I have always known that I don’t completely understand how fiat money works, however I have recently realized that I don’t understand it at all! Maybe some of my readers can clarify my confusion.

So let’s start a national economy from scratch, without international trade: so a group of people move to a deserted island, declare independence, the people have all kind of skills, they bring all kind of materials and machineries with them, the island has all kinds of natural resources and maybe a lottery system gives some people ownership of various plots of lands and mining rights.

Now some would-be entrepreneurs would like to begin hiring people with the right skills, buying or renting various stuff, and start some businesses. It seems that there is no loss of generality if I think of the entrepreneurs as just one person for the sake of what I want to think about. She is going to need to get a loan to start her business(es). Meanwhile, the new island government created a central bank, which issues theory dollars, or thollars, which are the currency of the island. The central bank “creates” thollars and lends them to banks, then the banks keep a fractional reserve and lend to the entrepreneur. Again, for the sake of what I want to say, there is no loss of generality if I identify the central bank and the other banks as just one entity.

So the central bank lends thollars to the entrepreneur, and she uses the money to start the business and being to pay people. At this point money starts circulating in the economy, and people will hire gardeners and babysitters, and lawyers, they will give to charities, they will hire computer science theory tutors for their kids, they will buy and sell houses to each others, and, crucially, will buy whatever goods and services the entrepreneur is selling. Now she is making a profit and she can pay back the loan to the central bank and invest in more … wait, she can never pay back the loan!

That’s because all the thollars in circulation are the ones that the central bank lent her, so there is no way that, as the money circulates, she can ever make more money that she owes!

Ok, so maybe people will also take loans to buy houses and stuff, so that’s more money that circulates, but is it really the case that, overall, it is impossible for everybody to be debt-free? That all the cash that any debt-free person has needs to be compensated by an equivalent amount of debt from other people? This is not how things seem to be in practice.

Now, clearly it is possible for everybody to have positive net worth, because, at the start, people have stuff and that stuff is worth money, but it seems strange that not everybody can be debt-free.

Maybe the problem is deflation? That if the entrepreneur borrowed money to create a business that creates new wealth (because it makes stuff that people find more valuable than the value of the raw material and the value of the work that went into it), but the amount of circulating money stays the same, then there is deflation, and her debt is spiraling out of control in deflation-adjusted terms, even if the interest rate is zero?

It seems that there are only two ways in which you can have everybody be debt-free and have a positive amount of cash: (i) the central bank starts buying stocks of private companies, (ii) the government runs a deficit, and the central bank buys government debt.

Is this correct? Normally, we think of people and companies being debt-free (or having more cash than debt) as ideal, and a government running no deficit as ideal, and usually central banks don’t buy stocks (they only buy bonds, which is formally equivalent to lending), so are these three conditions contradictory?

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