Have I got your attention? Good. Because this deserves your attention. While we weren’t looking for the last few centuries, banks have created a system of extraordinary privilege to ensure their financial profits in perpetuity. They have been granted special privileges that no other corporations in our economy have. The ability to create money out of nothing, and then charge interest on that money. This interest added ensures that we can never repay existing total debt. It is literally impossible for the world economy to get out of debt. Let that sink in. And then consider that the only way to service existing debt, is to go into even more debt in the future. This system has the characteristics of a Ponzi scheme. What’s a Ponzi scheme? The US Securities and Exchange Commission (SEC) define a Ponzi scheme as:
…an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors.
What does this have to do with the economy? All payments in our economic system (i.e. economic growth), MUST come from new funds (i.e. money) entering the system. Where does this money come from? It is literally loaned into existence, with interest applied, by our banks. And when I say literally, I mean literally. One minute new money doesn’t exist, and the next it does. It’s as beautifully magical as that. What’s that, you don’t believe me? Here’s what the Bank of England (UK’s central reserve bank), has to say about it:
“Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan… it credits [the borrower’s] bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.”
How does this work? Putting aside the various specifics, let’s look at a really simple example based around how most of us imagine banks work. Unfortunately we don’t think about the consequences that follow from this. If Alice deposits $1000 in her bank account, and Bob then borrows that $1000 from the bank, new money has been created. That’s it. No shit.
$1000 of initial deposit, is now $2000 of deposits ($1000 in Alice’s account, and $1000 in Bob’s account). Apparently money really does grow on trees!
The key to understanding how this creates money is in the distinction between real hard-currency (notes and coins), and what’s called ‘commercial bank money’ (that is, cheques, and more commonly today – electronic money – i.e. what you use when you pay by eftpos card or bank transfer). Alice’s deposit has now been converted from cash, to cash-equivalent electronic money. If there was no such thing as electronic money (or cheques), then both Alice and Bob couldn’t spend their money at the same time. Alice could only spend her money if Bob had repaid the loan. Cash equivalents, like cheques and electronic money, allow the expansion of the total money supply in the economy without there needing to be a corresponding physical amount of cash/coins. This is actually an important feature, as without an expanding money supply, there would be a mismatch between the money supply and the money value of the economy (GDP). In this case we’d get deflation, which kind of defeats the purpose of adding value to an economy/society.
So if we need an expanding money supply – that is, creation of new money as the economy grows – then why is this a problem? There’s a couple of “smaller” problems. And then there’s the ‘Ponzi-scheme level’ problems.
One of the obvious smaller problems is a ‘bank run’. That is, if too many people try to withdraw their money out as currency over a short time, the banks can run out of available physical money. As word gets out about this, panic sets in and the whole process snowballs. This is what happened in Argentina in the early 2000s and in a number of banks around the world during the global financial crisis (GFC). A lot of countries governments now guarantee, or insure, against bank runs. Unfortunately, this guarantee (among others) to come to the banks aid just reinforces risky behaviour from the banks. You’ve probably heard the saying “Privatise the profits, socialise the losses”.
Another ‘smaller’ problem is the issue of democratic control over money creation and the effect it has on society. At present, something like 95% of the money supply in Australia (and most of the world) is ‘commercial bank money’. That is, money created out thin air, with interest applied, by the private banks. By leaving the vast majority of money creation in the hands of private corporations, we cede a lot of control over how much money is created and where it is spent in the economy. Of course, government can loan a bunch of money from the banks and spend it where it wants too. And it does. But as we know, part of the neoliberal ethic is to get government out of social spending and leave as much funding of health, education, science, welfare, etc, to the free market. And that essentially puts more power over social spending into the hands of the banks. Corporations whose primary goal is to make profits for their shareholders.
And indeed, this profit focus is reflected in the balance sheets of banks, where 60% of their loans (which make up around three-quarters of their assets) are home loans. What better profit generating investment than fuelling a housing bubble? Why invest in a small business (of which more than 90% fail) with little collateral, when you can invest in a booming housing market and take collateral over the asset? Other assets include financial instruments not that far removed from the type of convoluted and frankly fraudulent crap, like synthetic CDO’s etc, that brought down the global financial system during the GFC.
To be clear, the banks are regulated, and they can’t just create unlimited money nor loan unendingly into a bubble market. But again, neoliberal ethic dictates that we reduce regulations on the financial sector and let the ‘free market’ play a bigger role.
There’s another problem with banks creating so much money for financial speculation – aka gambling – and that’s inflation. As I mentioned earlier, we want money supply to roughly match the size of the economy. This means that each dollar buys roughly the same amount of goods and services next year as it did this year. The more new money that goes into non-productive economic activity (like second hand housing markets), means that money creation outstrips economic growth. This can contribute to inflation. This component of inflation is essentially a tax on consumers (i.e. you and me). As it happens, as will be explained below, the economy needs inflation for the purpose of encouraging spending/investment (i.e. discouraging saving) and therefore economic growth. Without this inflation, the economy would fall over in a screaming heap.
A screaming heap? That sounds like ‘Ponzi-scheme levels’ of problem. And indeed it is. Ponzi schemes fall over when the amount of new money into the system isn’t enough to sustain the payments required out of the system. How could this apply to our current economies and monetary systems? It’s a possibility because, as mentioned earlier, virtually all new money in the system is created as debt with interest applied. It’s a vicious circle. Outstanding debt grows exponentially due to compound interest. To pay off outstanding debt requires paying off both the principle and interest. Given virtually all money in the system is debt in the first place, there is no money to pay off outstanding debt without loaning new money into existence. Money which itself is compounding debt, requiring even greater borrowings to pay off!
