Introduction
In Chapter 2, we explored a concept that is gradually gaining recognition, even among economists: money is created as debt. Whenever a loan is made, new money enters the economy, and that money continues to exist until the debt is repaid. But this revelation is only part of a larger, more intricate picture. In the world of finance, debt doesn’t just create money; it circulates as money, creating a system far more complex and far-reaching than most people realize.
In the everyday economy, most people interact with money in straightforward ways—using it to pay for groceries, services, or rent. However, in financial markets, something far more intricate is happening. Debt instruments, ranging from government bonds to corporate loans, are being traded, repackaged, and even used as collateral in other transactions, allowing debt to circulate through the economy much like money itself. This circulation doesn’t merely add another layer of complexity to the financial system; it actively fuels a relentless demand for more debt.
This phenomenon has far-reaching implications. As debt is transformed, repurposed, and traded, it leads to a kind of “debt on debt,” where the same original money can end up servicing multiple layers of borrowing. What begins as a single loan doesn’t end with its repayment but instead cascades into a series of interconnected obligations. This process underpins a financialization of economies, especially in developed countries like the United States, where the scale of financial activity now dwarfs the real, productive economy.
The result is a system where financial markets have grown far beyond the scope of what traditional economic models can capture. The productive economy—where goods are made, services are provided, and real value is created—has become a minor player, a mere rounding error compared to the vast circulation of debt within the financial sector. This dynamic leads to a fragile equilibrium, where even a minor disruption in financial markets can send shockwaves through the real economy, draining resources and causing upheavals far beyond Wall Street’s trading floors.
In this chapter, we will delve into this often-hidden world of debt circulation, exploring how it has led to the financialization of developed economies and why this reliance on circulating debt makes the system increasingly vulnerable. By the end of this journey, it will become clear that the widespread use of debt as money is not merely a technical detail of modern finance—it is a fundamental characteristic that shapes the risks, rewards, and fragility of our entire economic landscape.
The Mechanics of Debt Circulating as Money
At the core of our financial system lies a simple process: loans create money. When a bank issues a loan, new money is introduced into the economy, becoming available to be spent, invested, or saved. This process does not necessarily create problems; it’s the way our financial system operates. However, issues arise when that original loan begins to circulate as money or is marketed and repackaged in such a way that it adds multiple layers of debt into the system. This is where debt stops being merely a tool for financing and starts becoming a form of money.
Let’s start with the example of a government security, such as a U.S. Treasury bond. When the government borrows money by issuing a bond, the funds used to purchase that bond comes from money that is circulating in the economy but was created by bank lending. This bond now represents a new layer of debt circulating through the economy, distinct from the original loan that created the money. In essence, that same money is now responsible for servicing two separate obligations: the original loan and the newly created government debt.
Before the debt that created that money used to purchase the bond can be repaid, the money must first repay the bod. Only after the bond is repaid, can the money be used to repay the original loan that created the money. That completes the cycle of money creation and destruction.
While money is fungible—that is, it can be used interchangeably, and any particular dollar is not tied to a specific loan—the macroeconomic effect of this layered debt becomes significant when repeated on a large scale. This process means that a single unit of created money ends up tied to multiple layers of obligation, all needing to be serviced before the original loan can be repaid. This creates a situation where the amount of debt circulates far beyond the amount of money originally created, multiplying the overall debt burden within the economy. The size of this mismatch is staggering. The productive economy is a mere rounding error to the mountains of layered debt.
One of the more pronounced ways this layering happens is through entities that treat debt as an asset. For example, when an investment institution acquires a loan, that loan becomes an asset on their balance sheet. The institution can then borrow against this asset, using it as collateral to take on additional debt. This new debt creates additional money, but in the macroeconomic sense, it needs to eventually circulate back to satisfy this new debt so cannot be used to satisfy the original debt.
