Debunking the Federal Reserve
Conspiracy Theories (and other financial myths)

by Edward Flaherty
(last updated September 6, 2000)



Myth #11: The Antidote to the Debt Virus
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 deposits.

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 principaland 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 enjoyable.

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 withoutany debt being created to burden the non-bank public -- debt-free money, to use Jaikaran's terminology.  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 government bonds.

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, totaled $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 other ways of obtaining money.  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 totaled $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 or borrowing, then the M1 money supply would more than double in a year.  The annual inflation rate would hit at least 100 percent within two years!

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 on some people.  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 otherwise be inert.  But instead of directing their efforts toward real social, economic, and political problems,they tilt windmills.  What a waste.
 


Reference:

Jaikaran, Jacques. Debt Virus: A Compelling Solution to the World's Debt Problems, Lakewood, Co.: Glenbridge Publishing.
 


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