John Tomlinson

A Challenge to Banking

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SECTION ONE - Dishonest Money

The Hourglass Is Emptying

Is Western society running out of time? Can we afford to ignore the warnings? One economic crisis seems to follow another; each downturn seems to plunge the Western world into a deeper recession. We have had the Third World debt crisis, the collapse of the US savings and loan associations, two UK property crises, the Japanese stock market has collapsed, the international exchange value of both the dollar and the pound have fallen dramatically, the ERM is under immense strain, German re-unification is undermining the strength of the Deutschmark, and we have had three major economic downturns - culminating in the recession of the early 1990's, the worst since the depression of the 1930's. All of these have occurred since President Nixon closed the "gold window" in 1971.

There can be little doubt that the imprudence of the banking community has played a major role in each. These crises may now be signalling to us that the international banking system has already expanded the world's money supply to its point of imprudence. With no international lender of last resort, collapse of the world monetary system must be a strong possibility. Indeed, the establishment of the Bank for International Settlements as a "World Central Bank" has already been mooted. Yet the establishment of an international Central Bank can only temporarily avoid the eventual collapse of our existing paper money system. It could bail out existing central banks which have difficulties. They could in turn bail out existing commercial banks which have been imprudent. But, we've seen all of this before. That's how Central Banks came into existence in the first place.

In the early days of banking, when depositors began to worry about the security of their deposits in a particular private commercial bank and all arrived simultaneously to withdraw them, because the bank had built its business on the back of misrepresentation there was not sufficient money available to repay every depositor. Either some depositors would lose all of their deposits or all depositors would lose some of their deposits.

This, in turn, would raise questions in the minds of depositors in other private commercial banks and would often pose a threat to the survival of all banks and their deposits. It was under these circumstances, where the interests of both banker and depositor coincided, that Central Banks were born. Under pressure from both depositor and banker alike, governments established Central Banks as lenders of last resort. The newly created Central Bank could then provide funds to meet withdrawals where commercial bankers could not otherwise meet them. Thus, the existence of Central Banks ensured the continuity of both the customers' deposits and the commercial banks.

Herein lies the problem. By providing a safety net to bankers whose misrepresentation had reached its point of imprudence, Central Banks allowed the misrepresentation to continue and gave it legitimacy. What we now face is the result of allowing this behaviour to continue: imprudence on a massive scale by governments, Central Banks themselves and the commercial banking system as a whole.

The establishment of a "World Central Bank" can only prolong the agony. It will license the continued imprudence of governments, central banks, and commercial banks. Each will then be free to continue its habitual misrepresentation until a new point of imprudence is reached. Following that, there can be no higher level upon which to create a lender of last resort. There will be no further way of underpinning the world's monetary system. Eventually any system based on misrepresentation must collapse.

Individual governments are pursuing a relentless path of economic expansion, without heed to the consequences. From their perspective, it appears that the only way out of a contraction is to create an expansion: to change the negative ripples for positive ones. But the changes required to create an expansion weaken the system.

In the course of a contraction, those borrowers who can survive the decreased volume of exchanges and still set aside sufficient units of money to repay their debts will do so. Their repayments will help to strengthen the position of the surviving banks. When the banks have received sufficient units of money through repayments and new deposits, they may feel confident once again to begin to expand their lending activities. But many borrowers who have proven their worthiness by repaying their loans will have no need to borrow to expand existing productive capacity. Excess productive capacity will still exist in most industries. Thus the bankers' natural drive for expansion will be frustrated.

To continue to expand its lending business, the banking community has historically had to look beyond its list of previously acceptable borrowers. Criteria were adjusted so that the borrowing market could be expanded to embrace a larger proportion of the population. This has required a lowering of standards of credit worthiness, weakening the assets against which depositors' money has been secured. Emphasis has shifted from the financing of productive capacity to the financing of consumption. These changes in criteria have allowed the banking system to increase its overall lending. Increased lending means increased interest earned: means increased profitability: means increased inflation.

Yet it is this propensity which leads to a repetition of both business and economic cycles. As lending is expanded, the number of ripples which provide benefits will increase, and, in due course, a general expansion of the economy will once again begin. The difference between a business and an economic cycle merely relates to the extent of the market-place affected. At the root of both is the money lending activity of the banking system.

