The money paradox

Since starting to look into the nature of our monetary system, there is one particular argument I have heard played out time and time again:

On one side we have: “Banks can create money out of nothing. They do not need to have somebody’s savings in hand in order to make a loan”.

On the other side we have: “Banking regulations dictate that banks are only allowed to lend out a fraction of their depositors money”.

These arguments appear irreconcilable. So who is right? And how could there have been any doubt?

The reason the argument rages so often is that they are both right. The reason for this is quite subtle and not discussed at all in standard economics textbooks.

People will point out that banks can only lend out a fraction (albeit a large fraction) of money they are looking after from their depositors. And they may have to pay interest to those depositors whose money they are lending. This way banks are seen as making money from the difference between the interest they pay to whoever they got the money from and the interest they charge to whoever they lend the money to.

They point out that banks are not allowed to lend out money they don't have.

This is where we have to examine things a bit more carefully. We need to consider how this is enforced: Let us consider those people at the bank who's job it is to make loans. Do you imagine that they have a hotline to some other person in bank that monitors how much money the bank has on deposit on a second by second basis? Can you imagine a situation where you go into a bank, discuss a loan and then the banker says “hang on, I have just heard that we used up all our funds twenty seconds ago, can you come back tomorrow?” Of course not, the system is managed on a much more approximate basis where the loans made and the deposits taken (or money borrowed from other banks) are monitored over some period of weeks. The regulations are only concerned with these long-term averages.

But this attention to averages opens up an opportunity for a leak in the system: what can now happen is that banks can lend out money they don't currently have and then in order to comply with regulations they can borrow the money from other banks at a later time. You may note however that the (created out of nothing) money lent out will end up being in another bank somewhere. Thus money can then be borrowed back by the bank that made the loan in the first place. This means that no previously existing money was required. The bank has created money out of nothing and borrowed it from a depositor!

To summarise: It is true that banks make money from the difference between what they have to pay in interest from wherever they get their money from and what they receive in interest from whoever they land money to - but because the order of events (borrow-then-lend vs. lend-then-borrow) can occur either way round, it is also true that banks can create money out of nothing.

The number of economists that are aware of this subtle phenomenon is tiny.

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Is interest repayable?

Some people, when presented information about how our monetary system works, become concerned about where the supply of money for interest payments could possibly come from. They say things like: “If the total size of the money supply was fixed then there is no possible source of money for paying interest.” This may be followed by: “So this proves that the money supply is forced to increase forever, otherwise borrowers could never pay the money back.” They suspect that a proportion of borrowers must on aggregate, by definition be unable to repay the interest. This view is very widespread and has been stated in numerous popular articles and videos on YouTube.

This view is however, mistaken. The key thing to note is that the interest paid does not simply accumulate at the bank. Nobody runs a business in order to just make a big pile of money to keep in a safe. The banks spend the money back into the economy through staff wages, running costs and dividend payments to shareholders. All these outflows of money will ultimately be spent on real goods and services produced by the rest of the economy. This flow of money is a source of money for the interest payments.

You can get an idea of what is going on by imagining an economy with a fixed money supply. The figure below shows a hypothetical flow of the money in the economy. The flow marked "trade" and is simply the money circulating back an forth between households and industry as people earn money and spend it on what has been produced in the factories.

In a steady state, the rate of flow of money being created as new loans (shown as "loans" in the diagram) will be equal to the rate of flow of money being paid back in principal repayments (i.e. before interest payments).

At the same time the loan interest payments are equal to the spending by banks (those staff wages, running costs and dividend payments to shareholders).

As you can see, the flows can balance. Nothing is broken, no new money needs to be added to pay the interest. The system can continue indefinitely.

A more realistic model of our monetary system has been simulated on computer by Professor Steve Keen of the University of Western Sydney. His simulations also show that there is no problem repaying interest, even if the money supply is constant.

The fact that there is no in-built mathematical paradox to avoid when paying back interest does not necessarily guarantee that all loans will be paid back; far from it. If someone borrows a large a sum on the basis that they expect healthy future income to repay the interest there is always scope for things to go wrong. They may lose their job, or they may become ill; perhaps their business plan was flawed and the product they are making proves unpopular. Any of these problems may lead to a situation where the loan repayments are larger than the borrower can ever reasonably pay back. This is possible even if the loan was interest free.

In conclusion we can now see that it is not essential for the money supply to grow in order for interest payments to be made on loans without defaults. There many problems caused by fractional reserve banking, some of them severe, but inherently unpayable interest is not one of them.

Contagion?... Armageddon?... Why?

