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Edition 02: 18 November, 2010.

Edition 04 : 08 August, 2011.

Revised edition 05 : 22 August, 2011.

Edition 08 : 09 February, 2013.




Information on monetary reform :


Summaries of monetary reform papers by L.F. Manning published at


NEW Capital is debt.


NEW Comments on the IMF (Benes and Kumhof) paper “The Chicago Plan Revisited”.


DNA of the debt-based economy.

General summary of all papers published.(Revised edition).

How to create stable financial systems in four complementary steps. (Revised edition).

How to introduce an e-money financed virtual minimum wage system in New Zealand. (Revised edition) .

How to introduce a guaranteed minimum income in New Zealand. (Revised edition).

Interest-bearing debt system and its economic impacts. (Revised edition).

Manifesto of 95 principles of the debt-based economy.

The Manning plan for permanent debt reduction in the national economy.

Missing links between growth, saving, deposits and GDP.

Savings Myth. (Revised edition).

Unified text of the manifesto of the debt-based economy.

Using a foreign transactions surcharge (FTS) to manage the exchange rate.


(The following items have not been revised. They show the historic development of the work. )


Financial system mechanics explained for the first time. “The Ripple Starts Here.”

Short summary of the paper The Ripple Starts Here.

Financial system mechanics: Power-point presentation. 





By Lowell Manning:   Revised version 5 dated 14 August, 2011.


Sustento Institute  Christchurch


We are almost blind when the metrics on which action is based are ill-designed or when they are not well understood 01 .


01  Stiglitz et al 2009 p9.


Key Words:  accumulated current account deficit, CPI, current account deficit, debt, debt model, debt growth, deposit interest, domestic credit, exponential debt growth, Fisher equation, inflation, national accounts, revised Fisher Equation, structural debt growth, systemic debt growth, systemic inflation, unearned income.






01.        INTRODUCTION.                                                                                                                         


02.        The DEBT PROBLEM.                                                                                                                


03.        The simple economy.                                                                                                           


04.        The unsustainable economy.                                                                                       


05.        The unsustainable economy with foreign debt.             


06.        The debt model.                                                                                                                     


07.        Systemic Inflation AND INFLATION POLICY.                                            


08.        THE DEBT EXPLOSION AND FINANCIAL STABILITY.                                     


09.        CULTURE AND INSTITUTIONS.                                                                              


10.        CONCLUSIONS.                                                                                                                            


11.        BIBLIOGRAPHY.





This paper shows how debt evolves in the interest-bearing debt-based financial system and why debt growth is exponential.  It analyses the fundamental mechanisms of debt growth and provides a sound theoretical base to support the analysis. The theoretical foundation is a revised form of the Fisher Equation of Exchange that, for the first time, takes the structural effects of interest bearing debt on the financial system into account.


Some earlier work [such as Snyder, (1940); Danks/Social Credit (1955); Friedman, (1962)]  may at a superficial first glance appear to have some common grounds with the analyses set out in this paper. This is not so. The only common ground of this paper with the cited works is that it supports a quantitative approach to the supply of money and credit in the economy.  With some exceptions, mostly relating to war and economic crises, the world’s money supply has always been based on the quantity of money rather than the price of money. 


The change to a price-based monetary system accelerated after US President Nixon abandoned the US$ gold peg in 1971. Since then, deregulation of the monetary and banking sectors, increased globalization and unrestrained capital flows have produced a system almost entirely dependent on the price of money.


This paper shows how the price of money paid as interest on deposits in the banking system produces a pool of unearned income that causes self-reinforcing exponential debt growth.


The price-based financial system has not prevented economic growth around the world, but that growth has come at incalculable human and environmental cost. It has led to economic, political and environmental instability and a widening gap between rich countries and poor countries as well as between rich and poor within countries. 


The figures given in the paper are preliminary. They suggest that price-based debt expansion in developed economies is gradually becoming unstable.  The gross cost of paying interest on the pool of unearned income Ms  is about twice the systemic inflation in the economy. Were it not for taxation on interest, New Zealand’s economy could now be in a structural deflationary spiral because it would be unable to afford the deposit interest. This could lead to a collapse of the banking system.


The immediate effects of crises like the current one in New Zealand are large-scale loss of “savings “ (S in the debt model)  and equity, reduced incomes and purchasing power in the productive economy  with associated job losses, growing income inequality and a declining quality of life.


The paper shows that the current price-based financial system based on interest bearing debt is self-destructive. It will destroy the global economy unless it is changed. The world must return to a financial system based on quantitative principles that remove or at least reduce to a minimum the growth of unearned income that is causing the unsustainable debt growth.





Recent financial crises around the world, beginning in the United States in 2007 02 , appear to have reinforced the widely held view among economists, governments and regulatory authorities that the world’s financial problems are related to excess debt.  Some say the excess debt arises from large fiscal deficits as in the Baltic States, Greece, Ireland and elsewhere. Others say it arises from housing or other bubbles generated from poor lending and borrowing practices, low borrowing costs, inadequate financial regulation or the rapid growth of “off balance-sheet” derivatives within the financial sector.  Nearly everyone from the Governor of the US Federal Reserve and the heads of the International Financial Institutions down to university economists now agree excessive debt growth needs to be restrained.


In recent decades, thousands of learned papers and articles have been written about the phenomenon of rapidly expanding debt but little work has been done on debt growth from a structural or systemic point of view. Credit expansion has long been seen as a function of the demand for new credit moderated predominantly by its price, the risk perception of the borrower by the lender, the reserves financial institutions have to hold to manage their lending risks and, in some cases, deposit withdrawals. 


There is now overwhelming evidence to suggest the existing debt management system is dysfunctional. The best efforts of the world’s monetary authorities have failed to prevent excessive debt growth. Debt levels have continued to expand much faster than measured nominal economic output despite periods of turmoil in the world economy, high or low interest rates, widespread changes in financial regulation and even bank bailouts. This suggests a more fundamental cause of debt growth exists outside the present financial architecture that has either been taken for granted or overlooked by existing economic theory and practice.


This paper will explore the underlying causes of rapid debt growth and what can be done to prevent excessive debt growth in the future. Later papers will examine other initiatives that might then be taken to improve New Zealand’s economic position. 


Section 2 of the paper proposes that debt growth in modern debt-based economies is predominantly caused by the generation of unearned income in the form of interest paid on bank deposits 03.  Modern developed countries operate on a debt-based financial system whereby nearly all deposits arise from borrowing debt at interest through the banking system.  The paper shows how unearned income arising from the payment of interest on deposits causes exponential debt expansion 04. 


02  Arguably Northern Rock in the UK was the first collapse but it was caused by US toxic assets.

03  Earned income is the income generated from the production of goods and services that form part of the Gross Domestic Product (GDP). Unearned income is income arising from the payment of interest on bank deposits that is unproductive and does not add to GDP.

04  The decision whether to save or invest unearned income depends on the real interest rate (the difference between the interest rate paid and inflation) and the perceived risk weighted financial returns available in the investment sector. If real interest rates are very low, as in Japan, savings may be invested off-shore as happens with the so-called “carry” trade.


To test the unearned income hypothesis, Section 3 models a simple economy.  Figure 1 in Section 3 shows how that simple economy can function properly and still fully satisfy the requirements of the international System of National Accounts (SNA) without debt expansion beyond the needs of the productive economy.


Section 4 examines the economic transformation that occurs when deposit interest is introduced into the simple economy model shown in Figure 1.  In Figure 2, deposit interest in the form of unearned income introduces inflation into the model and also stimulates debt growth, thereby proving the basic hypothesis linking deposit interest to debt growth.  Equations are provided to show the debt growth is exponential. The analysis of Figure 2 shows that debt expansion and inflation are both readily quantifiable, and it demonstrates why, in practice, almost all price is inflation 05.  Figure 2 shows how the pool of unearned income arises incrementally from payment of interest on bank deposits but, in aggregate, remains outside it. The increment of unearned income from each production cycle is permanently transferred to the investment sector while the debt giving rise to it remains a burden on the productive sector.


Section 5 describes what happens when a country such as New Zealand runs persistent current account deficits, resulting in the loss of economic sovereignty under existing financial policy. This is shown in Figure 4.  Section 5 also discusses the circulating transaction deposits (My) and their speed of circulation (Vy) in some detail.  My* Vy equals the Gross Domestic Product GPD(d).


Having proven the main thesis about debt growth, theoretical support for it is offered in Section 6 by introducing a new debt model that has been derived from Irving Fisher’s well-known Equation of Exchange that dates back to 1912 (Fisher, 1912, Manning, 2009). The revised Fisher Equation supersedes the original Fisher Equation of Exchange because it takes into account the growth of an independent investment sector based on unearned deposit income 06. My* Vy mirrors MV in Fisher’s original equation, which didn’t take into account the effect of interest-bearing debt. The paper shows how debt interest is compounded exponentially.


05  The simple economy of Figure 1 has very little if any inflation while in the economy shown in Figure 2  inflation  in the productive economy is linked directly to the deposit interest rate.  Figure 3 shows how total inflation has accelerated as developed economies have become more and more dependent on interest-bearing debt. This paper proposes that nearly all the inflation shown in Figure 3 arises from unearned deposit interest so that in practice all price arises from inflation.

06  Quite the opposite of previous work (such as Snyder, 1940) whose early support for monetarism was based on empirical statistical analysis.


In the following Section 7, an entirely new concept of systemic inflation is discussed in some detail.  In the debt model annual systemic inflation is roughly 0.5*(M3 minus repos)* I*K caused by the interest rate I% paid on deposit interest and K is (1 – the tax rate T paid on the gross deposit interest). The study shows there is no mechanism within the existing debt-based financial system to directly manage inflation and that orthodox interest rate policy works through the debt servicing requirements of the investment sector. It establishes two primary concepts:


-Individually it is possible to save debt-free money but in aggregate, it appears difficult, if not impossible, to save earned income generated from debt.  Conceptually, from Figures 2 and 4, non-productive “saving” in the debt system reduces the money available for consumption, resulting in either a fall in prices or a fall in consumption. In practice consumption usually falls much faster than prices because incomes are “sticky” 07. Earned savings 08  therefore tend to produce a loss of consumption capacity from the productive economy unless they are replaced by net non-income capital borrowing and consumer debt 09, Db  in the revised Fisher Equation of Exchange.


- Inflation in the existing debt system is systemic and unavoidable. Orthodox interest rate policy only briefly suppresses systemic inflation at great economic cost to the real productive economy and the wider community.


Section 8 sets out the historical debt growth in New Zealand along with another new concept, the incentive to invest. In aggregate, the pool of unearned deposit interest stays in the investment sector. The debt giving rise to it remains with and is serviced by the productive sector. The incentive to invest is defined as the growth of the investment pool Ms over and above the interest needed to service it expressed as a percentage of GDP, minus SNA price inflation  as it is represented by systemic inflation 10.



Instead of being used for consumption where it would cause rampant inflation as it is represented by systemic inflation .


Section 9 contains a brief review of the way culture and institutions have contributed to the lack of awareness of the issues addressed in this paper.


The overall conclusions from the paper are that unearned income in the form of deposit interest is the direct cause of the problem of excessive debt, and that consequently, debt growth and its accompanying systemic inflation can only be managed effectively by greatly reducing and preferably removing the payment of interest on bank deposits.


Section 8 sets out the historical debt growth in New Zealand along with another new concept, the incentive to invest. In aggregate, the pool of unearned deposit interest stays in the investment sector. The debt giving rise to it remains with and is serviced by the productive sector. The incentive to invest is defined as the growth of the investment pool Ms over and above the interest needed to service it expressed as a percentage of GDP, minus SNA price inflation . 10


Section 9 contains a brief review of the way culture and institutions have contributed to the lack of awareness of the issues addressed in this paper. Historically, New Zealand “had” its 2008 financial collapse after October 1987, albeit without the added complications of a large “shadow” derivative economy. New Zealand (and Australia) avoided the 2008-2010 problems suffered by the United States because the lessons from 1987 ensured that the investment bubble based on direct excessive speculative borrowing was readily manageable 11. 


