THERE is a fundamental flaw at the heart of our economic system, one that makes the system simultaneously unstable and prone to cyclical recession whilst also distributing wealth unevenly thus damaging economic growth and encouraging economic exclusion.
Ninety seven per cent of all money circulating in the economy is created not by the Government but by private banks through loans. Banks don’t lend the money they have on deposit (there isn’t enough of it) they effectively create money out of thin air in order to meet the lending demand and when you pay the loan back they delete the money they created to lend you, but keep the interest as profits. Given that banks can charge interest on money they don’t actually have it follows that the more money they create in the form of loans the more interest they get paid and the more profit they can make. The system therefore encourages banks to lend at levels that are unsustainable, allowing people to consume more causing inflation and to out-bid one another for houses, causing property bubbles and inevitable crashes. Every so often the market realises that lending has reached an unsustainable level and the banks panic, stop lending and the boom-and-bust cycle goes around one more time.
Money is a socio-economic construct, a complex IOU system that we believe in because it is convenient to do so. Bank notes are nothing more than IOUs and money transferred electronically and agreed as debts, such as mortgages, don’t really exist either, it’s just an electronic promissory note from an organisation which doesn’t actually have that money. Have you ever wondered why your £10 note states that “The bank promises to pay the bearer on demand ten pounds sterling at their head office”. In the late 80s I walked into the HQ of the Bank of Scotland, handed over a £10 note and demanded sterling to see what would happen, the lady behind the desk smiled sweetly and turned to her colleague and said: “We have another first-year economics student here”. If money doesn’t actually exist outside of a statement of trust then the big questions this raises are why do we trust banks? Indeed why do we trust in money? And what would happen if only governments were able to create new money?
The boom-and-bust cycle is a horrendous problem and can cause significant stress and hardship for those that lose jobs and their homes when the busts come. It is often argued that many of the world’s most successful companies were founded in the teeth of recession and took advantage of choppy waters to introduce new business models and cost, saving technologies but that doesn’t make the boom-and-bust cycle necessary, just an opportunity for a few. Making the claim that they could “end boom and bust”, Gordon Brown and Alistair Darling decided to de-regulate much of the financial sector allowing banks to lend more freely and to create more money from loans. This, as we all now know, led to a bigger, longer boom as people were able to easily access personal credit and then, not unsurprisingly, to a bigger, longer bust. This mistake by Brown and Darling may be viewed in generations to come as the biggest UK regulatory mistake of all time. This bigger, longer bust means that we may not have completed the required recovery before the next natural bust or major housing bubble burst and if the London housing bubble reaches critical mass in 2017, as I have previously warned, then there just won’t be any way out.
Following the crash the need to inject confidence back into the banking sector meant that governments all over the world had to borrow to bail out the banks and create massive interest charges on the government. A crucial element of the refinancing measures was the use of quantitative easing which is often described as printing new money but actually just means issuing government bonds, mainly to pension funds, to increase the money in circulation, in the hope that it will have a knock-on effect of increasing bank lending. However, there is a huge flaw in QE. Using QE to buy gilts meant that government interest payments on debt fell, the banks became more solvent, and stock market prices were forced upwards – all good. However, increased asset prices boosted the wealth for private owners of assets with the top five per cent of households holding 40 per cent of assets, increasing inequality – a major cause of economic instability.
So the fact that privately owned banks are allowed to almost magically create money in the form of deposits every time they arrange a loan, that they are not just limited to lending their reserves, means that the system encourages unsustainable “stupid lending”. Add to that the fact that they are guaranteed to be saved from failure by the tax-payer and that the government’s main way of creating new money in a crisis increases the net wealth of the rich means that the system not only creates cyclical recessions, it encourages the distribution of wealth from the poor to the rich. This makes many people economically inactive and dependent on credit, slowing economic growth and trapping people in debt.
The economic system is broken: not just taking a dip or struggling to recover, the fundamental flaw is now a crack that can’t be papered over and major reform is needed now. There are two ways to respond. We can tighten regulation, separate casino banking divisions from high-street deposit operations, curb bonuses and increase the link between loan book and reserves – pretty much the very least that can be done, though these mini-reforms won’t solve the bigger problem.
But if we really want to make a difference, we have to start gradually moving towards creating a state monopoly on money creation. If the state creates all money on behalf of the people then banks can lend money that they have on deposit, and charge a fee for managing people’s money.
The banks can also profit from stock market investments that are lower risk and longer term and therefore more beneficial to building long-term business growth and employment. Government spending could be higher without costing billions a year in interest, it would significantly reduce business cycles, stabilise the economy, massively reduce government debt, make quantitative easing for the people a highly effective economic stimulus tool, make a basic income paid to all more affordable and, basically, democratise the finance system.
Why do we need such radical change? Well – if there is another major shock soon it won’t be a bust before the boom, it will hit more like a thousand-year storm. If we haven’t restructured our economy from the outdated 170-year-old banking system that we use… we won’t be ready.