A Challenge to Banking

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SECTION TWO - Honest Money

A Major Re-Think

To see how best to achieve the goal we set above, we will have to consider the legal framework within which money trades and is invested. It is most likely that any country wishing to have sound money will have to change existing legislation.

For instance, in most countries, contract and tax law have created a market-place where debt investment is given advantages that equity investment is not. If we look at the decisions individual investors have to make, we can see why.

People wishing to store money for future exchanges have several choices:

1. They can store it in a safe.
2. They can exchange it for some other commodity, product or property.
3. They can exchange it for whole or part of a business venture.
4. They can lend it.

Storing money has the disadvantage of cost. Safe and secure storage facilities are not free. Whether the investor rents space, or builds his own storage facilities, costs will be incurred. If the exchange value of money does not increase, then there is nothing against which to offset these costs, and the amount stored will be reduced by the cost of the storage. To reduce storage costs, less secure facilities might be an option. But this increases the risk of loss: a loss which could be total.

The saver can exchange his money for some other commodity, product or property which might increase in value more than money will over the period. But, there is a risk. Exchange is permanent. The value of any commodity, product or property could also fall. The saver might then incur a greater loss than he would have from paying for storing units of money. Products and commodities also have to be stored during the period of saving and properties have running and maintenance costs.

A permanent exchange is also involved in an equity investment. An equity investment is an exchange of units of money for a proprietorship, a partnership, a joint venture agreement or a shareholding in a company. The exchange is permanent. The investor will no longer have money. The investor will now own a bit of something. It can be called "wealth" but it will not be money.

A successful equity investment will mean that the exchange value of the equity will increase and that its portion of the profits generated will provide its owner with an income. There are genuine clear risks associated with any equity investments. Its value can fall as well as rise. A business, for instance, may not make a profit; it might fail. In which case its investors will not receive any income: worse still, they could lose their entire investment. But the risks are born only by the investors.

Lending is also a form of investment. It is only a temporary exchange and thus avoids the risks that accompany permanent exchange. By lending, investors merely give the use of their units of money to someone on a temporary basis. The exact amount loaned must be returned on a specific date. Debt agreements and claims on collateral are enforceable under the law. Lenders can use the law and the law-enforcement agencies to help them to collect their debts. The law-enforcement agencies are required to use their time and energy, paid for by the taxpayer, to help prevent lenders from losing either the amount of money loaned or the interest payments due on it.

If your home is repossessed, it is the servants of the courts who repossess it. If you are made bankrupt, it is the courts who make you bankrupt. So, taxpayers are required to spend their money in order for the lender not to lose his. Even when a court sends receivers into a business which has been made bankrupt, the costs of the receivers are paid for by the bankrupt business. If there is any equity remaining which might benefit the owners, it is out of these interests that the costs are first taken.

The existing legal arrangements are designed to protect lenders from losses associated with investments into which they have freely entered. The reality behind a failed loan, however, is that the lender has made an error of judgement in making the loan in the first place. His error can be seen as the same error that was made by the borrower. Both believed at the time the loan was agreed that it would be able to be met. If it cannot, both have made the same mistake. The law, however, treats one error rather differently than the other.

In fact, looking at the choices an investor has to make, an astonishing degree of legal bias is evident. Businesses do fail, for a variety of reasons: sometimes insufficient planning, sometimes insufficient capital; ineptitude, or even dishonest or dishonourable behaviour. An equity investor will have to bear the full responsibility for his own error in judgement: possibly facing total loss. The debt investor, on the other hand, has a substantial degree of protection: taxpayers place at the disposal of the lender the full support of police departments, bankruptcy courts and, in some cases, even prison services, to help the lender recover what he can of his investment.

The effect of this is to allow lenders to transfer what they can of their recovery costs to the taxpayer. Taxpayers, therefore, are required by law to waste their money in order to minimise the losses of lenders. Collective society gives to lenders a shield of protection which it denies to equity investors. Where debt finance is concerned, the risk is taken first by the borrower, second by the taxpayer and only then by the lender. Equity investors must bear the risks by themselves.

The discrimination in favour of debt investors actually goes much further. Governments, through tax laws, allow interest payments to lenders to be made from pre-tax profits, while insisting that dividend payments to equity investors can be paid only from those profits which remain after tax has been deducted. Therefore businesses must earn significantly more to give an equity investor the same return as a debt investor.

If, for instance, you loaned £100 to a business at 6 per cent interest, that business would have to earn £6 before taxes to pay your interest charges. Had you bought £100 worth of shares in the business, it would have had to pay taxes before it paid you a dividend. At a 33 per cent tax rate, the business would have had to earn £9 and pay £3 in taxes before it would have had £6 after taxes to pay you as a dividend.

As a result, investors find themselves positively encouraged to structure their investments so as to use the maximum amount of debt investment and the minimum amount of equity investment. In this manner they will pay less tax. On the other hand, by allowing this bias to continue, governments will receive less tax from the business community than they would otherwise and as a result individual taxpayers must shoulder a higher proportion of public expenses than they would otherwise.

Lenders have been granted special privileges under the law. What does the taxpayer get in return for granting these privileges? Lenders' actions debase our currencies producing inflation, they cause the business and economic cycles which lead to very high levels of unemployment and they produce the many other social and economic distortions which have been identified earlier in this work. Further, their interest charges are the fastest growing and the most significant section of the very government budgets to which ordinary taxpayers are being asked to support disproportionately.

It is time to level the playing-field. Why should taxpayers continue to spend their money in order to minimise lenders' losses? Haven't government budgets enough to do as it is? Why should lenders' income be subject to less tax than the income of other investors? Why should everyone else continue to put up with the divisive and destructive effects which follow in the wake of this fundamentally flawed money-lending mechanism?

