So far this series has looked at the misleading and distorting way we measure economic success and at some of the basic dysfunctions in our so-called free markets. A third component of modern economies, the monetary system, is perhaps the least appreciated but most powerful source of economic dysfunction. The monetary system comprises the rules under which currency is created, issued into circulation, deissued and cancelled. (It is quite distinct from monetarism, an economic management doctrine that found brief favour in the 1980s.)

In the currently prevalent monetary system, new money can be created out of nothing by private banks and loaned with interest due. We are used to the idea that someone can deposit their money with a bank and the bank can then loan it to someone else. It is reasonable to charge interest on someone else’s money if the money’s owner would have to do without it until the loan is repaid. However as our economies grow, extra money is needed, so new money has to be created. The new money, of course, was not somebody’s hard-earned cash, so no-one will have to do without if it is issued into circulation. There is no justification for charging interest on the new money, because the bank has incurred only trivial expense in creating it.

Because our new money is issued through interest-bearing loans, there is never enough currency in circulation to repay the loans when they are due. This is because the debt is then the sum of the original principal plus the interest accumulated, which is larger than the original amount of currency issued via the loan. For there to be enough currency to repay the loan, someone, somewhere will have to take out a new and bigger loan. This fact is hidden away among all the thousands of loans and loan repayments happening all the time, but it is nevertheless an inevitable consequence of issuing new currency through interest-bearing loans.

As a result of this system, debt keeps increasing inexorably. Professor Robert Blain has documented the exponential increase of U.S. debt since 1791 [Blain, 1987] . Since we have to keep taking out loans in order to have currency, we are trapped in an ever-increasing spiral of indebtedness. The consequences reverberate profoundly through our economy and our society.

Because of the scramble to repay debt with an insufficient supply of currency, the rising debt drags the economy along behind it, and interest charged on new money becomes a primary driver of growth.

Thanks to Sean Leahy.

Inflation occurs when the amount of currency outruns the amount of wealth it represents, so the currency devalues relative to real wealth. In our present system the main way the currency supply is regulated is through interest rates. When inflation goes up, interest rates are raised so we’ll take out fewer loans, thereby reducing the amount of currency. Aside from being a singularly indirect and barely effective way of regulating the currency supply, raising interest rates only aggravates the existing shortage of currency relative to debt, so we can’t exchange as much as we would like, the economy slows and more people are excluded from the economy and rendered unemployed. Thus a nexus between interest rates and unemployment is created which would not exist if we had a debt-free currency system.

Another feature of our monetary system is that banks can loan out more money than they hold. In fact they only have to hold about 10% of what they loan. This is called “fractional reserve banking”. Of the several undesirable impacts of this practice, the most concerning is that it destabilises the currency supply and therefore the economy. If someone defaults on a loan, the bank’s reserves decrease not just by the ten percent applied to that loan, but by the remaining value of the loan, which could be ten times greater. If the bank were fully stretched it would have to cancel loans up to nine times the value of the defaulted loan. This could cause businesses to fail and other loans to be defaulted. Thus a cascade of defaults and decreasing currency supply could ensue. This happened many times during past centuries and was a major factor in the great depression.

We can do better. What is called a mutual credit system features 100% reserves and no interest charged on new currency. Instead of interest, a fee is charged for the service provided (the supply of currency), with the crucial difference that debt and currency are kept in balance, so there is always a sufficient supply of currency to repay the current level of debt. The total currency supply can be directly regulated through credit limits on banks, such as were used only a few decades ago. Fees can be structured to discourage hoarding, so the currency remains in circulation to facilitate exchange. The storage and loaning of wealth can be accomplished through investment portfolios, as at present, but currency supply and investment can and should be completely separated.

Such a system would allow inflation to be managed much more effectively, without creating unemployment. Debt would not increase inexorably through a design fault of the system, so we could choose whether and how the economy might grow. The 100% reserves would eliminate the intrinsic instability of currency supply induced by fractional reserves, and thus a primary driver of recessions and depressions.

Mutual credit systems already exist at small scales, as so-called barter or LETS (Local Employment and Trading Systems) systems (see Greco, 1994 and Kent, 2005). Such systems were implemented locally in Austria and Germany during the great depression, and they quickly lifted their communities out of depression. However they were closed at the insistence of central banks, whose monopoly was threatened.

An important attribute of debt-free currencies is that they can be established locally with little or no legislative action. They could then grow by recruitment alongside standard “legal tender”. The only political imperative is to permit them to grow, which would require politicians to be educated in their considerable advantages. Community-based banks like the Bendigo Bank illustrate the potential for local initiatives to provide alternative sources of credit, and similar local initiatives could establish alternative currencies. A major attraction to local communities is that wealth stays in the community, rather than being siphoned off through interest payments to distant bank shareholders. Other attractions are intrinsic stability and a dependable supply of currency regardless of what the mainstream economy is doing. In fact alternative currencies tend to proliferate when the mainstream economy is in recession. The potential, however, is for debt-free currencies ultimately to displace debt-burdened currencies and thus to enable more stable, full-employment economies.

Blog Comments

You wrote:

“The new money, of course, was not somebody’s hard-earned cash, so no-one will have to do without if it is issued into circulation. ”

Well, in some sense it was earned by somebody, because it was introduced in the economy in order to account for growth. Although maybe the person who created this growth did not deposit the money in the bank. It would also be interesting to know what you think abou the circulation theory of money.

I agree with most of what you write, though. There is something fishy in bank credits … For instance, by charging 5% interest on a loan to an entrepeneur, the bank is forcing the entrepeneur to make the inversion grow by 5% (at least). And I mean actual grow. Otherwise, the entrepeneur will have to make someone else poorer by that 5%. Or fail and refinance debt (but this will make the problem worse). If the whole economy is not able to grow in order to account for that 5% interest (at least), someone else will be poorer (or out of work) except the bank, who can still claim that 5%! I would say that both the bank and the entrepeneur are making a bet that the inversion will grow by 5% (at least), but in practice, the risk is assumed only by the entrepeneur (or the borrower). In fact, the 2008 crisis has been caused by banks poor estimation of the risks involved in lending. But it seems it is the rest of us who are paying that risk.

It would be interesting if someone in the know, wrote a piece about how money is created. Current explanations are very unclear because of the jargon used. For instance, in the wikipedia it is written that:

“A central bank usually introduces new money into the economy by purchasing financial assets”

and they’ve already lost me, right at the start. What is a financial asset? Who sells financial assets to the Central Bank? How it is possible to introduce new money by buying currently existing financial assets? Or does the CB sells financial assets to itself? But then, the CB creates the financial assets out of air … Somebody would care to explain? 🙂

What is the difference between governments “printing money” and governments taking loans from banks? Can governments still “print money” at no interest?

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