The overall conclusions from the paper are that unearned income in the form of deposit interest is the direct cause of the problem of excessive debt, and that consequently, debt growth and its accompanying systemic inflation can only be managed effectively by greatly reducing and preferably removing the payment of interest on bank deposits. In the absence of multilateral agreements 12 to reduce or eliminate deposit interest, unilateral action is feasible 13 but it requires carefully constructed financial instruments to manage cross border capital flows 14.


07  “Sticky” is the term used in economics to describe resistance to downward pressure on variables like incomes and prices. For example, wages are “sticky” because it is very difficult in many countries to lower them once they have been increased.

08  Not to be confused with savings arising from UNEARNED income referred to above.

09  As happened in the United States where until recently consumption was maintained by growing household and consumer debt until consumers became debt-saturated and could no longer meet their debt-servicing obligations as discussed briefly in section 4 of this paper.

10  See Figure 11. The incentive to invest is (M3 minus repos)*I*K/GDP(d) – Inflation% where I is the interest rate on deposits and K is (1-the tax rate on interest). When I =0 there would be little incentive to invest other than human nature. Man has always “saved for a rainy day” and that would continue. When I is close to zero there will be little or no inflation.

11  There was arguably a housing bubble but that arose directly from the mechanics of the debt system as described in this paper and not from speculative debt (see paper section 6 and Db in the debt model)

12  For example, through the Bank for International Settlements, the International Monetary Fund and the World Bank.

13  As will be shown in Papers 2, 3 and 4 of this series.

14  The situation is different for different countries. Japan has near zero deposit interest but can sustain capital outflows (such as Uridashi and similar offshore investments) because it has a large current account surplus. Countries like New Zealand with large current account deficits cannot sustain such outflows. They must therefore apply appropriate measures to maintain their current account balance and manage capital flows.





The interest-bearing debt financial system in use all over the world today evolved from the fear King William III of England had in 1694 for the wrath of his subjects were he to increase their taxes to pay for his wars in Europe.  Afraid of a political backlash and bereft of the will to responsibly address his financial difficulties, King William borrowed from a group of wealthy citizens. In doing so, he put off the day of reckoning by pledging future taxes in perpetuity to fund his debt. Future taxes had to be pledged because previous experience had taught lenders the Crown was not fully creditworthy 15. The lending arrangements were written into law in the Tonnage Act of 1694. By that means “modern” banking was born in the form of the Bank of England. Since then, debt expansion has gradually accelerated, more recently aided by increased automation within the banking sector and on-going financial deregulation.  The point has now also been reached where the role cash transactions play in generating measured economic activity has all but been eliminated in the developed western economies. That has happened despite the fact that cash, being debt free and interest free, provides a continuous and costless means of exchange as long as it is in circulation. Instead, cash has progressively been replaced by expensive interest-bearing debt created for profit by the commercial banking system 16.  In most developed countries, cash makes up  3% or less of the broad money supply, and much of that circulates outside the productive economy 17. Unlike the famous greenbacks printed and spent into circulation by the United States government during the US Civil War (1861-1865), banks in modern debt-based economies buy cash from the Central Bank. The banks pay for the cash by issuing a cheque against their own internal accounts 18.  The use of cash as legal tender is limited to public demand for it, and it is in the banks’ interest that as little cash as possible is in circulation. Less cash means more bank debt and more profit for the banks.


15  The previous King, James II, defaulted on his debt ruining many of those who had lent him money.

16  The elimination of cash is quite recent. In New Zealand in 1978, for instance, up to half of all economic activity may still have been cash.

17  In the “black” unmeasured economy for example, such as drugs, gambling and other illicit activities. In New Zealand, as of November 2009 there was NZ$ 3.37 billion of notes and coin in circulation while the broad money supply M3 was NZ$ 210.7 billion, so cash made up just 1.6%  [Source Reserve Bank of New Zealand Table hc 1].

18  The central bank/treasury makes a profit from selling notes and coins that cost much less than their face value to produce.  The profit is called seigniorage.


Many trillions of dollars of interest-bearing debt are now being added to the world’s economies every year. It is now widely acknowledged such rapid debt growth is unsustainable because debt costs are absorbing a disproportionate and growing share of earned incomes. The existing monetary authorities have proved incapable of managing debt growth short of financial collapses such as the one that occurred during the recent worldwide crisis that began in 2007. Logically, if the present financial system is unable to cope with excessive debt growth, there must be some other mechanism at work that does not fall within existing economic theory.


This paper proposes the alternative view that debt growth in modern economies is predominantly caused by unearned income in the form of interest paid on bank deposits 19. The paper shows that whenever interest is paid on deposits a corresponding debt is created somewhere else, usually in the productive economy. That makes most of the debt giving rise to deposit interest a structural part of the productive economy. The interest has to be paid by the productive economy or from asset inflation and must be included in prices.  The only ways to keep prices stable when interest is being paid on deposits are to increase productivity or to reduce disposable incomes 20.


In the debt system the debt is created before its corresponding money deposit 21. Since unearned deposit income cannot come out of thin air it must arise from new debt. Without new debt there can be no new money. Paying unearned income in the form of deposit interest demands that new debt be created within the productive economy to fund it. Otherwise deposits in the productive economy would keep falling 22 as they are transferred from the productive sector to the investment sector or paper economy. In the debt system there isn’t enough money in the productive economy to pay depositors interest on their deposits, unless it is first created into existence to pay to them. As long as unearned income deposits continue to increase, so must their corresponding debt be carried as a permanent burden either in the productive economy or through asset inflation. The generation of new debt in the productive economy has been growing beneath the modern economic radar screen for many decades. If this new view of debt growth can be proved to be correct, either a way must be found to slow or stop paying interest on deposits or the world’s debt-based economies must face imminent financial collapse as the debt servicing demands become unsustainable in the productive economy.


In practice the collapse has already begun in the United States and elsewhere. In the US, the debt grew so large and the expectations of the investment sector became so high, consumers were loaded with more debt than they could service, leading to large-scale debt default. When those defaults were fed back through the banking structure, destroying the banks’ net worth, the whole financial system began to collapse. That collapse is on-going because the debt-servicing demands on consumers have not been substantially reduced while their net worth (their borrowing capacity) has gone down because property values have plummeted, and wages and most incomes are falling.  Unless the financial system is changed quickly or bank lending and incomes are rapidly increased, the United States has entered a period of terminal decline.


Some readers may at first sight see some similarity between parts of this paper and earlier proposals 23 supporting the inflationary issue of interest-free credit. This analysis, especially section 4 of this paper clearly demonstrates that is not the case.


19  Deposits and debt go together but they are not the same. For every dollar of debt there is a dollar deposit somewhere. First someone signs a loan (debt) agreement with the bank. When the loan is drawn down (activated), a corresponding deposit is entered into the borrowers account. The debt (loan) and the deposit are numerically equal but the debt is an asset in the bank’s books and the corresponding deposit is a liability in the bank’s books. Deposit interest usually, though not always, makes up a large part of the interest borrowers pay on their loans. Loan interest = Deposit interest + the bank margin or spread.                      

20  Raising interest rates to manage inflation causes a reduction in consumption capacity (Manning, 2009)

21  The loan agreement with the bank always precedes the deposit appearing in the borrowers account.

22  This would produce a deflationary spiral in the productive economy because there would be less money circulating there to produce the same amount of goods and services.

23  Such as C.H. Douglas’ ideas on social credit




The first step in revealing how the present debt system works is to show how a simple debt economy can function without large-scale debt expansion and without deposit interest 24. It’s close to the way economies used to work when they were based on cash rather than debt. 


The simple dynamic debt economy is shown in Figure 1. Figure 1 satisfies the international System of National Accounts (SNA) in use worldwide except that it assumes for simplicity that a country has a balanced international trade account and that business inventories are stable.


The first step in revealing how the present debt system works is to show how a simple debt economy can function without large-scale debt expansion and without deposit interest. It’s close to the way economies used to work when they were based on cash rather than debt.


The simple dynamic debt economy is shown in Figure 1. Figure 1 satisfies the international System of National Accounts (SNA) in use worldwide except that it assumes for simplicity that a country has a balanced international trade account and that business inventories are stable.




Conceptually, there is no residual debt after any individual production cycle, and no residual deposits. Each cycle in Figure 1 is self-clearing and the debt is self –cancelling 25. Nor can there be any aggregate earned savings 26. If there were, the cycle would not be self-clearing. Inventories would change and/or prices P would change and/or output q would change. In sum, what is produced is sold, including new capital goods. Figure 1 allows for the transaction deposits My to change over time and for prices P and output q to also change according to the institutional rules in place for the time being, productivity growth and population changes. As described below, the simple model in Figure 1 does not need to make specific provision for a “market” in existing capital goods or for their progressive depreciation over time. In practice, the basic production cycle doesn’t literally “pulse” as shown in Figure 1. Instead there is an ongoing stream of production and consumption, a corresponding quantum of  transaction deposits My continuously in circulation and an equivalent quantum of deposits always in bank accounts.


24  The simple model economy assumes that no interest is paid to depositors on the account balances.

25  Interest on any production debt is included in both the income (production) and consumption sides of Figure 1 and so is self cancelling, but increases in interest (bank spread) will lead to cost inflation and vice versa.

26  For each individual who has “earned savings” others must carry a corresponding amount of consumer debt.


It does not matter how many transactions there are in a production chain, or when they take place 27. Each transaction follows the cycle shown in Figure 1. 


The production cycle shown in Figure 1 uses the transaction deposits My to produce capital goods as well as goods and services for consumption. The capital goods make up the “Gross Fixed Capital Formation” shown in SNA Table 1.1 on the lower right in Figure 1. Figure 1 assumes the producer of a capital good sells it to other existing deposit holders for the time being, so its purchase price comes out of employee incomes and the gross operating surplus. The banking system intermediates among deposit holders to enable such exchanges of capital goods to take place.  The borrower repays loan principal by transferring future income to the lender. The lender can then consume the repayment or re-lend its purchasing capacity to others who wish, for the time being to consume more than they earn.  Such arrangements are a matter of agreement between the parties and will usually include the payment of interest. Such payments are like borrowing from a non-bank finance company. They involve a transfer of wealth (future income) from the borrower to the lender but they do not affect the total amount of bank deposits.  There is no inconsistency between the interest-free system of Figure 1 and the idea that willingness to delay consumption is “worth” an interest premium.


In the absence of interest on deposits, the system is in balance and there is no inflation.


A capital good would typically be put to good productive use to generate additional income in subsequent production cycles. The transaction deposits My, incomes, the gross operating surplus and q would all rise to accommodate the real growth from new capital goods so repayments could be made from the economic expansion. That’s why, as shown in Figure 3, there was no inflation in Britain during the industrial revolution despite huge increases in population and output 28.


27  Danks (1955) pp. 12-15

28   In some countries, investment banking became widespread, pooling cash and deposits to fund capital investments such as rail, shipping and other industrial expansion.


Sales and transfers of capital goods mean the banking system is left with debtors and creditors in like amount at the end of the production cycle when My is conceptually cancelled.  That distributive effect leaves some players in the economy with net deposits and some with net debts, and that, as will be shown below, is where the problems with systemic debt expansion begin as soon as interest is paid on system deposits. 


