JCT: These are the Ed Flaherty
Debt Virus posts I will be working
from at my presentation defending my LETS Banking Systems Engineering
Analysis on Wednesday Nov 12 1997 at 6pm. in classroom #3208 in the
Russell Sage Bldg at Rensselaer Polytechnical Institute in Troy, New
From: firstname.lastname@example.org (Edward Flaherty)
Subject: Antidote to the "Debt Virus"
Date: Tue Oct 14 15:58:26 1997
The Antidote to the Debt Virus
by Edward Flaherty
A financial crisis looms over the United States economy, and
indeed the global economy, the likes of which history has never
seen. The source will not be incompetent bureaucrats or chronic
government budget deficits. It won't be Wall Street and it's
probably not even an international conspiracy. The cause will be
your neighborhood bank. According to Dr. Jacques Jaikaran, a
plastic surgeon and author of _Debt Virus: A Compelling Solution to
the World's Debt Problems_, something as fundamental as the very
nature of the monetary system will deliver the calamity.
The central thesis of Debt Virus is that there exists in the
economy an insufficient quantity of money to repay both the
principal and the interest on all the currently outstanding debt.
To illustrate his point Jaikaran conjures an imaginary world he
calls Planet Doom. A place very much like Earth, Planet Doom has
a small population, six to be exact. There is a doctor, a
carpenter, a fisher, a farmer, a shepherd, and of course a banker.
Initially, no money of any sort exists here until one day they all
decide to allow the banker to create money in the form of checking
The banker's first customer is the farmer. He acquires this
money by negotiating a loan of $1,000 at an annual interest rate of
10 percent to be repaid in one year. Upon granting this loan, the
banker creates checkbook money with a stroke of his pen on his
ledger. The money supply on Planet Doom suddenly increases $1,000.
The problem, Jaikaran notes, is that when the principal and
interest are due for repayment, there is not enough money in the
economy for this purpose. The farmer will owe $1,100 but only
$1,000 will exist within the whole economy. Thus, no matter how
earnest or frugal the farmer might be, there is simply no way he
can satisfy the terms of the loan. It is, as Jaikaran wrote, a
mathematical certainty the farmer cannot repay both the principal
and the interest. Planet Doom's only hope is for the banker to
make yet another loan to the farmer, a loan sufficient to pay the
interest on the original. But it is obvious this only delays the
inevitable. The planet is, well, doomed.
By expanding this simple example to the real world, Jaikaran
argues, it becomes easy to see the impossibility of repaying all
the debt in the U.S. economy. The problem is as with Planet Doom:
when banks lend money, only the principal is created and never the
interest. Thus, the money supply can never be sufficient for total
debt retirement. He warns this condition is a financial time bomb
which will eventually cause an economic crisis severe enough to
dwarf the Great Depression. At first he pinpoints his prediction
for this event to 2012, but then later contradicts himself by the
more general guess of sometime between 1995 and 2005.
Fortunately for us, Jaikaran's model contains two gaping holes
which collapse his entire thesis. Let's return to Planet Doom.
After the farmer acquires the money from his initial loan, he will
most likely spend it when buying the goods and services produced by
the other inhabitants of his world. He may strain his back on the
farm and thus pay a visit to the doctor. Or perhaps he wants an
addition to his home and hires the carpenter for the task. These
other inhabitants will use at least part of their earnings to
purchase the necessities of life, including food from the farmer.
In short, we would expect the kind of normal trade to take place on
Planet Doom as we would anywhere in the real world, with checkbook
money acting as the medium of exchange.
But what of the banker? Initially, no one has any money and
only he can create it. How will the banker purchase the sustenance
he needs from the farmer without the money to do so? How will he
purchase clothing or acquire medical services? Why not just use
the same pen which magically created money to lend to the farmer,
only this time use it to purchase the necessities of life? Doing
so would add new money to Planet Doom's economy without creating
additional debt for the rest of the inhabitants to repay. This is
the primary flaw in Jaikaran's story. The banker is not an
ethereal entity. No, he is a living, breathing person who needs to
purchase the products and services which make life possible and
Banks are no different in the real world. Commercial banks
and savings and loans have expenses to pay just like any other
firm. They must pay their employees, purchase office supplies, and
meet the other expenditures which are a part of doing business.
When they do this banks spend money back into the economy without
any debt being created to burden the non-bank public -- debt-free
money as it were. The revenues banks collect from interest on
loans and other services do not disappear into an economic void.
Instead, those revenues are used to meet the bank's operating
expenses, to purchase assets to generate future income, or are paid
to the shareholders as dividends. Those are the only three places
any firm's revenues can go.
The other major flaw in the Debt Virus hypothesis is that it
ignores the role of the central bank in the money-creating process.
The Federal Reserve creates a measure of debt-free money when it
buys government bonds from the public. The Fed buys the bonds on
the open market and pays for them by creating new checkbook money.
The new money is therefore created without any additional debt
appearing in the economy. Jaikaran's central thesis that new money
is created only through new bank lending is thus countered by the
facts that banks create debt-free money when they pay their
operating expenses, purchase assets, and disburse dividends, and
that the Fed creates debt-free money in the process of buying
We can also examine the validity of Jaikaran's hypothesis by
a simple appeal to the data. According to Jaikaran the money
supply can only increase with a corresponding increase in bank
credit, that is, an increase in bank loans and bank purchases of
government bonds. According to the F.D.I.C., as of September 1996
bank credit at all F.D.I.C. insured institutions, which includes
both commercial banks and savings and loans, totalled $4,436.6
billion. The Federal Reserve's M3 money supply estimate was
$4,822.3 for the same month. If bank credit is the only source of
money in the economy, then what is the origin of this excess money?
Consider also that in February 1996 bank credit increased $10.8
billion over the previous month, but the M3 money supply increased
$37.3 billion. Jaikaran's Debt Virus hypothesis cannot account for
the existence or the creation of this "extra" money. We must
therefore reject the idea as wrong.
The idea is also objectionable for other less direct reasons.
