Shortcomings of fiat money and some resultant problems
National currencies, which are nowadays crafted worldwide in the same basic manner, as fiat money, have a number of grave deficits in their very construction – which have in turn created many of the problems which we face today. Most of these problems result from (a) compound interest and (b) the definition of banking as a profit-oriented business rather than a profit-free community service.
As noted on the previous page, all central bank money, and commercial bank promises of the payment of money ("checkbook money"), can only be borrowed into circulation. The commercial banks must pay interest on money to the central banks, but must provide it interest-free to their customers for a corresponding debit to a giro or check account. They recoup their interest costs to the central bank, together with their operative costs, by charging interest on all the loans they make.
Note that positive bank account balances can only come into existence after money has come into circulation, for which it must initially be borrowed. For example, a company startup loan may be used for salaries – the employees get positive bank balances; but the money paid to them had to be borrowed by the company. Thus all money in circulation is accruing interest somewhere…
In regard of collateral, sadly, some are more equal than others. The central bank or government creates the fiat money without any intrinsic value or commodity backing, and simply declares it by law to be "legal tender", which means it must be accepted at face value. But on a personal level, for larger bank loans normally collateral is required, e.g. a mortgage loan takes the building for which it is used as loan security. If a debtor defaults on repayment then the bank takes possession of the collateral ("mort-gage" = "death pledge").
- Gregarious money
The current system systematically pumps wealth (in the form of bank account balances) from the poor and middle-class (producers) to the rich (privileged non-producers). It does so in various ways:
- Since much of the money used to finance companies is borrowed, the cost of interest must be passed on to consumers via prices. Bearing in mind that all products and services are the end-points of long supply chains, this interest sums to a surprisingly large percentage of the retail price.
- The same applies to taxes levied – they are used by the government to pay for goods and services which contain the hidden interest mentioned above. Furthermore most governments are in debt, many nowadays alarmingly so, so that a percentage of taxes must be used directly to pay the interest on this debt (USA: ca. 15% of the national annual budget [or more], UK: ca. 16% of the budget).
- Thus the poor and middle-class have a negative overall interest balance, even when they have no personal debt or even some wealth, due to all the interest hidden in their purchases and taxes. The german alternative financial guru Helmut Creutz has calculated for 2007 and 38 million representative german households that taken together, the overt and hidden costs of interest amounted to about 35% of the money spent.
- The very rich have in contrast to all others a positive overall interest balance – they get even richer simply because they are already very rich. Furthermore, they can borrow more money from the banks at lower interest rates than those offered to the less well-off (e.g. to "expand their portfolio"). They are favoured customers of bankers.
- Unethical money
The middle class, and most companies, are of neccessity (due to the way the system works) often in debt, e.g. mortage loans, leasing contracts, business loans, and so must work hard to pay interest to the banks; whereas the rich need not work since they can live from positive interest (and/or reinvest it) – they consume much more than they produce. It also undermines democracy by propagating the values and interests of the rich and multinational concerns throughout society.
- Misallocated money
Money available for investment tends to be misallocated. This is because bankers are defined as businesspeople (i.e. their jobs are defined as striving for profit), rather than as professionals or civil servants, who would work for a fixed remuneration as a service to the community. Since commercial banking (see point  Interest) is in fact a rather limited task, the field of investment banking (effectively speculation) offers more scope for profit. Thus money is often allocated to wherever it will bring the most returns – which will probably not be local businesses, and may nowadays be anywhere in the world.
- Pretence of value
The application of compound interest – together with a host of modern derived "financial products" – give national currencies a perceived value of their own, which as a medium of exchange they should not have. Money appreciates in value (due to interest) while the goods and services which it should represent lose value with time (rot, rust, storage costs etc.). The money thus has an "unfair advantage" over goods and services and therefore develops a life of its own, a path ending in speculation and reckless gambling, with results such as the sub-prime crisis and the pending global financial meltdown.
A popular assertion in alternative currency circles is that money is by design scarce, because the interest to be paid on loans does not exist in the monetary system. This argument can be summarised as follows:
Defaults on repayment and/or exponential inflation of the amount of
money in circulation are programmed into the system, since money needed
to pay the interest does not (yet) exist – either some debtors must
default, or the central bank must "create" new money and give it away*, or
new money must be borrowed into existence from commercial banks. By design
there can never be enough.