In an interest-free environment, the chains of transactions needed to make productive investments in infrastructure, whether public or private, are the same as those shown in Figure 1. Investment in infrastructure made by a government or other public body is traditionally funded from taxation. If there are sufficient labour and material resources available, it could also be funded using new producer transaction deposits My within the context of Figure 1.  In that case repayments are typically met in the form of (sometimes extra) taxes and levies. Since in Figure 1 the cost of such goods and services are stable, they are known. Private contractors bid against each other for public work. They do this on the basis of technique, method, and organisation. Contrary to what some authors might seek to suggest (Danks, 1955), there is no conflict in such cases between private enterprise and an interest-free economy. 29


The story is a little different for unproductive capital goods such as residential housing where the capital expenditure does not increase production beyond the construction phase. Aside from increasing their work efficiency or working longer hours, most homebuyers have to pay for their home from their future earnings or by realising capital gains because they lack a new independent income stream to pay for the capital good. This greatly accentuates the distributive effect already referred to because residential homebuyers become heavily indebted to other players in the economy 30. Until about 200 years ago housing formed only a small part of economic activity. Since then, and particularly during the twentieth century, housing expectations in modern economies have risen sharply to the point where, in New Zealand, expenditure on housing absorbs just over 15% of all average household incomes 31. The widespread concern worldwide about the economic role of residential property and property is valid but poorly understood.


Despite the various issues around capital goods, the simple economy works very well, especially where appropriate income redistribution is used to ensure a socially acceptable level of housing is affordable to all.


People all over the world owned property, borrowed and loaned money and successfully conducted all manner of economic transactions long before interest was routinely paid on bank deposits (Danks, 1955) 32.  Payment of interest on bank deposits relates to the structure of the debt system itself, not to interest-bearing contractual obligations between consenting parties where one party chooses to defer consumption and another chooses to buy the use of that party’s consumption capacity 33 .  Reducing or removing interest on deposits would reduce or eliminate inflation, leading to stable rents and prices 34. 


29  Danks, (1955) pp 48-51.

30  The quantum of residual debt is readily quantifiable but outside the scope of this paper.

31   Source: Statistics New Zealand Household Economic Survey (income)  June 2009.

32   Danks, (1955) pp 57-58.

33  As discussed later in the paper, the system presently requires banks to compete for deposits but that competition would still be possible in the absence of deposit interest.

34  Investment resource allocation would still be based on cost-benefit analyses exactly as happens now, but with the benefit that finance charges would play a smaller part in “efficient” allocation. In addition, other instruments such as variable reserve ratios are available to central banks to restrain demand for bank lending.





Having isolated the broad fundamental problem of debt and shown how a very low- debt simple economy can function (without inflation), the next step is to explore how the present system using deposit interest is structured and what causes exponential debt growth.


The only difference between the stable simple economy shown in Figure 1 and the unstable economy shown in Figure 2 is the introduction of deposit interest on all bank deposits arising from debt 35 . If Figure 2 demonstrates conclusively how debt expands exponentially when interest is paid on deposits, then it necessarily follows that the cause of unsustainable debt growth lies in the payment of deposit interest.


The introduction of deposit interest If% 36 produces systemic changes throughout the economy. In Figure 2, to enable all production to be consumed, producers must first borrow  (and then pay out in the form of incomes) the deposit interest through the production phase of the production cycle and then recover it by way of increases in their prices during the consumption phase. Incomes are assumed to keep pace with inflation. Otherwise the production cycle cannot clear itself.


When each production cycle is cleared there is residual debt and corresponding residual deposits as shown toward the bottom left of Figure 2.  Those deposits take on a life of their own because they are reinforced by every subsequent production cycle but exist outside it. The pool of deposit interest plays no further part in production. Instead, it makes up what is usually called the investment sector or paper economy that includes the non-trade sector and derivatives market. Deposit interest acts as a debt pump, pumping more and more deposits into the investment sector Ms while leaving the corresponding debt in the productive sector. The investment sector is what creates the inflationary “market” in existing assets.  The deposit Ms supporting the investment sector Ds is un-repayable because it represents unproductive unearned deposit interest that resides outside the productive sector.


It does not matter how many transactions there are in a production chain, or when they take place 37. Each transaction follows the cycle shown in Figure 2. There is no inconsistency between the deposit interest based system of Figure 2 and the idea that willingness to delay consumption is “worth” an interest premium.


Figure 2 does not directly specify who in the economy has the deposits and who has the corresponding debt at the end of the production cycle  (lower centre of Figure 2).  However, net deposit holders emerge from the redistribution of debt arising from the purchase of capital goods as already discussed in relation to the simple economy in Figure 1. The production cycle itself remains a zero-sum game but in Figure 2 the cycle is constantly being loaded with the extra debt needed to pay the deposit interest (unearned income) on the investment sector Ms. In addition, when interest-bearing debt is used as in Figure 2 the consequential transfer of wealth that takes place is accelerated in comparison with the stable economy of Figure 1  (Danks, 1955) 38.


35  The analysis in this paper uses the average funding (deposit interest) rate counted over all of the domestic credit. The average funding rate for New Zealand is found at NZ Reserve Bank table hc 10.

36  Net deposit interest after tax is I*K where K is (I – tax rate on gross deposit interest).

37  Danks, (1955) op cit pp. 12-15.

38  Danks, (1955) op cit p. 12.


It should be stressed that ownership of productive infrastructure is irrelevant from a national macro-economic point of view. Who owns what depends on political choice. In the case of publicly owned productive infrastructure, the benefits of the investment are distributed directly amongst the population. They may for example take the form of shorter travelling times for all (tunnel), improved education facilities (school), or improved public health (a sports centre). Where infrastructure is privately owned, the temptation to charge users for services may be greater and the resulting profits may accumulate in the hands of a few.


The investment sector funded by the accumulated interest paid on bank deposits produces nothing itself.  It is paid for through inflation of the productive sector and from realised capital gains.


Neither the SNA (System of National Accounts) nor Figure 2 provides any direct mechanism to enable increases in interest rates to reduce inflation. Interest rate policy works through borrowers (such as home mortgage holders), the holders of the Ds debt that supports the accumulated deposit interest on bank deposits. Raising interest rates typically increases their interest payments on mortgage and other debt, and thereby reduces their purchasing power. Raising interest rates to “manage” inflation, as is commonly done under orthodox economic policy, transfers even more consumption capacity from the productive economy to unearned income for deposit holders in the investment sector 39.


39  The quantum can be estimated from equations 1-3. On an annual basis it is roughly the change in the deposit interest rate*K* (the domestic credit (Ddc). At the moment, based on the Model calibration for New Zealand, a 1% change in the deposit interest rate alters the GDP by about 1.2%, leaving an ever-smaller window for the Reserve Bank to manage inflation using interest rates. In 1990, a 1% change in deposit rates would have produced about 0.6% change in GDP, and in 1980 just 0.4%, assuming an average tax rate on deposit interest of 25%.


Figures 1 and 2 provide an alternative insight into the real productive economy. The orthodox view is that people and firms borrow to invest on the basis their financial return will exceed their costs including interest. Their net profit after tax is often put in the bank and the holders of those banked profits then expect to be paid interest on it. Figure 2 shows such deposits (or other earned “savings”) by their nature force others in the economy into new debt to replace those savings in the economy if production and consumption levels in the economy are to be maintained. Figure 2 also shows that any deposit interest paid on those “savings” deposits increases My and inflationary pressure in the productive economy. This is discussed further in section 7 of this paper where it is proposed that traditional “savings” as set out in the System of national Accounts (SNA) represent the difference between increases in consumer debt plus new bank debt for the purchase of capital goods on the one hand and principal repayments relating to previously purchased capital goods on the other. As shown in section 6 of this paper, those “savings” are typically offset by the bubble debt Db in the revised Fisher Equation of Exchange. When interest rates are increased to manage inflation the higher deposit interest is not  (immediately, anyway) compensated in wages and other incomes. In effect, producers and income earners are forced to gift to investors “savings” they do not have. 




In Figure 2 the reduction of consumers’ purchasing power forces prices P down. The large-scale collateral damage from the loss of consumers’ purchasing power is that production q in Figure 2 falls in turn, leading to unemployment and recession.


Deposit interest prevents the efficient functioning of the economy unless the interest  is fully compensated in employee incomes and the gross operating surplus. Orthodox economic policy typically fails to match incomes to inflation because of arbitrary limits placed upon measured CPI (Consumer Price Index) inflation. Such mismatches create the boom and bust features so typical of modern business cycles as interest rates change. They also accentuate the drift of wealth away from wage and salary earners towards the holders of deposit interest.


The key to understanding Figure 2 is that only that part of the domestic debt that is not already committed as Ds to fund the unearned income pool  or to Db as “savings” is available for use in the productive economy.


Debt can only be used once. If the debt Ds is used to support the pool of unearned deposit income it cannot also be used to fund the production cycle unless the corresponding Ms deposits are directly re-invested in new production or productive capital goods. 


In aggregate, re-investment of deposits arising from the debt Ds into the production cycle is not common, in part because there is a financial incentive (discussed later) for them to remain in the investment sector, and in part because saving is instinctive. People have always saved. Instead, holders of unearned income deposits tend to find the investment “game” more profitable, trying to increase their share of those deposits by trading among each other in existing capital goods such as equities, property and financial derivatives. Figure 2 shows that the investment sector debt creates an exponential expansion of unearned income Ms given by the expressions (based on annual figures) 40


Ms1 =  Ms0*(I+I1*K1)+11*(My1*Vy1)*K1   where Ms0 = 0                            (1)


Ms2 =  Ms1*(1+I2*K2) + I2*(My2*Vy2)*K2                                                  (2)


Msn =  Ms(n-1)*(1+InKn)+In*Myn*Vyn)*Kn                                                   (3)


Where Msn  is the pool of deposits representing the debt Dsn that has been created to fund deposit interest.

I1  ….. In  is the average deposit interest through each of the years 1 …. n

My1 … Myn  is the average transaction deposits through each of the years 1 ….. n

Vy1  Vyn   is the number of production cycles during each of the years 1 …….n

K1……..Kn is the proportion of deposit interest remaining after deduction of tax T1….Tn during each of the years 1 ……..n


Equations (1) to (3) are derived directly from Figure 2. They create an exponential series, and the only difference between Figure 1 and Figure 2 is the introduction of deposit interest. The thesis that deposit interest is the cause of unsustainable debt growth is proven. Since the investment sector deposits Ms are largely funded directly by the productive sector by price inflation and by realised capital gains, if Ms is exponential, both the accumulated price inflation and the transaction deposits My in the productive sector must also be exponential.


Figure 3 shows the dramatic impact of inflation in England over the past 700 years, and in particular the abrupt change that occurred following the introduction of the United Nations System of National Accounts (SNA) in 1953 and subsequent financial deregulation 41. These effects have been accentuated by the decline in the cash economy to the point where, in developed countries, cash transactions contribute only a negligible amount to measured economic activity. Those cash transactions were important because they were debt-free and interest-free and slowed the increase in debt growth in the economy. Until the advent of “modern” banking, there was no exponential increase in the financial system, not even during the industrial revolution when, in part due to vast industrial productivity increases, prices actually fell 43.




40  Equations (1)-(3) include the effect of net debt Ds directly borrowed for investment, which is introduced in section 6 of this paper, but do not include any accumulated current account deficit or bubble debt that also introduce further system deposits and net deposit interest.

41  Such as the removal of the US$ gold peg in 1971, “globalisation” and its accompanying freeing up of capital flows, the introduction of Basel I risk-based capital requirements and the repeal of the Glass-Steagall Act in the United States.

42 Sources: Inflation figures 1300-1800 from Gregory Clark  The Price History of English Agriculture, 1209-1914 ” Research in Economic History, 22, (2004):  41-124 and The Long March of History: Farm Wages, Population and Economic Growth, England 1209-1869Economic History Review, 60(1) (February, 2007): 97-136.