Jaikaran's main warning is that if we wished to repay all the debt,
we would be unable to do so because of the shortage of money. But
why would we wish to retire all the outstanding debt in the
economy? Loans and bonds have a variety of maturities and only the
most remarkable synchronicity would have them all, or any
appreciable portion of them, come due at once. Moreover, most
firms try to preserve a certain level of debt even if they have the
capacity to repay it. They do so because sometimes debt financing
is cheaper than issuing stock. Jaikaran's argument also ignores
the fact that most debt in the U.S. economy is in the form of
bonds, not bank loans. This is important for his thesis because
unlike the lending process, the issuing of new bonds and the
retiring of old ones does not affect the money supply. Therefore,
a given money supply can repay a total bond debt many times its
size, in fact, a debt infinitely greater than the money supply.
The flaws of his thesis notwithstanding, Jaikaran presents his
solution to the country's alleged debt problem. He proposes having
the federal government print currency to finance its entire budget,
thereby eliminated its need to tax or to borrow. This would create
an infusion of debt-free money which would make it possible for the
economy to repay all its debts. Since he argues that inflation is
really caused by interest on debt, this would have the added
benefit of generating price stability. Unemployment, crime,
marital difficulties, and war are each merely symptoms of our debt-
money system and can be cured by something so simple as a switch to
a debt-free money supply. In short, Jaikaran promises the reader
an economic paradise if only the government would end taxation,
cease borrowing, and instead print money to pay its bills.
Any economist in the world would recognize this idea as a plan
for economic chaos. One of the best demonstrated theories in this
social science is that an excessive growth of the money supply
always causes inflation. The federal government's expenditures
totalled $1,560.1 billion in fiscal year 1996. If it were to print
and spend all the money for similar budgets rather than raise it
through taxes, then the M1 money supply would more than double in
a year. The annual inflation rate would hit 100 percent within two
Of course, Jaikaran is not an economist; he is a plastic
surgeon. Nor is he much of an historian. Somehow he expects his
plan would not be hyper-inflationary, even though it was tried once
before in American history. The Continental Congress, which
organized the principal army which fought the American
Revolutionary War, did not have any taxing or borrowing authority
of its own and thus had to rely on the meager contributions given
to it by the newly independent States. But from 1775 to 1780 it
also printed $250 million in debt-free currency and spent it
directly into existence. This increase was well out of proportion
to any growth in output and hence caused some of the worst
inflation in U.S. history. Jaikaran is well aware of this
inflationary episode because he discusses it in Debt Virus. But he
does not address why his plan would somehow not be inflationary
even though it is identical to the Continental Congress fiasco. He
also displays a bizarre sense of cause and effect. Early in Debt
Virus he writes that a monetary-induced crisis caused an economic
collapse in France from 1790-1795 which then caused the French
Revolution. This is odd because the peasants seized the Bastille
and began the Revolution on July 14, 1789.
Despite the crucial defects in the central thesis of Debt
Virus, the book has had a significant impact among ultra-right
activists. Grassroots organizations cite it as inspiration for
various reform efforts. The Coalition to Reform Money is a
thorough believer in the debt-money myth and proposes what it calls
the "Monetary Reform Act" with provisions very similar to those of
Jaikaran's plan. Bo Gritz, an unofficial interstate leader of the
militia movement, not only believes the Debt Virus hypothesis but
views it as part of the larger international banking conspiracy.
To him and many other militia followers, this is just a mechanism
by which the international bankers can capture our wealth and, at
the appointed time, collapse the U.S. economy, paving the way for
the New World Order.
There is no danger of the Debt Virus thesis becoming an
accepted idea in Congress, and certainly not among economists, but
this has not limited its adverse effects. It has clearly lead many
people to an erroneous interpretation of the workings of the
financial system and has caused them to direct their political
activist energies toward an imaginary problem. At least one
benefit, however, is that it has spurred some people into political
awareness who might othewise be inert. But instead of directing
their efforts toward real social, economic, and political problems,
they tilt windmills. What a waste.
URL to open: http://garnet.acns.fsu.edu/~eflahert/virus1.html
Exposing the Debt Virus Fallacy.
Part One: The Debt Virus Hypothesis
by Dr. Edward Flaherty, University of Charleston
(last updated July 14, 1996)
What is the cause of recessions, financial crises, and the periodic
wave of bankruptcies that have characterized the United States economy
throughout its existence? Economists have studied this question
intensely and have produced a variety of competing answers and
recommendations that fully satisfy no one. However, there is an
interesting hypothesis that departs from traditional macroeconomic
analysis. This alternative approach cites the fractional reserve
banking system as the source of the instability. When a loan is
created, the argument proceeds, only enough new money is created to
repay the principal portion, never enough to repay both the principal
and the interest. Thus, the system is always short of money and this
causes the periodic waves of bankruptcies and bank foreclosures.
Eventually, this system will cause a terrific crash of Depression-era
proportions. This idea, sometimes called monetary extinguishment,
contains a serious flaw because it fails to consider how banks
interact with the economy.
The idea of monetary extinguishment and proposals for monetary reform
come from several sources. The most detailed are the books Debt Virus
by Jacques S. Jaikaran, a plastic surgeon, and The Truth in Money by
Theodore Thoren and Richard Warner. Both texts are nearly identical in
their analysis, conclusions, and recommendations. There also exist two
organizations that support these ideas and are dedicated to increasing
public awareness and support for reform. They are the Coalition To
Reform Money and Sovereignty. The groups differ in their solutions.
The Coalition proposes the "Monetary Reform Act" which would have the
U.S. Treasury print currency and spend it to meet all federal
expenditures. Eventually, this would eliminate the need for any
federal taxation. Sovereignty recommends only a one-time policy of
additional federal spending financed by newly printed Treasury money.
Although each of these groups and the two books do have some
differences, they are fundamentally the same in that their thesis is
based on the ideas presented in Debt Virus. For my convenience, I will
refer to the general thesis as "the Debt Virus hypothesis." In Part
One of this essay I will present a summary of this hypothesis and
various recommendations based upon it. I will then present a critique
of it in Part Two.