This process creates yet another layer, and as these layers build upon themselves, it forms complex layers of obligations and additional money that creates a financial economy separate from the productive economy. This “thrashing” of money produces nothing. Financiers will explain that this additional money can fund enterprise, but the scale of financialization is out of proportion to the amounts needed for enterprise.
This process is at the heart of financialization in developed economies. As debt continues to circulate, it fuels more borrowing, more layers, and an ever-growing financial sector that becomes disconnected from the real, productive economy. This dynamic creates a fragile system where the productive economy—the part that generates actual goods and services—must bear the weight of servicing an expanding web of debt obligations. In this way, the circulation of debt as money doesn’t just expand financial markets; it creates vulnerabilities that can have far-reaching consequences for the entire economic landscape.
This layered nature of debt means that obligations are often tied to multiple, overlapping commitments. The implications are profound. When the economy is growing and financial markets are stable, this circulation of debt can amplify growth, fueling investment and innovation. But in times of stress, when cash flows tighten or credit becomes scarce, the entire system feels the strain as more and more entities scramble to meet their debt obligations. This scramble can lead to a sudden withdrawal of money from productive uses, causing economic activity to contract and creating the conditions for financial crises.
The circulation of debt as money is not just a feature of modern finance—it is the driving force behind the financialization of developed economies. It allows the financial sector to grow far beyond the productive economy’s size, but it also means that the entire system rests on a foundation of borrowed money, making it inherently fragile and prone to shocks. This fragility is at the heart of the story we’re telling, and as we will see, it has far-reaching consequences for the health and stability of our economic systems.
How Debt Circulation Outpaces Government Oversight and Control
As debt circulates more freely through financial markets, the sheer scale and complexity of this process have made it increasingly difficult for governments to monitor, regulate, and control the financial sector. While governments and central banks strive to manage the economy through monetary policy, the rapid expansion of debt-driven financialization has created a system that often operates beyond their reach, leading to a shadow financial system that functions with limited oversight.
The Shadow Banking System
One of the most significant challenges to government oversight is the rise of the “shadow banking” system. Despite its name, shadow banking is not inherently nefarious or illegal; it simply refers to financial activities that occur outside the traditional banking sector. Unlike regular banks, which are regulated by government agencies, shadow banking entities operate in a largely unregulated environment, making them harder to monitor and control.
Shadow banking includes institutions such as hedge funds, private equity firms, money market funds, insurance companies, and even certain investment arms of major corporations. These entities engage in activities similar to traditional banking—such as lending, borrowing, and investing—but they do so without being subject to the same regulatory standards or oversight. They can create, hold, and trade debt in ways that are less transparent than activities conducted by traditional banks.
The shadow banking system plays a significant role in the circulation of debt as money. For instance, these institutions often purchase bundles of securitized debt, such as mortgage-backed securities or corporate bonds, and use them as collateral to borrow more money or engage in further lending. This process creates additional layers of debt that circulate within the financial system, contributing to the overall growth of financialization. However, because these activities occur outside the regulatory framework, they can add risk and instability to the financial system without the checks and balances designed to prevent such dangers.
The Role of Central Banks and Quantitative Easing
Another key factor in how financialization has outgrown government control is the expanded role of central banks in the economy, particularly through a process known as quantitative easing (QE). In response to economic crises, central banks like the Federal Reserve, the European Central Bank, and the Bank of Japan have employed QE as a way to inject massive amounts of money into the financial system.
Quantitative easing works by having central banks purchase large quantities of government bonds and other financial assets from banks and financial institutions. This process provides these institutions with cash, which they can then use to make new loans or invest in other assets. Essentially, QE removes debt from the balance sheets of private institutions and replaces it with cash, allowing them to engage in even more lending and investing.
However, the scale of this intervention is unprecedented. By purchasing trillions of dollars’ worth of assets, central banks have effectively become some of the largest players in the financial markets. This infusion of money into the financial system has enabled financial institutions to expand their activities significantly, but it has also contributed to the acceleration of financialization. With so much liquidity available, banks and other entities are incentivized to create more debt, trade more financial products, and seek out more opportunities to profit from debt circulation.
