The modern banking system evolved from private lending in Europe during medieval times and gradually took over the role of creating money in the economic system. The modern banking system creates money; it doesn’t lend saving deposits to borrowers as commonly perceived. The banking system creates new deposits, which is money, from thin air with new loans (click for Bank of England publication). This is the only way money is created in the modern economic system. The banking system creates money, not the government treasury.
When banks give loan they create a deposit to borrower from nothing and when the borrower repays the loan the deposit cease to exist. The money brought into existence by banks in the economy as loans exists in circulation as long as it is not paid off. If the only way banks create money is through loans and if they are paid off, then there should be no net increase in the quantity of money in the economic system. There is indeed no net money in the system; money in the system is created as debit and credit at the moment of lending by banks and when the loans are paid off both credit and debit disappear.
Questions arise about the common perception of increase in money supply with economic growth and why there is inflation. This perception is caused by one big loan that can never be paid off; the debt accrued by government through loans from the system to fill the fiscal deficit. Since government can never pay the entire debt with interest and it continuously grows, money supply in the system outside government increases over time.
The economy with modern banking can never grow without government debt. This can be illustrated by a model of an ideal government that doesn’t borrow and a banking system that gives out loans with interest. The loan creates economic activity; the borrower has to spend it for his input cost, which includes government taxes, to create output. The output has to be sold at a price greater than his input cost to repay principal with interest. At ten percent interest rate with a loan term of five years, about 75% of all bank loans should default for the remaining 25% loans to successfully repay principal with interest.
Even the 25% loans can only succeed if the banking system doesn’t insist on recovery from defaulters, if banks recover loans from defaulters, money created through loans is destroyed when recovered and the remaining 25% borrowers would also default. So, modern banking system with efficient recovery process and an ideal government that doesn’t borrow will fail any attempt for economic growth. The primary impact of such banking system and government would be transfer of ownership of assets from borrowers to depositors through extractive lending and not economic growth.
Above 75% probability of failure is too big for any adventure towards economic growth and certainly the current trajectory of economic growth doesn’t indicate the existence of such ideal government and efficient banking system that recovers all loans. In the modern economy government through limited liability protection to corporations and through its investments in economy via debt in a much skewed way greatly enhance the overall probability of businesses to succeed.
In the current system, government through public utilities and infrastructure can never recover all the dues for the services through taxes on businesses, and also achieve economic growth. The government has to subsidize the services for the economy through its own debt which grows at a faster rate than real GDP growth because it also has to pay interest.
The expenditure of government, through borrowed money, in creating public assets and services but without recovering all the expenses, rescues the entrepreneurship of entrepreneurs. Even the cost of limited liability of a corporation is ultimately transferred to the government, since banking system factors such losses in interest charged on loans. The reason for massive government debts in every country is not populist and reckless spending as fiscal and market fundamentalists propagate; if economic growth is desired then government debt is inevitable with the present money system through banks.
All debt created by banking system is either recovered through asset transfer from the defaulter or transferred to government. Default loans don’t create sustainable economic activity, when banks recover them the money they inject in the system gets destroyed with transfer of asset ownership. Economic activity leading to successful repayment of debt to banking system would indirectly transfer debt to the government, this results in the illusion of increase in debt free money supply in the outer economy while government bears equal amount of debt.
If government has to repay its debt, it needs all the “free” money owned by public in the economy; this means combined net income and savings of all economic participants, excluding the loans they owe to the banking system. If economic growth halts banking system cannot create money through loans, without economic growth and increase in money supply government cannot borrow forever from the system to repay debt, and the whole debt monetary system collapses.
All debt has interest and since the government is ultimate borrower for the economy to sustain economic growth, it ultimately ends up paying interest on all existing money supply in the system. The government has to pay interest and part of principal periodically to maintain trust in this Ponzi scheme; it does so by borrowing more from the system.
What exactly causes money to lose purchasing power over time is the next big question. Though government inefficiency because of corruption and indiscriminate consumer loans from banking system also cause inflation, the main reason is interest on the money charged by banking system throughout its existence.
All money bears interest throughout its existence even if the possessors don’t pay it directly. There is no debt free money in the modern economy. While principal part generates economic activity to give value to money, interest, excluding the part needed to maintain bank employees and bank infrastructure, is just continuous exponential expansion of money supply, with no productive activity to generate value.
