NGO Another Way (Stichting Bakens
Verzet), 1018 AM
SELF-FINANCING, ECOLOGICAL, SUSTAINABLE, LOCAL INTEGRATED DEVELOPMENT PROJECTS FOR THE WORLD’S POOR.
Edition 01 : 23 January, 2012.
Edition 02 : 21 October, 2012.
Edition 04 : 09 February, 2013.
Summaries of monetary reform papers by L.F. Manning published at http://www.integrateddevelopment.org
The referenced papers :
NEW Capital is debt.
General summary of all papers published.(Revised edition).
(The following items have not been revised. They show the historic development of the work. )
THE MISSING LINKS BETWEEN GROWTH, SAVING, DEPOSITS AND GDP
By Lowell Manning firstname.lastname@example.org VERSION 3 21/10/12
Key words: debt, debt model, deposits, deposit interest, domestic credit, Fisher equation, GDP, growth, inflation, revised Fisher equation, saving, savings, systemic inflation, unearned income.
1. EXECUTIVE SUMMARY
3. THE DEBT MODEL
4. DEBT AND DEBT GROWTH
5. THE MISSING LINKS
The author wishes to thank Raf Manji and the Sustento Institute for their ongoing support of this research and Terry Manning of NGO Bakens Verzet for his perceptive critique and editing of the drafts.
This work is Licensed under a Creative Commons 3.0 Attribution – Non-commercial – ShareAlike licence.
1. EXECUTIVE SUMMARY.
This paper brings together the concepts explored in a series of earlier papers for which links are given at the top of Page 3. It summarises the main elements of two of them, “The Savings Myth” and “ The DNA of the Debt-Based Economy”. Those two papers show how the current account and exchange settlement processes work, the principles of production in the debt- based economy and the concept of systemic inflation.
Section 3 describes a debt model that can be used to analyse the debt-based economy and concludes with Figure 8. Figure 8 shows “DNA” helices that relate GDP to accumulated Saving and Growth. The debt model is a form of the well-known Fisher Equation of exchange revised so it can be applied to a debt-based economy.
Section 4 uses the concepts in Sections 2 and 3 to explain debt growth in more detail. It shows that when the current account is balanced the overwhelming cause of exponential debt growth is the unearned income derived from the interest banks pay on banking system deposits. Figure 11 shows the process of debt creation based on the banks’ risk based capital, the influences of the central bank and how government debt is generated.
Section 5 explains
how the differences between the historical orthodox “fractional reserve”
explanation of debt expansion and the existing risk-based capital method of
debt expansion arose. The orthodox explanation was based on a Savings and Loan
model of banking that was discarded decades ago prior to the implementation of
The paper shows that interest on the accumulated investment debt (the GDP according to “The DNA of the Debt-Based Economy”) can only be paid out of productivity gains made available from new productive investment. If the productivity gains are insufficient to fund the interest, the productive sector must inflate to make up the shortfall.
There are systemic
connections between debt, deposits and GDP.
The final section of the paper discusses the links between debt, deposits, and unproductive saving, and concludes that the entire modern monetary system is based on inflation. In a debt-based financial system, household deposits represent the accumulated cost-push systemic inflation in the productive economy plus the accumulated demand-pull inflation of the accumulated current account balance. The net international investment position (NIIP) could be used instead of the accumulated current account balance.
Except for real
added production, the financial system debt and deposits are determined
endogenously through deposit interest and exogenously through the accumulated
current account balance [or NIIP].
This paper explores the links between Growth, Saving, Deposits and GDP discussed in some of the author’s previous papers.
The papers are available at www.integrateddevelopment.org
General summary of all papers published. (Revised edition).
The Savings Myth. (Revised edition)
The interest-bearing debt system and its economic impacts. (Revised edition).
How to create stable financial systems in four complementary steps. (Revised edition).
How to introduce a guaranteed minimum income in New Zealand. (Revised edition).
Financial system mechanics explained for the first time. “The Ripple Starts Here.” (Original version, not updated. This is now for historical reference only. Other papers incorporate up-dates and revisions. )
Short summary of the paper The Ripple Starts Here. (Original version, not updated. This is now for historical reference only. Other papers incorporate up-dates and revisions.)
Financial system mechanics: Power-point presentation. (Original version, not updated. This is now for historical reference only. Other papers incorporating up-dates and revisions.)
This paper relates mainly to the papers “The Savings Myth” and “The DNA of the debt-based economy”.
THE SAVINGS MYTH.
