The debt-interest system of money creation
This section attempts to explain the cycle of lending, and how the profits from lending cause the banks to be able to lend even more.
Discussion of the way money is created is endlessly confused and confusing, partly because of the terminology used, and partly because what is happening is so surreal. This page attempts to address the problem graphically with reference to the diagram below, in the hope that visualisation will aid comprehension. I am not an economist, thank god, but an average intelligent person who has made huge efforts recently to get my head around the problem.
Start at the top. There are 2 players, the borrower and the bank (or other lending institution). The borrower asks for a loan, the bank officer decides the borrower is a safe bet, and provides the loan.
This is where things get confusing. People naturally assume that in the act of making the loan, the bank draws on a like sum from the bank's reserves. There is indeed a ledger entry in the lending branch's accounts. But the bank itself makes the loan on the basis of faith and confidence: confidence that the lender will honour the debt to the full, and faith that not all the bank's depositors will want to withdraw all their money at the same time.
The loan from the bank has a dual nature: it is both an asset (in the sense that it is believed that the loan will be paid with interest), and a liability (in the sense that loan might not be paid).
Confused? Doubtful? Read this reassessment of a bank's asset sheet.
The key thing is that the bank's loan is not drawn from the bank's reserves as such. The relation of the loan to reserves is via a multiplier, called the Fractional Reserve (FR). With a 10% FR the bank can lend out 90% of what it holds, and must hold 10% in reserve for reasons of bank security. In fact in the UK this reserve has been abandoned in favour of a voluntary code called "capital adequacy", leaving prudence (which in the case of Northern Rock was in short supply) as the only limit to lending, with the effect that FR in operation now in the UK is 3%: that is, for every £3 capital held by a UK bank, it can lend out £100.
(Use the Comments button at the foot of this page if you want to question this)
The loan creates a credit that appears in the borrower's account, and an equal and opposite debit that appears in the banks accounts. These values have a dual nature: to the borrower his loan is both an asset that he can use and also a liability to be paid off; to the bank it is an asset (in the expectation that it will be paid off with interest) and also a liability, in that the borrower might default.
The borrower can now spend her money into general circulation, perhaps buying machinery to increase the productivity of her business. All the time she works she is paying off her loan, first the interest, and finally the principal - that is, the sum she borrowed in the first place. When that happens, the loan (debt on the bank side) is written off the banks books, so the bank loses the both the liability (no more risk of default) and the asset (no more interest payments). The banks loan books have reverted to where they were before, except that the bank's assets have increased from the interest payments.
This process can be dynamically repeated by a multiplier, explained here.
Meanwhile, the man who sold the machinery to the borrower has made a profit, and he may be able to put some of this in the bank as savings. So from interest repayments and savings, the bank's assets and reserves increase, leaving the bank in a position to lend out even more money.
Note that the bank makes more money from lending than providing a safe deposit for savings. See what happened to Egg customers. It has to pay interest out to the saver (although it uses the increased reserves from the savings to boost its lending), whereas a borrower pays a higher rate of interest.
This analysis predicts that (a) the money supply and (b) the debt in the world economy will be increasing. The money supply graphs bear this out. (I saw a graph once showing that the world's money supply is increasing by between 4% for established economies and 16% for emerging economies - Unfortunately the graph has been lost).
UK M4 has a doubling rate of 8 years up to 2007.
Debt is ubiquitous and also increasing. All but five of the world's nations have | significant foreign (external) debt, which is the total debt owed to agencies and people sited abroad. The UK has debts equivalent to 4 years' worth of GDP. Our debt in 2006 was $11,5000,000,000,000. Each of us owes $190,000. We are the second biggest debtor (behind the USA) and ranked 4th biggest debtors on a per capita basis, behind Ireland, Monaco and the Democratic Republic of the Congo.
It is amazing that only five countries have no foreign debt. If debts were owed from country to country, it would be expected that debtors and creditor countries would be divided roughly equally. Since this is not so, it is reasonable to assume that the debtis owed to private individuals and corporations,
The economist Margit Kennedy quotes a German study showing that interest on borrowed money represented around 30-50 percent of the prices of all goods and services, depending on whether you owned your own house without a mortgage or not, as housing is such a big factor.
This system is unsustainable (no doubling series can be sustained) and is one of the drivers for economic growth.
It has evolved from a system where the government used to create the money supply (see feature=related this video to understand the evolution of banking).
The creation of money by interest bearing loans is one of the factors behind the economic divergence between rich and poor. The rich have surplus money, so they can lend it to banks or stock markets, becoming richer (unless the stock markets crash). The poor have no money, and so have to borrow - if they can - and become poorer since they have to pay the interest.
The economist Hyman Minsky argues that the financial system is inherently unstable. This is not surprising, given that it is a house of cards built on confidence /faith/belief that everyone continues to believe in the system, and that debtors will continue to repay their debts. The minute that conference disappears, the whold house of cards comes crashing down.
There are alternatives available, in which the Government itself issues money into the economy by funding beneficial projects (for example, renewable energy generators). This solution always raises the fear of hyperinflation, but this does not have to be the case if the government is careful not to inject too much money.
Private lending versus Government lending.
"If the interest rate was zero there would be no private loans because there would be no incentive for them to lend".
This lies at the heart of our remedy for the financial crisis.
Private financial corporations, acting for the profit of their shareholders in an effectively free (that is, unregulated, or as we should rather put it, "unguided") market would not lend if there there was no incentive. Interest is what gives private financial corporations the incentive to lend.
It is a different matter entirely if the Government is the agency that lends
the money. Government is a non-profit organisation. It exists to bring about
conditions that create a secure and happy[comfortable] existence for all the
people living within its borders, including future generations. At least, that is what green government is about. In reality, Government aims are is pretty obscure, and corrupted be vested interests.
So if Government, after taking the best advice, decides, for instance, that an offshore wind farm linked to a low-voltage grid would help to secure energy supplies in the UK. and would in other ways benefit the planet as a whole, it would issue low- or zero- interest loans to the wind turbine construction companies &c. Those companies would then be able to buy supplies and labour with that loan money, and would in time deliver the goods. The product (electricity) would be cheaper than that from privately financed companies, because they would have had to pay off the loan interest to the private finance corporations. The cost of private loans add to the construction companies' costs, which they would pass on to the consumer.
So the sentence above, to be accurate, should be amended to read "If the
interest rate was zero there would no incentive for private corporations to
lend, although Government would be able to lend to projects that benefit
society and / or environment".
Government the guarantor
In the end, the people, through governments who are their servants, are the ultimate guarantors of financial stability. The recent privatisations of Northern Rock, Fannie Mae, Freddy Mac and AIG are illustrations of this point.
When financial institutions fail, they come to Government for a bail out, arguing that they are "too big to fail" - the repercussions would have a domino effect, bringing down the whole financial system.
Since Governments are the ultimate guarantor of financial security, why should they have to borrow money from the banks, at interest, if, say, they need billions to invest in big renewable energy projects? Investments must be wise if they are to succeed. What could be wiser than to ensure our energy security and protect against climate change by providing money to build Concentrated Solar Power installations in the desert?
References
Magrit Kennedy on financial stability
