Apr 11 2013
In this article I want to look primarily at the way new money is created for the economy. It is actually quite sobering to think that something so fundamental to the way we all live our lives is given so little critical thought. Yes, there is plenty of varied economic discussion on the television news and in the newspapers but that one key question as to precisely how new money is brought into being is rarely, if ever, asked. We’ll start by taking a closer look at how commercial banks actually operate and we’ll see that the way the vast majority of people think they work is quite different to the reality.
During 2007 and 2008 I, along with many many others, saw a great deal of money that I had invested in the UK banking sector disappear into thin air as the financial crisis hit home and the UK taxpayer was drafted in to bail out banks which were essentially bankrupt. I had bought into the conventional wisdom that financial services and commercial banking were the great British economic success story. My father had worked for the Royal Bank of Scotland for his entire career and his pension is heavily reliant on RBS shares after years of the bank incentivising staff by offering benefits in the form of company shares. The financial body blow I took as a consequence of my investment in both RBS and Lloyds TSB followed by continual doom mongering in the media about massive (and still rising) public debt and the need for big cuts to public services left me with a real sense of helplessness. As the years since 2007 and 2008 have passed this feeling had been replaced by one of grim resignation as to what the future might hold. I suspect I’m not alone in feeling this way.
Have you ever puzzled over the perversity of the general fact that the wealthiest and most advanced countries in the world are also those with the highest levels of public debt? Have a look at the eye-watering global debt clock on The Economist website. The UK has one of the highest levels of public (and private) debt in the world and yet the evidence of my own eyes tells me that this is still, in global terms, a vastly wealthy country. We have been told, for example, that our schools cannot be modernised due to insufficient available funding. This is despite the fact that we have both the raw materials and the workforce (in the form of rank upon rank of unemployed people) sitting idle. In purely physical terms this plainly could be achieved so how is it possible that we cannot afford to do it? Surely human beings can achieve more. My contention is that we are being hamstrung by a deeply flawed financial system of our own making. Let’s dig a little deeper.
The above situation regarding modernising schools is accepted by the public at large because it is assumed that a lack of money actually means a lack of something vital. It is assumed by (almost) everyone that financial figures provide an accurate statement of our affairs as a nation. If we are in so much debt and only just managing to service those debts then we must work ever harder, cut spending on education, health and other public services, create jobs and increase manufacturing and exports. The problem is that every other country needs to do exactly the same thing because we’re all in massive debt. All countries need continual economic growth to service increasing levels of debt but indefinite economic growth in a finite world is an impossible dream. I want to show you that the assumption that the monetary statements and statistics currently used to make economic decisions are valid is seriously misguided. Money, as we use it in the modern world, is not a neutral medium, it does not reflect reality (note the absurdity of wealthy countries with massive public debt or wealthy individuals with huge mortgages). At this point when discussing the subject with people their eyes tend to glaze over or they begin to look at you like you have taken leave of your senses but bear with me here. The key to understanding the whole sorry structure is the way in which the vast majority of modern money comes into being.
Asked how a bank operates most people assume that the bank takes money from depositors and then lends that money out to borrowers, essentially operating as a middle man. In fact, to express the process in the simplest of terms, when a modern commercial bank or building society issues a loan in the form of a mortgage or a personal or business loan it essentially creates new money out of thin air as bank credit by typing a few digits into your account. This new money then goes out into the economy via adjustments in credit and debit columns in different bank accounts as you spend it. However, money created in this way is lent with interest payable on it over time. The interest amount is not created by the bank at the time of making the loan and so we must rely on economic growth to fund future interest payments. As things stand around 97% of all money in the economy has been created in exactly this way. So nearly every pound in existence is matched by an equivalent pound in debt. That doesn’t sound good to me and I’ll take some convincing that this is the best way to structure the economy. Read the last few lines back again. Money is created for the economy out of thin air and interest charged on it by commercial banks, not the state you understand, rather a commercial institution. It really is no wonder banks can generate such huge profits and pay their top staff such obscene salaries and bonuses. Don’t take my word for this:
“When banks extend loans to their customers, they create money by crediting their customers’ accounts.”
Sir Mervyn King, Governor of the Bank of England [source]
The banks do not need to have the matching deposits before they make new loans to customers. It is a system known as fractional reserve banking. The proportion of deposits held in reserve by most institutions is actually quite low. In 1968 the reserve ratio requirement in the UK was over 20%. By 1998 it was just 3%. Today, brace yourself, there is no minimum requirement and the Bank of England operates a voluntary system!
Most people when faced with this reality will throw up their hands and wave you away, denouncing you as a conspiracy nut or sad obsessive. There must be good, sound and wise reasons for the system operating like this they say. The system has evolved into the current form through incremental alterations designed to try and stop instability in the economy. As far as I can tell, after a lot of reading on the subject, there are no good reasons for the system to operate like this. The system as it currently operates carries a 100% guarantee to increase inequality over time and makes full employment all but impossible. No realistic appraisal of society could state that the economy responds to what people actually want out of life. Do we actually want to send our young children into nurseries at 6 months and send all new mothers (or fathers for that matter) back out to work? Do we want a system that forces the state to top up people’s salaries via tax credits just to give them a living wage? Do we want a system that demands economic growth to service government debt (currently to the tune of around £125 million every day)?
Clearly, changing the current system is not a small task. The necessary steps as I see it are, very briefly, as follows:
1. Abolish the practice of fractional reserve banking and remove the ability for commercial banks and building societies to create new money.
2. Create a new, accountable and transparent public body to create new money for the economy debt-free when able to do so in times of low inflation. This body should be free from influence by lobbyists from either the state or the financial services industry.
3. The new money should be put into the real economy, via government spending, rather than into the financial markets.
This is the first of several posts on this topic. I’d very much welcome comments and debate. Perhaps I’m overestimating just how many readers will have made it this far but nonetheless, do get in touch.