A Challenge to Banking

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SECTION ONE - Dishonest Money

Economic and Business Cycles

On an individual level, it is not difficult to see the financial hardship and emotional suffering caused by dishonest money. Our Baltimore investor could not buy his Ford: disillusioned pensioners in Portugal could no longer afford even a curtailed life-style abroad. Grandparents, investing realistically for a new grandchild's school fees, have found ten years on that they can only make a meagre contribution.

The destruction is evident, too, in the history of many individuals and businesses who found it impossible to survive the misguided cure most often advocated by economic experts and - unfortunately - also most often applied by governments: high interest rates.

As a cure, high interest rates are similar to the ancient medical practice of leeching. They, too, drain the life force from the system. The small proportion for whom leeching actually worked offer a greater testimony to the strength of the human body and spirit and to nature's continuing struggle for survival than to the practice itself. Nevertheless, at least leeching had no direct effect beyond the individual to whom it was applied. High interest rates, on the other hand, have a much wider swath of devastation.

The most recent extended period of high interest rates in the United Kingdom has left a mass of families dispossessed of their homes, an enormous number of individuals and businesses bankrupted and a significant portion of the population unemployed. The combination of these direct effects has brought economic and social devastation to many communities and regions of the country. Worse, it has destroyed the hope of large numbers of working people, the middle classes and, most devastating of all, school-leavers. None of this was necessary. The policy was wrong. Increasing interest rates is not a cure for inflation. It is, however, the habit of those who are preoccupied with measuring and controlling economic and business cycles. We must encourage them to look again at the causes of these cycles.

The creation of money by the commercial banking sector is one of the principal causes of economic and business cycles. These are a direct effect of the money-lending function of the banking system. Its role becomes more apparent when we consider the role of money as a store of exchange value.

Each identical unit of money must contain an exactly equal amount of exchange value. When new units are created without any substance behind them, the value needed to fill them must come from the value already stored by the previously existing units.

If, for instance, you lived in a small community and it had its own money, and the total existing money supply were 1,000 units, and 100 new units were minted by your local government, what would happen to the exchange value of the original 1,000 units? How can some be transferred to the recipients of the new 100 units?

The primary beneficiary of the production of these new units is the local government itself. It will put them into circulation by using them in exchanges. Perhaps none of those who accept them in exchanges will be aware that these units are newly minted and an addition to the previously existing money supply. Then the price which they ask in exchange for their commodities will not be affected and the government would receive in exchange, products to the value of 100 of the previously existing units.

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The ripple effect

The government of your community with its extra 100 units of money can purchase more goods and services than it otherwise could. Perhaps it will buy a new computer for one of its departments which it would not have bought had it not minted the new notes. The computer sales company will then have sold a computer which it would not normally have sold. So, too, would the computer manufacturer have made an extra sale. Each would, therefore, have made an extra profit - a profit which it would not otherwise have made. Therefore, each can spend more than it could have. If the computer cost 100 units, then one supplier will have received 100 units extra. If the computer cost only 1 unit, the government will have bought some other goods and services with the remaining 99 units and a number of suppliers will each have received a portion of the 100 new units. As a consequence each will purchase supplies from their suppliers in excess of the amount they would otherwise have purchased and each succeeding exchange on the outward ripple would occur at a smaller level of exchange value. So the benefits will continue to flow outward from the primary beneficiary in a ripple-like manner.

Each supplier along the ripple will be able to set aside as profit or savings a number of units of money which he could not have done if the government had not minted and exchanged those extra notes. The newly set aside units will allow their owners to satisfy some of their unsatisfied needs or wants. Thus, new demand will be created. The new demand will lead to either increased production or increased prices. (It has often led to a mixture of the two.)

To the extent that the increase in demand brings an increase in prices, those who have not benefited by being part of the ripple but who purchase products whose prices have increased, will find that they have fewer remaining units of money following the purchase. They would then have to forego the purchase of some products which they would have purchased otherwise. They will have lost some of their purchasing power and their only available compensatory action is to increase the price of the products or services which they produce.

