central banks monthly. [11]

 

[8] The effects of secondary non-bank lending are not included in Section 3 but they are considered later.

[9] Repos refer to inter-institutional lending. 

[10] More accurate assessment of the cash contribution to GDP over time requires further detailed study.

[11] At this point the model does not include secondary non-bank lending thought to be around 10% of DC. This point is considered in Section 4 of this paper.

[12] The accumulated sum of capital transfers could be included here, in which case the net international investment position (NIIP) would be used instead of the accumulated current account. The decision affects the size of the “residual” Db.

 

At any point in time there are four broad blocks of domestic debt in the domestic financial system. Three of them together add up to DC such that:

 

DC   = Dt  + Dca [12]  + Dr                                                                                                                       (3)

 

Where:

 

Dt       is the productive debt supporting the transaction deposits Mt.

 

Dca      is the whole of the debt created in the domestic banking system to satisfy the accumulated current account deficit. [13]

 

Dr           is the residual debt to balance equation (3).  

 

Db,         is the virtual “bubble” debt, the excess credit expansion or contraction in the banking system such that Dr - Db  = the debt Ds supporting the accumulated deposit interest Ms defined above.  Therefore, Dr= Ds+Db.  Db can be positive or negative.

 

By definition in this paper : My x Vy = GDP; and Ms = Ds ; and Dr=Ds+Db, and 

Dt= My-M0y; and the cash contribution to GDP = M0y * Vy.  .

 

By substitution into equation (3):  [DC   = Dt  + Dca [14]  + Dr  ]                                                                                                           

 

[13] This is greater than the monetary deposits Mca because the banking system may have sold commercial paper to borrow foreign currency to satisfy the foreign exchange settlement as shown in Figure 8.

[14] The accumulated sum of capital transfers could be included here, in which case the net international investment position (NIIP) would be used instead of the accumulated current account. The decision affects the size of the “residual” Db.

 

DC  = (GDP)/Vy  - M0y + Ms + Dca +  Db                                                                               (4)

 

Ms =Ds = (DC – Dca ) – GDP/Vy + M0y  - Db                                                                         (5)

 

GDP = Vy *(DC - (Ms +Dca +Db ) + M0y  )                                                                             (6)

 

My  = GDP/Vy  = DC - (Ms  +Dca  + Db) + M0y                                                                           (7)

 

where the terms are as defined above.

 

Equations (4) to (7) are all forms of the economic debt model shown in Figure 7.

 

In equation (5), all the terms except GDP/Vy = My and Db are known or can be estimated with reasonable accuracy. My can be approximated in equations (4) and (5) using trend-lines because it is small compared with Ms and DC. Db is unknown but can be approximated through model calibration. The calculations in equations (6) and (7) involve the subtraction of large numbers to get relatively small numbers, which leaves them sensitive to modelling and data error.

 

If Ms, calculated as “the accumulated deposits arising from unearned deposit income on the total domestic banking system deposits M3 (excluding repos) ” as defined on page 10, agrees more or less with that calculated in equation (5), bearing in mind the value of Mb, the proposition that debt growth is determined by deposit interest will be proven.  The model will require further calibration as further data becomes available.

 

FIGURE 7.  THE SCHEMATIC DEBT MODEL OF A DEBT-BASED ECONOMY.

 

Db will be positive during periods of rapid expansion, particularly as bubbles form, and will become negative during periods of rapid contraction, particularly as bubbles collapse. The classic case of this in New Zealand was where financial contraction continued following the 1987 share market crash long after the asset bubble was gone. [15]

 

[15]   This is discussed at length in the paper “The interest-bearing debt system and its economic impacts” referenced above.

 

The dependence of the gross domestic product (GDP) on the Domestic Credit DC and the interest rate on bank deposits in the modern cash-free economy from which Ms is calculated has profound implications for economics.

 

In the light of the worldwide financial chaos of 2007-2009 the indicative debt model shown in Figure 7 provides a powerful argument in support of public control of a nation’s financial system. In Figure 7, the blue curve (DC+M0y) is drawn to scale (the total was about NZ $310 b. in New Zealand in March 2011) to demonstrate the exponential debt growth that has taken place. The other curves are purely to illustrate the debt model structure, but all of them are also exponential.

 

The present debt-based system shown in Figure 7 leaves the world economy at the mercy of private banking institutions working for private profit by allowing irresponsible increases and contractions (Db in equations (4) to (7)) of the Domestic Credit and its associated bubble formation. The problem is systemic because the existing financial system requires exponential growth. In the case of New Zealand and similar debtor countries, the expansion of foreign ownership caused by the accumulated current account deficit Dca largely defines the deposit interest rate and systemic inflation.