Each general expansion has been followed by a general contraction. The duration of each general contraction has been determined by the length of time required for the banking system to re-build its reserves through the receipt of debt repayments. When their reserves have become sufficiently strong for them once again to begin seriously to expand their lending activities, historically they have often had to look to a wider market of acceptable borrowers. Even here the hourglass is emptying: there is little room for expansion.

Initially the privilege of borrowing was restricted to the wealthy, to those individuals who possessed assets whose value far exceeded the amount borrowed or who possessed sufficient power to command the money with which to repay a loan. Property owners, merchants, industrialists, kings, princes and governments could borrow. Today it is not even necessary to have assets. Tomorrow's pay - unearned units of money of unknown future value - is now acceptable as collateral. Thus the borrowing market has been expanded from yesterday's rich and powerful to embrace today the most humble of society's working men and women.

Certainly in the Western industrial countries it is difficult to envisage an expansion of the borrowing market so as to embrace more individuals. But where is the market beyond the West? It is unlikely that the wage levels in non-industrial nations would allow their wage earners sufficient borrowing capacity to fuel a significant expansion of the lending activities of the Western banking system. Over the course of history, long-term contracts have kept the real prices paid to many less developed countries for raw materials at a low level. Witness the combined effects of long-term contracts and inflation on the purchasing power received per barrel of oil by the National Iranian Oil Company. It was not until the major oil producers in the world united to form a cartel that they held sufficient power to raise the price of oil and redress their losses. Few other producers of the raw materials required to fuel the manufacturing processes and standard of living of the Western industrial nations have been able to unite to form such cartels.

During this same period, wage and price levels in the industrialised countries have increased substantially. So, too, has the cost of finance and the cost of plant and equipment. The net result is that, in the West, raw materials now often represent an unrealistically small portion of the cost of production.

In addition, many of the principal producers of these natural resources, whether they are mines producing ores or large farms producing foodstuffs, are also the principal employer in their local economy. This leaves them in the position to maintain downward pressure on the level of wages that they pay to the local work force. In one province of the Dominican Republic, for instance, there is one principal bauxite mine and little else to provide employment. There is thus little competition for local employment to provide a balancing upward pressure. The same can be said of many of the mines in Africa and of much of the sugar-cane production in the Caribbean or Central America.

Wage earners of less developed countries have, therefore, not been able to command a high level of wages and earnings are substantially lower than in the industrial West. Expanding the borrowing market to include the working people of the less developed countries cannot produce a consumer-led boom of any consequence in the industrialised nations.

On the other hand, an expansion of the borrowing market in these countries can lead to economic growth in their own markets. This is what is happening in the Pacific basin. Korea, Taiwan, Singapore and Malaysia have booming economies. China is following closely. Industries in these economies will compete with the industries of the West. They have their own expanding banking systems. In time they, too, will be unable to expand further.

Very real limits to the progressive march of expanding and contracting cycles do exist. These cycles can only continue until all existing borrowers and potential borrowers have borrowed to their maximum, thereby saturating the borrowing capacity of the entire world population. After that there can be no major expansion of the borrowing market. Any expansion which could follow would have to be a result of repayment of existing debt or expansion of world population. Neither can occur at a rate sufficient to fuel a new expansionary wave.

It could also happen that, before the borrowing market becomes totally saturated, total world productive capacity might so exceed that required to satisfy world demand that no one would seriously contemplate the construction of any new productive capacity. Without the construction of new productive capacity there will also be no major expansionary wave.

Yet expansion of the money supply is required to produce the new units of money necessary to meet withdrawals and maintain customer confidence. Without continuing expansion the banking system cannot survive. Without new lending the current banking system cannot expand. Without change the future of the Western monetary and banking system looks very bleak indeed.


SECTION TWO - Honest Money
Corrective proposals flow with impeccable logic from the analysis in Section 1, including a massive world-wide conversion of debt to equity.

The Requirements of Money
Before undertaking any change, it is vital that we have a clear picture of the requirements of sound money and a sound monetary system. Here we set out the goal that any change required must achieve.

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