Inflation figures 1800-2000:   O’Donoghue J, Goulding L (Office for National Statistics Great Britain and Allen G, (House of Commons Library) “Consumer Price Inflation since 1750”, Economic Trends 604, March 2004

43 By comparison, in New Zealand in 1893 (a crisis year – RBNZ (2009b)) production was estimated to be about 28 m pounds, bank debt was 13 m pounds,  (deposits 14.5 m pounds at banks plus 4m pounds at savings institutions and building societies). Just over half the bank deposits were interest bearing.(Intermediated pastoral finance company lending is not included in these numbers). The banks held about 3m pounds of coin and bullion and another 2.3m pounds of discounted notes and bills. There were about 1 m pounds of notes in circulation plus an unspecified (but large) amount of coin. [source NZ official year books]. Most transactions were in cash. As late as 1978 a substantial proportion of transactions contributing to GDP were in cash compared to almost zero in 2010.  In 1893, deposit interest on total domestic bank debt as % GDP was less than 1% compared to 7% in 2009             


In England, for many centuries, long-term price increases, as distinct from those resulting from variations in production, arose from the physical change in the per capita money supply relative to per capita output. Between about 1560 and 1910 prices increased just 50% in 350 years before doubling during WWI.


Figure 2 shows how exponential growth in prices is a structural part of the debt-based financial system.  Figure 3 suggests this has been a twentieth century phenomenon.

The price index increased from 100 in the year 1300 and 635 in 1910 to around 50,000 today, an increase of 500 fold and 78 fold respectively. This means almost all price must be inflation 44. 


Figures 1, 2 and 3 suggest inflation is predominantly caused by the interest rate on deposits. In that case, an obvious way to achieve a stable economy is to remove interest on deposits to return the financial system closer to what is shown in Figure 1 45.  Low inflation cannot be maintained in an economy when it must increase as a function of the deposit interest I and often faster 46.


44  In New Zealand the Consumer Price Index (CPI) increased by 583% between March 1978 and March 2010, while during the same period domestic credit increased by roughly 3000%. [source RBNZ table hc3].

45  Together with stabilising the current account and progressively retiring foreign debt.

46  Annual inflation in Figure 2 is a function of My*I*Vy, but My can be increased by any injection of debt, such as mortgage or consumer debt, from outside the production system which increases My instead of  I.


Reducing or removing interest on deposits would have no impact on bank lending decisions, nor, with appropriate policy instruments in place would it lead to excessive demand for new debt. Lending decisions relate primarily to the creditworthiness of borrowers.  Bad lending decisions, like those in the United States in the years leading to the sub-prime boom and bust there in 2007, were about greed and deceit replacing common sense. The banks (mis)prioritised resource allocation, not the government or the public at large.  This paper confirms demand for new debt would relate to borrowers’ ability to pay. In a low inflation, low interest environment with stable prices and incomes related to real productivity gains, borrowers’ debt to equity ratio would still limit their borrowing capacity. In addition, the banks’ underlying ability to expand credit could be managed as well or better by quantitative restraints like reserve ratios than has been the case in recent decades using arbitrary policy interest rates settings to manage the price of credit.  The internal rate of return on proposed investments would still guide business investment decisions as, in practice, it has always done with or without deposit interest. The number of capital projects and availability of new debt would still be governed by those decisions. This paper argues for a reduced moral hazard associated with demand for new debt. The world has seen the current system produce exponential increases in debt to the point of collapsing the global financial system.  As discussed above, reducing or removing deposit interest doesn’t remove interest from the economy, but with appropriate volume controls in place it will stabilise debt growth and improve resource allocation.


On-going efforts by central banks to control Consumer Price Index (CPI) inflation have done little to halt inevitable rises in prices within the existing interest-bearing debt-based financial system. They have superficially succeeded up to a point only at incalculable cost to human lives, wellbeing and development over the past century or more while at the same time transferring nearly all the increased wealth to the minority of people and institutions holding large deposits in the banking system. While the quality of life of some of the world’s people has improved during that time the improvements are patchy and fewer than they might otherwise have been. Exponential debt growth appears to have reached the point where the productive economy can no longer satisfy the profit expectations of the investment sector despite excessive and unsustainable exploitation of the world’s labour force and natural resources.   


The unearned investment sector deposits Ms shown in Figure 2 give rise to the cumulative unearned interest income on the deposits in the banking system. Consumer prices are also locked into exponential expansion though normally at a lower rate than Ms itself.


Consumer prices inflate with the deposit interest rate I*K to pay the deposit interest on the existing My into the unearned income pool Ms.  Ms also increases by the amount of new deposits that have to be added at  each production cycle to pay the deposit interest on Ms itself as well deposits arising from bubble debt Db and the accumulated current account deficit. 47 


Figure 2 provides for numeric inflation equal to I*K*My*Vy to fund the interest on the productive sector. If Ms is not less than or equal to My*Vy  the interest difference would have to be drawn from My   itself which means producers are paying some of the costs directly from their real incomes. Those holding debt backing deposits arising for example, through the use of credit cards and new mortgages that are used to buy non-productive capital and consumption goods that have already been produced also have to find some way to fund the interest on them. That debt can only come from realised capital gains on the sale of existing assets or from “bubble” debt Db. Bubble debt injections allow wage and income earners to consume beyond their financial means 48 but they are offset by “savings” in non-productive speculative investment.  Some leakage of Ms deposits back into My or leakage of My deposits out of My  (as earned savings, for example) is also possible. Any such net flows will destabilise the production cycle as previously discussed.


Since nearly all price is inflation the value of assets and goods and services would become far more stable and predictable if interest on deposits, and hence inflation were to be reduced or phased out.  Interest destroys value. The present system not only guarantees unsustainable exponential debt growth, it also guarantees an exponentially increasing transfer of wealth from borrowers to bank deposit holders. This worsens the already critical problem of inequitable income distribution typical of much of the developed world, especially New Zealand and the United States.


47  Db is described at section 6 of this paper.

48  The “keeping up with the Jones’s” syndrome is encouraged through advertising and social pressure. The concepts of systemic inflation developed here are very close to the “one-for-one” link between interest and inflation predicted by Irving Fisher in his famous “ The Theory of Interest”, New York, Macmillan, 1930 that has never before been proven.



05. The unsustainable economy with foreign debt.


Recent decades have seen vast changes in trade and capital flows giving rise to “free trade”, globalisation and financial deregulation. The collapse of the sub-prime mortgage market in the United States in 2007-2008 and subsequent systemic financial problems worldwide have led to some reassessment of that neo-liberal approach to economics. This section supports the view that liberalisation of trade and capital flows needs to be bounded by maintaining balanced current accounts.  It shows how foreign debt drains the economies of debtor nations, increasing the “Figure 2 effect”.


Large-scale foreign debt is a relatively new phenomenon in modern economies 49. Until 1971 most of the developed world’s economies operated most of the time on a gold standard using fixed exchange rates (albeit for a time indirectly through what was known as the US$ gold peg) 50. A fixed number of currency units would buy a troy ounce of gold.  Whenever a country’s current account was out of balance the difference was settled in gold, and when a nation’s gold reserve was depleted it would devalue its currency by increasing the number of its currency units needed to buy a troy ounce of gold.  This made its exports cheaper and its imports more expensive correcting the imbalance and reversing the gold flow.


US President Nixon was forced to abandon the US$ gold peg in 1971 because the cost of the US war in Vietnam was causing substantial current account deficits. Without the US$ gold peg in place many countries began to float their currencies, allowing them to automatically find their own levels against their trading partners according to the supply and demand for their respective currencies. In practice the expectation that currencies would find their own level has not been met in many cases because there has been no prompt penalty applied for growing surpluses and debts as JM Keynes proposed at Bretton Woods in 1944 51.  In many countries like New Zealand, the imbalances arise from non-trade related financial flows. Large accumulated imbalances create a feedback effect that weakens nations’ ability to manage their own monetary policy.


49  Though national bankruptcies were far from unknown in earlier times. For example the French Court of King Phillip IV was bankrupted in the early 14h century having borrowed heavily for a failed crusade to the holy land.  Other instances were King Phillip II of Spain and King Louis XIV of France.

50  In times of crisis some countries were forced off the gold standard. This occurred during WWI when Britain was forced to borrow very heavily from the United States to help pay for the war. The US$ gold peg was crucial to the system because of the pre-eminent role of the United States dollar as the world’s reserve (or trading) currency.

51  The  Bretton Woods conference was where the WWII allies agreed on the framework for the post WWII financial architecture, including he World Bank and the International Monetary Fund.


Progressive deregulation of capital flows, the growth of unearned income from interest on deposits (Ms) and the introduction of ever more complicated derivative trading instruments have long since destroyed the principle of automatic exchange rate adjustments based on real cash flows.  Many debtor countries including New Zealand have all but lost their economic sovereignty. Their exchange rates are now substantially determined by speculative global investment flows such as the carry trade, and by United States based debt-rating agencies. The carry trade is counter-intuitive as it ignores the current account position while making it worse. The “carry” trade works by selling a low interest yield currency to buy one with a high interest yield. For example, an investor might sell the Japanese Yen and buy the New Zealand dollar or other currency that has a higher interest yield. This in turn pushes up the value of the “Kiwi” which encourages more imports and depresses exports making the current account balance worse.  Current account debtors then have to offer higher rates of interest to sell their sovereign debt to fund their deficits. This cycle is self-reinforcing and leads to currency crises on a regular basis as well as causing major problems for those trading in productive goods and services internationally.


Figure 4 is the same as Figure 2 except that it makes provision for current account deficits.  It clearly demonstrates how “carrying” the current account deficit through the productive economy as set out in the System of National Accounts increases inflation throughout the productive economy as well as increasing the pool of unearned deposit income that makes up the investment sector.




The balance on external goods and services is shown in Table 1.1 of the SNA as a (foreign) debt arising outside the production cycle shown in Figure 2  52.  The trade deficit for any period forms part of the nation’s accumulated current account. Theoretically, with a floating exchange rate and open capital markets there should not be any surpluses or deficits in the current account. Persistent current account deficits should produce a lower exchange rate, automatically correcting the inwards and outwards flows of goods and services. In practice a single monetary policy instrument such as the Official Cash Rate (OCR), as it is used in countries like New Zealand, is insufficient to manage two independent variables, such as inflation and the exchange rate 53.  Moreover, for New Zealand, the inward capital investment is itself substantially in the form of interest-bearing debt. The exchange rate for the New Zealand dollar and the deposit interest rate I used in this paper have become at least as dependent on the profit expectations of foreign lenders as on the OCR policy rate of interest set by the Reserve Bank of New Zealand.


Current account deficits result from aggregate withdrawals from the accounts of importers and parties repatriating profits or otherwise transferring funds offshore. Transfer of funds abroad should result in a corresponding sum of bank deposits in offshore beneficiary accounts 54. Those offshore deposits are used to buy investments that are recorded in the debtor country’s financial (capital) account 55. In one form or the other, the nation’s current account deficit is paid for by the sale or mortgage of part of the country and its productive assets. On-going failure under monetary policy to curb current account deficits is serious, as national wealth is being systematically transferred to foreigners.  In the case of New Zealand, as of March 2009,  the net  international investment position (NIIP) was about NZ$ 161 b., 87% of GDP that then stood at NZ$ 184.8 b. 56.  Meanwhile foreign claims against New Zealand’s net non- residential productive capital assets have reached 56%, including control of nearly all the banks operating in New Zealand.


52  The trade deficit is subtracted from the consumption side in SNA Table 1 so the trade account results in “saving” when it is in surplus and “dis-saving” when it is in deficit. The deficit is, for those countries whose currency is not a reserve currency, necessarily met by borrowing on the current account accompanied by compensating inward capital flows.

53  There is now a considerable body of research on this but the statement is obvious from high school mathematics. You can solve for y with one variable x  in y=(f)x  , but not in y= (f)x+(f)z .

54  Any good primary economics textbook should set out the process.

55  For the New Zealand dollar, Statistics New Zealand publishes detailed information quarterly in its  “Balance of Payments and International Investment Position”.