This flies in the face of how most people imagine an economy works. The intuitive view, and indeed the view espoused by virtually all economic journalist and apparently a lot of economists too, is that increased productivity leads to increased growth and profits which is what we use to service debts. Think of financial cycles. In hard times we borrow against the good times when the cycle changes and we can afford to repay debt. There’s an inherent view that monetary wealth is created by economic growth. It seems to me that this is a fallacious extrapolation from the entirely reasonably view that ‘value’ is created by economic growth. It’s fallacious because, unlike value which is subjective and therefore isn’t a zero-sum game, monetary wealth is objective. Monetary wealth can’t emerge independent of money. It is directly tied to money. And as we’ve seen, nearly all money is created as a corresponding credit and debt. That is, it IS a zero-sum game. When economies grow and monetary profits grow, by necessity debt grows the same amount. In fact, it grows more due to the interest applied to the debt.
In a similar fashion, the intuitive view about how money is loaned, is arse-about too. Banks don’t sit around waiting for people to deposit money before they make loans. It’s actually the other way around (both practically and systemically). Loans create deposits. Without loans, there are no deposits! It’s literally incoherent to believe that loans follow deposits. Deposits are loans.
So we see how inflation, economic growth and money creation are all inextricably linked. It forms a vicious circle. Economic growth is needed to create the money to pay off the amassed debt. But economic growth actually proceeds from money creation. So economic growth actually creates debt. Inflation is necessary in such a system to encourage people not to save too much (i.e. pay off too many debts; or hold off on new debts). To explain, in an inflationary system, money loses its value over time. So sitting on it, instead of using it as collateral for new debts or investments, is like voluntarily taxing yourself (with the tax money disappearing into a puff of dust after your pay it). However, if money didn’t lose value over time, there would be no need to continue to strive to increase the amount of money you have – i.e., strive for more economic growth.
This has all been a bit abstract up to this point. Let’s look at what growing debt looks like. This is total US debt over time, and also shows how debt is ballooning in comparison to gdp growth:
And as is the case with exponential growth at this rate, it’s just going to keep doubling every 10 or 15 years.
What can we do about this mess?
Absolutely nothing with the current monetary system. While ever money is created as debt, and particularly while it has interest applied to it, new debt has to exceed current debt just to service that debt. As you can see, the only way to to remain solvent is to go further and further into debt. To be honest, I’m having trouble wrapping my head around this. On the face of it, it appears spectacularly unsustainable. But given that money isn’t based on any real commodity, perhaps it is possible to keep creating money in an exponentially increasing fashion. After all, if Zimbabwe can print $100 trillion bank notes (see below), then perhaps it is possible. Perhaps any readers of this who can conceptualise an ever increasing indebted system could give your opinions on this. I mean it when I say I’d love to hear them. I’m at a bit of an impasse on this.
So, what if we took a step back and were somehow able to remodel the system we have? Imagine if banks couldn’t create any new money in the first place. In terms of debt the system would be perfectly balanced. If Alice loaned Bob $1000 (via Bank A) and Bob loaned Carol $1000 (via Bank B) and Carol loaned Dave… etc etc, it would be theoretically possible to unwind all the debts back to the original $1000. That is, all debt could be resolved (i.e. everyone, and the economy, could remain solvent) and no money would be created or destroyed.
Ok, let’s just run the system like that then. No more electronic money can be used/created from this day forth! Bzzzt, sorry. That won’t work either. In fact, the reason why it won’t work is why ‘cash equivalents’ are so important. By restricting money in the economy to the original supply of physical cash/coins, we’d greatly reduce the speed at which money could flow through the economy (and therefore drive the economy). After Carol lent Dave $1000, and Dave bought a computer from Ellen, and then Ellen hired a car from Fred etc, what if Carol decides she needs $600 of that money back to buy a bike? She’s going to have to wait until that $600 dollars of repeatedly loaned and transacted money winds its way back to her before she can buy a bike. Multiply this inactivity by the whole population (and therefore the whole economy) and you can see why such a situation would essentially stall an economy.
In fact, if we put aside the application of interest on debt, this is the essentially the same type of system as we have now. Without going into the boring details, it’s enough to know that when a loan is repaid, the new money created at the establishment of that loan is winked out of existence as magically as it was created. Therefore again, it would theoretically be possible to pay off all debts and wind up back at Alice’s original $1000. However, maintaining a set supply of money in a growing economy (if it managed to grow with all that standing around and waiting) will contribute to deflationary pressures. And as mentioned, our whole system relies on unending (yet manageable) inflation. Take a look at Japan and the mess it’s been in for decades due to deflation.
So, we need to keep some form of new money creation. At present, it is the interest on outstanding debt that necessitates the creation of new money. If we get rid of interest, or at least remove it from certain sectors of lending, then there needs to be a new mechanism that drives money creation. There needs to be a way to rationally assign ‘free’ money supply to sustainable productivity, in a way that is at least broadly democratically accountable. Not too democratically accountable, as that would result in the very undesirable situation of putting money creation into the hands of politicians. It needs to be at least one step removed from that in terms of democratic representation.
Unfortunately, I don’t have a solution to this problem. I think the discussion of that could form a future blog post. Although, I’m willing to state right now that a universal basic income funded from free money creation would be a good step in the right direction, both in terms of the systemic problems we face with our ‘money from debt’ system, and also in terms of more urgent short-term macroeconomic problems like inequality, growing under-employment, and stagnating growth. The Financial Times has an article with some ideas for structural reform of the monetary system (hint: use Google cache if you don’t have a subscription to FT).