It seems my pea brain is incapable of grasping the world of finance... Maybe you can help me underst

The problem I'm having trouble with is really quite simple. A model economy illustrates the point very clearly:

As I understand it, money is fed into our economy by the Federal Reserve making loans to the government and to banks.

With that system as our guide, consider this tale of lending a helpful hand:

Mr. Shrub is considered wealthy. Mr. Bia is not - but he's ready for his day in the sun. Mr. Shrub proposes that they set up a little economy so Mr. Bia can come up.

Mr. Shrub will loan Mr. Bia $100 at 20% APR for 1 year. So, Mr. Bia will pay Mr. Shrub $10/mo. for 1 year, for a total of $120 paid to Mr. Shrub by the end of year/loan.

Now this concept of dollars is new to the area. Mr. Shrub issues Mr. Bia these paper "dollars" which are easier to handle than coins. People in the area accept this cause they know Mr. Shrub will back up the "dollars" value should the need ever come up. The question of "With what?" will he back up those dollars with is skillfully evaded.

So Mr. Bia takes the dollars and buys some stuff for $2 and sells it for $3. Well eventually, they guy will pay him next week (cause the guy doesn't have any "dollars" yet - some guy is gonna buy his goat for $5 on Tuesday - at which point he'll be able to pay Mr. Bia)

And so our little economy goes. Each month, Mr. Bia goes to Mr. Shrub and pays him $10 and everyone is happy. Come October, people are so carefree anymore. Mr. Bia mopes up to Mr. Shrub and hands him his $10... "Only two months to go!" Mr. Shrub comments. Mr. Bia says nothing and mopes away.

Here's the issue: for the last few months, Mr. Bia has had a hard time making ANY money, much less his loan payment. Mr. Bia just figures everyone is saving up for winter. The truth of the matter is that it is PHYSICALLY IMPOSSIBLE for Mr. Bia to pay back the loan. Think about it. $100 was put into the system - $100 is all that's can come out - not $120. And this translates over to our economic system in the USA ...and the world for that matter.

Because the amount of money in the system is equivalent to the principal amount loaned, even if the principal amount was paid back, at that point, there would be no money left in the system with which to pay the interest. Which is exactly where Mr. Bia is. He has paid back Mr. Shrub for 10 months i.e. $100. He can't make any money because THERE IS NO MONEY. Just like in the USA. If people and banks hoard cash, there's none in the system to pay the loans prematurely. Forget about the fact that there ISN'T enough cash - BY DEFINITION - to pay the interest on the loans.

So, do I have this correct? as far as I can tell, it is physically impossible for our economic system to work. yeah?

Kind of, but there are plenty of other people borrowing from Shrub who Bia could have made a profit off of.
But in the end, someone, or a lot of people, do get screwed.

it is physically impossible for our economic system to work. yeah?

Certainly it can work. The loan is never paid off. It is refinanced. Mr. Shrub continually produces more money and continually lends it Mr. Bia. Thus, the total amount of money in the system, as well as the total amount of debt, continually increases. Yes, the amount of the debt will always be greater than the total amount of money. Yes, because the number of dollars continually increases, the relative value of those dollars tends to decrease over time.

The system works so long as Mr. Bia continues to lend money, never attempts to collect on collateral, and as long as the people in the system are willing to start ignoring zeros on their currency.

The system works, but it does have a few problems. In particular, if Mr. Shrub stops issuing new currency, the entire thing collapses. Mr. Shrub may then attempt to collect collateral. If Mr. Shrub is unscrupulous (for example, if this was his intent the entire time) he can choose to manipulate the money to deliberately take ownership of everything purchased on credit for which there is no longer currency available to pay for. Or he may simply cut the money supply to freeze commerce altogther. Remember, Mr. Shrub created and in a sense "owns" those dollars even when they're not in his possession. It's understood that they will return to him, and presumably be destroyed by him. (Though in a fiat system like this one, the destruction of currency isn't especially important, since nobody can use currency to redeem anything of value from the issuer. In a backed currency system, it's in the interest of the currency issuer to destroy currency, since anyone can use it to redeem whatever is being used to back the currency.)