While QE was initially introduced as a temporary measure to stabilize financial markets during times of crisis, it has, in many ways, become a permanent fixture of the financial landscape. This ongoing support has allowed financial institutions to leverage more debt, trade more aggressively, and engage in increasingly complex financial activities, often with little regard for the underlying health of the productive economy. As a result, the financial sector has grown to a size and complexity that far exceed what any government can realistically monitor or control.
The Limits of Government Oversight
This combination of shadow banking activities and the expansive role of central banks through quantitative easing has made it nearly impossible for governments to keep track of all the debt circulating in the economy. Traditional regulatory frameworks are designed to monitor the activities of banks, but much of today’s financial activity occurs in unregulated or lightly regulated areas, making it difficult for authorities to assess the true scale of financial risk.
Moreover, as financial institutions continue to develop new, more complex financial instruments—derivatives, structured products, collateralized debt obligations, and beyond—they often operate several steps ahead of regulators, who struggle to understand and respond to the latest innovations. This lack of oversight creates an environment where financial risks can build up unnoticed until they reach a tipping point, at which time the consequences can be severe and far-reaching.
In this environment, the government’s ability to influence the economy through traditional tools, such as interest rates or fiscal policy, becomes increasingly limited. The circulation of debt as money and the rise of financialization mean that the levers of economic control no longer operate in predictable ways. Even central bank interventions, like quantitative easing, risk becoming ineffective or counterproductive over time, as the financial system absorbs this liquidity and continues expanding in ways that defy conventional economic models.
The result is an economy that is not only highly financialized but also increasingly beyond the reach of government control, leaving it vulnerable to shocks that can reverberate throughout the real economy. This phenomenon is one of the most defining features of modern financialization, and it underscores the growing gap between the financial world and the productive activities that underpin true economic growth.
The Global Circulation of Debt and Its Implications
The phenomenon of debt circulating as money is not confined to any single nation but has become a defining characteristic of the global financial system. As countries interact through trade, investment, and financial markets, the circulation of debt-based instruments spans borders, making it a central aspect of international finance. This interconnectedness means that disruptions in one part of the world can quickly spread, impacting economies across the globe.
Sovereign Debt as a Global Currency
One of the most prominent ways debt circulates internationally is through sovereign debt. Government bonds, particularly those issued by the U.S. Treasury, the European Union, and Japan, are widely held by central banks, financial institutions, and investors worldwide. These bonds serve as a form of “reserve currency,” allowing countries to manage their foreign exchange reserves and stabilize their own currencies. For example, the U.S. dollar’s dominance as a global reserve currency is directly tied to the widespread use of U.S. Treasury securities as a store of value and a means of conducting international transactions.
Foreign governments, like China and Japan, hold vast amounts of U.S. Treasuries, not just as investments but as tools to influence their exchange rates and trade balances. This process creates a feedback loop where debt issued by one country becomes a vital component of another’s monetary policy, linking their financial health and stability. As a result, changes in interest rates, investor confidence, or government fiscal policies can have immediate and far-reaching effects on the global economy, transmitting shocks across borders.
Currency Swaps and Cross-Border Borrowing
Another aspect of debt’s global circulation involves currency swaps and cross-border lending. In a currency swap, two parties exchange debt obligations denominated in different currencies, effectively borrowing from each other. This practice is common among central banks, multinational corporations, and financial institutions looking to manage currency risks or access foreign capital. Such swaps facilitate international trade and investment but also create a complex web of obligations that tie countries together.
When a crisis hits, these cross-border debt obligations can become problematic. If a country’s currency devalues or interest rates rise, the cost of servicing foreign-denominated debt increases, leading to financial strain. This can trigger a chain reaction, forcing other countries or institutions to adjust their own positions, resulting in capital outflows, market volatility, and potential financial instability on a global scale.
