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The Role of Debt in the Economic System

Andrew Schrader

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By Andrew Schrader, eHow Contributor

Debt in our current economic system is necessary for growth.

The American economic paradigm is based almost exclusively on debt-based financing--whether it be a person using a credit card that carries interest, a corporation borrowing money or capital, or the government borrowing money from the banking industry. Interest plays a major role in the debt-based economy, as do several factors that determine how debt and money are distributed, like fiat currency and the standards of a fractional reserve banking system. Debt is responsible for economic growth--if there were no debt, there would be no growth.

1. Fiat Currency

   • Until the 1970s, the world was still officially on the gold standard, meaning that money circulated was redeemable in a certain amount of gold. Once taken off the gold standard, the dollar became backed only by peoples' faith in the currency. A fiat system--where money is not backed by any physical commodity--allows for the infinite creation of money (in the United States and other countries this is determined usually by a central bank, like the Federal Reserve). This increases public and private debt as more money is printed.

   Fractional Reserve Banking

   • For every dollar a bank accounts for, it is able to loan out $0.90 on additional loans. (Banks must hold 10 percent of money accrued, leaving 90 percent to loan out.) If a bank loans out $0.90, for instance, and that money is put into another account, the bank can then claim an additional $0.90 in their books, and loan out 90 percent at interest. This process can continue into infinity, creating economic expansion at the expense of creating more debt.

   The Federal Reserve

   • The Federal Reserve (or Fed), created in 1913, loans money to banks and the U.S. government at interest to maintain a stable economic system. It regulates the reserve requirements of the banking industry, determining the percentage of money banks must hold to make loans on. The Fed prints money as needed to promote liquidity and economic expansion; however, in creating more money, it creates more debt (at interest). The Fed is the chief supplier of money and debt in the current economic system.

   Interest

   • When loans are made--either by the Fed to banks or by banks to consumers--there is an attached interest rate. The interest demanded on loans increases the amount of economic debt, as well as the overall money supply. In other words, the interest on loans creates more money out of money that was originally created without the backing of any physical commodity. Interest, along with fiat currency and fractional reserve banking, creates money out of nothing.

   Warning

   • Inflation is the chief concern among those who worry about the state of debt in the economic system. Critics of the economic system, like Congressman Ron Paul, state that inflation is a hidden tax on the public, as it corrodes the value of money. Essentially, when money is printed at will, it lessens the value of money already in circulation--causing price increases on consumer goods and "bubbles" in markets (where commodity prices are overvalued). Inflationary pressures also cause the Federal Reserve to heighten interest rates to curb demand for loans; this, in turn, causes declines in economic growth.

References

• Kwaves: Overview of Fiat Money
• Lew Rockwell: Fractional Reserve Banking
• "Secrets of the Temple: How the Federal Reserve Runs the Country"; William Greider; 1987

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