SANE Views

Vol.3 No.15, 29 April 2003

How Money Could be Made Without Debt

By Margaret Legum

Debt is a major problem worldwide. Developing countries with rich resources are unable to invest, because what they produce is consumed by repayment of debt. The US borrows $4 billion a day to service its deficit. The debt incurred by individuals in all countries is a steadily rising proportion of their income. Millions are drowning in debt. There were 3 million insolvencies in the US in 2002; and Europeans are not far behind.

In South Africa household debt is proportionately less than in the US and Europe. But there is a 'silent crisis', according to Tradex economist Mike Schussler. Three thousand people every day attract debt judgements that effectively 'take them out of the economy' by blacklisting them. Schussler points out that this is five times the number that daily contract HIV. Debt judgements have grown by 107% since 1994.

Have you ever wondered why debt is so burdensome today compared with thirty years ago? It is in fact because of the way that money now comes into existence. Money has no value in itself: you can't eat it or build your house with it. But clearly it is essential to enable people to trade with each other. So how is new money produced to match new traded goods and services?

It is not complicated, though bankers have tried to make it so. The economist J.K. Galbraith wrote '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.'

Has a bank ever told you that it proposes to lend your money to someone else, and you should desist meanwhile from using it? No? But commercial banks claim they are no more than intermediaries between borrowers and lenders - charging borrowers interest and giving interest to lenders, with a small profit for themselves. Do they perhaps make an educated guess about who will make what demands on their reserves and when?

No. The 'intermediary' story is a myth. The truth is that, in addition to taking in savings, banks create money - loans - out of nothing. In response to a request for a loan by a customer whom they consider credit-worthy, they simply create a ledger item in their account, and register the collateral to back it. Their only legal obligation is to keep their loans at not more than about 9 times their assets - which are largely customers' deposits. But the process is self-perpetuating. When one of us borrows R100, we will pay bills to someone else, who deposits it in a bank; and that becomes another deposit on which that bank is entitled to lend another nine times its value - R900. All loans must be repaid, as well as the interest. Both become the property of the bank, created from nothing. Neither has anything to do with lending out someone else's money.

Sounds like nice work if you can get it! And so it is - literally a license to print money. Originally it belonged to monarchs, and was known as 'seigniorage' - the right of kings to print money to finance their courts and their wars. Today, governments - successors to monarchs - retain only the practice of printing minted notes and coins; but in all modern economies these constitute only about 5% of the money in circulation. The other 95% is the fiefdom of the commercial banks. The government tries to influence the amount the banks create, by controlling the demand for loans through the interest rate, but this is a blunt instrument.

Notice two things. First, every time banks create new money, they do it through making a loan. No money (other than coins and notes) comes into the economy except through new debt. Thirty years ago, the proportion of new money created by governments directly through the mint was much higher - up to 45% in some countries. So the poison of debt was very much less.

Second, the banks do not create new money to cover the interest demanded; so all borrowers must compete with each other to find the means to pay the interest. That works only when enough money is coming on stream through new loans in 'boom' periods. In the end that is inflationary, interest rates are raised, and the economy 'busts' as people cannot find the money for the interest they owe. Hence insolvencies. And hence 'boom-and-bust'.

Surely there is a better way to put into the economy the new money that is needed to oil its wheels. Indeed there is. The commercial banks should limit their activity to what they claim they are now doing - lending savers' money to borrowers, thus keeping savings roughly equal to borrowing. Meanwhile governments, via the Reserve Bank, should calculate the amount of new purchasing power needed each year to activate the country's resources. They should then spend that money directly into the economy via normal expenditure on schools, health, roads, police and so on.

If they put too much money in, we would have inflation; if too little, recession would follow. But at least their influence would be direct, and we would know whom to blame if it were wrong. Who blames banks for booms and busts?

Consider the effects of such a change. First, governments would not have to use taxpayers' money to pay commercial banks interest on what they must now borrow. Today taxpayers subsidise banks to the tune of millions every year. All of that would be available for non-inflationary government expenditure. Second, new money needed for growth would come into existence free of debt and interest. The economy would be freed of the automatic 'boom-and-bust' cycles of debt-based money. Third, people who needed to borrow money could still do so from the commercial banks as long as others were doing enough saving. The huge disconnect between savings and credit expansion that now fuels financial instability would be ended.

Fourth, governments could create as much money - but no more - as is needed to bring all the people into the economy. At present only people considered credit-worthy have access to new money, so resources stay in the hands of the relatively well-off. Thus we have the ridiculous situation that millions are impoverished and unemployed while resources to meet basic needs lie idle; and we are told this is because 'there is no money'.

The return of seigniorage to governments is not a new idea. President Lincoln was an early proponent, and periodically other leaders have followed. The banking lobby has so far defeated them. Internationally a new movement in favour is gathering force. You can follow its progress and read the research on sane.org.za and www.neweconomics.org.