Some writers claim that interest due
on bank loans is a time bomb. They argue that bank loans provide only enough
money for borrowers to pay off the loans and none to pay the interest due. That
means additional borrowing is required just to cover the interest on previous
loans. The public’s debt to banks must therefore be compounding at the average
interest rate on loans. The popular name for this hypothesis is the debt virus.
The debt virus hypothesis is based on
a very incomplete model of money flows between the banking system and the
non-bank public. In reality, money flows in both directions in about
equal amounts. Deposits lost when interest is paid on bank loans reappear
as deposits somewhere else in the banking system. They are
created directly or indirectly as a result of bank spending.
alternative but equivalent way of stating the debt virus hypothesis is as
follows: Assume bank loans are all rolled over but no new loans are
made. Interest payments on existing loans would end up completely
draining the money supply. We will focus on the alternative case because it is easier to
understand. In either case the economy would crash.
Interest payments on existing bank loans
would result in a reduction in bank deposit liabilities, and thus free up reserves.
The question to be considered then is what would banks do
with the freed-up reserves. A
bank can use the excess reserves to (1) pay for its operating costs,
(2) pay dividends, (3) buy securities as investments, (4) buy
deposits at other banks, or (5) hold the excess reserves to earn
whatever interest the central bank pays on them.
should be obvious that options 1 and 2 create new bank deposits dollar
for dollar, and thus do not drain the money supply, defined as total
deposits plus currency in circulation. Option 3 does the same, although
in some cases
indirectly. For example, suppose a bank uses its excess reserves
to buy securities directly from the Treasury. It pays by crediting the
Trreasury's account at the bank with a new deposit. (For simplicity,we
assume the Treasury has an account at the bank.) Then how does the
purchase of Treasury securities result
in new deposits for the public?
answer is through government
spending. When government spending exceeds tax revenues, the deficit is
by the sale of securities to the public. The spending itself creates
deposits equal to the value of the securities sold. Thus when the
buys new Treasury securities with its interest earnings, equal
deposits must have been created somewhere in the banking system. It is evident
then that option 3 represents no net drain on the money supply.
If the bank uses the excess reserves to buy deposits at another bank as
in option 4, the receiving bank would then have acquired excess reserves.
It may hold a portion, but would generally use them as in
options 1, 2, or 3. Thus any loss in deposits from option 4 would be
small and self-limiting. Option 5 would indeed drain deposits dollar for dollar
but would be self-limiting because banks can normally earn
more from buying securities than they earn from interest on reserves.
It is clear that banks return nearly all of their earnings to the
public one way or another, thus any drain on deposits is small and
limited. But the debt virus hypothesis asserts that without additonal
bank lending, the interest paid on existing loans would drain the
entire money supply.
Obviously that is not true, so the hypothesis is false.