What is a debt based monetary system?

As the financial crisis grows more and more intense, it seems increasingly certain that many of our major banks will be taken into state ownership. This is a mistake – if we are to nationalise anything, it should not be the banks, but the money supply itself.

Contrary to popular belief, most money in our economy is not created by the government or the Bank of England. It is created by the commercial, high-street banks every time they issue a loan, mortgage, credit card or overdraft. This is made possible by the fact that most money these days is not cash or coin, but simply electronic numbers in computer systems. Whenever a loan is made, these numbers are not actually transferred, but simply duplicated. This sounds unbelievable, but happens simply because the current method of accounting within banks is 500 years old, and has not been updated to take account on this new, non-physical money.

You might initially be thinking that it does not really matter if money is paper or electronic computer entries and you would be right. There is nothing, inherently wrong with number-money, just as there is nothing wrong with paper money. There is however something wrong with how it is created and who creates it. Not just wrong, but catastrophic and I don’t use that word lightly.

How is money created?

The process that allows commercial banks to create 97% of our money supply through debt is what is known as fractional reserve banking. Fractional reserve banking involves the issuance and creation of money through a commercial bank, giving banks the ability to increase our money supply through loans.

Through fractional-reserve banking banks keep only a fraction of money deposited in a bank in reserve and lends out the remainder. This practice is universal in modern banking.

To highlight the process through a simple example imagine you deposit £100 into Bank A. Assuming a 10% fractional reserve ratio, Bank A then takes 10 percent of it, or £10, and sets it aside as reserves and then loans out the remaining 90 percent, or £90. At this point there is actually a total of £190 in the system, not £100; because the bank has loaned out £90, kept £10 in reserve, and substituted a newly created £90 IOU claim for the depositor which charges interest and is a profit loan for the bank. At this point Bank A still holds £100 reserves on its books, but £90 of those reserves are soon going to be needed to satisfy the loan recipient. The loan recipient soon spends the £90. The receiver of that £90 then deposits it into Bank B. Bank B demands £90 to be delivered from Bank A to Bank B.

Bank B is now in the same situation as Bank A started with, except it has a deposit of £90 instead of £100. Similar to Bank A, Bank B sets aside 10 percent of that £90, or £9, as reserves and lends out the remaining £81, creating £81 of IOUs to its depositors. As the process continues, more electronic number money is created.

Although no new money was physically created in addition to the initial £100 deposit, new commercial bank money is created through loans.

As this process continues, more electronic number money is created. The amounts in each step decrease towards a limit. When the reserve rate is 10%, as in the example above, the maximum amount of total deposits that can be created is £1000 and the maximum amount of commercial bank money that can be created is £900. This money is lent out plus interest and is counted in the profit of a commercial bank. This is how 97% of the money in the UK is created – as debt.

The effect that fractional reserve banking has on the money supply has far-reaching ramifications for monetary inflation, price inflation, interest rates, and the business cycle.

Only 3%

As a result, we have arrived at the point where less than 5% of money in existence is actually issued by the government and the authorities. The remainder, many hundreds of billions of pounds, has been created through individuals and companies taking out loan after loan, mortgage after mortgage, and borrowing money that has already been borrowed many times before.

This problem is at the heart of the financial crisis. All the currently proposed reforms – including better regulation, state ownership of banks, bonus/malus schemes for the City boys, or a complete end to capitalism – are simply treating the symptoms of a problem that is barely being discussed, but in history has been one of the most topical issues.

Who is to blame for the crisis?

The key question is this: did the banks’ privilege of creating bank-account money to lend to us and one another play a significant part in fuelling the credit bonanza, subprime market and financial boom that led to bust, leaving such a tangle of international interbank indebtedness that central banks and other authorities like the Financial Services Authority could not assess the potential consequences if it unravelled?

The answer, of course, is yes. There is a particularly perverse effect of this current monetary system: common understanding would state that, as the banks lend more and more money, they will eventually run out of money to lend, and any lending boom would eventually run out of steam. In reality, the more money that the banks lend, the more money they have available to lend. Every loan they make returns to the banks, is recorded as new money, and then can be lent again, indefinitely. A lending boom therefore fuels itself and accelerates, until things become unsustainable and it all comes crashing down. That collapse is exactly what we are seeing now.

Is capitalism dead?

So is capitalism dead? I don’t think so. The current problems are not a result of capitalism – they are a consequence of using a banking system that still assumes that all money is either cash or coin.

Under the current, debt-based monetary system, the growth of our economy depends entirely on the amount of debt that we can support. Is there any clearer evidence of our economy’s reliance on debt than the fact that the main concern of governments at the current moment seems to be re-open credit lines and re-ignite lending?

So what should we do now?

We need to nationalise our money supply and we need a monetary system that does not rely on debt.

The reform is not especially complicated – the most practical proposal simply involves changing the internal accounting practices of banks and would require no real change for the average member of the public.

Estimates by Huber and Robertson back in 2000 suggested that the loss to the government of allowing commercial banks to create money was in the order of £49bn per annum. Add to this the cost of servicing the national debt, at £32bn per annum, and the cost of stimulating recovery during recession after recession, which runs to hundreds of billions, and the absurdity of allowing our high street banks to create our money supply should be clear.

If this is your first introduction to the issue of monetary reform, your head may be spinning right now. The reaction that I see when I present this topic to students or those currently working in the City is usually one of puzzlement – as though they had just heard the Earth was round in the time of Galileo. As I ask them to question some of the key assumptions of economics and the monetary system, they soon come to an understanding that something is very wrong, and I expect more and more of the public to come to the same understanding over the next few months.

This is a serious issue that needs serious discussion. When the G20 meet in London this coming April I suggest this problem should be top of the agenda. There can be no recovery from this crisis until these problems are addressed and our debt-based monetary system is reformed.

simondixon

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  1. [...] banks were not in charge of creating our nations money supply we would only really be discussing their bonus if we were considering a career as a CEO of a bank [...]

  2. Yes, virtually all money is ELECTRONIC DATA transmitted from one bank account to another. This is central to my Transfinancial Economics Project. However, people do not like to think of their money as merely electronic digits tapped out on a computer. This is understandable to a certain extent…and ofcourse anything can act as money as it is only a medium of exchnage at the end of the day….