56  NIIP NZ$ 176.6b–derivatives NZ$ 2.0b–managed funds NZ$ 3.7b–overseas shares held by NZ residents NZ$ 10.6b.


Within the SNA international accounting system, a current account surplus is shown  as “Saving” 57 in the same way as a surplus in the balance on external goods and services. However, the idea that New Zealand has regularly generated billions of dollars of  “Saving” as claimed in Table 1.2 of the National Accounts when it has been accumulating large annual current account deficits 58 and a very heavy burden of foreign ownership of New Zealand’s economy is inconsistent with the production cycles shown in Figures 1 and 2. There is no provision in Figures 1 and 2 for generating earned “Saving” other than through the balance on external goods and services 59 which has also been negative  in New Zealand in most recent years 60.  Instead, as shown in sections 6 and 7 of this paper, “saving” is represented mainly by capital gains in the debt model developed from the Fisher Equation of Exchange. Physically, those capital gains are backed by some of net new debt that makes up the increase in domestic credit.


In the SNA National income and outlay account the current account balance is shown as part of the nation’s cash flow but it is, apparently, except for goods and services, kept outside of the production system. In practice, current account shortfalls seem to result from deficit balances relating to productive activities and the foreign borrowing is needed to meet profit and interest payments on the offshore debt and deficits from current transactions 61. To allow for this, transaction deposits My shown for New Zealand in Figure 5 62  “carry” the current account deficit dCA with it through the productive cycle as shown in Figure 4. The deficit is ultimately exchanged for capital assets of the same value in the debtor economy, as discussed above and required by orthodox economic theory 63. Figure 5 shows that despite the overall trend, increases in the circulating debt are not quite automatic because My is affected by several factors such as falling interest rates, fluctuating current account deficits, and changes in the bank spread. Figure 6 shows the speed of circulation Vy of the circulating debt My in New Zealand. The slope of the Vy trend line shown in Figure 6 is thought to be due to structural changes in payments systems and the proportion of cash transactions in the economy.






57  The SNA National income and outlay account shows a current account surplus, “investment income from the rest of the world, net” on the income side and the residual “Saving” on the “use of income” side.

58  As shown in the National Accounts; National income and outlay account, Table 1.2 .

59  Shown on the right hand side of Figure 1 as “exports less imports”.

60  The SNA National income and outlay account is suspect not just over the issue of saving but also because it incorporates an imaginary number “consumption of fixed capital” to allow for depreciation that has nothing to do directly with cash flows in the productive economy. “Consumption of fixed capital” belongs only to assessments of net capital stock. The appropriate figure to use for income/outlay purposes is “principal repayments on capital goods”.

61  Statistics NZ Balance of Payments and International Investment Position, March 2009, Table 10.

62  In line with the common saying that countries with current account surpluses export inflation while those with current account deficits import inflation.

63  Though in practice there is an on-going transfer through the cycle rather than a lump sum at the end.





The first version of the debt model was published in the paper:  Manning, L “The Ripple Starts Here: 1694-2009 : Finishing the Past”,  presented at the 50th Conference of the New Zealand Association of Economists (NZAE), Wellington, July 2009 64.  


While the debt model is based on the volume of debt, it is unrelated to earlier volume-based reform proposals like those of Social Credit that failed to offer a viable theoretical basis to support them.


The premise in both the debt model and Figure 2 is that the circulating deposits and cash My = Prices P x output q where q is the quantum of domestic output produced by My over a single cycle.  Taken over a whole year, the SNA definition of Gross Domestic Product GDP is given in the debt model by mathematically integrating the expression Pq* Vy, where Vy is the number of times the circulating deposits and cash My are used during the year 65.


The SNA should reflect an expression of the original Fisher Equation of Exchange as shown in Figure 1 66.  The only difference is that the money supply M in the Fisher equation of exchange included hoarded cash, whereas in the debt system shown in Figure 2 for practical purposes there is now very little cash contributing to measured GDP. 


In Figure 2 My cannot include hoarding of debt beyond the term of the production cycle because all the productive bank debt giving rise to My is conceptually repaid at the end of the cycle 67.


64. . Non-members can access the paper by Google search: NZAE The Ripple Starts Here   (use “quick view”).

65. The contribution of cash transactions in industrialised countries is now (very) small.

66. The Fisher equation has been very widely discussed in relation to the economic difficulties arising from the sub-prime mortgage defaults in the US 2007-2009. 

67. As previously noted, in practice there is a continuous flow of production and consumption so the deposits and cash My are always present, but they are being used in the production cycle, not hoarded.


At any point in time there are five broad blocks of deposits in the domestic financial system.


They are:


Mt  The transaction deposits representing the productive debt My - M0y so:


My =  Mt + M0y                                                                                      (4)


Mca The accumulated domestic deposits representing the sale of assets to pay for the accumulated current account deficit (see section 5 of this paper for details). 


M0y The cash in circulation included in My and used to contribute to productive output.


Ms The net after tax accumulated deposits arising from unearned deposit income on the total domestic banking system deposits M3 (excluding repos) 68.


 (M0-M0y)  Cash hoarded by the public and not used to generate measured GDP.


In this paper the total of these deposits, that is, Mt + Mca + M0y + Ms , is provisionally assumed to be the M3 (excluding repos) monetary aggregate published by most central banks monthly less the amount of cash in circulation M0 except for the part M0y that is included in My. In this paper M0y is assumed to have the same speed of circulation as My. In industrialised countries, the contribution of cash transactions to the measured output of goods and services (GDP) has been declining in recent decades and their contribution to the GDP has been provisionally calibrated for the purposes of this paper 69. 


In this paper, the total debt in the domestic financial system is assumed to be the Domestic Credit, DC debt aggregate published by most central banks monthly.


At any point in time there are four broad blocks of domestic debt in the domestic financial system. Three of them together add up to DC such that:


DC   = Dt  + Dca 70  + Ds                                                                                                  (5)


Where :


Dt    is the productive debt supporting the transaction deposits Mt.


Dca   is the whole of the debt created in the domestic banking system to satisfy the accumulated current account deficit 71.


Ds      is the residual debt to balance equation (5)  


68. Repos refer to inter-institutional lending 

69. More accurate assessment of the cash contribution to GDP over time requires further detailed study.

70. Arguably the accumulated sum of capital transfers could be included here, in which case the net international investment position (NIIP) would be used instead of the accumulated current account. The decision affects the size of the “residual” Db.

71. This is greater than the monetary deposits Mca because the banking system may have sold commercial paper to borrow foreign currency to satisfy the foreign exchange settlement as shown in Figure 4.


The fourth block of debt is :


Db,  the virtual “bubble” debt, the excess credit expansion or contraction in the banking system such that  Ds - Db  = the debt supporting  the accumulated deposit interest Ms defined above.  Db can be positive or negative as discussed further below in relation to Figure 9.


There is also a fifth block of debt Is that is, conceptually, not bank debt .


Is is the total debt accumulated by investors to buy capital goods arising from Saving Sy = S/Vy. where S is national saving measured as gross capital formation less repayments of principal made on all existing capital goods.


Conceptually the investor borrows the purchase price of the capital goods from employee incomes and the business operating surplus. The investor pays the investment Iy =I/Vy = Sy = S/Vy   to the producer and the money is used to retire the outstanding part of My relating to the investment in question. The principal repayments on productive capital investment, being part of Iy (=Sy) is included together with the interest on the investment principal as a production cost in the subsequent production cycle loans My, allowing the investor’s debt to producers to be repaid over time.


The predicament of new homeowners is quite different. They cannot service their debt because they cannot, conceptually earn more than they were before they bought their new home, because the home itself is nearly always unproductive. There is no new income stream from their housing investment. If economic demand is to be maintained, homeowners must, in aggregate, rely upon increasing house prices and refinancing of their properties, creating an aggregate “pass the baton” systemic increase in debt.  


When non-productive investment assets are traded there is typically a capital gain because of asset inflation on investment (Dca + Ms + the property component of Is).  The new purchaser pays more for the asset because of asset inflation, allowing the seller to retire the outstanding mortgage debt on the property.


By definition in this paper :


My *Vy = GDP

Ms = Ds


The cash contribution to GDP = M0y * Vy.  Therefore :


DC  = (GDP)/Vy  - M0y + Ms + Dca +  Db                                                      (6)


Ms =Ds = (DC – Dca ) – GDP/Vy + M0y  - Db                                                (7)


GDP = Vy *(DC - (Ms +Dca +Db ) + M0y  )                                                    (8)


My  = GDP/Vy  = DC - (Ms  +Dca  + Db) + M0y                                                     (9)


Where the terms are as already defined above.


Equations (6 ) to (9) are all forms of the debt model developed in an earlier paper 72.


72. Links are provided in the conclusion to this paper.


Ms is the same format as Ms in the earlier forms of the model. It has been freshly calibrated. Unlike the previous forms of the model equations (6) to (9) are general and include the contribution made to the economy by cash transactions.


In equation (7), all the terms except GDP/Vy = My and Db are known or can be estimated with reasonable accuracy. For the purposes of equations (8)  and (9) My can be approximated using trend-lines because it is small compared with Ms. Db is unknown but can be approximated through the calibration as in Figure 9. The calculations in equations (8) and (9) involve the subtraction of large numbers to get relatively small numbers, which leaves them sensitive to modelling and data error.


If Ms , calculated as “the accumulated deposits arising from unearned deposit income on the total domestic banking system deposits M3(excluding repos) ” as defined above, agrees more or less with that calculated in equation (7), bearing in mind the value of Mb , the proposition that debt growth is determined by deposit interest will be proven.  The model will require further calibration as further data becomes available.  Despite that, it is self-evident Db will be positive during periods of rapid expansion, particularly as bubbles form, and will become negative during periods of rapid contraction, particularly as bubbles collapse. The classic case of this in New Zealand is shown in Figure 9. Financial contraction continued following the 1987 share market crash long after the asset bubble was gone.


The dependence of the gross domestic product (GDP) on the Domestic Credit DC and the interest rate on bank deposits in the modern cash-free economy from which Ms is calculated has profound implications for economics.


In the light of the worldwide financial chaos of 2007-2009 the indicative debt model shown in Figure 5 provides a powerful argument in support of public control of a nation’s financial system.




The vertical axis in Figure 5 applies to the Domestic Credit for New Zealand only. The other curves are purely to demonstrate the debt model structure. The present system shown in Figure 5 leaves the world economy at the mercy of private banking institutions working for private profit by allowing irresponsible increases and contractions (Db the fourth block of debt referred to in the discussion over equation (5)) of the Domestic Credit and its associated bubble formation. The problem is systemic because the existing financial system requires exponential growth (Figure 6), that allows the accumulated current account debt Dca to expand. In the case of New Zealand, the expansion of foreign ownership caused by the accumulated current account deficit largely defines the deposit interest rate and systemic inflation. (For more details refer to section 5).


It isn’t possible to have a simpler model of the economy than equation (8):


My =Nominal GDP/Vy  = domestic credit DC less (unearned net deposit income Ms + the accumulated current account Dca + the cash contribution to GDP  M0y  plus a correction for bubble activity Db (+/-)).


Domestic Credit DC, Unearned Income Ms and nominal GDP must all grow exponentially because they are all a function of the deposit interest rate. The exponentials of the curves in equations (6) to (8) will be different with respect to each other and because of large variations in the deposit rate over time. In New Zealand, Domestic Credit has grown exponentially by an average of about 9% per year since 1993 while nominal GDP has increased by about 5.25% annually as shown in Figure 6. Figure 6 shows both the 2005-2009 bubble and the 2010-2011 bust clearly. The difference between the two curves is mainly the result of domestic debt needed to fund the accumulated current account deficit that, in New Zealand, is  roughly 90% of GDP.

Click here to view FIGURE 6 :  EXPONENTIAL DEBT AND GDP NEW ZEALAND, 1993-2011.


It is theoretically impossible to maintain exponential debt expansion faster than GDP expansion over an extended period because the added debt servicing costs will always leave the productive sector insolvent.


To avoid national bankruptcy, each nation must maintain, in aggregate, a zero accumulated current account deficit.


