John Tomlinson

A Challenge to Banking

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SECTION ONE - Dishonest Money

Paper Money

If we return to Mr Goldsmith and his new bank, and substitute a hundred dollars in paper money for the gold coin, the reason why there is no reality behind the current Western paper money system will unfold, and we shall discover why unless the system is altered, it will collapse. The same misrepresentation, two receipts against one deposit, will occur as it did when gold was the standard.

Accounting balance

Deposits: $200 Cash: $100
  Loans: $100
  $200   $200

Actual position

Receipts issued: $200 Stock in hand: $100

Yet it will not be as easy to see. Under the paper monetary system we are easily confused. The deposit looks just like the receipt. Each is usually merely a piece of paper with the number of units of money written on it. The logic of our former example, however, does also apply with paper money: although the bank's books will balance, the money supply will actually have doubled.

We are equally easily confused when trying to determine the value of current paper money. There is no real physically measurable substance behind a unit of paper money. Nor, when a loan is made, is there any real physically measurable substance or value behind any of the newly created units of money. Nor is there any real substance behind units which are deposited. They are not guaranteed to be exchangeable for any fixed amount of anything.

Their value comes from their being the only legal and valid medium of exchange. They are effectively a claim on everything and anything that is offered for sale in the market-place. The great difficulty is that both the amount of money and the volume and mix of the goods and services against which they can claim is continually changing. There is, therefore, little opportunity to measure accurately one against the other.

If the supply of units of money were fixed, when the demand for them increased, so too would their value; and as the demand for them decreased, their value would also decrease. There would be a minimum demand for units of money. It would represent the minimum volume of exchanges required for the population to survive. Thus, each unit of paper money would have a minimum exchange value.

Each would also have a maximum exchange value. It would represent the level of exchange value at which savers are motivated to withdraw their money from savings and use it to take advantage of its greater purchasing power. A withdrawal will then increase the volume of money used in exchanges, leading to a decrease in its exchange value.

Thus, it is possible to see how a fixed supply of paper money can lead to a range of exchange values between this minimum and maximum. In due course, the exchange value of a unit of money would begin to fluctuate more and more narrowly within this range, eventually leading to stability.

Unfortunately the money supply is not fixed. New units of money are virtually produced according to demand. Bankers create new units of money every time they create net new loans. They are in business exactly for this purpose. Their normal activity produces a continuing expansion of the money supply.

Governments are meant to control the money-creating activities of banks. Current controls, however, are not effective.

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Legal Reserves

A system within which each bank must hold a specified portion of its deposits in investments known as Legal Reserves has been one of the principle mechanisms by which governments have tried to control the money supply. Legal Reserves are promissory notes issued by borrowers deemed least likely to default. They are therefore the most saleable or convertible into cash in the event of an emergency.

Under this system, a bank is theoretically limited to creating new units of money in an amount equal to that of its excess Legal Reserves. If, for instance, a bank had deposits of £50,000 and the reserve requirements were 20 per cent, it would be required to hold a minimum of £10,000 in recognised Legal Reserve instruments. Suppose the bank actually held £15,000 in such investments. It would have another £5,000 which it would be permitted to advance as loans to its customers, thereby creating new demand deposits.

When we look at the banking system as a whole, we immediately expose a major weakness. The system can actually create a much larger amount than the amount of excess reserves.

Suppose, for instance, that all of the excess reserves in the system were lodged in one bank, Barclays perhaps, and that each of the other banks was willing to receive new deposits and to issue new loans to the limit of its reserves. If Barclays had the £5,000 excess referred to above, and it created new units by lending them to me, and I then spent them on one purchase at Harrods, and Harrods deposited them at the Midland, then the Midland would have a new deposit of £5,000. The Midland would then be required to invest £1,000 or 20 per cent in Legal Reserves. It would then have £4,000 in excess reserves and could lend £4,000 to one of its clients. Its client could spend it similarly, and Lloyds might then receive £4,000, invest £800 in Legal Reserves, and lend £3,200 to one of its clients. This process could continue until approximately £25,000 had been created.

Thus while an individual bank is limited to the amount of its excess reserves, the system as a whole can produce new units in multiples of the total excess reserves within it.

Nor is this limitation absolute. If we look closely at Legal Reserves, they are themselves loans. For instance, many types of government securities, including Treasury Notes, are considered Legal Reserves, and, in some cases, so are bank-endorsed bills. Treasury notes are receipts issued by the government for money loaned to it. The government uses the borrowed money to meet it obligations. Bank-endorsed bills are also loans and are used by the borrower to meet his obligations. In both cases the money is immediately back in circulation. It will be re-deposited and then it will be available to be loaned again. Reserve instruments are not a protection against misrepresentation. They are actually themselves part of the very misrepresentation they profess to be controlling.

The only limitation imposed by the use of a Legal Reserve system is the borrowing requirements of the issuers of reserve instruments. Where their appetite is insatiable there is no limitation at all.

