Bank Credit, Compound Interest, Ponzi Finance.



My recent postings about savings, debt, and money have attracted some interest especially from the “people who are aware that money is [not a commodity] but wish it was” camp (see Pixies in the Garden?). One respondent wrote: “And so [bank credit] goes on, like a ‘pyramid’ system”. I take it that he was referring to what is commonly known as ‘Ponzi’ finance, named after 1920’s trickster Charles Ponzi.

The main differences that these people have with me is over the following beliefs: that money can represent a debt that does not have an offsetting credit; that interest necessarily compounds with destructive consequences because it is the creation of banks; and that bank credit is unhelpful per secompared to forms of money. (On the latter point I would definitely favour the hapless Royal Bank of Scotland over the hapless [for different reasons] David Parker as supplier of our money.)

The most important question about commercial-bank credit is ‘when’ rather than ‘whether’ it is a problem. Like most things in life, we can have too much or too little.

Bank credit makes the money supply highly elastic, contrary to what most economists think. Commercial bank money is created when it is demanded, and is extinguished when it is not demanded. The non-commercial monetary authorities (central banks) have influence over money’s ‘price’ – the rate of interest – and can place other constraints in the form of controls over bank lending. They can also create money via the central banks’ balance sheets, but cannot force debt-averse people to spend it.

The bank-money system is a socially liberal decentralised monetary system. The alternative state-monopoly system has much greater capacity to be oppressive.

If banks create money (as debt and credit) when we have too much saving, then that’s a good thing. It recycles those prior savings, minimising the damage caused by excess saving. (The easiest way to imagine excess saving is as: ‘saving for no particular purpose’. Such saving tends to go unspent, into savers’ estates on death. In Inequality, consumer credit and the saving puzzle, Christopher Brown [2008] notes that retired people have higher rates of saving than other groups in the population. Retired people may not be the dissavers that we assume them to be.)

Banks lend to customers who intend to spend. It’s that spending that offsets the non-spending that saving represents. (It also means that the distribution of spending – the main arbiter of present living standards – is less unequal than the distribution of income, because savers have higher incomes [including interest] on average than do borrowers. This mitigates but does not solve the income distribution problem. Acknowledgement of public equity – through, for example, a universal basic income– is a necessary prerequisite to the resolution of the income distribution problem.)

TDB Recommends

If banks create too much money when we have too little saving – and they can quite easily do so, because even our unsaved money is held in the bank – then we do have a problem. (This is the situation of a supply-constrained economy – discussed in Constraining Credibility – that I argued we have not actually faced since the early 1970s.) This is the problem of trying to buy more goods and services than we are able to produce; it is the orthodox inflation story. It is in these circumstances that monetary policy constraints are appropriate to slow down the rate of business expansion.


Compound Interest

Compound interest is the epitome of modern alchemy. It is widely understood as a way of amassing riches by doing nothing other than wait. And, from the point of view of productive debtors, it is sometimes understood as a constant shifting of the goal-posts, creating a kind of business debt-serfdom that can be resolved only by constantly expanding their output, necessitating economic growth.

Here’s a simple example of a debt contract. In 2014 creditor C lends $60,000 to debtor D for a period of 10 years, with interest at 5.24% compounded annually. D must pay C $100,000 at the 10-year maturity date. What it really means is that D enjoys $60,000 worth of goods and services in 2014 that C was entitled to. In exchange C contracts to enjoy $100,000 worth of goods and services at D’s expense in 2024. (In reality D would normally service her debt in instalments, but it amounts to the same thing.)

There’s no big deal here. It’s a freely arranged contract between C and D. C is saving for a purpose; the purpose is to enjoy more goods and services later. (Saving for a sunny day, not a rainy day.)

What if the Eastpac Bank managed the arrangement? C and D both bank with Eastpac. Imagine it this way. D borrows $60,000 from Eastpac at 6.25% per annum, and buys $60,000 worth of goods from C (or acquires $60,000 worth from C’s entitlement). C deposits the $60,000 at Eastpac on a 10-year term deposit, advertised at a fixed annual interest rate of 5.24%. Debtor D arranges an associated credit facility of $50,000. Thus D’s interest liability is allowed to compound at an annual rate of 6.25%. On the maturity date in 2024, D must forego $110,000 of goods so she can repay her creditor and service provider. $10,000 worth goes to Eastpac’s shareholders (E); $100,000 worth goes to C.

