Economic Reform Australia Blog

The fallacy that the debt-virus hypothesis explains the excessive growth of debt

The debt virus hypothesis is an explanation of the debt-growth imperative and the excessive growth of debt, which asserts that money needs to be created (which implcitly, under a fractional reserve system, is by the commercial banks) specifically in order to accommodate the interest portion of every bank loan repayment, otherwise the money supply will be subjected to an ever-increasing loss.

The reason why this explanation of debt growth is wrong is that the deposits destroyed when interest is paid on bank loans almost entirely reappear in the economy as deposits somewhere else. They return directly or indirectly as a result of bank spending. That includes spending on assets for the bank itself.

There is a small element of truth in the hypothesis by virtue of the option open to any bank to sit on some of the excess reserves acquired from the interest payments on its loans, rather than spending them. However it seems likely that the amount of excess reserves from interest earnings on bank loans would be self-limiting rather than cumulative. In that case, there would be some fixed loss in aggregate deposits, but not an ever-increasing loss as in the debt virus hypothesis.

There is a related issue in regard to the interest paid on bank deposits, which is sometimes conflated with the debt-virus hypothesis. Money invested in interest-bearing bank deposits (e.g., term deposits) is commonly rolled over – when each deposit reaches its date of maturity. This process includes the interest component, and therefore such investments compound exponentially. The interest-bearing deposits make up a large fraction of all bank deposits, and it may be concluded that the interest component which is tied up in these deposits is an ongoing drain on transaction money, M1. This is not necessarily a problem if goods and services are growing at the same rate as (or greater than) the average interest paid on bank deposits. The real issue here is the impact of saving on spending.

John Hermann