 

It probably isn’t possible to have a simpler model of the economy than equation (7):

 

My =Nominal GDP/Vy = domestic credit DC less (accumulated unearned deposit income Ms + the accumulated current account deficit Dca + the cash contribution to GDP, M0y plus a correction for bubble activity Db (+/-))

 

Domestic Credit DC, Unearned Income Ms and nominal GDP must all grow exponentially because they are all a function of the deposit interest rate. The exponentials of the curves in equations (4) to (7) will be different with respect to each other because of large variations in the deposit rate over time. In New Zealand, Domestic Credit has grown exponentially by an average of about 9% per year since 1993 while nominal GDP has increased by about 5.25% annually.

 

The difference between the two curves is mainly the result of domestic debt needed to fund the accumulated current account deficit that, in New Zealand, is more than 80% of GDP.

 

It does not appear to be theoretically possible to maintain exponential debt expansion faster than the GDP expansion over an extended period because the added debt servicing costs will always leave the productive sector insolvent.

 

To avoid national bankruptcy, each nation must maintain, in aggregate, a zero accumulated current account deficit.

 

The financial system is dynamic.  The debt used to purchase capital goods is continually repaid from economic growth. In aggregate, as long as new investments exceed repayments, both the debt and deposits expand together. The paper “The DNA of the debt-based Economy” shows that the total outstanding Saving and the total outstanding debt at any time are equal to the aggregate sum of economic growth and that this must also equal the GDP as shown as Figure 8.  Box 1 describes Figure 8. Figure 8 depends upon, and satisfies the basic principle of orthodox economics that the long run financial profit of business is zero.

 

 

BOX 1.  FIGURE 8 - THE DNA OF THE DEBT-BASED ECONOMY.

 

The following three-dimensional diagram (Figure 8) represents the DNA of the debt-based economy. It is tilted forward from the top to make its features easily understandable.

 

The diagram is made up of two mirrored helical strands of financial DNA. The blue strand represents the total accumulated GDP output for a given period while the red strand represents the total outstanding productive investment principal. The vertical axis of the helices represents time. The diagram shows a random period of four years.

 

On the blue helix, Vy bases of production output My are added over the time span needed to make one full turn of the blue helix (usually a year). On the red helix, Vy bases of national saving Sy (net new productive investment) are added over the time span needed to make one full turn of the red helix (usually a year). For ease of consultation, the bases are shown only for year three. The drawing shows nineteen of them, as this is the approximate speed of circulation Vy of productive deposits My in New Zealand.

 

The helices replicate by extension. The blue helix showing GDP “dies off” at the end of each period. The helices grow exponentially by the transfer of net Saving Sy from the blue helix to the red one over each notional production cycle.

 

For each of the bases the national saving Sy is returned to the next production cycle on the blue helix in the form of net new capital investment Sy (Saving = Investment) as shown. Individual bases can vary in size (up or down) reflecting the state of the economy.

 

The annual length or growth ring Lz of the blue helix shows the GDP as it accumulates during that year. The nominal, usually annual, GDP growth in the blue DNA is the change in length Lz of the DNA spiral over the period z compared with the corresponding length L z-1 over the previous period. In the diagram, the length (and therefore the diameter) of the GDP spiral is shown to be increasing exponentially from year to year.

 

The annual increase in the length of the growth ring Lz of the red helix shows the annual increase in outstanding investment principal S which also equals the nominal GDP growth for that year. The total length of the red helix at any time is the sum of all outstanding investment principal.  It equals the current (annual) GDP at any time.

 

At the end of each (annual) period z (and only then) the value of output represented by length Lz of the blue helix (the GDP for that year) equals the value represented by the whole of the red helix (its total length representing the sum of all outstanding investment principal).

 

The plan diameter of the helices typically expands exponentially. The helices vary together with the state of the economy. In the case of recessions they show up as changes in the annual rate of increase of the helix diameters, and therefore the length of the spiral loops. In the case of depressions they would show up as an actual annual decrease in the helix diameters.

 

 

FIGURE 8. THE DNA OF THE DEBT-BASED ECONOMY.

 

n

 

n+2

 

n+3

 

n+4

 

EACH (BLUE) BASE=My =GDP/Vy

 
4. DEBT AND DEBT GROWTH.

 

The following sections of this paper explore the relationships between the debt model variables and the DNA of the debt-based economy shown in Figure 8. At first sight, Figure 8 suggests a Saving and Loan model of financial organisation.  It shows that collectively, those with incomes derived from the production of capital goods (savers), must invest those incomes by buying the capital goods they have produced.  If they do not do so the market cannot be cleared of those capital goods unless their purchase price is borrowed from the banking system. If the purchase price to buy the capital goods is borrowed from the banking system, there are surplus “hoarded” deposits held by the savers. Those deposits would then remain in the bank with nowhere to go other than for non-productive investment in existing assets.

 

Figure 9 shows a Savings and Loan model described above. [16] In Figure 9, the Saving deposits become physically unavailable to the savers for a time.  The investor uses them to pay the producers of the capital goods. The producer uses them to cancel the production debt created to produce the capital goods.  At the start, the investor has a debt to the Savers and an asset represented not by a deposit but by the asset itself.  At the end the investor has no debt and the savers regain their deposit (with interest).