The ideal outcome is that the full $110,000 of D’s foregone goods are acquired by C ($100,000 worth), and E ($10,000 worth). D brought forward her enjoyment. C and E delayed theirs.

The more likely outcome, in 2024, is that D’s foregone $110,000 is wanted neither by C nor E. They would rather have the money than the goods that D had to sell in order to acquire that money. (We may note that banks pool risks and rewards. Thus all would have been well had C and E acquired other goods, and other depositors of Eastpac or another bank had acquired the goods D forewent. In my story here, though, all may not be well.) If no other creditor could be found to acquire the $110,000 worth of goods, then the banking system, acting on behalf of its saver-creditors, has to go out and find and fund another debtor who would buy the $110,000 worth of goods, enabling D to meet her contracted obligation. The banks must create the money needed to service their existing debts, because the banks’ creditors choose to not receive goods and services when their credits mature.

Another variant of the story is that inflation has taken place. Inflation compounds, just as interest does. If the annual average inflation rate had been 6.25% then D’s $110,000 worth of goods in 2024 would have been no more than $60,000 worth in 2014. C’s $100,000 worth of goods gained in 2024 would have been less than the $60,000 worth ceded in 2014. Not exactly the free compound interest bonanza C might have expected. (We note that this is part of Japan’s Abenomics’ solution; attempts to create negative compound interest through higher inflation rates than deposit interest rates. D is the Japanese government and C is the Japanese private sector. It’s improbably hard to create much inflation, though, when people will not spend, even at negative effective interest rates. Japan has created some inflation, but only through its depreciating Yen. Currency depreciation, of course, can never be a global solution.)

There are many other variants of the story, in which D may be a car-purchaser, a small businessperson, a mortgagor, a speculator.

But, to cut to the chase, why might the interest rate on term deposit be around 5% with the inflation rate at about 1%? It should mean that many people identify with D and few identify with C; many want to borrow and few want to lend; so the compensation price to lenders must be high. Banks are subject to competition; their margins are no monopoly rort. Most of the interest paid to banks is cycled back to their depositors; they in turn (by not spending it) cycle it back to the banks, creating a savings glut.

The correct market solution for a savings glut is negative compound interest rates on deposit. The mathematics of negative interest rates lead to stabilisation rather than the destabilisation associated with positive compound interest. Today’s goods and services would go mostly to those who can make best use of them. Savers continue to maintain claims – albeit diminished claims – on future production.

Negative interest rates represent an institutional challenge of the first order, however. (See “Why has the ECB introduced a negative interest rate?“.) Savers across the world have a sense of entitlement and have the potential to create a middle-class rebellion on an unknowably large scale. So the competitive banking system is pretty much obliged to pay positive nominal interest rates (hoping that some inflation will create negative effective interest rates). (Would you switch banks if your bank charged you a negative interest rate? Or would you withdraw stashes of banknotes and stuff them under the bed?) Thus the banking system has to do a hard-sell on the debit side of its ledger. Its best bet is to lend on the security of real estate and company shares to the extent that the people who own these assets will borrow and spend, and the people who sell these assets will spend the loans advanced to the purchasers. It’s this spending, necessarily created as debt, which prevents the savings glut from becoming an economic depression, while also enabling the banks to pay positive interest rates.

While this accumulation of financial thin air can go on for as long as we believe it can go on for, the illusion is that compound interest has created huge wealth for a privileged minority. And indeed if a few people cash in and spend their compounded fortunes, they may actually realise that illusion. (Alchemy may work for the few; never for the many.) However, if a sufficient fraction of the savings glut is reversed, if too many of these savers cash in and spend at the same time, the whole economy may break. This apparent wealth is built on the unrecoverable debts of the chronically or suddenly underprivileged. Illusory wealth may be OK for simple insurance purposes. But – thanks to Christchurch – we all now know what happens when everyone calls in their insurance simultaneously.


Ponzi Finance

One variant way in which our system handles savings’ gluts is called Ponzi finance. And a variation of Ponzi finance in which an unscrupulous debtor takes advantage of glut savers (savers who are not actually saving for anything) is a Ponzi scheme.

