SANE Views

Vol.2 No.24, 16 September 2002

How to Make Money Debt-Free

By Margaret Legum

Now here is something different. Forget for the moment the arguments over GEAR and NEPAD, and the battles for and against globalisation. Enter the arena of how money is created and how that could be changed to benefit you and me.

Don’t be put off by the subject matter. The American economist J.K. Galbraith, sainted for his ability to clarify economics and confound economists, has said: The process by which banks create money is so simple the mind is repelled…Where something so important is involved, a deeper mystery seems only decent.

Money is only a means of exchange and a store of value. It is not valuable in itself. But for it to work we need the money stock to expand at roughly the same rate as available goods and services. If there is too much money you get inflation and if too little recession.

Governments see it as their job to keep that relationship between money and goods roughly in line. But at present their influence is indirect. Given the money that exists, the government can raise or lower taxes to change consumption patterns. But that only tinkers with the problem, which is about new money. To affect that governments must use the clumsy instrument of interest rates to influence borrowing and saving.

The extraordinary fact is that new money is created not by governments but by commercial banks – not, as we suppose, by lending one person’s savings to another, but out of thin air. When you ask for a loan, it is granted (or refused) by reference to the collateral you offer and your estimated capacity to repay - not because someone else’s savings are available. It is purely a ledger item, created from nothing. It becomes part of the bank’s assets; and when you repay, both the capital and the interest swell the bank’s wealth.

It is true that banks are obliged not to exceed a ’fractional reserve’ – a fraction of what they lend must be covered by others’ deposits. But this ‘fraction’ is only around 5%. Moreover, when a loan is given it becomes someone else’s deposit. Say I borrow R100 and pay it to you; the bank can lend someone else R95. So the fractional reserve is practically meaningless.

The implications are enormous. First, the supply of credit - new money - is decided by banks on commercial principles – not by reference to the monetary needs of an economy. Second, there is an almost total disconnect between credit and savings. Third, debt is created every time the supply of money is increased. Fourth, the bank creates the principal but not the interest. So debtors must compete for inadequate money to pay the interest as well as the loan.

In boom times this works, because more money is being created as new loans. But that can’t go on forever. Governments get worried about inflation and raise interest rates, bank lending slows, people go bankrupt and lose their collateral; we get recession. The cycle of boom and bust is inherent in this system.

There is a small exception to the creation of money through loans. Governments produce the notes and coins we use in everyday commerce. And they spend that money into the economy directly as part of their spending programme. It does not constitute a debt. Sadly that is only between 3% and 10% in modern economies.

This is the clue to change. Originally all money was created by the monarch. This right was known as seigniorage. It created no debt, since the monarch simply spent the money into the economy to buy what he needed as ruler.

Suppose governments were to restore that right to themselves as representative of the people - extending the principle from creating notes and coins to the electronic supply as well.

First, they would require banks to limit their activities to lending only the savings of other customers. Second, the government would calculate how much new money would be needed each year to match the economy’s capacity to expand, replacing the new money now created by bank loans. Third, it would spend that amount in the form of the services and goods it offers. It would not borrow anything – relieving its citizenry of the annual millions now paid as interest on loans. Taxation would take care of expenditure needed above that paid for by new money. None of what government spend would entail loans or the payment of interest.

The danger that governments would create too much money – hence inflation - for populist reasons must be countered by involving an independent Reserve Bank or equivalent. It would be charged with the task of estimating how much new money is needed, and then creating it for spending through the Finance Ministry

British MPs of most parties have signed an Early Day Motion calling for the government to instruct the Bank of England to start such a process. More detail on www.intraforum.net/money