Big companies go bust every now and then, and in the process some of their smaller suppliers may go bust too. But the cascade/wave of bankruptcies is usually pretty limited. In the run up to the company failure, you never hear politicians desperately trying to prop-up the company on the grounds that contagion is going to trash the world economy (though they may wish to prop up the company for other reasons). So why are politicians so frightened to let any major banks go under? Is there a difference between a bank failure and the failure of any other kind of business? The answer is yes, and the reason the situation is so precarious is down to our crazy and unstable monetary system.

Most people imagine that money works as a system of tokens (either paper or electronic) that get passed from person to person as trade is carried out. They imagine that the total amount of money would be constant, were it not for occasional money printing by governments. Indeed money could work this way should governments have chosen such a system (known as full reserve banking), but currently our monetary system works in a surprisingly different way.

Under the current system, money has a life cycle, it is continuously being created and destroyed. Money comes into existence when private banks make loans, and money disappears back out of existence when the loans are paid back (OK, I am simplifying here, but this is the gist of it). In order for the total amount of money in the economy to be held approximately constant, the rate of new money creation via loans needs to be approximately the same as the rate of money destruction through loan repayments. If there were a pause, or slowdown, in the rate of money creation, then there would naturally lead to a decline in the total money supply as existing loans were paid back.

A significant contraction in the money supply is a dismal prospect... A shrinking money supply makes the repayment of loans harder and is generally a horrible economic environment, as anyone who lived through the great depression would testify. So now we need to consider the following question:

Is there any reason why banks should suddenly be prevented from making new loans?

Sadly, and frighteningly, the answer is yes. It all boils down to the rules governing how much money banks are allowed to lend, the so called “Basel accords”. The rule makers decreed that banks should only be allowed to lend out, at most, a fixed multiple of the current value of their capital. The ratio of loans that are made, to the value of a bank's capital is known as the “capital adequacy ratio”. The system is all well and good so long as there are no sudden changes in the value of those assets… and herein lies the problem. Under certain circumstances, assets can lose value precipitously. One particularly awkward example is government bonds. The Basel committee decided that government bonds should be valued, for the purpose of assessing capital adequacy, as if there was zero chance of default. We shall see why this is dangerous in a moment…

Banks are deemed as bust when their capital adequacy falls below the prescribed limits. Currently, Greek government bonds are held by assorted banks as part of their capital and (according to the regulations) valued at 100% of their face value. If Greek bonds are defaulted on, then the banks that hold them as a significant part of their capital, are instantaneously bust. Any attempt to restart the bank - perhaps under new ownership, or government ownership, will involve a choice between using taxpayer’s money to make up the capital shortfall (which is becoming increasingly difficult for governments to do) or a shrinkage of the money supply by an amount far greater than the value of the bonds. For example of the capital adequacy ratio was 5%, then a default of 10 billion Euro would lead to a reduction in lending ability (and hence a shrinking money supply) of the bank, in the region of 200 billion. A smaller money supply makes loans generally harder to repay and increases the likelihood of further defaults, hence the contagion effect.

Government bonds are not the only form of capital tied up in the Armageddon scenario.. a shrinking money supply necessarily leads to a reduction in the price of assets in general (deflation), including share prices. So a bonds default may be the trigger but the cascade/wave can be carried on by falling prices of almost any asset.

The rules of our current monetary system directly leads to a multiplier effect on defaults. This is what makes defaults in the banking sector so different to the collapse of ordinary businesses. The Armageddon scenario is a cascade of loan defaults, each one leading to ever larger reductions in banks ability to make loans and hence each leading to further reductions in the money supply.

Another way of looking at this issue is to consider the better-known phenomena of monetary expansion, where a small increase in the value of a banks capital leads to a large increase in the amount of money a bank is allowed to lend out. All I am doing here is pointing out the corollary to this, i.e. a small amount of capital loss causes a large amount of money loss.

If we instead had a monetary system in which money was indeed simply tokens that got passed from person to person as trade was carried out (known as full reserve banking), then there would be no default-multiplier-effect, no contagion and no Armageddon scenario. I think its time to move to full reserve banking.
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Just one question...

"You always remember that moment, if you've done it, when you get that key and you walk into your first flat, it's a magic moment. It's a moment I want everyone in this country to have, not just better-off people."

My question to David Cameron is this: If everyone was to get mortagages to buy houses... who would they be borrowing from?

How can demand be less than supply?

There are some economists who believe that total demand in an economy must equal its total supply. The argument goes something like this: When people sell their produce, they must, almost by definition, receive enough money to buy the equivalent value of other peoples goods. Or to put it another way, the sum total of what people earn from producing their stuff, must be enough to purchase the sum total of all the stuff produced in the economy. So the idea of a lack of demand being a cause of unemployment is seen as nonsensical.