“The Savings Myth” discusses Saving in relation to the System of National Accounts (SNA) used around the world to measure economic activity and growth. The paper concludes there are serious problems with the structure of the national Income and Outlay and Capital Accounts in the SNA and that “Saving” recorded in the SNA bears little relation to Savings = Investment as set out in classical orthodox economics. Some of the main features in the paper are:
a) A positive balance of external goods and services swaps domestic consumption goods and services for foreign capital assets. It is therefore a negative domestic growth factor in the exporting country at large and a positive growth factor for that country’s business interests. While it may reflect domestic economic activity it does not reflect domestic growth because the income is not spent where it is earned.
b) A study of the nature of the current account and foreign exchange settlement processes shows there is no such thing as foreign debt. There is only foreign ownership of the domestic economy in debtor countries when there is an accumulated current account deficit there. That ownership can be direct or it can be in the form of commercial paper that represents claims on the domestic economy.
Figure 1 reproduces Figure 1 from “The Savings Myth”. It shows how assets and deposits are exchanged through the foreign exchange interface.
Foreign ownership of a debtor nation’s economy drains its domestic economic growth through outgoing current account payments of interest on commercial paper and dividends and profits arising from the physical foreign ownership of its assets.
Foreign ownership of a debtor nation’s economy exposes it to high interest rates and the permanent risk of capital flight.
c) The decline in Saving for Investment is structural. The decline arises from persistent business demand for faster depreciation allowances. Part of that demand arises from rapid innovation and planned obsolescence, but part of it is greed. Higher depreciation provisions usually increases bottom line profits. That means faster repayment of investment principal and therefore a lower surplus for productive investment. Less productive investment means slower growth. National Saving has been swapped for short-term profit.
d) The structural decline in national Saving cannot be addressed anywhere in the world using existing orthodox economic theory and policy.
e) Non-productive “Savings” schemes around
the world (such as Kiwisaver and the so-called “Cullen” Superannuation Fund in
f) Figure 2 reproduces Figure 2 from “The Savings Myth”.
Figure 2 shows that in a dynamic economy the investment process is internal to the production cycle. There are sufficient incomes in aggregate to buy the capital goods produced. Some incomes earned in the production of capital goods are “Saved” by employees and businesses and subsequently “Invested” by entrepreneurs who wish to buy them. The internal lending allows the production loans to be repaid. For simplicity Figure 2 does not separately include loan interest. Therefore:
Saving = Investment (exactly as is found in most orthodox economics textbooks)
The internally self-cancelling production process shown in Figure 2 is mediated by the banking system. At any time, the total outstanding loans used to buy the capital goods produced equals the total outstanding principal still owing on those capital goods (the orange boxes in Figure 2). Net capital formation, equals “gross capital formation” as shown in the SNA less principal repayments on existing capital goods.
THE DNA OF THE DEBT-BASED ECONOMY.
The paper “The DNA of the debt-based Economy” extends the discussion set out in “The Savings Myth” and relates the systemic processes taking place in the productive economy to the Fisher Equation provided by Irving Fisher in 1912 
in his well-known equation of exchange that takes the form:
MV = PQ (1)
M = the amount of money in circulation
V = the speed of circulation of that money; the number of times M is used over a given period T
P = the price level of goods and services an economy produces during time T
Q= the total quantity of monetised goods and services an economy produces during time T.
The product PQ is what is known today as Gross Domestic Product or GDP. Some of the main features in the paper are:
a) Figure 3 reproduces Figure 1 from “The DNA of the debt-based Economy”.
The economic activity shown in Figure 4 is still self-cancelling because there is no interest included on the debt. It does not show the internal Saving = Investment function of Figure 2 which focuses on the production and sale of capital goods as distinct from the broader Gross Domestic Product (GDP) that includes both capital goods and consumption goods and services. Figure 4 describes the self-funding, self-cancelling nature of the economic cycle itself as a whole. The green boxes show the income (production) side, and the blue boxes the consumption side of the productive cycle.
Because the market is held weekly there are 52 weekly markets in a year and so on an annual basis the speed of circulation Vy of the money My in the Fisher equation in that case would be 52. Figure 2 also assumes that there is no hoarding (“saving”) of money so that all the money supply My is used each week. If that were not so either prices P or output q, (or both) would be smaller.
b) Developed economies are no longer cash-based as shown in Figure 2. Instead, they have become debt-based. Figure 4 reproduces Figure 2 from “The DNA of the debt-based Economy”. Figure 4 shows how debt instead of money is used in the production cycle shown in Figure 2. It also shows how the basic production cycle relates to the System of National Accounts discussed in “The Savings Myth”.
c) Figure 5 reproduces Figure 4 of “The DNA of the debt-based economy” .
