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I've just read Money Creation in the Modern Economy, an article published by the Bank of England.

This article brings about a lot of questions in my mind. This article talks about money being created through commercial bank loans, and that central banks only have the authority to set interest rates or to employ quantitative easing in order to stimulate the economy. Loans being repaid should theoretically destroy the money that was created and balance the books, but inflation grows in that economy as banks earn interest (and in this case, the interest is actually the money that never existed, assuming that they destroy the rest of the money paid back).

So, my questions is:

How is this fair for every other constituent in the economy who has earned money the hard way, by working and not by generating it so freely like interest returns on loans do for commercial banks?

How is inflation fair, as populations increase and every time someone gets a bank loan, new money is added to the economy over time as they pay back that loan, and everyone else's currency is de-valuated?

Consider country X which has one constituent named Roger who works at a commercial bank in X and, coincidentally is also the president of X. He gets a loan from his bank for 100 dollars (with an interest rate of 5%), however, in his economy, only 100 dollars of money exists as actual currency and he has 0 dollars in his bank account. He will never be able to pay off his interest rate of 5% without getting another loan. His bank or state will coincidentally not be able to pay him his wage over time without printing new money from a central bank or giving his bank a loan, or, perhaps a bail-out. All this interest will do is inflate the economy, and you can only fight interest with interest.

Now apply this concept to our current economic system on a macro level, and it feels to me like it will ultimately fail as a system, because inflation can only combat inflation for so long until the price of every asset reaches infinity.

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    $\begingroup$ There's nothing silly, or fair, about someone taking out a fresh loan and devaluating everyone else's existing currency in my opinion. I've updated my question a bit. $\endgroup$ – Alexandru Jun 2 '15 at 22:08
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    $\begingroup$ I agree with @FooBar here. I'd also say there are some pretty solid misunderstandings about inflation and monetary policy in general. When you get a better background in this stuff, you might be able to ask this question in a clearer way. $\endgroup$ – Jamzy Jul 29 '15 at 0:26
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    $\begingroup$ @Jamzy I'm not a conspiracy theorist, but commercial banking is a global epidemic. No offense, but maybe its time to take a step back and reevaluate the society you have been born a part of, especially if you can't understand the clarity of my question? $\endgroup$ – Alexandru Jul 29 '15 at 1:04
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    $\begingroup$ I'm not alone in finding this question unclear. It also looks like I have voted up this question. I guess because I thought it was nearly a good question and a close vote is easy to undo but a down vote can linger. I would however suggest that you have a better understanding of fractional reserve banking and monetary policy before condemning it. The intuition is pretty tough but in the end there are at least some key advantages it offers and disastrous consequences if it's eliminated. $\endgroup$ – Jamzy Jul 29 '15 at 1:13
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    $\begingroup$ @denesp Well, I have a few views on what's not fair about the current model. For one, it creates rapid inflation that is perceived to be temporary as people pay debts back, but realistically this is exponentially going to keep growing, and it happens very quickly and all at once. Secondly, because of double entry book keeping, this loaned money is temporarily created until paid back (it literally comes from nowhere - a liability on the bank's account as you would). Third, the prime rate is money that is purely inflationary that banks get to earn and keep - why should anyone have this power? $\endgroup$ – Alexandru Jul 29 '15 at 12:12
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The description you're providing of how interest works is based on a couple of fairly common misunderstandings about how the system actually works, so lets clear that up first.

Fractional reserve banking and the gold smith banking systems preceding it, are a result of the development of an accounting technology called double entry book keeping in the 13th century.

Double entry book keeping grossly simplified. Each transaction must consist of a debit and a credit tuple, occurring in two separate books. Asset books are traditionally written on the left, and liability and equity on the right. On the right hand side (liability and equity side), credit adds, debit subtracts, and its the opposite on the left hand side, debit adds, credit subtracts. Just remember the right hand side is what you think it should be, the left hand side is the opposite.

