A Challenge to Banking

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SECTION ONE - Dishonest Money

Creating Distrust

In the 1960's and early 1970's, a portion of the more affluent British middle class found retirement to Portugal an attractive proposition. Sumptuous villas cost around £15,000; living and maintenance costs, including a daily maid, gardener and swimming pool maintenance, were around £2,000 per annum. So on a pension of £4,000 per annum, the yearly outgoings could be comfortably met. With the gentler climate and lifestyle of Portugal, couples in their sixties were anticipating twenty years of warmth and comfort.

By 1978, many elderly couples could be found struggling with the problems of maintaining their large homes and extended gardens themselves. They often had to clean the swimming pool themselves. The mental and physical stress was not easy for them as they became older and more frail.

Living and maintenance costs had risen to £6,000 per annum. Pensions provide only a fixed income, and disillusioned pensioners faced financial hardship, if not penury. Their careful planning had gone seriously awry. Many blamed their advisers for bad financial advice, only to be told that no one could have anticipated the oil-price hike of October 16th, 1973, and the massive inflation which followed.

This is simply not true. The Member of the New York Stock Exchange who told us about the man who went to buy a Ford, warned us about the perils of inflation ten years before the oil-price hike. He was worried about the chaos that would follow the breaking of the link between the American dollar and gold. He predicted serious inflationary consequences. It is unlikely that he was the only one to see this danger. But most did not. Unfortunately, few professional advisors are prone to admit their mistakes. There is a human need to find a scapegoat: OPEC's (Organization of Petroleum Exporting Countries) actions were a natural choice.

The idea that inflation is merely a response to the increase in the price of oil is false. We have already seen how one individual, after saving the price of a brand new Ford for twenty years, was unable to purchase more than half over a new Ford in 1957. He experienced serious inflationary effects sixteen years before 1973. Those who study the history of Germany in the early twenties will confirm that inflation is not a new phenomenon - and so should any student of financial history. Yet many have vented their anger at OPEC for having brought us inflation.

When OPEC was first formed and flexed its muscle on October 16th, 1973, the West suffered a great shock. But from the perspective of the Iranians, the initial increase is not excessive. The cost of a barrel of oil was raised from 1315.9 to 2346.7 pennies. A massive increase in monetary terms - almost double. In terms of a more constant value, however, it purchased only 130.4 pounds of bread. In 1956, the Iranians had agreed to 100.8 pounds of bread per barrel. They had been short changed by more than 25 pounds of bread per barrel over a period of 17 years.

Value per barrel of oil

British Petroleum acted in good faith throughout. They agreed to 512.5 pennies in 1956 and increased that by 20 per cent by 1968. They increased it a further 100 per cent by October 1st, 1973. I have seen no evidence that British Petroleum intended to mislead the Iranians in order to gain excessively for themselves. Yet Iran suffered losses. These losses eventually led them to question the integrity and sincerity of their Western trading partners.

Following OPEC's increases many others raised the price of their product or service. Some because their costs increased, others because the opportunity was there. Everywhere the man in the street felt the crippling effects of inflation. Many demanded higher wages. They blamed OPEC or the Government or some other cause. They did not examine the mechanics of the monetary and banking system. In the long run, both the West and Iran are losers from this situation. Instead of building a better world together, they have been brought into conflict with one another. Dishonest money is the culprit.

Inflation is a problem of the Western monetary and banking system. It indicates the existence of a major fault somewhere. We need to take a critical look at the basic mechanics of the system, and find out where that fault lies. We begin by defining exactly, what we mean by "inflation".

Prices increase for one of two reasons. Either the value of the product being produced increases, or the value of the commodity in terms of which the price is stated decreases. In the former case the price of a specific product will increase as a result of supply, demand, design or any other market influence which affects the product itself. Changes in these factors can also cause the value of the product to fall. Such price movements are the result of normal market activity.

Inflation, on the other hand, is a general increase in prices. All prices go up. In terms of money the value of things will have increased. The corollary is that the value of money will have gone down. Money will have lost value. Inflation can thus be seen as the loss of value by money and as purely a monetary phenomenon.

In the modern paper monetary system there is no direct connection between the production of a new unit of money and the amount of products or commodities upon which it can validly claim. Any increase in the supply of units of money will mean a decrease in the exchange value of each previously existing unit. More units will be required in exchanges to equal a given previous level of exchange value. Or, more simply, prices will go up.

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Wrong tools

Interest rates are often used as the principal tool to control the money supply. Interest is the amount of money charged by the lender for use of his money. The payment of interest transfers existing units of money from one person or business to another. A transfer does not create any new units of money and is not of itself inflationary.

Any increase in the amount of interest payable will simply cause more units to be transferred from the borrower to the lender. This, of course, will increase the income and profits of the lender which, in turn, will encourage him to lend more.

As we shall discover, net new lending increases the money supply. This is the real cause of inflation. If we increase interest rates we simply provide an incentive for lenders to lend more. (Witness the most recent period of high interest rates in the United Kingdom. Throughout the period of the highest rates letter boxes were stuffed with enticements from banks and other money lenders to borrow, borrow, borrow.) In the short term this is counter-productive. In the longer term it is deadly.

Increased interest rates will add to a borrower's expenses and thus decrease the amount he will have available to spend. The same process will apply to his customers who will order less, and therefore the borrower's income will be reduced. His profits will be squeezed from both ends. From the wider perspective, the production of goods and services - the wealth of the community - will be reduced and the vitality of the market-place will be sapped. Hard working and industrious producers will find their efforts thwarted by factors beyond their control.

Increases in interest rates sap the life force of the economic system. Increases in interest rates do not cure inflation: they destroy an economy. They are the wrong tool. Inflation can only be cured by stopping the production of new units of money. The charging of interest does not produce new units of money.

We need to take a critical look at the basic mechanics of the monetary and banking system, to see exactly where the production of new units of money occurs. Then, we must remove the cause of their production. That is the minimum required to repair the fault and provide a more accurate and reliable system.

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