Figure 5 shows what happens when interest is introduced into the financial system.
The result is a build up of debt and interest external to the productive cycle. The productive cycle is then, in aggregate, no longer self-cancelling. Instead, it produces unearned income in the form of interest on deposits that must be funded by the productive economy. Unearned income, by definition, produces nothing because it is not backed by productive activity. In Figure 5 If is the average interest rate paid on deposits. Ms in Figure 5 is the accumulated pool of unearned deposit income.
The price change formula P=P*(1+ If % /(Vy *100)) shown at the bottom right of Figure 5 refers to a single production cycle producing the (constant) economic output q.
d) Figure 6 of “The DNA of the debt-based Economy” is reproduced as Figure 6. Figure 6 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 Price P. It must be mathematically integrated to give the numerical inflation. This aggregate increase in the annual GDP output caused by the price increases shown in Figure 5 is called systemic inflation.
Subject to several qualifications, systemic inflation is therefore equal to half the average interest rate paid on deposits. 
At this point, the financial system is made up of:
i) the self-cancelling cycles of production shown in Figure 4 that includes internal Savings = Investment as shown in Figure 2, funded by a dynamic pool of transaction account debt supporting the productive transaction deposits.
ii) the systemic inflation arising from deposit interest shown in Figure 5 represented by the accumulated unearned income.
iii) the accumulated debt, including government bonds, borrowed to service the current account shown in purple at the bottom left of Figure 1. Deposits corresponding to that debt arise from the sale of debtor country assets together with commercial bank foreign exchange borrowing to satisfy the foreign exchange settlement requirements (top left of Figure 1).
iv) any expansionary “bubble” debt representing debt borrowed outside the productive economy to fund the purchase of existing assets.
3. THE DEBT MODEL. 
At any point in time in the debt system there are five broad blocks of deposits and some circulating currency in the domestic financial system.
Mt The transaction deposits representing the productive debt My - M0y so:
My = Mt + M0y (2)
M0y is the cash in circulation included in My and used to contribute to productive output.
Mca is the accumulated domestic deposits representing the sale of assets to pay for the accumulated current account deficit. It equals Dca defined below less the Net Foreign Currency Assets (NFCA).
Ms is the accumulated deposits arising from unearned deposit income on the total domestic banking system deposits M3 (excluding repos). 
M0 is the total cash in circulation so that (M0-M0y) is cash hoarded by the public and not used to generate measured GDP.
The total of Mt + M0y + Mca + Ms, is provisionally assumed to be the monetary aggregate M3 (excluding repos) published by most central banks monthly, less the amount of cash in circulation M0 except for the part M0y that is included in My. 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. 
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  + Dr (3)
the productive debt supporting the transaction
Dca is the whole of the debt created in the domestic banking system to satisfy the accumulated current account deficit. 
Dr is the residual debt to balance equation (3).
Db, is the virtual “bubble” debt, the excess credit expansion or contraction in the banking system such that Dr - Db = the debt Ds supporting the accumulated deposit interest Ms defined above. Therefore, Dr= Ds+Db. Db can be positive or negative.
By definition in this paper : My x Vy = GDP; and Ms = Ds ; and Dr=Ds+Db, and
Dt= My-M0y; and the cash contribution to GDP = M0y * Vy. .
By substitution into equation (3): [DC = Dt + Dca  + Dr ]
DC = (GDP)/Vy - M0y + Ms + Dca + Db (4)
Ms =Ds = (DC – Dca ) – GDP/Vy + M0y - Db (5)
GDP = Vy *(DC - (Ms +Dca +Db ) + M0y ) (6)
My = GDP/Vy = DC - (Ms +Dca + Db) + M0y (7)
where the terms are as defined above.
Equations (4) to (7) are all forms of the economic debt model shown in Figure 7.
In equation (5), all the terms except GDP/Vy = My and Db are known or can be estimated with reasonable accuracy. My can be approximated in equations (4) and (5) using trend-lines because it is small compared with Ms and DC. Db is unknown but can be approximated through model calibration. The calculations in equations (6) and (7) 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 on page 10, agrees more or less with that calculated in equation (5), 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.
