It is no surprise to anyone who is paying attention that the world economy is in trouble. One need only skim over the financial news to learn about the “sovereign debt crisis” or hear about how personal debt is soaring to unprecedented levels. Pundits everywhere exhort us to live within our means. Austerity measures are demanded as a condition of bailout relief. Yet nothing seems to have had any impact on the economic crisis which has now been going on long enough that we will soon be measuring it in decades. But is overspending the real reason we are currently rattling headlong toward bottomless abyss? A detailed analysis of the way money actually works reveals a surprising truth.
First, consider what the purpose of money is. Its sole purpose is to facilitate commerce, or more precisely, to facilitate trade. Why is that exactly? It’s not actually necessary to have money to have an economy. Barter has been going on as long as one person had something another wanted and vice versa. But consider what happens as the number of people involved in an exchange increases? Barter becomes unwieldy or even impossible. I’m sure you’ve seen the comical scenes in some movies or TV shows where someone needs X from Y. But Y doesn’t need anything X has but instead wants Z which can only be obtained from A. But A wants C from B who wands D from E and so on. It makes for a great comic relief routine in an otherwise serious show. But it does illustrate the fundamental problem with pure barter. How do you get all the various parties together so that everyone gets what they want? It’s easy enough if everyone is at a particular market but what if they are spread out over a whole town, or county, or country?
Enter money as a convenient place holder. Instead of me needing to have something that Anton the Baker needs in order to obtain bread from him, instead I provide him with money in exchange. Anton can then use that money to obtain flour from Hilda the Miller, who can then use it to obtain grain from a farmer who can then use it to hire me to fix his house. While this might have been possible in a pure barter system, you can easily imagine how such a simple series of exchanges can become insanely complicated very quickly as the number of people involved in the economy increases.
So what is the problem today? After all, we have money and a plethora of means to exchange it for goods and services. But it turns out there really isn’t any money anywhere. It’s all fictional. (Well, almost all, anyway.) The entire modern economy is an inverted pyramid balanced on a single spectacular fraud – the notion that you can lend something you do not have. It is so deeply entrenched that most people believe it is the One True Way and it even has a name: fractional reserve lending. The basic idea is that a bank can lend money so long as it has assets equal to a fraction of the total amount it lends. Note that it need not even be cash deposits! What this means is that banks actually create money when they make a loan rather then putting any of their own assets at risk. It actually gets even worse. The precise details are well explained by the folks at positivemoney.org.uk and moneyasdebt.net.
It turns out, upon deep investigation, that it is not just fractional reserve lending that is the problem. It is lending in general, and more particularly, twice lent money. Even if there were not interest charges (which, it turns out, are not the real culprit in the ultimate collapse but they do hasten it), lending money that was already borrowed once will eventually lead to there being no money left to pay the second debt, assuming the first is paid off. Sure, that is a pathological worst case but it is not so hard to imagine. Say A loans $100 to B at 0%. Then B lends $100 to C. Suppose A manufactured that $100 under a 0% reserve system but B is not a bank so actually lent the money he had to C. Now suppose that C spends his load in such a way that B ends up with the $100 he needs to pay back A. Now the money A created by making the loan no longer exists but C’s debt to B still does! Suppose that $100 is the only money that ever existed. Now C has no option but to default! Hence the problem with twice lent money. See the moneyasdebt video series for a detailed explanation of this particular problem. Interest charges only make matters worse.
Now, let us come back to sovereign debt. Why does this even exist? Does not a sovereign nation issue its own currency? Instead of borrowing money, why does it not just print money? First, let us consider where the money in your pocket comes from. It is not actually money issued by the government of your nation. It is, instead, bank notes issued by your national central bank. How does the national central bank issue said money? By granting loans to the national government by buying bonds in exchange for its bank notes or electronic equivalent. The government then spends it into the economy which increases the money supply with all the attendant inflation effects that entails. Then, this money circulates, gets used as reserve assets by banks who issue loans (bank credit money) which inflates the money supply even further. And at every stage along the way where money is created, an interest burden is created. And, as we have seen, because there is no real money backing even the first loan to the government, it is actually impossible for all these loans to be repaid, even if there were not an interest charge at every stage. With interest, you have an even larger drag on the economy.
The only way to allow everyone who borrowed twice or thrice or more lent money to repay it is to continually create more money, at an ever increasing rate, just to make the interest payments! And the money required to do this is created the same way the money that caused the problem was: by borrowing it!