Finally, even if Mr. Shrub is well intentioned, if interest is being charged on the loan principal (all money), the collective effect of interest over time will eventually cause the rate of currency devaluation to be extremely problematic. Let's say there are 100 dollars, a loaf of bread costs one dollar. That's fine. Now let's say that ten years year later there are 200 dollars, and a loaf of bread costs two dollars. One dollar is worth "half" what it was ten years ago, but there still isn't any problem. A loaf of bread can cost a billion dollars and that's fine, so long as there's enough liquid currency in the system. However...it takes time for the market to adapt to change. Ten years is plenty of time for storekeepers and wage payers to adjust their numbers to accomodate the devaluation of the currency. However...as interest starts being charged on interest over time, the rate of the currency devaluation accelerates. 50% over ten years is probably fine, but if currency devaluates 50% in the time it takes you to walk from the bank to the grocery store, again the system falls apart.

...

So yes, there are problems with the system. Personally I suspect these problems are by design. Mr. Shrub deliberately chose to do things this way in order to effect a controlled collapse in order to take control of collateral in the forms such as land, and businesses. Mr. Bia presumably didn't understand this, and fell for it.

While it's a fine point...I would say that the 'fiat' nature of the system is not a problem. Money being irredeemable for anything such as gold is fine. The system is based on trust, and the perception of value, but fundamentally, if you ask me, that's not all that different from a system backed, for example, by gold. Gold, like paper currency, is mostly only valuable because people think it has value. If nobody was willing to accept your gold in exchange for things you wanted, it wouldn't be worth anything either.

The real problem is the interest. That's what causes the system to self destruct. If we simply printed paper money and put it into circulation without anything backing it, and without any interest, these problems would be greatly diminished.

[edit on 21-10-2008 by LordBucket]

That is a pretty good example. However, the "genius" of the agreement is that Mr. Shrub knows he will never be paid back and in fact, does not want to be. What Mr. Shrub wants is to have leverage or control over Mr. Bia due to Mr. Bia's' inability to pay back his loan.

This control mechanism continues on and on with Mr. Shrub continuing to grant additional loans to Mr. Bia to keep him solvent. When Mr. Bia eventually dies, his debt obligation falls onto his children, thus allowing Mr. Shrub to control yet another generation of Bias. As more and more money is loaned into the small economy it becomes worth less thus whereas Mr. Bia senior was able to buy/sell a goat for $5, Mr. Bia Jr. will have to pay/receive $10 for that same goat.

Essentially, this process continues until Mr. Shrub, who by the way is for all intensive purposes immortal, decides he no longer wishes to control future generations of Bias or some future generation of Bias decide they will no longer tolerate this control and destroy Mr. Shrub. Mr. Shrub will never decide he no longer wishes to have leverage over the Bias because how else will he get to live in his ivory tower. Mr. Bia IV will most likely never decide to destroy Mr. Shrub because if he does, the money lent to him by Mr. Shrub will be essentially worthless and he will have to resort to the barter system to get what he wants/needs.

There are two ways Mr. Bia can destroy Mr. Shrub. He can physically set fire to Mr. Shrub's home with Mr. Shrub in it, which would be bad because Mr. Shrub has built a laser defense system which can vaporize anyone who attempt to set fire to Mr. Shrub's home. Or, Mr. Bia can use his brain instead of his brawn. Mr. Bia can attempt to turn in the paper Mr. Shrub issued him in return for some goods of actual value. When Mr. Shrub is unable to produce these goods Mr. Bia can prove that the paper never had any real value in the first place thus destroying Mr. Shrubs ability to make any further loans and exert control on future generations of Bias. However, again, does Mr. Bia really want to accept the consequences of destroying Mr. Shrub???

[edit on 21-10-2008 by BluegrassRevolutionary]

Originally posted by LordBucket

The system works so long as Mr. Bia continues to lend money, never attempts to collect on collateral, and as long as the people in the system are willing to start ignoring zeros on their currency.

This is what I'm talkin about - that doesn't seem like a sustainable system? Although, we've adapted to using the word "trillion" pretty quickly.

charged on interest over time, the rate of the currency devaluation accelerates. 50% over ten years is probably fine, but if currency devaluates 50% in the time it takes you to walk from the bank to the grocery store, again the system falls apart.

I can't prove it, but it seems like this is inevitable. doesn't the interest ultimately always increase like a compounding interest balance?

The real problem is the interest. That's what causes the system to self destruct. If we simply printed paper money and put it into circulation without anything backing it, and without any interest, these problems would be greatly diminished.

Agreed. I think as a precursor to the interest free currency initiation, we should just 0 everything out and start over. Cause really, anybody who is holding the trillions upon trillions of debt the gov't has, (not to mention private sector banks etc. - yes, I'm implying China) will still have the necessary infrastructure to continue to profit without the regular interest payments the US is coughing up each year.