The Debt Virus Hypothesis:
I: Fractional Reserve Banking
The fundamental cause of instability in the U.S. financial system is
fractional reserve banking. This is a system in which a commercial
bank, at any given time, has on hand only a fraction of its customers'
deposits as coin or currency. Such a system dates back with certainty
to thirteenth century Venice, and perhaps as long ago as ancient Rome
(Dunbar, 1892). For example, in February 1995 commercial banks in
United States had about $2,546 billion in customer deposits but only
about $216 billion in cash assets (Federal Reserve Bulletin, Table
1.26, Oct. 1995). How could such a large disparity between deposits
and cash reserves come to be? The answer is in the lending process.
When a bank makes a loan, it does not present the
customer with a
large sack of cash. Instead, the bank makes an electronic accounting
entry and deposits the loan amount into the customer's checking
account. Since checkable deposits are a form of money, this means that
the banking system can create money out of thin air. Because the money
is produced via a debt-creating transaction, this form of money is
sometimes called credit-money or debt-money. As Table 1 shows, most of
the money used in the U.S. for daily transactions is checkable
Composition of the M-1 Money Supply,
Dec., 1995 (in billions)
M-1 Component Amount
Coin and Currency $ 372.5
Travelers' Checks 8.9
Checkable Deposits 741.6
Total M-1 Money Supply $1,1
monthly averages and are seasonally adjusted.
The main problem with this system arises when it
is time for the loan
to be repaid. When the principal is repaid by check, which is almost
always the case, the demand deposit the bank earlier created for the
customer vanishes. This accounts only for the principal, what of the
interest due? Even if the individual who borrowed the money employed
it profitably, there is insufficient money in the system to repay both
the principal and the interest. The only way the additional money for
the interest can come into being is for the bank to create a new loan
for at least the amount of interest due. Of course, eventually this
new loan and its interest will come due, and the same problem will
reappear and compounds the initial problem. Thus, we arrive at the
fundamental principle of the Debt Virus hypothesis: the financial
system is continuously short of money; not enough money exists, or can
exist in the current system, to pay off all the existing debt and its
interest. Because "all money is created only when loans are made and
debts incurred," it is impossible to repay all the principal and
interest (CRM, p.4). The data in Table 2 seems to support this claim.
U.S. Money Supply and Debt Measures,
Nov. 1995 (in billions)
M-3 Money Supply $ 4,648.3
Non-Bank Debt 13,804.2
Source: Federal Reserve Bulletin, Table 1.21, March
1996. M-3 is
defined as coin, currency, travellers' checks, checkable deposits
(except those owed to other banks), time deposits, money market
balances, and U.S. Eurodollar deposits. Non-bank debt is the
outstanding credit market debt of the domestic nonfinancial sectors,
including both federal and non-federal sectors.
Since ckeckable deposits are destroyed by repaying a loan, how can we
repay over $13 trillion in debts with only about $5 trillion in money?
The financial system appears to be short of money. Dr. Jaikaran writes
that at current rates of growth the interest on the federal debt will
exceed the M-1 money supply no later than 2012. "At this time, the
bubble will burst and there will occur a total financial collapse in
the United States" (p. 105). However, later he writes that the
impending depression will happen before the end of the nineties.
Indeed, "there is no way that it cannot" (p. 125).
The Debt Virus Hypothesis:
II: Currency and the Federal Reserve System
Even our tangible currency itself is created with debt. Federal
Reserve Notes, which constitute nearly all currency in circulation,
are borrowed into existence via the relationship between the Federal
Reserve and the Treasury. The Bureau of Engraving, a department in the
Treasury, actually prints all Federal Reserve Notes and then sells
them to the Federal Reserve Banks for the cost of printing which is
usually about 3 cents per bill. However, the law requires that a
Federal Reserve Bank can only order an amount of Federal Reserve Notes
commensurate with the Bank's holdings of Treasury securities (12 US
Code ''411, 412). On balance, then, the Federal Reserve banks are
paying the Treasury only a few pennies per new dollar purchased from
the Treasury and then collecting large amounts of interest on the
Treasury bonds the Banks hold.
This arrangement between the Federal Reserve and
the Treasury suffers
from the same money shortage problem as the fractional reserve banking
system. New currency enters the economy by essentially borrowing it
from the Federal Reserve. However, because the Treasury must pay
interest on the securities the Federal Reserve Banks hold, again not
enough money exists to pay both the principal of the securities and
The Debt Virus Hypothesis:
III: Implications of Monetary Extinguishment
The imbalance between the debt level and the size of the money supply
is the source of financial instability. The instability manifests
itself in three ways:
1. Rising Prices
Because interest is another type of expense in the production
process for a firm, the ever-increasing level of debt and its
corresponding interest obligation increases the cost of
production which forces retail prices higher. This forms a
growing wedge between resource prices and retail prices and
is the reason the price level rises continuously over time.
2. A Slow Growth Economy
The financial system generates interest rates that are much
higher than they would be under what the Coalition calls a
"wealth-based" monetary system. In turn, this causes the
unemployment rate to be much higher than it could be and the
growth rate of the economy much slower than it would be.
The imbalance causes occasional bouts of bankruptcy so that
banks can seize real property in lieu of monetary interest
payments. Over time these waves of bankruptcies grow and
become more intense. Jaikaran writes that the impending
disaster "will make 1929 look like a Sunday picnic"
(Jaikaran, p.125). Despite the vagueness of his statement, he
predicts it will happen with certainty before the end of the
The Debt Virus Hypothesis:
IV: Solutions and Proposals
The solution to the economy's catch-22 is a fundamental change in the
order of the financial system. The Coalition To Reform Money believes
we must switch our money supply from a debt-based currency to a
wealth-based currency. "Wealth-based" money is money that is spent
into existence rather than borrowed into existence. In the nineteenth
century, the Coalition reminds us, the Treasury, under various
free-coinage acts, would mint for free gold and silver coins for
anyone who brought them sufficient amounts of the metals. This money
was produced from the wealth of the population rather than being
created by having someone take a loan. Hence the terms wealth-money
and debt-money. Specifically, the Coalition and Sovereignty have the
following combined proposals:
1. Create New Debt-Free Money
Rather than have new money borrowed into existence through
the current Fed-Treasury arrangement, money should be spent
directly into existence by permitting the Treasury either to
print and to spend its own currency, or to instruct the
Federal Reserve to give the Treasury free of charge the
appropriate credit in its checking account at the Fed. The
new currency would eventually replace Federal Reserve Notes
which are our present currency. For a historical example,
Sovereignty cites United States Notes which were printed and
spent by the Treasury itself at various points in U.S.
history. Current law restricts the volume of U.S. Notes to
$300 million or less (31 US Code ''5115, 5119). The
Treasury estimates that most of existing U.S. Notes are in
the hands of collectors.
