Lately, I was engaged in a major discussion (thanks, uncle 😉 ) about the inner workings of the money and economic system. It was not really clear where the money to pay interest comes from … so now I invested some hours and found out about it. Here is a collection of various results.
Modern Money Mechanics
There is a great document titled “Modern Money Mechanics“, issued by the U.S. Federal Reserve Bank. It shows in good clarity the system of fiat money / fractional reserve banking. Here are some important insights from that, and based on that:
- ”Assuming a constant rate of use, if the volume of money grows more rapidly than the rate at which the output of real goods and services increases, prices will rise. This will happen because there will be more money than there will be goods and services to spend it on at prevailing prices.” (p. 3) This states that it is necessary to increase the money base (M1) in the same rate as the economic output rises, to keep prices stable. (Note that economic output is not the same as GDP, as the GDP already may include price changes that as the effect of teh above mechanism; GDP cleared from inflation would be the way to measure economic output.)
- “Changes in the quantity of money may originate with actions of the Federal Reserve System (the central bank), depository institutions (principally commercial banks), or the public.” (p. 3)
- It was a small step from printing notes to making book entries crediting deposits of borrowers, which the borrowers in turn could “spend” by writing checks, thereby “printing” their own money.” (p. 3) And if individuals would act just as banks do, they would issue way more checks than they own deposits on their bank, trusting that only a limited number of checks would be converted to cash at any given time, while the rest would be used as means of payment much like currency.
- In the fiat money system, banks could create money infinitely; this is limited just by the necessity that money must be trusted by the population or they would not use it. That is, it must maintain scarcity in relation to its usefulness (which is a verbalization for “value”, used in “Modern Money Mechanics”).
- In a fractional reserve fiat money system that requires 10% minimum deposit at the reserve bank, every piece of money you deposit on your account is worth ninefold as much to the bank!!! Because it is allowed to, and will, create the ninefold amount of loans from that, keeping your money as the reserve 10%. So if you deposit 1000 EUR, it’s worth 9000 to the bank to work with.
- Why do banks want people to never withdraw large amounts of currency, or carry large amounts of currency in their pockets, and rather pay with credit cards etc.? Because currency counts as reserve money, so has much higher value to the bank than to the customer. See: “A bank can always obtain reserve balances by sending currency to its Reserve Bank and can obtain currency by drawing on its reserve balance.” (p. 5).
- “When deposits, which are fractional reserve money, are exchanged for currency, which is 100 percent reserve money, the banking system experiences a net reserve drain. Under the assumed 10 percent reserve requirement, a given amount of bank reserves can support deposits ten times as great, but when drawn upon to meet currency demand, the exchange is one to one.” (p. 18)
- Now if deposits of their customers are of such a much higher value to the banks than to the customers (ninefold, in Europe), why do customers still get a crappy interest rate, even much lower than the onefold interest rate on loans people get from this deposited money times? Truly banks are the champs of capitalism. And, they even don’t tell customers what they do with their money … making loans from the the ninefold amount of it!
- The reserve bank’s base rate of interest is the rate it charges other banks if these lend reserves. Yes really. Banks not only are allowed to create money by multiplying reserves, they are also allowed to lend the reserves to do this. Normally the base rate is the limiting factor to this, but in tough times, this rate can be 0%. (As done by the EZB during the 2008-2010 economy crisis.) A 0% base rate effectively allows the creation of unlimited money …
- Central bank money is not money, according to “Modern Money Mechanics”. It is virtually destroyed until re-issued by the central bank. See the definition of M1 in “Modern Money Mechanics”. This means that central bank money makes noone any richer as long as it is owned by the central bank.
- The increase of deposit money by means of the reserve multiplier in a fractional reserve banking system is the only way how deposit money increases; and deposit money is the same as “book money” (German “Buchgeld”), so this is the way that Buchgeld increases. (And not some strange, often quoted re-lending of loans).
- In the Eurozone, the fractional reserve is 2%, that is the resever multiplier is 50! That is, each currency euro is worth 50 euro for the bank …
- Currency is central bank money. It is (logically) only created once when introdcing a currency, by handing everybody a free “start package”, or converting from previous currency.
- Money as deposit money (that is, 97% of M1 in the U.S.) loses its trustworthiness if a good part of it was created with faulty securities, that is, no value that does back it. As this is the case currently, these subprime credits do not only endanger the borrowers themselves but also all people’s money because money itself is endangered. This danger becomes apparent in bank foreclosures; and takes effect if there are more foreclosures than the foreclosure insurance does protect people from. And if / as the whole bank system is full of faulty credits, the full deposit money system is endangered.
Is all money debt?
