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Bad Money Chasing

The reasons for the credit crunch, though, are far more numerous just people falling behind on their mortgages. Money is created primarily through the issuance of credit in the forms of mortgages, credit cards, business loans, and so on. Banks are able to create this money out of thin air, based on how much other money they have on deposit which has also been created out of nothing.

As long as loans are being paid back over time, this money creation scheme can continue for long periods of time. But the problem comes in when the principal for loans are created but not the interest. Banks make money from collecting interest, but they only create the principal amount of the loans.

This leaves the entire economy with a vast shortfall between the money created through debt and the money needed to pay back the interest on all of this debt. People who take out loans are forced to compete with each other to obtain as much money as they can in order to pay back the interest on the money they have previously borrowed but which had never been created.

The results of such a system are easy to predict: some homeowners will be able to gather enough money through production and pay off their debts in full. Others, though, may engage in successive cycles of borrowing, refinancing their homes and taking out new loans to pay back old interest but never coming out ahead.

Eventually, some people who borrow money will find that they have not gathered enough of principal money from other borrowers and they will have no choice but to default on their debt. Defaults are eventually written off by banks or the loans are discharged through bankruptcy proceedings, but the debts are eventually destroyed.

Banks, of course, plan for a certain amount of their loans to go bad or their borrowers to fall into bankruptcy. It is a necessary cost of creating principal out of thin air but never issuing enough money for all of the interest to be paid back. These loans, which the bank counts as assets because they were expecting to be paid back, are simply written off and the money is counted as destroyed.