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
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 7 provides a powerful argument in support of public control of a
nation’s financial system. In Figure 7, the blue curve (DC+M0y) is drawn to
scale (the total was about NZ $310 b. in
debt-based system shown in Figure 7 leaves the world economy at the mercy of
private banking institutions working for private profit by allowing
irresponsible increases and contractions (Db in equations (4) to
(7)) of the Domestic Credit and its associated bubble formation. The problem is
systemic because the existing financial system requires exponential growth. In
the case of
It probably isn’t possible to have a simpler model of the economy than equation (7):
My =Nominal GDP/Vy = domestic credit DC less (accumulated unearned deposit income Ms + the accumulated current account deficit Dca + the cash contribution to GDP, M0y plus a correction for bubble activity Db (+/-))
between the two curves is mainly the result of domestic debt needed to fund the
accumulated current account deficit that, in
It does not appear to be theoretically possible to maintain exponential debt expansion faster than the 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.
system is dynamic. The debt used to
purchase capital goods is continually repaid from economic growth. In
aggregate, as long as new investments exceed repayments, both the debt and
deposits expand together. The paper “The DNA of the debt-based Economy” shows
that the total outstanding Saving and the total outstanding debt at any time
are equal to the aggregate sum of economic growth and that this must also equal
the GDP as shown as Figure 8.
n n+2 n+3 n+4 EACH (BLUE) BASE=My =GDP/Vy
EACH (BLUE) BASE=My =GDP/Vy
The following sections of this paper explore the relationships between the debt model variables and the DNA of the debt-based economy shown in Figure 8. At first sight, Figure 8 suggests a Saving and Loan model of financial organisation. It shows that collectively, those with incomes derived from the production of capital goods (savers), must invest those incomes by buying the capital goods they have produced. If they do not do so the market cannot be cleared of those capital goods unless their purchase price is borrowed from the banking system. If the purchase price to buy the capital goods is borrowed from the banking system, there are surplus “hoarded” deposits held by the savers. Those deposits would then remain in the bank with nowhere to go other than for non-productive investment in existing assets.
Figure 9 shows a Savings and Loan model described above.  In Figure 9, the Saving deposits become physically unavailable to the savers for a time. The investor uses them to pay the producers of the capital goods. The producer uses them to cancel the production debt created to produce the capital goods. At the start, the investor has a debt to the Savers and an asset represented not by a deposit but by the asset itself. At the end the investor has no debt and the savers regain their deposit (with interest).
In Figure 9 there is no net bank debt created. The savings repaid by investors to Savers are available to trade in existing assets. The amount available is the original purchase price of the assets less the outstanding loans. When an existing capital asset is on-sold, the purchaser typically borrows the (re) purchase price from the banking system. The original asset owner (investor) repays his outstanding debt to the Savers, and, depending on the sale price and outstanding principal may make a capital gain.
Figure 10 shows what happens when investment is funded by commercial bank debt rather than rather than internally from Savers.
The main difference between Figures 9 and 10 relates to the existence of bank debt. In the Savings and Loan model (Figure 9) there is no net bank debt involved because the bank has on-loaned the savings deposits. Savers (at least nominally) do not have access to the their deposits. Only net repaid investment loans would be available to pay for the exchange of existing assets. When savings S = Investment I, there are no net repayments. The bank-funded model (Figure 10), on the other hand, involves bank debt and Savers have full access to their bank deposits. The dynamic balance in Figure 10 only also holds when the total outstanding investment equals total saving.
Savings S in Figure 10 must be invested in some other kind of investment because there is nothing new to buy with them. That applies even if it means just leaving them on deposit at the bank. In the paper “The Savings Myth” savings of this kind are referred to as a myth. The investment is backed by debt rather than savings and so does not qualify as investment as required by the principles of orthodox economics.
The difference between the Savings and Loan operation where the Savers’ deposits are used to retire the production debt, and the bank intermediation outlined in Figure 10, is profound. In the former case, shown in Figure 9, Savers hold an IOU (rather like a corporate bond) from the entrepreneurs and new homeowners while the entrepreneurs and new homeowners have their capital asset on the one hand, and the debt to the savers as a liability on the other hand. There are no corresponding deposits in the system because they have been used to repay the residual part of the production debt Dt.
In Figure 9, savers lend to entrepreneurs and homeowners while in Figure 10 the bank lends to entrepreneurs and homeowners. In Figure 9, the Savings are used to retire the producer debt whereas in Figure 10 the deposits arising from the new bank loans are used to retire the producer debt. So Figure10 introduces a new layer of debt and deposits into the system that were not there before.