Click here to view a 1953 United States Note.
Switching to this form of money would end the periodic waves
of bankruptcies, stem the rising tide of debt, and reduce the
gap between resource prices and retail prices because
interest costs would be substantially lower.
2. Spend the New Money on Capital Projects
Sovereignty specifically proposes that about $360 billion of
this new money be printed and spent by the Treasury on
various capital projects by the federal government, or loaned
interest-free to local governments for their own projects or
debt retirement. This would improve the production capacity
of the economy, reduce the Treasury's annual interest costs,
reduce the debt burden of state and local governments, and
most importantly help to relieve the money shortage.
3. Eliminate Fractional Reserve Banking
To prevent banks from creating additional debt-money,
Sovereignty proposes that all banks be required to maintain
100 percent reserves against deposits, that is, an end to
fractional reserve banking. This would leave the government
as the sole supplier of money for the economy. This idea is
not unique to Sovereignty. Economist Irving Fisher advocated
100 percent reserve banking as early as 1910, and some
monetary economists today also advocate this, although for
The Coalition, Sovereignty, and the authors of the books earlier
mentioned claim a variety of benefits that would follow the adoption
of their proposals: a sharp reduction in the level of debt in the
economy, lower taxes, full employment, a faster growing economy, price
stability, and a reduction in welfare expenditures. In other words it
would bring economic utopia.
The desire of these groups to improve the performance of the U.S.
economy is certainly admirable. However, their proposals are based on
what they call a mathematical certainty: that the financial system is
substantially short of money. Far from being a certainty, this idea is
a serious fallacy. In the essay that follows, I provide a detailed
criticism of the Debt Virus hypothesis.
Exposing the Debt Virus Fallacy.
Part Two: A Critical Examination
by Dr. Edward Flaherty, University of Charleston
(last updated July 18, 1997)
As explained in detail in the first part of this essay, Debt Virus by
Jacques S. Jaikaran and other similar works argue that the financial
system is unstable because the fractional reserve banking system
produces an inherent shortage of money. They claim this flaw is
responsible for an ever-growing level of debt, bankruptcies, a slowing
economy, and will, with mathematical certainty, eventually lead to a
very serious economic crisis. In this essay I detail the fallacy upon
which these arguments are based and explain the probable economic
consequences of some of their proposals.
The System is Not Short of Money
The first and most critical flaw of the Debt Virus hypothesis is that
the financial system is always short of money, specifically, that
there is never enough money in the system to pay both principal and
interest. This is wrong because it fails to account for how banks
interact in the economy. In Dr. Jaikaran's model, the only interaction
a bank has with the economy is to extend a loan and to collect on it.
At no point does the bank in his "Doom" model actually pay its
expenses or purchase the fixed assets actually needed to operate a
bank. In the real world banks must pay their employees, pay interest
to their depositors, meet their other expenses, and purchase
equipment. When the banking system does this, it spends into existence
new "debt-free" money (debt-free in the sense that no one outside the
banking system is required to obtain a new loan). In other words, the
system creates a new demand deposit out of nothing, adding to the
money supply without the creation of any additional bank credit (loans
plus bank-held bonds) being necessary. Contrary to the Debt Virus
thesis, new bank credit is not the only source of new money.
Click here for a general analysis or for a detailed T-account
analysis of this key counterpoint.
The Coalition to Reform Money writes, "... all money
is created only
when loans are made and debts incurred. There is no 'money' create
without someone obtaining a loan and going into debt" (CRM, p.4). This
is a concise statement of the Debt Virus hypothesis. If it is correct,
then the only ways deposits can increase are if either banks create
new credit or if new currency enters the economy and is deposited into
the banking system. We can test this hypothesis with data easily
obtained from the Federal Reserve Board of Governors.
Changes in Bank Credit, Money Supply, and Deposits
>From Prior Month (figures in billions of $)
(1) (2) (3) (4) (5)
Bank Coin & Debt Virus
Month M3 Credit Currency Deposits Prediction
Dec 95 + 13.9 + 12.0 + 1.6 + 17.1 + 10.4
Jan 96 + 28.3 + 26.5 + 0.4 + 28.1 + 26.1
Feb + 37.3 + 10.8 - 0.3 - 6.3 + 11.1
Mar + 40.8 - 8.9 + 1.9 + 20.5 - 10.8
Apr + 4.3 + 15.9 + 0.7 + 15.9 + 15.2
May + 12.0 + 4.4 + 1.1 - 0.5 + 3.3
Bank Credit is bank loans and bonds held by the banking
is seasonally adjusted. Source: Tables H.8(510) and H.6(508) of
Federal Reserve Statistical Releases, Board of Governors.
In this table column (1) measures changes in the
M3 money supply from
the previous month. Column (2) measures changes in bank credit, which
consists of both bank loans and bonds held by the banking system. The
latter should be included because whenever the system buys or sells a
bond, or when it matures, the money supply is affected as in the case
with bank loans. Column (3) represents changes in coin and currency in
circulation. Column (4) is the change in the total amount of deposits
of the system. Column (5) shows the change in deposits predicted by
the Debt Virus formula shown below in equation (1).
According to the Debt Virus hypothesis, changes in
the deposit portion
of the money supply are due only to changes in bank credit or
currency. Specifically, it states:
(1) dD = dBC - dC,
where dBC is the change in bank credit, dC is the change in currency
held by the public, and dD is the change in total deposits (the d
symbolizes the change in the variable from the previous period). In
other words, deposits can only change through the process of bank
loans, banks trading securities, or currency being deposited or
withdrawn by the public. Let's see if the data agrees with this idea.