The problem is excess saving. Excess saving accumulates because savers tend not to meet their side of the inter-temporal exchange. They defer consumption indefinitely, whereas debtors must furnish the goods for repayment strictly as in terms of their contracts.

So we have an economic cake characterised by saved goods (and services) that must somehow be allocated to some debtor. (We note that when a government says that it must reduce its borrowing, what it is really saying is that someone else must be increasing their borrowing. When x% of GDP is saved and lent, the critical financial question is who will receive that x% of GDP as debt.)

Ponzi finance exists when a debtor or group of debtors consume part of that x%, as debt, without intending to forego future consumption. Thus, their intent is to take on future debt as a means of servicing past debt. If they choose creditors that tend to be happy to allow their credits to compound, then all these debtors have to do is maintain the façade of being creditworthy, rather than to actually service debt out of foregone income.

Most Ponzi finance is open; there is no deceit. The US government has fought several wars funded mainly by Chinese saving. (Reducing taxes while fighting wars, as the US did, is not orthodox public finance.) There’s no subterfuge about this, however. Further, nobody expects the US to plunder the oilfields of the vanquished Iraqis in order to make good American indebtedness to Chinese savers. Rather everyone suspects that the Chinese savers will not seek to exact their pounds of flesh in the form of consumer goods ‘made in America’. In the meantime, individual Chinese savers can spend their savings if they wish. Likewise individual Ponzi creditors can always withdraw their funds, just so long as there are few who wish to do so.

Not only is the US economy, openly, a Ponzi debtor; the world economy actually depends on the US economy persisting in that role. The combined current account surpluses of the rest of the world exactly match the current account deficits of the United States. One reason we don’t worry about Americans consuming the wealth created by the rest of the world is that we suspect, if push came to shove, that the US could produce much more than it does.

Another open Ponzi finance debtor is the Japanese government. Japan moved into recession this year largely on account of a small increase in its equivalent of GST, from 5% to 8%.  While Japan plainly has the economic capacity to pay taxes at much higher amounts than it does, the Japanese people clearly prefer a saver-funded than a fully tax-funded public sector. Ponzi public finance is a benign evil in Japan. Public spending in this minimal-growth post-industrial economy is funded by borrowing; borrowing that also pays the interest on the public debt.

Ponzi finance becomes a problem when deceit is involved. In the mid-2000s the Icelandic banking system was running a Ponzi scheme based on debtor self-deceit, creditor naiveté and government wilful blindness. Those Icelanders paying themselves huge salaries and bonuses from creditor savings pretended to themselves that they were clever investors, when they were really just bumbling speculators.

The Ponzi schemes that have made the headlines – Bernie Madoff in the USA, and lesser NZ lights such as David Ross and John David Milne – are unambiguously fraudulent because of the intent behind them. Yet these schemes represent opportunistic behaviour – as is dumpster diving (listen to What food-wastage tells us) and free downloading of music – that trades one set of adverse consequences against another. Ponzi finance flourishes in a savings-glut environment.



The savings-glut economy with its 10-year cycle of leverage and deleverage may seem like an insoluble problem. It’s the norm in the economic history of capitalism; the years 1940 to 1970 are the exceptional years. And it is unsustainable. Bank credit is not the problem. Purposeless saving is the problem; too many of us produce more than we wish to consume, requiring others to consume – as debtors – our excesses.

What we see as our private economic security becomes the economic insecurity of others. Further the unsustainability of our practices of persistently producing more than we want to consume must eventually compromise our survival as a species. I know of a David Low cartoon from the 1930s, which shows the rich scrambling for the dry end of a leaking boat. Did that behaviour actually make the rich more secure?

The solution, in its broad sense, involves two parts. The first part is to make a small but consequential change to the rules of income distribution. That is the explicit recognition of public equity as a proper source of private income.

