A Debt Based System

A debt based system? Inflation? How does this affect me??

Our financial system requires debt to keep functioning. There are many facets and variables to understanding this concept fully, but we’ll keep things simple for the purposes of this little blog post. Let’s have a quick thought experiment to illustrate the point. 

What does it mean to have a debt based system?

Imagine if only one dollar exists. You go to the bank to borrow that one dollar, and the bank lends it to you, expecting to get it back with some interest at some future date. If only one dollar exists, then where does the money to pay the interest come from? If you’re thinking that it has to be created (out of thin air) so that the interest can be paid, you’d be correct. So, the money that exists needs more money to be created so that the debt can be serviced. More and more money is needed to keep the system going. This is a simple version of what actually happens on a massive scale. This is a debt based system, which is what we have, and it is based on Keynesian economic theory.

Now, how does that relate to inflation? Well, if more and more currency units need to be created to service debt, then we have more and more dollars (or francs, or yen, etc) in existence as time goes on. The thing about this is that the more currency units that are created the less each one is worth. The more dollars we have in existence, the less the purchasing power of each dollar. So, for example, people often think that their house has doubled in value over time and it is worth twice as much today as it was, say, 10 years ago; but actually, what has happened is the purchasing power of the dollars used to buy it today has been cut in half in relation to the dollars from 10 years ago. We inherently assume that each dollar today is the same as each dollar from the past, but this is not the case. The number may be the same (one loonie from 10 years ago sure looks and feels like one loonie today) but the ability and power of that loonie to purchase something today is less than it was in the past. That is the loss of purchasing power, also known as inflation. 

So how does inflation rob you of your savings? Let’s do another thought experiment. Imagine that you were alive and had $20,000 in 1975. You have a choice to either put that money under your mattress and save it, or you can purchase the average Canadian 3 bedroom home for $20,000. You decided to put it under your mattress and not purchase the home. You then go to sleep and wake up 35 years later and check under your mattress. Yup, the $20,000 is still there, phew! Then you get out of bed thinking you’ll go out and buy that average Canadian home now. You are then startled to see that the exact same home valued at $20,000 in 1975 is now worth $500,000 and you don’t even have enough for a minimum down payment.

If currency represents the storage of your labour (you work, you get paid), and you decide to sit on your hard earned dollars for a relatively lengthy period of time (under your mattress, or more likely, in your savings account), then you are being robbed of purchasing power by the nature of the system. Or to put it another way, the storage of your labour and effort are being eroded and the work you did is being devalued. This can be seen as a hidden tax that will make a huge dent in your financial well-being unless you realize what is going on and do something about it! 

Evan Legakis

We’d love to hear about your investment journey. Do you have money under your mattress or in your savings account? Share your thoughts and any questions in the comments below.