Economists and politicians get worked up about the peril of Public Sector Debt, but seem far less worried about Private Sector Debt. This is surprising, because Private Debt should be at least as dangerous. It seems subject to far less scrutiny, even though it is subject to constant selective pressure towards instability.
Here, I will argue that Private Debt and Banks provide the formal equivalent of a perfectly regressive tax system. The less money you have, the higher your rate of tax.
“Thin Air” Money
We know from Modern Monetary Theory (MMT) that Governments create money out of thin air. (Where else did the pound in your pocket originate?)
Governments next spend the money that they have created. I would argue that they “invest” it, either wisely or otherwise, and that taxes can be thought of as “dividends” on their investments.
MMT proponents sometimes argue that when Governments recoup as tax the thin air money they have created, they turn it back into thin air. In reality, as fast as a Government collects money as tax, it spends it again. There is effectively no cancelling out.
So why does the amount of money in the economy not increase endlessly? Quite simply, there are other processes that turn thin air money back into thin air. One of these is via Private Debt and the Banking System.
The role of banks
It is now recognised that, just like governments, banks can make loans with money they create out of thin air.
But wherever the money the bank lends comes from, there are three components to the repayment:
The loan itself is repaid. If the bank has created the loan with “thin air” money, it is indeed cancelled out – a closed system.
The interest on the loan, however, must have come from elsewhere. If bank lending is a closed system, it cannot have been created by the bank. It has to be money that was created earlier by the Government and was invested in the wider economy.
There are two components to bank interest. Part is the Bank’s profit, Government-created money comes out of the economy and (in theory) goes back into the wider economy.
However, part of the interest on the loan is “insurance” against the loan going bad. The “insurance” on loans that are successfully repaid is used to cover the cost to the bank of loans that default. It is regarded as natural that the worse the credit risk, the higher the “insurance” component of the interest.
This makes Private Sector Debt and the Banking System a potent driver of inequality. Banks cover the cost of bad loans by preferentially draining Government-created money from that part of the economy where there is least money to start with. Those with the least pay the most. The equivalent of a perfectly regressive tax system.
(In contrast, with Public Sector Debt, it is regarded as natural that when the Government “invests” in the economy and receives its “dividends” as tax, those best able to pay should pay a higher rate of tax. Potentially a progressive tax system.)
Question 1: Why are Governments criticised for creating more money than they collect as tax, when they may simply be replacing the money drained from the system by Private Sector Debt?
Question 2: Does the money lost to bad debt really disappear? If not, where is the money that vanished in 2008? My suggested explanation is that when banks lend to buy an asset, they increase competition for that asset and push up its price. This falsely increases the apparent security of the loan, which encourages more lending against that class of asset, while in reality increasing its risk. Worse, ”thin air” lending against an asset blurs the distinction between money and assets, turning money into a highly unstable form, which can appear or disappear at will. In a rational world, Private, rather than Public Sector Debt would be regarded as the menace.