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Where does Debt come From?

As the Government looks to cut funding to Higher Education Institutions, graduates are instead being asked to pay for the void Messieurs Cameron and Clegg have left them with. With the possibility of student debt rising to £40,000, students have been vociferous in their response against the hikes in tuition fees. The previous article called to students to make a rational response against the proposals and tackle the issue by confronting the core problem of debt. But before addressing this key matter, it is important to understand why we have debt in the first place.

There is a common saying that ‘money makes the world go around’, yet it is astounding how little the general public know about it. We generally see money as a means by which to purchase commodities, and something readily available to us from the ‘hole in the wall’. However what does our money really represent and where does it come from? Only once we are able to answer these questions can we move on to understand why debt is so ubiquitous in our current economic system.

The roots of our modern banking system can be traced back to the 17th century, where a customer would deposit his gold coins (which was state money at the time) to the goldsmith for safe keeping, and in return the customer would receive a paper ‘bearer receipt’ for this. The goldsmiths would charge the customer a fee for keeping the gold in their vaults, and upon presentation of the ‘bearer receipt’, the goldsmith would have to give the customer their gold.[1]

Rather than going to the bank to obtain their gold deposits for purchasing goods, customers found it more convenient to purchase commodities by handing over the ‘bearer receipt’ to the vendor of the goods so that they could withdraw the deposits if they wished to do so. This system of purchasing became quite popular, and so, more people began depositing their state money with goldsmith, and then trade with the ‘bearer receipt’. As these receipts remained in circulation for a long time, they eventually became money. Thus, a situation emerged where two types of money began to exist; ‘state money’ being that of gold coins, and ‘bank money’ consisting of paper receipts issued by the goldsmiths.[2]

The goldsmiths realised that with so many people depositing their gold and trading in receipts, they had large amounts of gold sitting idle in their vaults. They decided that it would be in their favour to lend this gold to people of reputable stature at interest, so that they could obtain some return on their deposits. When lending gold to investors at interest, the goldsmith had to be cautious on the amount of gold he was lending. He would have to keep enough gold to meet the requests of depositors who wanted redemption of their receipts. Naturally, there would have been instances where customers would make huge withdrawals in one day, forcing the bank to close its doors to the public. This would then lead to a lack of confidence in the system, causing the infamous ‘bank run’. The key word here is confidence; so long as the public believed that they would get their money on demand, confidence in the system would remain high.

Most of the time, however, withdrawals would generally be relatively small, and so, banks could afford to lend most of the deposits in their possession. The amount of money the bank should keep against the value of receipts it issued is what is known today as the ‘fractional reserve’. Some argued that this ratio should always be 100%, in which the amount of gold in its possession would equal the value of receipts it issued. This meant that the bank would have always been in a position to meet requests for withdrawals. Others however were tempted by the lucrative nature of having a reserve as low as 20%, such that if a bank had £1000 worth of gold, it would keep £200 for honouring withdrawals, thereby allowing it to lend £800 at lucrative interest rates.

It later became apparent to bankers that they didn’t have to physically loan out the gold in their possession, as the receipts they issued equally had the power to purchase goods. Therefore, supposing a banker had £1000 of gold in his vault, if he operated on a reserve of 20%, he could print receipts to the value of £5000, giving £1000 worth of receipts to depositors, with the remaining £4000 being used for loans. This was a crucial development, as it gave the banker the power to ‘manufacture’ money out of nothing, and at little cost. It also illustrates how the bankers had a firm control on the supply of money in circulation.

In 1844, Robert Peel passed the Bank Charter Act which aimed to prevent banks from printing money in excess of their gold reserves. However, the banks tried to side-step this piece of legislation by creating the cheque and account system, which would allow them to retain the power of creating money. Let us assume there are two customers of a bank, A and B, each of whom has a zero account balance. A wishes to buy goods to the value of £100 from B, and so writes him a cheque for that value. The bank credits customer B with £100, whilst customer A is in overdraft to the value of £100. In this way, the bank again has created £100 out of nothing. From this we can see that one group of customers must always be in debt to an amount that equals the supply of bank money. Moreover, if A repays his debt by depositing a cheque of £100 drawn on customer B, then money is essentially destroyed.[3]

By understanding the evolution of modern banking, we can appreciate the situation today in which the Bank of England prints paper money and the commercial banks create money in the form of electronic credits. Modern day currency is not associated with a commodity such as gold, but in reality is just a piece of paper. Thus, we have gone from a situation in which state currency was in the form of gold and bank currency in the form of paper, to today where the central bank prints money is in the form paper and commercial banks create money in the form of electronic credits. The principle theories, upon which early banks operated however, remain the same. Banks still operate on the fractional reserve system, they lend money and profit from lending through interest, and they have the ability to create money out of nothing. Furthermore, the amount of bank money in circulation must balance with amount of customers in debt. As we have illustrated above that banks create money through debt, repayments of loans are not in the bank’s interest as this destroys money, and a decrease in money supply leads to recession. Hence, debt must always exist.