In Table 3 we see that in December bank credit increased
and currency held by the public increased $1.6 billion. According to
the Debt Virus hypothesis, deposits should have increased $10.4
billion. In reality they increased $17.1 billion, or $6.7 billion more
than for what the Debt Virus thesis can account. Comparing columns (4)
and (5) we see that the relationship predicted by equation (1)
contains considerable error. Obviously, the Coalition statement that
new loans are the only means to increase deposit money is contradicted
by the empirical evidence. Equation (1) does not hold because it is
missing several variables to represent other means of deposit
Clearly, the Debt Virus hypothesis about deposit
creation is wrong.
How else can the banking system create deposits other than through new
bank credit? The above link to the T-account analysis answers that
question, but consider the following sequence of equations. Let's
start with the basic accounting identity:
(2) Assets = Liabilities + Capital,
which states that a firm's assets must always equal its liabilities
plus the funds contributed by the owners (the capital). Almost all of
the liabilities of the banking system consist of deposits, so we can
rewrite (2) as:
(3) Assets = Deposits + Capital.
Rearranging the terms yields:
(4) Deposits = Assets - Capital.
For convenience, let me rewrite (4) as
(5) D = A - K,
where D is deposits, A is assets, and K is capital. We are interested
in how new deposits can be created, that is, how the variables in (5)
change over time. Rewriting (5) in terms of the changes in each
variable we get:
(6) dD = dA - dK.
This says that the banking system's deposits can change due to either
a change in the system's assets or its capital. Let's examine dK
Capital changes primarily due to profits and losses (for simplicity
assume that no additional stock is issued during the period). Profit
is revenues minus expenses, or P = R - E, where P is profit, R is
revenue, and E is expenses. Capital also declines when dividends are
paid to shareholders. Therefore, a change in capital, or dK, can be
(7) dK = R - E - V,
where V is the dividend payment. Substituting (7) into (6) we get:
(8) dD = dA - R + E + V.
This says that revenues paid to the banking system by the public, such
as interest on loans or account maintenance fees, cause deposits to
fall and that expenses and dividends paid by the system cause deposits
to rise, assuming the system makes no changes to its asset holdings.
This contradicts the Debt Virus hypothesis: new deposits can be
created without additional loans.
Turning our attention to dA, the banking system's assets consist of
loans (L), bonds (B), cash reserves and their equivalent (R), and
fixed assets (F). We can then write (8) as:
(9) dD = (dL + dB + dR + dF) - R + E + V.
Let's consider some of the implications of equation
(9). Suppose a
bank wants to purchase a computer system, that is, it wants to
increase F, its holdings of fixed assets. Then for the identity
equation in (9) to hold, the bank must either decrease its holdings of
other assets or increase its deposit liabilities. In other words, the
bank can pay for the computer system by paying the vendor out of cash
reserves (decreasing R), or by increasing the vendor's deposit
account. If the former is chosen, then the money supply increases
because cash held by the banking system is not counted as part of the
money supply to avoid double-counting. Once a bank releases cash to
the public, unless there is a corresponding decrease in a deposit, the
money supply increases. If the latter method is chosen, again the
money supply increases because deposits are a part of the money
supply. Either way, new deposits are created by the banking system
without the need for additional loans, contrary to the Debt Virus
Summarizing the first counterpoint, the banking system
"debt-free" money in the form of new deposits whenever it pays its
expenses or purchases fixed assets. These deposits do not represent
loan principal or interest which the non-bank public must eventually
repay. This interaction of the banking system with the rest of the
economy is the flaw in Dr. Jaikaran's model of the economy.
The Federal Reserve's Role in Money Creation
Another significant source of "debt-free" money is the Federal Reserve
system. The Fed's chief tool for increasing the money supply is open
market operations. The Fed buys pre-existing Treasury bonds on the
open market. To pay for these bonds, the Fed creates new deposits out
of thin air. This represents an increase in the money supply without a
corresponding increase in the amount of debt held by the public or by
Debt Exceeding the Money Supply is Misleading
The observation that total debt in the U.S. economy exceeds the money
supply is very misleading. The debt measures used to make this claim,
such as the data in Table 2 of Part One of this essay (or in Chapter 7
of Debt Virus), include corporate and government bonds. This is
misleading because, unlike a bank loan, when a bond is issued money is
not created, and when it is repaid money does not vanish.
Click here for a T-account illustration of how bonds enter and exit
the financial economy.
Banks are not the only means to borrow money. When
a firm or a
government issues a bond, it is essentially trading its IOU for the
public's demand deposit; no new money is created, unlike when a bank
extends credit. When the principal and interest of a bond are repaid,
no money is destroyed, unlike when a bank loan is repaid. When money
is used in a transaction to retire one bond issue, the money is
immediately available for other transactions since it still exists
within the economy. Therefore, a given supply of money can be used to
repay any balance of outstanding bonds without having an effect on the
level of the money supply.
The exception to this is bonds held by the banking
system. A bond held
by a bank is functionally the same as a loan in terms of its effects
on the money supply. When a bank purchases a bond, money is created;
and when a bank sells a bond, money is destroyed. The exceptions are
when banks trade bonds with each other or with the Federal Reserve. If
the former is the case, then there is no change in the money supply at
all. If the banks buy bonds from the Fed, then the monetary base
decreases. If they sell bonds to the Fed, then the monetary base
increases. Commercial banks are permitted by law to hold only federal,
state, or local government bonds; they may not own any corporate bonds
for their own ac
debt should include bank loans plus bonds held by the banking system
that is, total bank credit. The repayment of these types of debt
destroys money. All other bonds must be excluded from the debt
measure. The correct measure of debt is presented below, along with
the current level of the money supply.
