If indeed the time has now arrived to seek monetary justice and to harness public indignation at usurious banking practice, then it is also time to seek a better understanding of how it all went so suddenly wrong and what is to be done about it.
The current procedure – where commercial banks create around 97% of all money in use – emerged several hundred years ago when the goldsmiths started issuing receipts for gold that had been deposited for safe keeping. The goldsmiths came to understand that issued receipts could exceed actual deposits – this was the origin of the current system, known as fractional reserve banking. The paper receipts became a convenient form of currency.
Currently, only a small amount of money (about 3%) are coins and banknotes issued by the national central bank in conjunction with the Treasury. Commercial banks are licensed – after depositing some money from customers or from their own funds as security at the national central bank – to create the money supply as repayable debt. The security deposit is only a small fraction (between 3% and 10%) of the money they create as debt for customers taking out loans.
National central banks, as distinct from commercial banks, are characterised by usually doing what the government requests. In the UK the central bank is the wholly government owned Bank of England. The central bank in the USA, the Federal Reserve Bank, is privately owned. Major issues raised by the bankers’ activities have to do with exploitation, with the widening gap between haves and have-nots, and the unfairness of the licence granted to the commercial banks – matters begging for huge indignation and unrelenting protest.
In a process that sped up since Margaret Thatcher deregulated some of the financial sector, there has been a global rush to disaster. The commercial banks’ spectacular failure has been described by John Lanchester. In his recent book, “Whoops!”, he asserts that the credit crunch was based on a prevailing climate (defined by a post-cold war victory party of free market capitalism), a nasty problem (sub-prime mortgages), a Nobel Prize-winning mistake (the mathematical model of risk) and a failure (that of the regulators).
The power of today’s banks derives largely from their power to create money. Money is created by banks in the form of debt, and it disappears again when that debt is repaid. When a consumer approaches a bank to ask for a loan, the bank does not actually have a stockpile of money from which to draw cash. Instead, the money is created as needed. Throughout the process, no money is printed. The only thing that changes are numbers on computer screens. Accountancy rules for banks permit this magic by double-entry book keeping, where amounts of money that are virtually created are entered simultaneously as both assets and as liabilities. The effect of this is that banks can lend out sums of money that vastly exceed the actual resources they own.
For banks, this is profitable business. They can charge interest on debts created from nothing – a usurious practice that would, if unlicensed, amount to fraud. There are several ways for debtors to pay back the interest. It can come from further loans (which simply perpetuates the cycle of indebtedness). It can come from the real economy, thereby transferring money from the productive economy to the financial sector. And it can derive from unsustainable asset inflation. Here is what that means: Assume that someone buys a house with a market price of £100,000 by using a mortgage plan. By the time the mortgage principal is repaid, total interest might amount to another £100,000. And the house has very likely reached an inflated market value of £200,000. For the national and for the global economy this unsustainable asset inflation is the slippery slope to ruin.
Taken together, the creation of money and the interest charged on debt separated banks from traditional service institutions. If we can remove from them the licence to both create money and charge interest on it banks can become no more threatening than a grocery store or a bus service. The controversial questions – from bankers’ bonuses to the separation of investment banking and deposit/consumer banking – arise because of fractional reserve banking.
Yet bank’s practices were not only bad for economic growth and for consumers – they also destabilized the financial sector itself. The result of fractional reserve banking and deregulation was that commercial banks could amass “toxic” (i.e. high-risk) assets and over-extend themselves significantly. Since their security deposits were only a fraction of their liabilities, a market crash could quickly drain a bank’s actual assets and force it into default. One example: If a bank’s leverage is 35 then only 1/35th of the equity (less than 3%) has to be seen as valueless for the bank to become insolvent. Average 2008 leverage in US banks was 35, in Europe 45 and 18 in Canada (where there were no bank bailouts).
Yet what is the alternative? The first simple step for ending fractional reserve banking is to enable the Bank of England to emerge as sole creator of money – as repayable debt – and to distribute it, interest free, for the benefit of the whole economy in terms of socially useful investment. Investment can go to infrastructural projects (such as hospitals, roads, bridges, or clean power), manufacturing and to consumers. It can sustain employment in the productive economy, rather than transfer money from the productive sector into the financial sector.
To achieve this first step, the government must be persuaded to make it happen. The further, less formidable, task is to arrange for the banks and other financial institutions to administer these loans along the lines given above. For other borrowers ineligible within these guidelines commercial banks would either own the funds they lend out, or take deposits from informed and willing depositors. In either case, they would not lend out more money than the total sum of assets under their control. It would be prohibited to charge interest on loans created by the national central bank. While alternative providers of loans could still charge interest, their packages would become less attractive by comparison. In effect, money created by fractional reserve banking either would be prohibited, be crowded out or be allowed to fade away as the new interest-free funds were distributed.
Yet there is an unhappy divide among proponents of money reform: Who is supposed to control the creation and spending of money? National banks – or strictly regulated privately-owned banks? Ben Dyson, of Positive Money, writes on his website that “… [Stephen] Zarlenga has researched around 3000 years of monetary history to find out what has really worked, leading him to conclude that the only real solution is publicly-created, debt-free money…”. Apart from the problem of attaching a meaning to “debt-free” money – possibly an oxymoron – the underlying message is that government needs to be trusted with creating money and spending it into the economy. This policy is supported by the slogan ‘spend not lend’ and happens to be prohibited by European Treaty obligations. Many may be reluctant to put so much faith in government…
By Jasper Tomlinson, a trained physicist, retired water resources consultant and longtime activist for monetary justice. He can be reached at jaspertomlinson@gmail.com.