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
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
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
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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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
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:
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
"Inflation is the result of the production
of new units of money. It has nothing to with the distribution
of existing ones." Why current solutions to the
problem of inflation are misguided and will not stop
or even reduce inflation.
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