The second part is to match our selling behaviour to our buying behaviour. If we believe that we wish to buy an average of $50,000 worth of goods and services a year, then we should aim to earn on average $50,000 (after tax) each year; no more. (There are actuarial techniques that enable us to manage the uncertainties; further, governments with the power of taxation can act as insurers of last resort to ensure a degree of collective economic security.) If savers cannot or will not voluntarily match selling behaviour to buying behaviour, they can be induced to do this through the development of financial techniques that allow deposit interest rates to become negative. (Islamic banking may help us in this regard, though I am not sufficiently familiar with it to be sure.) Negative interest rates defuse the compound interest time bomb.

When we save we should save for a purpose. We should save today with the intent of dissaving in the future. Or we borrow today content to facilitate the dissaving of others tomorrow. Save for a sunny day; insure against a rainy day; borrow when we need a sunny day; keep the Ponzi environments away.



  1. The main differences that these people have with me is over the following beliefs: that money can represent a debt that does not have an offsetting credit; that interest necessarily compounds with destructive consequences because it is the creation of banks; and that bank credit is unhelpful per se compared to forms of money.

    Very distorted interpretations you have there. To restate them more accurately:
    #There is always more debt than credit in the current system because the a corresponding credit is not made to counteract the interest on bank loans.
    #Debt interest compounds faster than credit interest and this is unsustainable.
    #The amount of bank credit is unhelpful because it is directly controlled by the banks who, for selfish reasons, create an excess that fuels bubbles followed by a decrease that deepens recessions.

    Of these points the third is by far the most important one to address.

  2. So you think the Reserve Bank having full control over the total amount of New Zealand dollars is too prone to oppression, but taxing away peoples wealth if they don’t spend it fast enough isn’t?

    That sounds like a recipe to force people into commodity money (gold, bitcoin).

    • I am trying to establish meaning from your expression “taxing away peoples wealth if they don’t spend it fast enough”. You either spend it or you don’t spend it. If you have a piece of cake you either eat it or you don’t eat it. If you don’t eat it all then presumably you are happy for someone else to eat the remaining sliver of cake.

      The concept of a person’s (eg your) ‘individual wealth’ has three meanings: the share of the planet, its structures, and its biomass that you exercise title over; ‘financial wealth’ which is the debt (ie promises or claims) that you own [not owe]; and ‘economic wealth’ which is the portion of the economic cake that you also call your income.

      It is essentially the third meaning of wealth that this discussion is about. Thus your wealth is your income share of goods and services produced. There are only two things that can happen with your ‘wealth’: you can enjoy it yourself (spend it) or have someone else enjoy it instead. If you don’t spend it then you can lend it or transfer it. (Taxation can be thought of as a form of transfer of cake; so is gifting; so is stealing; so is wasting it. While my analysis here largely ignores the transfer option, it certainly is better to tax uneaten cake than to waste it.) So, what I am saying is that your wealth is either spent or lent (or a mix of the two). Spent means that you enjoy it. Lent means that someone else enjoys it but has an obligation to facilitate your future enjoyment of future cake. That obligation may include interest.

      If you don’t have all of your share of this year’s cake, then someone else should have the part that you do not have. That surplus sliver of your slice of the cake is lent (unless it is transferred). The bank may facilitate the lending of that sliver to that someone else. The bank is an intermediary, and the money it creates is a medium of exchange. If interest is involved then you are pledged to get most of the interest; the rest is pledged to the bank as a service fee. The promise of slivers of future economic cakes is your financial wealth. Interest is as much a part of that promise as is principal.

      Things go awry in the future if you refuse to enjoy the slivers of future cake that are repaid to you.

      • If we believe that we wish to buy an average of $50,000 worth of goods and services a year, then we should aim to earn on average $50,000 (after tax) each year; no more.

        This sounds a lot like anarchist economics to me, at this point you may as well just dispense with money altogether.

        If savers cannot or will not voluntarily match selling behaviour to buying behaviour, they can be induced to do this through the development of financial techniques that allow deposit interest rates to become negative. … Negative interest rates defuse the compound interest time bomb.

        How is this not taxing away any money in a bank account that is not spent fast enough?

        Have you heard of the concept of saving up for something? Can you not imagine how complicated this will be.
        At this point I re-read your response. I think I get what you are saying now; people should be allowed to invest/save, but once that interest comes back in they have to spend it or lose it. They have to eat the cake [spend the money] right then and there (within reason) or else give it to someone else (government/banks/whoever) to eat [spend].