U.S Money Supply and Bank Credit
Sept 1996 (billions)
M-3 Money Supply $4,822.3
Bank Credit 4,436.6
Bank Loans 3,364.6
Bonds Held by Banks 1,072.0
Data is for all FDIC-insured commercial banks and
Sources: FDIC, 3rd quarter 1996, Federal Reserve Board of
Table 4 shows that if all bank loans suddenly came
due, and if all
government bonds held by banks were retired, then there is more than
enough money in the U.S. economy to repay the principal and interest
due on both the loans and the bonds. This observation is also contrary
to the Debt Virus hypothesis. Including corporate and government bond
issues as part of the debt measure is erroneous because repaying those
loans does not cause the money supply to decrease. The same deposits
could be used any number of times to extinguish all bond liabilities
while leaving the money supply unaffected. (Note: Jaikaran uses M-1 as
the measure of the money supply. This is far too narrow a definition
for this purpose because the principal difference between M-1 and M-3
is time deposits. Given sufficient time for certificates of deposit
and other time deposits to mature, non-checkable assets will convert
into checkable balances, or M-1.)
Federal Reserve Earnings Go To the Treasury
The Debt Virus explanation for how Federal Reserve Notes enter the
economy is correct, but it neglects two very important points. First,
like a commercial bank, the Federal Reserve system has expenses which
are met by spending the interest income it collects from the Treasury.
Second, nearly all of its remaining earnings above its operating costs
are paid to the Treasury. It then spends this money as part of its
general revenues. For example, consider the following distribution of
Federal Reserve earnings in the 1994 calendar year:
Source and Distribution of
Federal Reserve Earnings for 1994 (in billions)
Interest on Treasury Securities $19.2
Profit From Foreign Exchange 2.4
Other Items, Net - 0.1
Payments to Treasury $20.5
Board of Governors 0.5
Dividends to Member Banks 0.2
Transferred to Equity 0.2
Total Outlays: $21.5
Source: Annual Report 1994, Board of Governors of the Federal Reserve
System. Washington, D.C., 1995.
p. 310-312. This data can be confirmed from the Treasury's income
In 1994 the Federal Reserve paid more to the Treasury than the
Treasury paid to the Fed in interest. This is typical for all years.
In effect, the Treasury securities held by the Fed are interest-free
loans to the federal government. Federal Reserve Notes therefore do
not carry a net interest obligation. The Treasury can then use this
money to spend on Congressionally appropriated items free of any net
cost. This is exactly what the Coalition and Sovereignty groups want,
except that they would have the Treasury print and spend the money
directly rather than through indirect process via the Fed (more on
Interest Does Not Cause Higher Prices
It is difficult to discern the relationship between interest costs and
retail prices among the various Debt Virus advocates. On some
occasions they assert that interest causes higher prices. In other
cases, they claim interest causes higher inflation. These are two very
different conjectures. Let me first examine the supposed link between
interest and the price level.
In the Debt Virus model, interest is a cost of production and is
therefore passed along to the consumer in the form of higher price
This is wrong for several reasons. First, in the short-run interest
expense is a fixed cost of production in that it does not vary with
the level of output. Because it is fixed, it does not affect the
marginal conditions in the short-run, meaning it affects neither the
price nor the output decision. It affects only the total profit of the
firm. In the long-run an increase in interest costs alters the
incentives for a firm to enter or exit an industry and then has a
impact on price and output. If this is happening across many
industries, then it would represent a change in the the price level,
not a change in the inflation rate.
Click here for a brief mathematical treatment of this point.
Second, a change in interest costs will affect firms
depending on how much debt they carry and how it is financed. Even if
a change in interest rates makes a substantial difference in price i
the long-run, prices for some goods will be affected more than others.
This is not price inflation; it is a change in the relative prices of
goods. Inflation is a continuous rise in the average level of all
prices in the economy, not just a group of prices. Only an increase in
the supply of money relative to the amount of goods for sale can cause
sustained price inflation. This is one reason why inflation is
destructive: it alters short-run relative prices which causes the
market to misallocate resources.
The hypothesized link between interest and the price
level can be
tested empirically. If interest costs form a wedge between resource
prices and retail prices, then higher interest rates ought to make the
wedge bigger and increase retail prices. That is, an increase in
interest rates ought to increase the price level. Conversely, a
decrease in interest rates should lower the price level -- as the
wedge gets smaller competition between firms will bid prices down.
Table 6 presents correlation coefficients between the Consumer Price
Index (CPI) and the 90-day Treasury bill interest rate. The data
employed is monthly from January 1970 to November 1995. If the Debt
Virus hypothesis is correct, then there should be a strong positive
correlation between the CPI and the T-bill rate. A coefficient of 1.0
indicates a perfect positive correlation between two variables. A
coefficient of - 1.0 indicates a perfect negative correlation. A value
Correlation Coefficients for
the CPI and the T-Bill Rate
Period Coefficient t-statistic Observations
---------- ----------- ------------ ------------
1970-1995 - 0.109 - 1.93* 311
1970-1980 0.691 10.89*** 132
1981-1995 - 0.789 - 17.09*** 179
The CPI is the Consumer Price Index, not seasonally adjusted. The
T-bill rate is the interest rate on the 90-day Treasury bill. Data is
monthly beginning 1/70 and ending 11/95. Source: Federal Reserve Bank
of Chicago. An * indicates that the null hypothesis of no correlation
between the variables can be rejected at the 90% level in favor of the
alternative hypothesis of either a positive or a negative correlation.
An *** indicates the null can be rejected with 99% confidence.
For the 1970-1980 period, a positive correlation existed as is
evidenced by the positive coefficient and that the coefficient is
statistically significant. This supports the Debt Virus hypothesis.
However, during the 1981-1995 period the coefficient is negative and
significant, indicating that an inverse relationship existed. This
contradicts the Debt Virus hypothesis. For the entire sample period, a
negative correlation was present between the two variables. This also
contradicts the Debt Virus position. Seelig (1974) performs a much
more sophisticated test of this hypothesis and also rejects it.
That the price level and interest rates are generally
also be seen graphically. Click here to view Figure 1 which plots
the CPI and the T-bill rate.