A first approximation for the speed of circulation Vy of productive debt plus cash transactions My is given in Figure 7.  Vy varies with the change in the payments systems. Minor secondary shorter-term cyclical variability also occurs through changes in the average time taken to pay bills.  When times are tough people take longer to pay their bills, and each change of a day in the time taken to pay them can alter Vy by perhaps 0.25%. The process is usually reversed in better times. Otherwise Vy reached a constant value of about 18.7 in 2006 and Vy will remain more or less constant unless the payment systems change 73.


73. Vy is estimated at the moment so the present figures are indicative. Once further research accurately refines the present estimates, Vy will be sufficiently accurate for predictive purposes.


Click here to view FIGURE 7 : SPEED OF CIRCULATION Vy NEW ZEALAND 1978-2011.


Note that in Figure 7, no correction has been applied to Vy for secondary increases in payment time during recessions or decreases in payment time during economic boom periods. The maximum correction in Vy appears to be in the order of +/- 0.3 or up to 1.5%. The series shown is less stable from 1978 to 1989. This is possibly due to distinctly different growth exponentials 1978-1989 arising from the very high interest rates that were typical during those years.


As shown in Figure 8, My in New Zealand was about NZ$ 10 b or  just 5% of GDP. 




The methodology used to calculate Vy in Figure 8 is as follows. The GDP in New Zealand in March 2010 was made up of about 45% compensation to employees, 42.7% gross operating surplus and 12.3% indirect taxes such as GST (VAT). That distribution varies over time and is influenced by political decisions. For example, in 2005 in New Zealand the proportion was 42%, 45%, 13% respectively, but small variations do not have too much effect on My.


Businesses pay suppliers monthly, and indirect payments are usually made on a monthly basis too, so their speed of circulation is about 12 on average. Most workers get paid fortnightly (though some get paid weekly and some monthly) so an average speed of circulation of 26 has been assumed for that.


When the above figures are weighted the weighted average speed of circulation is (12 * (42.7+12.3)+45 * 26)/100  = 18.3.


A similar estimate of payment trends and a separate Vy calculation was made for each of the other years, and a polynomial best fit curve was drawn as in Figure 8. 


My was then obtained by dividing the official GDP figure by the speed of circulation taken off the best fit trend curve.  This gives the data series shown in Figure 9 and used  when applying the debt model.


The methodology is easily replicable using better information about payment trends and is applicable to any country.


Figure 8 shows the preliminary estimate for estimated production debt and cash My in New Zealand between 1990 and 2011. The reason the exponential for My in Figure 8 (5.72%) and GDP in Figure 6 (5.27%) are different is that the speed of circulation Vy has also been changing from year to year (as a second order polynomial). Vy has been changing because income payment patterns have changed over time as shown in Figure 7, especially as a greater proportion of people have been paid fortnightly instead of weekly. The productive debt Mv is obtained by dividing the actual gross domestic product (GDP) by the estimated value of Vy. The curve of My clearly shows the expansions and contractions in New Zealand’s economy over the past two decades. The loss of productive liquidity in the March 2010 year is the stand-out event over the past 20 years.


Figure 9 shows an indicative comparison between the residual debt Ds for New Zealand calculated from equation (5) and plotted against the model Ms calculated as the accumulated after tax deposit interest on M3 (excluding repos). The curve for Ms is a first approximation because assumptions have been made on the average tax deducted from the gross payments of unearned income (M3 (excluding repos x the average interest paid on deposits). The tax is the average tax paid by each income-earner on his or her total income. It is not the marginal tax rate 74.  The losses from the 1987 share market crash in New Zealand were very large. Figure 8 suggests a figure as high as 10% of Domestic Credit.


Once the tax rates on Ms have been accurately calibrated, the size of any debt bubble Db can be immediately calculated. Measures can then be taken to eliminate the bubble without risking any economic downturn.


Click here to view FIGURE 9 : BUBBLE DEBT Db AND Ms NEW ZEALAND 1978-2011.


74. In theory, the average tax rates could be quite accurately determined from income tax returns.


One of these, of interest to New Zealand’s recent economic performance, relates to the impact of banks increasing their reserves by increasing the bank spread, which is the difference between the lending (or claims) rate they charge their clients and the interest they pay on their customers’ deposits (their funding rate).


Were the banks to set aside some of their income for reserves instead of feeding it into the income stream in wages and profits the effect would be similar to the case for aggregate earned savings 75.  In both cases, deposits arising from debt My supporting the transaction deposits in the productive economy are withdrawn from the production cycle. While earned savings, could they in the aggregate occur, would be transferred from the productive sector to the investment sector, bank reserves are withdrawn from circulation altogether and do not form part of the productive money supply. Less income would then remain available to consume the productive output. In the short term, in Figures (1,2,4), the market would not be able to clear and either prices P would tend to fall or output q would tend to fall as inventories rise, creating deflation and unemployment. More typically P and q would both fall. The only other possibility is that consumers seek to replace the shortfall by borrowing more from the bank to maintain their levels of consumption.  


Widespread borrowing for consumption purposes does not alter the principle that in the basic economic cycle described in Figures (1,2,4) “Earned Saving” is used to fund and repay principal on existing capital goods . Any other “savings” must be borrowed. 76  77  


Banks seek to increase their reserves when they foresee future losses from bad debt arising during economic downturns. They then need higher reserves because losses are drawn from the banks’ net worth that includes their reserves 78.  The increases in reserves can be funded from retained profit or by increasing the bank spread. The banks could also generate new capital through the issue of shares, bonds, or debentures. Recent figures for New Zealand are shown in Table 1.


75. Earned savings, could they occur in aggregate, would be the portion of total productive  (earned) income hoarded by consumers for later use, for example as a deposit on a future home purchase, superannuation funds (including funded government superannuation schemes), and worker/employer savings schemes like Kiwisaver in New Zealand.

76. The mechanics of unearned “saving” are outside the scope of this paper.

77. For example, “Economics Principles and Policy” William J Baumol and Alan S Blinder, 4th Edition Harcourt Brace Jovanovich, 1988.

78 . .Paying losses from deposits is illegal and traditionally happens only when banks fail. That is why some western countries, including New Zealand, presently have deposit insurance systems.

























% spread






























(Source RBNZ Table hc10)


Mainly to increase their reserves, the banks operating in New Zealand drew almost NZ$ 3.5b  (nearly 2% of GDP) more from the New Zealand economy in the calendar year 2009 than they were drawing on an annual basis in March 2008. That is why many people justifiably complained the banks failed to promptly pass on to their clients the interest rate cuts from late 2008 through much of 2009. The withdrawal of so much debt from circulation had a powerful deflationary effect on the New Zealand economy and is one direct cause of its protracted recession 79. The banks operating in New Zealand forced their clients to directly cover the banks’ lending risk after the government had already eased interest and deposit rates.  By doing so they caused some of the very defaults they were seeking to protect themselves against.


79. Bank reserves do not form part of the “money” supply. Arguably March 2008 represented a low point in the banks’ historical spread, but the economic impact of the withdrawal of bank reserves from earned incomes was nevertheless very real.






Figure 2 shows what happens when funding interest If % is paid on bank deposits. The dynamic production debt My is all repaid in full to the bank at the end of each cycle. The funding interest If % paid by a bank is a bank liability, not an asset. The deposits belong to deposit holders. The bank must transfer to them the deposit interest it receives when the production debt My is repaid. At first sight the bank would be losing money because it would be left in debt by the same amount as the deposit interest.


In practice, the production system does not “pulse” as shown for simplicity in Figure 2.  Instead, there is an ongoing dynamic flow of production and consumption funded by the dynamic production debt My. The pool of residual debt (My in this paper) shown at the lower centre of Figure 2 is the accumulated interest component My*If % /(Vy*100) created through each nominal business cycle. 80  Since the price P itself is the sum of the price increases shown at the bottom right of Figure 2, price P must represent the total price inflation.


Assuming production Q is constant, the deposit interest If % (less tax) can be paid to depositors only if prices P increase as shown.  Otherwise the production debt My cannot be cleared when the economic production Pq 81 is sold. In this paper, the inflation caused by the deposit interest on the dynamic production debt My is called systemic inflation.


In an economy based on interest bearing debt, almost all price is inflation.


80. My is a dynamic variable similar to those used in almost iterative computer programme. The new total becomes the old total for that variable plus the increment added to it each cycle.

81. The quantity of production q is what is produced in the single nominal production cycle shown in Figure 4. The amount q must be multiplied by the speed of circulation Vy to get total output Q.




Figure 3 gives a historical overview of inflation in England from 1300-2000.


By the beginning of the 20th century prices had increased by just 6 times in 600 years, with nearly all the increases due to the “great debasement” of the mid-Tudor period and the Napoleonic wars around the turn of the 19th century. Prices fell by about one third between 1800 and 1900 during the industrial revolution due to vast improvements in productivity.  Higher productivity means more goods and services are produced for the same input costs leading to lower prices P if money M and speed of circulation V remain constant.

The price change formula P=P*(1+ If % /(Vy *100)) shown at the bottom right of Figure 2 refers to a single production cycle producing the (constant) economic output q. Figure 10 shows that, assuming the deposit interest rate If and output Q are more or less constant, physical inflation is half of If %. The figure P* If % /(Vy *100) is the rate of change of P. It must be mathematically integrated to give the total numerical change in P. This increase in price in called systemic inflation.


Click here to view FIGURE 10 : SYSTEMIC INFLATION.


Systemic inflation is a structural part of the debt-based financial system whenever interest is paid on deposits.


Figure 11 compares systemic inflation with consumer price inflation (CPI) in New Zealand from 1978 to 201182 .




Rapid wage increases increase the debt for production My faster than would normally be the case. From the original Fisher Equation (1) MV=PQ, if M rises while V and Q stay the same, P must rise in proportion to the rise in M.  This is what happened before the debt-based financial system became dominant after WWII as shown in Figure 3. It also seems to have happened in New Zealand from the late 1970’s through to the mid 1980’s with the exception of the period of the wage and price freeze in the year ended March 1984. 83 The reverse applies when wages are “squeezed” as seems to have been the case in New Zealand in the 1990’s. Changes in indirect taxation also have to be considered separately when considering inflation data because they affect prices but have nothing to do with systemic inflation or the productive system.


82. This raises an interesting debate about comparing averages with indices and the relationship between price indices and measured economic growth. The saw-tooth form of the official SNA data in Figure 7 suggests serious issues with economic management from 1978-1999.

83. The 1983 and 1985 years will still have been affected by wage factors even though they fell partly within the period of the wage-price freeze.


When economic productivity increases, more goods and services are produced using the same productive debt My because, in aggregate, the unit cost of each item produced is a little less than it was previously.   In the original Fisher equation  (MV=PQ),  if  M and V remain constant and Q increases then P must decrease.


The price of many items has fallen dramatically over the years as shown, for example, in Figure 3 during the industrial revolution in England during the 19th century.  More modern examples are the steep decline in the costs of some consumer electronics.


Productivity growth is inherently deflationary.

Labour productivity is often measured by dividing the value of total production, the gross domestic product (PQ), by the total number of paid hours worked.  Capital productivity is often measured by dividing PQ by the total current productive investment.. Education and skill levels play a major in both measures because they allow new ideas and new technologies to be introduced.  Caution needs to be used when applying productivity figures because the methods used to measure them can be inaccurate. Typically, employees with higher education and skill levels are paid more.  That tends to increase some incomes at the expense of others, distorting the income distribution in most western economies.  The most extreme form of this is the very high compensation packages now being paid to the executives of large corporations.


This paper assumes that, in aggregate, wages inflate at systemic inflation plus the rate of productivity growth to maintain overall price levels.  One key reason why so many employees in modern industrial economies feel and are in fact worse off is because the benefits of productivity increases are skewed as discussed above 84. The increasing skew can be corrected only by income redistribution within the economy.


