Why don't creditors soak up all the money?

[SimpleDon]

Sorry, I missed this at the top of your response to me that I already responded to.

First, some other ways to avoid this economic Goetterdaemmerung:

* The creditors voluntarily deciding to forgive their debtors' debts.

* Would-be debtors refusing to go into debt.

This is the fatal flaw of capitalism, first realized by Marx. His solution for it was even more flawed as we found out, but that doesn't detract from the veracity of it.

...

Refusing to go into debt might not solve the problem. It might be a part of the economic fallacy that what is good for the individual is bad for the economy as a whole. Especially in the condition that we have today in the US and in most of the Anglo economies around the world, where all of the proceeds from improved productivity and innovation goes into profits and none into increased real wages. There is no growth in real wages and there is no increased demand to spur the growth in the economy. Then growth in the economy depends entirely on increased private debt.

The data proves the case, private debt was about 40% of GDP in the US after World War II, it decreased to about 25% of GDP until the magical year of 1980, and then it increased to about 300% of GDP immediately before the Great Recession of 2008. I have a graph of this that I can't find at the moment, I will try harder to find it if someone needs it.

 

[Alcoholic Actuary]

I bolded the primary reason I think all the money doesn't end up with the lender. To command any kind of interest on debt there has to be a risk of default.

aa

Unfortunately, to rely on default to correct the problem of high private debt requires a delicate balance between the moral hazard of too easy bankruptcy and turning the collection of debt into a moral good. A balance that is too easily tipped in favor of one by too much political power by one camp or the other. Witness the current situation with student debt.

I felt the question in the OP was theoretical (which does have a limited real-world application). Theoretically the rate of interest is an insurance policy against the losses of default on borrowed money. In reality, the rates of these theoretical insurance policies have been grossly over-priced. This has more to do with the fact that 'the market' prices this risk (as opposed to risk pricing professionals). This is the source of our current im-balance of power between lenders and borrowers.

aa

 

[lpetrich]

If you are questioning if Marx predicted, incorrectly, that capitalism is self-destructive, I would respectively suggest that your reading of Marx is somewhat lacking on the whole.

I'm not questioning that. Karl Marx is well-known for believing that capitalism involves exploitation of labor, but I hadn't known about him on finance.

 

[Alcoholic Actuary]

In my experience the bank has a problem with it.

The bank loses future profits but not the amount of the loan. And of course, the bank that holds the loan works hard to prevent default because they don't want to lose those potentional profits.

Please try to read my whole post, not just to the point that you can make one of your non-responses.

Please read the article on fractional reserve banking, if you need to, and tell me whose money it is that makes up the non-reserve portion of the loan and where it comes from.

I also think that Fractional Reserve Banking allows for lenders to capitalize on market mispricing of risk. As long as default rate is less than the fractional reserve rate, there is really no real problem with holding the actual amount of capital required to service all loans (less defaults). The problem begins when interest rates creep significantly higher than default rates - by significantly, I mean almost double. And still, this tends to be less than fractional reserve rates for most lending institutions.

The ultimate result of Fractional Reserve Banking is that banks do get to create money, but that creation should cause interest rates to get depressed closer to the actual rate of default. Higher reserve ratios slow down the velocity of lending and increase the interest rates on borrowed money.

aa

 

[Loren Pechtel]

The bank loses future profits but not the amount of the loan. And of course, the bank that holds the loan works hard to prevent default because they don't want to lose those potentional profits.

Please try to read my whole post, not just to the point that you can make one of your non-responses.

Please read the article on fractional reserve banking, if you need to, and tell me whose money it is that makes up the non-reserve portion of the loan and where it comes from.

I also think that Fractional Reserve Banking allows for lenders to capitalize on market mispricing of risk. As long as default rate is less than the fractional reserve rate, there is really no real problem with holding the actual amount of capital required to service all loans (less defaults). The problem begins when interest rates creep significantly higher than default rates - by significantly, I mean almost double. And still, this tends to be less than fractional reserve rates for most lending institutions.

The ultimate result of Fractional Reserve Banking is that banks do get to create money, but that creation should cause interest rates to get depressed closer to the actual rate of default. Higher reserve ratios slow down the velocity of lending and increase the interest rates on borrowed money.

aa

Without fractional reserve banking why would a bank every pay anyone interest? They couldn't do anything with the money on deposit, it would only be a liability for them. Banks would charge substantial fees to provide service and they wouldn't be a source of lending at all.