The obvious potential flaw in this argument is that people may choose not to spend all of the money they just earned from selling their produce. The counter argument to this though, is that if people choose not to spend a portion of their earnings they must instead save it. But savings are simply used by banks for investment. Savings can therefore be seen as simply spending on investment projects like building new factories or buying new machinery. Thus saving is simply spending on different types of produce. New plant and machinery are still the fruits of people’s labour and so can provide just as much employment as any other type of produce. This is an argument often used by economists from the Austrian school. I shall be returning to this point later, so I will summarise it as follows:

The Austrian argument…
All earnings must be spent on something, even if that spending is in the form of investing in new plant and machinery.

So if the Austrians are right, there is no way for demand to be less than supply.

Another argument in favour of demand keeping up with supply is that it if weren’t true, there would be huge amounts of unsold goods building up continuously. There would be mountains of the stuff!

A clash of ideas: The idea that demand must equal supply clashes with the notion of the “paradox of thrift” whereby attempts by too many people simultaneously saving, leads to a lack of demand and a downward spiral of recession and unemployment. This idea was popularised by Keynes though it seems it was known of since antiquity.

So who is right, the Austrians or Keynes? The answer is undoubtedly Keynes. There are in fact two separate mechanisms that can lead to a shortfall of demand:

Mechanism 1. A falling money supply: Not many people are aware of the fact that the money supply can fall as well as rise but it most certainly can. This is because our monetary system was designed such that most money has a certain lifecycle. It comes into existence when banks make a loan, and it expires back out of existence when the principal is paid back. During depressions the desire to take out new loans (creating money) falls below the rate at which existing loans are paid back (destroying money). This state of affairs can go on for years, even decades. During the great depression, the money supply in the US fell by around a third.

The fact that there may be a small net expiration of money interferes with the “Austrian argument” made earlier. In a falling money supply environment, not all earnings will be spent on something. A small net flow of earnings will be given back as loan principal repayments where the money will expire out of existence. This is where things get a little more complicated. The thing is, if everyone adjusted their prices downward perfectly in step with the falling money supply, then demand could once again be matched to supply. Unfortunately, the economy is not quite capable of coordinating a fall in prices without some companies getting into trouble. The problem is that the fall in demand will inevitably be uneven and nobody will want to lower their prices unless they get a clear and sustained signal that they need to do so. You never see a restaurant adjusting its prices up and down a few percentage points depending on the previous night’s demand and you would never see an arrangement where a shopkeeper could have his rent reduced by 2% because the takings over the previous week had been below par. Both of these mechanisms can occur to some degree, but it is not quite slick enough to occur without some companies going bust in the process.

At this point we must address the question of why there aren’t piles of unsold goods building up in the process. Surely everything that is made has to be sold, so even if the money available in each round of selling is less than in the one before, prices must fall. Indeed this is true. Virtually everything will get sold, but a portion of them will be at newly distressed prices by people whose companies are in the process of being liquidated.

Mechanism 2. Purchasing non productive assets:

Another problem with the Austrian argument is the notion that savings must be spent on something that requires work to be done, like building a new factory. There are in fact many things that can be purchased as a form of savings that require almost no work to be produced. Land, traded gold, shares purchased on the secondary market. All sorts of financial products correspond either to work that was completed in the distant past, work that will be done at some point in the future, or even no work at all. An aggregate increase in the flow of spending on these types of product will naturally result in a fall in spending on products that require work to be done in the present. So even with a constant, or even rising money supply, there can be a fall in the money available for items that require current labour.

High unemployment for years to come?

Politicians everywhere are proclaiming that we must all reduce our debts and they acknowledge that this process may take many years. What they don’t seem to realise is that the money supply and our levels of indebtedness are almost one and the same thing. Under our current monetary system reducing debt necessarily means reducing the money supply. The employment outlook for the coming years is therefore rather bleak. This is on top of the unemployment that will necessarily come through public sector cuts.

Is there any way to repay debts without the money supply falling?

In a word yes. You may have noticed that earlier on I said “most money has a certain lifecycle”, this is because there is a small fraction of the money supply that does not expire. So called debt free money. Our monetary system can work perfectly well with either type. If new debt free money is injected into the system at the same rate or faster than there is net debt-money expiry, then the money supply can be held constant even as loans are repaid. Unfortunately EU regulations currently forbid the creation of additional debt free money... but in the current environment we may need radical solutions. It is time to change the regulations.

Central banks are attempting to stop the money supply falling...

I have been telling everyone that would listen that the problem we have been facing for the past few years is a falling money supply. The so called "credit crunch" is in fact, a "money crunch". Frustratingly, over the past four years I have not heard a single person in the mainstream media concur with this fact... until now. On the 25th October, the Governor of the Bank of England, Mervyn King said

"What we were doing was injecting money into the economy and what the banking system has been doing is destroying money".
"What we were doing was to partially offset what would otherwise been an even bigger contraction."

http://www.bbc.co.uk/news/business-15446545

Book review

I was excited to see a very nice review of my book has just appeared on the renegade economist website. Take a look.