In the existing debt-based economy almost all money is created as interest-bearing debt and almost every deposit arises from a bank loan. Borrowers typically sign a loan agreement before their bank gives them credit by putting money into their bank account. The bank creates the money out of nothing. The loan is an asset of the bank because the borrower agrees to repay it over time. The deposit is a liability of the bank because the bank allows the borrower to use the money it has created in return for the interest he or she pays on the loan. The process is shown in Figure 11. For completeness Figure 11 also shows the role of the central bank in creating bank liquidity, quantitative easing and bailout funding and the banks’ lending to the government to fund government debt.
Contrary to what happens under the savings and loan model (Figure 9), banks never lend their customers deposits in the debt model shown in Figure 11 because doing so would deprive the borrower of the right to use of the money they have borrowed. In accounting terms banks cannot lend their liabilities. This is different to the Savings and Loan model (Figure 9) where savers do not automatically have access to their deposits until their term deposit matures. 
From the relationships shown on page 11 the following derivation can be developed
DC = Dt + Dca + Ds + Db (8)
Of the total, Dt alone relates to the dynamic transaction account debt used to fund the productive economy. The rest makes up the so-called (non-productive) “investment sector” that trades in existing capital goods and financial assets. The non-productive investment sector can be called Di such that:
Di = Dca + Ds + Db (9)
Equation (8) is a modified form of the well-known Fisher Equation of Exchange (M*V=P*Q) described in Section 2 that takes account of the debt-based economy.
DC= M3 – NFCA - R (Residual)  (10)
Which can be rewritten as
M3- (NFCA + R)  = DC . If the monetary deposit base of the economy is taken as (M3-repos) rather than M3 to remove the effect of inter-institutional lending, and since in the productive sector My=Py*Qy/Vy, and in the investment sector Mi=Pi*Qi/Vi, equation (8) can be rewritten as the Fisher equation where
(M3-repos)=Py*Qy/Vy+ Pi*Qi/Vi =(Dt +M0y)+ Di+ (NFCA+R) – repos (11)
Di is as in equation 9, Pi is the price level in the investment sector, Qi is the quantity of investment assets (or alternatively the quantity of investment assets exchanged) over any given period and Vi is the speed of circulation of Di. Vi will depend on which version of Qi is used.
Debt growth in the investment sector is exponential because, as shown in the debt model (described at section 3 of this paper) any interest rate creates an exponential curve when the interest is continually added to the existing debt. Debt growth in the productive sector must also be exponential because the productive sector has to fund the investment sector debt Di. The growth rate of the total debt DC will change over time according to the interest rate and physical changes in the debt base like those arising from the balance of trade, population growth and productivity.
The prices of existing capital assets tend to rise whenever the pool of investment sector debt Di increases faster than the net value of new capital assets being added to the investment pool. Asset prices can also be affected when savers (non-productive investors) "sit on the sidelines" by leaving their deposits "in the bank". In that case, the speed of circulation Vi falls, which means either asset prices will fall or there will be less trading so that Qi falls, or both.
The increase in domestic
debt DC is net of debt repayment, so when some non-bank investors deleverage,
or "take losses" to repay their debt, Di will be lower
than it otherwise would have been and asset prices will tend to remain static
or sometimes fall. In
Call Dnb the pool of all non-bank created debt and call Msnb the accumulated interest paid to depositors arising from Dnb. Since Dnb does not directly add to deposits (contrary to Ds which is assumed to mirror Ms, and Mb which is assumed to mirror Db in the debt model), then:
DC + Dnb =(Dt + Ds + Dca+ Db) + Dnb (12)
M3(-repos) = Mt + M0y + Mca + (Ms + Msnb ) (13)
That means that if interest rates remain comparable, (M3-repos) and DC both have an extra exponential added to them to supply the extra deposits Msnb. Remembering that from page 10, Mca=Dca+ NFCA, and (Mt+M0y)=My
DC = (Mt+ M0y) + [Dca + NFCA] + (Ms + Msnb) + repos - (NFCA +R )
= My + Dca + (Ms + Msnb) + (repos -R ) (14 )
If the current account is balanced, the overwhelming driver of exponential debt growth is the interest paid on deposits.
secondary lending in the form of non-bank debt Dnb were to become an important factor as it
would, for instance, if the proposed Bank of
From equation (11) DC= Pt*Qt/Vt + Pi*Qi/Vi - [(NFCA+R) – repos], when DC increases sharply the investment sector Pi*Qi/Vi will also usually increase. Since there is, in normal times, little reason for Qi to increase sharply or for Vi to decrease sharply, investment prices will usually tend to rise faster than the productive economy whenever DC increases faster than nominal GDP growth. 