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The production of money by Central Banks

Central banks produce new units of money via several mechanisms. The most obvious, of course, is the minting of new notes and coins. In most countries it is the Central Bank which is responsible for the mint. New notes and coins are produced either to replace old and worn or damaged ones, or to maintain sufficient cash in the system to service the needs of the daily transactions in the market-place. The need for cash varies from market-place to market-place. For instance, some companies still meet their payrolls using cash in small brown envelopes. Others use cheques. Some shops and businesses will accept credit cards or cheques. Others prefer cash. Each market will vary.

Nevertheless, in general, between 6 and 8 per cent of the total money supply needs to be in cash to keep the market-place functioning effectively. The rest can remain as entries on the books of banks, representing the deposits held in clients accounts. As the money-lending function of the banking system then expands the money supply, Central Banks are required to mint more and more cash just to keep this ratio.

Central Banks also put money into the market-place by what they call their "open market" activities. In these activities they buy and sell their government's debt instruments. If, for instance, a Central Bank buys government bonds or treasury certificates on the "open market", it is not providing cash to the government. It is providing cash to the former holder of the bond or certificate who will, presumably, then either spend it or invest it. Buying, thus, is intended to create more economic activity in the market-place.

Selling the certificates and bonds held, on the other hand, takes money from investors and, provided the Central Bank does not use that money for its own or government purposes, provided that the money simply remains unused within the Central Bank, the selling activity will reduce the amount of money available for investment and spending, thereby reducing the economic activity in the market-place.

From the perspective of the money supply itself, when the Central Bank has to create new units of money to purchase bonds or certificates, the money supply will expand. Otherwise its activities will simply shift the location of existing units of money from one place to another, enticing them into savings (removing them from the market-place by a time factor), or causing them to be withdrawn from savings and spent or invested.

Foreign exchange transactions can also result in the production of new units of money by Central Banks. To see how this happens, suppose we were back in the days, when Central Banks could claim on each others' gold. Following the agreement between international Central Banks at Bretton Woods in the early 1940's individuals were no longer able to claim gold with their paper money or use gold as a medium of exchange, but governments could. Under the Bretton Woods Agreement each currency had a fixed exchange rate with the dollar and the dollar was guaranteed to be exchangeable for 1/35th of an ounce of gold; or $35 per ounce.

To see how this works, suppose that General Motors in America wanted to buy Land Rover in England, before 1971. General Motors would want to use dollars, the English owners of Land Rover would want to hold pounds. The English sellers, if they accepted dollars, would exchange them for pounds at their bank. If the bank had customers who wanted dollars, it would then exchange the dollars for pounds. If the bank had no customers wanting dollars, it would look to the foreign exchange markets to exchange them for pounds. Failing that, it could exchange them for pounds at the Bank of England.

If the Bank of England had no pounds available to offer the commercial bank for the dollars, it would create them. The Bank of England would then take the dollars to New York to exchange them for gold. As a result it would receive an additional amount of gold into its reserves. So there would be no misrepresentation as a result of this transaction. In fact, the real money supply (the amount of gold itself) would have increased, decreasing the gap between the amount of gold required to satisfy all claims and the amount of gold actually held.

The position in America would be quite different. Once the dollars were returned to New York, the number of dollars in the American market-place would have returned to its previous level, but the amount of gold against which the dollars had been issued would have decreased by the amount given to the Bank of England in exchange for the returned dollars. So, in America, the gap between the amount of gold required to settle all claims and that actually available would have increased. Had General Motors borrowed the money at its bank, there would have been a double dose of the increase. New dollars would have been produced against existing levels of gold, and existing levels of gold would have been reduced by the amount transferred to the Bank of England.

The increase or decrease in the size of the gap occasioned by this transaction would be unlikely to have affected the exchange value of gold in either country. In each, the level of misrepresentation would already have been sufficiently vast to have pushed the exchange rate of gold to its minimum level.

So long as the exchange rate of gold itself did not change, and so long as both dollars and pounds were considered as valid claims against gold, then the domestic exchange value of dollars and pounds in their respective markets would also be unlikely to change. Therefore, under the gold system, or the dollar/gold system (following the Bretton Woods Agreement), prices would not have increased or decreased as a result of these foreign exchange transactions. Only the size of the respective gaps would have changed.

When President Nixon closed the gold window in 1971 a new era of the paper monetary system began. The importance of this change has not yet been widely recognised. Dollars can no longer be exchanged for a fixed amount of gold. Other currencies can no longer be exchanged for a fixed number of dollars. Each country's banking system will debase its currency at a different rate. There can be no fixed relationships. The floor beneath the value of the paper money has been removed. The value of each unit can now plumb untold depths.

The same transaction under the paper money system since 1971 will produce very different results in each country. As units of paper money are no longer freely exchangeable for gold by the issuer, the dollars cannot now be returned to America to be exchanged for gold. Instead they will be held by the Bank of England as reserves.

These dollars will be held either physically outside the United States, or on deposit with the Federal Reserve Bank in New York. They will be deposits set aside as a store of value for future use by the depositor. They will no longer be part of the US domestic money supply, but they will be part of the total US money supply. Being removed from their domestic market-place by a geographical factor, they will no longer have a direct affect on domestic US prices. But they will exist.