 

[16] This is an idealised diagram that assumes producers and entrepreneurs are different groups. This is discussed further at Section 5.3.

 

FIGURE 9. BANK INTERMEDIATION IN SAVINGS AND LOAN MODEL.

 

In Figure 9 there is no net bank debt created. The savings repaid by investors to Savers are available to trade in existing assets. The amount available is the original purchase price of the assets less the outstanding loans. When an existing capital asset is on-sold, the purchaser typically borrows the (re) purchase price from the banking system.  The original asset owner (investor) repays his outstanding debt to the Savers, and, depending on the sale price and outstanding principal may make a capital gain.

 

Figure 10 shows what happens when investment is funded by commercial bank debt rather than rather than internally from Savers.

 

FIGURE 10.      FUNDING OF INVESTMENT USING NEW BANK DEBT.[17]

 

[17] Figure 10 is an idealised diagram that assumes producers and entrepreneurs are different groups. This is discussed further at Section 5.3

 

The main difference between Figures 9 and 10 relates to the existence of bank debt.  In the Savings and Loan model (Figure 9) there is no net bank debt involved because the bank has on-loaned the savings deposits. Savers (at least nominally) do not have access to the their deposits. Only net repaid investment loans would be available to pay for the exchange of existing assets. When savings S = Investment I, there are no net repayments. The bank-funded model (Figure 10), on the other hand, involves bank debt and Savers have full access to their bank deposits. The dynamic balance in Figure 10 only also holds when the total outstanding investment equals total saving.

 

Savings S in Figure 10 must be invested in some other kind of investment because there is nothing new to buy with them. That applies even if it means just leaving them on deposit at the bank. In the paper “The Savings Myth” savings of this kind are referred to as a myth. The investment is backed by debt rather than savings and so does not qualify as investment as required by the principles of orthodox economics.

 

The difference between the Savings and Loan operation where the Savers’ deposits are used to retire the production debt, and the bank intermediation outlined in Figure 10, is profound.  In the former case, shown in Figure 9, Savers hold an IOU (rather like a corporate bond) from the entrepreneurs and new homeowners while the entrepreneurs and new homeowners have their capital asset on the one hand, and the debt to the savers as a liability on the other hand.  There are no corresponding deposits in the system because they have been used to repay the residual part of the production debt Dt.

 

In Figure 9, savers lend to entrepreneurs and homeowners while in Figure 10 the bank lends to entrepreneurs and homeowners. In Figure 9, the Savings are used to retire the producer debt whereas in Figure 10 the deposits arising from the new bank loans are used to retire the producer debt.  So Figure10 introduces a new layer of debt and deposits into the system that were not there before.

 

In the existing debt-based economy almost all money is created as interest-bearing debt and almost every deposit arises from a bank loan.  Borrowers typically sign a loan agreement before their bank gives them credit by putting money into their bank account.  The bank creates the money out of nothing.  The loan is an asset of the bank because the borrower agrees to repay it over time. The deposit is a liability of the bank because the bank allows the borrower to use the money it has created in return for the interest he or she pays on the loan.  The process is shown in Figure 11.  For completeness Figure 11 also shows the role of the central bank in creating bank liquidity, quantitative easing and bailout funding and the banks’ lending to the government to fund government debt. 

 

Contrary to what happens under the savings and loan model (Figure 9), banks never lend their customers deposits in the debt model shown in Figure 11 because doing so would deprive the borrower of the right to use of the money they have borrowed. In accounting terms banks cannot lend their liabilities.  This is different to the Savings and Loan model (Figure 9) where savers do not automatically have access to their deposits until their term deposit matures. [18]

 

[18] This is the basis, for example, of the Investment Pool in the Bank of England (Creation of Currency) Bill being promoted by Positive Money UK. www.PositiveMoney.org . However, unlike the proposed Bank of England (Creation of Currency) Bill as it was worded at the end of 2011, traditional Savings and Loan banks were limited to lending out a maximum proportion of their deposits.

 

From the relationships shown on page 11 the following derivation can be developed

 

DC   = Dt  + Dca  + Ds + Db                                                                                                                                       (8)

 

Of the total, Dt alone relates to the dynamic transaction account debt used to fund the productive economy. The rest makes up the so-called (non-productive) “investment sector” that trades in existing capital goods and financial assets.  The non-productive investment sector can be called Di such that:

                          

Di   = Dca  + Ds + Db                                                                                                                                                       (9)

 

Equation (8) is a modified form of the well-known Fisher Equation of Exchange (M*V=P*Q) described in Section 2 that takes account of the debt-based economy.

