I have a lot of debt.  Not counting the mortgage on our house, I personally owe about twice my annual salary to creditors.  That’s a lot of money.  Well, okay, my salary isn’t anything to write home about, but it’s the ratio that’s important.

That means that if I had no expenses at all (including taxes) and spent no money on anything else (even pastry), I could completely wipe out my debt in two years.  Except of course, that my creditors get to collect interest on the whole shebang for those two years.  That means that I’d have to work for a few months more to actually get free and clear.

From a standpoint of my own financial independence, this is a very bad thing.  After all, if I had no debt, I could potentially afford to take a reduction in pay, which might make it easier to change careers from what I’m doing now to something that I’d like better.  Heck, my wife and I could potentially afford not to work more than one or two days a week if neither of us had any debt.

What’s the point of owing debt and paying interest then?  After all, at one time there were usury laws that prohibited lending money for profit.  Of course, back then, most of a nation’s economy was conducted without cash.  Probably 90% of the entire population rarely handled actual currency.  If they did, it was usually very small amounts squirreled away in the event of a bad harvest. Instead, most people bartered real goods and services directly for other goods and services.

Today, though, currency (money) is the primary mode of exchange.  If you walk into Starbucks and offer to trade a pound of cheese for a venti latte, they’re probably going to laugh you out of the store.  Of course, it is a lot more convenient to trade symbols of value for tangible value.  Imagine how quickly your cheese would go bad if you had to carry it around in your car to buy gas.  The key point to remember is that money is a symbol of value as opposed to a source of value.

The concept of consumer debt arose when the value required to produce a desired good exceeded the likely stockpile of value that the average person could readily amass.  Although the concept is ancient, the modern incarnation dates back to the early 20th Century with automobiles.  Interestingly, Henry Ford strove to keep the Model T cheap enough so that many families could afford to save up and buy one.  Of course, the Model T was pretty bare bones and there were plenty of people who still couldn’t manage to save up for one.

Enter Billy Durant and his General Motors Acceptance Corporation (GMAC, now Ally Bank).  Durant let customers take possession of a car before they had amassed the wealth (stored value) to buy one outright.  It’s interesting that GMAC came into being only six years after the Federal Reserve System in the United States.  GMAC became possible because of significant changes to banking laws, including new ways of approaching “Fractional Reserve Banking”.

What is “Fractional Reserve Banking”?  It is basically a set of rules that allows banks to lend out most of the money they receive as deposits.  For instance, at a fractional reserve rate of 25%, the bank can lend out 75% of its deposits and has to keep 25% on hand in case people want to cash checks or whatnot.  This makes a lot of sense, especially when your currency is made of gold or silver, or is readily exchangeable for such metals.  You need to have a supply on hand to pay out.

In many cases today, banks have a 10% fractional reserve rate.  That means that 90% of the money a bank receives as deposits can be lent out.  What’s odd about this is the nature of modern money, which is called “fiat” currency as opposed to “hard” currency or specie.  Because our fiat currency is purely a symbol of value and has no inherent commodity value, there is no solid upper limit to how much money can be lent out.

There is a theoretical cap, called the “money multiplier”.  The money multiplier is a mathematical function of re-lending deposits that are themselves loans.  At a 10% (0.1) fractional reserve rate, the multiplier is 10 (=1/0.1).  That means that for every dollar on deposit in the bank, there can be nine dollars out on loan.  So, in theory, for every “real” dollar, there are nine “fiat” dollars out there in the world.

Back in the old days, if your money was made of silver, there was only so much silver around and therefore only so much money could be in circulation.  This kept the money multiplier capped at its theoretical maximum.  Of course, it also created all sorts of other problems, including some of the underlying causes of Shays’ Rebellion.  A number of recessions and depressions were also traceable to limited money supply.

The alternative, the one in use today, is that our money has no value except what we all agree to believe it has.  We arbitrarily start defining things in our environment by their dollar value instead of their practical or sentimental value.  Of course, without some kind of value to back it up, the symbol collapses (hyperinflation) and the economy goes ker-plunk.

This is pretty much what happened back in 2008 when our economy imploded.  A whole bunch of banks were “securitizing” loans (turning them into bonds) and selling them off.  Most banks sell loans from time to time to free up cash.  What was different during the housing bubble is that banks were using these “securitized debt obligations” to “leverage” their fractional reserve.  Leveraging is basically using someone else’s money to allow you to throw more money at something than you have.

In small doses, leveraging is good for an economy because it allows entrepreneurs to make smart investments in a timely fashion.  In huge doses, as we saw with the Wall Street crisis, it can make for devastating risks.  Basically, some banks and investment houses were using leverage to keep making new loans after they hit their theoretical fractional reserve limit.  The worst example I heard of was about one-half of one percent (0.005), but I think that one percent was more common amongst the toxic assets crowd.

Let’s think about this for a second…

If a bank has an effective fractional reserve of 0.01 (1%), then for every dollar they actually have, they’ve lent out ninety-nine dollars!  Because those dollars are “fiat” money, they are backed by one thing:

Debt.

Those dollars only have meaningful symbolic value because someone agreed to make them “real” by inputing actual value into the economy (work) to pay off the loan.  If that person defaults on the loan, then there is only one emergency backup- the house or other property that the loan was used to purchase.

This can go round and round, but suffice it to say that the easy availability of credit raised demand for houses, which raised prices and increased new construction rates.  When the bubble burst and people started defaulting on loans, guess what happened…

House prices plummeted in many areas.  That devalued not just the loans that went bad, but the emergency backup for all the other loans!  If a bank didn’t have enough fractional reserve to keep paying the bills, they either went bankrupt or ran crying to Uncle Sam to bailout their stupid fannies.

So, to come full circle, debt is necessary to the functioning of our economy because it is currently the way that we add new money into circulation so that people can buy stuff.  Debt is also very dangerous to our economy because when too much of the money in circulation is tied to risky debt, the money “pops” and we get the Great Recession.

There is one other issue with debt- where does the interest go?  In some cases, as with a local bank, it usually keeps the bank’s lights on and funds new loans to your neighbors.  In other cases, as with big national MegaBanks, that interest exits the economy by going into some rich dude’s portfolio.  Mind you, I’ve got nothing against rich people, nor rich people earning interest.

My problem is with people who get rich by manipulating the inefficiencies in our currency model.  That wild rush to “mine” the last nanogram of profit from the movement of imaginary currency adds absolutely no value to our economy and leads to the kind of thinking that created the Great Recession.  It also raises demand for more circulating currency, thus driving up inflation (the devaluation of currency).

People who want to get rich should do so by creating value, i.e.- by enriching other peoples’ lives and getting fair compensation in return.  Inventing the light bulb, the iPhone, or a better kind of toilet paper are all good things. Selling people good food, repairing their car, or giving them backrubs are useful and valuable contributions. Inventing new ways to lend money to people who can’t pay the money back so they can buy overvalued houses so that you can make a quick buck before the bubble collapses is not just morally bankrupt, it’s ethically unacceptable in a republic such as ours.

So, to help liberate our lives, Kara and I are working with a local bank to restructure our debt and reduce our monthly payments.  It looks like we will cut about $300 from our expenses.  That’s money that we can invest in paying down our other debts and in buying real goods and services.

If you think back over the journey that we just took through our crazy currency system, I’m sure that you can see how buying actual products and paying real people for services with “money” instead of “debt” is a very powerful way to get our economy back on track.  If you are serious about putting America “back to work”, get your monthly payments down as far as possible and start buying stuff from your savings instead of from your future earnings.