84. Discussion of the income skew is outside the scope of this paper, but one common way to measure it is by using GINI coefficients. The higher the coefficient the more skewed he income structure is. Over the past 30 years New Zealand has gone from a low GINI coefficient similar to those  of  northern Europe to one of the most skewed in the developed world, behind only Singapore , Hong Kong and the United States.  NZ and the US both now have GINI coefficients around 40 compared to coefficients in the mid to upper 20’s  in  Scandinavia.


In a debt-based economy where interest is paid on deposits, systemic inflation is half the interest rate If paid on deposits provided adjusted incomes rise in line with inflation and productivity growth and there are no changes to indirect taxes.


Distributing the benefits of productivity increases throughout the economy by improving real wage levels and purchasing power requires socially mandated income redistribution.


Many developed countries have failed to redistribute the benefits of increased productivity, with consequent loss of consumption capacity in the wider economy. The classic case of this in recent years is the tax cuts made by recent republican presidents in the United States 85.


Deposit interest rates declined in New Zealand from 1991-1994.  Further research is needed to confirm why, in those years, the recorded CPI inflation was so low compared with the systemic inflation, but it could be due to relative wage deflation or a short-term reduction in Vy 86 or  even a decrease in productivity.  The same could also be true of the period 1996-1999 despite rising interest rates then. Some income earners were harshly treated during the National government administration in New Zealand from 1990-1999.


85. New Zealand “led” the way when it reduced the top income tax rate from 66% first to 48% on 1 October 1986 and then later, through several steps, to 33%. 

86. Other possible explanations are the backward “smoothing” of official data after the introduction of the revised System of National Accounts (SNA 93) in 1996 and the implementation of the Basel 1 accord that was first published in 1988 and implemented in the so-called G10 countries in 1992.




Eliminating systemic inflation by removing deposit interest would resolve New Zealand (and the world’s) inflation problems 87. The monetary policy decisions presently giving rise to the saw-tooth price jolts and attendant boom and bust cycles shown in Figure 9 could be avoided and residual inflation reduced to low levels 88.


87. People would still “save”, given the chance, even with zero deposit interest, as long as there is little or no inflation. People saved for thousands of years before the debt system was in use because, like some other species, HUMANS ARE HOARDERS. Protecting themselves against hard times is instinctive.

88. Japan has had almost zero inflation and zero deposit interest for the past decade and has maintained modest real GDP growth through that period.  Source: WEO (World Economic Outlook).  Current account surpluses remove purchasing power from My . Japan’s current account surplus from 2004-2008 alone was over US $900 billion which is why the Bank of Japan had to inject about US$ 1 trillion into the Japanese economy during that time to avoid deflation.


In New Zealand, the sharp reductions in interest rates from the end of 2008 reduced the inflationary impact of systemic inflation at the same time banks began increasing their margins and “shutting up shop” by making lending more difficult. The banks’ actions drew money out of the economy at the same time the government was trying to stimulate it.  Better policy coordination would have reduced the depth and length of the recent recession.


Aggregate increases in inventory are also a sensitive indicator of declining purchasing power in the economy. They mean consumers lack the disposable income needed to consume all the current production. That lack of income can arise in part from efforts to hoard “earned” savings 89.  It can also be caused by reductions in employees’ incomes that result from increases in interest rates applied under orthodox monetary policy settings to manage inflation. Consumers’ disposable incomes will fall unless the interest rate increases are fully compensated in employee incomes 90. There is a reduction in consumption with accompanying unemployment until either inventory is returned to normal levels or consumption demand expands.


89  That will be made a lot worse by current suggestions in New Zealand to implement compulsory superannuation contributions that will result in lower living standards unless ALL the money collected is channelled into productive investment, that is, into the circulating debt My  and subsequently on-loaned to entrepreneurs.

90  As already described, disposable incomes are reduced by the extra interest claimed by the investment sector as a result of the higher interest rates.


While a full discussion of savings lies outside the scope of this paper, government efforts in New Zealand to increase savings for investment purposes, as, for example in the 2010/2011 budget speech of 20th May 2010 are problematic. Trying to draw savings from the productive debt My in a wholly debt based financial system prevents the productive economy from expanding properly because it reduces both consumption capacity and the gross operating surplus in the economy as a whole. Such saving would make sense only if it were re-directed immediately as part of My into new productive investment, thereby offering significant productivity gains to the economy. This paper shows such investment would then need to be accompanied by increased incomes to enable that new production to be consumed.  Exactly the opposite is happening. Savings are being withdrawn from consumption and mostly invested in the investment sector offshore. Conceptually they form part of Db in the revised Fisher equation.  This gives New Zealand the “worst of both worlds”.  The economy receives little or no productive investment from the savings 91 while it is also being drained by the withdrawal of consumption capacity; exactly the opposite of what the government and monetary authorities say they want.


91  There might be some repatriation of dividends on the investment but, in New Zealand, that appears to be minor when compared to the transfers being sent offshore from earned incomes.


This paper reduces the savings debate to a single simple proposition:


In aggregate it is possible to save debt-free money but it is not possible to save debt unless that debt exists as speculative investment (Ms ,Dca ,Db) outside the productive economy. If the “savings” are reinvested in the productive economy they become part of My and have to be reflected in new productive incomes while those who took on the extra debt still carry it until it is paid off.


There does not appear to be any financial mechanism available in the current financial system, as it is detailed in this paper, to bring about long term inflation stability other than by very low  (or zero) deposit interest rates. Low deposit interest rates will, in turn, probably require quite drastic action to prevent capital flight and bring the current account into balance, such as by the application of an appropriate surcharge on New Zealand dollar exchanges for foreign currency. Preston (2009) has suggested something similar. While an export led recovery to reverse the current account crisis, promoted so widely among economists and in government circles, is a “nice” idea, it is unlikely New Zealand now possesses enough independent productive capacity to meaningfully achieve it within an acceptable time frame. The situation is more likely to worsen as more and more manufacturing capacity and services are moved offshore or placed under the control of foreign operators who shift their profits off-shore.


There are no existing monetary policy instruments available to adequately address the systemic nature of inflation in the productive economy.


A separate paper is needed to further “flesh out” the impact of taxation on unearned income deposits. While the New Zealand banks supply a tax deduction certificate for each account they hold, that aggregate information may need to be collated from the banks themselves, and then some assessment made of how that tax is adjusted within individual tax returns; a complex task beyond the scope of this paper. That necessarily means Figures 9 and 11 are provisional and indicative. The additional research is needed because the debt model application is dependent on the numerical value of the accumulated deposit interest Ms. The taxation of deposit interest significantly affects the net Ms value 92.


92  Using the gross pre-tax value of Ms, as in Manning (2009), distorts the numerical model application.





Figure 12 shows New Zealand’s foreign ownership plotted against the increase in GDP. For illustrative purposes, a constant total of NZ$ 35 billion has been added to the foreign “debt” to show how the foreign “debt” curve almost exactly follows the GDP curve 93.


Figure 12 shows that for all practical purposes, all of New Zealand’s nominal GDP growth for nearly thirty years has been borrowed abroad. The country has persistently lived beyond its means, adding to its debt problem.




The process described in this paper setting out the mechanics of the present debt-based financial system does not seem to have been described anywhere before, but, as Figure 6 clearly shows, debt expansion in New Zealand has actually taken place, as it must, in accordance with the revised Fisher Equation of Exchange and the debt model presented in 2009 94. New Zealand’s domestic credit has expanded 23 fold in the past 30 years, from about NZ$ 12.9 billion in March 1981 to NZ$ 294 billion in March 2010. The physical demand for that debt expansion was satisfied until recently in New Zealand using a method of debt creation called fractional reserve banking.  More recently following further deregulation of the financial system under the Basel I and Basel II Accords 95  those reserves have been replaced in many countries by rules relating to “capital adequacy”. The effect, though, is still the same. The banking system is still able to multiply its “risk weighted” capital many times over.


93  The NZ$ 35 billion is an arbitrary amount added for visual effect.

94  Manning, 2009.  

95  Issued by the Bank for International Settlements (BIS) in Basel Switzerland


The mechanics of fractional reserve banking are widely known and described in many good primary economics textbooks 96. The process was that central banks 97 purchase securities, mainly bonds, usually from commercial banks. The banks “sell” a loan to the central bank that then “pays” for the loan by writing deposits into their reserve accounts at the central bank (RBNZ 2008b). Because the central banks, from an accounting point of view, have borrowed from the commercial banks, the central banks pay interest (called the coupon rate) to the commercial banks on the deposits the central bank has itself created for them. 


Central banks gift the “high powered” deposits they put into the commercial banks’ reserve accounts and pay interest in perpetuity on those gifts 98. 


96  See for example Blaumol W.J & Blinder A.S.  “Economics  Principles and Policy”, Harcourt Brace Jovanovich, fourth edition Chapters 13 & 14 .

97  Central banks are bankers’ banks that are responsible for implementing government monetary policy and maintaining the stability of the financial system. Some central banks like those of Australia, New Zealand and Canada are publicly owned while others like the US Federal Reserve Bank, (the FED), are publicly owned but  largely controlled by the banks themselves. The central banks in turn have their central bank called the Bank for International Settlements (the BIS) based in Basle Switzerland, which plays a dominant role in regulating world banking and financial institutions.

98  The central banks retain the power to sell their bonds, that is require repayment from the banks, but that is rarely done to any large extent because it would cause a big drop in bank lending capacity. Treasury T-bills (bonds with less than 1 year term) and the Official Cash Rate (OCR) are typically used to adjust lending capacity.


From the public perspective it is very hard to conceive of a less fortunate way for governments through their central banks, some of which are not even publicly owned, to increase the base money supply. The “risk-weighted” capital method now in use may be  even worse than the reserve method because there is no direct mechanism for central banks to rapidly expand lending when there is a credit squeeze (such as, for example, from 2007-2010) other than by the injection of new central bank funding or government treasury debt.


The reserves created by the banking system from the banks’ sales of bonds to their central banks were like cash. They are what the banking system used to exponentially expand lending in the manner set out in the textbooks so that banks could continue lending and pay interest on the deposits held in their clients’ deposit accounts.


In the investment sector every loan made by commercial banks to facilitate the purchase of an existing capital good such as property, shares or securities requires deposit interest to be paid. Each of those loans produces its own corresponding residual Ms debt and exponentially increases the pool of un-repayable 99 unearned deposit interest. Annually, the pool of deposit interest on the accrued residual debt Ms increases on itself at the rate of the deposit interest rate I*K as shown in Figures 2 and 4. It is “pumped” into the deposit interest pool from the production cycle 100 along with My , Dca , and Db.


The size of the non-productive investment sectors Ms and Db , especially when “off-book” derivative transactions are included, relative to the amount of circulating debt My together with the net worth the banks have accumulated to cover any debt defaults, has increased the instability of the present debt system.


Domestic banks must expand their lending to support the deposit interest burden on the domestically accrued debt. If the banks do not lend enough to do so they would be unable to pay all the deposit interest due on their customers’ deposits unless My  itself is reduced assuming Vy is structurally stable. The effect is clearly shown in Figure 9.


The present fractional reserve mechanism of debt expansion is haphazard because it is not properly based on the true demand for debt from within the financial system as shown in Figures 2 and 4 and in the debt model referred to in this paper. Instead, present debt creation is dictated by monetary policy that produces discontinuities in the available supply of new debt. Despite the best efforts of the monetary authorities, those discontinuities inevitably lead to mismatches in the production cycle and associated expansions and recessions characterised by boom and bust cycles. 


Lending must continuously and smoothly satisfy the mechanical systemic demands of the financial system rather than the whims of monetary policy. This paper provides a basis for more accurate assessment of the amount of new debt needed for the smooth running of the economy without the distortions created by orthodox monetary policy.