When a bank makes a loan, it performs the book keeping operation:

[debit loan, credit customer account]. 

This creates the loan, and it creates money in the form of the matching deposit. When loan capital is repaid, the operation is:

[credit loan, debit customer account] 

and this removes the deposit money that was created.

So how does interest get paid? Well in your example, Roger gets a loan for 100, lets say it's a 10 month, simple interest loan (easier math.)

The first month, Roger repays 10 capital, and 5 in interest. That's:

[credit loan 10,        debit Roger account 10]     

[                       debit Roger account 5, 
                        credit bank interest income account 5] 

The bank's interest income account is also classified as a liability, although not strictly as a deposit account. Once the bank has recognised that income, it can then use it to pay expenses. Let's assume Roger works for the bank, and the Bank pays Roger a monthly salary of 5. That just reverses the operation above, ie.

[                       debit bank interest income account 5, 
                        credit Roger account]

The next month, Roger pays another 10 in capital, and pays 5 interest, and gets the interest back in salary. This continues until the loan is repaid.

The key concept is that in an economy, money is exchanged and individual units of money are constantly circulating through the economy and being re-used, as in the example above. It's a flow system essentially, and this applies to interest payments just as much as payments for food, etc.

Money in a fractional reserve monetary system today also predominantly takes the form of liability bank accounts, rather than physical currency, and most banking operations these days operate as transfers from bank account to account. The writers who concentrate on physical currency in describing this system seem to miss this point, and consequently get key points incorrect.

This doesn't mean that there isn't a very challenging accompanying inflation problem. Generally over time, banking systems tend to create more new loans at a slightly higher rate than they are repaid, and so the system is in a more or less continuous state of growth. There's no reason why it couldn't be regulated to be stable - but the problem is nobody at this time knows what that would do to the economy. The best guess at the moment is that a low but positive rate of expansion is optimal.

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  • $\begingroup$ How does this concept apply to, say, when you deposit cash into your bank account? You have 100 in cash, you give it to the bank, they debit your account for 100. That's twice as much money in circulation at this time. However, at this point in time, the bank has 100 in cash and you have 100 in your bank account. Is the money deposited their liability? What is the money they hold? What do they do with this cash? $\endgroup$ – Alexandru Jun 4 '15 at 2:10
  • $\begingroup$ They actually credit your account with 100, they debit their cash account (asset), and stick the cash in their vault. That money is now no longer part of the active money supply, but it gets used when transfers occur between banks. If you put this up as a new question, I'll go through the double entry book keeping. You can find a fairly good description in this paper: cosmosandtaxis.files.wordpress.com/2015/03/… $\endgroup$ – Lumi Jun 4 '15 at 11:43
  • $\begingroup$ You touched on a great point, that banking systems tend to create more new loans at a slightly higher rate than they are repaid, which, despite efforts of central banks to regulate inflation by setting interest rates (permanent inflation/growth), inflation will still happen as commercial banks create new loans (temporary inflation/growth). This inflation is only seen as temporary by most, because the books need to be balanced, but populations will increase (in some countries faster than others) and banks will have to create more and more new loans, so at any given snapshot of time... $\endgroup$ – Alexandru Jun 4 '15 at 14:45
  • $\begingroup$ ...I feel like the temporary growth will vastly outnumber the permanent growth, which causes effective inflation to occur much faster and faster over time until the system becomes un-affordable without increasingly greater and greater debt, which I think is a scary thought. $\endgroup$ – Alexandru Jun 4 '15 at 14:47
  • $\begingroup$ As long as the quantity of money is increasing at the same time (which standard FRB guarantees) if you think about it, then the system is in some sense just running to stand still. (Not saying there aren't issues with inflation, just that the growth issue isn't one of them). However, if you want an example of something that causes banks to create more loans than money, have a look at loan securitization. $\endgroup$ – Lumi Jun 4 '15 at 15:15

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