* Central banks do create new money, but they don't give it away to debtors, rather they lend it to commercial banks, which then have more reserves against which they can make even more loans).
Critics of this view maintain that interest to be paid by customers is not lacking in the system: When a customer pays some interest on a loan, this (promise of) money is now owned by the bank, which brings it back into circulation as wages, taxes, interest on savings, operating costs and so on. A small part of it may get 'locked up' as increases in company capital of the bank, but in general the interest money paid on loans returns to circulation, and is thus again available to repay more interest on loans.
Such different viewpoints probably exist because the truth is more complex than either of these pristine arguments. Interest paid to commercial banks may in fact be used in a number of ways, e.g. to reduce their own debt to the central bank, to increase their own reserves, or, if the bank is not only a commercial but also an investment bank, it may instead gamble it on the global casino, in which case it is not (directly) returned to circulation (certainly not locally and probably not even in the original currency).
What we can safely say is that a great many people do experience a scarcity of money, leaving them often comparatively worse off than people were before money existed; and that while austerity measures are now being applied in many countries, huge sums are looking to be invested for the highest possible profit. But these latter statements, while true in themselves, refer primarily to the distribution of money and not to the question of whether it must be scarce by design of the monetary system. So we'll leave this question without a definitive answer and move on to one which we can answer.
The simple answer is: No and Yes. No, they do not create central bank money, but Yes, they do create commercial bank money ("checkbook money"), which has the same purchasing power for consumers. This method of increasing public purchasing power is known as the money multiplier, and how much multiplication is possible is governed by the fractional-reserve banking system. Governments have given checkbook money an advantage over central bank money by stipulating that taxes cannot be paid in money, only in checkbook money.
As you can read in the above-linked articles, and in many other sources, there are mainstream and alternative theories about how this system really works and regulates itself / is regulated. Of particular academic dissent is the question of whether money creation is endogenic (originating internally), i.e. by the banks loaning money which they did not have, but only a fractional reserve of it; or if it is exogenic (originating externally), i.e. governed by customers first depositing money which the banks can only then lend to other customers.
Here's an example for the exogenic view: Alice lends her bike to Bob, Bob lends it to Cathy, and Cathy to Donald. Now, there is still only one bike – but there are three loans (Alice to Bob, Bob to Cathy and Cathy to Donald), and also three IOUs (Donald to Cathy, Cathy to Bob and Bob to Alice). It's similar with money – we have a small amount of actual money, which gets lent and borrowed a number of times, creating a much larger volume of loans and deposits, which are not themselves money – but nevertheless require interest.
In this exogenic example, nobody can lend the bike until they have it – a fact which does not hinder the multiplication of loans and IOUs. In the endogenic view, the commercial banks don't even need a bike in order to loan one out, they effectively create a bike by lending it.
One might think that this question could be answered by looking at the balance sheets of banks, but this is not so due to double entry bookkeeping: When the bank makes a loan, they credit one account and at the same moment debit another account by the same amount – so their books always look balanced. So while Helmut Creutz seems to favour the exogenic view, others like Andreas Popp and Bernd Senf claim to prove the endogenic view. Yet many, such as Friedrich Müller-Reißmann in Humane Wirtschaft 2011/03+04, maintain that pursuing this question is not fruitful and that we should concentrate on moving forward in real life – we concur with this pragmatic standpoint.
Two salient points that can be safely made are:
- Commercial banks do create checkbook money and charge interest on it. Their books remain balanced due to the double entry bookkeeping system – the checkbook money created appears on two accounts, the checking account of the borrower for her or his use (it accrues no positive interest there), and an equal negative amount on their loan account, where it gets charged compound interest. This sounds like a good deal for the bank, and indeed it is. We should however not forget that the bank must also pay interest on savings and cover all its own costs, while competing on an open market with other banks – so this system does not mean that they have a "licence to print money" in the sense of getting rich for nothing.