 

Domestic Credit DC is directly linked to deposits M3 by the expression: 

 

DC= M3 – NFCA - R (Residual) [19]                                                                                    (10)

 

[19]  Many central banks regularly publish financial aggregates that clearly demonstrate this relationship. Residual includes the banks’ net worth and several smaller items. NFCA is Net Foreign Currency Assets.  As previously noted at footnote 11 the debt model does not at this point provide separately for secondary non-bank debt, nor does it allow for a substantial proportion of cash transactions.

 

Which can be rewritten as

 

M3- (NFCA + R) [20] = DC .   If the monetary deposit base of the economy is taken as (M3-repos) rather than M3 to remove the effect of inter-institutional lending, and since in the productive sector My=Py*Qy/Vy, and in the investment sector Mi=Pi*Qi/Vi, equation (8) can be rewritten as the Fisher equation where

 

(M3-repos)=Py*Qy/Vy+ Pi*Qi/Vi =(Dt +M0y)+ Di+ (NFCA+R) – repos                                (11)    

 

Where:

 

Di  is as in equation 9, Pi is the price level in the investment sector, Qi is the quantity of investment assets (or alternatively the quantity of investment assets exchanged) over any given period and Vi is the speed of circulation of Di. Vi will depend on which version of Qi is used.

 

[20]  Except where the entire banking system is insolvent (that is, has negative net worth), R is a negative number.  NFCA is also likely to be negative in debtor countries (like New Zealand)

 

Debt growth in the investment sector is exponential because, as shown in the debt model (described at section 3 of this paper) any interest rate creates an exponential curve when the interest is continually added to the existing debt.  Debt growth in the productive sector must also be exponential because the productive sector has to fund the investment sector debt Di. The growth rate of the total debt DC will change over time according to the interest rate and physical changes in the debt base like those arising from the balance of trade, population growth and productivity.

 

FIGURE 11 DEBT CREATION LIQUIDITY BONDS AND BAILOUTS.

 

The prices of existing capital assets tend to rise whenever the pool of investment sector debt Di increases faster than the net value of new capital assets being added to the investment pool. Asset prices can also be affected when savers (non-productive investors) "sit on the sidelines" by leaving their deposits "in the bank".  In that case, the speed of circulation Vi falls, which means either asset prices will fall or there will be less trading so that Qi falls, or both.  

 

The increase in domestic debt DC is net of debt repayment, so when some non-bank investors deleverage, or "take losses" to repay their debt, Di will be lower than it otherwise would have been and asset prices will tend to remain static or sometimes fall. In New Zealand and elsewhere this effect is accentuated when private banks become less willing to lend to their customers or to each other. While in developed countries most economic activity is based on debt as described above, it is easy to introduce non-bank debt and cash transactions into the model. Non-bank debt has not been separately introduced into the debt model so far because establishing an accurate figure for it requires further research and it is small compared to DC.[21]  Non-bank debt does not directly increase system deposits because it arises from on-lending existing deposits, but it does increase the system debt and therefore the pool of unearned income, which will quickly affect asset prices.

 

[21] For example, under the proposed Bank of England (Creation of Currency) Bill the repeated on-lending of Customer Investment Accounts would create a very large pool of bank debt outside of the Domestic Credit or monetary deposit figures.

 

Call Dnb the pool of all non-bank created debt and call Msnb the accumulated interest paid to depositors arising from Dnb. Since   Dnb does not directly add to deposits (contrary to Ds which is assumed to mirror Ms, and Mb which is assumed to mirror Db in the debt model), then:

 

DC + Dnb =(Dt + Ds + Dca+ Db) + Dnb                                                                             (12)

 

M3(-repos)  = Mt + M0y + Mca + (Ms   + Msnb )                                                            (13)

 

That means that if interest rates remain comparable, (M3-repos) and DC both have an extra exponential added to them to supply the extra deposits Msnb. Remembering that from page 10, Mca=Dca+ NFCA, and (Mt+M0y)=My

 

then

 

 DC = (Mt+ M0y) + [Dca + NFCA] + (Ms  + Msnb) + repos - (NFCA +R )

 

        = My + Dca + (Ms  + Msnb) + (repos -R )                                                                   (14 )

 

If the current account is balanced, the overwhelming driver of exponential debt growth is the interest paid on deposits.

 

If secondary lending in the form of non-bank debt Dnb  were to become an important factor as it would, for instance, if the proposed Bank of England (Creation of Currency) Bill were implemented, the exponential growth would increase quickly unless secondary lending Dnb were carefully managed and/or the deposit interest rate reduced.

 

From equation (11) DC= Pt*Qt/Vt + Pi*Qi/Vi  -  [(NFCA+R) – repos], when DC increases sharply the investment sector Pi*Qi/Vi will also usually increase.   Since there is, in normal times, little reason for Qi to increase sharply or for Vi to decrease sharply, investment prices will usually tend to rise faster than the productive economy whenever DC increases faster than nominal GDP growth. [22]

 

[22] Qi and Vi can move in tandem, as, for example, when there is a slump in house sales due to recession or changes in bank lending criteria, especially when an exchange form of Qi/Vi is used.