The Coalition and Sovereignty groups also postulate a strong positive
correlation between interest rates and inflation. On this economists
can agree. However, there are two problems. First, a link between
interest rates and inflation does not logically fall out of the Debt
Virus hypothesis. In their model, an increase in interest rates will
push up costs and retail prices. This is a one-time increase in the
price level. Inflation is the rate of change in the price level over
time. To quote Makinen and Woodward, "Sovereignty adherents are off by
one derivative" (Makinen, 1994). For the Debt Virus hypothesis to be
correct, a single increase in interest rates would have to cause a
continual and proportional increase in the price level, and there is
nothing in the hypothesis which permits such an effect.
Second, their arrow of causality points the wrong
rates do not cause inflation; inflation causes interest rates.
Economists agree there is a strong link between interest rates and
inflation, but that it is inflation that causes interest rates.
Financial markets and creditors build their expectations about future
inflation into the current interest rate they charge to protect the
purchasing power of the principal they lend. Moreover, the idea that
changes in inflation cause changes in interest rates is supported by
strong empirical evidence. Ironically, it was economist Irving Fisher
who first proposed the idea in its modern form and it is sometimes
called the Fisher Effect in his honor (Fisher, 1930). The irony is
that Sovereignty admires Fisher for recommending 100 percent reserve
banking, but they ignore his interest theory which contradicts their
Contradictions in Sovereignty Arguments
Makinen and Woodward point out several contradictions in the arguments
and proposals of Sovereignty. First, Sovereignty and the Debt Virus
hypothesis argue that Federal Reserve Notes and Treasury money are
different. However, in their supplemental publication, All You Wanted
To Know About the Sovereignty Loan Plan But Were Afraid To Ask,
Sovereignty states that neither currency adds to the federal
government's interest expense because the Fed must pay its earnings to
the Treasury. This clearly contradicts the Debt Virus assertion and
their own contention written elsewhere that a difference between the
two currencies exists. In light of their supplemental publication,
their recommendation for printing Treasury money seems pointless.
Second, in a promotional video a Sovereignty advocate,
Mrkvicka, states that Treasury money, "if phased in correctly, is not
inflationary any more than any added dollar to the money supply is
inflationary." This appears to be an admission that their proposal has
inflationary consequences which again contradicts the basic Debt Virus
hypothesis that Treasury money would be less inflationary than Federal
Third, in another supplement, Everything You Wanted
to Know About the
Sovereignty -- Supplement #1, they also argue that "we need a more
rapid growth of money until we reach full employment, then we need the
money supply to grow steadily at the same rate at which the real
economy can grow." This is already a part of conventional
macroeconomic thought and is generally the policy the Federal Reserve
already pursues. This reduces the Sovereignty arguments from pointing
out a "critical flaw" of the financial system to a mere disagreement
over current monetary policy within the context of the current system.
Fundamentally, all Sovereignty proponents want is a faster money
supply growth rate than what the Fed considers to be adequate.
Evaluating the Coalition and Sovereignty Proposals
1. Issue New Debt-Free Money
The principle recommendation of both the Coalition and Sovereignty
groups is that the Treasury print various amounts of its own
debt-free money and spend it directly into the economy. The
Coalition wants to phase out taxes as the primary means to finance
federal expenditures and replacing them with Treasury currency
printed as needed. They claim that such large, regular increases
in the money supply would not be inflationary. This idea is
dubious for many reasons.
First, under U.S. law there is no such thing as "debt-free" money.
Even the U.S. Notes which Sovereignty uses as a historical example
of their recommendation are classified as part of the non-interest
bearing portion of the national debt (31 US Code '5119). It is
true that additional money of this type would increase the
national debt without increasing interest payments for the federal
government, but this is already the current situation with new
issues of Federal Reserve Notes. As explained earlier, the
Treasury pays no net interest on the volume of Federal Reserve
Notes outstanding because Fed earnings must be paid to the
Treasury. The volume of Treasury bonds held by the Federal Reserve
Banks as backing for the currency they issue is a part of the
national debt (about 7 percent), but bears no net interest
obligation to the Treasury. It is true that the law could be
changed so as not to count U.S. Notes as part of the national
debt, but the law could also be changed to not count the Treasury
securities held by the Fed.
The key difference between the current arrangement and the one
advocated by Sovereignty and the Coalition is that issues of
currency are now controlled by a mostly non-political body, the
Board of Governors of the Federal Reserve system, whereas under
their scenario it would be controlled by purely political bodies,
Congress and/or the executive branch. Several economists have
examined the relationship between central bank political
independence and inflation (See for example Wyss and Blondia
(1988) and Grier (1987) ). For the major industrialized countries
the studies have found that economies with a central bank tied
relatively closely to the political process, such as in Great
Britain and Italy, had higher average annual inflation rates
during the 1955-1990 period than those economies with mor
independent central banks, such as Germany and the United States.
I do not think this is a coincidence.
Second, such large regular increases in the money supply would be
very inflationary. Few ideas in economics have been demonstrated
so well by governments throughout history: when the money supply
rises faster than the growth of real output of goods, inflation
must be the result. The U.S. is no exception to this rule (See
Friedman and Schwartz, A Monetary History of the United States,
for a thorough treatment). The higher rates of inflation would
then increase, not decrease, interest rates via the Fisher Effect.
Are Debt Virus advocates ignorant of history? The Continental
Congress from 1775 to 1780 printed and spent directly into
existence, without interest, nearly $250 million in Continental
dollars to pay for the expenses of the War for Independence. The
result was absurd inflation that eventually produced the
well-known phrase "not worth a Continental." This is exactly what
the Debt Virus proponents propose we now do with federal finance.
Jaikaran is aware of the Continental fiasco because he discusses
it and its inflationary consequences in his book (p. 117). But
somehow the contradiction between his proposal and historical
experience seems to elude him. Jaikaran and other advocates of his
ideas never explain why Treasury money printed and issued in the
same manner as Continental dollars would not be inflationary.
2. Spend the New Money on Capital Projects
Sovereignty recommends spending about $360 billion of this new
currency on federal and local capital improvements or to retire
existing local government debts. This idea has some merit.
Investing more resources in the productive capacity of the economy
is an idea many economists and policy makers support. However, the
Sovereignty method of financing these improvements is the
questionable part of their proposal.
