People need to understand how loans work

[Recursion]

The total number of US Dollars in the world economy is about 15,000,000,000,000, fifteen trillion.

I'm pretty sure we're all good with the idea that there's nowhere near that much physical currency printed, and nobody wants there to be. Most of those dollars are just numbers in a bank account.

That 15 trillion includes all of the currency in circulation, all of the money in US checking accounts, all of the money in US savings accounts, and all of the money in US money market funds that isn't part of an IRA or 401(k). (If you're curious, the money is about half in savings accounts, a quarter in checking accounts and money markets, and a quarter in currency, roughly.)

Now, we all know banks don't physically keep enough cash to meet every depositors' full deposits because 99% of the time that would be incredibly silly and pointless. But here is where people completely misunderstand what banks do, for which I blame Frank Capra. We've all seen the scene in It's a Wonderful Life where he explains to the angry mob that he took their deposits and lent them out to make their money grow, blah blah blah. Heartwarming, well-written and performed, and absolutely not what banks do. George Bailey ran a thrift, not a bank; a thrift is essentially a savings & loan: it takes in deposits, lends them out at interest, and uses a portion of that interest to pay interest to depositors. Again: this is not what banks do.

If Alice starts a checking account at Bank of DU, and deposits $5000 cash, this simply removes $5000 cash from the money supply, and adds $5000 to the money supply in the form of checking account deposits. No biggie: the money moved from one category to another, and the money supply is still 15 trillion. (The bank now also records a $5000 liability in its books.)

Now, let's say Bob wants to get a loan from the Bank of DU. Once he's approved, the bank deposits, say, $35,000 in his checking account. Now, this is the important part: the Bank of DU didn't subtract $35,000 from any other account. The bank is not "lending out Alice's deposit". The bank has increased the money supply by $35,000: it is now $15,000,000,035,000. There are more dollars in the world after the loan was created than before. (The bank now also records a $4000 asset in its books; see below for why.)

Read that last paragraph again because not understanding this is the cause of so many category errors in the public conversation about loans and debts.

After some time Bob pays back the loan: $35,000 in principal and, say, $4000 in interest (to keep it simple let's say he pays both of those all at once at the end of the loan). The bank keeps the $4000 in interest and either literally keeps it in its vault or deposits it in a reserve bank. But the $35,000 principal disappears when Bob repays it. The money supply goes back to $15,000,000,000,000. This is why the bank recorded a $4000 asset earlier: because the value of the loan to the bank is the interest it expects to receive.

TLDR: Banks don't lend out deposits or reserves. Banks create money when they originate loans.

The important thing to understand is that the bank never had $35,000 at stake in the loan: it had $4000 at stake in the loan. If Bob defaults, the bank has not lost $35,000, it's lost $4000.

So, when we talk about there being $1.3 trillion in student loan debt, this is what's important to remember. It is not the case that somebody took $1.3 trillion existing dollars and handed it to students: somebody created $1.3 trillion dollars on the expectation of receiving the interest payments on that.

This is important because there are two entities that are harmed by a loan default: the originating bank is harmed by the amount of interest payments it lost, and the money supply is harmed by being inflated.

$1.3 trillion has been injected into the economy in the form of student loans: it became research, dissertations, ramen noodles, and beer in some proportion. The question we face is not some moral question of "should borrowers give back the money" because nobody wants the principal "back"; it's just going to be annihilated if it's paid off (there is a moral question of the interest payments, but this is several orders of magnitude less money). The question is "should we demonetize $1.3 trillion from the economy and if so what money should we destroy?" The particular debt instruments used to create the money initially don't really help us make that decision.