The net result in your community - all other factors being equal - will be a level of production similar to that which existed prior to the minting of the new units of money, a 10 per cent increase in the amount of money in the market-place, and a general rise in prices averaging somewhat less than 10 per cent, depending on the amount which the various beneficiaries were able to set aside as extra savings.

In addition, the government will have acquired and retained a sizeable portion of the products which had been available for exchanges. A great number of your neighbours would have had to forego products which they would normally have acquired. The market-place would have returned to its previous level of production and exchange; but exchanges would be occurring at a higher level of prices. These same processes and effects occur on a larger scale every time governments produce new units of money.

Where new units of money are created by the banking system, the effects, although similar to those produced when governments mint new notes and coins, are more complex. This is because three beneficiaries each receive 100 per cent of the new units created, and because the repayment of a loan can create a reverse ripple bringing in its wake decreased demand and decreased production.

The three primary beneficiaries are the creating bank, the banking system and the borrower. Each receives 100 per cent of the newly created units of money. Each benefits. The first beneficiary is the creating bank. Its benefit is the earning capacity of the units of money created. It charges the borrower interest for the loan. It remains a beneficiary as long as the loan is outstanding. That much is obvious.

It is not quite so obvious that the biggest beneficiary is the banking system as a whole. It continues to receive its benefit indefinitely. Once a loan has been repaid, the newly created units do not disappear. They are used to issue new loans or to meet withdrawals. When used to issue new loans, the issuing bank receives the benefit. When used to meet withdrawals, the benefit shifts to the banks which next receive them as deposits and can then use them to create new loans.

The banking system as a whole gains the benefit and retains it. Once new units of money have been created by the lending mechanism they remain in existence until there is a bank collapse. Only in that event, when some of the units stored within the collapsing bank disappear, will the number of units within the banking system as a whole diminish. The third beneficiary is the borrower. He also receives 100 per cent of the newly created units of money. He can, with those units, acquire a greater portion of the assets available for exchange in the market-place than he could have otherwise.

If, for instance, the borrower were a manufacturing company and it used the money to purchase a new machine which allowed it to increase its rate of production and if all the additional units produced could be sold, the assets acquired with the new money would provide a basis for the borrower to increase his volume of sales and, one hopes, to retain more of the units of money as profits. Or, on the other hand, the new machine could allow the company to produce the same number of products at less cost than previously.

In either case, the units of money generated by either the additional profits or the cost savings can be set aside to meet both interest payments and repayment of the money borrowed.

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Negative ripples

If the assets acquired do not provide a basis for setting aside sufficient extra units to meet both interest and principal repayments, the borrower may then find himself in the position of having to reduce his overall level of purchases or his labour force in order to be able to provide sufficient units of money to meet both interest and principal payments.

If the assets acquired provide a production capacity in excess of market requirements, then either the manufacturer who borrowed or one or more of his competitors will be unable to sell all of the product which it produces. Thus one or more manufacturers will need to reduce its level of production and, consequently, its volume of purchases from its suppliers. Where the level of trade with one or more suppliers is reduced, each of the suppliers whose level of sales will have been reduced will similarly need to reduce its level of trade with one or more of its suppliers.

Thus, in either of the above cases, a ripple of reduced demand will have been produced. The reverse ripple will bring in its wake both lower levels of production and fewer units of money received in exchanges. Fewer individuals will then be able to set aside money for non-business-related exchanges, and the ripple will flow outward beyond the realm of those directly associated with the new unit of production.

There are exceptions, of course. New loans are continually being issued. Many of the borrowers use their newly acquired funds for projects which embrace common materials or components. Some suppliers will find that the level of new orders exceeds the level of completed orders, and for them and their suppliers there will be no ripple of reduced demand.

The construction industry, for instance, embraces a number of common materials. Manufacturers of bricks, glass and cement will find that their businesses can continue to expand even though the construction projects which they have supplied draw to a close and are completed. This is because sufficient new projects can be started to allow the rate of receipt of new orders to exceed the rate of completion of existing orders.

