The implication of cancelling all world debt

Okay, so let’s do a little exercise here. We’re going to build a money-based economy with fractional reserve banking from scratch. You’ll understand why in a minute.

In order to keep this simple, we’re going to stipulate a couple of things from the start. First, we stipulate that in this imaginary world we’re constructing, everybody tells the whole truth all the time. Second, we’ll stipulate — and really, this is just a consequence of the first thing — that everybody just takes everybody else’s word for everything. Those are the ground rules, okay?

Now, we want to have a money-based economy in this world. That means we need money, obviously. Money does not currently exist in this world we’re imagining, so we need to invent it.

Poof. Money exists.

There, that was easy. Money now exists in this world because everybody agrees that it does. That’s all it takes, literally.

But that’s just the first step. Because while we’ve all agreed that money exists, we haven’t actually created any money yet! Money exists, as a concept, but nobody has any. Walk up to any person on the street and ask him how much money he has; he’ll tell you that he doesn’t have any.

So clearly, now that we’ve invented money as a concept, we need to go about creating some money, so we can get it moving around.

To do this, we’re going to invent two institutions. The first institution we invent is called the treasury. Poof. The treasury exists. The treasury is an institution that we empower, purely by consensus, to borrow and spend money. That’s all it can do, okay? Borrow money and spend money.

How does the treasury borrow money? It borrows money by issuing bonds. A bond is, in essence, a promise to buy the bond back at some future time. For instance, I might offer to sell you a one-year bond for $100; you give me $100, and I give you my promise to buy the bond back from you after one year for $100. It’s essentially a very specific and formalized type of loan. (In the real world, bonds are sold with interest, but we don’t care about that right now.)

So we empower the treasury — by consensus — to issue bonds, and sell them, and then spend the money it raises by doing so. This is what the treasury does.

But remember, nobody actually has any money yet. So there’s nobody for the treasury to borrow money from; nobody can buy the treasury’s bonds. So clearly we aren’t done. We need another institution, which we’re going to call the central bank. Like the treasury, the central bank exists purely by consensus; poof. A central bank exists. And like the treasury, we give the bank certain specific powers: The central bank can buy and sell treasury bonds. And that’s all.

But wait. We just got through saying nobody has any money yet. So where does the central bank get money to buy treasury bonds? We give the central bank the power to create money to buy treasury bonds out of thin air. The central bank, then, is the source of all money. But remember we also said the central bank has the power to selltreasury bonds; that is, the central bank can exchange one of the bonds it’s holding for some money that somebody in the economy has. When this happens, that money — the money the central bank takes in exchange for the treasury bond — disappears. It ceases to exist.

The central bank, therefore, is both the source of all money, and a money sink. Money can come out of the central bank from nowhere, but any money that flows into the central bank disappears forever.

And that’s it. We’re done. We now have a money-based economy.

Well, almost. We have all the pieces, but we haven’t actually set them in motion yet. What we need to do is have the treasury issue a series of bonds, say $1,000 worth in total. Then we need to have the central bank create $1,000 and use it to buy those treasury bonds. Then the $1,000 goes from the central bank to the treasury, and then the treasury spends it. Thus does that money we created at the central bank go into circulation.

Once the money is in circulation, though — that is, once the treasury has spent it, by giving it to people in exchange for goods or services — interesting things continue to happen to it. Here’s a person, Alice we’ll call her, who gets some money from the treasury. Maybe she helps to build a road or something, and the treasury pays her $100 for her labor. Whatever. Point is, Alice gets some money.

Alice goes to the bank — not the central bank, but just an ordinary commercial bank — and asks to open an account. The teller says “Okay, how much money do you want to deposit?” And Alice says “One hundred dollars, please.” The teller — who just takes her word for this, because remember, everybody tells the truth all the time — says “Okay, now we have your $100, but you can come back and ask for it any time you want.” This is what’s called a demand deposit account. It’s an account into which you deposit money with the understanding that whenever you want, you can demand it back. Alice is happy with this, so she leaves.

The next person in line at the bank is Bob. Bob doesn’t have any money — he didn’t get one of those cushy government jobs — so he wants to borrow some. He asks to borrow $50, which he’ll pay back in a month. The teller says this sounds fine, so she takes $50 which Alice deposited and gives it to Bob. Bob takes that $50 and uses it to buy something from Carol, who then takes the $50 and deposits it in her own demand deposit account at that same bank.

Alice’s $100 — which she got from the treasury, which got it from the central bank by issuing a series of bonds — has now multiplied. In addition to the $100 Alice had in her account, Carol also has $50 in her own account, $50 that was created out of thin air when Bob borrowed it.

And those are the two ways that money is created in our economy. Some of it is created by fiat — that is, the central bank wishes it into existence and then uses it to buy bonds from the treasury — and the rest is created byborrowing.

But notice something. Every dollar that gets created in this imaginary toy economy we created is accompanied by a dollar of debt. The central bank creates money to buy treasury bonds, and treasury bonds are debt. Banks create money when they lend out their cash reserves, but those loans are also debts. In other words, every dollar that exists is backed — that’s the jargon term for it — by debt.

Which means if you just waved a magic wand and declared that all debts are forgiven … all the money would vanish. Every red cent of it, from everywhere, instantly.

Of course, if you have a magic wand you could also say that the debt disappears but the money doesn’t … but remember, it’s debt that’s backing the existence of the money in the first place. If you make the debt disappear, the money can linger — as a number in a ledger with a dollar sign on it, or whatever — but the thing that backedthe money no longer exists … which means the money is worthless. It would all revert to being unbacked, meaning it wouldn’t be real any more, in the economic sense. Having $20 in your pocket that’s unbacked by debt would be no different from just pretending you have $20 in your pocket. You might be able to find somebody who’s dumb enough to accept your pretend money in exchange for goods or services, but you aren’t guaranteed to, because your pretend money isn’t actually worth anything.

So long, long, very-very long story made short? If you waved your magic wand and made all the debt go away, you’d either explicitly or effectively be making all the money go away too. Because money and debt are two sides of the same coin; you can’t have a dollar without somebody, somewhere owing somebody else a dollar.