In Money Part I, we saw that money is mostly electronic, and it's created out of thin air by banks. Curiously, the way capitalism is currently put together, it's a requirement that everything grow: there must be more and more people borrowing more and more money to consume more and more stuff, or the entire system collapses.
When banks create money, mostly it's a loan. There are a lot of ways to get a loan - a mortgage on a house, a car loan, a signature loan, or a balance on your Visa. These various loans have interest associated with them. A mortgage will typically be about 6% interest, a car loan perhaps 10%, a signature loan 15%, a Visa balance 18%. This means if you borrow $10,000 for a full year then pay it back, you owe the bank the original $10,000 plus the interest, which would be $600 for the mortgage, $1,000 for the car, $1,500 for the signature loan, $1,800 on the Visa. Here's the interesting part: the bank only created $10,000. Where does the interest money come from? This is not a small problem: if you borrow $250,000 at 6% interest for 30 years to buy a house, your payments total $539,595. This is the original $250,000 you borrowed and $289,595 in interest. To repay this loan you need more than double the amount of money the bank created to make the loan. In the graph at the right, the bars represent monthly payments over the life of the loan. The purple portion is the interest, the blue portion the principle. For the first 21 years more than half your monthly payment goes to interest.
If there were only two people in the world, a banker and you, and only the banker could create money, then the answer is that you could not pay back the interest: no money was created for this purpose. This is the basic paradox of charging interest, the money to pay it back seemingly doesn't even exist.
In the real economy, there are literally billions of people constantly borrowing money and paying it back, so the interest money is sort of like musical chairs: you chase the money around and somehow get your hands on enough to pay the bank back. So long as people keep borrowing more and more money, the system keeps working. This is one of the most worrisome traits of modern capitalism: the amount of money has to keep increasing, or the system falls apart.
From where does this money come? There are several possible ways for money to get reasonably created. The best way is for productivity to improve. If everyone makes 4% more stuff this year than they made last year in the same amount of time, then you can increase the money in the economy by 4% and everything will be the same. Next, you can grow your working population. Notice that having a bunch of babies doesn't help, at least not until they get old enough to work. It also doesn't help to have more retired people. But if you can, say, let 12 million workers into your country, especially if the 12 million workers come from a poor country and have very low living expectations, then you can increase the money supply to account for their work. You can find someone else from outside your economy to loan you a bunch of money. Finally, you can just print more money, but this leads to inflation, then eventually to runaway inflation and a complete breakdown of your economy.
Suppose we found ourselves in a country where people were having few babies, they were unwilling to allow lots of immigrants, and more and more people were getting older and retiring. In this society it would be very difficult to increase the money supply: banks don't want to lend lots of money to retired people, or people who will likely retire soon. This country would have to find a way to deal with paying interest on loans in a society where the total amount of money was contracting. This means there would be less and less money chasing the same products, and prices would go down. When prices go down, people tend to delay purchasing waiting for a better deal, and prices are driven down even more. This is called deflation, the heart disease of capitalism. This country exists: it's Japan since about 1990. Their official government interest rate is zero, and has been for many years. These people have redefined "recession" as "normal."
China, due to their one child policy, will also soon face a declining working population. In their case this will not be obvious right away due to the enormous improvement in worker productivity as they bring workers in from home farms and train them to work on modern production lines. However, we can expect that in 30 to 50 years their factories and workers will all be as productive as anywhere else in the world, and then they will be in for a world of hurt.
America found itself in a position where bankers wanted the money supply to increase faster than people
could borrow. For the last 15 years, they were accommodated by Asian countries. Asians had uncertain
economies last century and have few social programs for medical care or retirement, so they are very
interested in saving a lot of money and investing it somewhere stable. Asians were very happy to work hard
and instead of consuming send their money back here to buy stocks, bonds and real estate. So we ran a big
trade deficit and all that money came into our country, feeding the Internet and real estate bubbles of the
last ten years. Today America is only looking like a good investment in comparison with other countries,
where prices are falling even faster and further. We cannot expect that Asians will continue to send us
money indefinitely. We're going to have to learn to live with lots of immigrants, or declining prices,
savings and standard of living. Or invent a new form of capitalism that's smarter than a shark, who has to
move forwards or die.