        So I think your point is that no-one should be able to become rich off of continually re-investing their own money. And, to ensure that, interest payments will be diverted if they are not spent quickly (somehow).

        Personally I think wealthy people could be dealt with a bit more simply and broadly with death and wealth taxes. Say a death tax of 33% beyond the first million dollars, 66% beyond $10 million and 99% beyond $100 million. With annual wealth tax rates of maybe 1% beyond $1 mil, 2% beyond $10 mil and 3% beyond $100 mil. Maybe those rates need to be adjusted, but it seems to me to be a lot easier to implement than your idea.

        • I think you are getting closer. What I am saying appears difficult because it’s different to what we normally hear.

          We have to stop equating the words ‘money’ and ‘wealth’. Money is a social medium that is often treated as if it was wealth.

          We also need to understand that saving and investment are antonyms, not synonyms. Saving is not spending. Investment is the kind of spending that should lead to economic growth. Saving (non-spending) needs to be matched by spending; economists tend to favour investment spending over consumption spending.

          Yes, I’m very much in favour of saving up for something; that’s saving with a purpose.

          I don’t favour policies that force people to spend. As an economist I favour a mix of social awareness and incentives. If we become aware of the consequences of savings gluts, then we are more likely to choose to work less (ie become happy to sell fewer services, reducing our incomes to match our spending). In addition, we may respond to incentives to work less; such incentives could be higher taxes or negative effective interest rates.

          One useful incentive would be to have government guarantees only on non-interest-bearing bank deposits. We should understand that all lending with the expectation of interest is a risk-taking activity. And we should understand that there are really only two peaceful forms of financial rebalancing – default and inflation. It’s better if our economies do not become so unbalanced that large-scale rebalancing is necessary. The best approach is for us to voluntarily reduce our disposable incomes when our incomes are clearly much greater than what we need; we don’t have to work less, we could give away more and lend less.

          • So it’s an honesty system? Just give away what you don’t think you’ll need? What an excellent way of doing things.

  3. Commercial bank money is created when it is demanded, and is extinguished when it is not demanded. The non-commercial monetary authorities (central banks) have influence over money’s ‘price’ – the rate of interest – and can place other constraints in the form of controls over bank lending. They can also create money via the central banks’ balance sheets, but cannot force debt-averse people to spend it.

    Economists tend to think of people as soulless automatons that always make the most rational self-interested choice, you have made the same mistake here with bankers. It’s not that people suddenly stop having good business ideas or get discouraged during a recession, it’s the banks that get discouraged about lending and taking risks when their books have just taken a massive hit (a bubble bursting).

    If banks where rational they wouldn’t lend to speculators or fund bubbles. If banks where rational they would increase productive (S&ME) lending during a down-turn as that’s the only they could get themselves out of a downward spiral.

    The point of full-reserve banking is to take the central banks (inadequate) influence over money creation and make it total control thereby insuring that bankers’ dodgy decisions don’t fuck up everyone else’s lives (beyond those who unwisely decided to invest with that bank).

    Full-reserve banking is also about separating the payments system from the investing (money recycling) system. The reason the banks absolutely had to be bailed out was that the two were combined. Losing the payments system would probably have led to a 90% reduction in global GDP at least.

  4. “(This is the situation of a supply-constrained economy – – that I argued we have not actually faced since the early 1970s.) This is the problem of trying to buy more goods and services than we are able to produce; it is the orthodox inflation story.”

    This is the situation with the NZ housing market. Rampant inflation fed by bank credit and foreign funds. There is no benefit to NZ any more than there was to France when the fashion was to invest in Biarritz.

    Your banker optimism does you no credit.

  5. The elephant in the room here in usury, which the state condones as interest. Usury is forbidden in Island and in Judaism, expect that it is permitted in Judaism as means of conducting economic warfare on enemies.