Their proposal is essentially expansionary fiscal policy combined
with monetary accommodation by the Federal Reserve, that is,
combined with expansionary monetary policy. If the Fed were to
commit to purchasing an amount of securities equal to the amount
of additional federal spending, then the effect would be identical
to the Treasury printing the $360 billion needed and spending into
the economy. Such arrangements between the Treasury and the
Federal Reserve have taken place several times in the past, always
with inflationary consequences. How inflationary this proposal
would actually become would depend on whether the spending took
place in a recession, when there is plenty of slack in the economy
and it can handle increased production without much inflation, or
whether it was done near full employment. If the latter is the
case, then there would be no appreciable increase in real output
with the entire effect of the plan being inflationary. This would
hold true whether the $360 billion were literally printed by the
Treasury, or whether the Fed provided monetary accommodation. This
increased inflation would boost interest rates in accordance with
the Fisher Effect, and this would actually increase the Treasury's
interest burden, not decrease it.
3. Eliminate Fractional Reserve Banking
While many economists probably would not support this Sovereignty
proposal, there is a minority of economists, including Nobel Prize
economist Milton Friedman, who would support it, but for different
reasons. Like Sovereignty, these economists would argue that
fractional reserve banking is a source (but not necessarily the
source) of economic instability because it greatly limits
government's ability to control the money supply effectively.
Others advocate it in conjunction with a return to a gold standard
(Salerno, 1983). If banks were required to keep 100 percent
reserves, then they would be reduced to providing checking deposit
services and brokering loans between the owners of the bank and
credit customers. Their ability to create checkbook money via the
deposit expansion process would be eliminated.
However, requiring banks to keep full reserves would not prevent
the re-emergence of the deposit expansion process. In the current
banking system, most deposits are created by the extension of
credit from the bank to a customer. If institutions called "banks"
are no longer permitted to conduct such transactions, then other
institutions will evolve to do it (Meiselman, 1983). The need for
credit is extensive in a capitalist economy. No government can
prevent two parties from agreeing to an exchange of credit. Nor
can government prevent the private sector from accepting paper
representations of such transactions as money. This is what the
deposit expansion process does: it creates a new IOU, a checking
account credit, which the private sector chooses voluntarily to
use as a means of exchange.
In addition to the problems detailed here, Jaikaran's book, Debt
Virus, also contains a plethora of other flaws. Jaikaran, a
self-described "monetary scientist," demonstrates on several occasions
that he does not know how some basic financial processes work. His
explanations of a currency devaluation, the process of issuing new
Treasury securities, and the market's pricing mechanism are each just
plain wrong. His mis-interpretation of the quantity theory of money is
comical. In many instances he injects his own subjective values into
his analysis, such as when he describes profits as immoral and
interest as usury. A scientist must be an objective, dispassionate
observer of his subject. Personal values have no place in scientific
analysis. Self-contradictions and non sequiturs abound. He also
demonstrates a lack of knowledge about basic accounting principles, a
fault which may seem trivial, but it is actually consequential because
much of the mistakes generated by the Debt Virus hypothesis arise due
to a lack of understanding on this point (accounting procedures may
seem like gimmickry, but if checkbook money is just an accounting
entry, then does it not make sense to understand accounting
principles?). His book is generally poorly documented, filled with
alleged interviews with unnamed mystery economists and government
officials. Apparently, much of his research was conducted by
exchanging anecdotes over dinner and lunch. He also displays what is
either a bizarre sense of history or an ineptitude for proof-reading.
In his first chapter he describes an economic collapse in France in
1790-1795 that "triggered the French Revolution" (p. 25). This is odd
because the French Revolution began in 1789. The Debt Virus is a good
example of how not to form and defend a thesis.
The Debt Virus hypothesis is wrong. Its error is due to its failure to
recognize how banks interact in the economy. The error was here shown
with a detailed T-account analysis of this interaction and was
demonstrated with two simple empirical tests of the predictions and
implications of the hypothesis. The first test examined the prediction
that deposits can grow only as much as new bank credit plus new
currency emissions. Data for six recent months showed that the
deposits in the banking system grew considerably more than what can be
accounted for by additional bank credit and new currency -- an
unmistakable contradiction of the Debt Virus hypothesis. The second
trial examined the prediction that the price level and interest rates
are positively correlated. To test this claim, I collected price level
and interest rate data from 1970 to 1995 and calculated a simple
correlation coefficient. The statistical and graphical results
demonstrated that no such correlation exists. The Debt Virus
hypothesis failed this test as well. Combined with flaws in logic, a
fundamental misunderstanding of how the financial system actually
works, and several contradictions in its body of thought, the Debt
Virus hypothesis must be rejected. Consequently, the recommendations
of Jaikaran, the Coalition to Reform Money, and Sovereignty are based
on fallacious arguments and should also be rejected.
Board of Governors of the Federal Reserve System. Federal Reserve
Bulletin. March 1996.
Coalition to Reform Money. "Making a Profit," Money Talk$, Volume II,
Dunbar, Charles F., "The Bank of Venice," Quarterly Journal of
Economics, Vol. 6 No. 3, April 1892.
Fisher, Irving. The Theory of Interest. New York: MacMillan, 1930.
Grier, Kevin. "Presidential Elections and Federal Reserve Policy."
Southern Economic Journal, October 1987.
Jaikaran, Jacques S. Debt Virus: A Compelling Solution to the World's
Debt Problems. Lakewood, Colorado: Glenbridge Publishing, 1995.
Makinen, Gail E. and G. Thomas Woodward. "The 'Sovereignty' Proposal:
An Appraisal." Congressional Research Service. Library of Congress,
No. 94-789E, Sept. 1994.
Money: Essays on Monetary Reform, eds. James Dorn and Anna Schwartz.
University of Chicago Press, 1983.
Salerno, Joseph T. "Gold Standards: True or False?" The Search For
Stable Money: Essays on Monetary Reform, eds. James Dorn and Anna
Schwartz. University of Chicago Press, 1983.
Seelig, Steven. "Rising Interest Rates and Cost-Push Inflation."
Journal of Finance, No. 4 Vol. 29, Sept 1974.
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