The intrinsic cost of money

Borrowing and lending are the same act, engaged by two different actors. The act itself puts credit to use.

The use of credit puts money into the economy just as surely as the open market operations of the FOMC.

However, when the FOMC buys something, the money it puts into the economy does not come with interest charges or repayment obligations to be paid by the recipient. The money is unencumbered, free and clear. It is as if you sold your old car to your neighbor: the cash you receive comes with no intrinsic costs.

By contrast, when a borrower takes a loan, not only money but also debt is created. After a time the debt is extinguished by repayment; this repayment also destroys the money that was created by taking the loan. Your lender puts money into the economy by lending to you, and takes money out of the economy when you repay the loan.

The difference is that your bank lends money and the Federal Reserve spends money. We see, then, that the money in the economy is of two kinds: encumbered, and unencumbered. When I show the Debt-per-Dollar graph, I am showing the relative proportions of these two kinds of money.

Graph #1: Total Accumulated Debt per Dollar of the Money We Spend

In 1966, when the rate of interest was about 5%, our economy had about $7 debt for every dollar of circulating money. Each circulating dollar therefore, over the course of the year, carried an interest cost of about 35 cents. In 2006, when the rate of interest was again about 5%, our economy had about $24 debt for every dollar of circulating money. Each circulating dollar carried an interest cost of about $1.20.