With such an economic model, the cycle of economic boom and bust cannot be prevented. It is a fact that we will have periods of a false sense of security leading to ‘economic growth’ when money supply is high only for such periods to be followed by periods of recession in which people struggle to repay debts ultimately due to a lack of money supply.

Such an economic model can have serious consequences, not only to the individual, but also to small businesses, larger ones, and even nations. The dangers of such an economic model were highlighted by Thomas Jefferson:

If the American people ever allow the banks to control the issuance of their currency, first by inflation then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers occupied. The issuing power of money should be taken from the banks and restored to Congress and the people to whom it belongs. I sincerely believe that banking institutions are more dangerous than standing armies.[4]

Relating this to the situation of British students, it should be apparent that merely calling for the abolishment of planned hikes in tuition fees does not answer their problem of debt. Even if they manage to have the motion repealed, they will still be in debt when they graduate, and will continue to be forced into further debts when they start their climb on the housing ladder. Having students start their adult lives with high levels of debt works in favour of the current economic model, and also helps to understand how debt has become the norm, and not the exception, in our society. Perhaps the problems of our current banking system are best summarised by Robert Hemphill:

We are completely dependant on the (centralized) commercial banks. Someone has to borrow every dollar in circulation, cash or credit. If the banks create ample synthetic money (through the fractional reserve system) we are prosperous; if not we starve. We are absolutely without a permanent money system…It is the most important subject intelligent persons can investigate and reflect upon. It is so important that our present civilization may collapse unless it becomes widely understood and the defects remedied very soon”[5]

When one takes time to reflect upon the nature of our current banking system, it should become quite clear that the issue of debt is something which affects us all. But with students being amongst the most vulnerable in this economic system, the nature of their response against the hikes is quite important. Protesting against the hikes, whether performed peacefully or violently, will not lead to an end in debt. The ultimate solution to putting an end to the huge sums of personal debt we all face is to question our current economic model which essentially functions on the creation of debt. Students should initiate a public debate by putting our current economic model on trial against an alternative paradigm which isn’t based on debt creation. By doing so, they will be taking the first steps to help ease the suffering of many throughout the world who have been crippled by debt.



Islam21c requests all the readers of this article, and others, to share it on your facebook, twitter, and other platforms to further spread our efforts.

[1] Tarek El-Diwany. Travelling the Wrong Road Patiently. Viewed on 14th December 2010

[2] The Problem With Interest. Tarek El-Diwany. (London:Kreatoc, 2003) pp36-37

[3] Tarek El Diwany. Why Are We All in Debt (youtube Video). Viewed 14th December 2010

[4]Thomas Jefferson. Autobiography, Correspondence, Reports, Messages, Addresses and other Writings. the Writings of Jefferson, vol. 7. 1861, p. 685

[5]Irving Fisher. 100% Money. 1935, p. Foreward

About Sameer Mallick


  1. reply to Rich Buckley
    reply to Rich Buckley: You asked what does the islamic banking system do if there is a massive default on payments of rent?

    Firstly, the islamic economic model hugely reduces the risk of stock market crashes and boom & bust cycles – prevention is better than cure. hence less chance of massive default on payments of rent.

    Secondly Inflation is much better controlled under an islamic model, so for example, here in the UK, a house worth £1891 in 1952 inflated to £185000 by 2007! This obviously creates great pressure on first time buyers, leading to much bigger and riskier mortgages putting the whole system under pressure of collapse.
    Again, this risk would be avoided in the islamic model.

    Thirdly, in an islamic model there would exist a large number of private investors wanting to put their wealth into properties since interest based investments are not allowed, so it wouldn’t necessarily be the banks who are providing all the loans anyway.
    Again, risk is reduced in the islamic model.

    Fourthly, Islamic societies have much greater family ties and it is extremely common for families to help each other with purchasing property and/or living in close quarters, I even see this happening a lot in the west, with parents using their savings or equity from the no longer needed large family house to help offspring make their first step on the property ladder.

    You see the Islamic economic model is not restricted to a limited set of principles, it is part and parcel of the whole islamic way of life and intertwines and benefits from unique islamic social conditions.
    Hence even though islamic economic principles would benefit the west greatly, for the entire system to function to its maximum potential, it really needs to operate within a muslim society.

    This reply is barely scratching the surface but i hope it helps.

    Im surprised the “islamic” bankers you spoke to were not able to answer this!

  2. Mohammed Ashik

    Please check out Tarek El Diwany’s work
    @Rich Buckley, please out Tarek El Diwany’s work for views, critique and information on macro-economic reform based on genuine Islamic principles.

  3. Public Sector Borrowing
    Ali A. Shah
    BA; LLB Hons; MA Politics; MA Economics
    83 Woodwards, Harlow, Essex, CM19 4NX
    Tel 01279 423915
    [email protected]


    Re: Public Sector Borrowing

    There was a report in The Times (22.12.2010) that “public sector borrowing surged to an unprecedented £23 billion. Interest payments on the national debt rose by 50 per cent to hit a record £4.5 billion — or £150 million a day”. Obviously it is painful.