Financial system stability also depends upon unearned income deposits arising from deposit interest remaining in the investment sector or paper economy as it is often called 101. For this to happen the expected financial return from keeping the deposits in the investment sector must exceed the perceived benefit arising from any corresponding investment in production or consumption.  The numerical incentive for deposits to remain locked into the investment sector is the extra annual amount (Ms+ Dca+ Db)*K*I added to the investment sector deposits, because they inflate the investment sector by that amount raising prices there relative to the productive economy.  The incentive to invest can be expressed as a percentage (Ms+Dca+Db)*K*I/(M3-repos)*100 less the systemic inflation and changes in indirect taxes in the productive sector expressed as a percentage of GDP.


99 The debt Ms supporting the accumulated deposit interest  is unrepayable because the holders of the deposits are not the same as those who hold the debt. Provided the bank does not fail, Ms always remains in the system whatever happens, even when debtors default on their loans.

100 Some degree of quantification of price effects within the investment sector appears to be theoretically possible using the debt model and deserves further research.

101 The only other place it can go is into the productive economy, increasing incomes and gross operating surplus thereby increasing measured inflation. There is little doubt such transfers do occur both ways.


During the periods some decades ago when GDP (My * Vy) expanded faster than the accumulated deposit interest there was a much higher incentive to invest in new production instead of speculation, so the GDP usually increased as fast or faster than the prices of existing assets. For the past 20 years there has been an incentive to leave money in the investment sector instead of using it to expand production.


As Figure 8 shows, that is no longer the case in New Zealand. In the March years 2009 and 2010 the transaction deposits  My , which represents the system liquidity, collapsed in a way not seen in the past 20 years. The structural demand for deposit interest Ms is consuming some the circulating debt My because My is not increasing fast enough to enable the pool of deposit interest to be serviced. According to the model calibration used in this paper, My fell slightly in both 2009 and 2010 while Vy remained constant. GDP is extremely sensitive to changes in My. The only way to correct this is to inject liquidity into the productive system to expand the economy either by new production or by inflation. This has been starkly portrayed in the United States during the housing market crisis in recent years where the stimulation package there was aimed at the financial sector but not the productive sector.


A likely outcome should deposit interest If or the incentive to invest approach zero would be an increase in finance company lending and greater investment in equities and other productive activity. The “incentive to invest” as shown in Figure 13 is an entirely new economic concept.


Click here to view :  FIGURE 13 INCENTIVE FOR DEPOSITS ARISING FROM DEBT TO REMAIN IN THE INVESTMENT SECTOR NEW ZEALAND  1988-2010. Figure 13 includes assumed taxation rates on deposit interest of 50% from 1978-1993, 40% from 1994-1999, 30% from 2000-2005, 26% from 2006-2009, and 24% from 2010-2011.




The financial debt mechanisms described in this paper could have been observed and understood at any time since the Bank of England was established in 1694. They could have become more obvious as debt growth and accompanying monetary expansion accelerated over the past century.  One reason the mechanics of the debt system have not come to light until now could be the asymmetrical exercise of power in the world economy through dominance of its national and international financial institutions by vested interests. 


The French economist Perroux (1966) first introduced the concept of dominant revenue.  He traced the evolution of economic domination from the landowners (aristocracy) of the middle ages through mercantilism (merchants) of the colonial period to industrial capitalism (industrial corporations) from the industrial revolution until post world war II, and more recently to finance (banking and financial institutions).  Strange (1996) has reinforced the notion of power as “the capacity to conceive, legitimise, implement and control rules for individual and collective action” even when there is large-scale opposition to those rules. Other writers like Palley, (2009) suggest what some of the “problems inherent in the neo-liberal US growth model” are. None of them examines the system mechanics underlying those problems.


Finance as the “dominant revenue” 102 is maintained through an unbroken chain of authority reaching down from the Bank for International Settlements (BIS) through international financial organizations like the International Monetary Fund (IMF) and the World Bank, to Central Banks like the US Federal Reserve and its member organisations, and some universities like the University of Chicago who have continued to support existing orthodox economic theory after it became apparent the present system had become dysfunctional. In the United States especially, the lack of effective constitutional restraints on campaign spending, advertising and lobbying have effectively rendered democratic institutions like the US Congress and the US Executive branch captive to the centres of power, especially that of finance. The financial collapse that began in the United States in 2007 103 has reinforced the view among many economists that the time has come to consider new options for managing the financial system.


Some of the debt “contagion” that has swept the world in recent years probably would have been avoided had the world adopted the principle of balanced trading accounts proposed by John Maynard Keynes representing the UK delegation at the Bretton Woods conference in 1944 104.  That UK position was effectively vetoed by the United States, leading progressively to the expansion of capital flows that have caused so many problems in recent decades.


102  Exemplified in recent times by the huge bonus payments made by the dominant US banks and Wall St trading houses while the rest of the economy is staggering in disarray.

103  Northern Rock in UK was the first large failure, but the failure  was induced by US “toxic” assets.

104 The conference at Bretton Woods New Hampshire in 1944 established the basic outline of the international financial system that was to be established after WWII.


The mechanisms described in this paper are still forcing the vast US capital base to expand exponentially, while the US economy has become ever less able to support it. This is due in part to economic expansion in other parts of the world, especially the BRIC countries (Brazil, Russia, India and China), as well as United States’ offshore military interventions 105. These events are producing growing current account deficits in the US, increased government debt and relatively lower domestic consumption capacity.


Inflationary consumer borrowing in the US and elsewhere, using residential property as security, allowed excess consumption to continue until the point was reached where consumers could no longer fund their debt. This happened in part because under the Basle accords that regulate bank investment risk residential property carries a much lower risk weighting than business lending (RBNZ, 2009c). Those factors combined with the growing concentration of wealth in US society suggest US economic power and the “full spectrum (military) dominance” of the Project for the New American Century 106, are likely to erode over time. Over time, such broad institutional influences are likely to weaken the role of finance as the dominant revenue.


Weakening finance as the dominant revenue is also inherent in the necessary changes in the world’s financial structure implied in this paper. This could, in turn, lead to the third great economic revolution the world has seen, being one based on human and natural capital in its broadest sense. The third revolution, just beginning, will recognise and accept the environmental constraints of human activity and ethical limits to human population expansion, valuing the quality of life rather than, or at least as well as, the quantity of material wealth 107. 


An exclusive right for a publicly-owned authority to issue new debt (and money) would mean that private banks could no longer create new debt. New debt (and e-money) spent into circulation would still finish up in deposits with the private banking system. These earned deposits could then be used by deposit-holders and/or on their authorisation by the banks on terms, including the rates of interest, they see fit. The banks would be acting as savings and loan institutions. Should deposit-holders not spend their money, they are in fact limiting their own consumption by saving. One (instinctive) purpose for doing this is to create a reserve for times of need. Saving for a specific purpose is another. If they lend their deposits with or without interest to another party, they allow a matching increase in the level of consumption of the other party. Where interest is charged, the borrower must pay both the capital and interest back. The borrower does this as agreed either by increasing his productivity or, if required, in turn reducing his level of future consumption. The choices made by the two parties are entirely subjective.  They are not subject to regulation.


The bankers’ “spread” which covers the banks’ costs and profit as well as occasional changes in their provision for bad debts need not change at all. As prices stabilise, the rate of increase of their volume of business should, however, decrease. The values of land , housing and rents, superannuation schemes, savings banks deposits, life insurances, hire-purchase items would stabilise. Consumers’ confidence would increase with their sense of economic security.


Governments in democratic countries are periodically elected on the basis of programmes including their promises about how they will manage public institutions and protect the public interest. If voters perceive a government has done its work well, the government may be returned to office. If voters are unhappy, they may vote another government in. Contrary to what some past authors may have believed 108, properly functioning financial mechanisms are themselves independent of the political orientations of the government currently in power.


105  Funded in part from government borrowing rather than taxation. Military materiel is largely produced domestically in the US, providing incomes, but is consumed offshore, making foreign wars inherently inflationary as Britain found out during the Napoleonic Wars, WWI and WWII when prices roughly doubled as shown in Figure 3.

106 http:/  The semi-official military and foreign policy of the United States government under George W Bush. The site states: “The Project for the New American Century is a non-profit educational organization dedicated to a few fundamental propositions: that American leadership is good both for America and for the world; and that such leadership requires military strength, diplomatic energy and commitment to moral principle.”

107 The first great revolution was the development of agriculture and associated land and property rights and the second was the Renaissance and the development of science that has brought the world, for better or worse, to where it is today.

108  Danks (1955) pp. 57-59.




The paper shows how exponential debt expansion in the financial system used worldwide is caused by interest paid as unearned income on bank deposits. It describes analytically for the first time the fundamental transfer mechanism whereby the financial system  “pumps” deposits from the production cycle into the investment sector or paper economy. This process leads to endemic systemic inflation in both the productive and the investment sectors.  In the current economic system inflation is unavoidable except in the presence of substantial current account surpluses.


Neither the System of National Accounts  (SNA) nor orthodox economic theory provides a direct mechanism to manage systemic inflation. Instead, orthodox inflation policy works through the investment sector.  Higher interest rates increase systemic inflation while at the same time increasing deposit interest and reducing purchasing power. The inflation transmission mechanism persistently damages the profitability in the productive economy as inflation is temporarily slowed by lower consumption, lower producer margins and higher unemployment. This is but one reason why using an Official Cash Rate (OCR) to control inflation within our present system is fundamentally flawed.


While some, mostly debt-free, individuals may succeed in hoarding financial reserves, the existing debt system does not appear to allow for any aggregate earned savings.  As a result, earned savings have to be offset by net borrowing of new capital, consumer or other non-productive debt from outside the production cycle.


Speculative global financial flows make current account imbalances worse and cause instability by “chasing” large deficit, high yield currencies. This process creates a self-reinforcing cycle of overvalued currencies, high interest rates, and financial crashes especially where central banks rigidly apply very low inflation targets.


Excessive debt growth has now reached the point where the global financial system is imploding because the productive economy can no longer satisfy the profit expectations of the investment sector.


The pool of unearned income in the investment sector does not usually mix with the production cycle because there is a net financial incentive for unearned interest deposits to remain in the investment sector.


An economic debt model based on a revision of the Fisher Equation of Exchange provides analytical support for the analysis given in this paper.


The theory and model described in the paper allow, in principle, ready quantification of debt expansion, systemic inflation, growth and the incentive to invest.


Exponential expansion of debt and prices can be slowed or stopped by reducing or removing deposit interest from the financial system. This could be done on a multilateral basis but is more likely to be implemented unilaterally.


Cultural and institutional “capture” of economic debate may explain why the causes of debt growth and inflation have not been closely examined before now.




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The author gratefully acknowledges the support and advice of  John Walley and Les Rudd and the New Zealand Manufacturers and Exporters Association (MEA). Thanks to Raf Manji and the Sustento Institute  for  their encouragement and advice and to Terry Manning and the NGO Bakens Verzet whose editing and constructive critique have been crucial as the paper has evolved over time. 



More information on monetary reform :


NEW Capital is debt.


NEW Comments on the IMF (Benes and Kumhof) paper “The Chicago Plan Revisited”.


DNA of the debt-based economy.

General summary of all papers published.(Revised edition).

How to create stable financial systems in four complementary steps. (Revised edition).

How to introduce an e-money financed virtual minimum wage system in New Zealand. (Revised edition) .

How to introduce a guaranteed minimum income in New Zealand. (Revised edition).

Interest-bearing debt system and its economic impacts. (Revised edition).

Manifesto of 95 principles of the debt-based economy.

The Manning plan for permanent debt reduction in the national economy.

Missing links between growth, saving, deposits and GDP.

Savings Myth. (Revised edition).

Unified text of the manifesto of the debt-based economy.

Using a foreign transactions surcharge (FTS) to manage the exchange rate.



(The following items have not been revised. They show the historic development of the work. )


Financial system mechanics explained for the first time. “The Ripple Starts Here.”

Short summary of the paper The Ripple Starts Here.

Financial system mechanics: Power-point presentation. 



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"Money is not the key that opens the gates of the market but the bolt that bars them."

Gesell, Silvio, The Natural Economic Order, revised English edition, Peter Owen, London 1958, page 228.



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