We should insist that the law be changed so that money-lenders have to bear the full cost of their own errors in judgement, so that ordinary taxpayers will no longer be required to subsidise any portion of the recovery cost of lenders' errors in judgement and so that profits in general are all taxed on the same basis.

The statutes which protect money-lenders are the sinews which bind the money-lending function to the banking system. Without them banks could not lend with security. These laws can be changed so that all debts, like gambling debts are now, are declared unenforceable. Money-lenders would then have no more security than equity investors. They would not be able to lend depositors' funds with any degree of certain repayment.

Depositors would no longer continue to have confidence that banks which loaned money will be safe depositories for their cash or savings. Would you have confidence that your money would be safe if you put them in a bank which used them to make legally uncollectable loans? If something went wrong, how would you get your money back? Banks would have to cease their lending activities.

A money-lender would be totally dependent upon the integrity of the borrower for the return of his investment; an equity investor would have both the integrity of his associates and the ownership of his portion of any assets involved. Equity would suddenly become a more attractive option.

Existing statutes and taxation policy can be changed: where tax advantages and debt-collection support are provided for lenders, governments can alter policies and statutes can be amended or removed from the statute books. These changes will not prohibit money-lending as a form of investment. Individuals will still be free to lend money if they wished. They will simply have to bear the risks themselves.

Changing the law would simply be an open declaration that society is no longer prepared to protect moneylenders from their own errors of judgement. Taxpayers would no longer pay for the errors in judgement of money-lenders. Court, bailiff and police time could be freed for more useful purpose. It would add loan debts to the position already occupied by gambling debts. They will not be legally enforceable. Illegal methods of debt collection will not be tolerated for loan debts any more than they are for gambling debts. Lack of security would then bring about the demise of money-lending as the standard method of finance.

Credit would certainly continue. If credit worthiness is already established, credit arrangements will be likely to continue. Producers will still need to produce and sell their products. If you were running your own business, manufacturing widgets for example, and this change in the law came into existence, you would be bound to review all your customers and their credit facilities. You may well continue to issue credit to those whom you knew to be people of integrity and who paid your invoices promptly. Others will cause you to consider carefully the risk involved with issuing them further credit facilities.

You will have to decide, in each case, between the benefits of various levels of production of widgets, the size of the order and the likelihood of not being paid. No doubt you would end up with some customers of whose integrity you were fully confident and others of whose integrity you were less confident but whom you believed for one reason or another would be most likely to pay. The degree of risk would be tempered by both the need to stay a profitable business through maintaining a minimum level of production and by the amount of profits generated at various levels of production.

This need to stay in business will ensure the continuation of consumer trade and credit. But the risks involved will be taken only by the individuals and businesses offering the credit. That is not the case today. Today, banks provide the credit and, in doing so, produce the inflation which steals purchasing power from each unit of money and puts at risk savers and those on fixed income.

Those who issue credit will have recourse only to the integrity of the individuals involved, regardless of their financial strength. Without knowledge of the integrity of those with whom one is dealing, few would risk their cash or savings. Today, the personal integrity of those to whom credit is issued is often of less importance than the ability of those who issue credit to enforce the terms of their agreements under the law. Without recourse to the law there will be a growing and ongoing demand for personal integrity. Human behaviour will have to change.

The above proposed changes in the law can be approached in one of two ways:

1. Existing debt can be allowed to continue under the current framework, so that only debts incurred after a specific date would become legally unenforceable.
2. All debt can be made immediately legally uncollectable.

If the second option is chosen, the changes in the law must also simultaneously convert all existing debt to equity - except in those instances where both parties agree to continue the investment in the form of a debt.

Any changes made must provide just and equitable treatment for both existing lenders and existing borrowers. There will always be unscrupulous borrowers who, given the opportunity, will simply refuse to repay their debts. At a minimum, each existing debt investment will have to be converted to some proportion of the ownership of the venture in which it was invested.

Banks would thus receive shares in the businesses to which they had loaned money. Conversely, to the extent to which banks had insufficient cash to match deposits, each depositor would receive shares in his particular bank.

The simultaneous action of repealing the laws which protect money-lenders and converting debt to equity can benefit society in the following ways:

1. It will stop the production of new units of money by the banking system. This can bring inflation to a complete halt, and it will stop the leakage of exchange value from existing units of money. Savings and frugality can then, once more, be encouraged.

2. It will convert to shares many units of money which have been removed from their domestic market-place either by a time or a geographical factor. This will preclude their re-entry into the domestic money supply and the consequent reduction in exchange value of the units already there.

3. It will stop the re-distribution of exchange value by the banking system. Purchasing power would no longer be removed from depositors and transferred to borrowers. Removal of this re-distributive mechanism will reduce the need for a taxation system designed to re-distribute it once again.

4. It will help to re-establish the merit of a venture itself as the principal factor in investment decisions. Historically, banks have only tended to lend to those with acceptable collateral. Those whose ideas and projects have merit but who have no acceptable collateral, have often found raising capital difficult. For equity investments, the investor's security rests solely in the success of the venture itself: equality of opportunity based on merit would suddenly become a reality.

None of this will happen by wishful thinking. Legislation will be required. Following legislation, a considerable period of adjustment will ensue before stabilisation occurs. Nor will the passage to a healthier economy be an easy one. The Western economies are currently desperately ill. Palliatives have been tried and they have failed. They now need major surgery and time to heal. In our final two chapters, we therefore look at the nature of the surgery involved, the necessary steps to heal the system, and the benefits that can result.

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