5. THE MISSING LINKS.
5.1 CAPITAL BASED AND DEPOSIT BASED DEBT GENERATION.
The confusion over how debt is created is astounding. The box on the left of Figure 11 clearly shows how debt is created in the present debt-based system. In the capital based system a bank can and does typically create debt on demand as long as it meets its capital and liquidity requirements and provided the bank is prudent and has creditworthy customers.
In the present debt-based system deposits follow debt creation.
The “competing” deposit story of debt creation arises from the Savings and Loan model shown in Figures 8 and 9 that follows from the orthodox economic theory shown in Figure 2. That theory states that savings, productive investment and debt growth are three sides of the same triangle. Savings = Productive Investment, and the cumulative investment is the cumulative debt owed by homeowners and entrepreneurs to income earners generally.
In the Savings and Loan model, debt follows deposits instead. The deposits are expended to repay the production loans. Savers give up their deposits in return for an IOU (debt) from entrepreneurs and new homeowners.
The orthodox model applies only in a Savings and Loan system where the actual Saving is on-loaned to the buyers of capital goods. In that case, savers do not have immediate access to their deposits.
The debt system is
not operated on a Savings and Loan basis.
Instead, Savers, as shown in Figure
5.2 INTEREST AND EXPONENTIAL DEBT.
Nominally, the only deposits in a Savings and Loan system are the dynamic deposits My in the productive sector. That changes in the debt-based system shown in Figure 10. Since domestic housing is not usually productive once it has been built, both the repayments and the interest relating to domestic housing must be funded from productivity growth if the economy is to remain stable. The productive economy must therefore fund interest and repayments for both the productive sector and the unproductive (housing) sector.
Any interest on the accumulated productive investment debt (GDP in “The DNA of the Debt-Based Economy”) must be paid out of productivity gains and the corresponding higher incomes made available through the new productive investment. Otherwise according to the debt model (equation (11)) prices in the productive sector must inflate .
The economy will become unbalanced very quickly if the interest and repayments on new housing investment exceed what the productive economy can support. If the productive sector inflates, My in the debt model (Section 3 of this paper) will expand exponentially even though it is small. That is exactly what happened when money was used instead of debt in centuries past and the coinage was often debased by reducing the amount of gold and silver in the coins. This was done to pay for non-productive expenses, such as unsuccessfully waging war where the “booty” failed to cover the war costs.
Exchange of existing capital assets in a Savings and Loan system occurs by selling the asset for its market value. Any remaining debt on the asset is repaid, and the new owner re-borrows the new purchase price. The system remains balanced as long as the market value equals the original purchase price less the principal repayments already made, its “residual” purchase cost. If there has been inflation, or if, for some reason, the new owner pays more for the capital asset than its “residual” purchase cost, there is nowhere to obtain the extra funding within the savings and loan system. In that case the additional part of the purchase price must be paid for from new bank borrowing.
Banks lend money to make money. The net profit they make on their bank spread (the difference between the interest rate they charge borrowers and the interest rate they pay on their deposits) is legitimate income, just like profit in any other business. The difficulty with the banking system is that more lending typically means more profit. It is, therefore, in the banks’ interest to lend as much as they can.
There are four main ways to increase bank lending.
The first way is by minimising the contribution of cash transactions counted in the GDP. In many developed economies the cash contribution to the economy is approaching zero. While there are still a lot of cash transactions, they add very little to GDP. Cash in circulation also “uses up” bank capital, because the bank swaps vault cash (capital) for a customer deposit. The customer deposit costs the bank far less capital because, unlike cash, the bank can use it authorised capital leverage when it creates the loan that gives rise to the deposit.
The second way to increase bank lending is to raise capital by retaining profits or by issuing new shares. If the authorised bank leverage were 8%, the banks would be able to lend about 12 times their capital. More capital means more lending.
The third way to increase bank lending is to lend to governments, because sovereign debt is typically, though by no means always, deemed to be risk free. Therefore there are usually few limits on the amounts governments can borrow as long as the nation’s tax base is deemed large enough to support the interest payments on the public debt.
The fourth and possibly most important way to increase bank lending is to pay interest to depositors. Section 2 of this paper shows how deposit interest causes systemic inflation. Equation (14) on page 21 shows that, apart from persistent accumulated current account deficits, the increase in the accumulated deposit interest (Ms + Msnb) over time is by far the biggest contributor to exponential debt growth. In equation (14) when (Ms + Msnb) increases, debt measured as domestic credit (DC) increases by the same amount.