Their position will not be dissimilar to that of units of money removed from their domestic market-place by a time factor. A five-year deposit, for example, will play little part in the domestic market-place during its five-year term. The existence of such units of money is often effectively forgotten, only to become obvious when they mature and are redeposited as demand deposits. If inflation becomes so high that investors are unwilling to renew time deposits and will only redeposit funds as demand deposits, the money supply appears to increase dramatically. The apparent increase is false: money which had been removed by a time factor simply returns.

Similarly when units of money which have been removed from the market-place by a geographical factor return, the domestic money supply increases. But until they do return, the transaction between General Motors and the English sellers will have diminished the American money supply and reduced the amount of money available for exchanges unless, of course, the purchase was financed by a loan from General Motors' American bank.

If the purchase was financed by a loan, the new money created will have been exported. Previously existing units will not have been exported and thus the domestic money supply in the United States will remain unchanged.

In the meantime, back in England, the Bank of England will also have produced new units of money. They will have issued new pounds to exchange for the dollars received. So the British money supply will have increased.

Following Richard Nixon's decision to close the "gold window", the Bank of England is obliged to hold the dollars so acquired as reserves until market conditions change and they are needed to exchange for pounds. When they are exchanged for pounds, the pounds received in the exchange will not be destroyed. They will be used in accordance with the domestic money requirements of the Bank of England, and will remain a part of the British money supply. So the reduction in Bank of England reserves will not bring with it a commensurate reduction in the British money supply to compensate for the earlier production. The inflation produced by the foreign exchange transaction will remain in the British market-place.

When the dollars are returned to their domestic market-place, the American domestic money supply will increase and, where the transaction was financed by a loan, the inflation produced by the transaction will reach its ultimate objective: its own domestic market-place. In due course, all national currencies must return to their own domestic market-places. So the existing Eurodollar "mountain" can be seen as a continuing threat to the domestic exchange value of the dollar.

On the other hand, if market conditions were such that the dollars were required to finance a purchase in some other country, then those dollars would enter the Central Bank reserves of that other country. The money supply of the receiving country would then increase, and the inflationary effects of the transaction would be felt in yet another market-place.

Under the new paper money system, units of money removed from their domestic market-place can move from nation to nation, increasing each country's money supply en route, and leaving a continuous swell of inflation in their wake.

There are two primary dangers in this process. The one which we have already observed is the importation of inflation by the receiving nation. This can often be signalled when the reserves of a Central Bank increase. If these increases are due to the accumulation of foreign paper money, they might reflect foreign investment in the domestic market-place. If that is the case the domestic money supply will have increased proportionately, and it follows that the domestic purchasing power of that currency will, in due course, decrease.

The other, which is potentially more dangerous, is the ability of international banks and the international divisions of multinational banks to expand any nation's money supply. Consider, for example, Eurodollars: they are accepted as deposits and loaned with regularity by international bankers. These deposits and loans are unsupervised by any monetary authority. In this wider market-place there is no international Central Bank. So there is no lender of last resort, and no restrictions on the expansionary money-lending activities of these banks. The only practical limitation upon the productive capacity of these lending institutions are the willingness of borrowers to borrow, the credit worthiness of borrowers, and the prudence of international bankers.

Nor does the Exchange Rate Mechanism (ERM) stop inflation. It indexes a basket of individual currencies. Each individual currency will be being debased by its own banking system. Each will have no floor: have no level of depreciation beyond which it cannot go. The rate and extent to which each will be debased must, therefore, be different. The most that can be said for the ERM is that it is meant to synchronise the rate of debasement. It cannot stop it.

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Imprudent behaviour

If history is an accurate guide to the future, we can confidently expect to see the number of claims, receipts or units of money in the world expand to a point of imprudence. From an historic perspective, first individual banks expanded their receipts and claims to the point of imprudence. Bank failures were experienced and the term bankruptcy was coined. Central Banks were then established as lenders of last resort to bailout individual banks which had reached their point of imprudence. The effect was, by giving them a safety net, to license all commercial banks to expand their operations to their individual points of imprudence. Central Banks then allowed their national money supply to be expanded in multiples, until the international banking and monetary system as a whole reached its point of imprudence. This brought the collapse of the gold standard system.

It follows logically that the international banking community will now expand the world's paper money supply to its point of imprudence. Thus we must each ask ourselves some serious questions:

Will the entire system then collapse, destroying the savings and liquid assets of everyone, including our own?

Will the system's survival instinct produce yet another palliative which allows some parts of the banking system to survive and continue their current imprudent and destructive practises, while the remainder fails?

Will our savings and liquid assets be in the part that survives or the part that fails?

Would we not be wiser to take action now to correct the system and thus avoid the risk?

Economic and Business Cycles
"...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." How the use of interest rates to control the financial hardship and emotional suffering caused by dishonest money creates economic and business cycles.

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