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Limits to expansion

In the final analysis, all products of businesses and industries must be paid for, consumed or utilised by individuals. Continued expansion must therefore be a function of the number of individuals who have both the will and access to sufficient units of money to purchase the products of a given business or industry. Once existing demand is being satisfied by existing productive capacity, continued expansion of productive capacity becomes a function of increasing demand. So long as the numbers of individuals who want its products expand at the same rate as the productive capacity of any business or industry, then that business or industry can continue to expand. When numbers cease to expand the expansion of that industry must also cease.

There are other practical limitations to the expansion of productive activity. Without access to units of money in excess of those necessary for survival, a businessman would not be able to construct new premises, acquire new plant and machinery: nor could an individual purchase a new house, car, refrigerator or television. Responsible lenders will set criteria defining the acceptability of borrowers. Responsible borrowers will only borrow if they are confident of their ability to repay.

Once a borrower has borrowed his maximum, he must withdraw from the market-place until he has repaid sufficient to qualify again as a borrower. This can take some time. In the case of a business, new construction or completion of productive capacity must first be completed, and then the business must sell sufficient of its products for it to set aside enough units of money to both survive and repay the loan.

At the same time, the money which was borrowed would have been returned as deposits to the banking system by those who received it in exchanges. The bulk of the money would therefore be available almost immediately to potential borrowers. So, the rate at which money-lenders can satisfy borrowing capacity is in excess of the rate at which individuals or businesses can repay their loans and return to the market-place as borrowers.

In time, the numbers of acceptable borrowers who are willing to borrow must diminish as the borrowing market becomes saturated. At this point, those borrowers who are acceptable to the lenders will either have borrowed to their capacity and will be busy earning money to meet interest payments and principal repayments or they will be unwilling to borrow.

Therefore, the level of borrowing to expand production capacity will diminish. The sales of those who supply the goods and services used to expand that productive capacity must also diminish. It follows that the amount of those goods and services produced and the number of individuals required for their production will also be reduced.

With unemployment climbing and sales declining, fewer individuals or businesses will be capable of setting aside units of money for exchanges which are not essential in terms of simple survival, meeting interest costs and capital repayments or are production related, and even fewer products and services will be required.

Some businesses will then be unable to set aside sufficient to meet all of their essential requirements (payroll, suppliers, interest, or loan repayments), and corporate bankruptcies will ensue. More individuals will lose their jobs and the market demand for products will shrink still further. Thus a major economic contraction begins.

A fall in demand or an excessive productive capacity in some specific business or industry is not sufficient to cause a major contraction. Even during a period of booming economic expansion, markets change and some products and services go out of favour or are replaced by technological advancement.

No, a major economic contraction stems from an excess of lending by the banking system as a whole. It will reflect the saturation of the total borrowing market for a particular banking system and will therefore encompass the entire market-place which that banking system services. Demand in general will fall because few will be in the position to borrow and spend. Of course, there will be exceptions and some businesses will thrive and expand (accountants specialising in bankruptcy, for instance), but the bulk of the ripples will reflect negative demand.

The rate at which a negative ripple can move or grow, is much more rapid than that at which an expansionary ripple can move or grow. An expansionary ripple moves at the rate required to construct new productive capacity. A contraction, a negative ripple, requires no more time than is necessary to decide to cease using existing productive capacity.

So economic and business cycles are one of the results of having superimposed the mechanism of money-lending onto the system for storing and distributing money. As we have seen earlier, other effects are:

1. Inflation
2. The destruction of the role of money as a unit of measurement of exchange value.
3. The destruction of the role of money as a store of value for future exchanges.
4. The redistribution of purchasing power and thus of wealth from savers to borrowers.
5. The impoverishment of those on fixed income.
6. The rewarding of dishonest behaviour and the penalising of honest behaviour.
7. Social distrust and divisiveness.

There cannot be any doubt that allowing this superimposition to occur and to be institutionalised has been a major error. It cannot be allowed to continue. The serious question to which we must now address ourselves is: How best can we remove it?

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