One way where the additional money to pay interest rates could come from would be, from new debt. This would be clearly the case if all money would be debt (where debt means, a liability with a non-zero interest rate). Let’s see:
In the U.S., at least all deposit money (that is, book money) is issued in exchange for debt:
Federal Reserve Governor Marriner Eccles testified before the House Committee on Banking and Currency, September 30, 1941. Congressman Wright Patman asked Eccles how the fed got the money to purchase two billion dollars worth of government bonds in 1933. Eccles answered, “We created it.” Patman asked, “Out of what?” Eccles replied, “Out of the right to issue credit money.” Patman queried, “And there is nothing behind it, is there, except our government’s credit?” Eccles responded, “That is what our money system is. If there were no debts in our money system, there wouldn’t be any money.” [source; a more reliable source would be great]
In Europe, currency is not debt but an asset: because the mean fractional reserve of central bank money is stored in the central bank accounts, and banks get paid interest for that [source] rather than the other way round. While they pay interest if they lend money from the central bank [source]. (The first kind of interest increases the money base (money creation), the second decreases it (money destruction); while the loan capital flow has the opposite effect.)
So, in both the U.S. and Europe, all deposit money is created from debt [source]. Central bank deposit money can be converted to currency 1:1. And sometimes central bank money is lended out for 0% interest. Still, this does not mean that customers could acquire new money that is not debt, as they can acquire newly created (deposit) money only through normal banks, which always charge an interest. So in effect, there have to be additional debts for successful payback of all interests. Successful repayment of all debts increases the money supply (M1), so necessarily increases the debt, as debt is needed as the counterpart to issue new deposit money.
However: the amount of new money (so, the amount of new debt), after being cleared from the debt destroyed in depressions and great depressions, seems to be a representation of the increased efficiency of economy [source: “On fractional reserve banking”, section “World destruction”]. This produces the paradox situation that increased economic efficiency (which is a good thing) leads to a larger and larger debt load through interest (which is a bad thing). It is bad, because this debt load has to be managed. Over time, an economy becomes more and more unstable and crisis prone this way. What could be done against this problem?
Means against the debt trap
Note that this section contains mostly my own proposals.
- Inflation. Inflation (as measured by rising prices) is a devaluation of debt. Inflation as such is actually a number not saying much. If the price of an average small car between one year and the next stays constant, but the new model includes technical improvements (as they always do), this is actually deflation (because the same amount of money can buy more now)! In this sense, to get stable prices, we need inflation rates that are equivalent to the efficiency gain rates / technological improvement rates of the economy. This whole thing is not mentioned by people comparing the purchasing power of money from before 50 years or so with the current one. So, if the inflation rate would be exactly as high as the rate at which the money supply increases through new debt, the net worth of all debts would be unchanged and remain manageable. Currently however, interest rates (the rate at which debt increases) are normally higher than inflation rates, which means aggregation of debt until it becomes unmanageable. But when always letting the inflation rate be as high as the interest rate; or in other words, the debt would stay manageable. This keeps the economy stable, but might have disadvantages in that it discourages research to improve efficiency, as higher inflation will shorten the benefits gained through efficiency increases (though there are always benefits in relation to competitors, but not in respect to the rest of economy, that is, to purchasing power of earned money).
- Good crashes. Crashes large and small will and need to come whenever there is a disparity between expectation of interest and producable interest by technological advancement or current gain ratio. That is, crashes do cure greed. There are many small crashes like losing money on the stock market; but if small crashes are saved up by government means like bail outs etc., they aggregate to larger and larger crashes, ranging from economic crisis to state bankrupty to world bankruptcy. Which would mean just the devaluation of all currencies because they got untrustworthy, that is the need to replace them with others. So, people: Don’t save up the crashes. If you do, it is like saving the blows earned for greed, until they all break lose in a fury that is nothing less than a beating to death. Instead, undergo the small crashes as they come, and learn from them. They will come until you have learned to not expect more interest than there is technological gain in efficiency. We should see them as necessary and good things, and develop ways to let them happen in less panic prone ways (smaller crashes, but more often; or better liquidation procedures even for large banks, states etc.; or “continuous crashing” procedures). Because, what is a crash if not the destruction of too high expectations of interest by investors, when it becomes apparent that these expectations were too high. See: “Even so, if we were to act rationally, interest would still compound at a steady and slower rate, it would still be cumulative though, if inflation can not in the end destroy enough value something else has to, a crash.” [source]
- Limiting interest rates. On average, all interest expectations that exceed the gain in technology and organizational efficiency are too high. So another idea against economic unstability would be to prohibit interest rates that exceed the gain of efficiency in a company or organization or even a state (that takes loans). In the latter case, citizen investors would have a motivation to strive for efficient usage of their invested money! The only thing that produces value is gain in technological efficiency, by technological aggregation of knowledge and experience (for efficient procedures) and aggregation of infrastructure (for efficient execution of processes). Both would have to be factored in to calculate the maximum allowable interest rate (as everythig else leads to a crash in time). Note that GDP increase is not the same as efficiency gain, as the technological improvements (causing deflation) are registered nowhere. Interest rates might be somewhat to the limit of this efficiency gain (or rather, to the limit of half that value, to allow the company itself to earn also from that gain). Being near to that limit motivates to keep up efficiency development, and even to improve that speed if possible; but it does not beat people along in enormous, unbearble stress like in the current economy, where one has to pay a 9% interest rate on average even though the overall efficiency gain is perhaps 3% (rough estimate). (Note that a 3% increase seems small, but can produce uninterrupted exponential results, so after 20 years: (1+0.03)^20=19.24.)
