Ever wonder how everyone can supposedly get richer? Compared to the 1930's the average worker in the US earns significantly higher wages today than they did nearly 80 years ago. At the same time, the cost of goods has also risen but at a slower pace. Why is that? On the surface, the answer is obvious: inflation. But what exactly causes inflation?
Assume the economy had a total of $10 dollars, and 5 people lived in this world. Assuming each person received $2 each, there would be $10 of total money supply in the system. Let's say one person is smarter than the others. He invents the wheel. Each wheel sells for $1 each and it costs 50 cents in material and labor. 2 persons think it's helpful for them, so they each buy one. That leaves $1 to 2 persons ($2 starting - $1 spent), the 1 person who invented the wheel hires the 2 remaining persons that didn't buy a wheel at a rate of 50 cents per wheel made. That means at the end of 1 goods cycle, 1 person would have $3 ($2 starting + $2 earned - $1 in materials and labor), 2 persons would have $1 plus a wheel, and 2 persons would have $2.50. The world economy still only has $10 of total money supply, but now 2 persons converted 1 of their dollar into a wheel. Unless those two can figure out how to take money from the other 3 using that wheel, they'll never have more than $1 now. What this example shows is that in a closed economic system, you have a balance between money supply, labor, and goods. The money supply is constantly shifting between people as they trade the money for goods. No good will sell for more than can be afforded by the people (since they can only buy what they have money for), and the amount of goods available would never go beyond the total demand. If one couldn't afford to pay, they could borrow from another with the intent of paying that back. Although they could lend and borrow, the key difference between reality and my example is that there would be no interest due and the credit would come out of their pocket! With no interest due, even with credit, there would remain $10 in the entire economy and every good would still remain at fixed prices. The only effect would be the borrower would have more money in hand, but they would still have to repay the money somehow. Also, within this closed system, no one group of people would control all the money as they would eventually have to trade that money for goods (unless they also produced their own goods).
Now what happens when the population grows? Let's say the world grows by 7 person that year. We now have 12 persons in the world, but still only have $10 in the economy. Eventually, those 7 extra persons will add to the work force and the net effect will be a lowering of wages due to an increase of labor. But along with that come more efficiency leading to higher productivity (assuming a perfect world where everyone contributes work). Therefore, even though the population grew, the supply of goods grow as well due to an increase in productivity. This leads to lower wages, but it also leads to lower prices and this reduction of money supply in the economy (because the population grew, but the total amount of money stayed constant) is called deflationary. Again, the net money supply remains constant.
Granted, this is all a bit of an "Amish-world" scenario where every member of society contributes work when capable, and everyone buys within their means.
Now let's take a look at what happens when one person who lends, we'll call him brother Fed, decides he wants to be paid to lend his hard earned money. He adds a surcharge called "interest" to the amount due. Now, if a person borrows $1, and the lender charges him 10% to borrow it, the borrower must repay $1.10. How does he repay that? In our fictional world, he would have to work harder to earn that extra 10 cents, or forgo buying something to save that 10 cents. So as you can see, interest alone is not a big deal, since it just means the borrower must be more productive in his earnings or consume even less.
Now let's suppose the same borrower goes to brother Fed, and brother Fed decides he's not willing to risk all of his hard earn money. So instead, he gives the borrower his money in the form of an IOU. We'll call the IOU, "Credit". The credit is good because brother Fed says it's good and he's got the net value to back it up. The other 10 persons in this world decides that's as good as cash and accept brother Fed's credit. What just happened? Well, brother Fed in essence, introduce $1 of new money into the world economy. Now, we no longer have $10 in the world, but $11! $10 is real, $1 is imaginary. But the world moves on because the credit is accepted as tender so the net effect is to have an economy worth $11! Now that is a big problem! We just introduced $1 into the world that didn't exist, but the real money supply hasn't grown! In fact, Brother Fed, the lender, still has his $1 that he didn't lend, and the borrower has his original $1, but he also has this imaginary $1! They're both going to compete for the same amount of goods, but 1 person will have more money than they normally would have. They can afford to buy more than their share of goods, taking supply away from the other people! Now those people either accept paying higher prices for the goods to compete, or they go without.