 

5. THE MISSING LINKS.

 

5.1 CAPITAL BASED AND DEPOSIT BASED DEBT GENERATION.

 

The confusion over how debt is created is astounding. The box on the left of Figure 11 clearly shows how debt is created in the present debt-based system. In the capital based system a bank can and does typically create debt on demand as long as it meets its capital and liquidity requirements and provided the bank is prudent and has creditworthy customers.

In the present debt-based system deposits follow debt creation.

 

The “competing” deposit story of debt creation arises from the Savings and Loan model shown in Figures 8 and 9 that follows from the orthodox economic theory shown in Figure 2.  That theory states that savings, productive investment and debt growth are three sides of the same triangle. Savings = Productive Investment, and the cumulative investment is the cumulative debt owed by homeowners and entrepreneurs to income earners generally.

 

In the Savings and Loan model, debt follows deposits instead. The deposits are expended to repay the production loans. Savers give up their deposits in return for an IOU (debt) from entrepreneurs and new homeowners.

 

The orthodox model applies only in a Savings and Loan system where the actual Saving is on-loaned to the buyers of capital goods.  In that case, savers do not have immediate access to their deposits.

 

The debt system is not operated on a Savings and Loan basis.  Instead, Savers, as shown in Figure 10, in aggregate, typically (though not necessarily always) leave their deposits in the bank or make non-productive investments, investors (entrepreneurs and homeowners) borrow separately from the bank. That borrowing creates a layer of bank debt and bank deposits that previously did not exist. As described in the debt model (Section 3 of this paper),  interest on those deposits is the cause of systemic inflation.

 

5.2 INTEREST AND EXPONENTIAL DEBT.

 

Nominally, the only deposits in a Savings and Loan system are the dynamic deposits My in the productive sector. That changes in the debt-based system shown in Figure 10. Since domestic housing is not usually productive once it has been built, both the repayments and the interest relating to domestic housing must be funded from productivity growth if the economy is to remain stable.  The productive economy must therefore fund interest and repayments for both the productive sector and the unproductive (housing) sector. 

 

Any interest on the accumulated productive investment debt (GDP in “The DNA of the Debt-Based Economy”) must be paid out of productivity gains and the corresponding higher incomes made available through the new productive investment. Otherwise according to the debt model (equation (11)) prices in the productive sector must inflate .

 

The economy will become unbalanced very quickly if the interest and repayments on new housing investment exceed what the productive economy can support. If the productive sector inflates, My in the debt model (Section 3 of this paper) will expand exponentially even though it is small.  That is exactly what happened when money was used instead of debt in centuries past and the coinage was often debased by reducing the amount of gold and silver in the coins. This was done to pay for non-productive expenses, such as unsuccessfully waging war where the “booty” failed to cover the war costs.

 

Exchange of existing capital assets in a Savings and Loan system occurs by selling the asset for its market value. Any remaining debt on the asset is repaid, and the new owner re-borrows the new purchase price.  The system remains balanced as long as the market value equals the original purchase price less the principal repayments already made, its “residual” purchase cost. If there has been inflation, or if, for some reason, the new owner pays more for the capital asset than its “residual” purchase cost, there is nowhere to obtain the extra funding within the savings and loan system. In that case the additional part of the purchase price must be paid for from new bank borrowing.

 

Banks lend money to make money. The net profit they make on their bank spread (the difference between the interest rate they charge borrowers and the interest rate they pay on their deposits) is legitimate income, just like profit in any other business. The difficulty with the banking system is that more lending typically means more profit. It is, therefore, in the banks’ interest to lend as much as they can. 

 

There are four main ways to increase bank lending.

 

The first way is by minimising the contribution of cash transactions counted in the GDP.  In many developed economies the cash contribution to the economy is approaching zero.  While there are still a lot of cash transactions, they add very little to GDP.[23]  Cash in circulation also “uses up” bank capital, because the bank swaps vault cash (capital) for a customer deposit. The customer deposit costs the bank far less capital because, unlike cash, the bank can use it authorised capital leverage when it creates the loan that gives rise to the deposit.

 

[23] For example, cash is still widely used in retailing in many developed countries, but the average net profit on those transactions is small and retailing as a whole makes up only a relatively small part of GDP  (say, 10%).  Say, roughly 20% cash transactions x 10% GDP = about 2% contribution to GDP.

 

The second way to increase bank lending is to raise capital by retaining profits or by issuing new shares. If the authorised bank leverage were 8%, the banks would be able to lend about 12 times their capital.  More capital means more lending.

 

The third way to increase bank lending is to lend to governments, because sovereign debt is typically, though by no means always, deemed to be risk free.  Therefore there are usually few limits on the amounts governments can borrow as long as the nation’s tax base is deemed large enough to support the interest payments on the public debt.