The bank interest paid on deposits is an unproductive overhead in the system that doesn’t contribute economic value but causes inflation. The principal part of money contributes to real economic activity and transforms into wages or income of producers. Since, price of a product includes both principal and interest, income earned through productive activity, which is just principal part of the loan, can’t buy the output. Producers can’t afford their own economic output as the prices are more than their income, which is the seed for inflation.
Inflation is integral to interest based monetary system, producers have to frequently raise prices to chase their own economic output as consumers. No participant in the economic system, particularly poor and middle income groups, can have the instant flexibility to adjust the price of their output upward, to match the continuous exponential growth in money supply disproportionate to real economic growth. So, in the context of responsible productive bank lending, inflation would lag the interest rate resulting in net real income gain to depositors.
When banking system causes inflation to shoot up beyond interest rate with indiscriminate consumer and speculative lending, leading to asset bubbles, interest rates are raised by convention, and maintained ahead of inflation, to provide net real income gain on deposits. The banking system punishes productive activity even for its mistakes and mismanagement, the real value of bank deposits would continuously grow, money may not grow on trees but it certainly grows in bank deposits continuously.
Now the question arises who owns bank deposits. If bank deposits match savings in the economy, since savings are proportional to income, low income groups should have least or no savings, because they barely survive and majority of them can’t even access banks. It is not an exaggeration or unreasonable to conclude that almost all deposits in banking system are owned by middle and above income groups.
The middle class by definition earns middle per capita income and savings from this class are also average. The surplus savings from upper middle class and rich are either reinvested or deposited in banking system; this class automatically makes more money through interest. The middle class savings are protected from inflation but incomes are not, in the long term interest driven inflation is also net loss to this class.
The net income share of rich and upper middle class in economy continuously expands through interest rate, without any exertion from their part, at the cost of poor and middle class. The poor bear the maximum brunt of this free continuous transfer of resources to rich. The gains from interest are periodically converted to property gains, over time the system would massively drain real assets, income from poor and middle class to a small group of rich.
Interest integrated into monetary system continuously increments the income of rich and facilitates the unlimited profiteering model and cartelization. The inherent inflation created by interest in the system clouds the economy with uncertainty and price volatility. This uncertainty and insecurity is reflected in all aspects of socio-economic life.
Interest gives massive advantage to early entrants in the economic game as it continuously increases establishment costs with time. New entrants would face massive cost disadvantage to compete with well-established entities at the same output prices, this helps few early entrants to monopolize the economic activity and dictate the prices for unlimited profit. The general inflationary environment and price instability caused by interest gives cover and justification to upward price changes of cartels for unlimited profit. The unlimited profit path snatches all real assets and pauperizes masses, and pushes them into never ending debt slavery when nothing is left with them.
Institutionalized interest and debt money is also heavily destructive to environment. The debt money system can’t sustain without continuous economic growth to repay debt with interest. The government would default on its debt commitments without economic growth. So, it has to promote economic activity, irrespective of need, at huge cost to environment. Construction, destruction and reconstruction are permanent features of economic agenda of government, to somehow maintain growth, re-pay debt with interest that can never be totally repaid.
The idea of interest has a legitimate role in society and civilisation when it is between private individuals and within the limits of natural justice. There would always be demand for extra money and it’s not improper if that demand is met and gains made through legitimate and fair means taking risk of potential loss. Institutionalized risk-free interest-bearing debt money means the whole socio-economic system is in permanent un-payable debt and is forced to slog as an indebted slave to repay it.
Roadmap for a debt free economy
Sustainable growth can only be a mirage in an extractive monetary system promoted by modern banking. Civilisation needs debt free money to enjoy the prosperity of its hard work. Money which is just a measure of creative activity becomes its overlord when it becomes debt. Economic growth is increase in the quantity and variety of goods and services. It can be classified broadly as (1) basic economic growth (2) vertical economic growth (3) horizontal economic growth.
Basic economic growth: With increase in population basic economic growth corresponding to population growth has to be achieved to meet the demand for goods and services. If no resource constraints on economy the limit of basic economic growth rate is equal to population growth rate. Basic economic growth increases GDP but doesn’t increase per capita income since there is no rise in per-capita consumption. Debt money for basic economic growth is analogous to an animal devouring its offspring.