The work referred to at the start of Section 2 of this paper is thought to be the first in the world to demonstrate the systemic links among deposit interest, inflation and exponential debt growth.
5.3 THE LINKS BETWEEN DEBT, DEPOSITS AND GDP.
The debt model and “The DNA of the Debt-Based Economy” shown in Figure 8, and Figure 9 hints that the system deposits should, in some way, be related to My + GDP.
From equation (13) on page 21, M3(-repos) = Mt + M0y + Mca + (Ms + Msnb )
Since Mt + M0y = My, GDP should be directly related to Mca + (Ms + Msnb ) in the above hypothesis. The debt model described in Section 3 of this paper proposes that the quantity of debt determines economic outcomes in accordance with a modified version of the Fisher equation of exchange.
The postulated direct link between the money supply and GDP is the last missing element in the debt model that already directly links deposit interest, inflation and exponential debt growth, as noted above. Linking the money supply directly to GDP will provide further powerful support for the quantity theory of money and debt proposed by the debt model.
Figure 12 gives the figures
The purpose of this paper is to indicate the links between the theory proposed in “The DNA of the Debt-Based Economy” and the monetary aggregates. There is no reason to suppose deposit aggregates “should have” followed GDP on a one to one basis in practice. The “wobbles” about the trend line can easily be related to the boom and bust periods and the creation and “popping” of bubbles (Db in equations (8) and (9)).
There are five main reasons why there is not a direct one to one relationship between the monetary aggregate and GDP in Figure 12. Each of those reasons is systemic and can be quantified with further research.
The first reason is that a lot
of funding of the purchase of capital goods used to be done using the Savings
and Loan model shown in Figure 9. Savings and Loan funding for new capital
assets does not generate bank deposits.
The second reason is that businesses used to retain profits and reinvest them directly in new capacity. In the idealised funding models shown in Figures 9 and 10, it was assumed that all the Savings were saved as deposits and on-loaned to entrepreneurs and homeowners. However, that has never been wholly so. When producers collectively contribute their own profits to the purchase of some of the capital goods they themselves produce, those profits (Saving) are converted to equity. There is then less borrowing needed from other income earners or from banks. Increased corporatisation and globalisation in ever more deregulated capital markets have all but eliminated the retention of profits for reinvestment. 
The third reason the GDP to deposit ratio has changed is increased social mobility. More people move more often which creates more sales of existing capital assets, especially homes. As discussed at page 24, this can create demand for new bank lending where the amount paid for the asset exceeds the outstanding debt on the asset. This applies even though the buyer may have some equity or “savings” either from the sale of a previous home or from some other source.
The fourth reason is that in
The fifth reason is that
personal incomes have not been rising fast enough to enable most people,
especially homeowners, to meet their capital debt-servicing commitments. The problem arises from growing income
distribution inequality around the world.  As that inequality increases,
home ownership typically becomes less affordable. In
Amounts attributable to each of the four factors mentioned can be quantified. Further research will show that, subject to those factors, there is a direct and specific relationship between banking system deposits and GDP.
Figures 12 and 13, the debt model, “The Savings Myth”, and the “DNA of the Debt-Based Economy” demonstrate how very poor public understanding of the financial system mechanics has produced so much economic instability around the world. The role of the banks in that overall process deserves wide public debate. The single most relevant observation from this paper is that the financial system is fundamentally flawed and requires major systemic review.
5.4 THE RELATIONSHIP BETWEEN DEBT, DEPOSITS AND UNPRODUCTIVE ‘SAVING”.
Conceptually, no deposits arise from productive Investment (see Figure 9). Saving = Investment both in orthodox economics and in “The DNA of the Debt-Based Economy” create debt but no deposits. According to the debt model described in Section 3, the fewer deposits there are the less inflation there will be.
As discussed in Section 5.3, the real world is, however, different in that the deposit base has become more like Figure 10 with some add-ons such as the ones derived from the third and fourth reasons on page 27 and the fifth reason referred to above. The more bank debt is used the larger Ms in the debt model will become, increasing the non-productive investment “savings” pool.
In practical terms all price is inflation. That must be so because inflation is measured by prices rises. Those price rises are accumulated over time, so, in the limit, all price is inflation. “Cost-push” price inflation is caused by the payment of unearned income in the form of interest to deposit holders.  The unearned income is funded by systemic inflation in the productive economy. Inflation in the productive economy increases the prices of new capital assets as well as consumer goods and services. Therefore numerically, the GDP is also almost entirely made up of inflation and that in turn means that the price of new capital goods is almost entirely made up of inflation. If the price of new capital goods is almost entirely inflation, then the debt used to buy them also reflects that inflation.