- Free banking. Another solution would be free banking. Where a bank would be simply: an institution emitting a resource of sufficient scarcity and trustability to have value, in exchange for deposits of other resources that have value. The emitted resource would be the money of that bank. For example, one kind of money might be gold standard based and extremely trustable, another might be fractional reserve based and less trustable but better investable. Fiat money as such is not much of a problem resp. would work well if banks are trustable, self-supporting institutions (not the faible, weak, breakable things they are now). Then, banks would be the required trustable third parties for trustable value exchange and storage, and earn for this service, and not from speculative lending.
- Adjusting the reserve multiplier. Fiat money is monetary value in exchange for binding value by means of rights to things [source] or rights to currency [source]. So a bank simply brings such other forms of value into a more liquid form, which would be ok to do. What is not ok, and makes the economy unstable, is that banks accept faulty securities, for example the hopes of companies to make money. And they do so simply because they want to lend out all their money, as this is their way to earn money. So as a solution, the reserve multiplier would have to be lowered until banks do no longer grant risky loans because they have just enough money to grant secure loans.
- Less liquidity. “Die Steuerung der Geldschöpfung obliegt heutzutage fast ausschließlich den Geschäftsbanken, da die Zentralbanken im Sinne einer ausreichenden Geldversorgung der Realwirtschaft (die fast ausschließlich von den Geschäftsbanken gewährt wird) den Geschäftsbanken jederzeit ausreichend Zentralbank- und Bargeld zur Verfügung stellen.” [source]. Which means nothing else than that central banks produce all money that banks want. Money is only still a non-scarce resource (i.e. a valuable thing) because it can be obtained from banks only when paying an added interest. Now both creditors and debitors are greedy, ready to take a loan with an attached interest in the hope that the credit can be paid back: this way, greed can jump in as motivation, using excess liquidity for granting risky loans in the hope to earn still more than currently. And this speculation of banks and bank customers is what then leads to crashes. With less liquidity, economy might develop slower, but more constantly: without crashes that would destroy too fast development anyway. So the central banks should lower liquidity!
- Keynesian politics to control also the boom. Limiting the speculative granting of risky credits, which takes place in economic booms, is an important factor in economic politics: “The problem for the world economy is that everybody remembered Keynes’s lesson about the need for countercyclical policies only when the crisis erupted, after demanding to be left alone – with no symmetric policy intervention – during the preceding boom. But managing the boom is more important, because it addresses what causes crises in the first place.” [source]
- Demanding better securities. Another bad thing is that it seems that high interest rates are necessary in market economy, to secure the bank against the risk of credit defaults. In market economy there is no central resource planning, so that every participant needs to do resource planning on his / her own, which is necessarily speculative: one tries to do something that will create gain, but cannot know whether this does work or not as customers can only buy after the product is there. This speculative investing is risky, potenially resulting in a small crash; and this leads banks to use high interest rates to still earn money. These high interest rates in tun make investing by loans still more risky, and create still more stress on the economy. There are simply not enough secure loans to grant in a market economy, as market economy is inherently speculative; or, if banks would only grant secure loans, they would earn just a little bit, which lures them to grant sub prime loans as well. So the problem of economic instability might be, at least in part, the inherently speculative nature of the market economy.
Stopping to grant risky loans also would increase unemployment; because many people currently are employed in companies based on risky loans, hoping to make net gain in the future. In this sense, if we want to keep market economy, we need to keep a good part of risk.
- Planned economy. If speculative risk (and therefore, st least small crashes) is such an integral part of market economy, I want to propose a planned economy where people can freely form cooperatives to order the development or production of something. Governance is possible by electronic means like web portals. There would be no risk (of overproduction, or producing things that nobody wants) because everything is built and developed to order, from food to cars to tools etc.. Another good side effect would be that customers can again get the quality they want.
All stress in this economy is credit-induced through interest rates, and because the banks and companies are stock companies, induced by our own greed for money through stocks. We are our own slave masters! (Poor workers are pure slaves, and rich rentiers are pure slave masters, but the average citizen is both.) We do stress ourselves for no reason, and this even does lead to a crash afterwards, in addition to all the workplace stress!!!
The thesis that the existence of interest itself does lead to a crash by a chain letter system is too simplistic. Instead, too high interest rates do, but simply by being unrealistic expectations.