 

The fourth and possibly most important way to increase bank lending is to pay interest to depositors.  Section 2 of this paper shows how deposit interest causes systemic inflation. Equation (14) on page 21 shows that, apart from persistent accumulated current account deficits,  the increase in the accumulated deposit interest (Ms + Msnb) over time is by far the biggest contributor to exponential debt growth. In equation (14) when (Ms + Msnb) increases, debt measured as domestic credit (DC) increases by the same amount.

 

The work referred to at the start of Section 2 of this paper is thought to be the first in the world to demonstrate the systemic links among deposit interest, inflation and exponential debt growth.

 

5.3 THE LINKS BETWEEN DEBT, DEPOSITS AND GDP.

 

The debt model and “The DNA of the Debt-Based Economy” shown in Figure 8, and Figure 9 hints that the system deposits should, in some way, be related to My + GDP. 

 

From equation (13) on page 21,  M3(-repos)  = Mt + M0y + Mca + (Ms  + Msnb ) 

 

Since Mt + M0y = My, GDP should be directly related to Mca + (Ms + Msnb ) in the above hypothesis. The debt model described in Section 3 of this paper proposes that the quantity of debt determines economic outcomes in accordance with a modified version of the Fisher equation of exchange. 

 

The postulated direct link between the money supply and GDP is the last missing element in the debt model that already directly links deposit interest, inflation and exponential debt growth, as noted above.  Linking the money supply directly to GDP will provide further powerful support for the quantity theory of money and debt proposed by the debt model.

 

In New Zealand, as of March 2011,  M3(-repos) was NZ$ 227.6 billion, GDP (expenditure side) was NZ$ 197.4 billion and  My is estimated to have been  NZ$197.4/18.7 = NZ$10.6 billion. [(M3-repos)-My] was NZ$217.0 billion.

 

Figure 12 gives the figures for New Zealand from March 1978 to March 2011.  While the two curves have much the same shape,  ([M3-repos]-My) was NZ$30 billion (40% of GDP) below the GDP in 1990 and NZ$20 billion (10% of GDP) above GDP by 2011.  Nevertheless, the relationship is systemic, as shown in Figure 13, which shows the monetary aggregate [(M3-repos)-My] as a percentage of GDP.

 

The purpose of this paper is to indicate the links between the theory proposed in “The DNA of the Debt-Based Economy” and the monetary aggregates. There is no reason to suppose deposit aggregates “should have” followed GDP on a one to one basis in practice. The “wobbles” about the trend line can easily be related to the boom and bust periods and the creation and “popping” of bubbles (Db in equations (8) and (9)).

 

FIGURE 12.  NEW ZEALND 1990-2011  GDP v MONETARY AGGREGATE.

 

FIGURE 13. MONETARY AGGREGATE AS PERCENTAGE OF GDP.

 

There are five main reasons why there is not a direct one to one relationship between the monetary aggregate and GDP in Figure 12. Each of those reasons is systemic and can be quantified with further research.

 

The first reason is that a lot of funding of the purchase of capital goods used to be done using the Savings and Loan model shown in Figure 9. Savings and Loan funding for new capital assets does not generate bank deposits.  In New Zealand, that applied especially to home loans that were predominantly funded through the Government State Advances Corporation and the Post Office Savings Bank, through solicitors’ trust funds and through lodges and similar private savings groups. In New Zealand in 1960, 90% of bank lending was business lending for investment and transaction accounts.  By 2010, fifty years later, the vast bulk of private bank lending was unproductive lending to households, especially on property, rather than lending to businesses. Similar proportions apply in other developed countries.

 

The second reason is that businesses used to retain profits and reinvest them directly in new capacity.  In the idealised funding models shown in Figures 9 and 10, it was assumed that all the Savings were saved as deposits and on-loaned to entrepreneurs and homeowners. However, that has never been wholly so. When producers collectively contribute their own profits to the purchase of some of the capital goods they themselves produce, those profits (Saving) are converted to equity. There is then less borrowing needed from other income earners or from banks. Increased corporatisation and globalisation in ever more deregulated capital markets have all but eliminated the retention of profits for reinvestment. [24]

 

[24] US corporations have reportedly built up reserves of more than US$1.5 Trillion since 2008.  The money is presumably not being reinvested in new production because domestic incomes are not rising fast enough to consume the additional production that could be created.

 

The third reason the GDP to deposit ratio has changed is increased social mobility. More people move more often which creates more sales of existing capital assets, especially homes.  As discussed at page 24, this can create demand for new bank lending where the amount paid for the asset exceeds the outstanding debt on the asset.   This applies even though the buyer may have some equity or “savings” either from the sale of a previous home or from some other source.