So why hasn’t this house of cards collapsed? Because, up until recently, it has been possible to sustain an ever increasing rate of expansion of the exploitation of natural and other resources. However, with peak oil, peak agriculture, peak population, peak <insert thing here> all looming, the obvious is finally becoming clear: such a system cannot be sustained.
Surely there must be a way out? Well, actually, yes. There are many suggestions. The two sites mentioned above both have such suggestions. However, the solution as suggested by moneyasdebt.net is so radical that it will take some time to gain acceptance. Positive Money’s solution is actually a subset of that radical solution which is also radical enough that it is having trouble gaining traction. Part of the problem with changing things is that there is a large volume of existing debt contracts that need to be dealt with during the transition, some of which are very long term measured on the order of multiple decades. (Long term bonds and mortgages for instance.)
How would such a transition look? Well, first the fractional reserve system must be abolished. This is an absolute requirement for any even remotely sustainable reform. Otherwise, the commercial banking sector will continue to make the problem worse even while the solution is playing out. This cannot be done overnight but it can be done quickly by raising the reserve requirements over a time frame until they reach 100%. Note that in this case, the reserve requirement means that for every dollar in demand deposits a bank has, it must have one dollar in cash. Thus, if every depositor demanded all of his demand deposits all at once, the bank would be able to pay even if it required obtaining physical currency from its central bank reserves.
While the reserve requirement is being adjusted, the government will need to being printing money (or creating its electronic alternatives) instead of borrowing because even the central bank must not be exempt from the reserve requirements. In fact, once full reserve requirements are in place, the central bank will merely be a convenient point at which commercial banks can deposit their cash reserves. It would also be the bank governments would write their cheques on and so on.
With fractional reserve gone and the government issuing money instead of borrowing it, its debt service payments will rapidly decline, reducing that drain on revenue and freeing up a lot of tax revenue to put into social programs, infrastructure, and so on, all without raising taxes!
But wait, isn’t printing money bad? Doesn’t it lead to inflation? Well, yes, it does, if the amount of money created is greater than the necessary volume needed to sustain the liquidity of the economy. (Don’t think about that too hard.) But that is already a problem when banks create money by making loans under the current system and commercial banks have absolutely no reason to consider the public good while a government at least has the notional accountability to its people. But if new money were simply spent into existence by the government, there would be no debt burden to be repaid later.
Now how does this solve the twice lent money problem? Simply. If money is taken out of circulation through hording, saving, etc., deflation will tend to occur because there is less money available to sustain economic activity. By spending more money into existence, that liquidity can be restored, thus giving person C above a chance to obtain $100 of the new money to pay B back and then B can use that $100 to buy his stuff and so on. As long as the rate at which new money is entered into the economy does not exceed the liquidity requirements of the economy, no inflation will occur. And, as just demonstrated, liquidity is the problem facing us as a result of centuries of fractional reserve lending.
Eventually, with governments simply printing money, inflation will become a problem. Thus, taxation is still required. If there is too much money in circulation, which is bound to happen as the final batch of profit taking from the fractional reserve system begins to be spent, or if economic activity shrinks due to population decline or what have you, the government can simply spend less than it takes in in taxes, thus reducing the money supply and also reducing inflation.
Even without eliminating the twice lent money problem, such a resulting system would be vastly superior to the current mess and it would, at least, have a means to prevent the twice lent problem from becoming a show stopping issue.
If you’re like me, however, you don’t trust governments as far as you can throw Jupiter. It turns out that by generalizing money creation a bit and having it created as coupons redeemable for real goods and services, a self correcting system can be devised and implemented using modern communications technology, aka the Internet. That is the notion behind the proposal at digitalcoin.info. Once you fully understand the proposal there, you will see that it is really a superset of the “print money don’t borrow it” notion. However, though the scheme is brilliant with its simple arithmetic, it is not clear that the additional complexity is actually needed. It would be a truly radical departure from the familiar and it will probably take a lot of careful steps to deploy it usably. Such steps will likely take much longer than the simpler transition to “print money instead of borrowing it”. However, as noted, once governments are printing their own money instead of borrowing at interest, it would not be so much more of a leap to get to the more democratic money suggestion of digitalcoin.info. And, by that time, financial institutions and patrons alike will have adjusted to the fact that investment accounts have risk and demand deposits do not bear interest, no matter what kind they are.
Here’s hoping you spend some time studying the above mentioned sites and also think about where that $5 bill in your pocket or the numbers in your bank account actually came from. And here’s hoping that some sort of reform gets started yesterday if not sooner.
As a side note: this sort of reform is going to be necessary for any sort of ecologically sound steady state can be achieved. It is simply not possible to be ecologically responsible under the current monetary regime!