- The system by its design requires regulation by a central agency. If the commercial banks create checkbook money to the full extent which fractional-reserve banking allows, then central banks can grow or shrink the public money supply simply by controlling the supply of central bank money. But if the commercial banks don't or can't make as many loans as their reserves would allow, they end up with excess reserves – and the central banks can then still pull money in by restricting the supply, but they can't push money out by increasing it, since the commercial banks already have excess reserves which they can't use. This situation is called "pushing on a string". The central banks are then forced into "quantitative easing", i.e. direct purchase of financial assets, as we have seen the Fed do in recent years, and lately also the ECB.
A very illuminating exchange, originally via eMail:
Josh Ryan-Collins wrote:
When a bank makes a 'loan' it does not borrow the money from anyone else. The loan is registered as a deposit in someone's account and that person can spend this brand new purchasing power in to circulation. You can have a semantic argument over whether the deposit is really 'money' before it's actually spent (the same applies to an unspent overdraft) but the point is that the bank has created new purchasing power. At a macro-level, when banks, in aggregate, lend out more than is being repaid, the money supply increases and vice versa.
To make the point clearer, the government is not allowed, according to EU rules, to do this. Governments can only raise funds by issuing bonds, and when the private sector buys those bonds, the private sector's purchasing power is reduced correspondingly (often called 'crowding out' by economists). So the net money supply is not altered. In contrast when a bank creates credit, no-one else's purchasing power is reduced.
Tom Greco replied:
What if a bank buys a government bond?
You need to consider the aggregate amount of government bonds that are bought from private owners who purchased them with previously created money, compared to government bonds that are bought by banks with newly created money. That's the same as the bank making a loan to the government.
When the central bank buys a government bond, it creates new reserves ("high powered money"). The government spend that money into circulation. It then makes its way into banks when some companies and individuals deposit it. Now the multiplier kicks in and the banks are able to lend many times the amount either to the private sector or to the government.
Josh Ryan-Collins responded:
Yes, you are right about the difference between banks and the non-financial sector buying bonds. The problem arises, of course, when the interest that governments have to pay on their bonds reaches an unsustainable level, as is now happening in Europe. Whereas when a bank creates new money, it doesn't have to pay interest to anyone in a way that is directly relevant to the loan (of course it has to pay interest on deposits held with it). In Europe, the Maastricht Treaty bans Central Banks or Ministries of Finance directly purchasing government debt in the way you are describing Tom (article 101). They can only do this on the 'secondary market', i.e. after the bonds have initially been bought by the money markets. This is what the ECB has just done in Spain and Italy to try and drive down interest rates on their sovereign debt.
The entire monetary system is thus privatised/marketised. Governments
cannot create new, interest free purchasing power (credit) to invest
in (non-inflationary) productive goods and services. Commercial banks can
create new credit whenever they want, for whatever they want subject to their
own perceived risk on the loan and wider liquidity risks.
This is not democracy!
Effects as evidence of their causes
It would be tempting at this point to demonstrate and berate many other dubious and asocial mechanisms of the current financial system – but also unneccessary, as we can nowadays read about their effects daily in the news and many other sources. We do however mention that in the USA the exhaustion of credible loan takers and the ensuing mortgage loans to low-income groups led to the sub-prime crisis; and that the indirect purchase of government bonds by the ECB, bonds issued by countries which most probably will not be able to repay them in full, will mean the european taxpayer picking up the shortfall at the end of the day.
Rather than getting into in-depth academic discussions about the exact causes, we find it more pertinent to look at where this current monetary and financial system has led us to, these results being undeniable:
- A veritable debt-mountain in the USA, which will not be serviceable.
- A lot of investment-seeking capital from the northern hemisphere has been invested in the southern hemisphere, so that the interest paid by south to north has long been a multiple of the development aid flowing from north to south.
- Capitalism is successively bringing the majority of people into poverty.
- The fortunes of the worlds three richest people together exceed the combined national products of the 48 poorest countries.
- The worlds richest 225 people own more than the poorest half of the worlds population.
- Every day, a billion human beings must survive on less than one dollar.
Is it not time, high time, to think again? When the system we use has led to
such inhumane conditions then obviously we need a radically different system.
Minor changes to the old one will not be enough! We invite and urge every reader
to take responsibility and actively help in creating a world in which we can
all enjoy the present and look forward to the future!
Footnote, 16. May 2013: Read what Pope Francis has said about the global cult of money.