 

The fourth reason is that in New Zealand the accumulated deposit Mca from the sale of domestic assets to foreigners has been growing rapidly in recent years relative to GDP. That has happened despite banks finding it cheaper to borrow foreign currency to settle their exchange settlement requirements than pay interest on domestic deposits arising from the sale of domestic assets to foreigners. Mca is a key contributor to Ms because of the deposit interest banks pay on the Mca deposits.  Mca is not physically a part of GDP though the interest on it must be funded by the productive economy or by bubble debt Db.  That feedback loop between Mca and Ms means that the financial aggregate curve for a debtor country will have a different (and higher) exponential than the GDP curve.

 

The fifth reason is that personal incomes have not been rising fast enough to enable most people, especially homeowners, to meet their capital debt-servicing commitments.  The problem arises from growing income distribution inequality around the world. [25] As that inequality increases, home ownership typically becomes less affordable.  In New Zealand, the price of the medium family home as a proportion of median income has more than doubled over the past 50 years. The same is true elsewhere. Many people cannot fund their home from increased productivity and increased income.  They can only fund heir home from lower consumption, which slows down the productive economy, by multiple refinancing of their homes, thereby “using up” equity as happened on a grand scale in the United States prior to the collapse of the housing bubble there, or by taking on other forms of (expensive) consumer debt which further aggravates their debt problems.

 

[25] This is discussed in the paper “How to create stable financial systems in four complementary steps.” for which a link is provided at the start of Section 2 of this paper.

 

Amounts attributable to each of the four factors mentioned can be quantified. Further research will show that, subject to those factors, there is a direct and specific relationship between banking system deposits and GDP.

 

Figures 12 and 13, the debt model, “The Savings Myth”, and the “DNA of the Debt-Based Economy” demonstrate how very poor public understanding of the financial system mechanics has produced so much economic instability around the world. The role of the banks in that overall process deserves wide public debate. The single most relevant observation from this paper is that the financial system is fundamentally flawed and requires major systemic review.

 

5.4  THE RELATIONSHIP BETWEEN DEBT, DEPOSITS AND UNPRODUCTIVE ‘SAVING”.

 

Conceptually, no deposits arise from productive Investment (see Figure 9).  Saving = Investment both in orthodox economics and in “The DNA of the Debt-Based Economy” create debt but no deposits.  According to the debt model described in Section 3, the fewer deposits there are the less inflation there will be.

 

As discussed in Section 5.3, the real world is, however, different in that the deposit base has become more like Figure 10 with some add-ons such as the ones derived from the third and fourth reasons on page 27 and the fifth reason referred to above.  The more bank debt is used the larger Ms in the debt model will become, increasing the non-productive investment “savings” pool.

 

In practical terms all price is inflation. That must be so because inflation is measured by prices rises. Those price rises are accumulated over time, so, in the limit, all price is inflation.  “Cost-push” price inflation is caused by the payment of unearned income in the form of interest to deposit holders. [26]  The unearned income is funded by systemic inflation in the productive economy.  Inflation in the productive economy increases the prices of new capital assets as well as consumer goods and services.  Therefore numerically, the GDP is also almost entirely made up of inflation and that in turn means that the price of new capital goods is almost entirely made up of inflation. If the price of new capital goods is almost entirely inflation, then the debt used to buy them also reflects that inflation.

 

[26] The other kind of inflation, demand-pull inflation occurs when more money is injected into t he economy in the absence of a corresponding increase in production.

 

The entire modern monetary system is founded on inflation.

 

Section 5.3 showed there are specific quantifiable links between GDP and deposits. In equation (13) [M3(-repos) = Mt+ M0y + Mca + (Ms   + Msnb )], the amount (Mt + M0y) is the dynamic production deposits My while the  sum  (Ms  + Msnb ) is the systemic “cost-push” inflation from the productive sector. Mca , on the other hand, mostly represents “demand-pull” inflation in the non-productive investment sector caused by the sale of domestic assets to foreigners to settle the foreign exchange mechanism in those countries with accumulated current account deficits as shown in Figure 1.

 

None of the deposits arises from choice. They arise from necessity in that they are a consequence of the current financial system mechanics. The deposits exist.  Their owners “invest” them in non-productive investments. Everything that doesn’t belong to the productive sector My is by definition non-productive. In New Zealand, about half of all deposits remain in customer bank accounts.  The other half is recycled into managed funds, pension funds and various savings schemes, equities and the like where they finish up included in institutional deposit balances.

 

Most countries’ central banks provide a breakdown of who holds the deposits.  The data for New Zealand is shown in Figure 14.  The total of NZ$ 213 billion for December 2010 closely matches the NZ$ 216.8 billion estimated at the top of page 24 for March 2011.

 

FIGURE 14.  HOUSEHOLD FINANCIAL ASSETS IN NEW ZEALAND.[27]

 

[27] The table is part of Table HA&L (Household Assets and Liabilities) published by he Reserve Bank of New Zealand.

 

The household deposits represent the accumulated cost-push systemic inflation plus the accumulated current account-based demand-pull inflation of the debt system.

 

In the case of New Zealand, some of the household financial assets represent forced “saving”. As discussed in “The Savings Myth” compulsory saving (such as the Kiwisaver program and the National Superannuation Fund in New Zealand) pulls incomes out of the productive economy.