  6. Banks lend to customers who they consider credit worthy.They do not lend out other peoples savings.Banks worry about their reserve position later.Your idea about modern banking is bollocks.the state could create credit at next to no cost.You also leave out bank fraud and how that operates.Maybe you should read Bill Blacks book, The Best Way To Rob A Bank Is To Own One.Do you remember when the banks where deregulated in the 80’s and went bellyup not long after! We were saved last time by the Chinese communist! O dear the bloody commies! This time round we won’t be so lucky,with a bunch of economic illiterates running the Titanic, who look the other way when fraud occurs.Remember the last time oil prices took a dive back in 2008 and what happened not long after.Private debt in N Z is the elephant in the room.This is the result of predatory banking.To think our banks are not involved in criminal behavior like their overseas
    counterparts is laughable.The last thirty years of austerity economics is coming home to roost. The Japanese Govt.can service its debt.It like N Z issues its own currency .It cannot go bankrupt.THe Chinese does not fund the U S.

  7. If you can persuade the government of the day (whoever) and the banking system to stop thieving from the taxpayers; and

    if you can guarantee that older people will be able to live in at least modest comfort for the entirety of their remaining lives; and

    that it is actually safe to spend, then the great money-go-round can continue.

    However – when the institutions such as local government, gleefully hike costs to rate and rent payers every year by greater than the adjustments to pay or fixed income: and ‘financial institutions’ continue to be morally and ethically deficient, then – you must be seriously having a laugh if you expect people to gaily spend.

    Not in this demented, distorted and rigged economic environment, sir. Not.

  8. With purposeful (as opposed to “purposeless”) saving the purpose presumuably should be its own reward so that receiving interest should not be necessary.

  9. Brian, I agree with what you say. Whether a person saves for a purpose, or simply because he has a surplus, really doesn’t matter in the greater scheme of things. Bill English is always berating us for not saving enough, but then he would, since his austerity economic program is in tatters, so he needs to find an excuse.
    As you say, banks dont need savings in order to lend money. The lending process has been exposed in all its obscene simplicity. If a loan looks good the banks will lend it and look for the ‘reserves’ later. This is explained in detail in Positive Moneys book “Modernising Money”.
    Keith’s comment about money that “You either spend it or you don’t spend it”, though obviously true superficially, ignores the fact that for the majority of Kiwis there is no choice. The first call on their income is to repay their debt. If they dont they can lose their house – which they foolishly put up as collateral for a loan that cost the bank absolutely nothing. I wonder how many of the ‘slackers’, who will sleep on park benches tonight, do so because they couldn’t pay their debts. Reserve Bank statistics show that debt is taking up an increasing portion of our disposable income, so more people are inching toward the abyss.
    If they are able to meet their debt payments this week the capital portion will be erased from the economy leaving a hole that must be filled by another borrower, or the economy will collapse. Every day this scenario is played out thousands of times. There is no choice. Compared to the need to pay our huge debts, for which the banking system is entirely responsible, the question of purposeful or purposeless saving is insignificant.
    Brian, you dont even question whether there is any need for every loan to generate new money. You simply take it for granted. I am quite certain that most loans ought not require new money.
    Some very good economists are saying that the system that you apparently approve, is simply wrong; that debt is overwhelmingly our biggest problem and that savings is just a side show.

    • The difference between purposeful and purposeless saving does matter. The former is serviced by goods and services conceded to the creditors (savers) by the offsetting debtors. In the case of purposeless saving, the creditors will not accept payment in goods and services, so the banking system has to find other debtors who will buy goods and services so the original debtors can service the creditors in money rather than in goods and services. Thus the process of debt overhang (the problem that you are very concerned about) takes place with creditors collectively extending their credits and debtors collectively extending their debts, creating the conditions for future financial crises.

      While banks don’t need prior savings in order to lend, in a demand-constrained economy there always are prior savings present, and the lending of the banks facilitates the spending of those savings. The issue about banks creating money through lending being a bad thing only applies to supply-constrained economies.

      Yes, people with debt are generally prepared to service/repay that debt. But they can only do it by selling goods and services (including selling services to an employer). The difficult bit is getting the creditor savers to buy those goods and services (or the employers’ goods and services). That takes us back to the important distinction between purposeful and purposeless savings. When there are purposeless savings, debts just keep getting shuffled around the debtor community. Repayment only takes place when the creditor community accepts goods and services rather than money as payment.

      Overall the comments that you make are perfectly valid for a supply-constrained economy, where the big problem is our attempts to buy more goods and services than the economy can supply. I have argued in various postings that we have not had a genuine supply-constrained world economy since the early 1970s.

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