The Role of International Financial Institutions
International organizations, such as the International Monetary Fund (IMF) and the World Bank, play a significant role in facilitating the circulation of debt as money across the globe. These institutions provide loans to countries facing economic challenges, often in exchange for implementing structural reforms or austerity measures. While these loans aim to stabilize economies, they also add another layer of debt that circulates within the global financial system.
The IMF’s lending practices, for example, often require countries to adopt policies that make their economies more open to foreign investment, encouraging the inflow and outflow of capital. This process can stimulate economic growth but also exposes countries to the risks of financialization, where speculative capital flows can cause rapid shifts in currency values, asset prices, and debt levels.
The Risk of Financial Contagion
The global circulation of debt means that financial crises can spread rapidly from one country to another, a phenomenon known as financial contagion. The 2008 financial crisis is a prime example of how problems in one part of the world can ripple across the globe. What began as a crisis in the U.S. housing market, where mortgage debt had been packaged into complex financial products and sold worldwide, quickly escalated into a global financial meltdown. As the value of these debt instruments collapsed, banks and financial institutions around the world faced severe losses, leading to a freeze in credit markets, a sharp decline in international trade, and widespread economic hardship.
The interconnected nature of global debt markets means that when one country struggles to service its debt or experiences a financial shock, the effects can be transmitted to other countries through the networks of loans, bonds, and financial instruments that bind them together. This creates a fragile system where a crisis in a relatively small economy can trigger panic and capital flight from much larger markets, amplifying the impact far beyond the initial source.
The Accumulation of Global Debt
The expansion of debt on a global scale has reached unprecedented levels. According to the Institute of International Finance (IIF), global debt reached a staggering $300 trillion in 2021, an amount that far exceeds the world’s total GDP. This massive accumulation of debt underscores the extent to which borrowing, lending, and the circulation of debt have become central to economic activity across the globe. As countries continue to rely on debt to finance growth, investment, and consumption, they become increasingly vulnerable to shifts in interest rates, exchange rates, and investor sentiment.
The circulation of debt as money has allowed for remarkable economic growth and investment opportunities, but it has also created an intricate web of obligations that bind nations together in a delicate balance. As we’ll explore further, this interconnectedness means that the stability of the global financial system depends not just on the health of individual economies but on the complex and often fragile relationships between them.
The Financial Economy vs the Productive Economy
The financial economy and the productive economy represent two vastly different facets of modern economic activity, and understanding their relationship is crucial to grasping the true impact of debt circulation as money.
The Productive Economy: The Source of Real Wealth
The productive economy is the part of the economy that creates real, tangible wealth. It includes industries like manufacturing, agriculture, construction, technology, and infrastructure development. This sector produces lasting assets such as roads, bridges, buildings, machinery, and technological advancements. These assets are the foundation of an economy’s wealth, providing the means for future productivity, growth, and an improved quality of life. When a country builds a highway, constructs homes, or develops new technologies, it creates something of enduring value that can continue to serve society for years or even decades.
However, it’s important to recognize that the production of real wealth constitutes only a fraction of what the productive economy generates. Most of a modern economy’s output consists of consumables—goods and services that are quickly used up or replaced. These include everyday items like food, clothing, entertainment, and energy consumption, which, while essential for maintaining a certain quality of life, do not contribute to the accumulation of lasting wealth. They provide immediate utility but do not build assets that continue to generate value over time.
This distinction is critical because it means that much of the money circulating in the productive economy is not engaged in creating lasting wealth but rather in facilitating the consumption of goods and services. The challenge arises when this money, created through debt, must be repaid. The productive economy is responsible for servicing the debts that enabled both the creation of wealth and the consumption that keeps the economy running. As a result, the productive economy is burdened not only with sustaining itself but also with supporting the larger financial structure that depends on the circulation of debt.