 

In the first instance, the effect of compulsory saving is to transfer earned incomes to the non-productive investment pool, Mi , [Mi = Mca + (Ms   + Msnb ) from equation (13)].  If consumption remains the same, the “savings” withdrawals leave less income for debt servicing and to pay for capital goods forcing an increase in bank borrowing or a decrease in new capital investment, or both, as discussed at length in “The Savings Myth”. 

 

More generally, except for added real production, financial system debt and deposits have just two sources.  The first source is the debt and deposits created endogenously through deposit interest on the productive transaction accounts in the productive sector (Figure 5). The second source is the debt and deposits created exogenously through the accumulated current account deficit debt Dca and the deposit interest on that part of it (Mca) returned to the debtor country following the sale of domestic assets to foreigners (Figure 1).

 

Unproductive “saving” is determined by the system mechanics. Government decisions requiring forced saving are like squeezing a balloon.  The contents remain the same until the balloon breaks.  Otherwise, an expansion in one place means a contraction somewhere else.  Economic growth means blowing more air into the balloon instead of squeezing the air it already holds.  The extra air is generated from increased economic activity. That means jobs, incomes and productive investment.  

 

Macroeconomic numbers partner economic activity, they don’t lead it.

 

6.        CONCLUSION

 

This paper closes the theoretical loop established in the series of earlier papers for which links are provided at the top of page 3. The primary determinants of macroeconomic outcomes are:

 

*         The interest paid on bank deposits.

*         The accumulated current account balance. [28]

*         The allocation of productive resources.

*         Private debt creation for profit.

 

[28] The net international investment position could also be used.

 

The interest paid on deposits is the cause of systemic cost-push inflation. Deposits returned to a debtor country through asset sales to foreigners arising from an accumulated current account deficit are a cause of demand-pull asset inflation.

 

Increased productivity necessary for per capita economic growth requires new productive investment.  Overemphasis on new non-productive capital investment such as housing distorts the productive sector because homeowners can only service their debt through higher incomes and higher productivity.

 

The confusion surrounding the orthodox “deposit” based debt expansion of bank “reserves” and the existing “capital” based debt expansion is historical.  The banking system changed from being “reserve” based to being “capital based” when the Basel I accord became operative in 1992.  In practice the “reserve” system was also capital based except that the capital requirement was limited to a fraction of the banks’ transaction account deposits.  Government debt did not directly cause “fractional reserve” debt expansion, but it did then, as now, introduce new deposits into the banking system thereby expanding the banks’ balance sheets.

 

The dominant features of the debt-based interest-bearing financial system are interest paid on deposits and the accumulated current account balance (or net international investment position, NIIP).  Interest on deposits creates systemic cost-push inflation in the productive sector, while an accumulated current account deficit  (or NIIP) creates demand-pull inflation in the non-productive investment sector caused by  deposits arising from the sale of debtor country domestic assets to foreigners. Those accumulated current account deposits also create a deposit interest feed back loop that adds to systemic inflation.

 

The paper shows the entire modern monetary system is founded on inflation, and that there is a systemic relationship between GDP and the monetary aggregate (M3-repos). The rate of change of the exponential growth curves [(M3-repos) – the dynamic production deposits My]/GDP has been linear in New Zealand for more than 30 years. The variables involved in that relationship are quantifiable.

 

This paper is based on a debt model of the debt-based economy that shows that world debt cannot be managed without removing unearned income from the system caused by the payment of interest on bank deposits and by balancing each nation’s current account.


THE REFERENCED PAPERS.

 

The referenced papers :

 

NEW Capital is debt.

 

NEW Comments on the IMF (Benes and Kumhof) paper “The Chicago Plan Revisited”.

 

DNA of the debt-based economy.

General summary of all papers published.(Revised edition).

How to create stable financial systems in four complementary steps. (Revised edition).

How to introduce an e-money financed virtual minimum wage system in New Zealand. (Revised edition) .

How to introduce a guaranteed minimum income in New Zealand. (Revised edition).

Interest-bearing debt system and its economic impacts. (Revised edition).

Manifesto of 95 principles of the debt-based economy.

The Manning plan for permanent debt reduction in the national economy.

Missing links between growth, saving, deposits and GDP.

Savings Myth. (Revised edition).

Unified text of the manifesto of the debt-based economy.

Using a foreign transactions surcharge (FTS) to manage the exchange rate.

 

 

(The following items have not been revised. They show the historic development of the work. )

 

Financial system mechanics explained for the first time. “The Ripple Starts Here.”

Short summary of the paper The Ripple Starts Here.

Financial system mechanics: Power-point presentation. 

 


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"Money is not the key that opens the gates of the market but the bolt that bars them."

Gesell, Silvio, The Natural Economic Order, revised English edition, Peter Owen, London 1958, page 228.


 

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