Vertical economic growth: When a new product or service comes into existence, it adds to the basket of goods and services in the economy. To afford these new products and services the income in the economy has to grow. At a given standard of living the workforce and income in economy remains in equilibrium. A new product or service introduces new area of activity and this has to draw workforce from existing pool, as workforce availability in existing sectors decrease extra effort is needed to maintain the same economic output in those sectors. So, when the net economic output increases the workforce is making extra effort to achieve it; this has to translate to extra income. A new luxury product can be limited to a very small market of high-income earners, but products produced in mass scale become part of horizontal growth in economy
Horizontal economic growth: To make a product part of horizontal economic growth it should be sustainable from the perspective of environment. As horizontal growth would engage a significant workforce, it adds to economic growth and greatly increases per capita effort. Money supply has to match this per capita effort increase to raise per capita income and make the product affordable to the economy.
Debt and interest free money for economic growth
Money has to be created and issued as a measure and share of ownership for participants in economic growth. If there is economic growth then there is need to issue fresh money to measure and give ownership on it. This is the duty of institutions (government) following sound principles, and cannot be delegated to private profit making institutions. The government can use banking system to issue interest free money and create debt-free economy following some simple logical rules. A simple alternative banking model can illustrate how an agricultural economy can evolve into an industrial economy with debt-free money.
Modern development requires movement of work force from agro-economy into modern manufacturing and services. This means creating assets in manufacturing and service sector. The banking system can finance this transformation with interest-free money. The government has to play a significant role in creating basic infrastructure and services to facilitate economic growth and private enterprise
Entrepreneurs can receive interest free loans with full liability up to a percentage limit on investment. The loan issued should go into establishment cost of planned enterprise and wages. The cost of enterprise also includes banking cost and the bank would collect a fee upfront for the loan issued. The banking system would create a matching deposit of equal amount to the loan in the government account. The entrepreneur gets the loan and the government gets equal amount as deposit.
The government would decide a reasonable profit margin on the total loan amount issued by banking system, to provide for income or profit of entrepreneurs, the banking system would also create this money and add it to the government account. Successful entrepreneurs would get tax concessions from the government equivalent to the loan plus profit margin, distributed over the loan term to facilitate repayment. The distribution of tax concessions to the enterprise, over the period of entire loan, would ensure repayment through serious economic activity.
The freedom of individual entrepreneur to make profit is not restricted, but the intention is to limit profit potential in the system beyond a limit through money supply. The entrepreneur still can use his skill to maximize profit. The government through banking system, in a transparent manner, should promote diversity, fresh talent and small enterprises wherever feasible.
The deposit in the government account compensates the loss to government revenue for tax breaks provided to entrepreneurs. Same process has to be followed for loans to government enterprises. The government has to set targets to banking system, to issue qualified loans sector-wise, in accordance with growth potential and need in each sector of economy. No consumer loans should be allowed from the banking system
This process would not create any debt in the overall economy. A diligent and productive entrepreneur would be able to repay the loan over the loan period by serving the demand for his output, created by public expenditure. At the end of the term he would own the enterprise and make reasonable profit which is also his income. If he fails, he would be liable for the loan.
Since industrialization and modern services are part of vertical growth from agro-economy, there will be continuous burden on agriculture to improve productivity to support growth in economy. If agriculture fails to deliver on productivity no sector in economy can sustain growth. The per-capita productivity gains in agriculture needed to sustain economic growth also have to be rewarded. If farmers are allowed to fix reasonable output price, they automatically gain their share of income. The extra efforts to meet the demand have to gain extra income to afford economic growth.
Industrialization creates immense pressure on agriculture sector to deliver with continuous dwindling of work-force; if work-force falls too short, mechanization becomes inevitable. If income in any major sector has less GDP share compared to the workforce engaged, the sector can gain by gradual increase of its output price until per-capita income moves closer to GDP per-capita. This income rise has to happen in sequence, one sector after another, in sync with horizontal economic growth, to achieve a decent standard of living without losing balance in economy. As per-capita income across sectors closely matches GDP per capita, the workforce will have a general level playing field in the choice of profession.
The income balance between sectors through price rise is an effective idea to promote balance in economy and provide full employment. If automation limits employment in Industry and services, unemployment can be solved by moving people back to agriculture and raising its income share proportional to workforce.
- Money creation in modern economy
2. A lost century in economics: Three theories of banking and the conclusive evidence