Updated: May 31
It’s true; money doesn’t grow on trees. So, where does new money come from, and what does debt have to do with it? Let’s explain.
Gross Domestic Product (GDP) is a common measurement used to determine the size of a country’s economic activity. How does GDP grow? GDP growth can only happen when new money is created and spent. But new money is hard to come by. Believe it or not, all new money comes from some form of debt.
The GDP Formula
Several spending totals are used to calculate GDP. The expenditure formula for GDP is C + I + G + (X-M), where C is personal consumption spending, I is fixed investment spending, and G is government spending. Added to that are net exports (X-M) or, more specifically, the amount of goods and services sold to foreign countries which are exports (X), minus imports (M), which is the amount imported from foreign goods and services.
What causes GDP to increase? That’s right. Creating new money does. But to do that, there needs to be debt. Borrowing leads to growth because more money is being created. Therefore, loans are the only way to sustain economic growth.
The Meaning of Money
The term “money” can be defined in different contexts. The Federal Reserve refers to the money supply as M2, which encompasses mostly bank deposits, but includes currency in your pocket, and also money market funds. M2 was $21.21 trillion in December 2022. That’s roughly how much money is available to buy goods and services, which props up GDP.
Lending the Way
Bank lending is the main driver of creating new money, which in turn, creates new GDP. Let’s say someone borrows $100 from a bank. For the borrower, they get $100 in their checking account, along with a $100 liability owed to the bank. The bank now has a new asset of $100, along with a new $100 deposit liability. Simple dual entry accounting. Everything balances. What's important here is that the newly issued $100 in the checking account did not exist prior to the loan being made. Depository institutions have exclusive power to create money in the US.
Now, the money spent by the borrower contributes positively to GDP. But there’s a catch. It only does so if the money is spent on something productive, like a new house, new car, or other new asset. So, for example, borrowing to buy a new tractor creates new money and new GDP, but buying an existing home doesn’t directly add to GDP because that money has already been in play by the previous owners.
In addition to bank lending, there’s what the Federal Reserve refers to as “open market operations” (OMO). In this case, the Federal Reserve buys debt from the private sector primarily through U.S. Treasury securities or mortgage securities. The money can then be deposited back into the selling institution’s checking account to be used as new money.
While debt is inherently linked to GDP, it’s also a general rule that debt grows far faster than GDP, which means that economic systems get increasingly leveraged over time. But, in modern economies, the ability to save without causing collateral damage to the economy depends on an increase in debt-based spending.
There is what’s called velocity. GDP could indeed grow without debt growth when velocity is increased. That’s the spending of a given deposit more than once in the same year. But velocity has stayed within a reasonably narrow range. So much so that dollars typically don’t get spent more than 1.4 and 2.2 times annually—and dollars would have had to have been spent more than twenty times annually to have accommodated the growth of the past twenty years.
Then, “increased productivity” is often cited as a means of economic growth. While a positive, it doesn’t circumnavigate the need for debt. Ultimately, productivity, innovation, and velocity all play a role in growth. But each involves debt.
Money Solves Most Problems
It takes new money to grow an economy, and money is created by debt. Therefore, debt is necessary if GDP growth is to be accomplished. However, it’s a double-edged sword. Debt is both a necessary creator, and a potential destroyer if too much of it exists.
This blog is adapted from The Paradox of Debt: A New Path to Prosperity Without Crisis by Richard Vague.
For more insights on the vital role of debt—both government and private—in our economy as well as policy provocations that attempt to tame the dark side of debt while allowing it to continue to create wealth, be sure to pre-order your copy today!