    I am sure if you discuss it with the economists you will find a significant percentage of economists who will say that for a state to borrow in order to spend is not a good idea. Quantitative easing ie printing money is the answer. [Although a poorer nation’s need to borrow from abroad, in order to finance its essential imports, is unavoidable].

    Printing money in itself should not cause inflation, provided spending is done on genuine, essential and unavoidable demands of a political economy. You cause inflation (if you do) the moment you spend, whether money you spend is borrowed money or it is newly printed money. In fact you cause added inflation when you borrow in order to spend, as you have to pay interest too on the borrowings.

    We should not listen to those naive advisers who say that by borrowing money you take funds out of the coffers of the money lenders and you “disable” them and stop them from inflationary spending. It is false. The money you borrow comes from the extremely rich, corporate or personal, banks and the rest. If you don’t borrow from them their savings will stay in their banks as they have nowhere to spend. It is spare money. Their needs are already satisfied, except to make money out of money. Hence they will not cause inflation. And in any case the foreign creditors (governments and others) “disabled” by you or not, do not affect your inflation problems at all.

    Also price rises by greedy businessmen must be met by good, effective, and competent price controls. All Faiths of the current world allow it, in fact recommend it.

    It took several centuries for the West to take a giant step to print and accept paper currency. The intellect had to fight a tough intellectual battle to overcome foolhardiness. Then, it took at least another century for the intellect to prevail upon foolhardiness to convince the rulers to abandon the gold standard. That was the second giant step. Now we must take a third necessary step: We must sink the concept of public borrowing in the deep waters of Atlantic ocean with heavy sinkers around its neck. I am sure you will not lose anything.

    God bless.

    Yours in faith

    Ali A Shah January 2011

  4. Sharia
    The sharia economic sutem is the solution to that of which you speak. Abraham lincoln was going to institute such a system and i cost him his life.

  5. President, Peace And Conflict Resolution.Org, Corp (a 501-(c)3 Nonprofit Corp)
    I have struggled with banking reform concepts for decades. I confess to being part of the problem of failing to realize that Wall Street must always be carefully watched as human nature seems and tends to always drive an ‘otherwise good idea’ into an excessive use leading to eventual failure.

    We have learned that banking niches should not necessarily be filled simply because they happen to exist. Imprudent banking practices usually start with broadly recognized popular political concepts that then run under-regulated as a banking practice. Macro-economic catastrophes then spiral into existence.

    Frankly, I even looked at the Islamic banking model (if it is proper to refer to it as such) to see if there were new possible answers to the massive handling of debt by nations. I was hopping to find some ancient wisdom, different from the West’s model of banking practices, that might enable a smoothing-out of world economic cycles.

    I found none. All of the Islamic bankers at the highest levels failed to offer answers to the primary macro-economic question: What do the people collectively do under Islamic banking when there is massive default on payments of rent.

    The Islamic Bankers all held ready answers for the micro-economic model explaining how Islamic lending practices differ: (a) equity partners not lenders, (b) rent to equity partner, not interest. This they all understood and this I too understood. But what the Islamic banks could not answer was the following: What does the Islamic banking system do when then entire system collapses? Who ends up with what assets in the collapse? Who is left on the streets wanting? In other words who backs up the banks in the Islamic banking model when they fail? And is this solution recognized and employed on a national level? Has the solution every been tested in the real world? How does that differ on a macro-economic level from Western banking practices?

    No one inside the Islamic Banking industry would or could answer these questions which I was hoping to discover as a possible economic reformation within Western Banking.

    Then we had a banking crash (the one we are recovering from now) right here in the US (with world-wide ripples) and I discovered there existed great value in open democracy to somewhat mitigate politically through public opinion, state treasury, and regulated relief into the banking system a form of partial forgiveness of debt and liquidity-maintenance within the Western political system itself.

    Here is what I found in the last two major banking crashes in the US: (1)Banks have to be regulated and watched closely. (2) Auditors need to have a political voice even though individual confidences need to be protected. (3) Banks receiving extraordinary relief through from our national treasure, must be tasked to share the pain, it is in this department that the greatest reform may be possible both West and East.

    What I have discovered since is that no one East or West holds a final answer, that solutions are by their very nature always a moving target. These are the tenants of the current system I find to be true: A non-democratic system stifles creativity on the macro-scale level by preventing and interrupting free market allocation of assets in production (capital) and labor. A central planning model on the other hand is good at some things but very poor on other things. The central planning model that regulates everything, is unable to feed the creative enterprises (we too often enjoy hating) of a Wall Street. The formation of new wealth is prevented. A permanent state of social stasis seems to be Central Planning economy’s earmark. Finally, there is some emerging evidence that labor’s voice can be integrated into free-market business decisions of management but there will always be a trade-off to be paid. Germany does include labor representation on its public companies. It can not be concluded however that the German model is yet stabilized as a proven long term model. Banking after all is a relatively modern phenomenon in the history of human affairs.

    Peace and Conflict Resolution.Org where I volunteer, is always researching ideas that lift away dogmas of our perceived differences and focuses on how we might peacefully resolve them.

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