As you can see from my example, there were at least two consequences to the introduction of imaginary money into the world. One, prices will go up above the equilibrium due to an increase in money supply, NOT goods supply. However, that's just the initial effects. The other major consequence is that those who live within their means can no longer afford the rising prices as much as they could before. Therefore, their standard of living has just dropped. Unless they can earn more to compensate, they will eventually end up in the poor house! A side effect to prices going up is that with the extra money, the borrower can invest that extra money into other things rather than goods or labor. Specifically, one could spend that money on advancements in technology. With an investment in technology, you could increase productivity without increasing labor cost. That can have the effect of increasing goods supply, but initially, it will affect prices due to the increased upfront cost for the technology (capital investment). Over time, however, the increased productivity will eventually lead to an oversupply, and lower prices, if demand grows.
I mentioned two concepts in my example, interest on borrowing, and imaginary money supply based on credit. What happens when these two combine? Bad things happen. Very bad things. In fact, this is the start of a ponzi scheme. A ponzi scheme is a fraudulent investment term used to describe a situation where money is invested, but not enough money is made on that investment to repay the original investor. In order to repay the original investor their due return, more money from more investors are needed. Eventually, only those initially in the scheme get paid while the masses afterward get less and less of their money back. With interest and imaginary money, you have the same problem. When someone borrows money from the bank, that money is imaginary money. It's created out of thin air as an IOU. That's why it's called credit. The bank is crediting your account with that amount you're borrowing. It can be withdrawn as cash, but it's still imaginary money that was introduced into the economy out of thin air. Now the bank wants you to repay that money with interest. But here's the catch. The interest due is NOT created out of thin air as imaginary money. In fact, you have to earn that interest from the existing money pool.
So going to my example of brother Fed. He lends an IOU, but also charges 10% interest. The borrower must not only repay that IOU, but he has to either earn that 10%, or go without to save that 10%. But remember, because of the introduction of imaginary money, the cost of goods just went up! Now people will have to spend more of their limited money to stay alive. How does the borrower repay that 10%? Most likely, he'll invest that borrowed money and make it work for them. But that just means less money in the hands of the other 11 people out of 12. Now those other 10 (assume the lender is ok because of his little business making money out of thin air) can't survive due to prices increased from an increase in money supply. They go to brother Fed and ask for a loan to pay off their bills. They too owe 10% on the borrowed, but now Fed has just added even more imaginary money into the world. Now imagine everyone doing that over and over, not only to pay for goods, but also to repay their old debt obligations! Can you see how you can never have enough real money to pay back the imaginary money, nevermind the interest? This is a classic ponzi scheme! You borrow more money to repay borrowed money.
Our world is no different today from my example. Our money system used to be backed by hard commodities (gold). Today, it's just a piece of paper, an IOU. That in and of itself would be ok as a means of value exchange, as long as the money supply equaled the world net worth (ie. no imaginary money). But add the Federal Reserve, banks, and fractional reserve lending into the picture, and now you've got a world of imaginary money making its way into the economy! Ever wonder why prices keep going up and wages keep going up? That's because the money supply is constantly increasing. This is what leads to inflation! Why do we need inflation? Because we owe creditors not only the principal amount borrowed, but interest that wasn't created as imaginary money. Like I demonstrated in my example, with the increase in money supply in the world, you have an increase in spending capacity, and increase in productivity due to technology or a change in labor costs, either up or down, depending on the use of the debt. When wages drop, the worker might have to borrow to buy goods they want, which sustains or increases demand, which can cause prices to rise. When wages increase, that extra money supply in the economy creates more demand for the same supply, causing prices to rise. In either case, the effects of borrowing is felt throughout the economy as strong demand. If people didn't borrow imaginary money to exist, there would not be an increase in money supply to create more demand, as people would be used to living within their means (no money, no buying).
This example is my plain English description of what happens when interest and credit through fractional reserve lending exists. I didn't even mention the additional burden on the economy through taxes and non-productive costs.
Can a world exist where interest and imaginary money didn't exist? Unfortunately, no. That's what we call utopia, or paradise, or heaven. It's where people are not filled with greed, wants, desires, and selfish motivation. Instead, we live in our world, where those who have seek more, and those who don't borrow to have. This is what leads to destruction of civilizations because the basic human desire for more leads to corruption and ultimately to their demise.
So why did I write this? In the hope that people will realize that borrowing money for the sake of spending it is not good for them, or the country, or the world. It's what has caused the current economic crisis, and it's what will eventually lead to a decline in living standards as the have's continue to take from the rest of the world through interest and imaginary money, while the have-not's pretend to have by borrowing from the have's.