The Financial Economy: An Engine of Speculation and Debt
The financial economy, in contrast, has grown to a size and influence that far exceeds the productive economy. It encompasses activities related to the trading of financial assets, debt instruments, derivatives, and speculative investments. Here, the primary objective is not to create tangible goods or long-term assets but to profit from fluctuations in prices, interest rates, and market movements. The financial economy generates wealth primarily through the creation, trading, and leveraging of debt, and it is this aspect that allows debt to circulate as money.
Because financial institutions operate on leverage—using borrowed money to increase their exposure to investments—the financial economy can expand rapidly. This expansion, however, is not grounded in the production of real assets but in the manipulation of financial instruments. As financial entities package, trade, and repackage debt, they generate profits without necessarily contributing to the production of lasting wealth. The result is an economy where financial transactions and financial wealth vastly outstrip the real output of goods and services, creating an illusion of wealth that is often detached from tangible assets.
The Growing Disparity and Its Consequences
The disparity between the financial economy and the productive economy has profound implications. While the financial economy grows exponentially through the circulation of debt, the productive economy remains tethered to the real-world limitations of creating actual goods and services. This imbalance means that the productive economy is increasingly responsible for servicing the vast amounts of debt generated by financial activities. Yet, because so much of the economy’s output is in consumables, a significant portion of this debt does not contribute to the creation of wealth.
The productive economy must therefore divert resources to meet the demands of the financial economy, even though the financial sector’s activities often have little to do with the production of lasting value. This diversion creates a fragile system where the real economy is vulnerable to financial shocks. When financial markets experience disruptions, the productive economy can suffer severe consequences, as money is withdrawn from real investment to support financial assets, resulting in economic contractions, job losses, and reduced living standards.
Understanding the Bigger Picture
In essence, the financial economy has grown to such an extent that it now dominates the real economy, influencing how resources are allocated and how wealth is distributed. While the financial sector has played a crucial role in facilitating investment and economic growth, its expansion has led to a system where debt circulates endlessly, creating layers upon layers of obligations that the productive economy must eventually bear. This creates a situation where true wealth—the kind that builds infrastructure, homes, technology, and lasting assets—becomes secondary to the demands of an ever-expanding financial sector that thrives on debt.
Recognizing this dynamic is essential to understanding the risks and challenges facing modern economies. The productive economy, despite being the source of real wealth, is often overshadowed by the financial economy’s sheer size and complexity, leading to a fragile and sometimes unsustainable system that prioritizes debt circulation over genuine wealth creation.
The Fragility of a Multi-Layered Debt System
The intricate web of debt that underpins the financial system makes it inherently fragile, and this fragility stems from the layered, interconnected nature of debt circulating as money. As we’ve seen, the financial economy’s expansion is based on creating, trading, and reusing debt, while the productive economy, much smaller by comparison, carries the burden of servicing these obligations. This imbalance creates a precarious situation, where even minor disruptions can have far-reaching and severe consequences.
The House of Cards: Layered Debt and Leverage
The financial system is built on the concept of leverage, which allows institutions to use borrowed money to amplify their investments. While this can generate high returns in times of stability, it also means that even a small shock can lead to rapid, cascading losses. When financial institutions borrow against assets that are themselves forms of debt, they create multiple layers that rest upon one another, much like a house of cards. Should one layer falter, the entire structure is at risk of collapse.
For example, consider the 2008 financial crisis. At its core, this crisis was triggered by the realization that the debts backing mortgage-backed securities (MBS) were far riskier than previously thought. As the value of these securities plummeted, financial institutions that held them as assets faced sudden, massive losses. Because these institutions were leveraged, the collapse in value forced them to liquidate other assets, pulling money out of the real economy and causing a ripple effect that spread worldwide. The systemic fragility revealed by this crisis underscored how a relatively small segment of debt could destabilize the entire financial system.