The entire modern monetary system is founded on inflation.
Section 5.3 showed there are specific quantifiable links between GDP and deposits. In equation (13) [M3(-repos) = Mt+ M0y + Mca + (Ms + Msnb )], the amount (Mt + M0y) is the dynamic production deposits My while the sum (Ms + Msnb ) is the systemic “cost-push” inflation from the productive sector. Mca , on the other hand, mostly represents “demand-pull” inflation in the non-productive investment sector caused by the sale of domestic assets to foreigners to settle the foreign exchange mechanism in those countries with accumulated current account deficits as shown in Figure 1.
None of the deposits arises
from choice. They arise from necessity in that they are a consequence of the
current financial system mechanics. The deposits exist. Their owners “invest” them in non-productive
investments. Everything that doesn’t belong to the productive sector My
is by definition non-productive. In
Most countries’ central banks
provide a breakdown of who holds the deposits.
The data for
The household deposits represent the accumulated cost-push systemic inflation plus the accumulated current account-based demand-pull inflation of the debt system.
In the case of
In the first instance, the effect of compulsory saving is to transfer earned incomes to the non-productive investment pool, Mi , [Mi = Mca + (Ms + Msnb ) from equation (13)]. If consumption remains the same, the “savings” withdrawals leave less income for debt servicing and to pay for capital goods forcing an increase in bank borrowing or a decrease in new capital investment, or both, as discussed at length in “The Savings Myth”.
More generally, except for added real production, financial system debt and deposits have just two sources. The first source is the debt and deposits created endogenously through deposit interest on the productive transaction accounts in the productive sector (Figure 5). The second source is the debt and deposits created exogenously through the accumulated current account deficit debt Dca and the deposit interest on that part of it (Mca) returned to the debtor country following the sale of domestic assets to foreigners (Figure 1).
Unproductive “saving” is determined by the system mechanics. Government decisions requiring forced saving are like squeezing a balloon. The contents remain the same until the balloon breaks. Otherwise, an expansion in one place means a contraction somewhere else. Economic growth means blowing more air into the balloon instead of squeezing the air it already holds. The extra air is generated from increased economic activity. That means jobs, incomes and productive investment.
Macroeconomic numbers partner economic activity, they don’t lead it.
This paper closes the theoretical loop established in the series of earlier papers for which links are provided at the top of page 3. The primary determinants of macroeconomic outcomes are:
* The interest paid on bank deposits.
* The accumulated current account balance. 
* The allocation of productive resources.
* Private debt creation for profit.
The interest paid on deposits is the cause of systemic cost-push inflation. Deposits returned to a debtor country through asset sales to foreigners arising from an accumulated current account deficit are a cause of demand-pull asset inflation.
Increased productivity necessary for per capita economic growth requires new productive investment. Overemphasis on new non-productive capital investment such as housing distorts the productive sector because homeowners can only service their debt through higher incomes and higher productivity.
The confusion surrounding the orthodox “deposit” based debt expansion of bank “reserves” and the existing “capital” based debt expansion is historical. The banking system changed from being “reserve” based to being “capital based” when the Basel I accord became operative in 1992. In practice the “reserve” system was also capital based except that the capital requirement was limited to a fraction of the banks’ transaction account deposits. Government debt did not directly cause “fractional reserve” debt expansion, but it did then, as now, introduce new deposits into the banking system thereby expanding the banks’ balance sheets.
The dominant features of the debt-based interest-bearing financial system are interest paid on deposits and the accumulated current account balance (or net international investment position, NIIP). Interest on deposits creates systemic cost-push inflation in the productive sector, while an accumulated current account deficit (or NIIP) creates demand-pull inflation in the non-productive investment sector caused by deposits arising from the sale of debtor country domestic assets to foreigners. Those accumulated current account deposits also create a deposit interest feed back loop that adds to systemic inflation.
The paper shows the
entire modern monetary system is founded on inflation, and that there is a
systemic relationship between GDP and the monetary aggregate (M3-repos). The
rate of change of the exponential growth curves [(M3-repos) – the dynamic
production deposits My]/GDP has been linear in
This paper is based on a debt model of the debt-based economy that shows that world debt cannot be managed without removing unearned income from the system caused by the payment of interest on bank deposits and by balancing each nation’s current account.
THE REFERENCED PAPERS.
The referenced papers :
NEW Capital is debt.
General summary of all papers published.(Revised edition).
(The following items have not been revised. They show the historic development of the work. )