Interdependence and the Risk of Contagion
One of the most concerning aspects of the current system is its high level of interdependence. Financial institutions, markets, and even entire countries are linked through layers of debt and financial obligations. This means that when one entity faces financial stress, it can quickly spread to others, much like a contagion. The interconnectedness of global financial markets amplifies this risk, as institutions often hold debt issued by entities across different sectors and countries.
For instance, a sudden rise in interest rates in one country can make it more expensive for companies and governments to service their debts, leading to defaults or cutbacks in spending. Investors, fearing further losses, may pull their money out of other assets, causing asset prices to fall and triggering a cascade of financial stress in other markets. This process can create a self-reinforcing cycle, where fear and uncertainty lead to actions that make the situation worse, ultimately dragging down the productive economy with it.
The Inability to Predict or Manage Systemic Risk
The complexity and opacity of the financial system make it nearly impossible to predict or manage systemic risk. Many financial institutions engage in activities that are not fully transparent, often using complex financial instruments that are difficult to value or understand. As a result, even regulators and central banks can struggle to assess the true extent of risk within the system.
Models cannot capture this dynamic. Most economic models rely on the data collected from the productive economy. They do not capture the massive threat posed by the financialization of the economy.
This lack of transparency and predictability means that financial institutions themselves may be unaware of the risks they face, especially as they build new layers of debt on top of existing obligations. When a shock does occur, it can be challenging to identify which institutions are most exposed, leading to uncertainty and panic that exacerbates the crisis.
The Real Economy Pays the Price
The ultimate consequence of this fragility is that when the financial system falters, the productive economy bears the brunt of the damage. As financial institutions scramble to cover losses, they often pull back on lending, withdraw from investments, or sell off assets, which drains liquidity from the real economy. Businesses that rely on credit to finance operations find themselves unable to access funds, leading to layoffs, reduced production, and even bankruptcies.
Consumers, in turn, cut back on spending, further reducing demand for goods and services. Governments may attempt to intervene, but their ability to inject stability is limited when the scale of the problem stems from the financial system’s deeply ingrained reliance on debt. This cycle can lead to prolonged recessions, as the productive economy struggles to recover from the financial sector’s collapse.
In this way, the circulation of debt as money has created an economic system that is both highly profitable during times of growth and incredibly vulnerable to disruption. The layers of debt that enable financial institutions to thrive also make the entire system susceptible to collapse, highlighting the inherent fragility of an economy that depends so heavily on debt as the engine of its growth.
Conclusion
The circulation of debt as money has become a defining feature of modern financial systems, transforming the way economies operate. What began as a means to facilitate lending and investment has evolved into a complex, multi-layered network of obligations that now dominates the financial landscape. This process has driven the financialization of developed economies, where the creation, trading, and leveraging of debt have outgrown the real, productive economy that generates tangible wealth.
As we’ve seen, the productive economy is the source of true, lasting value—the infrastructure, technology, and housing that support society’s progress. Yet, it has become overshadowed by a financial sector that thrives on the circulation of debt, creating a fragile system where the real economy is often at the mercy of financial markets. The demand for debt continues to expand, fueled by mechanisms that encourage borrowing, lending, and speculation, but this expansion carries with it an inherent instability.
The layers of debt now circulating in the financial system are supported by a much smaller productive economy, which means that any disruption in financial markets can have disproportionate and devastating effects on businesses, workers, and consumers. This fragility underscores the need to understand the role of debt in modern economies, not just as a tool for financing but as a force that shapes how wealth is created, distributed, and, ultimately, sustained.
In future chapters, we will delve deeper into the implications of this financialization, exploring how it affects inequality, economic growth, and the potential for systemic crises. For now, it is clear that the circulation of debt as money is not merely a feature of our economic system—it is a driving force that has fundamentally reshaped the landscape of modern finance and will continue to play a pivotal role in shaping our economic future.